Now this is interesting. I had some dealings indirectly with Direct Lending (DLIF) as they had backed a FinTech consumer lender years ago I worked with. The recapitalization was messy because their fund was already in receivership so just to pay them off/buy them out was a nightmare. It’s not just private credit, side pocket direct equity investments in businesses, real estate, viatical settlement assets, timber, water, etc. Valuations can have a truck driven through them.
Weak Oversight Plagues Audits of Billions in Private Assets
Self-regulatory audit system fails to safeguard charities, pension funds and private companies, a WSJ analysis finds
Big Four accounting firm Deloitte agreed to pay $31 million earlier this year to resolve claims of negligence after its auditors failed to detect an alleged fraud.
PHOTO: BENJAMIN GIRETTE/BLOOMBERG NEWS
By Jean Eaglesham and Coulter Jones
Updated Aug. 13, 2021 12:17 pm ET
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Six months before Los Angeles-based Shepherd University collapsed into bankruptcy in 2017, accounting firm BW CPA Group Inc. gave the school’s finances a clean bill of health.
State regulators called the audit “grossly deficient,” saying it missed red flags for potential fraud and left numerous errors in the financial statements uncorrected. The year before, BW CPA Group failed its second every-three-year peer review in a row, state regulators said.
Until regulators took disciplinary action in 2019, there was no way for the public to know that a fellow auditing firm twice took the rare step of giving a failing grade to BW CPA. The firm was banned from auditing last year.
Firms that audit private entities essentially police each other, often with no public disclosure. A Wall Street Journal analysis of the system shows that auditors give top grades to one another, hardly ever find fault with the biggest accounting firms and often don’t disclose failures among smaller auditors.
Of the firms that disclosed their results, 91% got the highest “pass” grade and only 4% the worst “fail” score on the three-grade scale, the analysis found. None of the biggest 100 firms failed, and 99% of them got the top “pass” score, according to the analysis.
Research by the government and data from the auditing industry trade group show significant flaws in audits of private organizations, particularly those done by smaller firms.
This self-policing system covers the vast majority of U.S. audits, including more than 5 million private companies, some with billions in revenue, Labor Department data show. It also affects tens of thousands of pension funds, endowments, local governments, charities and billions in government grants, according to the auditing industry trade group. Investors in these companies, pensioners, donors to charities and local taxpayers are among those who could lose if auditors fail to detect problems.
BW CPA Group didn’t respond to requests for comment. A lawyer representing Shepherd University declined to comment. A spokesman for the state regulator, the California Board of Accountancy, declined to comment on the yearslong delay in taking disciplinary action.
The entire auditing industry used to police itself but that ended after the accounting scandals of the early 2000s. Firms’ audits of public companies are now overseen by a government-appointed regulator.
But there were no changes to the rules that govern the audits of private entities. “It’s a big hole,” said Steven Thomas, a Venice, Calif.-based attorney who specializes in litigation against big accounting firms. “Having audits which can involve billions and billions of dollars only being regulated by the profession is insufficient to ensure the auditors are doing their job.”
A significant number of the audits covered by self-regulation are flawed, industry data suggests. More than one in four audits reviewed last year fell short of professional standards, according to the American Institute of Certified Public Accountants. The AICPA said it was “likely that [recently introduced] highly complex accounting standards” contributed to this high failure rate.
Pension Peril
Most firms auditing employee-benefit plans do only a few per year.
Most firms auditing employee-benefit plans do only a few per year.
Source: Labor Department
AUDITS PERFORMED
1 - 5
6 - 24
25 - 99
100+
0
500
1000
1500
2000
2500
3000
3500
Federal studies put the failure rates much higher for some types of audit. More than a third of a sample of audits of pension and other employee-benefit plans were found to have major deficiencies in a 2015 Labor Department report, for example. For firms doing fewer than 25 of these audits a year, more than two-thirds of audits were substandard, the study found. A department spokesman said its continuing enforcement work “continues to identify audit quality problems.”
The flawed audits potentially affect the savings of millions of people. More than 200,000 employee-benefit plans, with $449 billion in total assets, are audited by firms that do fewer than 25 such audits a year, a Journal review of data for plans in 2018 found.
The accounting industry says things have changed since the accounting scandals involving Enron Corp. and WorldCom Inc. in the early 2000s. The AICPA, which oversees the profession’s self-regulation, said in a statement it has taken “great strides…to update its standards, educate members and help firms remediate problem areas.”
