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Peekaboo: New boss over corporate audits is much like the old one

By David S. Hilzenrath
Washington Post Staff Writer
Friday, July 9, 2010; 1:21 PM

Outside auditors play a crucial role in the nation's financial system. As the watchdogs of corporate accounting, they are supposed to protect investors. But after a series of spectacular failures -- Enron, WorldCom, Tyco, Adelphia, Global Crossing and more -- Congress put a new cop on the beat.

Eight years later, has that cop -- a board to audit the auditors -- made your investments any safer?

It's called the Public Company Accounting Oversight Board (PCAOB) -- "Peekaboo" for short -- and figuring out what difference it has made can be like a game of hide-and-seek.

In fact, the board looks a lot like the system it was designed to replace: slow to act, veiled in secrecy and weak -- or weak willed.

The wave of accounting scandals that devastated share prices and destroyed the Arthur Andersen accounting firm years ago left policymakers questioning the value of the audits. With Andersen gone, the stakes became even higher: Like some of the companies they audit, the remaining Big Four accounting firms are now regarded as potentially "too big to fail."

When the Supreme Court rejected a challenge to the board's constitutionality in June, the board breathed a sigh of relief. But should you?

Along with other watchdogs, auditors failed to prevent the financial crisis of recent years that had at its roots the proliferation of shoddy subprime mortgages and securities based partly on "liars' loans." Whether auditors share responsibility is a subject of litigation and debate.

At subprime lender New Century Financial, KPMG auditors "acquiesced in New Century's departures from prescribed accounting methodologies" and at times "acted more as advocates for New Century," examiner Michael J. Missal wrote.

At Lehman Brothers, the investment bank that collapsed in 2008, examiner Anton R. Valukas faulted auditor Ernst & Young for, "among other things, its failure to question and challenge improper or inadequate disclosures."

The government gave the PCAOB the power to write new standards for auditors, but the board has made little use of that power. The old standards -- widely criticized as having been written by the auditing industry to insulate auditors from liability -- for the most part remain unchanged.

When auditors are suspected of negligence or complicity in cooking corporate books, PCAOB enforcement cases can take several years to resolve. In the meantime even the fact that the board is investigating is concealed from the public.

Most of the board's announced disciplinary actions have involved small audit firms that are not as equipped to fight back as the big accounting firms that generally audit the largest companies.

In some ways, the PCAOB has been hamstrung by the legislation that created it. In deference to the accounting industry, Congress imposed tight limits on what the board can disclose about documented or suspected auditor malpractice.

And the board is no stranger to the revolving door that often ties regulators to the industries they regulate. After leaving his job as the board's chief auditor last year, Thomas Ray joined the audit and accounting firm KPMG. Before going to work for the board in 2003, Ray was a partner at KPMG. Before that, he helped set auditing standards at the group that doubled as a lobbyist and rulemaker for audit firms before the PCAOB took over.

Lynn E. Turner, a former chief accountant at the Securities Exchange Commission, said he would give the board a "B" for its routine inspections of accounting firms, a "C-minus" or "D-plus" for its standard-setting, and an "F" for enforcement.

"There's still a good chance for this thing to work, but time is running out," said Turner, who serves on a panel of advisers to the board.

Another adviser to the board, University of Tennessee accounting professor Joseph Carcello, said the board has transformed the culture of auditing for the better, because audit firms know that the board is looking over their shoulder. But Carcello said the enforcement process "is unbelievably slow." While cases against auditors are pending, "no one knows the quality of their work is substandard," he said.

The firms that audit corporations are called independent auditors, but the term has long been a misnomer because those firms are hired and paid by the companies they audit. In the pre-Peekaboo era, the industry was largely self-regulated. When Congress responded to the scandals at Enron and WorldCom by passing the Sarbanes-Oxley Act of 2002, one of its top priorities was creating the new watchdog.

Although the board exercises regulatory power, it is a nonprofit organization, and it pays private-sector salaries: about $547,000 for members and $673,000 for the chairman.

Answers to SEC

Today the oversight board stands at a crossroads. Its future will be shaped largely by the Securities and Exchange Commission, which must fill three of the five seats on the PCAOB's governing board. The chairmanship has been vacant for almost a year. Another seat is occupied by a member whose term expired in 2009, and a third is held by a member whose term expired in 2008, leaving the board largely in the hands of lame ducks.

For much of its existence, the board has been on the defensive -- against business groups that criticized it for imposing excessive regulatory burdens, a Bush-era SEC that held sway over it, and the legal challenge to its constitutionality brought partly by a tiny accounting firm.

The Supreme Court decided the constitutional challenge June 28, ruling that the PCAOB can stay in business. But its brush with death left it even more subordinate to the SEC, which always controlled its purse-strings and had the power to block any of its actions. Where the Sarbanes-Oxley Act said the SEC could dismiss PCAOB members for cause, the Supreme Court declared that the SEC can remove them at will.

Barbara L. Roper, director of investor protection at the Consumer Federation of America, said that as a result of the corporate backlash, "I think the board became more timid."

