For countless investors, professionals and amateurs alike, certified public accountants serve as curators of confidence, cops on the beat called Wall Street, passing judgement on the accuracy of the financial results reported by businesses. But key components of the audit process—the independence and objectivity of auditors—may be eroding, according to some industry observers. For example,
For countless investors, professionals and amateurs alike, certified public accountants serve as curators of confidence, cops on the beat called Wall Street, passing judgement on the accuracy of the financial results reported by businesses. But key components of the audit process—the independence and objectivity of auditors—may be eroding, according to some industry observers.
For example,Thomas Dunfee, director of Wharton’s Zicklin Center for Business Ethics Research, says that huge fees paid to accounting firms by their audit clients for non-audit services can entice CPAs to overlook improper activity for fear of jeopardizing a lucrative business relationship.
“Look what happened with Andersen,” says Dunfee, referring to a recent case in which the Securities and Exchange Commission leveled charges of fraud against Arthur Andersen and fined the Big Five firm $7 million in connection with its audits of Waste Management Inc. (Although Andersen paid the fine to settle the case, it did not admit or deny the allegations.) “This is just the tip of the iceberg,” Dunfee says.
But that’s not the way that some CPAs see it. Philip A. Laskawy, who recently retired as global chairman of Ernst & Young (which sold its consulting business last year to the Paris-based IT consulting firm Cap Gemini in an $11 billion cash and stock deal) says the SEC is creating controversy where it doesn’t exist.
Laskawy acknowledges that multi-million dollar consulting fees paid by audit clients for non-audit services may create the appearance of a conflict of interest, but argues that independence is a state of mind. Regardless of what firm they are with, he says, partners would generally never approve an inappropriate action because of a large fee. “The reputation of their firm is too important,” he says. “They wouldn’t cut corners.”
According to published reports, however, the SEC is pursuing close to 260 accounting fraud investigations, many of which are aimed at large corporations that presumably utilize the Big Five as auditors. (By way of comparison, only about 100 of the SEC’s enforcement cases involved accounting fraud last year.) While that doesn’t necessarily implicate the accounting firms, ranking SEC officials like acting chief Laura Unger have repeatedly expressed concern over what they see as conflicts of interest that are traceable to outsized consulting fees.
A certified audit is designed to comfort readers of financial statements, ensuring that the balance sheet, income statement and other related documents have been prepared in accordance with generally accepted accounting principles, and that the auditors followed generally accepted auditing standards. But Dunfee says the temptation to sidestep the rules may be overwhelming. And he notes that the inducement is built into the very relationship between auditors and their clients.
“In order to properly perform a certified audit, an accountant must thoroughly understand the operations of his or her client,” says Dunfee. “Given that level of involvement, it’s not unusual that a client would turn to the same audit firm to perform other services, like consulting.”
There are at least two consulting-related threats to auditor independence, he says.
“The first is the fact that consulting typically involves auditor evaluation of assets and strategies, or may involve setting up departments and systems for a client,” according to Dunfee. “Then, when an audit team examines the company and its financial results, they’re basically auditing their firm’s own work. This can easily lead to a confirmation bias, where auditors say if they ‘already did this, it must be right.’ So you don’t truly have an objective mindset.”
The second hazard is financial. “It’s a matter of self interest,” Dunfee observes. “If consulting revenues are material, an audit firm might be reluctant to rake over the client’s operations and records, fearing they may irritate management and lose a good chunk of business.”
In fact that was the underlying concern in the Andersen case, according to the SEC’s Unger. In a recent speech, while discussing auditor independence concerns, she noted that, “although the Commission did not charge Andersen with a violation of the auditor independence rules, the Commission’s order did summarize some of the factors that may have played into Andersen’s failure to make the hard decisions. For example, Andersen regarded Waste Management as a ‘crown jewel’ client; until 1997, every CFO and CAO (Chief Accounting Officer) had previously worked for Andersen. In addition, between 1991 and 1997, Andersen billed Waste Management approximately $7.5 million in audit fees and $11.8 million in non-audit fees.”
An Andersen spokesman later took issue with Unger’s remarks. “It’s regrettable that the SEC is making serious allegations that were never made in the complaint and that weren’t part of any settlement discussions…There was no independence violation and the SEC had no case to make one,” the spokesman said.
