Lifting the Lid: Auditor's subprime exits show risks

By Emily Chasan

NEW YORK, April 6 (Reuters) - The sudden resignation of Grant Thornton LLP, the No. 5 U.S. auditor, from two subprime lenders this week shows it may face a risky battle in gaining equal footing with the "Big Four" accounting firms.

The Big Four -- PricewaterhouseCoopers [PWC.UL], Deloitte & Touche [DLTE.UL], Ernst & Young [ERNY.UL] and KPMG [KPMG.UL] -- audit about 80 percent of all U.S. public companies and 97 percent of the largest companies with more than $250 million in annual sales.

But Grant Thornton's quick entry and exit from the subprime lending industry suggests that to gain access to larger firms and compete against the Big Four market dominance, smaller auditors may be picking up the unwanted leftovers of their bigger rivals and taking on additional risk, analysts said.

On Monday, Grant Thornton resigned as auditor for Fremont General Corp. FMT.N and Accredited Home Lenders Holding Co., LEND.O saying the two companies that make loans to home buyers with poor credit histories "no longer meet our requirements for client acceptance."

The resignations came just eight months after the firm had wrested Fremont from Ernst, its auditor of 33 years, and less than two years after it had taken over Accredited from Deloitte.

"It does raise the question as to whether or not Grant Thornton is picking up the real risky audits and is going to have more problems like this in the future," said former SEC chief accountant Lynn Turner, now director of research at investment advisory firm Glass Lewis & Co.

"There are always going to be some audits that are riskier than others, but you only want to pick up those where you can manage that risk."

The resignations are also signal that auditors are being more careful about taking on risky clients as dozens of investor lawsuits over weak audits have strained their resources and brought multimillion dollar settlements over the past several years.

"Grant Thornton is clearly trying to get larger clients and more prestigious clients," said Mark Lilling, chief executive of New York accounting firm Lilling & Co, and the founder of advisory service Audit Committee Consulting Team. "However ... this proves that they are intelligently managing their risk since they withdrew from these clients they just obtained."

A resignation is one of the strongest warnings an auditor can send to investors, particularly at Fremont, where the auditor and company disagreed about the reason for resignation.

In the past, auditors were sued when investors felt they should have resigned from an audit, but chose not to do so.

STRUGGLE TO COMPETE

But the fact that Grant Thornton took on auditing subprime lenders just before the sector tumbled into disarray raises questions about the kind of barriers that smaller firms face in competing with the Big Four.

Attracting clients is tough for smaller firms because of their smaller international networks and the belief by companies that the signature of a Big Four auditor carries more cachet with investors and lenders.

Despite recent growth, Grant Thornton is not an immediate threat to the Big Four. Its global revenues totaled $2.8 billion in 2006, far below the $17 billion to $22 billion posted by the Big Four.

Nonetheless, Grant Thornton has been working hard to build its reputation -- from launching a high profile ad campaign to taking public stances on accounting issues as often as its bigger brethren.

To some extent the efforts have paid off. Grant Thornton's U.S. revenue rose about 22 percent in 2006 -- about twice the growth of the Big Four in their American regions. Grant Thornton also wooed away 43 audit clients from its larger rivals last year -- more than double the number that any of its second-tier peers took in.

But those clients included Fremont, which Grant Thornton said no longer meets its standards.

RISKY AUDIT

Grant Thornton would not comment on why it took on the companies, and the companies do not have to disclose why they change auditors unless there is a disagreement.

A spokesman for Fremont would not elaborate further on why it left Ernst & Young.

But analysts said Grant Thornton likely assessed the company's risk, and since it was months before the subprime sector ran into trouble, it accepted Fremont as a client in August.

"I don't think anybody had concerns then that the companies were in as much trouble as they are today," said Ryan Lentell, a Morningstar analyst who focuses on mortgage lenders. "Early payment defaults really started to spike at the beginning of this year."

Ernst had given Fremont's financials and internal controls a clean bill of health for 2005.

Accredited Home and Deloitte had disclosed a material weakness in its internal controls in 2004, but Grant Thornton signed off on its financial statements in 2005.

However, when subprime lenders like New Century Financial Corp. NEWC.PK filed for bankruptcy, Grant Thornton "probably wondered how they ever signed up for this," Glass Lewis's Turner said.

Also, getting out of auditing contracts before issuing an opinion on the companies' 2006 financial reports is likely to keep the firm from facing a lawsuit, analysts said.

"An auditor is normally reluctant to take on a client and then to find it needs to resign, but sometimes the auditor learns information that it feels leaves it no realistic alternative," said Michael Young, a securities lawyer at Willkie Farr & Gallagher in New York. (Reporting by Emily Chasan, editing by J.S. Benkoe; Reuters Messaging: rm://emily.chasan.reuters.com@reuters.net;Tel: +1 646 223 6114))