In 2001, 158 companies restated earnings, according to an analysis by New York University’s Stern School and Financial Executives International. That’s three times the number in the mid-1990s. In 1981, there were three such cases. Sobering data, but for the most part the auditing process remained one of sticking with the status quo.
Then along came Enron, Global Crossing, and an increasing number of other accounting-related scandals, both in America and across the globe, that are shaking investor confidence and forcing a broad overhaul of regulations worldwide.
Where the current turmoil leads the accounting industry remains unclear, given the wide-ranging remedies proposed by everyone from the International Accounting Standards Board to the US Congress. One of the most extreme outcomes is to force auditors to sell off their consulting arms and focus solely on auditing work, though this may be a long shot given the lobbying clout of the Big Five accounting firms (soon to be four if Andersen doesn’t survive).
One side of the story that hasn’t received as much attention, however, is the effect the auditor crisis has had on companies’ investor relations and corporate communications efforts. The timing of the auditor crisis couldn’t be much worse, as investors were already looking askance at both corporate earnings and analyst credibility. This last chip that has fallen from grace, the audit process, is especially problematic.
Fuller disclosure
The question facing corporations is that if investors can’t trust the auditor’s stamp of approval, how do they trust the numbers the company is providing? This has prompted anxious investors to question auditor-related issues like never before. The obvious targets so far – aside from Andersen clients – have been those companies with complicated financial pictures, such as conglomerates GE and Tyco [see Fall of the house of Tyco], and other companies with off-balance sheet entities, including many banks.
Companies like GE and Tyco, for example, have been taking steps to provide more detailed information on their accounting practices than ever before. Tyco went so far as to begin weekly conference calls to answer what was becoming a chorus of negative publicity generated by investor criticism. GE, for its part, recently held its first ever earnings conference call. Other companies have simply prepared for the inevitable questions, and striven to demonstrate the checks and balances already in place.
ITT, the White Plains, New York-based conglomerate, had been an Arthur Andersen client since 1920. In March, the company dropped Andersen, appointing Deloitte & Touche in its place. ITT also took steps to answer investors’ questions on the audit issue. ‘We made sure we were clear from both the media and investor relations side,’ explains Theodore Economou, director of investor relations at ITT. ‘We prepared to address issues such as whether we have special purpose entities or if there are undeclared items. The answer to these questions, of course, is no, which made it easy for us.’
Economou and the head of the company’s public relations department constitute a steering committee established three years back. Between them they decide on themes aimed at highlighting ITT from an investment thesis point of view, as well as at creating a solid corporate identity. A significant part of the process includes surveys carried out to gauge the public’s and investors’ perceptions of ITT.
Following the collapse of Enron, the company commissioned one such survey. ‘In the multi-industry space, we found investors are looking for companies with high levels of transparency, full disclosure and very straightforward communications. The feedback we’ve received is that ITT is well positioned because of our level of disclosure and forthrightness,’ says Economou.
The thing investors were most curious about was the structure of the company’s system for internal audit and controls. ‘We have a number of checks and balances, which begin at the top, and which we explain to investors,’ says Economou, whose company, as of mid-April, was trading near its 52-week high. ‘Under a policy instituted several years ago by our CFO, Dave Anderson, our external auditor cannot also serve as our internal auditor. And we use an outside auditor, rather than company employees, to conduct the internal audit, and they report directly to our board of directors.
It gives us confidence to have another set of eyes. At almost every board meeting, the internal audit will report on their audit results. The auditors performing the internal audit, PriceWaterhouseCoopers, know their mandate is to recommend appropriate procedures, so they have the right incentive to do their work.’
The only game in town
Blue chips are not alone in endeavoring to illuminate or improve their audit policies. On-Site Sourcing, an Arlington, Virginia-based company with $40 mn in revenue, recently announced it had switched from a small, regional auditor to PriceWaterhouseCoopers. ‘We’ve substantially enhanced our audit committee guidelines in light of the recent events,’ explains Jason Parikh, the company’s CFO. ‘Most significantly, we’ve adopted an audit committee charter to ensure independence based on the Nasdaq guidelines covering audit committee member independence. We also have a much higher level of directors serving on our board.’
