Number Crunchers in Chastened Posture as New Rules Take Hold

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Accounting for Differences

Number Crunchers in Chastened Posture as New Rules Take Hold

By KATE BERRY

Staff Reporter

After all the bad publicity, new regulations and high-profile bankruptcies, auditors are erring on the side of caution these days.

Creative accounting practices, such as acceleration of revenue recognition and off-balance sheet debt, are still legal, but auditors view them with wariness. Audit committees now vet commonplace practices, such as giving tax advice on business transactions or signing off on aggressive management assumptions.

Bob Pearlman, an audit partner in Los Angeles at BDO Seidman, said auditors are “drawing a line in the sand,” primarily because of the huge threat of liability. He remembers in the not-so-distant past when a company could make a change to its financial statements simply by calling its auditor. No more.

“It used to be we were an advocate for our clients’ position and we could be creative and find ways to support what a company wanted to do,” he said. “Now, if you find sufficient deficiencies or material weaknesses, they have to be disclosed to the public.”

For all the reforms, accounting troubles still plague U.S. corporations. Last week, federal regulators announced that they had uncovered improper practices at Fannie Mae, the government-chartered finance company that underwrites a huge swath of the nation’s home mortgages.

Among the classic accounting gimmicks used: deferring expenses to meet executive bonus targets, using hidden “cookie jar” reserves to inflate earnings, and not complying with generally accepted accounting principles for hedging transactions.

KPMG LLP, the firm’s auditor, said it “stands behind” its audit work, according to a spokesman, Tom Fitzgerald, who was quoted by Bloomberg News.

While the extent of the financial restatement at Fannie Mae hasn’t been determined, investors have already paid a price. The news shaved more than $8.5 billion of market value in just two days.

But accountants say far more procedures are now in place to protect against fraud and even inadvertent mistakes.

“There’s no question that our profession had a strong wake-up call and our members are doing the best they can to do what is right,” said Arleen Thomas, vice president of professional standards and services at the American Institute of Certified Public Accountants. “I think the general profession was very upset, unhappy, with the several gentlemen who allegedly did these things.”

Blaming the system

Some academics argue that because accounting is not based on hard numbers more art than science auditors may unintentionally distort financial statements to favor their corporate clients.

After all, accountants have a vested interest in the outcome of their audits. They are paid by companies, and they can be fired for issuing negative opinions.

“Is the game-playing still going on? Yes,” said Kenneth A. Merchant, the Deloitte & Touche chair of accountancy at USC’s Marshall School of Business. “The thing to keep in mind is that in almost every financial statement a lot of numbers are based on estimates of the future. And anything that involves an estimate about the future can be manipulated.”

Don A. Moore, an assistant professor of organizational behavior at Carnegie Mellon’s Graduate School for Industrial Administration, sees a fundamental problem that all the new rules in the world can’t cover completely: a favorable bias toward clients. He’s studied the unconscious ways in which all individuals form rationales to support their desired views.

Another academic, Joshua Ronen at New York University’s Leonard N. Stern School of Business, has proposed a novel way of aligning the interests of accountants, corporations and shareholders in obtaining the best financial audits. He believes public companies should be required to purchase accounting insurance, with premiums based on the expected risk or accuracy of their financial statements.

Insurers would then hire their own auditors, who would have no interest in the final outcome of an audit.

“A company that knew its cost of capital would be dependent on its financial statements would have it in its best interests to get the best quality financial statement and to get a lower premium from its insurance carrier,” Ronen said.

Ronen points out that under the current system, as many as 600 class-action lawsuits are litigated every year against corporations that received a clean bill of health from their auditors.

Securities and Exchange Commission Chairman William H. Donaldson and others are looking at the idea.

The high road

Meanwhile, auditors have never been in more demand.

The Big 4 accounting firms KPMG, Ernst & Young, Deloitte & Touche and PricewaterhouseCoopers have seen as much as a 30 percent jump in their workloads due to Section 404 of the Sarbanes-Oxley Act, which requires that corporations set up internal financial controls and have auditors check them for weaknesses.

Tony Anderson, managing partner in the Pacific Southwest for Ernst & Young, said radical changes have come about from the increased involvement of audit committees and the requirement that chief executives and chief financial officers sign off on financial statements.

“I was with a CFO recently and he said that in the old days he would get dozens of ideas coming from his own people about things they could do in their reporting,” he said. “Today, he doesn’t get any phone calls.”

Tony Buzzelli, regional managing partner in Los Angeles at Deloitte & Touche, said documenting a company’s financial statements has become the biggest focus for accountants.

“There has been more pressure in the past than there is now to push earnings,” he said. He also pointed out that accounting is not always subjective. Many businesses simply don’t make money the old fashioned way, so their books aren’t as clear.

“When you back a truck or a rail car up filled with goods, you have evidence of a transaction,” he said. “When somebody sells you a computer system and you’re going to provide training and service over a three-year period, how do you rip apart the various elements of that?”

Still, the traditionally cozy relationships between auditors and their clients have not been put to rest.

Auditors already are complaining that Section 404 will “ding” as many as 20 percent of their customers. They fear that investing shareholders will overreact to any news of internal control weaknesses by selling off shares.

“I’m not sure if the public will understand what the disclosure is going to mean,” said Anderson. “If there are deficiencies, it doesn’t necessarily mean a company’s financial statements are bad. It means they have a deficiency in internal controls. The market will react and investors are going to have to interpret it and they are going to need to do some work to understand what the different reports mean.”

Inherent in the argument is that the new regulations, which have a disclosure mechanism designed to give the investing public a heads-up on deficiencies at companies, will somehow tarnish corporations and their auditor relationships. In other words, the public doesn’t need to know so much.

Because of the regulatory changes from Sarbanes-Oxley legislation, which was passed in 2002, many accounting firms are trying to put past transgressions far behind them.

Just last week, the California Board of Accountancy put Ernst & Young on three years’ probation for engaging in a business relationship with PeopleSoft Inc. at the same time it served as its auditor, from 1994 to 2000.

The PeopleSoft matter had already led the SEC to bar Ernst & Young in April from accepting any new publicly traded audit clients for six months.

Yet last week the firm notified the SEC that it may have violated conflict-of-interest rules again, this time for performing tax work in China for 100 U.S. audit clients.

Among other ongoing cases, Deloitte & Touche remains mired in shareholder lawsuits related to its work on Adelphia Communications Corp. Shareholders claim Deloitte failed to warn of the Rigas family’s use of Adelphia’s credit lines to buy Adelphia stock an issue that ultimately plunged the firm into bankruptcy.

KMPG has denied any wrongdoing in failing to identify how Xerox Corp. inflated revenue by $6.4 billion in 2001, when it immediately booked revenue from long-term leases of copiers and other equipment to inflate short-term earnings. Xerox ultimately reached a settlement with the SEC.

“Are auditors taking a harder line? I believe they are,” said Merchant. “They’re doing a lot more work, the audits have gotten better and they don’t want to be the next firm that fails.”

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