Auditor Independence

By Bimal Patel, Anthony Davidson, and Philip Zemen

In the movie "Wall Street," Gordon Gekko proclaimed, "Greed is good!" However, in today’s current corporate environment, greed has proven to be destructive. Simple accounting tricks have morphed into fraud, and the market is showing no mercy. The U.S. stock markets, which were already facing severe difficulties related to the economic slowdown, have plummeted. Stock prices have swooned amidst SEC investigations and financial restatements. In July 2002, WorldCom Inc. declared the largest bankruptcy in U.S. history. Furthermore, Tyco International Ltd., Dynegy Inc., and Qwest Communications International Inc. have all seen CEOs resign in recent months.

Among the many reforms waiting in the wings of corporate governance, auditor independence is at the top of the queue. Enron Corp. was the catalyst that prompted the SEC, the Nasdaq, the NYSE, and legislators to take a more stringent approach to ensure the accountability of boards (with special emphasis on the audit committee) and management. As a result, more and more companies in the post-Enron environment have been exposed for accounting fraud. The SEC is investigating a long list of companies, including Global Crossing Ltd., Tyco, Dynegy, Qwest, and others, for potentially "cooking the books." Amid accounting woes this year, Tyco lost approximately 80 percent of its stock value and Global Crossing filed for bankruptcy in January.

The Ugly Truth Underlying Earnings Restatements

An earnings restatement occurs when a company admits, either voluntarily or under pressure from regulators such as the SEC, that it has made a mistake in its accounting and corrects the error. Such restatements can be catastrophically large: Correction of overstated earnings contributed directly to the collapses of Enron and WorldCom. Furthermore, due to the aggressive behavior of CEOs single-mindedly focused on meeting Wall Street’s demand for earnings growth, financial restatements have more than doubled over the last five years.

Auditors, who sign off on a company’s quarterly and year-end bottom line results, are certainly not exempt from accepting a portion of the heat when companies restate their financial results. The auditor’s role is an important one because investors must rely on the auditor’s opinion to assure the accuracy of the company’s financial statements. However, the Enron, Arthur Andersen and WorldCom fiascoes, as well as the sheer number of accounting irregularities at large U.S. corporations, have caused investors to question the accuracy of these statements.

In October 2001, Enron, a $100 billion energy giant based in Houston, reported a $1 billion loss for the third quarter of the year. In November, Enron restated $586 million in profit over a four-year period beginning in 1997, and in December the company filed for bankruptcy protection. Enron subsequently was found to have hidden debt through partnerships and shifted losses and under-performing assets off the books.

In June 2002, WorldCom, the country’s No. 2 long-distance telephone company, admitted it had masked expenses and inflated earnings by $3.9 billion over 2001 and the first quarter of 2002 and said it would have to restate its financial results. In August 2002, the company said it planned to expand the magnitude of its financial restatement to $7.2 billion to reflect improper accounting that inflated profits as far back as 1999. Arthur Andersen audited the books for both Enron and WorldCom.

Arthur Andersen LLP is now facing the consequences of its actions in the Enron debacle, having been fired by hundreds of companies. On June 15, 2002, Arthur Andersen was convicted of obstructing justice for destroying Enron’s audit records. Andersen faces a $500,000 fine and could be barred from auditing public companies. In fact, Arthur Andersen agreed to cease practicing by August 31 unless the SEC determines that another date is appropriate.

The pain is not confined to Arthur Andersen. Until 1999 KPMG International audited Rite Aid Corp., the third largest drugstore chain in the U.S. In July 2001, Rite Aid acknowledged that it had overstated net income by $1 billion over fiscal years 1998 and 1999. Rite Aid said at that time that it would restate its financial results, erasing $1 billion in profit. Former Rite Aid executives have been charged with inflating earnings in order to meet performance targets for the purpose of incentive compensation payouts. KPMG has since quit as the company’s auditor, saying it could not trust the information provided by management.

Until October 2001, KPMG also audited the books of Xerox Corp., the world’s-largest copier maker, which in 2001 was ordered by the SEC to restate its results. Xerox was fined $10 million for prematurely booking $3 billion in equipment-lease revenue over a four-year period beginning in 1997. Xerox agreed to the fine without admitting or denying any wrongdoing, and the company changed auditors in October 2001.

