Economics

A Worldwide Trail of Failures

A COMPANY'S ACCOUNTANT is entrusted to record information about financial transactions, summarize the data and prepare reports for the public based on rules established by the profession and government. Unfortunately, the accountant possesses a bag of tricks which enables him or her to manipulate financial data to make the company look healthier than it is. The process of artificially pumping up net income or net assets is known as "cooking the books."

 The company hires external auditors as independent watchdogs to assure the investing and lending public that the financial statements are free of material misstatement. The auditors are supposed to review the company's financial statements and internal controls and issue opinions about the quality of the reports. Auditing standards are also established by the profession and government.

The "Big Six" auditors are the major players in the worldwide auditing game. Headquartered in the United States, these companies are organized as partnerships, so they are not required to disclose information about their operations to the public. A spokesperson for one of the Big Six, Arthur Andersen, even refuses to identify the countries in which the firm operates, claiming it is proprietary information.

The Big Six firms have been key players in a recent spate of audit failures around the world which are beginning to undermine the internal system of accountability on which the business world relies. But instead of focusing on improving their practices and regaining the public's trust, the Big Six have launched a full-scale campaign to reduce their liability for failed audits.

Auditing firms claim that they are sued not because of bad audits, but because, unlike their bankrupt clients, they have the money to pay aggrieved shareholders and other creditors. Testifying at an August 1994 U.S. House of Representatives committee hearing on a bill that would have limited auditor liability, J. Michael Cook, chair and chief executive officer of Deloitte & Touche explained, "We are joined in the suit because ... we are viewed as a ædeep pocket' whose supposed resources make the litigation financially worthwhile to the plaintiff's lawyers." He admitted that "mistakes were made" by the auditing firms, but recommended that the hearing "should not focus on finger-pointing about errors in the past."

S & L complicity

 Deloitte & Touche is hardly well positioned to argue for letting auditing bygones be bygones, however. U.S. government regulators have connected the firm to a number of savings and loans failures.

In March 1994, Deloitte & Touche agreed to pay $312 million to settle $1.8 billion in lawsuits and other claims brought by U.S. bank regulators. At the time, the Office of Thrift Supervision (OTS) issued a 120-page report detailing the firm's alleged violations. Among the OTS's allegations:

• Franklin Savings Association improperly deferred recognition of at least $119 million in losses on financial futures contracts. According to the OTS, even though Deloitte & Touche was aware of Franklin's improper accounting practices, Deloitte's audit opinion declared that the financial statements were fairly presented in conformity with generally accepted accounting principles.

• Columbia Savings and Loan Association classified its bond portfolio as an investment account, but should have classified it as a trading account. (Gains and losses on investment accounts are recorded in the accounting records when the investment is sold; gains and losses on trading accounts are recorded when the market value changes.) As a result, Columbia recorded $45.3 million in gains on sales of corporate bonds even though the bank actually had unrealized losses of $159 million. (Trading account losses are recorded when the market price of the bonds drops, even though the losses are unrealized until the bonds are sold.) According to the OTS, Deloitte & Touche failed to seek and examine competent evidence and instead accepted Columbia's classification and method of accounting for its bonds.

• Deloitte failed to review and analyze properly City Federal Savings Bank's allowances for loan losses, which are established to reflect estimates of outstanding loans that will not be collected. It therefore failed to discover that City Federal's allowances were understated by at least $55 million.

• Deloitte & Touche permits its auditors to discard preliminary documentation prepared in connection with audits of insured depository institutions. In violation of generally accepted auditing standards, adequate records of the work performed and procedures applied did not exist because information from the destroyed documents was not included in the audit workpapers.

Deloitte & Touche consented to the OTS's order without admitting or denying any of the allegations.

Worldwide failures

 The audit failures illustrated by Deloitte & Touche's shady past are not unique to the United States. The Big Six have settled and face charges around the world:

• In a letter to civil servants, the chief accountancy adviser to the British Treasury warned against awarding public sector contracts to 13 Deloitte & Touche professionals. The blacklisting is believed to be connected to the government's legal efforts against the firm to recover $234 million that the government paid investors in Barlow Clowes, a fund management company that Deloitte & Touche audited and which later collapsed.

