Fremont Can Count on Accounting Problems

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Fremont General Corp.’s audit committee has a tall order.


It must find its third accounting firm in less than 12 months, get it to attest to management’s financial assertions and file a delayed 10K with the Securities and Exchange Commission.


Then there’s the annual meeting of shareholders next month, during which the Santa Monica-based company will not have a certified annual report to pass out.


“No public auditor, no certified interim or annual reports, no assurance around financial statements for investors, equals no confidence,” said Randolph Beatty, dean of USC’s Leventhal School of Accounting.


As if Fremont’s spectacular fall from Wall Street’s grace amid the sudden meltdown of the subprime sector were not enough, last week it had to face the nightmare scenario every public company fears: losing its auditor in a financial imbroglio.


Grant Thornton LLP abruptly resigned as the auditor of both Fremont and Accredited Home Lenders Holding Co., another subprime lender in San Diego.


In a letter filed with the SEC, the Chicago-based Big Five accounting firm asserted Fremont failed to provide certain information by “dates previously agreed upon by management,” a charge Fremont has vigorously denied.


The resignation was particularly painful because Grant Thornton had been Fremont’s auditor only six months and Fremont had severed its relationship with Ernst & Young in August after 30 years of service. No reason was given for dismissing Ernst & Young, but the action came amid growing signs of problems in the subprime sector.


Last month, Fremont exited the subprime business amid rising defaults and losses, and sold off its subprime loan portfolio. The collapse of the business has taken a brutal toll on the company’s shares, which closed at $6.26 on April 5, down from an opening of $7 on Monday of last week and far from its range of $20 to $25 a year ago.


The company, which offered its subprime loans through its Fremont Investment and Loan arm, has commented little on the loss of its latest auditor. However, in a regulatory filing last week, it stated that it “could offer no assurances that it would find replacement auditors to certify their financial statements.”


Two members of Fremont’s audit committee Thomas Hayes, the chairman of the committee, and Russell Mayerfield along with the company’s spokesman, Dan Hilley, told the Business Journal “we are looking” for an auditor. They referred other questions to regulatory filings.


Obstacles ahead


Finding a new auditor could pose particularly challenging for the company, and not only given Grant Thornton’s brief service or the problems in the subprime sector.


There’s the issue of whether any firm but a Big Five auditing firm has the expertise or resources to dig through the mountain of complex paperwork involved and offer an informed opinion in a timely manner. In the case of Fremont, the audit will continue to revolve around estimates for loan-loss reserves as well as uncollectible paper.


Fremont retained Grant Thornton in August. By February, Grant Thornton asked to widen its audit scope because it wanted to know more. Without getting into the specifics of audit challenges, Grant Thornton spokesman John Vita told the Business Journal that what the firm did was consistent with today’s practices in an increasingly risk-averse public accounting industry.


“We concluded that the circumstances required we resign from the engagement,” Vita wrote in an e-mail.


According to regulatory filings and multiple sources who spoke to the Business Journal, of particular concern to the firm was the correct level of loss provisions for loans that Fremont was being forced to repurchase. Fremont had to repurchase loans that went delinquent shortly after they were sold in packages of mortgage-backed securities.


Also at issue, according to the filings and sources, was how to account for repriced loans being sold on the secondary market as investors demanded discounts given the rising default rates. Another problem: accounting for outright losses from defaults. All are complex areas even in the best of circumstances.


“Accounting for loan reserves is always a high-risk area auditors look at when engaged with financial institutions,” said William Stocker, an audit review partner for mid-sized CPA firm Marks Paneth & Shron LLP. “This is true when there’s no subprime debacle. But now as an audit partner coming in, you say, ‘OK, Ernst & Young left, not a big deal. Grant Thornton left. Oh wait, they resigned without finishing? That makes me skeptical. That makes me say, I’ll pass.'”


Almost certainly another issue: a cease and desist order issued by the Federal Deposit Insurance Corp. against Fremont last month demanding it stop making subprime loans.


And Sarbanes-Oxley compliance is also in question. The 2002 act requires an audit firm certify the soundness of company’s internal controls, but it appears that Fremont’s controls of its loan approval and review process were weak to non-existent. That means whoever ends up auditing Fremont’s books will first have to perform what’s known in the accounting world as substantive testing. That involves reviewing wider and deeper samples of financial documentation. The minimum amount of time for this testing is usually two months.


Communication breakdown


An added thorn in Fremont’s side is a Public Company Accounting Oversight Board regulation requiring communications between predecessor and successor auditors when a change of auditors is in process or has taken place.


“Someone’s going to have a long, long talk with (Grant Thornton) before they even decide whether to take the engagement,” Stocker said, adding that the average time span for a worry-free financial audit from engagement letter to final report is six weeks.


“That’s minimum and this is assuming people are working seven days a week, a perfect world, where all the stars are aligned, coffee is flowing. It’s likely to be much longer in this case. Much longer,” he said.


Yet despite its continuing troubles, all is not lost for Fremont. It is selling $4 billion in subprime loans at a $140 million pretax loss but recently received a $1 billion line of credit from investment bank Credit Suisse Global.


Further, its industrial bank remains relatively strong on deposits. According to filings with the FDIC, Fremont Investment & Loan had $10 billion in total deposits as of Dec. 31, up from $8.6 billion in the same period 2005.


“When and if the smoke clears the only remaining strength at Fremont will be based on its deposit mechanism at its commercial bank side,” said Theodore Kovaleff, an analyst with Sky Capital LLC. “Given the circumstances, deposits are still pretty good. If anything is going to keep them strong going forward, it’s this.”

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