When the Tank Is Empty: Auditing in the Time of COVID-19

The COVID-19 pandemic resulted in the shutdowns of much of the economic activity in the United States by mid-March 2020. Although there were and remain some variances among the several states, in general, businesses were shut, buildings were almost empty, and factories and warehouses (except for Amazon, according to media reports) were still. How do the outside auditors, who certify the reliability of the financial statements of businesses, fulfill their professional obligations, consistent with Generally Accepted Auditing Standards (“GAAS”), to check inventory, revenue, cash flow, operations during the COVID-19 pandemic?

In many cases, it has not been possible to perform physical, on-site audits for almost half a year. Properly completed audits are mandatory for companies whose securities are publicly traded. Absent those audits the federal securities laws and the SEC could and probably would suspend trading in those securities. As the Wall Street Journal notes (September 2, 2020, p. B 3, col. 2), “[o]ne of the jobs of an auditor is to locate information and evidence of a company’s financial well-being. … In a remote-work setting, auditors have [had to]come up with various alternatives.”

Some “Empty Tanks”

Why should this raise concerns for investors and the financial markets in general? In the late 1950s, a Texas businessman was heavily involved in the anhydrous ammonia business. He produced mortgages on nonexistent ammonia tanks, convincing local farmers to purchase those nonexistent tanks on credit, sight unseen. He then leased those “tanks” from the farmers with the lease payments equal to the mortgage payments (plus a “convenience fee” for the participating farmers). He used the fraudulent mortgage holdings as collateral to obtain loans from banks located outside Texas, which did not bother to confirm that the “tanks” existed and had ammonia in them. Even his friendship with Vice President Lyndon Johnson was not enough to save him from a fraud conviction.

In 1963, Anthony “Tino” DeAngelis, a former commodities broker, ran Allied Crude Vegetable Oil on the waterfront of New Jersey. He obtained a contract under the government’s “Food for Peace” program to sell excess food stocks to poor countries. He learned that he could borrow millions of dollars based on the company’s inventory of salad oil. Ships would arrive at the docks supposedly full of oil, as confirmed by inspectors; but those ships were filled with water with a thin layer of salad oil on top, which convinced the inspectors that the ships were full of oil. The company would transfer oil between different storage tanks while the inspectors were treated to lunch. The company claimed to possess 1.8 billion pounds of oil, when in fact it had only about 110 million pounds. The company raised over $180 million from investors, including American Express (which lost almost $58 million in the scheme). Tino served seven years as a result of his conviction for fraud.

In 1970, two enterprising fellows from Brooklyn started OPM Leasing Services, Inc., which became one of the five largest computer leasing companies in the U.S. OPM’s lease customers included Merrill Lynch, Xerox, American Express, General Motors, and the biggest, Rockwell International. OPM borrowed money to buy the computers; the lease payments serviced the debt. By 1972, OPM began forging and altering computer leases, sometimes using the same lease as collateral for multiple loans, and created fictitious leases, including fictitious leases for computers that did not exist. The scheme collapsed when a careful business lawyer represented a bank preparing to advance funds against a computer lease with Rockwell International. The lawyer contacted Rockwell to confirm the continuing validity of the lease and learned that the Rockwell “lease” was forged. The founders were sentenced for fraud, one to twelve years, and the other to ten years.

Managing Auditing Risks in the COVID-19 Pandemic

The Center for Audit Quality (“CAQ”) was established in 2007 as an affiliate of the American Institute of Certified Public Accountants, with the mission to improve and maintain audit quality. Since the Spring of 2020, the CAQ has been a leading source of guidance and leadership in maintaining audit quality, including a webpage dedicated to auditing issues arising out of the COVID-19 pandemic. Julie Bell Lindsay, Executive Director of CAQ, observed recently that “fraud risk is heightened.  Most people are going to behave ethically, but in this type of environment, [there is a lot of] pressure.” She noted that “[t]he standards [i.e. GAAS] have not changed.  It’s the application of the standards …[that  have to be adapted] in this environment.” The Wall Street Journal, in the same September 2 article cited above, “Remote Working Poses Challenge to Auditors,” reports some auditors have looked at goods and materials through live video feeds on cellphones, while others are using location-sharing mobile applications. In one case, Urban Outfitters, Inc., allowed its outside audit personnel to conduct physical on-site inventory at its stores and distribution centers in July, just as they were returning to operation.

Will these adaptations be enough? As Director Lindsay rightly noted, “[there is a lot of] pressure,” not to mention COVID-19-related uncertainty. We know from experience and history that some may go astray. Will the auditors in this current environment be up to the task to inhibit, or at least to catch, fraud? Investors and the financial markets must wait and hope that there is enough GAAS in “the tank,” to overcome the potential for emptiness.

If you have any questions about this or any other legal matter, please email me at pdhutcheon@norris-law.com. For more topics related to COVID-19, visit our Coronavirus Thought Leadership Connection.

We information contained in this post may not reflect the most current developments, as the subject matter is extremely fluid and constantly changing. Please continue to monitor this site for ongoing developments. Readers are also cautioned against taking any action based on information contained herein without first seeking advice from professional legal counsel.