On-Site Sourcing’s auditor switch, a reflection of its need for an auditor with greater depth and resources, highlights another issue: while critics bash the integrity of the Big Five, there are few alternatives out there. The same is true overseas, particularly in developing countries, where investors won’t touch a company that hasn’t been audited by anyone else.
But overseas, US auditors are coming under fire as well. In Russia, for example, a financial oversight panel plans to examine PriceWaterhouseCoopers and its audits of Gazprom. Minority shareholders maintain PriceWaterhouseCoopers helped hide the natural gas monopoly’s related-party deals, including granting billions of dollars in construction contracts to a company partially owned by relatives of Gazprom management. In the UK, investigators are examining Andersen’s role in accounting irregularities at SSL International, one of several inquiries taking place across Europe.
For those companies in developing markets that rely on the Big Five to lend them credibility, it seems the collapse of confidence should give rise to considerable concern. Instead, many say they are unaffected, with few questions coming from investors, even when their auditor is Andersen.
‘I think all of the companies are taking more care of who their auditors are and whether they are reliable enough,’ says Gyula Fazekas, a member of the investor relations team at MOL in Hungary. ‘We have Andersen. From my perspective, they are very thorough and we haven’t had any problems. Investors haven’t suggested we switch auditors, and they aren’t asking many questions.’
Alex Maracek, the head of investor relations at Cesky Telecom in Prague, Czech Republic, believes one reason investors haven’t turned the heat up on companies in Eastern Europe and other developing regions is expectations. ‘I think the issue was such a shock in the US because it’s assumed everything is fair. Here, you expect greater risks. But I think eventually, pressure will come.’
In fact, pressure is starting to come already, though the initial thrust is coming from investors. Ricardo Portugal Alves, CFO of Brazil’s Companhia Paranaense de Energia (Copel), says his company hasn’t had any problems with its auditor, Arthur Andersen, but he estimates that around 20 percent of investors have inquired about the auditor’s role. ‘They want to know if we’re going to change auditors,’ he reports. ‘The ones asking the questions are US and European investors – mostly US.’
The inquiries, however, aren’t behind the company’s decision to switch auditors next year. Instead, Brazilian securities law mandates that companies rotate to a new auditor every few years (an idea that Paul O’Neill, US treasury secretary, as well as a new proposal by the European Union, have mentioned in various forms, and one that is already in place in Italy and Austria). Still, Copel will stick with one of the Big Five firms. ‘We will always have one of the Big Five because we had bad experiences ten years ago. We bid the job and it went to a small company, and they didn’t do a very good job,’ says Alves.
Consulting conflict
Unlike companies in developing regions, US companies, as well as many in Canada and Western Europe, are feeling the brunt of increased shareholder activism over the issue of auditor independence and the overall integrity of the auditing process. One of the most ubiquitous topics is the lucrative non-audit services external auditors provide their clients. According to a Wall Street Journal analysis of the majority of companies comprising the Dow Jones Industrial Average and the disclosed fees reported through early April, 73 percent of the total $725.7 mn reported was for services other than an audit.
Critics contend that one reason the auditor role has been so tarnished is that auditors have been more interested in selling these more lucrative non-audit services to their clients. In an effort to preserve and bolster this business, they are willing to compromise their audits to keep their clients happy.
Last year, the US Securities & Exchange Commission imposed new disclosure rules, requiring companies to publish in their proxies the fees paid to auditors. Armed with the new transparency, US investors have filed a number of resolutions calling for companies to forbid their external auditors from providing consulting work. Surprisingly, many of these resolutions were filed before the Enron debacle unfolded, leaving shareholder activists looking extremely prescient.
