Unaccountable External Auditors

External auditing firms are supposed to provide detailed, accurate and unbiased information about the financial situations of their clients. However, the author contends that the failures of many external auditors helped contribute to the “Great Economic Meltdown.” He says a radical overhaul of the U.S. system of external auditing of corporate financial affairs is necessary.

This article is adapted from a chapter in “How They Got Away with It: White-Collar Criminals and the Financial Meltdown,” edited by Susan Will, Stephen Handelman and David C. Brotherton, published by Columbia University Press. ©2012 Used with permission. The author’s opinions aren’t necessarily those of the ACFE, its executives or employees.

Many culprits contributed to the factors that led to the recent "Great Economic Meltdown" — mortgage companies, investment banks and the Securities and Exchange Commission (SEC), among others. However, external auditing firms, which are supposed to provide detailed and accurate information about the financial situations of their clients, have mostly escaped implication, according to some.

Of course, the unaccountability of some external auditors isn’t a new problem. Here we’ll discuss cases that predated the meltdown, U.S. laws designed to encourage better auditing and a recommendation to foster a better system.

THE SAVINGS AND LOAN SWINDLES

The savings and loan collapses of the 1980s and 1990s involved a number of what one postmortem labeled “hired guns” — a category, according to this autopsy, that was led by accountants (Calavita, Pontell and Tillman 1997). By 1990, the U.S. federal government had sued 21 Certified Public Accountants for their role in the thrift debacle, 14 of whom worked for Big Six companies. One prosecutor called the accounting negligence of Arthur Young & Co. “the K-Mart blue light special” (Waldman 1990, 49). 

Arthur Andersen had endorsed the bookkeeping of the Financial Corporation of America before the institution had to be taken over, costing taxpayers $2 billion. Deloitte, Haskins & and Sells approved the books of CenTrust in Florida at a time when the owners were jacking up assets by a series of round-robin trades that wildly inflated the value of the properties involved. Similarly, Touche Ross confirmed the viability of the Beverly Hills Savings and Loan not long before it went belly up (Calavita et al. 1997).

SARBANES-OXLEY

Jeffrey Skilling, the former CEO of Enron who was convicted of 25 counts of fraud, persistently sought to exonerate himself from complicity in the company’s finagling of its books by repeating that he wasn’t an accountant and therefore didn’t possess adequate expertise to comprehend the crooked auditing schemes that were practiced. Skilling’s disclaimer was a major ingredient that fed into what is regarded as one of the most powerful elements of the reformist Sarbanes-Oxley Act of 2002 (formally the Public Company Reform and Investor Protection Act), enacted in the wake of (and because of) the Enron-Arthur Andersen and associated scandals.

The act holds chief executives and chief financial officers responsible for the accuracy of audits of companies with annual earnings of $1.2 billion or more. The two executives have to sign off on the reports that go forward to the SEC, and they can be held criminally responsible if the reports that they endorsed are found to be fraudulent.

The Sarbanes-Oxley Act requirements are monitored by an SEC-appointed five-person Public Company Accounting Oversight Board (PCAOB).The board survived a challenge on constitutional grounds that focused on what was claimed to be a violation of the separation of powers based on the fact that the board was appointed by the SEC rather than by the president — the latter requiring Senate approval. The Supreme Court in 2010 ruled that only minor rearrangements would be necessary to satisfactorily remedy what its challengers saw as its inadequacy (Free Enterprise Fund v. Public Company Accounting Oversight Board 2010).

Title II of the act established standards for external auditor independence, seeking to limit conflicts of interest. Section 201 of the title restricts auditing companies from conducting other kinds of business with the same client, such as providing bookkeeping services, conducting actuarial activities, engaging in management or providing various other forms of consulting (Fletcher and Plette 2003; Prentice and Bredeson 2008; Thibodeau and Freir 2007). An empirical inquiry found a positive correlation between the fees generated by an external auditor and non-auditing consulting services and company audit aberrancy (Frankel, Johnson and Nelson 2002; but for a contrary conclusion, see DeFord, Raghunandan and Subramanyam 2002; see also, generally, Ashbaugh 2004).

Title II also addresses the new auditor approval requirement and specifies that a company can’t be audited for more than five consecutive fiscal years by the lead or coordinating auditor having primary responsibility or by the person responsible for reviewing the audit. Also if the CEO, CFO or controller of a company had worked within the past year, that group couldn’t be hired as the company’s outside auditor. The act addresses circumstances that contributed to the Arthur Andersen-Enron debacle and, had they been in place, could possibly have prevented that occurrence. However, skilled attorneys are notably adept in finding ways around laws and regulations aimed at curbing corporate behavior.

