Thursday, April 2, 2009


According to the WSJ, KPMG, one of the remaining four large international accounting firms, is being sued by creditors of bankrupt subprime lender New Century. While these kinds of lawsuits take a long time to get to fruition, many investors and creditors will be watching this one closely. If it ends badly for KPMG, others may initiate lawsuits against the auditors of other subprime lenders. Given how pervasive and large the losses were, it could wreck havoc on the accounting profession.

The large accounting firms are already down to the Big Four from the Big Eight 15 years ago. To give you an idea of how large theses firms are, Number 5 is about 10-15% of Number 4. The markets can barely be served by four large firms and cannot easily withstand another large firm merging or going out of business.

Unfortunately, the accounting firms are deep pockets in situations where the other culpable parties don't have pants let alone pockets. KPMG will fight this vigorously. And while the plaintiffs have little to lose, I am concerned about one statement in the article that came from the complaint. Apparently the complaint alleges that certain KPMG auditors advised the senior partner on the engagement that some items were not properly accounted for and the senior partner overruled them to protect the firm's fees. That is a damaging allegation and, if true, will be difficult to mitigate. Accounting firms usually rely on the process of conducting good audit procedures which is not expected to catch everything. You can read the complaint via this CNBC article.

I was involved in a litigation against an accounting firm many years ago. It was a jewelry manufacturing company that had gone bankrupt due to inventory falsifications. I represented the committee who was suing the accounting firm. During discovery, I found a memo from a staff person that said, and I paraphrase, "As I tested the gold inventory, I was struck by the annual enigma, 'what is gold and what isn't gold?'

The staff person went on to conclude that he couldn't tell what was gold or what carat type the gold was that he counted. He concluded that the quantities were right but that he couldn't conclude as to the value since it didn't know if it was gold at all. The memo was in the workpapers and the audit partner admitted he never followed up on the memo. The insurance company settled during discovery for the full amount of the insurance and unfortunately, the accounting firm went out of business. It is ugly stuff.

Cheers, Mike

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