Audits of Small Business Investment Companies

Published by the Government Accountability Office on 1990-06-21.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                       Lhited    States Generai     Accounting     Of!Kce

GAO                    Testimony

For Release             Audits      of    Small    Business       Investment   Companies
on Delivery
Expected    at
9:30 a.m.
June 21, 1990

                        Statement          of
                        Brian    P.      Crowley
                        Director         of Planning       and    Reporting
                        Accountinq           and Financial        Management   Divislcn

                        Before    the
                        Committee     on Small         Business
                        U.S. Senate

GAO /T.*AF!?D-90..23
 Mr.      Chairman                    and      Members               of      the           Committee:

            I am pleased                          to      be here                today           to      discuss              certified                 public
 accounting                     firm         audits            of         small            business              investment                 companies

 (SBICs)           .       In         particular,                   you          asked           that          we address                 several
questions                 concerning                      audits            of         River          Capital               Corporation,                   an SBIC

that        owed          the          Small           Business               Administration                              (SBA)       $28.5             million

when        it         filed           for      bankruptcy                       in        August         1989.

            In         performing                   our        work,          we reviewed                       the         working          papers               for
the       final           River              ‘Capital            audit            conducted                    by     the      public          accounting
firm       of          Arthur            Andersen                and        discussed                    the        audit          with      officials

from       this           organization.                             Further,                 we discussed                      the        River          Capital
case       with           the          examiner                appointed                    by     the     Bankruptcy                     Court,           the          SBA

inspector                 general,                and          officials                    from         SBA’s            Investment               Division.

As agreed                 with           the      committee,                      we focused                    our         work      on the

investment                     valuation                area.

           The          following                 responses                  to        your           questions                reflect             the

results            of          this         work.

1.       Was there                    any       impropriety                       in       the        inspector               general's                  staff

sharing            a copy               of     the        draft             audit            report             for         River         Capital           with

Arthur            Andersen                prior           to        its      finalization?

           Offices                of        Inspectors                    General                (OIGs)             are      required,              by      the

Inspector                General               Act        of        1978,             to     perform                their          audits          in
accordance                 with         generally                accepted                   government               auditing                standards.

These         standards                 state          that          one     of         the       most        effective                ways         to

ensure         that          a report                 is     fair,         complete,                   and        objective              is     to

obtain         advance                review           and       comments                   by    responsible                   auditee

officials             and         others            as may be appropriate.                                         In     the         River
Capital         case,             the         OIG’s          draft         audit              report          questioned                Arthur

Andersen’s                 adherence                  to    generally                  accepted               auditing                standards

during         the         company’s                audit            of    River             Capital.                Because            the         draft

report         xas         critical              of        the       auditing                 firm,         we believe                 that         there

was      no impropriety                        in      the       OIG giving                      Arthur           Andersen             an

opportunity                  to       review           and       comment               on the             draft         report.

2.       Was there                any         impropriety                  in     how the                 office          of      inspector

general         handled                 the      River           Capital               case,           including                the      lack         of      a

final        report           on the             failure              of     River               Capital,            considering                    that

the      company            was         in     bankruptcy                  and         that           there        existed             the

possibility                 of        litigation                 between               the        agency           and     the         accounting


            As the          result             of      an allegation                          received             late         last         year,          we

examined             the      OIG’s            handling               of     the            River         Capital          case          and         found

that        no improprieties                           existed             in         its        handling            of    the         case.             We

considered                 several             points            in       arriving                at      this       conclusion.

            Generally                 accepted               government                     auditing              standards              state             that

written         audit             reports              are       to       be prepared                     communicating                       the

results              of     each         government                   audit          and       that          these        reports          are        to     be

 issued         promptly                 so     as        to     .make the                 information               available             for

timely          use         by management.

           The OIG conducted                               its        examination                    of     River         Capital          during

July       1988.              Although               it         had      not     yet          received             the      OIG audit

report,              SBA management                        was        aware          of      serious              problems          at     River

Capital.                  The company                     had      defaulted                 on      its      scheduled             loan

payments              to      the        Small            Business              Administration                       and,      in      August

1988,        SBA’s            Investment                   Division              transferred                      River      Capital             to    the

Office          of        Portfolio              Management.                         This         office           was      responsible                for
recovering                  SBA’s         $28.5            million              claim          against             River       Capital.                As a
result          of        this       transfer,                   River         Capital               could         receive          no

additional                  SBA funding.

           In    November                 1988,            the        Assistant                Inspector               General           for      Audit
reviewed              the        draft          OIG audit                 report             on River              Capital          and

instructed                  the      auditor               to      revise            it,       in     part,          to     provide            more

detailed              support             for        the         auditor’s                  conclusions.                    We reviewed                the

November              draft          report           and         agree          with          the         Assistant           Inspector

General’s                 conclusion                 on the              need        for       changes.

