For decades investors, lenders and other professionals have relied on audited financial statements to ensure that a company’s profit, cash position and other metrics are more than simply numbers on a page. But that confidence may have been weakened lately, following a spate of charges filed by the SEC against top-tier companies—including HealthSouth Corp. and Lucent Technologies—alleging improper revenue recognition and other fraud totaling billions of dollars. As more observers ask why outside auditors did not catch the alleged improprieties in a timely manner, professors at Emory University’s Goizueta Business School and others who have studied the situation say that a combination of factors—including the very structure of the accounting profession—may be at least partly responsible.

 

“There’s a disconnect when it comes to the behavior of auditors,” observes Kathryn Kadous, an associate professor of finance at Goizueta, referring to one of the conclusions arrived at in a paper she co-authored—with S. Jane Kennedy from the University of Washington and Mark E. Peecher from the University of Illinois at Urbana-Champaign—titled The Effect Of Quality Assessment And Directional Goal Commitment On Auditors' Assessments Of Client-Preferred Accounting Methods. “Although in a post-Enron era, many independent auditors say they won’t rely solely on management-generated information, our research shows that they are in fact often likely to go along with their client’s claims and with management’s preferences.”

 

In a previous paper, titled The Role of Incentives to Manage Earnings and Quantification in Auditors' Evaluations of Management-Provided Information, Kadous and her co-authors Urton Anderson and Lisa Koonce, professors at the University of Texas at Austin, noted that "auditors are sensitive to the potential for earnings management," especially when a company's management is eligible for bonuses and other incentives based on financial performance. But despite that sensitivity, their research also indicated that in cases where there is reasonable doubt about management's representations, auditors generally went along with management’s claims, regardless of whether they were backed up with quantified analysis.

 

The outcome of such a conciliatory approach may be demonstrated by what happened at HealthSouth Corp., a former leader in the health care segment that was accused of accounting fraud. In June, a forensic review of the company’s books from 1996 through 2002 identified “fraudulent or aggressive accounting” that totaled more than $3.3 billion. The company’s auditor at the time was Ernst & Young (E&Y).

According to a report in CFO.com, E&Y auditor James Lamphron testified in federal court that the CPA firm had received an e-mail from former HealthSouth asset manager Michael Vines, complaining about the health care company's "misallocation between asset and expense accounts." Lamphron says he notified HealthSouth’s audit committee and others about the allegations, but when U.S. District Judge Inge Johnson asked Lamphron if E&Y had checked any invoices against any checks (a standard procedure in an audit), Lamphron reportedly responded that he didn’t “know that we did that.”

 

Defending his audit, Lamphron testified that, “We reached a point where we were satisfied with the explanation the company provided to us. The situation that Mr. Vines described was in fact happening, but our procedures determined there was no problem with what they did and that's still our conclusion.”

 

If, as Kadous suggests, there is a disconnect between what auditors believe their mission is and the way they carry it out, there may also be a disconnect between the very objectives of the audit process and the rules of engagement. That’s a proposition advanced by George J. Benston, professor of finance, accounting and economics at Goizueta Business School, in a paper titled The Quality of Corporate Financial Statements and Their Auditors Before and After Enron (Cato Institute, Washington, DC).

 

As a starting point, Benston notes that financial statements of publicly held corporations “are prepared by corporate managers’ accountants and must follow Generally Accepted Accounting Principles (GAAP). They must also be audited by a registered public accounting firm (RPA) that assures investors that the statements were, indeed, prepared in accordance with GAAP, based on their audit of the corporation’s books and records.”

 

But he adds that in the wake of significant misstatements in the audited reports of “well-known and seemingly successful corporations,” including Enron Corp., Adelphia Communications Corporation, Global Crossing Ltd., and WorldCom Inc., an increasing number of people are questioning the integrity and usefulness of the U.S. approach to the auditing process.

 

“Are the GAAP rules inadequate? Or, were they just not followed?” asks Benston. “If not followed, why did their independent public accountants (IPAs) attest that they were followed?”

 

It appears to be a rhetorical question, since he notes that “there do not appear to be published studies showing why external auditors did not discover and prevent managers of companies from substantially misstating financial reports.”

 

But Benston is more certain about the issues in at least two corporate failures— Continental Illinois Securities Litigation, in 1987, and Phar-Mor Securities Litigation in 1995—in which auditors were charged with gross negligence. Engaged as an expert witness for the plaintiffs against the external auditors in both instances, Benston determined that “auditors’ failure to use statistical sampling to determine whether the records substantially reflected the correct valuation of important assets (loans and inventory) was the principal reason that the auditors did not discover the misstatements.”

 

Part of the problem with the current accounting model is the inherent difficulty in determining the economic values of tangible assets and liabilities, notes Benston. “Even more difficult to estimate are the values of intangible assets that are produced by the enterprise,” he explains. “In addition, the value of an enterprise to an investor is almost always greater than the sum of the values of its assets less the sum of its liabilities. Thus, for almost all corporations, even if investors and IPAs were willing to accept as trustworthy the managers’ estimates of the economic values of individual assets and liabilities, the amount shown as ‘fair-value shareholders’ equity would not equal the economic value of the enterprise.”