‘In the US, we’ve asked companies to establish policies where they won’t hire auditors for non-audit services,’ says Ed Durkin, director of special projects for the United Brotherhood of Carpenters & Joiners, which oversees $38 bn in pension funds. ‘We’d already had some problems with audit-related issues at Waste Management, MicroStrategy and Sunbeam, so these issues aren’t new. Once we got the numbers being disclosed on auditor work last year, we began drafting resolutions over the summer. We’d already filed many of them by the time Enron exploded.’
Together with those filed by other investors, over 37 shareholder resolutions had been recorded as of April 11, according to the Washington, DC-based Investor Responsibility Research Center (IRRC), all targeting the role of auditors’ non-audit related work for client companies. Because of the heat companies are facing on the auditor issue, a number have voluntarily adopted parts of the resolutions.
In January, for instance, Walt Disney announced it would no longer purchase consulting services from its external auditor. And that was just the first in what has grown into a string of similar announcements from major US corporations.
In 2001, Disney paid PriceWaterhouseCoopers $8.7 mn for auditing services and $43 mn for ‘other’ services. The company was targeted by the United Association of Plumbers & Pipefitters, which filed an identical proposal to Carpenters’. When it went to a vote February 19, it won support from 43 percent of shareholders voting.
Global pressure
Carpenters has begun targeting a number of Canadian companies on the same issue. ‘In Canada, there’s no regulatory requirement to disclose fees for the different services auditors provide, so we’re at step one there,’ comments Durkin. ‘We submitted nine resolutions to have the companies disclose this information. I would say most of the companies that got them early on have agreed or have kept them on the proxy for a vote before implementation. The next phase is to send representatives out to about 35 Canadian annual meetings to raise the issue on the floor.’
In the UK, companies have been required to disclose the fees paid for audit and non-audit work for several years, putting them ahead of, for better or worse, their Canadian and US counterparts. ‘In the past, consulting work was always done as part of a competitive bid and not automatically given to the external auditor. From now on, we’re saying the incumbent auditor won’t be allowed to bid or tender for the consultancy work,’ says Mike Haines, a corporate spokesperson at Anglo-Dutch food giant Unilever.
It is, however, too early to know just what norms of procedures or best practice will ultimately determine the best approach to both ensuring and communicating the integrity of the whole corporate auditing process. But companies not engaged on the issue may find investor sentiment has changed, in terms of both new resolutions filed and the actual votes.
In the past, companies have expected the appointment of auditors, as well as the controls set around the auditor’s role, to get an automatic pass from shareholders. ‘Nowadays, in response to the new disclosure rules in the US and the UK, we’ll vote against auditors that have received substantial payments for other services,’ declares Greg Kinczewski, vice president and general counsel at Marco Consulting, a US-based proxy advisor.
‘If a company is paying 20 percent or more to an auditor for non-audit work, that’s a red flag,’ says Kinczewski. ‘And we’ll look at it. Many are paying three times as much, and the problem is similar in both the US and the UK. So we’re voting against instead of a standard OK when a vote comes on hiring an external auditor.’ In fact, last year they voted no for Enron’s auditor – Arthur Andersen.
The line-up
US companies faced with auditor-related proposals as of April 11, 2002
Albertson’s
Allegheny Energy
Ameren
American Power Conversion
Apple Computer
Automatic Data Processing
Avon Products
Best Buy
Boston Properties
Bristol-Myers Squibb
Constellation Energy Group
Delphi Automotive
Dominion Resources
Duke Energy Corporation
Emmis Communications
Equitable Resources
Fedex
First Energy Corp
Halliburton
Johnson & Johnson
K-Mart
Labor Ready
Lafarge North America
Liz Claiborne
Manpower
Marriott International
McGraw-Hill
Motorola
Nike
PG&E
Reliant
Safeway
Sara Lee
TXU Corporation
VF Corporation
Viacom
Walt Disney
Source: IRRC
