Dirty Little Secret Unravels in Bermuda Blunder: Jonathan Weil

One of the long-standing raps on the auditing profession is that too many of its practitioners suffer from a check-the-box mentality, where rigid adherence to mindless rules obscures their ability to see the bigger picture.

For once, that mindset has worked to investors’ advantage.

Two weeks ago, the Public Company Accounting Oversight Board released its triennial inspection report on the Hamilton, Bermuda-based affiliate of KPMG, the Big Four accounting firm. And it was an ugly one. In one of the audits performed by KPMG- Bermuda, the board said its inspection staff had identified an audit deficiency so significant that it appeared “the firm did not obtain sufficient competent evidential matter to support its opinion on the issuer’s financial statements.”

This being the hopelessly timid PCAOB, however, the report didn’t say whose audit KPMG-Bermuda had blown. That’s because the agency, as a matter of policy, refuses to name companies where its inspectors have found botched audits. It just goes to show that the PCAOB’s first priority isn’t “to protect the interests of investors,” as the board’s motto goes. Rather, it is to protect the dirty little secrets of the accounting firms and their corporate audit clients.

That’s why it gives me great pleasure to be able to break the following bit of news: The unnamed company cited in KPMG- Bermuda’s inspection report was Alterra Capital Holdings Ltd. (ALTE), a Hamilton-based insurance company with a $2.3 billion stock- market value, which used to be known as Max Capital Group Ltd.

One Client

You see, just like their checklist of instructions told them to do, the folks who wrote this report were kind enough to disclose the number of U.S.-listed companies that KPMG-Bermuda had as audit clients at the time it was inspected. That number, the report said, was one.

The report also said the board’s staff conducted their inspection in November 2009, and that the audit deficiency they found was “the failure to perform sufficient procedures to test the estimated fair value of certain available-for-sale securities.” Armed with those data points and some stock- screening software, I quickly found KPMG-Bermuda’s audit report on Alterra’s 2008 financial statements, dated Feb. 19, 2009.

Alterra actually was one of two U.S.-listed companies for which KPMG-Bermuda signed an audit report that year. The other one got acquired before the agency’s inspection work began. And of the two, Alterra was the only one that classified any of its securities as available-for-sale.

Big Screw-Up

It’s when you look at Alterra’s financial statements that the magnitude of KPMG-Bermuda’s screw-up becomes apparent. Available-for-sale securities are the single biggest line item on Alterra’s balance sheet. They represented almost half of the company’s $7.3 billion of total assets as of Dec. 31, 2008, and a little more than half of its $9.9 billion of total assets at the end of last year.

Now consider that Alterra will hold its annual meeting on May 2, where shareholders will have the chance to vote on ratifying KPMG-Bermuda’s appointment as the company’s independent auditor. Even that doesn’t matter to the PCAOB, though. A spokeswoman, Colleen Brennan, said the board still wouldn’t confirm whether Alterra was the unnamed client. Never mind that the cat is now out of the bag. The board simply doesn’t care whether investors get the information they need.

Pure Luck

An Alterra spokeswoman, Susan Spivak Bernstein, declined to comment. As for KPMG-Bermuda, the firm’s managing partner, Neil Patterson, didn’t return phone calls.

The board’s inspection report also faulted KPMG-Bermuda’s work at a different public company where the firm wasn’t the principal auditor, this time for failing to test revenue properly. In a Dec. 6 response letter to the board, the firm said “none of the matters identified by the PCAOB required the reissuance of any of our previously issued reports.” Still, considering what the PCAOB’s inspectors found, this seems to have been nothing more than a stroke of pure luck.

What’s most troubling about the PCAOB’s secrecy here is it seems to be a matter of choice. Ever since it issued a 2004 policy statement on the subject, the board has clung to the position that a certain section of the Sarbanes-Oxley Act “expressly restricts” it from identifying the names of companies in the public portions of its inspection reports.

Exempt From Disclosure

The statute doesn’t actually say that, though. The section in question, titled “Confidentiality,” covers the handling of information that the board obtains through an inspection. It says the board can’t be compelled to provide such information in court proceedings, including civil discovery. It also says the material is exempt from disclosure under the Freedom of Information Act. In other words, the board doesn’t have to disclose it. That’s different than saying it can’t.

In fact, another section of Sarbanes-Oxley says the public portions of the board’s inspection reports “shall be made available in appropriate detail,” subject to “the protection of such confidential and proprietary information as the board may determine to be appropriate.” Put another way, it’s the PCAOB’s call whether to disclose clients’ names, although the Securities and Exchange Commission, which oversees the board, could overrule it. The board has chosen not to.

At least Alterra’s shareholders have been warned. If the PCAOB ever wants to shake its reputation as just another watchdog that doesn’t bark, it should start granting other investors the same courtesy.

(Jonathan Weil is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Jonathan Weil in New York at jweil6@bloomberg.net

To contact the editor responsible for this column: James Greiff at jgreiff@bloomberg.net

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