Unaccountable External Auditors

CHRISTOPHER STEER, RICARDO REITMEYER AND  DNY59/ISTOCKPHOTO

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.