In fact there’s plenty of ammunition on both sides.
Critics who say auditors may be swayed by high consulting fees were encouraged by a study conducted by the SEC’s Office of Chief Accountant. It concluded, based on recent proxy filings from more than half of the Fortune 1000 companies, that for every dollar in audit fees that clients paid to their independent accountants, they paid an average of $2.69 for non-audit services.
“On average, non-audit fees comprised 73% of total fees companies paid to their accounting firms,” says Unger. “The 10 companies that paid the most in IT fees paid their independent accountants between $3.57 and $32.33 for non-audit services for each dollar of the audit fee paid.”
While admitting that the numbers themselves don’t prove that the audits for these companies have been impaired, Unger says the SEC was “quite surprised by the disparity between the auditing and consulting fees.”
Unger couples this disclosure with another trend, the rise in the volume and dollar amount of corporate results that were restated because of writedowns and special charges against inventory, acquisitions, loans and a host of other assets.
In 1997 the SEC counted 104 instances of restated earnings, says Unger. In 1998 there were 116 occurrences, and 142 were recorded in 1999. “The growing trend in the number of restatements did not abate in 2000,” she adds. “According to a recent study, there were 156 restatements last year. The study further reports that the restatements resulted in total market losses of $31.2 billion in 2000, $24.2 billion in 1999 and $17.7 billion in 1998.”
Were the multi-billion-dollar disappearing acts evidence of sloppy bookkeeping or worse, or were they, as accountants and some economists say, simply telling the story of a high-tech sector implosion that dragged down the broader economy?
For Mark L. Cheffers, a former manager with PricewaterhouseCoopers who now runs AccountingMalpractice.com, a web site offering legal resources to accountants, there is an inherent conflict in auditing.
“A company pays for audit services and yet the auditing firm claims it is independent—that can be a problem in itself,” he observes. “Also, auditing is more than just evaluating a system. In a certified audit there’s a sense that you’re also there to help the company improve itself.” Consulting services, he notes, make the relationship even more complicated, because in those engagements an accounting firm acts as a clear advocate for the client.
In fact, last year the SEC was concerned enough about that issue to consider an outright ban prohibiting audit firms from providing consulting and other services to audit clients. Instead, after an outcry from the industry, the Commission required corporations to disclose payments for audit and non-audit services in annual proxy reports.
Even without a ban, however, companies like KPMG, Andersen and Ernst & Young have spun off their consulting practices. But did they do it because of independence concerns or simply because it was good business?
There were several reasons, according to E&Y’s Laskawy. “First, we wanted the consulting business to be global and needed the ability to make acquisitions and investments. To do that, we had to be able to access stock as well as cash. Also, our partners wanted to tap into the opportunity that stock and options offer; it’s a tool with which to attract and retain employees.”
Laskawy acknowledges, though, that SEC concerns were part of the firm’s decision. “We believed that SEC restrictions on business relationships with audit clients would be a stumbling block in the growth of our consulting business,” he recalls. “Another issue was the fact that although audit services have traditionally been a useful selling tool to promote consulting services to a client, the SEC activity took the bloom off the process.”
Cheffers, however, doesn’t believe spin-offs count for that much.
“Andersen recently spun off Accenture (the firm’s consulting services arm), but that doesn’t mean that the accounting firm can’t provide management advisory and other non-audit services to clients,” he says. “The best solution, I believe, is what the SEC currently requires: disclosure of fees paid for audit and non-audit services. Disclosure can work wonders.”
Wharton’s Dunfee also says that fee disclosure helps to maintain integrity, but he believes that sterner action on the part of the SEC may still be necessary. “Safeguards and disclosures, internal controls and peer reviews may be effective, but some types of engagements should simply be avoided,” he notes. “Because an audit firm knows its clients well, and may indeed be the best provider of consulting services, there are costs associated with an outright prohibition. It’s interesting that the SEC, under the relatively aggressive Levitt administration, did not issue some kind of prohibition. But a few more high-profile cases of cooked books and major restatements may pressure the SEC to reconsider its hesitancy” to take such action.