           In    February                 1989,            the        Assistant                Inspector               General           sent         the

revised          draft             to     SBA management                         and         Arthur           Andersen           for       review

and      comment.                  He and            his         staff         spent           the         next      months         revising                the

draft.           This             task        was made                more       difficult                  by     changes          in

personnel,                 including              the        retirement                  of         the     OIG auditor                    who

conducted             the         audit          and     initially                    drafted              the         report.

            River          Capital          filed            for         bankruptcy                  on August                 24,      1989.               In

October             1989,         the      SBA General                    Counsel              and        the      Assistant                U.S.
Attorney             asked         the      inspector                 general                 not     to         issue       the        final             audit

report         to     avoid          any     potential                    impact              on possible                  future

litigation                 against          River            Capital             officials                  and         Arthur          Andersen.

            Based          on our          review            of     the      draft             report             and      discussions                     with

OIG officials,                     and      in      light           of     the         requests              from          those
responsible                 for      litigation                    involving              the         River             Capital            case,           we

do not        believe              the      inspector                general              engaged                 in     any       impropriety

by not         issuing             a final             audit          report.

3.      Did     Arthur             Andersen             follow             generally                  accepted               auditing

standards             in     the        performance                  of      its         1986         and         1987       audits             of        River


         When conducting                         audits,             certified                  public             accounting                   firms
must       conduct           their         work         in         accordance                 with         generally                   accepted

auditing            standards.                   In     addition                 to     these             standards,                 the        American
Institute             of     Certified                 Public            Accountants                      (AICPA)            issues

interpretations                      and     audit            guides             on the             application                   of       standards.

These        interpretations                      and         guides             do not             have         the       authority                 of

standards,             but        auditors              and         others             rely         heavily              on them            for

 specialized                     accounting                     and        auditing                  practices                         within            particular

 industries.                      The         applicable                     AICPA             guide                for      audits                 of      companies

participating                         in      SBA’s             Small             Business                 Investment                          Company              (SBIC)

program              is     Audits                of      Investment                     Companies.                          The guide                      contains
the      following                    with             regard          to         the        issue             of         investment                     valuation.

          “The             independent                        auditor              does         not            act         as an appraiser

          for         security                    values             estimated                      in    good              faith             by      the

          board             of        directors,                     and          is     not         expected                     to         substitute

          his         or     her            judgment                 for         that          of        the         fund’s                  directors.

          Instead,                    the         auditor             should                 review             the          company’s

          procedures                        for         its      continuing                     appraisal                         of         such

          securities,                        determine                     whether              the         methods                     established

          for         valuation                    are          followed,                    and         make             certain               that         these
         methods                 have             been          reviewed                and          approved                     currently                  by

          the         board            of         directors.                       The         auditor                    should              review             the

         procedures                        applied               by        the         directors                     in      valuing                  such

          securities,                        and         inspect                 the         underlying                      documentation                             to

         determine                     whether                 the         procedures                     are             reasonable                     and       the

         documentation                             appropriate                         for      that            purpose.”

         The         valuation                     of         investments                     was         critical                      to      the       fair

presentation                     of        River              Capital’s                 financial                     statements                         because

investments                  represented                         85 percent                     of        its         assets.                      Based           on our

review          of        Arthur             Andersen’s                     working                  papers,                 it         appears              that

Arthur          Andersen                   took          steps             that         were             designed                  to         carry          out         the

guidance            contained                in     the      audit          guide            with         respect           to     the

 valuation             of     securities.                    The partner                     and manager                assigned             to      the
audit          attended            the       board         of    directors                  meeting           at      which          the

companies              in    River           Capital’s            portfolio                   were         discussed               and year-

end     valuations                 for       financial            statement                   purposes              were         determined.

The     information                  provided              the    Arthur               Andersen             officials                for     the

meeting           included               investment              overview,                   investment               strategy,              and

other          financial             information                 for        the        companies              in      River          Capital’s

portfolio.                  The working                papers           also           contained              the       audit            manager’s

notes        made during                   the     board's             annual              meeting          on the            valuation              of

companies            in      the         portfolio.

          Although             not        fully        documented                     in    the      working            papers,            Arthur

Andersen           representatives                        informed               us        that      the      audit          staff

evaluated            the      procedures                  used         by       the        board         during         the       valuation

meeting          and        considered                them       adequate.