AOL Time Warner, Inc.’s, accounting practices, already under SEC investigation, are now being investigated by the Justice Department. The SEC and DOJ are examining several of the media giant’s transactions that led to higher revenues at the America Online division. The SEC and Justice are also inquiring into how the company booked advertising revenue in 2000 and 2001. In May 2000, America Online Inc. said it would restate financial results from fiscal 1995 to 1997 to correct the prior recording of $385 million in marketing costs as an asset. Ernst & Young LLP audited AOL Time Warner Inc.’s books.

Qwest Communications International, Inc., which is also under SEC investigation for its accounting practices, expects to restate financial reports for 2000 and 2001 due to accounting errors. The telecommunication company announced on July 28, 2002, that it has uncovered misstatements which led the company to book approximately $874 million in revenue for 2000 and 2001 upfront instead of over a period of time. The company also reported that it understated expenses by $113 million in 2001, but overstated them by $15 million in 2000. Pending the outcome of internal investigations, the company has not determined the final magnitude of its financial restatement, nor has it determined where deliberate fraud underlies any of its past accounting practices. Qwest lost approximately 90 percent of its value this year. Arthur Andersen audited Qwest’s books.

The following table includes a recent list of companies that have announced financial restatements:

Table: Restatements (Based on reductions of net income)

*In August 2002, the company said it planned to expand its financial restatements to $7.2 billion.
Source: Bloomberg News as of June 26, 2002

Regulators, Start Your Engines

As a result of the corporate scandals, reformers have lent their support to auditor independence proposals which were initially undertaken in the 1990s. In the past, government agencies such as the SEC, then headed by Arthur Levitt, were powerless to institute these proposals. Levitt had warned years ago of the dangers of auditors who also provided clients with other services. But powerful lobbying forces, especially from the accounting industry, were able to effectively prevent any reform. But with the market in shambles and investor confidence eroding daily, institutional investors such as TIAA-CREF have stepped up pressure for governance reform and, in particular, auditor independence. TIAA-CREF, which has traditionally relied on closed-door talks with corporations, has increased its pressure because of the new momentum the reform movement has gained.

Due to these groups’ efforts and the resulting gain in momentum, Congress acted quickly to restore investor confidence. To this date, the primary legislation has come in the form of the Sarbanes-Oxley Act or the Corporate Oversight Bill. This law, among other things, establishes a new audit oversight board, restricts auditors from providing nine types of consulting services to corporate clients, and grants audit committees greater authority. Specifically, the law prohibits auditors from:

• Bookkeeping or other services related to the accounting records or financial statements of the audit client
• Financial information systems design and implementation
• Appraisal or valuation services, fairness opinions, or contribution-in-kind reports
• Actuarial services
• Internal audit outsourcing services
• Management functions or human resources
• Broker or dealer, investment advisor, or investment banking services
• Legal services and expert services unrelated to the audit
• Any other service that the board determines is impermissible

Moreover, auditors are required to rotate the partners’ client assignments once every five years. Finally, the bill increases the SEC budget by over 66 percent.

One of the main provisions of the new law is the new five-member oversight board. This new entity replaces the disbanded Public Oversight Board, which had no power to subpoena auditors or impose penalties for abuses. The new oversight board will have those powers. Moreover, the new board will set audit standards and will investigate any audit failures. The new board will act independently in theory and will coordinate its activities with the SEC. However, the SEC will have the authority to hire and fire the members on the board, control the board’s budget, and overrule the board’s decisions. In addition, the law sets new standards for audit committee independence and grants them additional powers, including the requirement that the audit committee pre-approve any nonaudit related work, subject to SEC approval.

Prior to the signing of the law, other groups also spelled out their own plans for accounting reform. The New York Stock Exchange has approved standards that, among other things, provided audit committees with additional powers. Specifically, the audit committee will now have the sole authority to hire and fire outside directors and to approve in advance all nonaudit related services provided by the company’s auditors. Furthermore, the audit committees of listed companies will comprise of independent outside directors as defined by the NYSE.

NYSE’s new listing standards also tighten the definition of independent outsiders on the board. Previously, relatives of employees, large shareholders (holders of 20 percent or more), and employees of a company’s outside auditor were considered independent. Now such individuals are considered nonindependent. These recommendations are similar to those proposed by Nasdaq, which had received criticism regarding its initial set of modest reforms but responded with a new set of proposals that are more in line with the NYSE’s proposals. The American Stock Exchange also has issued its own set of recommendations that follow those of the other exchanges but are less stringent. All recommendations must be approved by the SEC, but it is extremely unlikely that the embattled SEC would fail to support these proposals.