The Journal’s analysis looked at 659 firms’ assessments of each other, known as peer reviews, reported on the AICPA’s website. This sample of about 3% of the nearly 24,000 firms in the peer-review program was chosen at random by scraping the website. The AICPA declined to allow the Journal access to its full database.
Almost one in five firms didn’t disclose their peer-review results, according to the analysis. The AICPA assures its members that their results will be published only if “authorized or permitted by the firm.”
Veiled Vetting
Results of audit firms' inspections by fellow auditors
Source: WSJ analysis of AICPA data
Note: About one in five firms don't disclose the results. Percentages are for those that do.Results from a sample of 659 firms' peer review reports published by the AmericanInstitute of Certified Public Accountants.
%
Pass
Pass with deficiencies
Fail
0
10
20
30
40
50
60
70
80
90
100
The AICPA data for peer reviews of firms’ audit systems from 2018 through 2020, including ones that kept their results secret, show that 7% got fail grades and fewer than four out of five, or 79%, a pass score, with the remaining 14% getting the middle “pass with deficiencies” grade.
“It’s like the sixth grade playground—no one tells on one another,” said Lynn Turner, a former chief accountant at the Securities and Exchange Commission. This lack of accountability means there is little incentive for auditors to challenge a company’s management and risk losing that client, he added.
An AICPA official said most peer reviews are publicly available “through a variety of sources.” Anyone being audited can ask the accounting firm for a copy of its peer review, the official added.
The biggest firms’ near-perfect grading is in contrast with the assessments of their audit quality by the Public Company Accounting Oversight Board, an SEC-appointed watchdog that oversees audits of public companies.
Inspections of the top 100 firms by the PCAOB rate more than a quarter of their audits, on average, as having serious deficiencies, according to the Journal’s analysis. For the biggest 20 firms, the failure rate ranged from zero to 80% in their most recent PCAOB inspection reports.
Ken Bishop is chief executive of the National Association of State Boards of Accountancy, representing boards that license accountants to practice in individual states. He said that making checks on private-company audits as thorough as the assessments of public-company ones would cause tensions within the accounting profession.
“If you make it forensic, like PCAOB firm inspections…that [could] be damaging to the firm that you’re providing the peer-review services to,” Mr. Bishop said in an interview. The two systems have different aims, he said. “The PCAOB is looking out for investors, so it’s doing a much deeper dive.”
The AICPA said the firms subject to peer review are “committed to protecting the public interest through performing quality audits.”
Investors in private entities have been harmed by weaknesses in audits. Big Four accounting firm Deloitte LLP this year agreed to pay $31 million to resolve legal claims of negligence, after its auditors failed to detect an alleged fraud in private investment funds that cost investors hundreds of millions of dollars.
Brendan Ross, at a conference in 2017, was later accused by authorities of a multiyear fraud. He has pleaded not guilty.
PHOTO: PATRICK T. FALLON/BLOOMBERG NEWS
Deloitte was the auditor for Direct Lending Investments LLC, a Glendale, Calif.-based investment firm that advised private funds with assets totaling more than $800 million. The firm’s audits don’t say they were conducted under PCAOB oversight, which would be specified if that were the case.
Authorities last year arrested Direct Lending’s owner and former Chief Executive Brendan Ross, accusing him of a multiyear fraud that involved creating fictitious borrowers to pump up the apparent value of an investment in an online lender. Mr. Ross, who is on bail awaiting trial next year, has pleaded not guilty to 10 counts of wire fraud. His lawyer didn’t respond to requests for comment.
Deloitte’s auditors repeatedly accepted Direct Lending’s assurances at face value, rather than testing the evidence, a filing by a court-appointed receiver said. Deloitte’s “improper clean audit opinions” for the funds for 2016 and 2017 helped prolong the alleged fraud, increasing investors’ losses, the filing added.
Deloitte didn’t admit any liability in agreeing to the $31 million settlement of the investors’ and receiver’s claims. The settlement is awaiting court approval. The firm said that its audits conformed to the relevant accounting rules and didn’t breach its professional standards of care, according to a filing by the receiver. A spokesman for Deloitte declined to comment.
—Lisa Schwartz contributed to this article.
Write to Jean Eaglesham at
[email protected] and Coulter Jones at
[email protected]
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Appeared in the August 14, 2021, print edition as 'Oversight Is Weak of Private-Firm Auditing.'