Last of three articles
By Albert B. Crenshaw
And here's a deeper conundrum: How can a profession that once prided itself on its almost monastic isolation from ordinary business pressures cope with a competitive whirlwind that has cut the number of major firms almost in half over the past two decades? Can traditional accounting ethics survive in such a world where the loss of a major global client can have a devastating impact on a firm's financial results?
The competitive pressures of the modern marketplace are causing ethical dilemmas for all of America's professions. But nowhere is the crunch more painful than in the accounting profession whose members are, quite literally, the referees and scorekeepers for American business.
Among those worried about the ethics squeeze is SEC Chairman Arthur Levitt Jr. He has repeatedly warned that the independence of the auditing function is being threatened by the growing business ties between accountants and the companies they audit. Levitt fears that in the increasingly competitive marketplace, accounting services have become a loss leader a way for the giant firms to get a foot in the door so that they can sell more lucrative consulting services.
The question troubling the SEC, according to Mike Sutton, who until last year was the commission's chief accountant, is "how close the relationship between the auditor and the management of the [company] can be without creating ... in fact or in perception, a mutuality of interest that could impair the auditor's independence. At what point does the auditor become so involved in the success of the company and its management as a consultant or an adviser or a provider of a variety of newer services that there is a risk that private interests might be placed ahead of those of investors ...?"
An example of the business links that concern the SEC was a move by KPMG Peat Marwick LLP several years ago to offer consulting services to some longtime clients. The commission initially approved a 1994 KPMG proposal to establish an alliance with a newly formed consulting firm called KPMG BayMark Capital LLC. But the SEC decided the next year to reexamine the plan. Commission officials worried that KPMG's two hats auditor and management consultant potentially compromised the independence of its audits.
Then, in June 1996, the SEC's enforcement division launched an investigation into KPMG's dealings with one of its audit clients, Porta Systems Inc., a publicly traded maker of telecommunications equipment. Porta had retained KPMG BayMark to sell securities and had installed a former BayMark executive, Edward R. Olson, as its interim chief operating officer.
What troubled the SEC was that the firm had previously made a $100,000 loan to Olson. The SEC viewed that loan as a form of financial help to Porta, which would violate a ban on lending money to audit clients. Further, the agency staff found that because the accounting firm was entitled to a share of the consulting firm's profits, and KPMG BayMark in turn was entitled to a share of Porta's profits, KPMG had a financial interest in Porta, its audit client.
Last December, the SEC brought an enforcement action against KPMG, contending that the firm violated the independence rules in a number of ways in the BayMark matter. KPMG denies any wrongdoing contending that it "sought and obtained SEC approval of the BayMark alliance in 1994" and said it will "contest this unwarranted and unreasonable action."
In another instance involving KPMG BayMark, KPMG quit in 1996 as auditor of a small computer software company using BayMark for investment banking services following questions from the SEC about the appropriateness of the relationship.
KPMG ended its alliance with KPMG BayMark, which was later dissolved.
Another sign of the SEC's growing concern about accounting ethics is that at the end of last year it had about 100 accounting investigations pending in its enforcement division, according to senior commission sources. Many other cases have been settled over the past few years, sometimes informally, sometimes more formally with consent orders and censures.
Consider three actions taken last year:
The new pressures to cut corners worry the accounting profession enough that it agreed last year with the SEC to establish a new Independence Standards Board (ISB). The panel, which will include representatives of the public, will try to develop a better framework for evaluating how auditors can protect their independence in the increasingly competitive environment.
Up to this point, the SEC and the profession, which largely regulates itself, have relied on interpretations of past cases for guidance. Something "more subtle and sophisticated" is needed, something "beyond what's obvious and that reflects whats going on in the marketplace," according to John Hunnicutt of the Washington office of the the American Institute of Certified Public Accountants (AICPA).
The accounting profession doesn't want to lose its freedom to offer lucrative consulting services. The AICPA acknowledged in a white paper last October that business pressures "are redefining the audit function, placing new demands on auditors and permanently altering the relationships between accounting firms and their clients." However, the white paper said, "There is no evidence that the supply of non-audit services threatens auditor independence."
Barry Melancon, president of the accountant's association, said that consulting actually helps make an accounting firm more expert. "Because of the complexity of the business environment, the more [accountants] know about a business the better job they can do in an audit."
The head of the accounting standards board, William T. Allen, said the panel needs more information before it issues any new edicts on ethics. He noted that the SEC and the AICPA have different views of the problem, and that "the empirical data out there is not very good or very deep."
"The real conundrum facing ISB is the question of the appearance of breaches in the independence of audits," said New York University accounting professor Paul Brown. "Maybe the sophisticated investor knows you can have consulting or investment banking services provided to audit clients without creating real conflicts of interest. But unfortunately appearances of integrity matter here."
Accountants at large firms, while reluctant to speak on the record, concede that such pressures exist and that they could be perceived as a threat to auditors' independence. But they stress that big firms have some adequate safeguards in place to ensure audits' integrity.
These safeguards include careful screening of clients to weed out those that might want to press the envelope too hard, and home office review arrangements designed to spot problems and provide support to a partner who might find himself or herself under pressure.
"Sure, we want to sell our expertise, but integrity is the key to our business," said a partner in the Washington office of a large firm. Without that, a firm can't survive.
Waste Management Inc. offers an example of the issues that can emerge in a longtime auditing relationship. Last year, Steve Miller, the company's chief executive, met with representatives of his largest shareholders and did something that's highly unusual in Corporate America: He accused his auditing firm, Arthur Andersen & Co., of being too easy on the company.
