When Accountants Switch Sides

Is it time for the SEC to prohibit corporations from offering jobs to their external auditors?
Craig SchneiderApril 3, 2002

Following the collapse of Enron in October, scores of lawmakers and regulators started looking into the tangled relationship between Enron and the company’s lead audit team from accountancy Arthur Andersen. In a number of cases, the inquiries have focused on Andersen’s role as both independent auditor for Enron and a provider of consulting services to the Houston trading company. The premise of some of the inquiries: Andersen auditors may not have been overly eager to put the kibosh on fee-generating deals proposed by Andersen consultants.

The $62 billion bankruptcy in Texas has led many legislators to call for new rules prohibiting corporations from buying consulting services from their independent audit firms. But in the rush to wall off accountants from consultants, lawmakers and regulators appear to be ignoring another possible conflict of interest between auditors and their customers. The conflict? Auditors sometimes find themselves working with clients who used to work for them.

CFOs know the scenario only too well. A management team hires an independent audit firm. Over the course of a year, that audit team works closely with members of the company’s management team, going over the books and such. In turn, the company’s management team gets to know — and feel comfortable with — members of that audit team. Eventually, the company’s management offers a member of that audit team a job — usually on the company’s finance staff. Often, the original accounting firm stays on as the company’s independent auditor. Says Ed Durkin, director of specialty programs at the United Brotherhood of Carpenters and Joiners of America, “It’s very common to have senior people within the corporations who were formerly employed at the audit firms that the companies still use.”

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This cozy relationship, critics charge, can lead to trouble. Case in point: Richard Causey, former chief accounting officer at Enron, who joined the company after working as a senior manager at Arthur Andersen in Houston. While at Andersen, Causey worked on the Enron account.

Admittedly, it’s difficult to assess what role (if any) Causey played in Enron’s descent into bankruptcy. He was, however, chief accounting officer at the company, and as such, was probably responsible for keeping close track of Enron’s books. In that job, it seems likely he would have worked with Andersen employees in developing and implementing accounting procedures, policies and strategies at Enron. But in a report released in February, a special investigative committee of Enron’s board of directors seemed less than thrilled with some of Causey’s decisions: “[Causey] presided over and participated in a series of accounting judgements that, based on the accounting advice we have received, went well beyond the aggressive.”

The chief accounting officer’s connection to Enron’s auditor was not lost on members of the committee. In its report, the committee noted, “The fact that these judgements were, in most if not all cases, made with the concurrence of Andersen is a significant, though not entirely exonerating, fact.”

Take My Auditor, Please!

While cause-and-effect is hard to prove, it’s easy to see how an audit team might be less than objective when dealing with a colleague-turned-client.

Roger Barton, a partner at Barton Barton & Plotkin, believes even the best financial processes can be circumvented when corporate managers have close ties to their auditors. He says his law firm has recently taken on a rash of cases that involve allegations of embezzlement by CFOs and controllers. “Even if the company has the internal controls that it should have,” he says, “the auditing firm doesn’t pick up on the defalcations or improper acts. And most times, the reason for that is that there is a cozy relationship between the controller or the CFO and the outside auditing firm.”

The relationship gets even cozier when a company’s management continually hires finance employees from its audit firm. Until 1997, for example, every CFO and chief accounting officer hired by Waste Management worked previously at Arthur Andersen — Waste Management’s independent auditor. All told, 14 former Andersen employees went to work for the Houston-based waste treatment and disposal company during the ’90s. According to the SEC, most of the former Andersen auditors took jobs in key financial and accounting positions at the waste treatment and disposal company.

Last week, the SEC filed a lawsuit against five former managers at Waste Management, claiming the executives perpetrated “an egregious accounting fraud.” Three of the five executives named in the suit worked in Waste Management’s finance department (one was the company CFO). In a statement, the SEC was also highly critical of Waste Management’s auditor Andersen. The commission noted that the “defendants were aided in their fraud by the company’s long-time auditor Arthur Andersen LLP, which repeatedly issued unqualified audit reports on the company’s materially false and misleading annual financial statements.” The previous employer of the three former executives named in the SEC suit? Andersen. According to the SEC, two of the finance staffers listed in the suit worked on the Waste Management account while at Andersen.