AN UNHEALTHY HEALTHSOUTH

The CEO of HealthSouth became the first person charged with violation of the Sarbanes-Oxley requirement that a public company’s executive officers certify its financial reports. The indictment charged that since 1999, the company, located in Birmingham, Ala., and one of the nation’s largest health care providers, which employed more than 50,000 people worldwide, had misstated its earnings by at least $1.4 billion (Johnson 2003). The apparent impetus for the fraud was the insistence of Richard M. Scrushy, the company’s founder, CEO and chairman of the board, that the company had to appear to meet or exceed the earnings expectations established by Wall Street analysts. When earnings didn’t reach that level, Scrushy’s orders were to fix things so that they would. 

In accordance with the requirement of the Sarbanes-Oxley Act, Scrushy and Davis had certified under oath that the earnings report contained “no untrue statement of a material fact.” The indictment maintained that the HealthSouth financial position was overstated by 4,722 percent (Johnson 2003). Scrushy, however, was acquitted in a jury trial, perhaps because he had developed a very positive image in Birmingham through philanthropic donations (Morse, Terhune and Carms 2005). Soon after, he received a prison sentence of six years and 10 months when convicted of giving Alabama Governor Don Siegelman half a million dollars in exchange for appointment to a seat on the board that regulated hospitals (Lewis 2010).

A major question raised by the HealthSouth case was whether the Sarbanes-Oxley Act, when employed as the basis for a criminal prosecution, could effectively produce the result it sought by punishing a wrongdoer and — much more difficult to determine — whether it could inhibit others from engaging in the same kind of illegal behavior (Taylor 2005). Certainly, the subsequent economic meltdown strongly suggested that allegedly independent auditors — persons with considerable outsider access to the details of the financial condition of corporations — had failed to alert others to situations that foretold impending doom.

THE DODD-FRANK ECONOMIC REFORM MEASURE

One provision in the 2,000-page economic reform package that worked its way through Congress and a Senate-House reconciliation committee before being signed into law by President Barack Obama in 2010 is particularly pertinent to the thesis of this article. One of the problems said to contribute to the onset of the meltdown was the wrongheaded ratings of toxic derivatives by Standard and Poor’s, Moody’s and Fitch — the three leading organizations that determine the relative risk of investment offerings.

The Dodd-Frank Wall Street Reform and Consumer Protection Act seeks to alleviate this unseemly situation with a provision that allows bondholders to sue raters if they think they’ve been misled by malfeasance. In addition, rather than continue to permit issuers to choose which rating organization to deal with, an investor board overseen by the SEC will choose the group that will assign letter evaluations of which bonds. 

Given a choice, companies sensibly have sought to deal with the most friendly and accommodating group to evaluate their products. For their part, rating agencies, who are extremely well paid for this activity, may have been much too careful about not alienating actual and potential customers by taking hard-nosed positions. This conflict of interest was exacerbated by the fact that the instruments that they were rating were often as incomprehensible to the raters as they were to their issuers.

ESTABLISH AN OVERSIGHT BOARD

The performance of external auditors, in the opinions of many, has left a good deal to be desired. It’s no longer fashionable, much less sensible, to parrot the Adam Smith platitude that capitalism, left unattended by government oversight, invariably will in time cure itself of whatever ails it. Taken literally, this position would advocate the total elimination of outside auditors, who could be viewed as superfluous interference with the health and vitality of what should be an unfettered market.

It could be argued that ridding the business world of the necessity for outside audits is a good idea — but for reasons other than Smith’s economic axioms. Audits represent expensive endeavors that fail to achieve their purposes. External auditors too often create a “Potemkin Village” that hide the real state of a firm’s finances, and in so doing they may impede the judgment of those who might rely on what they report to the authorities and the public. Compare, for instance, the sage, albeit utopian, advice offered to external auditors by Warren Buffett. The man famously regarded as one of the nation’s top financial savants has three standards: 

1. If the auditor were solely responsible for preparation of the company’s financial statements, would they have been done differently? And if “differently,” the auditor should explain both management’s argument and his own. 
2. If the auditor were an investor, would he have received the information essential to understanding the company’s financial performance during the reporting period? 
3. Is the company following the same audit procedure that the auditor would if he himself were CEO? If not, what are the differences and why? (Buffett 2007, 612) 

More generally, researchers stress that “auditors must come to appreciate the profound impact of self-serving biases on judgment” (Bazeman, Loewenstein and Moore 2002, 103).