"At the end of the Bush years, it wasn't so much captured by industry as captured by an anti-regulatory philosophy," added Roper, who is also on an advisory panel to the board.

The acting chairman of the PCAOB, Daniel Goelzer, who has been on the oversight board since its beginning, declined to be interviewed on the record. Board spokeswoman Colleen Brennan said she was unable to arrange an on-the-record interview with any other board official.

The board "is making a meaningful contribution to investor protection" but still faces "a variety of challenges to realizing fully the audit oversight that Congress envisioned," Goelzer told Congress in May.

The board "plans to aggressively improve auditing standards" by issuing several new ones this summer, Brennan said by e-mail.

Assessing the audits

One possible measure of audit quality is the number of accounting corrections, known as "restatements," issued by companies. They soared to 1,795 in 2006 from 614 in 2001 and then plunged to 674 last year, according to the research firm Audit Analytics.

Interpretations vary: The numbers may be driven by the extent to which companies are misstating their financial results -- or by the degree to which auditors and regulators detect errors and demand corrections.

Board inspectors continue to find serious lapses at audit firms. But the Peekaboo's public reports describe those shortcomings in opaque terms, they don't name the companies that were improperly audited and they offer little if any sense of perspective. They consist largely of boilerplate.

Some of the most detailed information about the performance of auditors in the lead-up to the financial crisis comes from reports of court-appointed examiners who have investigated major corporate bankruptcies.

For example, at New Century Financial, which operated with grossly deficient reserves, a dispute over what ultimately proved a small item illustrated larger dynamics. The day the company's 2005 financial statements were due at the SEC, a specialist on the KPMG audit team was still objecting to one of the company's accounting practices, according to the examiner's report.

The lead KPMG auditor sent the specialist an e-mail: "I am very disappointed we are still discussing this. As far as I am concerned we are done. The client thinks we are done. All we are going to do is piss everybody off."

With minutes to spare, KPMG issued a clean audit opinion. New Century Financial made its deadline -- and the company eventually changed its accounting, conceding that it was wrong, the examiner reported.

Lehman Brothers, whose implosion in September 2008 helped lead the financial markets to the brink of collapse, masked the degree to which it was leveraged by using an accounting device to remove tens of billions of dollars of assets from its balance sheet, according to an examiner's report. Ernst & Young was "aware of but did not question" the transactions and "took virtually no action to investigate" a Lehman executive's allegations of accounting improprieties, the examiner wrote.

A KPMG spokesman declined to comment; Ernst & Young defended its performance. "Throughout our period as auditor of Lehman, we firmly believe our work met all applicable professional standards, applying the rules that existed at the time," Ernst & Young said in a statement.

Based partly on the Lehman examiner's report, the PCAOB issued an "alert" in April reminding auditors about their obligations.

Investigates in secret

In the realm of enforcement, the PCAOB shares powers with the SEC and was intended to bolster the SEC's policing efforts. But Turner, the former SEC official, said the board may have the opposite effect. Because PCAOB investigations unfold in secret, audit firms "are much better off if the action is brought by the PCAOB where it can be kept under wraps, slowed down and dragged out without anyone knowing anything whatsoever about it," Turner said by e-mail.

The board's acting chairman made a similar point in recent testimony, saying the law gives auditors "an incentive to litigate, rather than settle, in order to delay any adverse publicity."

So far, the board has issued 31 disciplinary orders, some of which send mixed messages.

After the chairman of a computer services company in India confessed to inflating profits for several years and overstating a cash balance by $1 billion, two auditors affiliated with PricewaterhouseCoopers allegedly failed to cooperate with a PCAOB investigation. The board disbarred the auditors in March-- about a year after it first sought their testimony.

In 2009, the board disciplined a former Deloitte & Touche auditor for misconduct that allegedly took place more than five years earlier.

In another case, a BDO Seidman auditor was disbarred for allegedly backdating records to make it appear that an audit was done properly -- and directing a subordinate to do the same. The auditor left the firm, according to the order. Two years after disciplining him, the board reinstated his right to audit public companies.

Carcello, the Tennessee professor, said the outcome of some cases left him wondering: "What does it take to be disbarred for life?"

'Should' means must

In the realm of rulemaking, the board "gave teeth to auditing standards" by making it clear that, where the old rules say auditors "should" do something, "should" means must, board member Steven B. Harris said in a recent speech.

Others give the board less credit. The board has done "relatively little to update and improve standards of auditing," said William R. Kinney, an accounting professor at the University of Texas.

One of the board's initial forays into standard-setting was to prescribe requirements for audits of companies' internal controls -- the checks, balances and accounting systems that are supposed to ensure that investors receive accurate financial reports. Business groups mounted a counterattack, and the board issued another standard -- backtracking from the first.

Almost a year ago, the board said it was considering a proposal that accountants in charge of outside audits -- not just the audit firms -- be required to sign the opinion letters through which firms put their public stamp on corporate financial statements. The idea was to make auditors more accountable. Big accounting firms protested that the change would increase auditors' liability.

The proposal has not been implemented.

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