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A Cure for Accounting Shenanigans

Category: Regulators


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A Cure for Accounting Shenanigans

 

By Jason ZWEIG / January 14, 2012
 

Should accountants have term limits?
 

One giant company after another has gone bust without any warning to investors from its independent auditors that it was in danger. Like the credit-rating firms whose triple-A seals of approval often turned out to be signs of impending doom, accounting firms appear to have analyzed many companies not with green eyeshades but through rose-colored glasses.
 

One possible explanation: Auditors work for the same company for so long that instead of being independent, they end up co-dependent.

[investor] Christophe Vorlet for The Wall Street Journal
 

Since the Securities Act of 1933, public companies have been required to get independent audits each year, assuring investors that a fresh set of eyes has inspected the books.
 

But those eyes aren't always the freshest.
 

According to Audit Analytics, a research firm in Sutton, Mass., 30% of the 1,000 leading U.S. companies have used the same firm to audit their books for at least a quarter-century. Fully 11% have used the same audit firm continuously for 50 years or more. Eight companies haven't changed auditors in at least a century; the last time any of them hired a new accounting firm, William Howard Taft was in the White House.
 

The Public Company Accounting Oversight Board, which regulates auditing firms, is asking whether long tenure might lead to complacency. Late last year, the board sought opinions on whether it should require listed companies to rotate their accounting firms every few years.
 

The last of those 611 public comments came in to the PCAOB earlier this month.
 

An overwhelming 94% were opposed to term limits. The common refrain: Rotating audit firms every few years would raise costs, reduce the familiarity of accountants with a company's books and impair the quality of audits.
 

PricewaterhouseCoopers and Deloitte pointed to studies casting doubt on whether changing auditors improves financial reporting. Ernst & Young said that some clients have threatened to hire a different firm if E&Y didn't bless a dubious decision—which E&Y refused to do. KPMG said it evaluates the judgment and ethics of each partner at least once every three years.
 

"We know from our own inspection reports that there is a problem," says James Doty, chairman of the PCAOB. "Without independence, it's unlikely you're going to get skepticism or a healthy look for disconfirming evidence."
 

In a written pitch to prospective clients, one of the biggest accounting firms declared that "your auditor should be a partner in supporting and helping [you] achieve [your] goals…and not second guess our joint decisions."
 

"That doesn't sound like somebody who's going to be independent, objective and skeptical," says Martin Baumann, chief auditor at the PCAOB. He declined to name the firm that produced that proposal.
 

The problem, says Howard Schilit, an accounting expert at Financial Shenanigans Detection Group in Key Biscayne, Fla., is simple: "When you're an auditor who's trying to protect a long-term relationship, you have to suck up to the client, and the client knows it."
 

A revolving door also needs to be walled off. With some restrictions, auditors can bounce between accounting firms and the companies they audit, raising potential conflicts of interest—as I can attest firsthand.
 

In 1992, I sat in the boardroom at the headquarters of JWP in Purchase, N.Y., interviewing the chief financial officer, Ernest Grendi. Critics had accused the industrial-contracting company of using aggressive accounting techniques.
 

JWP's books had been audited since 1985 by Ernst & Young, where Mr. Grendi had once been a partner; the auditors there, he told me, were especially tough on JWP because he was an alumnus of the firm.
 

By the end of 1993, JWP had been placed into involuntary bankruptcy after revising its previous earnings and writing off more than $60 million in acquisitions and other assets.
 

Although he didn't penalize the firm, a federal judge found that Ernst & Young's auditors, because of their "close" relationship with Mr. Grendi, had "apparently lacked the backbone" to question JWP's accounting. I couldn't locate Mr. Grendi this week for comment. Ernst & Young declined to comment.
 

Accountants who audit a company for years know more about it, says Don Moore, a psychologist at the University of California, Berkeley, who has studied conflicts of interest. But that knowledge, he says, "comes at a great cost—a web of personal connections with the company that cannot help but influence an auditor's preference for how the numbers come out."
 

As the Arab Spring shows, presidents-for-life are finally going out of fashion. For the sake of investors, we should phase out auditors-for-life, too.
 

Source: WSJ / intelligentinvestor@wsj.com; twitter.com/jasonzweigwsj

 



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