          In     addition,                the      working             papers              showed          that      the         audit       staff

performed            a number               of     other         steps            related            to     the       investment

account.             For      example,                they       confirmed                  equity          and debt              holdings

and     interest             receivable                from       companies                   in     which          River         Capital

invested,            physically                   observed             securities                   and     compared              the      results

with     company             records,              and       tested             changes             in     investment                account


            Finally,                Arthur               Andersen            qualified                   its         audit        report             based        on

uncertainties                       concerning                      the     investment                 and            interest               receivable

balances            contained                      in     River           Capital’s                 financial                statements.                        The
report,           which              is      in       accordance                 with         the      AICPA’s               audit            guide,

stated           that         the          investment                 values

            “were        estimated                       by    the        board         of     directors                    in    the

          absence              of          readily             ascertainable                       market              values.                We

          have          reviewed                   the        procedures                used         by        the       directors                  in

          arriving               at         their             estimate             of        value         of        such        securities
          and       investments                         and      have        inspected                 underlying

          documentation,                              and      in     the     circumstances,                             believe              the

          procedures                      are         reasonable                 and     the         documentation

          appropriate.                             However,               because             of     the         inherent

          uncertainty                       of        valuation,              the        board             of        directors’

          estimate               of         values             may differ                significantly                           from         the

          values              that          would             have        been         used        had         a ready            market

          existed              for          the         securities,                    and     the        differences                    could

          be material.”

Arthur        Andersen                    also          qualified                its     report                with       regard              to     the

collectibility                        of        the       interest            receivable                       contained                in     the

financial               statements.

4.       Would          the      use          of        generally             accepted                auditing                   standards                 in    the

River       Capital              audit                by Arthur             Andersen                 have         revealed               the

overvaluations                    of        investments                    or       other         problems               which            led      to

River        Capital's                 failure?

            The     River         Capital                audits            by       the         OIG and            Arthur            Andersen            were

conducted             prior            to     River          Capital’s                    bankruptcy                  and,         as     such,

their        working             papers            and       other           records              did        not       specifically

identify            the         reasons            for        its         failure.                Our        work       did,            however,
raise        some questions                        about            the      adequacy               of       generally                  accepted

auditing            standards,                    as     interpreted                  by the             AICPA’s               audit         guide,

concerning                the     valuation                  of      investments                   by        SBIC        companies.

            Generally             accepted                  auditing                standards                require               that      the

auditor           gather          sufficient                   competent                   evidential                  matter             as a basis

for     formulating                an opinion                       on the           financial                  statements.

Therefore,               their          use        should            identify               excessive                  overvaluations                        of

investments                recorded                on a company’s                          financial                  statements.

            As mentioned                    earlier,                auditors               rely         heavily              on the          AICPA’s

audit        guide        when          planning               and         conducting                   their          audit            tests.

However,           while          we agree                  with       the          investment                  company             audit         guide’s

statement            that         auditors                  do not           act      as appraisers,                          we believe                 that

the     guidance            does            not        go    far       enough              in     detailing                  the        types       of

documentation                    and        records            that          auditors              should              examine             when

auditing           portfolio                 valuations                   determined                    by      boards          of        directors.

In    our     view,         the         audit            guide         wording              offers              the     opportunity                     to

conduct           less      than            a sufficient                     investigation.                            The guide                 should

 require          that          the      auditors             look         behind             the      financial                 and        summary

business               outlook             information               discussed                  during            the         annual         board       of

directors               valuation               meeting.

           For         example,              auditors           should            compare              planned            business
activities                   and      forecasts             with          reported              results            and         seek         out

information                   on similar                 companies              in     the       same          industry               for

comparison               purposes.                  When problems                      are          indicated,                 auditors
should           consider              visiting             some of             the       companies                and         examining

financial               and        other        information                  in       addition               to    the         data         provided

during           the     board’s              meeting.               In     addition,                  they        should             consider
contacting                   government             officials               whose            decisions                  may have             a

material               impact          on a portfolio                      company’s                 ability             to     continue

operations               or        achieve          its      planned              level          of         activity.

           We believe                  that        the      audit          guide         should              be revised                by         the
profession               after          sufficient                  study         and      deliberation.                             We have
contacted               the        Chairman            of    the      AICPA’s                 Investment                 Companies

Committee              who stated                  that      no plans                currently                 exist           for     revising

the      audit         guide.

5.       Could          or     should          other         changes              be made              in      either           the

Inspector               General’s              audit         procedures                  or      the         Investment                Division’s

review       of         SBIC        audits          which          might          help         determine                 whether             other

licensees              may be           in     jeopardy              in     spite          of        good         reports             from         the

public       accounting                    firms          which       are         performing                   annual           audits?

         We have    not     had the        opportunity          to perform        the detailed
analyses       of the      SBIC policies            and procedures            and inspector
general      examination           work needed         to fully       respond         to this
question.        However,          in a May 1988 report,               CPA AUDIT QUALITY:
Improved      Controls       Are Needed to             Ensure      Quality       Audits     of Federal
Loan Programs            (GAO/AFMD-88-3),             we made      several       recommendations           to
improve      controls       for      relying      on the     work of certified              public
accountants        (CPAs).           These      recommendations            included       agency

reviews      of the      quality         of CPA reports           and a requirement             that     CPAs
follow      generally       accepted           government       auditing       standards        when
conducting       their      audits.

         Mr. Chairman,            that    concludes        my formal         statement.         I will    be
happy     to answer       any questions            you or members of the                  Committee      may