Fool.com: Who's Auditing the Auditors? (Fool on the Hill) January 10, 2000

FOOL ON THE HILL
An Investment Opinion

Who's Auditing the Auditors?

By Yi-Hsin Chang (TMF Puck)
January 10, 2000

The U.S. Securities and Exchange Commission (SEC) last week issued a report citing 8,064 "widespread" violations of share ownership regulations by partners and employees at public accounting powerhouse PricewaterhouseCoopers (PwC), the largest auditor in the world. In other words, the SEC found that a significant number of the firm's partners and staff owned stock in client companies.

Some facts from the SEC:

-- Almost half of the PwC partners -- 1,301 of 2,698 -- self-reported at least one independence violation. The average number of violations was five; 153 partners reported more than 10 violations each.

-- Of 8,064 reported violations, 81.3% were reported by partners and 17.4% by managers; 45.2% of the violations were reported by partners who perform services related to audits of financial statements.

-- Almost half of the reported violations involved direct investments in securities, mutual funds, bank accounts, or insurance products associated with a client. Almost 32% of reported violations, or 2,565 instances, involved holdings of a client's stock or stock options.

What's the big deal? Well, public auditors are supposed to give an independent assessment of a company's financial statements, which many investors and analysts rely on for evaluating a company's financial position and cash flow. If there's a conflict of interest -- or even an appearance of a conflict -- the auditor's credibility is shot, and investors are left with financial statements that may not accurately reflect the success, or lack thereof, of a company.

If auditors own shares in a company that they are auditing, they could very well rubber stamp financial statements that may, in fact, overstate a company's success. The point is, regardless of whether auditors actually change their public opinion of a company they are auditing, the public may perceive that they have done so and therefore not trust the assessment. Either way, the system breaks down.

According to the SEC report, which was drafted by independent consultants, PwC acknowledges that the review "disclosed widespread independence non-compliance that reflected serious structural and cultural problems in the firm."

To be sure, one problem many accountants have with the SEC's sweeping rules is that they apply to spouses and even extend to other relatives. As Frank Harding, president of the International Federation of Accountants, told The Financial Times, "How do you find out that your brother-in-law has shares in x, y, or z if he doesn't tell you?"

Not only that, I'm sure your brother-in-law would be none too pleased if told he couldn't own a stock because you're auditing that particular company. This might've worked when few people owned stocks, but not today when stock ownership is at an all-time high and the stock markets offer such attractive returns.

What's more, the SEC independence requirements also cover many indirect interests in clients, including pension plans, mutual funds, or credit card balances. I think this is a bit extreme. Perhaps accountants should follow rules similar to those that apply to the president of the United States or the head of the Federal Reserve. President Clinton, for instance, is no day trader (maybe a future profession?). In fact, he isn't allowed to invest directly in stocks. However, his money is placed in escrow, and I would imagine is being managed independently by a fund manager.

As long as auditors don't know the specific companies their money is being invested in, they should be able to maintain their independence and objectivity. They shouldn't be prohibited from investing in the stock market indirectly simply because of their jobs. Talk about a strong incentive not to go into auditing.

Another issue is that many of the top ("Big Five") accounting firms now have extensive consulting operations. The strict SEC rules shouldn't apply if you are a consultant in the company and have nothing to do with auditing a company.

In short, this is a messy and complicated issue. Some changes need to be made to allow for more flexibility for those not directly involved with auditing and even for the auditors themselves, while maintaining the integrity of the process.