A Worldwide Trail of Failures

by Janice Shields

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 ędeep 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:

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:

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:

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:

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