-- Posted Monday, 23 April 2007 | Digg This Article
April 20, 2007
A few months ago, I got into a verbal shoving match with one Mr. Douglas Gnazzo regarding the audit of the U.S. Government-Owned Gold and Silver Bullion Reserves, or simply gold reserves, most of which are in the custody of the U.S. Mint (custodial gold and silver). After the debate spilled and spread all over the Internet, I decided to let Mr. Gnazzo have the last word because I could find no easy way to untangle the mess that he and I had made in the course of our disagreement. Well, I am happy to report today that I have found the solution and it turns out to be rather simple. A private third party audit firm has in fact conducted an independent audit of the gold reserves since 2005. More astonishingly, history will be made in 2007 as the audit firm, KPMG, is set to participate in the physical inventory of gold stored at Fort Knox.
Mr. Gnazzo made a claim last December that has turned out to be very important in retrospect. He said something to the effect that the U.S. Department of the Treasury's Office of Inspector General (OIG) may have conducted an audit of the gold reserves in 2005, but the U.S. Mint's own independent auditors, KPMG LLP, took no responsibility for auditing such gold reserves at all. And at the time, Mr. Gnazzo was absolutely correct. My own research had shown that KPMG issued an opinion on the Mint's 2005 financial statements (or "audit report") that read, in part:
"These financial statements are the responsibility of the Mint's management. Our responsibility is to express an opinion on these financial statements based on our audits. We did not audit the United States' gold and silver reserves (Custodial Gold and Silver Reserves) for which this Mint serves as custodian. These reserves were audited by to United States Department of the Treasury, Office of Inspector General (OIG) whose report has been - furnished to us, and our opinion, Insofar as It relates to these reserves, Is based solely on the report of the OIG." [Original KPMG audit opinion on U.S. Mint's 2005 financial statements; emphasis mine]
I copied the above quote directly from the original 2005 audit report as it appeared on the Mint's website on January 13, 2007. Unfortunately the report has since been deleted and is nowhere to be found. Perhaps somebody with a bit of foresight saved a copy on his or her hard drive and is willing to share? In any case, those who are curious about what the lost 2005 KPMG audit report looked like should examine the 2004 audit report prepared by a predecessor audit firm. My recollection is that the format and content of the 2004 and 2005 audit reports were very similar, which should come as no surprise since the first instinct of auditors is to follow a concept known as SALY, same as last year. I would note, however, that the 2004 audit opinion was worded differently compared to the above quote taken directly from the lost 2005 audit report.
In any case, the Mint had a valid reason for pulling the 2005 audit report from its website. You see, sometime between this past January and today, two new audit reports have been quietly posted at the OIG's website. One is for the Mint’s 2005 fiscal year and replaces the audit report that has mysteriously disappeared from the Mint's website. The other is for the year 2006 with comparative numbers for 2005.
To my utter surprise, both the revised 2005 and the just-released 2006 audit reports include a clean audit opinion pursuant to which KPMG, not the OIG, has taken full responsibility for the audit of the gold reserves. Now you understand why the above background was important. But wait, it gets even more shocking. The gold reserves are now listed as assets of the Mint, comprising more than 90% of the balance sheet.
Clearly, 90% is a very material number and means that KPMG must have performed significant, unprecedented audit procedures related to the gold reserves, which now constitute a critical focus of the independent audit. Unfortunately, KPMG's audit procedures have fallen short thus far of the holy grail of gold reserve audits: observing the physical inventory of gold bullion stored at Fort Knox. But according to a Treasury Dept. source, KPMG did observe the 2006 physical inventory at West Point, where more than 50 million ounces of gold (approximately 20% of the gold reserves) are said to be stored. And there is every reason to expect that 2007 will be the year when that most-troubling of questions for many gold bugs may finally be put to rest: does Fort Knox actually hold any gold? Regardless, nobody will be able to proclaim henceforth that an independent audit of U.S. gold reserves is not being performed. In fact, such whining is already two years past its "best used by" date. Any whining now will have to be limited to the quality of KPMG's audit, whether or not the audit firm is truly independent, the competence of the audit staff and other alleged problems that no doubt will continue to pester the conscience of a paranoid few.
The independent audit reports can be found here:
2005 Audit Report: http://www.ustreas.gov/inspector-general/audit-reports/2007/oig07006.pdf
2006 Audit Report: http://www.ustreas.gov/inspector-general/audit-reports/2007/oig07022.pdf
As if the discovery of the independent audit reports weren't enough, a careful reading of the fine print results in at least three additional revelations that I consider to be very enlightening.
