Remember back last summer, when Harvey Pitt vowed to run a kinder, gentler Securities and Exchange Commission than his predecessor, Arthur Levitt?
With Enron and all that has come after, last summer might as well be a lifetime ago. The audit firms are finding little sympathy at the SEC or even on Capitol Hill these days. On July 24, a Senate-House conference committee agreed upon the most sweeping changes to securities law, corporate governance, and the regulation of auditors since the Securities Exchange Act of 1934. Not even the legendary lobbyists for the big auditors could water down Sen. Paul Sarbanes's (D-Md.) bill in conference committee. Meanwhile, Pitt, who has had to recuse himself from more than a few SEC investigations in the past year because of his former ties to business, has been fighting to hold on to his post. Since the calls for his resignation started, he has been sounding less kind and gentle by the day.
Pitt's problems mark the end of an era. The Sarbanes-Oxley Act, which passed both the House and the Senate by huge majorities and was signed into law on July 30, is intended to fundamentally change the relations between public corporations and their auditors. It will place new restrictions on the services that auditors can provide for their clients, and it will establish an independent board to oversee the industry for the first time in its history.
Congress isn't the only purveyor of new regulations affecting auditors. The New York Stock Exchange will prohibit auditors of listed companies from serving on the boards of clients for five years. Meanwhile, Nasdaq-listed companies will be prohibited from hiring former auditors at all levels for three years. "No one could have imagined all the changes that have happened and are still happening in the industry," says Ed Nussbaum, CEO of Grant Thornton LLP, which, with $342 million in revenues last year, will be the sixth-largest audit firm in the country after Arthur Andersen officially ceases operations on August 31. "It's mind-boggling."
The ultimate responsibility for financial statements may lie with corporate managers, but by any measure, the audit firms have failed miserably in their role as financial watchdogs. And with their profession about to undergo a major overhaul, they have been a very quiet voice in the reform debate. "There's a void of leadership in the audit industry," says Michael H. Sutton, a former chief accountant at the SEC who testified in the Sarbanes hearings. "The firms are all in defensive mode."
For corporate executives, that defensive mode already means tougher, more-expensive audits and less wiggle room when it comes to the interpretation of accounting rules. "If anything, [the auditors] have become overly conservative," says David Banks, head of corporate communications at First Data Corp. The Sarbanes Act is no immediate cure for a deeply shaken market, but it may go a long way toward fostering a more independent and adversarial role for auditors of public companies. "It's a very different environment from nine months ago," says Nussbaum. "Instead of focusing on whittling down our fees, senior executives and audit committees are challenging us to make sure we're doing an adequate job."
An Auditor by Any Other Name
In the past two decades, the accounting firms have ventured far beyond their humble roots. While they have always provided some degree of nonaudit services to clients, the opportunities for new business have exploded in the past 20 years. With the spread of information technology, the biggest auditors became designers and implementers of IT systems. They expanded their tax, legal, and investment advisory services, and branched out into all manner of management consulting work. Since SEC auditor-independence rules enacted in November 2000 began requiring firms to disclose their sources of revenue, the magnitude of the industry's transformation has become apparent. A survey conducted by the Investor Responsibility Research Center found that 72 percent of the $5.7 billion in fees paid by 1,200 public companies to their auditors in 2000 was for nonaudit services.
In his seven and a half years as SEC chairman, Levitt tirelessly pushed the issue of auditor independence, arguing that corporate audits were being compromised by the firms' growing reliance on other sources of revenue. Indeed, in the broader offering of professional services by the audit firms, the actual audit has arguably become a loss leader to land more lucrative consulting contracts. "Some firms used to refer to audits as a commodity," says Nussbaum. "No one believes that now."
The American Institute of Certified Public Accountants (AICPA) has long argued that no evidence exists that the provision of consulting services has ever resulted in a tainted audit, but there is certainly an apparent conflict of interest. "Independence in appearance is as important as in fact," says Charles Mulford, an accounting professor at the Georgia Institute of Technology. "Even if there's a wall between the consultants who might design and implement a system and those who audit the statements, appearances matter."