• In Ireland, Ernst & Whinney (now Ernst & Young) reached an out-of-court settlement for $118 million with AIB Group, Ireland 's largest bank and administrator of the Insurance Corporation of Ireland. AIB accused Ernst of negligence when the bank discovered that an insurance company, audited by Ernst, that it had purchased just 12 months previously faced serious and unexpected losses on its underwriting business.

• KPMG was accused of faulty auditing which contributed to the $2.1 billion crash of Tricontinental, the merchant-banking arm of the State Bank of Victoria in Australia. The firm reached an out-of-court settlement for $106 million, but claimed that it had conducted its audit properly and that the audit did not extend the problem which led to the bank losses.

• The Spanish Institute of Accounting and Auditing recommended that Coopers & Lybrand be fined $300,000 due to alleged infringements of accounting norms in its audits of the Kuwait Investment Office's Spanish holding company, Torras Group. Torras' accounts, initially audited by Coopers, had shown profits of $31.8 million. At the request of Torras' new management, Coopers & Lybrand performed a subsequent audit that reported losses of $218 million. Coopers denies negligence, arguing that its previous audit report had included "qualifications," or concerns about the company's accounting practices or internal controls.

• In the United Kingdom, groups of Lloyd's of London investors, called "names," have sued Ernst & Young and have authorized legal proceedings against Arthur Andersen for alleged negligence in their auditing of Lloyd's. The names claim in a suit that the auditors "were negligent in that they failed to prevent under-reserving in earlier years of account, failed to identify the inadequacies of the reinsurance policies, and failed to identify the inadequacies of the manner in which the underwriting affairs were being conducted." The riskiness of the operation was therefore unknown. Ironically, the auditing firms' professional indemnity insurance is underwritten at Lloyd's - so the names may be suing themselves.

Who examines the examiners?

 At times, the Big Six find themselves on opposite sides of audit cases. For example, in the United Kingdom, Deloitte & Touche received a writ from Price Waterhouse, the administrators of the close-out of failed computer leasing company Atlantic Computers, over an audit of the company. Price issued the writ because the firm expected legal action by Ernst & Young, the administrators of Atlantic's former parent company, British & Commonwealth. Ernst & Young alleged that Atlantic had misstated its financial position when Atlantic was purchased by British & Commonwealth. In a simultaneous British case, the plaintiff/defendant roles have been reversed: Price Waterhouse faces approximately $12.5 billion in legal claims from the Deloitte & Touche liquidators of the collapsed Bank of Credit and Commerce International over Price's audit of the bank.

 In Italy, shareholders in the agrochemical group Ferruzzi Finanziaria and its industrial subsidiary Montedison plan to suePrice Waterhouse in the wake of the administrator of Ferruzzi and Montedison's finding of serious oversights in Price Waterhouse audits of the group's accounts over a number of years. He outlined a catalog of accounting malpractices, including: an irrecoverable credit of $261 million to a company in the British Virgin Islands, recognition of revenues of $146 million on nonexistent sales and huge undocumented payments to offshore companies, supposedly for consulting work. Many of the accounting irregularities were brought to light by fellow Big Six firm Deloitte & Touche.

But with Big Six firms alternatively filing and facing charges involving their fellow Big Six firms, questions of independence inevitably arise: are the firms actually shielding each other? In the United States, for example, First Home Savings Bank filed a lawsuit alleging that KPMG and Deloitte & Touche had conspired to cover up substandard audit work. The lawsuit accuses Deloitte & Touche of negligence in failing to detect an embezzlement of $6 million. For two years, Deloitte & Touche repeatedly refused to turn over key documents and finally said that a significant portion of them had been destroyed in a fire. First Home claims in its lawsuit that KPMG's initial report on Deloitte & Touche's audit work had stated that Deloitte had "failed to exercise due professional care in the performance of its examination." The lawsuit also alleges that KPMG removed the negative conclusions and agreed not to make any negative statements about Deloitte's work, even if KPMG discovered negligence by the accounting firm. KPMG and Deloitte deny the conspiracy charges. According to a KPMG spokesperson, "The client obviously got a report from us that they didn't like and have now resorted to making absurd charges against us."

Seeking relief worldwide

 As the Big Six face and file mounting charges of audit negligence worldwide, they have banded together to pressure national governments to reduce accounting firms' liability for bad audits. The firms claim that shareholders and other parties injured when a company fails sue the auditors because the auditors are believed to have "deep pockets" - money to pay settlements.