The core problem is, of course, a possible conflict of interest. Because external auditors are the hirelings of those they audit and because they depend on the lucrative assignments they receive, they’re much too likely to tread carefully and turn a blind eye, to avoid confrontations when they sense or know they might be pinpointing wrongdoing. 

If we accept the premise that companies should devoutly desire outside accounting scrutiny by qualified independent auditors of corporate financial matters, how might we better achieve this objective? Can the current conflict of interest be overcome?

A partial answer to this question can be extrapolated from the two pathways that have been laid out by innovations discussed in part 1 of this article in the March/April issue:  

1. Judge Rakoff’s negotiated settlement with Bank of America, which stipulated that the outside auditor and the disclosure counsel be fully acceptable to the SEC and, in the event of a dispute over the selection, that the matter be settled by the court. 
2. The provision in the Dodd-Frank economic reform measure that requires the SEC, rather than a company, to select the organization that will rate that its bonds have potential.  

A similar approach should be initiated in regard to external auditors. Companies should be assessed fees that are deposited in the coffers of an independent body that assumes full responsibility for the assignment and review of auditing work. Such a body, which might be called the Oversight Board, should have its own staff of skilled accountants and investigators and might well include lawyers who are given the power to file and try civil and criminal law suits against offending corporations. Funds recovered in such suits could be fed into the board’s operating budget. If an auditing team can justify the need for more financial support to follow disconcerting information, the board should be in a position to underwrite such extra funds. The Oversight Board also could encourage the work of newcomers to the auditing enterprise and foster their growth so the list of companies competing for business increases.

The author wishes to thank Mary Dodge for her comments and suggestions on this article.

Gilbert Geis, Ph.D., CFE, a pillar of the ACFE, was professor emeritus of criminology, law & society in the School of Social Ecology at the University of California at Irvine. He passed away Nov. 10, 2012.

References

Ashbaugh, Holly. 2004. “Ethical Issues Related to Provision of Audit and Non-Audit Services: Evidence from Academic Research.” Journal of Business Ethics 2:143–48.

Bazeman, Max, George Loewenstein and Don A. Moore. 2002. “Why Good Accountants Do Bad Audits.” Harvard Business Review 80:96–103.

Buffett, Warren. 2007. “Advice to Outside Auditors.” In “Honest Work: A Business Ethics Reader,” edited by Joanne B. Ciulla, Clancy Martin, and Robert C. Solomon, 612. New York: Oxford University Press.

Calavita, Kitty, Henry N. Pontell and Robert H. Tillman. 1997. “Big Money Crime: Fraud and Politics in the Savings and Loan Crisis.” Berkeley: University of California Press.

DeFord, Mark L., Kannan Raghunandan and K. R. Subramanyam. 2002. “Do Non-Audit Service Fees Impair Auditor Independence?” Journal of Accounting Research 40:1247–1274.

Fletcher, William H., and Theodore N. Plette. 2003. “The Sarbanes-Oxley Act: Implementation, Significance, and Impact.” New York: Nova Science.

Frankel, Richard M., Marilyn F. Johnson and Karen K. Nelson. 2002. “The Relationship Between Auditor’s Fees for Non-Audit Activities and Earnings Management.” Accounting Research 77:2–13.

Free Enterprise Fund v. Public Company Accounting Oversight Board, 129 S. Ct. 2378 (2010).

Johnson, Carrie. 2003. “HealthSouth Founder Is Charged With Fraud.” Washington Post, Nov. 5, A1.

Lewis, Michael. 2010. “The Big Short: Inside the Doomsday Machine.” New York: W. W. Norton.

Morse, Dan, Chad Terhune and Ann Carms, 2005. “HealthSouth’s Scrushy Is Acquitted.” The Wall Street Journal, June 29, A1.

Prentice, Robert A., and Dean Bredeson. 2008. “Student’s Guide to the Sarbanes-Oxley Act.” Mason, Ohio: Houston/West.

Taylor, Jaclyn. 2005. “Fluke or Failure? Assessing the Sarbanes-Oxley Act After United States v. Scrushy.” University of Missouri - Kansas City Law Review 74:411–34.

Thibodeau, Jay, and Deborah Freir. 2007. “Auditing After Sarbanes-Oxley: Illustrative Cases.” Boston: McGraw-Hill/Irwin.

Waldman, Michael. 1990. “Who Robbed America? A Citizen’s Guide to the Savings & Loan Scandal.” New York: Random House.

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