Concerned that these kinds of close ties between accountants and corporates can lead to mistakes in judgement — or worse — one attorney has started counseling clients to show restraint in hiring audit team members. Martin Lipton, a partner at the law firm of Wachtell, Lipton, Rosen & Katz, recently advised the firm’s corporate clients to refrain from hiring key members of the accountant’s team “for at least three years after the individual last worked on the company’s account.” He adds, “At no time should a significant number of the company’s finance and accounting staff be former employees of the account.”

Shareholder activists are also encouraging the accounting industry to rethink the auditor/client relationship. Some activists believe corporations should be required to rotate their independent auditors. And in February, the Council of Institutional Investors asked the accounting industry to impose cooling-off periods before audit firm employees can go to work for audit clients.

So far, that hasn’t happened. The Independence Standards Board’s Standard No. 3 (“Employment with Audit Clients”) offers safeguards to protect against the impairment of auditor independence, but does not recommend a cooling-off period. The American Institute of Certified Public Accountants has also issued guidelines for any company that does offer a job to a member of its existing audit team. And in November 2000, the SEC approved its revisions on auditor independence guidance — but did not endorse a cooling-off period.

It remains to be seen whether the commission will revisit auditor employment concepts like auditor rotation and cooling-off periods. Sue Coffey, AICPA vice president of self regulation and the SEC practice section, says that in the wake of the Enron collapse, the auditor employment issue is “on the periphery.”

Managers at many audit firms would probably like to keep it there, too. The reality is, for a great many accountants, corporate audit work is their entree into the corporate world. For these future C-level executives, a cooling-off period would place a sizeable roadblock in their career paths. The SEC noted this problem when it issued its revised auditor independence guidance. “We have determined that a cooling-off period unnecessarily restricts the employment opportunities of former professionals,” the commission stated, “and we have decided not to adopt a cooling-off provision.”

Such a provision might have cost Jon Gacek a shot at becoming CFO. In the mid-’90s, Gacek worked as an auditor at PricewaterhouseCoopers. Then, in 1997, Gacek took at finance chief job at software vendor Advanced Digital Information Corp. (ADIC) — one of his clients at PwC. In fact, Gacek, was hired by the software maker right before the start of an audit.

By Gacek’s lights, concerns about auditor independence should be focused squarely on auditors, not the audited. “The rules need to impact the firms, not the companies, and not the partners therefore leaving the firms,” he insists. “My view is we have a relationship with our auditor, but it’s their job to manage their independence, not mine.”

Under the Influence

It appears auditors think they’re managing their independence just fine. A number of accounting firms have examined the issue of auditors who go to work for clients. “Most firms have policies that exceed requirements,” claims Edward Coulson, national director of independence at Ernst & Young. “I personally don’t think there should be — or would be — a need for change.”

At least one other Big Five senior executive appears to agree with Coulson. In a SEC-sponsored panel examining auditor oversight, Deloitte & Touche CEO James Copeland noted: “I believe most of the proposals will take us backwards rather than forwards. We need to be careful with ideas like mandatory auditor rotation, and examine why it now makes sense when so many groups previously studied the issue and consistently concluded it was wrong.”

Nevertheless, two legislators appear undeterred by industry resistance to auditor employment restrictions. Senator Christopher Dodd (D-Conn.) and Sen. Jon Corzine (D-N.J.) recently proposed a bill that would in part ban any accounting firm from providing a public audit for a company whose controller or chief financial officer had worked for the firm in the previous two years.

The SEC did not go nearly that far when it issued its guidance on auditor independence. According to the commission’s guidelines, an auditor’s independence is not compromised if the auditor does not influence a company’s operations or financial policies, does not have a capital balance in the firm, or does not have a financial arrangement with the company, other than a fully funded, fixed-payment retirement account.

Under the SEC’s framework, when a auditor is approached by a client — and is considering a job offer — the auditor should pull out of the engagement. If the auditor accepts the offer, the accounting firm is advised to review the auditor’s work to ensure that there is an appropriate level of skepticism in the audit. Also, the firm should reassess whether its audit procedures need to be changed, or for that matter, whether members of the audit team need to be replaced.