 In March 1994, with heavy backing from the Big Six, Christopher Dodd, D-Connecticut, introduced the misnamed Private Securities Litigation Reform Act of 1994 in the U.S. Senate. If passed, the legislation would have made it much harder for stockholders to bring suits against those responsible for company losses - including not only boards of directors, but auditors. Specific provisions of the bill would have:

• excluded small stockholders from filing claims;

• imposed the winner's fees and costs on the losing party if the loser refused to proceed under an alternative dispute resolution procedure, thus making participating in a class action suit too risky for many victims;

• required plaintiffs to demonstrate the state of mind of each defendant at the time the alleged violation occurred;

• modified the joint and several liability rule to require that damages be proportioned according to each party's degree of responsibility. (Joint and several rules assume that a fraud could not have occurred if at least one of the participants had revealed its existence. Therefore, all participants are equally responsible for the outcome of the fraud and each is 100 percent liable for any damages. The proposed modification would mean injured plaintiff shareholders in a bankrupt company could not recover the full cost of their damages from the audit firms which failed to uncover improper accounting practices that contributed to the company's bankruptcy.); and

• limited the time period in which an action for loss could be launched.

The bill did not reach the floor of the Senate, but accountants are hoping for favorable action in the next session of Congress. To that end, the Big Six and their trade association spent $2.3 million in campaign contributions to support House and Senate candidates in the recent election. The largest slice of the Big Six action came from Ernst & Young's political action committee (PAC), which paid a total of $346,210 to 283 federal candidates. The biggest winner of the accountants' PAC payout was Representative Billy Tauzin, D-Louisiana, who introduced a House bill similar to the Senate's last session; he received $70,000.

On the other side of the globe, the New Zealand Society of Accountants is pushing for a similar set of proposals to limit auditors' liability. The Society has moved away from its original idea of a liability cap. Instead, it has proposed a wish list of measures, including:

• the incorporation of accounting firms, which would insulate auditors' personal assets from liability suits;

• modification of the joint and several liability rules for accounting firms;

• introduction of the concept of contributory negligence for the assessment of losses; and

• a cap on the amount of time in which victims could file claims.

Those in the New Zealand government "are going to have to do something," a partner at Ernst & Young told The Accountant, calling the mounting negligence claims against auditors "absolutely ridiculous."

Investors strike back

 Investors are starting to fight back against auditing failures and the auditors' political offensive. For example, fed up with the state of auditing in Canada, the Canadian Investor Protection Fund, a $75 million trust established in 1969 by Canadian stock exchanges, has started to develop its own auditing examination; only auditors who pass it will be permitted to audit Canada's brokers and investment dealers. In addition, the Fund is revising its uniform audit instructions and plans to spell out more forcefully how extensive audits must be before auditors can vouch for companies' accounting practices.

According to Donald Leslie, the Fund's president, "We have found that the quantity of [audit] work has declined to the extent that the statistical probability of an auditor detecting a material error, if it exists, is now often less than the flip of a coin - or 50 percent. ... Over the past 20 years, [the amount of work done in an audit] has been gradually reduced by perhaps as much as 50 to 75 percent." He claims, for example, that an auditor used to inspect inventory at 10 client locations, but now might count it at only three.

Meanwhile, working counter to the Fund is the Canadian Institute of Chartered Accountants (CICA), which is calling for the standard package of reforms, including modification of the joint and several rule and incorporation and other limits on the liability of individual partners. According to CICA, "We believe that the public's interest is best served when management, directors and auditors can play their respective roles without fear of unreasonable liability."

The international auditing firms are supposed to serve as independent watchdogs, exposing corporate abuses worldwide. But they are failing to live up to the level of public trust that their profession should engender. The changed perception is well illustrated by Donald Leslie, president of the Canadian Investor Protection Fund, who claims, "Twenty years ago, when I looked at audited financial statements, I was able to put a lot of faith in them. Now, I don't trust them at all."

The Big Six Auditing Firms and the Number of Countries in which they Operate

Arthur Anderson 74
Coopers & Lybrand 120
Deloitte & Touche 108
Ernst & Young 164
KPMG Peat Marwick 110
Price Waterhouse 117