Why aren't auditors heading off scandals?

7/20/2002

The reviled caricature of a pale form hunched over a ledger, one hand flashing over a calculator keypad and the other armed with a perfectly sharpened pencil, perhaps looks good to most auditors right now.

At least the auditor isn't perceived as incompetent.

Growing accounting scandals at WorldCom, Inc., Xerox Corp., Enron Corp., and the like have cast a darkening cloud over auditors as lawmakers and experts hash out industry reforms. Skittish investors are pulling money from Wall Street, and major stock indexes have plunged below their post-Sept. 11 lows.

Are auditors and their work at the heart of the problems? Academics, shareholder rights activists, and auditors themselves cite a complex web of factors.

Some critics say large accounting firms treat audits as a commodity that helps firms obtain more profitable consulting jobs.

One change under consideration by federal lawmakers is that accounting companies be barred from providing consulting services or internal auditing to firms whose books they check.

“Auditors used to consider themselves professionals, providing service to clients,” said shareholder rights advocate Nell Minow, editor of the Corporate Library research firm in Washington.

“The ethical obligation seems to have disappeared.”

Auditors counter that accurate audits hinge on corporate management furnishing correct information and say the most difficult fraud to detect involves management collusion.

“The audit itself is not designed to uncover fraud,” said Stephen Staelin, office managing partner for Ernst & Young LLP in Toledo, outside auditor for Toledo's Owens-Illinois, Inc., Findlay's Cooper Tire & Rubber Co., and a number of other local firms. Ernst & Young bought Arthur Andersen's Toledo office after the rival was criminally charged for its role in Enron's collapse.

Added Mr. Staelin: “That is a whole different set of procedures that you use to uncover fraud.”

What an audit does, he said, is ensure that financial statements comply with generally accepted accounting principles.

Potential problems, however, are pursued in the course of an audit, auditors said. They must be discussed with a company's audit committee, said John O'Neil, a Toledo partner with Plante & Moran LP, which added MBT Financial Corp. to its client list after the Monroe bank holding firm dropped Arthur Andersen.

But Charles Cullinan, an accounting professor at Bryant College in Smithfield, R.I. contends a revision in auditing methods has increased the difficulty of catching executives cooking the books.

He said in the 1980s and '90s, as companies pushed to reduce audit fees, auditors switched focus from looking at both the process for generating financial data and the numbers themselves. The current emphasis on the process alone helps catch fraud of low-level employees but not necessarily that of management, who can bypass internal checks, he said.

A study by Mr. Cullinan and Steve Sutton, an accounting professor at the University of Connecticut, shows that 90 percent of recent fraud was by high-ranking executives and 70 percent was by chief executive officers.

“In reality, the main type of fraud we're seeing is coming from the top,” Mr. Cullinan said.

“I don't think they purposely look away,” he said of auditors for WorldCom and others.

“They didn't pay attention enough to what they should have been paying attention to.”

Still, most of the United States' 6,000 public companies are in good shape, said Ms. Minow of the Corporate Library. “Investors should not panic,” she said.

Ms. Minow advised investors to find out who manages their pension funds - where much of their investments lie - and press those managers about what questions they are asking about audits.

Once the government puts a beefed-up auditing-supervision program in place, experts can figure out the best way to change policies, procedures, safety backstops, and other measures, she said.

To help investors and creditors better understand a company's finances, auditor reports should be graded like classes or movie reviews, said Paul Clikeman, an accounting professor at the University of Richmond.

The current “pass/fail” system doesn't allow auditors to distinguish between companies issuing exemplary financial statements and those barely meeting reporting standards, Mr. Clikeman said.

Plus, 99 percent of audits get unqualified opinions, and companies strive to disclose the least while manipulating earnings the most, he said.

“It encourages them to go to the absolute outer limit of what is acceptable,” Mr. Clikeman said.

Auditors should pay more attention to the principles of accounting, such as taking a conservative approach, instead of whether transactions comply with rules, said certified public accountant and attorney Steve Milner, managing partner of Squar Milner accounting firm in Newport Beach, Calif.

“Business has become so complex that accounting rules, even under the best of all worlds, can't keep up with them,” he said.

“To a large degree ... the vast majority of auditors are doing their job. Maybe the expectations of what an auditor does could be changed.”

One positive result from recent accounting irregularities coming to light is top corporate officials have a better understanding of the risks their companies face, said Mr. Staelin of Ernst & Young.

“What I have seen is corporate boards and committees that have been energized in this process and have been much more active.”