Despite these changes, questions remain concerning these proposals. Although legislative action and action by the various exchanges makes it more difficult for similar scandals to occur in the future, there may be a few loopholes in the new system. A key question is, who will serve on the new oversight board? The members of the oversight board are not allowed to receive compensation other than retirement benefits from any publicly traded company. As a result, individuals such as Arthur Levitt would be precluded from serving on the board. Another concern is the board’s interaction with the SEC. The SEC could effectively limit the power of the oversight board because it controls both its budget and the hiring and firing of board members. The powerful accounting lobby could, in theory, affect the future hiring of individuals who are more sympathetic to their interests, especially when the market recovers.

Because of the market downturn and the resulting public outcry, a variety of groups, including institutional investors, saw an opportunity to gain public support for their accounting reform proposals this year. Although some institutions had tried to reform corporate America for close to a decade or more, their proposals had fallen on deaf ears as the market provided consistent returns.

During proxy season 2002, ISS analyzed 22 companies whose shareholders submitted proposals regarding the adoption of policies prohibiting auditors from performing nonaudit services. Of these 22 proposals, ISS supported 13 on the basis that such companies did not codify their commitment in the form of a formal, written policy. In the absence of a formal, board-approved institutional policy with respect to auditor independence, ISS recommended and continues to recommend a vote for such proposals. The value of a written policy is two-fold: first, it allows shareholders to scrutinize and evaluate the particulars of the policy, and second, it ensures that the policy survives beyond the tenure of a particular management team or CEO.

Of the nine such proposals that ISS opposed, the reasons for the ISS recommendations varied. In some cases, ISS recommended a vote against such proposals based on the fact that the shareholder proposals were broadly drawn and would prohibit the auditors from providing certain services that, while not technically part of the audit, could arguably be performed legitimately by the same accounting firm. These services, while technically not included under the definition of audit services, are services that make sense for the independent auditors to provide to a company. These services include providing comfort letters to underwriters of the company's securities, providing consents to the SEC relating to registration statements, audits of employee benefit plans, assistance in conducting due diligence in connection with acquisitions, and consultation on accounting standards and their application to transactions being considered by the company.

While examining policies regarding nonaudit services, ISS prefers to see prohibitions on financial information systems design and implementation services, information technology systems consultation, and internal audit services, including internal control services. Aside from the aforementioned services, ISS expects companies not to retain their auditors for services prohibited by the forthcoming SEC regulations detailed in the Sarbanes-Oxley Act and listed earlier.

Two of the companies that received a vote against shareholder proposals regarding the establishment of a policy that would prohibit auditors from performing nonaudit services were Manpower, Inc., and American Power Conversion Corp. Manpower and American Power Conversion represent the two ends of the spectrum with regard to policies that ISS supported.

Manpower established a relatively thorough policy regarding nonaudit services that demonstrated that the company had reevaluated its relationship with its independent auditor and reexamined the procedures by which the company's audit was performed. Specifically, the policy specified a set of prohibited services such as design and implementation of financial information systems and services, and information technology systems consultation. Moreover, the policy prohibited the services that are prohibited by the forthcoming SEC regulations. The policy also specified a set of services that the auditor could perform with the prior approval of the company’s CFO. These services include: services related to tax planning, compliance, and reporting; services related to reporting under and compliance with the federal securities laws and the rules and regulations promulgated thereunder; services related to the company's employee benefit plans, including pension audits; due diligence services in connection with mergers and acquisitions involving the company; and other services that did not involve payments in excess of $75,000 for the engagement. However, with the prior approval of either the company's audit committee or the chairman of the audit committee, the company would be permitted to retain its auditors to provide nonaudit services that involved payments in excess of $75,000 for the engagement.

Additionally, the policy stated that the company's CFO would have to prepare and submit to the audit committee, on a periodic basis, a reasonably detailed statement of the nonaudit services provided to the company by the auditor. Furthermore, the company’s CFO would have to certify that no prohibited services were provided to the company by the auditors during such period.