FIRST, the definition of "Deep Storage" is now officially sanctioned by a major accounting firm. Basically, Deep Storage means gold and silver stored in sealed vaults as contrasted to gold and silver that is working stock for the Mint's coin programs. Personally, I am very appreciative of KPMG's endorsement of this definition of Deep Storage because now I won't have to waste so much time attempting to refute wild speculation from the gold conspiracy camp. I can simply refer them to KPMG.
SECOND, we find out that the U.S. Mint started a silver hedging program in 2006 whereby a "trading partner" acquires an interest in that portion of the Mint's silver held as raw material for the production of American Eagles and other coins. The hedged silver is automatically repurchased from the trading partner at prevailing spot prices as minted coins are sold, protecting the Mint from losses due to falling silver prices. Since title and custody remain with the Mint at all times, however, the only possible use the Mint's trading partner would have for this silver is to hedge a derivative short position, likely in COMEX futures.
The disclosure of the Mint's hedging program provides a rare purview into a realm that has long been the subject of conjecture. For my own part, I have claimed in the past that the practice of lending by silver users and forward selling by mining companies has supplied the commercials with the hedging ammunition to maintain a significant short position in COMEX silver. On the other hand, Mr. Ted Butler has alleged that the commercial shorts are naked; that is, there is no silver backing their positions at all. Based on how the Mint's hedging program is described and without the benefit of reading the actual contract, I have to admit that Mr. Butler is partially right. You see, the Mint has already earmarked the hedged silver to be sold in future apportionments to authorized coin distributors. So unless the trading partner/COMEX short was given superior rights under the hedging contract, there is neither a contractual nor external means for it to take possession of any physical silver. Put another way, a commercial short would never be able to use this type of a hedge contract to make delivery of silver, even when a futures contract could be rolled to a later date. This is unlike a forward purchase from a mining company where the commercial short is entitled to physical silver. In fact, the sole purpose of the Mint's hedge is price protection, meaning that it would not protect a trapped COMEX short against a delivery default. To Mr. Butler's point, there is no physical backing to this type of silver and therefore its use to obtain a commercial trader designation on the COMEX, assuming that is possible, would create a short position that is naked against forced delivery.
At the same time, we need to realize that these almost naked shorts have nothing to worry about unless and until a supply squeeze in the spot market is accompanied by a lack of buying interest in futures (preventing the shorts from rolling their contracts to future months). According to Prof. Antal Fekete, such a situation might only occur during a melt-up of gold and silver prices to universally-recognized monetary status. As an aside (i.e., shameless plug), my own work on the basis in gold and silver futures is meant to provide an early warning sign of just such an event. In every other instance, however, the commercial shorts can be secure in the knowledge that their paper silver will protect them from taking a beating, regardless of how high silver prices may reach. In fact, the shorts probably welcome increasing prices since the accompanying volatility will add to their potential profits. After all, they are long on paper and thus never fully naked. So it turns out Mr. Butler isn't entirely right, just in the event of a delivery default. In the meantime, the only thing that really matters is that commercial shorts will continue to rake in the profits.
THIRD, the disclosure of hedging activity involving a few million ounces of silver creates a strong precedent for KPMG to seek out and report other hedging, leasing or derivative transactions that might involve or impact the Mint's balance sheet, now consisting predominantly of the gold reserves. While not a guarantee that the gold reserves are free of all encumbrances, the oversight by KPMG should help ensure that accountability for the gold reserves is moving in the right direction.
The Pesky Details
This is probably the point where I should end this commentary on account of it being a bit too much to absorb in one sitting. In the interest, however, of discouraging the hatching of new conspiracy theories, I'm now going to address the seven most likely questions still bugging the inquisitive, suspicious and skeptical. Everyone else can probably stop here without risking sleepless nights.
NUMBER ONE. Why was there a change in the audit approach with respect to the Mint's financial statements after KPMG had already issued an audit report for 2005? The answer is actually quite simple. The Mint's original financial statements for 2005 (and prior years) were prepared and audited under a set of accounting standards applicable to private-sector enterprises. One could speculate why this might have been the case but a reasonable guess would be that the Mint's activities are more consistent with a for-profit, private enterprise than a government agency. In any case, sometime after KPMG had issued its original audit report for 2005 on a private-enterprise basis, somebody high up on the decision chain (a "decider") must have had an epiphany: the U.S. Mint may function in some ways like a private company but it is, in fact, a government entity. More than likely, this decider was some managing partner at KPMG responsible for firmwide accounting policy. In any case, what's important is the Mint's financial statements had to be revised to comply with its charter as a government agency. Among other things such as budgetary disclosures, this meant that custodial gold and silver would now become the primary assets (and offsetting liabilities) in the financial statements instead of just disclosure items. As a result, KPMG could no longer simply defer to OIG's audit given that the gold reserves now represented over 90% of the Mint's balance sheet. To do so would break the world record for auditor recklessness.
