Auditing the accounting industry

Editor

The accounting industry came under heavy fire in 2002. With major corporations such as Enron, Tyco, and Global Crossing embroiled in scandals involving misreported financial data, questions have arisen concerning accounting and auditing practices. How the industry responds to this scrutiny

PricewaterhouseCoopers, the largest accounting firm in the United States, is responding by taking a public stance in favor of more thorough and detailed audits. This position should make the firm more popular with investors and the American public, but may cause tension with the firm's clients who will be asked to pay for longer and more detailed audits. It is also a gamble because PricewaterhouseCoopers' own performance will be judged by the tougher auditing standards it is espousing. For this move to be effective, the company will have to practice what it preaches. In the past, that has been an issue. PricewaterhouseCoopers approved financial disclosures at Tyco International that, while technically permissible, were intentionally misleading. A report recently filed by Tyco with the SEC described these disclosures as "aggressive accounting that, even when not erroneous, was undertaken with the purpose and effect of increasing reported results above what they would have been if more conservative accounting were used." This case is a good example of the judgment calls accounting firms have to make, even with clients operating within the established rules.

Another step the accounting industry is taking is separating consulting operations from accounting services. KMPG and PricewaterhouseCoopers both sold off consulting divisions in August. The separation of accounting and consulting activities within the industry is a move to avoid the appearance of conflict of interest, which can be created when the firm auditing a company is also hired to perform other services.

While government regulators police the banking industry, accounting has historically been self-regulated through peer reviews and strict professional standards. Accounting and auditing standards are defined by the Financial Accounting Standards Board and by the American Institute of Certified Public Accountants (AICPA).

Prior to the public relations damage caused by corporate scandals coming to light, the industry has had little impetus to clean up its own act. A 2000 report to the SEC argued that auditors should provide much more documentation when approving a company's books. CPA's opposed the idea, afraid of leaving a paper trail that shareholder lawyers could use against them. A report by the industry's Audit Effectiveness Panel concluded in 2000 that standards for detecting fraud in an audit were inadequate, but the industry resisted improving the standards to meet the panel's recommendations.

The issue may be taken out of the industry's hands. On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act. Among other provisions, the law creates an independent oversight committee for the accounting industry with statutory authority to define and enforce its own standards. The effectiveness of this committee, called the Public Company Accounting Oversight Board (PCAOB), remains to be seen. The board is still assembling its staff, resources, and procedures. William Webster, the board's controversial first chairman, has already resigned, leaving the PCAOB leaderless. The PCAOB has the authority to set its own accounting and auditing standards and to enforce them with its own personnel. The question is whether it will do so. Contracting out the work to existing firms would re-create the current system of peer reviews that allowed Deloitte & Touche to give Arthur Anderson high marks even as its clients - including Global Crossing and Enron - were beginning to fail. If the PCAOB adopts the current industry standards, it will undermine its own authority and weaken the implementation of tougher accounting industry oversight.

The Sarbanes-Oxley Act contains some compromises. If the board finds a problem with the quality control systems of an auditing firm, that information will be kept secret if the firm addresses the problem within a year. Disciplinary actions may also remain secret until the SEC has considered any appeals, which could take years. This secrecy means that it will be hard for investors to know if the PCAOB is actually doing a good job.

The outlook for the accounting industry is difficult to foresee. The degree to which the industry will cease to be self-policing will depend on the development of the PCAOB. Even if the industry doesn't fall under effective government regulation, it will still need to create and meet higher standards in order to improve its tarnished reputation. One way or another, the industry needs to be held accountable.

Sources: American Banker, BusinessWeek, Done Deals, New York Times