The Sarbanes Act lists eight distinct services that firms will no longer be allowed to provide to their audit clients, and it gives the new oversight panel the authority to prohibit other services as it sees fit. It also requires that corporate audit committees preapprove all services provided by auditors to the company.
Investors have already been attempting to reduce the ties between public companies and their auditors this proxy season, says Ann Yerger, a director of research at the Council of Institutional Investors. A handful of shareholder proposals to eliminate all nonaudit service contracts with auditors made it onto corporate proxies this spring. Several were withdrawn after discussions with management yielded a compromise, but a few, including proposals at Walt Disney and Motorola, drew shareholder support in the range of 40 percent.
At Motorola, the Sheet Metal Workers National Pension Fund proposed that the company sever all nonaudit service contracts with its auditor, KPMG. Last year, Motorola paid the firm $19 million — only $4.1 million of which was for audit work. Thanks to a large IT implementation, the audit fees paid to KPMG in 2000 were only $3.9 million of a total bill of $62.3 million. Motorola spokesman Scott Wyman says the company had already committed to discontinuing IT consulting, internal audit, and financial transaction-structuring contracts with its auditor prior to the March 29 shareholder vote. It may have to further curtail its business with KPMG in the coming year.
Many companies are paying extra attention to their relationships with auditors these days. Beth Farbacher, senior vice president and general auditor for Pittsburgh-based health insurer Highmark, says that all internal proposals to use the company's auditor, PricewaterhouseCoopers, for nonaudit work have to be cleared with her first. "I'm sensitive to any engagement that presents a conflict of interest in fact or appearance — particularly in the financials or systems area," says Farbacher, who reports directly to the audit committee of Highmark's board of directors. In some cases — actuarial services, for example — Farbacher says the auditor has a base of knowledge that gives it an advantage over other providers. "It puts them in a position to make better assumptions or to poke holes in our assumptions," she says. The new restrictions in the reform bill, however, will likely force Farbacher to find another firm to perform Highmark's actuarial work.
Joe Martin, CFO of Fairchild Semiconductor, has to choose a new provider of internal audit services for his South Portland, Maine-based company. His auditor, KPMG, has performed the function up until now. "I have no problem with the new rules. We've seen it coming for a couple of years," says Martin, who has also hired KPMG for such other services as human resources management and appraisal work. He has recently been interviewing alternative providers. "It's been convenient to do one-stop shopping [with KPMG]," says Martin. "Now it's just going to be a little less convenient."
A notable exception to the new service restrictions is tax work — the assumption being that issues of tax are so intertwined with accounting and financial reporting that separating the two could jeopardize the quality of audits. Other nonaudit services, however, are also essential to the audit work, says PricewaterhouseCoopers global CEO Samuel DiPiazza Jr. "To perform good audits, we need more skills than just forensic accounting," he asserts. Specifically, DiPiazza suggests that general accounting skills, tax planning, risk management, and security analysis are all vital competencies for auditors to possess. "All these elements are embedded in the financial statements. If we legislate against providing these services, we could end up with poorer audits," he warns.
The new restrictions on the provision of nonaudit services don't resolve all conflicts of interest. The fact that clients foot the bill for their audits and can readily take their business elsewhere creates a basic conflict to begin with. But the new ground rules will at least reduce the appearance of conflicts of interest. "If we're going to rebuild trust in financial reporting, these things are needed," says Professor Mulford.
Bringing the Watchdogs to Heel
When Congress gave the task of setting accounting standards to the newly created SEC in 1934, it left the job of overseeing auditing standards and individual firms to the accounting profession. For the past 65 years, the job has been performed by the AICPA and its predecessor organization.
Industry self-regulation, however, has often meant no regulation. The recently dissolved Public Oversight Board, established by the AICPA to monitor the conduct of auditors and funded by the industry, had little power to enforce standards and discipline wayward audit firms. When it did examine audit failures and factors that may have compromised auditor independence, the industry simply threatened to cut off its funding. "The profession has resisted meaningful self-regulation for decades," says Sutton.
