EY chairman admits ‘regret’ over Wirecard failures in letter to clients

Is lax oversight a feature or a bug in the global audit industry? It seems every time a major fraud is uncovered the leadership breaks out the standard playbook: 1) We were fooled as well, 2) It’s not our job to uncover fraud and 3) we promise to do better. Though massive fraud garners the headlines, there are many more cases where the accounting is accurate but manipulated to maximize profits.

At the tender age of 26 I worked in the Capital Markets Group at the Savings and Loan regulator in the late 1980s (Federal Home Loan Bank). In my short time there I uncovered massive accounting irregularities in two cases.

In one case the S&L’s balance sheet was nearly entirely comprised of mortgage servicing rights. The servicing rights value was primarily dependent on historical prepayment speeds. I had suspected the calculation of historical prepayments was wrong and so I replicated it and found that prepayments were 2x as fast as they had calculated. That meant that the entire servicing value and therefore equity nearly disappeared overnight once I convinced them of the error.

In the second case, the S&L was writing naked put options on Mortgage Backed Securities. When the options expired worthless they booked the option premium into income; when the options were exercized in-the-money they simply booked the securities at the inflated exercise price. Large gains when options expired worthless, yet no losses booked when they had to buy at the inflated exercize price.

In this case I was able to convince the regulatory leadership that the auditors should have considered this derivatives trading and the transactions should be subject to mark-to-market accounting. Regulatory leadership agreed and this crushed the business model of the S&L. They were run by former audit partners. It was an operation where accounting arbitrage was the business model.

These are two cases where the accounting was technically “correct” and there was no fraud. However, the auditors in both cases should have looked deeper and raised the same issues I raised. For every Wirecard there are dozens, if not hundreds, of additional cases of aggressive accounting.

EY chairman admits ‘regret’ over Wirecard failures in letter to clients – https://on.ft.com/3hyVZOW via @FT