By contrast, American Power Conversion Corp. adopted a simple and straightforward policy stating that the public accounting firm retained by the company to provide external audit and audit-related services would not also be retained to provide nonaudit services, including internal audit services, in the same fiscal year. Although this policy lacked specificity with regard to permitted and prohibited services, it demonstrated the company’s willingness, in spirit, to prohibit such nonaudit related services.

Other companies that received shareholder proposals regarding auditor independence during 2002 included the following: Albertsons, Inc., Allegheny Energy, Inc., Avon Products, Inc., Constellation Energy Group, Inc., Delphi Automotive Systems Corp., Duke Energy Corp., Halliburton Co., Liz Claiborne, Inc., Marriott International Inc. (New), Motorola, Inc., PG&E Corp., Safeway, Inc., Sempra Energy Corp., State Street Corp. (Boston), VF Corp., and The Walt Disney Co.

Although none of the auditor independence proposals received a majority of votes cast at the relevant company’s meetings, investors can likely expect to see more such proposals next year, and greater shareholder support for such initiatives is likely.

The Auditors’ New Role

The Big Five auditing firms have also taken matters into their own hands by separating auditing services from consulting services. Many critics believe that the major cause of the accounting scandals is conflicts of interests among auditors who provide both consulting services and audit services for corporate clients. In some cases, the fees that auditors receive for nonaudit related work are significantly greater than the fees received for the actual audit. As a result, auditors have less incentive to take a tough stand when it comes to auditing a company’s books and greater incentive to preserve their lucrative consulting relationship with the company. Many groups, including some large institutional investors, believe that lack of true auditor independence was a major contributor to the recent spate of scandals in corporate America.

Andersen Consulting, now named Accenture, formally ended all ties with Arthur Andersen in January 2001 and completed an IPO later in the year. In early 2002, both PricewaterhouseCoopers and Deloitte & Touche said they were committed to separating their audit and consulting businesses. Ernst & Young was the first Big Five company to officially sever ties with all of its consulting business by selling its consulting division to Cap Gemini in May 2000. KPMG created a separate consulting division in February 2000 and took the division public as an independent company via an IPO a year later, in February 2001. In an effort to boost profit growth, KPMG Consulting plans to spend $840 million to acquire several of Arthur Andersen’s business-consulting units and the Austrian, Swiss, and German consulting units of KPMG International Inc. In addition, PricewaterhouseCoopers recently sold its consulting business to IBM. It is important to note that while some auditors have spun-off their consulting businesses, the continuing firms could still provide other nonaudit related services.

ISS’s Perspective on Audit Fees

According to ISS, audit services, as included in companies’ "Audit Fees" section in their relevant filings, should only include financial statement audit and review services performed by the auditor that are customary under generally accepted auditing standards or that are customary for the purpose of rendering an opinion or review report on the financial statements.

Examples of services qualifying under the "Audit Fees" section are the following:

• Attendance at audit committee meetings at which matters related to the audits or reviews are discussed
• Consultations on audit or accounting matters that arise during or as a result of an audit or review
• Preparation of a "management letter"
• Time incurred in connection with the audit of the income tax accrual

Examples of services not qualifying under the "Audit Fees" section are the following:

• Work performed in connection with registration statements such as due diligence procedures or issuance of comfort letters
• Due diligence procedures performed in connection with merger and acquisition procedures
• Audits of employee benefit plans
• Such services should be included in the "All-Other Fees" section.

Conclusion

Given the high level of attention devoted to audit issues in the post-Enron, post-WorldCom environment, auditors and company executives will be less inclined to break or even push the rules. On the flip side, investors and analysts are likely to take a pro-active approach by scrutinizing a company’s auditing practices and management’s actions. The SEC is also tightening its reigns on revenue recognition tactics used by companies in the energy, Internet, telecommunications, and manufacturing industries. According to Bloomberg News, following Enron’s collapse, the SEC said it had launched 64 investigations into financial reporting in the first quarter of this year, up from 31 in the same period last year.

Shareholders will breathe easier once the SEC and other regulators restore trust and accountability in corporate America. The creation of true independence among corporate auditors could go a long way towards restoring such trust. Nevertheless, shareholders should still heed traditional warning signs of problems at a company, such as a downgrade in the company’s credit rating, a new auditor resigning or getting fired, or a CEO resigning soon after unloading a large number of shares.