Miller said that past audit reports had been "weak," according to Nell Minow, a partner at Lens Inc., a Washington-based investment firm that has invested in Waste Management since 1995. Miller was responding to shareholder complaints that Andersen had repeatedly endorsed Waste Management's earnings figures, only to revise them downward later because of "special charges" totaling $2.5 billion over eight years the auditors had missed initially.
"We have always been uncomfortable with the numbers reported by the company," Minow said. She worried that the auditors may have shaded their financial reviews to please two top company executives who were themselves former Andersen managers in an effort to maintain the lucrative contract. "I have encouraged management to switch auditors," she said.
Miller said he cannot recall his precise language, but confirmed that he discussed the company's need to improve its accounting and auditing standards. An Arthur Andersen spokesman said the firm does not comment on its dealings with clients. Andersen continues as Waste Management's auditor. However, Waste Management recently agreed to merge with USA Waste Services. Who will audit the resulting firm is currently undecided, a Waste Management spokesman said.
Such controversies are likely to increase as shareholders and the SEC scrutinize the accounting profession more carefully. The underlying question is whether financial pressures on auditing firms will undermine the profession's integrity.
"The gloves came off in accounting some 10, 15 or 20 years ago," said Roman L. Weil, a professor of accounting at the University of Chicago. "That's when accountants allowed themselves to start competing with each other for audit jobs. When you start competing, prices go down. An audit is like a commodity. It's easy to work down the price."
Most accountants today acknowledge the new pressures, but say that the profession has been able to cope with them and render disinterested expert opinions.
"We think as a profession our record in 30 years" is something to be proud of, given "all the assets under protection, the pensions, the traffic in capital that has moved through the stock exchanges, the number and complexity of transactions," said the AICPA's Hunnicutt. "We think our integrity is not an issue in question."
Integrity on the Line
James R. Adler of American Express Tax and Business Services and formerly of Checker, Simon & Rosner in Chicago, recalled a client who was planning an initial public stock offering that would realize $10 million. The client was going to put that money into Treasury bills in his own name until it was needed for investment. "The investors were going to enrich his own pocket," Adler recalled.
When Adler insisted on disclosure, he recalled, the client "had a real problem with that. He screamed at me. He threw me out of his office. He told a partner here he never wanted to hear my name again."
But the accounting firm insisted and the disclosure was made. Later, when the project ran into trouble, investors threatened to sue. But the client was protected from this legal threat because the information had been properly disclosed, Adler recalled.
The client "is now my friend. He says I saved him millions of dollars," Adler said.
A Changing Environment
"There is a legitimate question now of independence," Weil said.
That question is crucial to regulators, and, ultimately, to the investing public.
Since 1933, when Congress wrote the laws that govern U.S. securities markets, auditors have shouldered much of the responsibility for preventing financial fraud against investors in publicly traded companies. That's why the SEC oversees the profession's self-regulation, sets reporting standards for companies and brings enforcement cases against auditors and companies that fail to accurately report to shareholders and regulators.
Critics, though, say the internal safeguards don't always work.
"I have found memos in the files of accounting firms which clearly stated that our objective is to get this other business," said Melvyn I. Weiss of Milberg Weiss Bershad Hynes & Lerach, a New York law firm that often represents shareholders in suits against corporations, their auditors and others.
"They would get very upset if the client went and got some other Big Six or Big Eight firm to give some consulting work to. ... That's the major sea change in the profession that creates this moral-ethical dilemma," Weiss said.
For smaller firms, the new competitive pressures have meant the loss of some of the bread-and-butter business that sustained them in the past.
"A lot of traditional services have gone in-house," said Ron Klein of CAMICO Mutual Insurance Co., which writes liability insurance for small and medium-sized accounting firms. "In the old days, every company had a CPA doing the books. Now you can get software for 49 bucks and do it yourself.
"This has caused tremendous economic stress on the dynamics of the [accounting] practice. Given human nature, this causes what you might term 'stress' on the ethical equation. When times are good it's pretty easy to be very ethical," Klein said.
The crunch comes when standing up to the client might result in a real economic blow to the firm. Klein said that in his experience conscious dishonesty by accountants is "extremely rare. It's more often where reality pushes up against good ethics. In the heat of the moment, people make not very good decisions or decisions that in hindsight don't look very good."
Such considerations also extend to large accounting firms. Though firms argue that they would give up even the largest client rather than compromise their standards, dependence by a single office or partner on one large client raises troubling concerns, regulators and others say.
"The difference today is partners can be fired. [Partnership in a big firm] is not considered a lifetime job, as it was 30 years ago," said Prof. Stephen E. Loeb, who teaches an accounting ethics course at the University of Maryland.
Can a partner today stand up to a client, lose the client and not be fired? Loeb wonders. "The ultimate proof would be to get one of the major firms to give a list of all their former partners who separated under less than voluntary circumstances, and correlate that" with lost clients. "Then you could tell," he said.
AICPA's Hunnicutt doubts that sort of client blackmail happens. "I'd be startled if any firm let go a partner who stood up to a client on the basis of professional ethics or integrity. ... I'd be dumbfounded," he said. "There would be very hard consequences for a partner in a firm that jeopardized that firm's reputation for a fee."
As in most professions, the real problems aren't the big things the gross breaches of ethics but the little things. What clients want isn't an outright lie, but a shading that casts the client's situation in the most favorable light.
These real-life dilemmas usually involve complex auditing issues that are open to professional debate such things as recording the full value of a contract into current income even if there might be some doubt about its completion, or carrying assets on the balance sheet when there might be some doubt about their value, or treating marketing expenses as capital costs in a way that improves a company's bottom line.
"I call these Pepto-Bismol moments," said CAMICO's Klein. "If you get one once a year that's not too rare. When you start getting them weekly, that's time to give us a call."
© Copyright 1998 The Washington Post Company