Credit crunch special: liability crunch

Against the background of considerable uncertainty in the financial markets
and a deepening economic gloom, there are some very real risks for accountants
in the work lying ahead of them.

Recently each month has seemed to bring a new chapter in the unfolding horror
story of the European financial market’s investment in mortgage-backed
securities, collateralised debt obligations and credit derivatives linked to
sub-prime lending in the US mortgage market.

Accompanying this have been the attendant evils of credit crunch, Northern
Rock and its ‘outlier’ business model, asset write downs, and the closure or
insolvency of a number of hedge funds and structured investment vehicles.

Claims often follow hard on the heels of corporate insolvency. The exercise
of judgment on complex issues is always vulnerable to challenge in the light of
subsequent developments.

It is obvious, for example, that significant adjustments to valuation
opinions over a short-time scale will attract the attention of any stakeholders
who have lost out. The sale or refinancing of a hedge fund with a large holding
in mortgage-linked structured credit investments rapidly starts to look like a
high risk operation for any accountant involved.

This heightened risk environment has been recognised by two Financial
Reporting Council publications. The first is intended as a checklist of key
factors for audit committees, in particular those in financial institutions that
are holding some of the affected investments or have sponsored some of the
investment offerings concerned. The second (APB Bulletin 2008/01), summarises
guidance on relevant issues for auditors.

The Financial Services Authority has also published a reminder to listed
companies about the need for prompt disclosure of price-sensitive information
and the desirability of providing information to investors about issues
currently under the spotlight such as special purpose vehicles.

The FRC documents highlight the two major risks in terms of financial
misstatement: valuation and going concern.

The litigation risks for accountants posed by current circumstances extend
beyond audit engagements for financial institutions.

The availability of credit is in a state of flux as lenders continue to
tighten up their criteria and lending policies. In the context of transactional
reporting, or reporting to lenders for example, the current turbulence in
various markets such as in the UK property market, will require considerable
care in relation to determining appropriate assumptions and identifying or
evaluating sensitivities, since recent past experience may no longer be such a
reliable guide.

The challenge

The risk management challenge for all concerned is to be able to demonstrate
that sufficient care has been taken to identify and address those risks of
financial misstatement that have been heightened by current conditions (for
example, provision for bad debts in some of the more badly affected sectors of
the economy).

It is of course the directors of companies who are chiefly responsible for
the content of the financial statements (including complex investment asset
values and debt provision) as well as for the business model being operated by
the company.

This legal responsibility for addressing these matters cannot simply be
delegated to the auditors, no matter how complex the accounting issues might be.

The FRC has rightly directed part of its guidance at financial institutions.
A range of risks (in particular the cost of borrowing and going concern issues)
are raised by the credit squeeze affecting SIVs and funds that are dependent on
short term finance.

Valuation is clearly one of the key risks that arise in connection with
mortgage-backed securities and related CDOs and credit derivatives. The problem
is essentially a two-fold one: identifying assets which are impaired or at risk
of being impaired, and valuing these assets.

The complexity and illiquidity of these asset types presents some major
challenges for their valuation. Some financial institutions (especially end
investors such as pension funds and insurers) will require external specialist
advice, and may look to accounting firms for this. Any future claimants will be
on the look out for auditors and advisers without an adequate grasp of the
issues, or who fail to make a robust assessment of the reliability of
valuations, or for those who overlook unusual or inconsistent methods and
assumptions.

Based on the disputes linked to mortgage-backed securities, CDOs and credit
derivatives, valuation of these assets is heavily dependent on information in
the hands of third parties and requires specialist expertise using a ‘mark to
model’ approach where there is no current market (as will be the case for
subprime mortgage-linked securities).

Criticisms made in the past by the Audit Inspection Unit regarding the use of
in-house specialists in audit engagements suggest that a major challenge for
auditors might be fielding appropriate valuation expertise of their own.

Assessing the reliability of the valuation used by the audit client will also
be difficult. Last month there were press reports of Credit Suisse being forced
to revise the values of its own asset holdings downwards because of deficiencies
in its valuation work. The independence of third party valuations may be an
issue due to the affiliation between valuers and the originators of these
securities.

The valuation issue catches accountants between the devil and the deep blue
sea: under-valuation may be as mortal a sin as over-valuation, causing
institutions to engage in undesired capital-raising activities or asset sales,
and perhaps pushing them towards insolvency.

If the underlying opinions were at fault, then under-valuation could in some
circumstances be a source of claims against firms for even larger losses than
over-valuation.

Given market volatility, it is probably no longer a question of whether
claims will be made against accountants, but how many.

Economic downturns have historically led to increased claims against
accountants and auditors. Very often, the driver for those claims is of course
the headline losses which a financially-strained claimant is seeking to recoup,
not the quality of the underlying work at all.

That said, whatever the ultimate motive for claimants, the difficult
accounting and auditing judgments made in the current environment are likely to
be subject to close judicial scrutiny in a court room.

Andrew Howell is a partner and Andrew Forsyth is an
associate director in the accountants’ liability team at Barlow Lyde &
Gilbert LLP