The successor to the old POB, the Public Company Accounting Oversight Board will be funded by mandatory fees from public companies and will operate under the oversight of the SEC. It is charged with establishing audit, independence, and ethical standards for auditors; investigating auditor conduct; and imposing penalties.
Formerly, auditors under investigation by the AICPA oversight board could simply refuse to participate. The new board will have the same subpoena powers as the SEC to bring auditors to the table. But its effectiveness will depend largely on the aggressiveness of the members chosen by the SEC to serve on it. Of the five members, only two can be current or former accountants.
While the industry begrudgingly accepts that an oversight panel with teeth is now a political reality, there are reservations about its role in setting standards for audit processes. Up until now, the job has been performed by the Audit Standards Board of the AICPA. The industry trade group, which declined requests for an interview, has argued that this task should remain in the hands of industry practitioners. "We firmly believe that standard-setting is better done by individuals who have an in-depth, current, and comprehensive understanding of auditing," wrote James Castellano and Barry Melancon, the two senior executives at the AICPA. This sentiment is echoed by others in the profession. "Auditing standards should be established by accountants, not by regulators and lawyers," says Nussbaum. "When standard-setting becomes a political event, it changes depending on what's popular, and that's not good for standards."
The reforms being imposed on the accounting profession by politicians and regulators may have auditors gnashing their teeth, but the long-term results may not be entirely negative from their point of view. "Enron and WorldCom have done a lot to strengthen auditors' hands," says Mulford. Corporate executives are now realizing that the credibility of their financial disclosures can be more important than the financials themselves. That should result in less pressure on auditors from executives trying to make their numbers. It also may improve the compensation auditors receive to conduct their work.
Nussbaum has already noticed the difference. In an effort to improve its ability to detect fraud, Grant Thornton has been increasing the number of procedures it performs to confirm receivables with customers and verify liabilities with vendors and other outside parties. And despite the weak economy, companies are accepting the increased expense from the added work. "I think our clients understand that if they want strong audits from reputable firms, the costs are going to go up," says Nussbaum. "It's one of the silver linings to this situation."
Of the parade of participants in the Enron hearings, none generated more outrage than the document-shredding Andersen auditors. Greed and corruption may be no more acceptable in corporate executives than in anyone else, but the auditors have borne a particularly large share of the public opprobrium from Enron and other corporate accounting scandals.
PwC's DiPiazza admits that the audit industry shares much of the blame for the loss of confidence in the capital markets. "Accounting firms must never forget that their work serves the interests of shareholders, not just the company that writes the check," he wrote in his recently published book, Building Public Trust: The Future of Corporate Reporting. He believes, however, that the reform debate has to shift to broader considerations of corporate reporting rather than just the failings of auditors. "If we're going to move toward a new auditing framework, we need to consider all the pieces of the puzzle," says DiPiazza.
U.S. generally accepted accounting principles, long considered the best and most accounting standards in the world, may be the most important piece of that puzzle. Growing numbers of financial accounting experts believe that GAAP itself may be part of the problem. As financial transactions have become more complicated, so too has the accounting for them. "Over the last 10 years, U.S. GAAP has evolved into complex detailed rules that encourage financial engineering rather than transparency," says DiPiazza. The highly politicized nature of the standards-setting process, wherein businesses lobby politicians to exert pressure on the Financial Accounting Standards Board, is a large part of the problem. New funding sources for FASB independent of the audit industry may improve the situation, but the legacy of the process is thousands of pages of rules riddled with exceptions for specific situations and opportunities to use aggressive assumptions. GAAP has enabled companies to comply with the accounting standards and yet violate basic principles of transparency and risk disclosure.