An alternate explanation is that KPMG never actually issued the 2005 audit report previously listed on the Mint's website; instead, the report might have been a draft that somehow was mistaken as a final product and posted by Mint personnel. This theory is supported by the possibility that the OIG website never had a copy of this original 2005 audit report. Furthermore, there are obvious formatting and grammatical mistakes (see quote above), which is quite uncharacteristic of the work of a Big 4 CPA firm such as KPMG.
NUMBER TWO. Assuming it was not just a draft mistaken for the final, what happened to the original KPMG audit report for 2005? Well, the auditing standards state that as long as an audit report has not been issued for a subsequent year, all copies of a superceded audit report for the current year should be returned to the auditor so that two competing versions of the same report are not in circulation. In the present case, one should expect vigorous efforts to stamp out any and all instances of KPMG's original 2005 audit report. Unfortunately, this occurred before I could save a copy to my hard drive, but several exchanges with Mr. Gnazzo imply that my arguments were constructed based on the now-missing 2005 audit report. For example, consider the following two statements:
"But since these are not the Mint's assets, KPMG is not required to look at the gold and silver when auditing the Mint's financial statements." [from Reply to Gold Reserve Audit 2005]
"The custodial reserves are in fact disclosed on the face of the Mint's financial statements. Not as assets but rather what is called parenthetical disclosures. Still, the gold does technically fall under KPMG's audit responsibility. As a result, KPMG is unlikely to have issued any type of opinion other than a disclaimer ('we are unable to express an opinion...') without some assurance about these gold and silver reserves that are in the Mint's custody. It sure looks like the only solution is the audit by the Treasury Dept." [Excerpt from e-mail to Douglas Gnazzo on January 13, 2007].
With respect to these examples, I was obviously talking about a set of financial statements that did not include gold reserves as Mint assets but rather as disclosures for which KPMG had not taken any audit responsibility.
NUMBER THREE. If the new audit report for 2005 was issued on November 11, 2006, why did it take until now for it to show up? One possible explanation is that the OIG takes its sweet time to get audit reports released. Another one is that some administrative procedure created the delay. In any case, this phenomenon is not restricted to the audit of the Mint. For example, the Office of the Comptroller of the Currency's 2006 audit report dated December 12, 2006 was released just before the Mint's 2006 audit report dated December 21, 2006. On the other hand, the Mint's website is still missing both the 2005 and 2006 audit reports as of today. It seems that some bureaucrats are slow to update websites, just like the rest of us.
NUMBER FOUR. How was KPMG able to audit the custodial gold and silver as of the fiscal year ended September 30, 2005 when clearly nobody at the time had anticipated that the gold reserves would have to be reported and audited as Mint assets? The only sensible answer I come up with is that KPMG did not actually observe any physical inventories during 2005. Rather, the audit firm apparently examined the OIG seals on the gold vaults at some later date, probably on or about September 30, 2006. This begs the question, what kind of audit did KPMG perform with respect to the gold reserves in 2005? Well, it would be quite difficult, but technically not impossible, to design a set of audit procedures as a substitute for being present during a physical inventory. I suppose the trick might be accomplished using an alternate audit program that includes procedures such as interviews with Mint police and OIG personnel, a thorough examination of all existing records including inventory documents and security logs, a direct confirmation of gold assays with the U.S. Assay Office (responsible for annual re-assays of a portion of gold reserves), conversations with auditors of the U.S. General Accounting Office (GAO) and who-knows-what-else.
Of particular note is the fact that the GAO reports directly to Congress and has an independent mandate, although seldom exercised, to oversee the audit of gold reserves. So if somebody wants to write a letter to Congress about gold reserve audits, he or she should start by asking Senators or Congressmen like Ron Paul to help make sure the GAO is exercising its authority in full. This is very important because the GAO apparently obtained a full list of the bullion bars held in the gold reserves during a co-audit with OIG in 1975. At a minimum, such list can and should be compared by the GAO to the bar list prepared during KPMG's audit of the gold reserves. That would provide an additional layer of assurance, one that I suspect has not escaped KPMG itself.
