By Albert B. Crenshaw
Washington Post Staff Writer
Friday, December 5, 1997; Page G2

The Securities and Exchange Commission said yesterday that its staff, after a lengthy investigation, has accused accounting giant KPMG Peat Marwick LLP of violating professional standards and securities rules by auditing a company with which KPMG had extensive business relationships.

The agency said it would conduct a public hearing to determine whether the allegations are true, and if so what punishment is warranted.

The SEC staff contends that KPMG's 1995 "Independent Auditors' Report" of a financially troubled Long Island company called Porta Systems Corp. was not truly independent because of ties between the accounting firm, a consulting firm it organized, and the president of Porta, who was a part owner of the consulting firm.

Among other things, the accounting firm had lent $100,000 to the president of Porta, its audit client, and was entitled to a percentage of the earnings and other assets of Porta, the SEC staff charged.

KPMG Peat Marwick managing partner J. Terry Strange called the charges "a stretch" and said the firm "sought and obtained SEC approval" for the formation of the consulting firm, known as KPMG BayMark, in 1994. Its audit of Porta "was not affected in any way by the BayMark alliance," and "resulted in an opinion that expressed doubts about Porta Systems' ability to continue as a going concern," he added.

Strange said the firm "is committed to protecting its independence and takes those responsibilities very seriously. He said KPMG Peat Marwick would "vigorously defend" itself and expects to be vindicated.

The case is significant because it involves a growing issue in accounting. CPA firms are increasingly expanding into consulting and other "value-added" services beyond auditing, and regulators are concerned that these new relationships could compromise the independence of their audit reports.

Audited financial statements are the data on which investors rely when evaluating companies and their securities. The SEC staff did not address the content of the audit but rather questioned whether KPMG should have conducted it given its relationship with BayMark and Porta.

Any suggestion that the audits are less than objective or that the auditors could benefit by shading the numbers they attest to could in the long run be very damaging to the nation's financial markets.

The growing perception of potential conflicts of interest also worries the accounting profession. Earlier this year, the profession agreed with the SEC to establish a new Independence Standards Board to try to develop a better framework for evaluating auditor independence in today's business world.

The KPMG case, as outlined yesterday by the SEC, illustrates the complex relationships that sometimes exist:

In 1995, KPMG Peat Marwick organized KPMG BayMark, owned by Edward R. Olson and three others, to engage in new lines of business, such as turnarounds of troubled companies. Later that year, KPMG was hired by Porta, a manufacturer and distributor of telecommunications equipment, to help with its problems. That relationship led to the installation of Olson as Porta's president. At the time, Porta was an audit client of KPMG Peat Marwick's Long Island office.

Olson, whom the SEC staff called the "principal decision-maker at Porta," received the $100,000 loan, which created "a direct financial interest in Porta" for KPMG Peat Marwick, the staff said.

BayMark also was entitled to fees, including a "success fee" of 5 percent of Porta's earnings for three years plus a percentage of its inventory and restructured debt. BayMark in turn was required to pay 5 percent of its income to KPMG Peat Marwick, creating what the SEC staff called "a contingent interest" in Porta's earnings, inventory and debt. Because of these and other relationships KPMG "lacked independence" when it signed off of Porta's financial statements, which rendered them "materially false and misleading," the staff charged.

KPMG has 20 days to respond and a hearing will be scheduled within 60 days, the SEC said.