Given the ground rules, auditors are not wholly to blame for helping finance chiefs negotiate their way through them. But the situation has fostered a culture of gamesmanship in which auditors help their clients engineer transactions to achieve their accounting objectives. Enron is a case in point. Andersen received millions of dollars for helping to structure Enron's labyrinthine network of off-balance-sheet entities. It clearly bears responsibility for not investigating what transactions the company was conducting in the entities more thoroughly, but at the end of the day, accounting rules may not have been broken.
The solution, says DiPiazza, is principles. Rather than focusing on whether or not the accounting complies with rules, executives and auditors should be evaluating whether or not it portrays the underlying economics of a transaction. "It's a lot harder for me to bend a principle than to bend a rule," says DiPiazza. He believes the International Accounting Standards movement, which relies more on a principles-based framework, can provide momentum for a similar approach in the United States. Of course, regulators may not be inclined to rely on the good judgment of auditors at this point, but integrity and adherence to principles are the only things that will restore confidence in the audit community and in financial disclosures. "The auditors have to be willing to take a position on principle," says Sutton.
The give-and-take between public companies and their auditors in the reporting of financial results won't disappear with the passage of a reform package. Accounting involves interpretation, and judgment will continue to play a part in how financial results are presented. "We want to be as transparent as possible, but we also want to help investors see our performance," says Banks of First Data. The two objectives will always create points of contention with auditors. "We have arguments about a lot of things. Some we win, some we lose," he says.
More than likely, the arguments will be a lot more vigorous going forward.
Andrew Osterland is a senior editor at CFO.
A Beautiful Friendship
The CFO Survey of Auditor-Client Relationships
For the second in a series of four surveys on corporate finance practices, CFO E-mailed questionnaires to 2,750 senior finance executives about their relations with their external auditors. Fifty-two percent of the 170 respondents carried the title of CFO or finance director, and 51 percent worked for public companies. All but two of the companies had their financial statements audited by certified public accountants.
The survey respondents represent a broad cross-section of industries and company sizes. The most-represented industries were financial services (11 percent) and health care (10 percent). Two-thirds of respondents worked at companies with less than $1 billion in revenue, 15 percent at companies with revenue of $1 billion to $3 billion, and 18 percent at companies with revenue of more than $3 billion.
The next two surveys will focus on investment-banking relationships and corporate-governance issues.
1. Has your auditor challenged any of your accounting practices during the past 12 months?
- Yes 38%
- No 62%
2. What part of your financial statements did this involve? (Based on 62 respondents who have been challenged. Total exceeds 100% due to multiple responses.)
- Reserves 69%
- Revenue recognition 36%
- Business combinations 12%
- Fixed assets 15%
- Investments 12%
- Leases 8%
- Other 8%
3. What was the result? (Based on 62 respondents who have been challenged.)
- Convinced auditor to go along with practice 25%
- Convinced auditor results in question were immaterial 32%
- Changed practice to secure auditor's approval 43%
4. Have you switched audit firms for any reason in the past three years?
- Yes 24%
- No 76%
What was the reason?
A majority of those that switched were former clients of Arthur Andersen LLP. Other common reasons for switching included mergers, price concerns, and mistakes by the former auditor. A few respondents cited the practice of regularly rotating auditors.
5. Have you hired your external auditor to perform internal audit as well?
- Yes 14%
- No 86%
6. Have you bought consulting services during the past three years?
- Yes 92%
- No 8%
7. In what area? Please check all that apply. (Based on 154 respondents who bought consulting. Total exceeds 100% due to multiple responses.)
- Tax 67%
- Information technology 52%
- Business combinations 36%
- Other 21%
8. Have you bought these services from the same firm that performs your external audit?
- Yes 54%
- No 46%
9. Did you work for your current external audit firm prior to joining your company?
- Yes 13%
- No 87%
10. Have you hired staff from your current external audit firm during the past three years?
- Yes 19%
- No 81%
11. Have you ceased any of the following practices during the past six months: (a) hiring enternal auditor to perform internal audit? (b) purchasing consulting services from external auditor? (c) hiring staff from external auditor?
- Yes 12%
- No 88%
Which one(s)? (Total exceeds 100% due to multiple responses.)