After having performed the above audit procedures and then some, KPMG must still have stretched the auditing standards almost to the breaking point in order to issue a clean audit opinion on the gold reserves for 2005. Recall that KPMG never directly observed a physical inventory during that year and typically that would necessitate a disclaimer of opinion. That, however, is clearly not what KPMG issued for 2005 the second time around. I'm only speculating here, but what probably helped convince KPMG to issue a clean opinion is the robustness of the Treasury seals placed by the OIG on the gold vaults to prevent tampering. You're probably thinking, those sure must be some very special tamper-proof seals! And you're probably right. You might also be thinking that the OIG inspectors came across to KPMG as incorruptible, irreproachable officers of the law. Yet it was most likely KPMG's presence during the 2006 physical inventory of gold held at West Point that would have provided the audit firm with the required level of confidence to issue a clean audit opinion on both 2005 and 2006. Obviously, KPMG must have been very impressed with the thoroughness and precision of the OIG and Mint staff's physical inventory procedures. Last but not least, it is inconceivable that KPMG did not request and receive assurances from the Mint and the OIG that the audit firm will be able to take part in the physical inventory at Fort Knox in 2007.
The bottom line is that KPMG has indeed conducted an independent audit of the gold reserves, but such audit has so far not included direct observation of the physical inventory of the gold held at Fort Knox, the primary gold depository where more than 50% of the reserves are held. But don't fret, that will have to happen in 2007 since otherwise the KPMG audits of 2005 and 2006 are frauds. Now you might still be left wondering why KPMG didn't attend the physical inventory at Fort Knox in 2006. My guess, one that is as good as any other, is that the change in reporting that required KPMG to take primary responsibility for auditing the gold reserves likely occurred after the Fort Knox physical inventory for 2006 had already taken place, but before the one at West Point.
NUMBER FIVE. Why did the OIG discontinue issuing audit reports on custodial gold and silver after 2005 (see 2005 report here)? This question has already been answered for the most part: KPMG is now officially in charge of the custodial gold and silver audit. Yet if KPMG was also responsible for 2005 as its revised audit opinion now states, why did the OIG issue a separate 2005 audit report that was no longer necessary? This brings us back to the point that KPMG became responsible for the gold reserve audit only after the OIG had already issued its 2005 audit report. Another way to state this is that KPMG did not actually participate in the 2005 physical inventory conducted by the OIG but rather performed a combination of substitute audit procedures at a later date. The inescapable implication is that KPMG continues to place a certain degree of reliance on audits previously performed by the OIG. This should become less of an issue with the passage of time as it would be unimaginable for KPMG not to materially participate in future physical inventories, particularly at Fort Knox.
NUMBER SIX. Why did KPMG's 2005 audit report not include comparative numbers for 2004 in contrast to the 2006 audit report that includes comparative numbers for 2005? The reason provided in KPMG's revised audit opinion for 2005 seems genuine but insufficient:
"As a result of the lack of comparability, the fiscal year 2004 financial statements have not been presented with the fiscal year 2005 financial statements."
The missing piece of the equation seems to be that in 2004 the predecessor audit firm did not audit the gold reserves, which now comprise more than 90% of the balance sheet due to the retroactive adoption of different reporting standards. It was probably too much of a stretch for KPMG to go all the way back to 2004 using substitute audit procedures since many of the records to be examined and personnel to be interviewed would have been much more difficult to locate. Following this somewhat convoluted logic, the exclusion of comparative 2004 gold reserves from the 2005 audit report tends to indicate that whatever audit procedures KPMG did conduct with respect to 2005, they represented a substantial improvement over the audit procedures, if any, that may have been performed by the predecessor auditor in 2004 and years prior.
Bottom line, KPMG's independent audits have not been ideal up to this point but they are leaps and bounds ahead of anything that has been done before. More importantly, everything is now in place for 2007 to mark the start of a new era in which the gold reserves of the U.S. are independently audited on an annual basis by an external audit firm that will for the first time in history observe the physical inventory of the bullion stored at Fort Knox. The time is short, enjoy your conspiracy theories while they last!
NUMBER SEVEN. Can we really expect that KPMG will be present for the physical inventory at Fort Knox in 2007 and beyond? Well, I must admit that we won't know the answer with absolute certainty for a few more months, but based on the fact that KPMG has already been granted historic access to the fabled Gold Vaults in 2006, possibly by presidential order, in order to examine the OIG seals at fiscal year end, the precedent has been set. In fact, it would be shocking if KPMG was willing to accept such a major limitation on its audit scope. After all, gold reserves now represent the lion's share of the Mint's balance sheet and KPMG could be held accountable for damages reaching into the many billions of dollars should the gold prove not to be there. Facing such unimaginable risk, do you think KPMG is going to settle for anything less than full access or full disclosure? I'm thinking KPMG must have brought a lot of firepower and pressure to bear on the Mint and the OIG so that a proper independent audit can be performed, something that the predecessor audit firm was unable to do.
THANK YOU KPMG! THE END.
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-- Posted Monday, 23 April 2007 | Digg This Article