Auditors Give Banks a Pass on Reserves, KPMG Report Shows

The Public Company Accounting Oversight Board defines an "audit failure" as a case where the auditor does not fulfill its fundamental responsibility – to obtain reasonable assurance about whether financial statements are free of material misstatement.

In its most recent report on KPMG, issued last month, the PCAOB inspection team found twelve deficiencies that were serious enough to be considered audit failures.  That's out of 52 audits KPMG conducted in 2010, the same percentage of deficiencies, 23%, as in 2009. The names of the companies whose audits were faulty are not named, per the Sarbanes-Oxley statute. KPMG audits Citigroup and Wells Fargo, as well as several other large banks such as Deutsche Bank, HSBC, Trustmark and PacWest.

The PCAOB does not choose the audits it reviews at random but based on risk. In the report card issued last year for KPMG, seven of the twelve audit failures in 2009 audits described deficiencies in the valuation and disclosure of hard-to-value financial instruments, such as collateralized mortgage obligations and other mortgage-backed securities. Deficient testing of fair value measurements, especially when third-party pricing services are used, is a source of several audit failures again this year.

In one case, KPMG auditors failed to identify or test controls over the use of prices received from an external pricing service for securities in an "available for sale" portfolio. At that same bank, KPMG failed to test assumptions used by its client to determine whether certain AFS securities with an unrealized loss position for more than twelve months were "other-than-temporarily impaired" and should be written down. KPMG is in good company allowing such shenanigans. When PricewaterhouseCoopers client JPMorgan Chase needed to mitigate the losses on the "London whale" trades, the bank sold securities from an AFS portfolio with "unrealized" gains. (AFS securities are recorded on the the balance sheet at fair value. However, unrealized holding gains and losses on AFS securities are not included in net income, as trading income or losses would be. Instead, they are reported in the statement of comprehensive income as other comprehensive income.)

In this year's inspection report, however, the focus was on the risk that KPMG auditors weren't sufficiently scrutinizing loan loss reserves and repurchase reserves or pushing back on executives using them to manage earnings. I've been saying for a long time that auditors are not forcing full disclosure of banks' potential losses and repurchase demands, as well as the related legal contingencies. Inspectors found loan loss reserves at one bank that were seven times more than a previous period with nothing but management's word to back them up. At another bank, loans had been reclassified to fool the models that calculate reserves. Inspectors cited more than one case where banks booked unallocated reserves with little or no explanation demanded by auditors.

I've written about KPMG client Citigroup's use of loan loss reserves as a  "cookie jar" to manipulate earnings each quarter. Although Citigroup claims it uses complex models to estimate additions to and releases from loan loss reserves, in reality all loan loss reserves are held in an unallocated top-level account and are available for losses in any category, anywhere across the globe.  It's a number that can be manipulated to plug a hole in earnings in any period.

One KPMG banking client cited in the report saw an increase in 2010 of demands from, and disputes with, buyers of mortgages it originated during the last five years. (This scenario is playing out all over the banking industry.) The PCAOB gave KPMG credit for identifying an understatement in the mortgage-repurchase reserve at year-end. KPMG also notably documented an internal control deficiency for inadequate processes for analyzing and reserving for mortgage repurchases and a lack of related controls. The bank's primary regulator and a loan purchaser had already identified weaknesses in the bank's loan origination and appraisal processes.

Still, according to the PCAOB, KPMG failed to sufficiently question this issuer's mortgage-repurchase reserve. And KPMG continued to judge the risk of material misstatement in the mortgage-repurchase reserve account to be low and said it was an insignificant balance sheet account.

KPMG should know better. One of the first failures of financial crisis era was mortgage originator and KPMG client New Century Financial. New Century did not adequately reserve for the possibility that, because of faulty representations and warranties, purchasers of its mortgages would all demand repurchase at the same time. KPMG allowed New Century executives to use incorrect and outdated models and assumptions for estimating required reserves. KPMG eventually settled lawsuits over its role in the failure of New Century.

We've got three more "Big Four" inspections reports to come – Ernst & Young, Deloitte and PwC  Don't be surprised if you see the same focus on loan loss and repurchase reserves and the same kinds of auditor deficiencies.  If only we knew which big banks' financial statements were being fudged.

Francine McKenna writes the blog re: The Auditors, about the Big Four accounting firms. She worked in consulting, professional services, accounting and financial management for more than 25 years.