- (a) 30%
- (b) 70%
- (c) 35%
12. Do you plan to cease any of the practices referred to above during the next 12 months?
- Yes 9%
- No 91%
13. Do you think audit firms should be banned from providing consulting services to clients?
- Yes 48%
- No 52%
14. Do you think auditors should be barred from going to work for clients for a specified period?
- Yes 35%
- No 65%
15. Do you think companies should rotate audit firms on a regular basis?
- Yes 48%
- No 52%
International Turf Wars
The new corporate governance rules and auditor oversight prescriptions in the Sarbanes-Oxley Act will apply to all companies that file financial statements with the Securities and Exchange Commission as well as all firms that audit those statements. Not surprisingly, the rest of the world — with Europe leading the way — is not pleased with the extension of U.S. regulatory reach to any company that has shares listed on a U.S. exchange. "Forcing the U.S. solution on the rest of the world is not acceptable," Mike Rake, the international chairman of KPMG, told the Financial Times. Adds Samuel DiPiazza Jr., global CEO of PricewaterhouseCoopers: "It could start a regulatory war, and audit firms might withdraw from servicing U.S. companies abroad." Others have suggested that the regulatory reforms will make the U.S. markets a far less desirable place to raise capital.
Frederik Bolkestein, the EU commissioner in charge of financial regulation, says that the EU and its members are already taking steps to improve corporate-governance rules and to tighten market supervision. They do not need U.S. regulators to do the job for them, he adds.
At issue is the reach of not only the SEC but also the new board created by Congress to oversee the auditors. With the large audit firms set up as limited partnerships, auditors outside the United States are accustomed to operating under local rules and regulatory frameworks. The oversight board will have the responsibility of creating audit standards, investigating audit-firm conduct, and disciplining the firms if necessary. "I think it has been demonstrated that the U.S. does not have the right answers to all these problems," says Rake.
Looks like regulatory reform could be one more issue for the old world and the new to argue about. —A.O.
Signing on the Dotted Line
The pressure on auditors to sign off on aggressive accounting practices by corporate managers was immense during the 1990s bull market. One tactic that the Securities and Exchange Commission hopes will help reduce some of that pressure is to force senior executives to swear by their financial statements. The CEOs and CFOs of 947 companies with revenues of more than $1.2 billion will have to sign a written statement under oath certifying that their company's most recent 10-K filing, and any 10-Qs or 8-K filings since the year-end report, are complete and accurate. For most companies (those with December fiscal year-ends), the deadline was August 14. And with the passage of the Sarbanes-Oxley Act, all public companies will eventually have to certify their statements.
The SEC's order is being embraced by many corporate managers. "It goes with the territory," says Joe Martin, CFO of Fairchild Semiconductor. "It will make us all more cognizant of our responsibilities to shareholders." Other companies, many not on the list of 947, have also announced that they will certify their financial filings. "People want the markets to hear that they are standing behind their financial statements," says Dixie L. Johnson, a partner at Fried Frank Harris Shriver & Jacobson. She is advising senior-executive clients to keep a file on all their efforts to review the financial statements, including attestations from people within and outside the company as well as a record of meetings and discussions they have had as part of their due diligence. "The quality of the review they undertake will correlate with the quality of their defense if they're ever charged," says Johnson.
Not every C-level executive is keen on the new order. Sun Microsystems CEO Scott McNealy reportedly complained that it will force him to spend too much time slogging through financial statements rather than generating new business. Those executives who do not certify their financial statements, whether because their companies are in bankruptcy or undergoing a period of restructuring, must supply reasons for not doing so. Of course, CEOs and CFOs already sign off on financial statements, and are potentially liable for misrepresentations therein to shareholders. Under the Sarbanes Act, executives who "willfully" certify statements they know to be false can now be criminally charged with perjury or making false statements to the U.S. government, and can face jail terms of up to 20 years and fines of up to $5 million.
That could also take some heat off auditors. —A.O.