WHEN TIES UNBIND
As their profession undergoes the big fix, auditors weigh in on reform.
By Andrew Osterland

Before the collapse of Arthur Andersen - a US company founded in 1913 and, up until last October, a name synonymous with starched white-collar probity - the big accounting firms fought tooth and nail to retain their auditing and consulting businesses under one roof. Starting with Enron, the US scandals have changed all that. With little ceremony this year, KPMG, PricewaterhouseCoopers (PwC), Deloitte Touche Tohmatsu (DTT) and others began separating their auditing and consulting divisions whole cloth, or erecting barriers between the two. "The firms are all in defensive mode," says Michael H. Sutton, a former chief accountant at the US Securities and Exchange Commission (SEC). Sutton was testifying in Congress during the hearings for the landmark Sarbanes-Oxley Act, which introduced sweeping changes to securities law, corporate governance and the regulation of auditors. "There's a void of leadership in the audit industry," adds Sutton.

Now, top executives in the auditing industry are attempting to fill the void by weighing in on the direction reform should take. They are - ever so slightly - taking exception to the stringency of reform, defending their profession against ill-considered measures rooted more in politics than accounting. Among them is PwC's global chairman Samuel A. DiPiazza Jr, who in recent statements has warned that limitations on the auditors' range of practice may backfire. Nonaudit services, he argues, are also essential to the audit work. "To perform good audits, we need more skills than just forensic accounting," he told CFO in the US, CFO Asia's sister publication. Among these 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.

"Auditing standards should be established by accountants, not by regulators and lawyers," says Ed Nussbaum, CEO of Grant Thornton, which, with US$342 million in revenues last year, is the sixth-largest audit firm in the US after Arthur Andersen officially ceased operations on August 31. "When standard-setting becomes a political event, it changes depending on what's popular, and that's not good for standards." He adds, almost wistfully: "No one could have imagined all the changes that have happened and are still happening in the industry. It's mind-boggling."

A Systemic Failure

Mind-boggling, but understandable. By any measure, audit firms have failed miserably in their role as financial watchdogs. It's no secret why. 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 US$5.7 billion in fees paid by 1,200 public companies to their auditors in 2000 was for nonaudit services.

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. The evidence of collusion between auditors and financial managers in many of the corporate scandals to emerge in the past year has vindicated the tireless campaign of former SEC chairman Arthur Levitt to separate the auditing and consulting arms of the big accounting firms.

In his seven-and-a-half years as SEC chairman, Levitt pushed the issue of auditor independence, arguing that corporate audits were being compromised by the firms' growing reliance on other sources of revenue. "Some firms used to refer to audits as a commodity," says Nussbaum. "No one believes that now."

Farewell, Auto-regulators

Nothing underlined auditing's central role in this season of scandal and reform more than the Sarbanes-Oxley Act, which passed both the House and the Senate of the United States Congress by huge majorities and was signed into law on July 30. The law will place new restrictions on the services that auditors can provide for their clients, and provides for an independent board to oversee the industry for the first time in the industry's history. The US 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.

The Sarbanes-Oxley 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.

The intervention of such a politically charged act of Congress into the staid world of accounting is unprecedented. 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 AICPA and its predecessor organization performed the job.

Industry self-regulation, however, has often meant no regulation. The recently dissolved Public Oversight Board (POB), 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 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. Others in the profession echo this sentiment.

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 Charles Mulford, an accounting professor at the Georgia Institute of Technology. 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.

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.

Pressure from Without

Investors have already been ensuring a kind of de facto reform, by 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 US$19 million - only US$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 US$3.9 million of a total bill of US$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 company to perform Highmark's actuarial work.

Joe Martin, CFO of Fairchild Semiconductor, has to choose a new provider of internal audit services for his Maine-based company. His auditor, KPMG, 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 also hired KPMG for such other services as human resources management and appraisal work. He has recently been interviewing alternative providers.

Second-guessing GAAP

PwC's DiPiazza admits that the audit industry shares much of the blame for investors' - and clients' - loss of confidence in its ability to resolve the inherent conflicts between auditing and consulting services. "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 recent book. 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 towards a new auditing framework, we need to consider all the pieces of the puzzle," says DiPiazza. US generally accepted accounting principles, long considered the best accounting standard 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 past ten years, US 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 US. 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 David Banks, head of corporate communications of electronic payment services company 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 in New York.