Thursday, November 13, 2014

An open letter to the auditor-general on 1MDB

10:40AM  Nov 13, 2014

By AH Manaf

Y Bhg Tan Sri, I read with concern your recent statement, “Why aren’t we auditing 1MDB? As far as their accounts are concerned, they are already audited by one of the big four.” To audit any firm was a “very laborious task”.

In view of the controversies surrounding 1Malaysia Development Berhad (1MDB), passing the buck to ‘The Big Four’ is simply not good enough. It also creates a misleading impression of the role, scope and limitations of external auditors.

Companies involved in the biggest scandals in financial history employed leading audit firms. Enron was audited by Andersen. Our own BBMB was audited by Touche Ross (later swallowed up by Deloitte who happens to be 1MDB’s current auditor). Deloitte was the auditor in the Transmile scandal.

Lehman Brothers, the golden boy of investment banking that went spectacularly bankrupt in 2008, was audited by Ernst & Young. It is chilling to remember that Lehman Brothers went bust by selling US$50 billion worth of toxic asset to Cayman Islands banks on the understanding that they would be bought back eventually.

What this created was the impression that Lehman Brothers had US$50 billion more cash than it did and US$50 billion less toxic assets than it held. All this under the nose of ‘Big Four’ Ernst & Young.

Auditors are not infallible, if they were there would be no financial scandals. Audit firms are businesses like any other and operate within the scope of auditing standards which themselves are not infallible.

Sir, I do not dispute that reopening 1MDB’s books is a “very laborious task”. The decision whether to take on this task should be determined among other things by the entity’s risk profile and I would like to ask did you factor these considerations into your decision?

1. 1MDB has gone through three of the ‘Big Four’ firms in the space of five years, according to reports in The Star, The Edge and the Singapore Business Times.

2. 1MDB’s first auditor was Ernst & Young who resigned without signing a single set of accounts (The Star, The Edge).

3. 1MDB’s second auditor KPMG resigned in late 2013 (ie many months after FY March 2013 ended) without signing off the accounts.

4. 1MDB’s third auditor, Deloitte, issued unusually lengthy notes and critical judgments to the FY 2013 accounts. In the industry this can be termed ‘Cover Your Back’, disclosing as much detailed information as possible in order to protect your reputational risk in the event of future problems.

5. Add to this 1MDB’s unusual and inexplicable late filings of annual reports for FY 2013 and FY 2014. Some of 1MDB’s subsidiaries have allegedly not filed accounts since FY 2013.

1MDB’s former 100 percent subsidiary SRC International’s accounts have not been filed since March 2012. This subsidiary is now 100 percent held by the Finance Ministry and has borrowings of RM4 billion via Retirement Fund (Incorporated) or KWAP bonds guaranteed by the government. The auditor of SRC in FY 2012 was Deloitte International.

Auditors are not infallible

As I explained, auditors are not infallible. They cannot 100 percent evaluate a company’s financial health. However they are trained to watch out for ‘alarm bells’ and evaluate fraudulent and other risk factors. The question to ask is why did 1MDB’s first two auditors extricate themselves from a lucrative and prestigious government account?

Tan Sri, with 1MDB’s multiple auditors, late filings, missing subsidiary accounts, I find it astounding that your alarm bells as the auditor-general of Malaysia have not rung at all.

You as the auditor-general have extensive powers as enshrined in the Audit Act 1957 including the power to “call upon any person for any explanations and information which the auditor-general may require in order to enable him to discharge his duties”.

I would like to ask, before dismissing the need for the “laborious tasks”, did you make any enquiries formal or informal to ascertain the claim and discover the reasons why 1MDB had three external auditors in five years?

Did you communicate with officials at the Finance Ministry to find out why 1MDB’s ex-subsidiary SRC, now 100 percent owned by the ministry, has not filed accounts since FY March 2012? With borrowings of RM4 billion from KWAP guaranteed by the government, surely this company warrants the interest of the Auditor-General’s Office.

In addition to the unusual pattern of 1MDB’s auditors and annual reports, there is publicly available information which also rings alarm bells and enhance the case for investigation.

1. 1MDB’s unusual revaluation policy. 1MDB’s revaluation surpluses recorded in the accounts are RM826 million (FY2011), RM569 million (2012), RM2.7 billion (2013) and RM896 million (2014).

Therefore total revaluation in the last four years amounts to a colossal RM4.9 billion. If you deduct this amount from 1MDBs current shareholders funds of RM2.4 billion, 1MDB is in a position of negative equity of RM2.5 billion ie the company would be ‘balance sheet insolvent’.

I will not go into the applicability of MFRS14 but this begs the question why did 1MDB adopt an unusual revaluation policy in contrast to most property developers who book in land at cost or book value?

The simple calculations show that if 1MDB did not undertake this unusual revaluation policy its shareholders funds would be negative to the tune of RM2.5 billion and the company would be considered ‘balance sheet insolvent’. In the event of a material downturn in the property market this has serious implications for 1MDB’s asset cover.

2. The infamous RM7 billion Caymans account (SPC). Tan Sri, as you know Segregated Portfolio Companies (SPCs) are notoriously difficult to value.

Deloitte took pains to highlight in the notes that they depended on unidentified ‘independent third party valuers’ meaning they themselves did not do a mark-to-market or other valuation.

Furthermore, much of 1MDB’s total RM16 billion cash and portfolio investments held abroad is classified by Deloitte in the notes as ‘Level 3 assets’ ie illiquid assets whose fair value cannot be determined by observable measures (high levels of Level 3 assets have been implicated in insolvent companies of the 2007 global financial crisis).

These issues are highlighted for users of the accounts to read and make their own informed interpretations. My question is, Tan Sri, did you?

Raising alarm bells

A brief look at the history of this Caymans RM7 billion and how it came into being as noted in the accounts is again enough to raise alarm bells. A JV with Petrosaudi, mubahara notes, KPMGs ‘emphasis of matter’ (audit flagging up significant uncertainty), stake purchased by an undisclosed third party and finally the RM7 billion proceeds placed in an off-shore Caymans account.

We therefore should ask the question, why did Deloitte highlight in the accounts that they did not evaluate this Caymans portfolio investment themselves?

Sir, taking all this into account can you really claim you have done everything in your power to dismiss all allegations and doubts before dismissing the need for the “laborious task” of opening 1MDB’s books?

I also address this question to the chairperson of the Public Accounts Committee (PAC), Datuk Nur Jazlan Mohamad, in view of the PAC’s role of examining not only the Audit Report but the “accounts of public authorities and those administering public funds” and “other matters it deems fit”.


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