But industry watchers assert that SEC guidance and industry self-regulation may not be enough. They argue that an auditor who goes to work for a client may be able to exercise undue influence over the remaining audit team. If several members of an audit team go to work for the same company, critics claim it tends to create an old-boy network between auditor and client.

Industry watchers also point out that an accountant-turned-finance staffer has great familiarity with a firm’s audit process. That knowledge could enable a former auditor to help a new employer game the system — or even circumvent audits completely. “As someone who has supervised the audit, he knows what the procedures are,” asserts Roy Van Brunt, a forensic accountant with Ten Eyck Associates who once worked with the SEC on the auditor independence issue. “So it becomes somewhat easier for him to hide something — at least in theory.”

Farm System

Paul Free puts considerable stock in that theory. Free, corporate controller at Delphi Automotive Systems Corp., avoids hiring auditors from the company’s independent auditor (Deloitte & Touche) when filling positions on Delphi’s finance staff.

Ironically, Free himself was a partner at Deloitte before joining Delphi, although he was not engaged in the company’s audit. Nevertheless, Deloitte and Free have put in a policy prohibiting the Delphi CFO from hiring Deloitte auditors at the managerial level — even ones that aren’t working on the Delphi account. The company’s audit committee, Free says, reviews his new hires on an annual basis “to make sure that my actions are consistent with my policy.”

Free grants that the policy, while probably best for shareholders, does make it somewhat tougher to staff the finance department at Delphi. “It’s unfortunate in some respects,” he explains, “because the management people who do [audit] Delphi know a tremendous amount about us. They’re learning curve would be less steep than someone who doesn’t.”

In fact, some CFOs see their audit firms as something akin to a farm system. Robert Ryan, CFO of Medtronic Inc., says the company does hire members from its independent audit team — but only for lower-level positions. He says he can then train them to move up at the company. “This, for us, is an opportunity to develop future leaders for the company,” says Robert Ryan, “You’re better off to hire three or four, get them acclimated to the company, and then you have the bench strength to send them out.”

Some shareholders activists concede new auditor employment laws could make it tougher for companies to find qualified finance employees. And union man Durkin say’s he not exactly certain what can be done to stem auditor/client abuses. “We’re not quite sure how you grapple with it,” grants Durkin, who is still in early-stage negotiations about employment relationships with audit committees. “Disclosure may begin to address those concerns.”

Human Beings Are Complicated

Possibly. Some shareholder activists suggest that if a CFO has worked for an audit firm within the last five years, that information should be noted in the audit committee’s report.

One company has already taken that tack. Last week, IndyMac Bancorp named Scott Keys to the CFO post. Keys came from IndyMac’s audit firm, Ernst & Young. In announcing the hire, management at the company noted that, “while Ernst & Young has been IndyMac’s auditors since June 2001, Mr. Keys was not a part of IndyMac’s year-end audit team.”

It remains to be seen if that sort of voluntary disclosure catches on at other publicly traded corporations. The fact is, many corporate managers value their long-term — and close — relationships with their audit firms. UAL, the parent company of United Airlines, employed Andersen as its independent auditor for nearly 67 years. As Richard Roe, partner in the law firm Proskauer Rose LLP, notes: “You have human relationships. But you could have those [close relationships] because the CFO has been the CFO and the audit partner has been the audit partner for years.”

Moreover, some CFOs say new auditor employment requirements could also be gotten around. “You can’t determine everything with rules,” argues Medtronic’s Ryan. “You need to have good reputable people with good judgement.”

Even some lawyers admit that laws may not be the answer. Notes Neil Lang, partner with Sutherland Asbill & Brennan: “I don’t know how you regulate someone’s state of mind.”

You can’t. You can’t stop people from conducting insider trading, either, but there are still laws against it. Lawmakers in Washington, feeling pressure from the public outrage over the Enron scandal, may well push through some sort of auditor employment legislation. Such legislation could forever change the nature of the auditor/client relationship, and the careers of countless accountants.

That prospect may cheer shareholders, but it probably won’t thrill many accountants. “It’s up to an individual company who they hire,” insists E&Y’s Coulson. “Presumably they hire people based on competence and knowledge, as opposed to some evil motivation that helps them perpetrate some fraud.”

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