Sunday, July 10th, 2005

Once there were eight green bottles (known as the Big Eight) in the accounting profession. Then with consolidations and mergers these became six and were referred to as the Big Six. Then Price Waterhouse and Coopers and Lybrand merged leaving the Big Five amidst concerns that the consolidation of the auditing profession would effectively reduce the competition for professional services and standards could suffer. Then came Enron, the darling of Wall Street and - for a time - the shining example of the new corporation that dazzled even the top business writers and management gurus. As spectacularly as Enron rose, it collapsed three years ago under the weight of debt and poor governance, taking with it its auditors, Arthur Andersen, leaving the world's top corporations to be served by four truly international auditing firms. The Big Four - KPMG, Deloitte & Touche LLP, Ernst & Young LLP and PricewaterhouseCoopers LLP - audit four out of five public companies in the US, with an even greater concentration among the Fortune 500 companies.

While the danger has existed that the Big Four could reduce further, it was thought that the regulatory mechanisms including the very strict Sarbanes-Oxley Act of the USA and the quality control measures within the firms constituted a high probability against failure. Others felt that the firms were too big to fail. That complacency is now under question as according to The Wall Street Journal, officials of the Securities and Exchange Commission are discussing possible steps in the event of a collapse of one of the four.

This is not the first time that the SEC has pondered the unthinkable, and indeed, since the collapse of Andersen such thoughts have never been too academic or remote. However, the concern has re-surfaced following recent developments and according to CNN/Money has assumed some urgency in the wake of news that the Justice Department may indict KPMG LLP for allegedly peddling illegal tax shelters. The rules for changing auditors are very strict and companies must follow the complex and prescribed procedures which take some time to effect.

To avoid any gap between auditors, the SEC would be facilitating those procedures in the event of any of the top firms collapsing or being indicted, which could cause a run from that firm as its clients come to believe that even a clean audit report from it is automatically tainted. The Journal pointed out, however, that no decision has been made, that the discussions are purely preparatory and that the plan has to obtain the approval of Rep Christopher Cox, President Bush's nominee to succeed William Donaldson, the SEC's current chairman.

Each of the Big Four faces from time to time huge actions brought by shareholders and clients for the auditors' perceived failures in the quality of their work, whether through negligence or for other causes, and all of them have pending actions running into billions of dollars. Many of these actions would be covered by professional indemnity insurance, and while the reputational damage is not inconsiderable, the limited choice of audit firms and private settlement have tended to minimise the public perception of the frequency and gravity of the situation.

Mis-direction but no resurrection:

Ironically, the only good news about the profession coming out over the past few weeks relates to Andersen, when the US Supreme Court overturned the conviction of the accounting firm for its role in the Enron scandal. The reversal does nothing for the thousands of employees and partners who lost jobs and benefits and remain the butt of jokes in the financial world.

The court ruled that the instructions to the jury were faulty since the trial judge had failed to indicate some guilty intent on the part of the partners of the firm in urging its employees to shred documents related to its Enron audits. Returning to the bench after his cancer treatment, Chief Justice William Rehnquist wrote that the instructions "simply failed to convey the requisite consciousness of wrongdoing." The court noted that document-retention policies are part of the usual business practice and that "it is, of course, not wrongful for a manager to instruct his employees to comply with a valid document-retention policy."

Understandably, attorneys for the company interpret the decision as a vindication, but for the staff of the firm it is no more than a pyrrhic victory. They cannot now add this to their CV or get back their losses. At a wider level, the decision of the highest court in the land offers some hope to directors and auditors that it (the decision) will curb the enthusiasm of some regulators who are inclined to treat as suspect and hold companies and their top executives accountable for what had been, until recently, routine business practices.

And in a related matter, the Securities and Exchange Commission has dismissed a case against two former Arthur Andersen partners who were accused of causing Spectrum Information Technologies Inc to issue false financial statements in fiscal 1993 on the grounds that the SEC enforcement staffers had not proved their allegations.

Now for the bad news:

KPMG LLP has admitted that it is engaged in discussions with the Department of Justice to resolve a federal investigation into its tax shelter practices. In a press release issued by the firm it sought to distinguish the "the unlawful conduct by former KPMG partners" from the firm for which an indictment involving the obstruction of justice and the sale of abusive tax shelters could have catastrophic consequences.

Such fear has prompted firms to take very defensive and preventative action and the firm has indicated that it would no longer provide the services in question; that it has parted company with the errant partners including the head of tax planning; that it was establishing firm-wide structural, cultural, and governance reforms "to ensure the highest ethical standards" and that it has undertaken "significant change in its business practices."

While the Justice Department must naturally take the matter of wrongdoing very seriously, The Wall Street Journal speculated on a deferred-prosecution agreement involving a substantial fine and some form of probationary conduct.

Deloitte and Touche:

And in an unfortunate and inadvertent disclosure by the SEC, it has been reported that Deloitte & Touche is the subject of the first formal probe of a Big Four firm by the Public Company Accounting Oversight Board, a body established post-Enron to protect the integrity of the profession.

The probe is in respect of an audit in which the firm may have failed to comply with several auditing standards, "in possible violation of [Sarbanes-Oxley], the rules of the board, the provisions of the securities laws relating to the preparation of and issuance of audit reports and the obligations and liabilities of accountants," according to a report quoted on CFO.com, a reputable website.

In April, Deloitte agreed to pay $50 million to settle charges stemming from its fiscal 2000 audit of Adelphia Communications Corp.

But Deloitte is also facing other problems in Europe. In Italy, in connection with its audit of the Parmalat Finanziaria SpA, the giant Italian company which had a fake US$5B bank balance, Deloitte has said that it might be prepared to settle two billion-dollar claims out of court as "an economic decision," for as chief executive William Parrett told Reuters "If we could settle the suit to an amount equal to or less than the cost to defend it, [we would]."

After the collapse which was covered in Business Page on January 4 and 11, 2004, Parmalat's investors brought legal action, claiming more than $10B from Deloitte in addition to a separate $10B suit brought by Parmalat's administrator Enrico Bondi against Deloitte, joint auditor Grant Thornton, alongside Bank of America and Citigroup.

And in the UK, The Times of London has reported that that country's independent investigative and disciplinary body for accountants, the Accountancy Investigation and Discipline Board (AIDB) is probing Deloitte & Touche concerning possible tax avoidance at its audit client MG Rover, a collapsed British carmaker.

The AIDB has the power to reprimand accountants and accounting firms or impose an unlimited fine if it uncovers wrongdoing.

Conclusion:

These are clearly trying times for the auditing profession and the Guyana laws requiring even the smallest and worst run businesses to have an audit exposes the auditor to grave risks. The profession needs to lobby for changes in the law while its members supported by its practising members refuse to accept those audit appointments where a proper audit is clearly not feasible. It is not a happy time to be an accountant.