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BDO Shouldn’t Have Blown This Audit

This SEC Accounting and Auditing Enforcement Order against BDO will be the best thing you read today. That is, if you enjoy reading about audit firms issuing an unqualified opinion when they absolutely had no business issuing an unqualified opinion. That is the case with the story of BDO's 2009 audit of General Employment Enterprises, Inc. (aka "GEE" which is perfect in a "GEE WILLIKERS, they really screwed this up" kind of way). Settle in, this is a doozy.

Back in 2009, BDO was auditing GEE's books and something was kinda funny with the company's cash:

During BDO’s 2009 audit of GEE’s financial statements for its fiscal year ended September 30, 2009, BDO learned that $2.3 million (comprising approximately half of GEE’s assets and substantially all of its cash) was unaccounted for when GEE’s chief financial officer (the “GEE CFO”) advised BDO, in November 2009, that (a) GEE’s purported 90-day non-renewable certificate of deposit (“CD”) at a New York bank had not been repaid by the bank after the stated maturity date in mid-October, (b) GEE was missing documentation supporting the CD, and (c) a bank employee had told GEE’s CFO that the bank had no record of a CD.

Missing cash! That's fun. It's this sort of scenario that will catch an auditor's attention, who then, in turn, will get the attention of more senior auditors, who then get the attention of even more senior auditors, who then take an action that, to use relevant parlance, appears reasonable: 

BDO’s engagement and concurring partners consulted with senior BDO partners, including the assigned BDO regional technical director, BDO’s national director of accounting, and BDO’s national SEC practice director. The consultation resulted in BDO issuing a five-page letter, dated December 21, 2009, in which BDO advised GEE of its belief that BDO had not been provided sufficient audit evidence to formally conclude on the matter and demanded that GEE’s audit committee commission a full investigation of the matter by an independent firm.

Now, if you believe auditors are protectors of the realm vis-à-vis financial reporting, this is where the showdown occurs and auditors' stewardship of GAAP conquers all. Of course if you believe this, you are kind of naive and silly in a way that grown men who wear caps to a sit-down restaurant are silly. Here's what really happened next:

BDO received conflicting information from various sources as to the existence of the CD and never received rational explanations as to why the $2.3 million went missing and why an equivalent amount was later received under suspect circumstances. Only days later, however, after GEE’s chief executive officer resigned, BDO agreed to withdraw its demand for an independent investigation and issued an audit report containing an unqualified opinion on GEE’s financial statements. Those financial statements, included in GEE’s Form 10-K filed on January 8, 2010, represented that GEE had a $2.3 million cash equivalent in the form of CD as of September 30, 2009, and had entered into an assignment agreement to sell the CD for full face value to an unrelated party.

How do you go from from "conflicting information from various sources as to the existence of the CD" to an audit report containing an unqualified opinion? It's pretty hilarious and interesting, actually.

Among the BDO partners closest to this mess were Sean Henaghan (engagement partner), John Rainis (concurring partner), Leland Graul (national director of accounting and risk management partner), James Gerace (regional technical director) and Wendy Hambleton (national SEC practice director). And when you read the Background section of the order — which I strongly recommend — it is the Kafkaesque nightmare that you would imagine it would be. It was so bad that Sean Henaghan sent an email that contained the following:

[G]iven the highly unusual nature of this issue and the significant amount of time it is taking to recover the funds, it is critical that we understand both the nature of the administrative error as well as the underlying cause of this error…. As I have never encountered such an issue with a bank or CD and any reasonable person (including the PCAOB or SEC) would certainly question such an issue, I need to be in a position to fully explain exactly what occurred… 

He goes on to list the items BDO needed to "gain comfort" over the availability of the $2.3 million. Later, when BDO finally demanded the independent investigation, Leland Graul and Wendy Hambleton had this back and forth:

Hambleton replied to Graul’s email, asking whether they “should go into detail of the issues in the letter.” Graul responded to Hambleton: “Short of saying we think there is fraud, the point is we have been looking for support for months and don’t have anything satisfactory to support a final opinion. If we give a list of questions, we’ll get answers to those questions and still not know what is really going on. An independent investigation is the only way to get to the bottom of this. The list doesn’t look like it would get us there.”

They suspected it! They suspected fraud! In fact, you get the sense that they knew there was fraud! This goes on and on; I'm really not doing it justice, but in order to move things along and give you an idea of how ridiculous this got: in this time, GEE appointed a new CEO (mentioned above) and BDO got a "senior NY Partner" the "Midwest Leader" and their General Counsel involved. I have to add this, too, because it's my favorite part:

Henaghan sent Rainis, Graul, Gerace, Hambleton, the NY Partner, the BDO Midwest Leader, and BDO’s general counsel an email on December 24, 2009, asking for their availability for a call [Ed. note: When? On Christmas Day?!] and stating he was drafting a memo summarizing current facts. Graul responded: “Unless there is something new that hasn’t been discussed in the last few calls, what’s the purpose?” The NY Partner replied: “The purpose is to try to salvage an account where they made [] changes in the management because of the alleged wrongdoing.” Graul responded: “Did they change the guy that can’t support the $2 million that supposedly was put into company? What about the two audit committee members that stalled the investigation and the lawyer that wouldn’t let us participate in a board meeting to preserve privilege. There’s something funny going on here.” The NY Partner replied that he had no disagreement with Graul on the last point.

Again, everyone knows this is fraud. They're not even dancing around it. And yet, what ultimately gave them comfort was an 8-K that discussed the CD that didn't exist and all the fishy circumstances around it. Here's a portion of that 8-K:

In July 2009, the Registrant purchased a $2.3 million certificate of deposit (“CD”) at a New York bank. When the CD matured in October 2009, the bank did not timely credit the proceeds of the CD to the Registrant’s account. Although the Registrant has made a formal inquiry of the bank, to date the Company has not received an adequate explanation for the bank’s non-performance relating to the CD. In December 2009, the Registrant was reimbursed in full through a nonrecourse assignment of the CD for face value to an unrelated party, who has other business interests with the bank. The purchaser of the CD is neither an employee nor a director of the Registrant. 

Once that was all settled, the 10-K was finally issued in early January 2010. All was good for about 2 months and then BDO got some unfortunate news:

BDO learned of a criminal complaint against the New York bank president. The criminal complaint alleged, in connection with a wide-ranging conspiracy involving, among others, GEE’s then-chief executive officer and GEE’s then-majority shareholder and chairman of the board, that (i) GEE’s purported $2.3 million CD never existed, (ii) the bank president signed a false confirmation to BDO, (iii) GEE’s $2.3 million was used to attempt to conceal a loan default connected to the broader conspiracy, and (iv) the entities that transferred the $2.3 million back to GEE were related to the bank president’s co-conspirators, including GEE’s then-majority shareholder and chairman of the board.

You might be able to argue that the BDO partners simply didn't have the confidence to call a fraud a fraud to "salvage an account," but the circumstances around GEE are so sketchy that it defies comprehension how BDO would issue an unqualified opinion.

The firm settled the order for $2.1 million and agreed to a slew of "undertakings" including a thorough review of its quality control policies. All over a phony certificate of deposit. Yeesh.

[SEC Order]