Teetering on the Brink — But No Audit Warning

Report: auditors often fail to provide caution in filings of foundering companies; more likely to raise concerns about smaller clients.
Stephen TaubApril 25, 2002

How reliable is the imprimatur of an audit firm?

That’s one of the biggest questions being asked about Arthur Andersen, which signed off on Enron Corp’s financial reports the year the energy trader went bankrupt. But according to a report by Bloomberg News, Andersen’s apparent unwillingness to sound warnings about its client’s financial health was not unusual.

In 54 percent of the 673 largest bankruptcies of public companies since 1996, auditors provided no cautions in annual financial statements in the months before the bankruptcy filing, according to Bloomberg. One for-instance: business software developer System Software Associates Inc. was given a clean audit even though the company was being investigated by the SEC for alleged accounting fraud.

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Bloomberg found that investors lost $119.8 billion in the 10 largest bankruptcies following audit opinions that raised no concerns. It also noted that, although Andersen is taking hits on all fronts these days, the indicted auditor actually issued audit warnings before bankruptcies more often than any of the Big Five accounting firms.

Bloomberg also found that auditors raise concerns much less frequently with large companies than with small ones. Indeed, auditors only issued warnings in 14 of the 50 largest bankruptcy cases since 1996. The implication: professional services firms don’t want to risk losing big accounts by sounding the alarm.

On the other hand, auditors raised red flags at 35 of the 50 smallest companies that declared bankruptcy over the past five years.

Moreover, five of the seven largest bankruptcies ever in the U.S. — including Enron, Global Crossing Ltd. and Kmart Corp. — followed annual reports with clean audit opinions.

In case you were wondering, 97 percent of all publicly traded U.S. companies are audited by the five largest U.S. accounting firms: Arthur Andersen, Deloitte & Touche, Ernst & Young, KPMG and PricewaterhouseCoopers. The accounting firms reported total revenue of $65.6 billion in 2001.

An SEC analysis shows that 31 percent of the firms’ revenue came from auditing in 1999, with the rest coming from other services such as consulting and tax work. This, of course, raises the question: if Congress passes legislation requiring professional services firms to hive-off their consulting services, can those accounting firms turn much of a profit? Some observers contend that an accountancy’s audit work is often a loss-leader — designed primarily to get a firm in the door at a company. Once in, the accountancy can pitch more lucrative consulting services.

(Editor’s Note: To see how corporate clients rate their auditors, click here)