Accounting & Tax

Big Five Get Low Grades for Performance

Survey shows that auditors mostly fail to uncover bookkeeping irregularities, and often fail to warn about clients headed for Chapter 11.
Stephen TaubJuly 12, 2002

Sunbeam. Enron. WorldCom.

What do these three companies have in common? Well, beyond the stain of accounting scandals, the three corporations were all clients of auditing firm Arthur Andersen.

That, of course, has led critics to charge that Andersen auditors were either in cahoots with these companies or incompetent. But was Andersen really that much worse at spotting bookkeeping irregularities than other large accounting firms?

Drive Business Strategy and Growth

Drive Business Strategy and Growth

Learn how NetSuite Financial Management allows you to quickly and easily model what-if scenarios and generate reports.

Not necessarily. As a group, it seems top-tier accounting firms have been uniformly lousy at uncovering accounting irregularities. Or at least, that’s the upshot of a new study put out by Weiss Ratings, entitled “The Worsening Crisis of Confidence on Wall Street: The Role of Auditing Firms.”

In the survey, Weiss found that auditing firms gave a clean bill of health to fully 94 percent of the public companies that were subsequently cited for accounting irregularities. The survey group included 33 publicly traded companies that reported bookkeeping errors.

The bad math cost shareholders dearly, too. The companies in the survey dropped from a total peak market value of $1.8 trillion to only $527 billion. That implies an aggregate loss to shareholders of almost $1.3 trillion.

Andersen audited 11 of the 33 companies in the survey; PricewaterhouseCoopers, 7; Deloitte & Touche and KPMG, 5 apiece; Ernst & Young, 4; and Tullis Taylor, 1.

Of the Big Five firms, PricewaterhouseCoopers came out best in the study. PwC issued a “going concern” warning on two of the seven companies it audited. Remarkably, that made PwC the only one of the six firms that actually issued going concerns for any of the 33 companies cited for accounting irregularities.

“The first and most important line of defense for investors is manned by the nation’s auditing firms,” says Martin Weiss, chairman of Weiss Ratings. “Unfortunately, the accounting industry has overwhelmingly failed in its responsibility to deliver independent oversight to corporate financial statements.”

Equally worrisome, Weiss Ratings found that 42 percent of the 228 companies that subsequently filed for bankruptcy between January 1, 2001 and June 30, 2002, were given a clean bill of health by their auditors. “Going concern” warnings were issued on 58 percent of the companies.

The Big Five firms audited 194 of the 228 companies that went bust, while smaller accounting firms audited the remaining 34. Weiss found a dramatic difference in performance by each of the auditing firms in alerting shareholders to bottom-line problems.

Ernst & Young was the best at alerting investors about impending corporate implosions. E&Y correctly issued warnings on 65 percent of the 46 firms it audited that later went bankrupt. PwC issued warnings on 63 percent of its 38 audit clients that went bust.

Interestingly, however, a group of second-tier accounting firms in the study correctly issued warnings on 59 percent of the 34 companies they audited. That put those smaller firms ahead of the rest of the Big Five. Andersen, for example, issued warnings on 56 percent of the 48 companies it audited that eventually declared bankruptcy. Deloitte & Touche offered warnings for 56 percent of its clients that later filed for Chapter 11. Conversely, KPMG only issued warnings on 42 percent of the firm’s 28 audit clients that ultimately went broke.

Overall, PricewaterhouseCoopers had the best track record among the Big Five in alerting shareholders to potential problems. For instance, PwC’s going-concern warnings were issued further in advance of the bankruptcy filings. On average, PwC warned 245 days before failure, compared to a global average of 209 days, according to Weiss.

Not surprisingly, Weiss found that when auditors issued their reports soon before a company filed for Chapter 11 (within three months), they were able to see a company’s weaknesses more clearly. In that scenario, auditors correctly warned of problems in 91 percent of the cases.

By contrast, when auditors issued their reports long before the Chapter 11 filing (between nine and 12 months ahead of time) it was more difficult to detect any weaknesses, and they correctly warned of problems in only 38 percent of the cases.

Weiss issues safety ratings on more than 15,000 financial institutions, including securities brokers, banks, insurers, and HMOs. Weiss also rates the risk-adjusted performance of more than 11,000 mutual funds and more than 9,000 stocks.

(Editor’s note: Weiss receives no compensation from the companies it rates. Revenues are derived strictly from sales of its products to consumers, businesses, and libraries.)