 

The problem is compounded by the fact that management can fine-tune results in numerous ways that may stray into “gray” areas without crossing a definable line into fraud.

 

“If management wants to pump up earnings for a particular period, it’s easy to slow research and development expenses, defer repair and maintenance or even time purchases so bills are incurred a bit later,” he explains. “Who can judge the way management runs its business? Achieving precision in a company’s numbers is nearly impossible, but at the same time analysts will focus on a penny-per-share difference between estimates and actual figures. It all contributes to the ability to manipulate results.”

 

Kadous also cites these “gray areas” as a concern, noting that in general, auditors are not charged with closely examining the way that management runs its operations.

 

“To a degree, so-called aggressive accounting is an effect of goal commitment since historically, the role of an auditor did not include comment on ‘gray’ areas” details Kadous. “But we also have to look at the risk-reward effect of aggressive accounting as it relates to auditors. The reward, of course, is keeping a client, while the risk of detection and punishment is not always that great. Even if financial penalties are imposed, it’s often years after the fact, and the auditor who should have caught the fraud may be long gone from the firm. Perhaps regulatory authorities should consider requiring improved monitoring of firms’ behavior; and consider how to spur auditors to look at a company’s shareholders and the broader market as a client, instead of only seeing the company as a client.”

 

Benston points out that individual auditors in charge of or confirming audits that allowed companies to produce fraudulent or grossly misleading financial statements are rarely punished.  In a Summer 2003 Emory Law Journal paper, “The Regulation of Accountants and Public Accounting Before and After Enron,” Benston cited a Dec. 6, 2001 Washington Post study of a decade of SEC enforcement action.  It found that while the state of New York had the most accountants (49) sanctioned by the SEC, only 17 were disciplined. In that paper he examines the effects on individual auditors who found nothing wrong with financial statements that turned out to be fraudulent and grossly misleading. Almost none were barred from practice before the SEC, he reports.

                   

Benston also points to a case involving Waste Management and its auditor Arthur Andersen, in which the CPA firm was fined $7 million after it was determined to have issued an unqualified audit opinion even though its auditors had identified and quantified improper accounting practices. Referring to a federal Government Accounting Office (GAO) study, he says that although two of the firm’s three auditors were fined $50,000 and $40,000 and barred from practice before the SEC for five years (the other was barred for one year), “The GAO states that they continued to be active partners of Arthur Andersen.”

 

He adds that in the Enron case, where Andersen was charged with destroying documents in advance of an SEC investigation, and, in a jury trial, was found guilty, “No mention is made of Andersen’s partner in charge of the audit, who destroyed the documents. The GAO does not indicate any actions taken by the SEC against the audit firms or the CPAs who conducted the audits of the seven other corporations where there were serious errors, misclassifications, and omissions that substantially overstated reported net income and assets and understated liabilities.”

 

Furthermore, in the United States the individual auditor-in-charge and confirming partner do not sign their names to the audit report.  Hence, it is almost impossible for analysts or researchers to learn who was responsible for professionally deficient or grossly incompetent audits to learn whether and to what extent these CPAs were held accountable.

 

According to Mark L. Cheffers, a former manager with PricewaterhouseCoopers who now runs AccountingMalpractice.com, a Web site offering legal resources to accountants, many accounting scandals may be driven by the hard-charging personalities of CEOs who persuade outside auditors “to see it their way. The CPAs may feel guilty, but they may also just interpret GAAP to justify the falsehoods.”

 

He thinks a revision of the format of the audit opinion might help the market itself to root out false financial statements.

 

“Right now, a certified audit is basically a pass/fail proposition,” he explains. “But consider other types of rating systems, like debt, which offer a range standards. Perhaps an auditor could assign a letter or other rating to the quality of the financial statements, and their clarity. For example, are Special Purpose Entities (SPEs) being fully disclosed? Is the company utilizing conservatism in its estimates? If the ratings in one or more areas dip, say from a “triple-A” to a “C,” then the market can judge how well the company’s doing.”

 

Another set of issues is raised by Martin D. Weiss, the chairman of Weiss Ratings Inc., who evaluates the financial strength of a wide range of companies and stocks. Weiss also submitted a paper, titled The Worsening Crisis of Confidence On Wall Street: The Role of Auditing Firms, to the Senate committee that originally considered the Sarbanes-Oxley Act.

 

“In the wake of Sarbanes-Oxley, and the implosion of Andersen, CFOs and accountants alike are scared, and are less likely to engage in outright fraud,” he observes. “But many issues that offer the opportunity for shenanigans, like the treatment of stock options, and the determination of funding levels for pension plans, still need to be addressed.”

 

In particular, says Weiss, underfunded pension plans may “come back and bite” companies.

 

“Right now, companies can basically determine their own return on investment for their pension-plan assets,” says Weiss. “We’re still seeing companies reporting 9% estimated returns, which sharply reduces their need to fund the plans. But at a time when Treasury yields are in the low single digits, and stock performance is uncertain, how wise is it to estimate a nearly double-digit return?”

 

Meanwhile, some progress is being made, says Kadous.

 

“Sarbanes-Oxley, which established the Public Company Accounting Oversight Board, and which tightened requirements for corporate boards, represent a move in the right direction,” she says. “But there’s still a long way to go to address aggressive accounting issues.”