Bid auditors prepare to lose an arm or a leg

SUNDAY TIMES (LONDON)

March 5, 2000

INVESTORS with their eyes glued to the ups and downs of share prices may not have noticed, but America's Securities and Exchange Commission (SEC) may be doing them a big favour. And, in the process, it may be opening up competition in the consulting business.

For a long time the big five accounting firms, which are responsible for auditing most of the world's top public companies, have also been in the consulting business and, more recently, in the law business in a big way. This has created two problems.

For independent consulting and law firms it means that many potential clients, eager to curry favour with their auditors, will engage the consulting or law arms of the accounting combines even when some small, independent firm is better qualified to provide advice.

Perhaps more important is the problem created for investors by these multidisciplinary firms. Investors need professional auditors to give honest opinions on the financial condition of the companies in which they invest - or at least the rational ones do. And there are still many rational ones about. These auditors, commonly derided as "bean counters", do a lot more than count beans, add up columns and make sure the arithmetic is correct. They exercise judgments that importantly affect what the companies report to the public.

If an auditor decides some loss-making event is not likely to recur, that loss will not be reflected in the reported operating profit. And the way an auditor classifies a lease for some piece of capital equipment will determine whether the full cost of that lease will be charged against current earnings.

Of course, the auditor must follow rules. But no rule, no matter how well drawn, eliminates the need for judgment.

Naturally, corporate chief executives would like their auditors to exercise these judgments in such a way as to impress investors with the desirability of buying or holding their shares. This is where the conflict of interest arises.

If the auditing firm also has large consulting contracts from the company it audits, contracts ultimately within the chief executive's gift, it may be tempted to stretch its auditing judgments just a bit - not so much as to invite lawsuits by shareholders if things go horribly wrong but enough to secure the goodwill of the chief executive, who is in a position to retain their consulting arm. And if the branch of the auditing firm that provides legal services also acts as advocate for its clients in tax matters, there is a danger that the lawyers will persuade the auditors to do things they otherwise would not.

This has long troubled some American politicians. Indeed, some 20 years ago John Dingell, then House of Representatives' commerce committee chairman and still one of the nation's most respected and feared congressmen, considered forcing the accounting firms to sell their consulting branches.

Now the SEC has taken up the cry, in response to what it feels was an overly lax audit of Cendant, and its belated discovery that partners in one of the big five, and not, incidentally, the world's largest professional-services firm, Price Waterhouse Coopers, violated rules by holding shares in some audit clients. The 8,064 violations involved half the firm's 2,700 American partners.

This is why Ernst & Young last week sold its consulting arm to Cap Gemini, a French computer-services company, for more than $ 11billion, creating a consultancy with 58,000 staff and almost $8 billion in revenues.

Pressure from the SEC is also the reason Price Waterhouse Coopers has announced that it will split its business into two parts, with separate management teams and boards - one to run the audit business, the other to run the consulting business, which brings in about $ 6billion in revenue.

It is not at all certain that the SEC will find this halfway measure satisfactory, since it is possible that clients served by both arms of Price Waterhouse Coopers will remain in a position to use consulting contracts to curry favour with Price Waterhouse Coopers' auditors. Nor is it yet clear just what steps other large accounting firms, such as Arthur Andersen, Deloitte & Touche and KPMG, will take to reduce the pressure coming from the regulators. Andersen, of course, is in the middle of arbitration proceedings to determine whether Andersen Consulting, which contends that it is much more profitable than its accouning counterpart, remains with its parent or splits off. Insiders say there is no question that the divorce will be granted; all that has to be decided is the terms of the settlement.

Some accountants want to stand pat and fight the SEC. They argue that the fear of lawsuits from shareholders, the requirement that accounting firms reveal to investors any consulting contracts they receive from audit clients and the fact that audit partners do not share in the profits of the consulting wing of these multidisciplinary firms provide protection enough for investors.

The SEC disagrees and is keeping the heat on the accounting firms to divest or, perhaps, come up with some reorganisation scheme that protects shareholders from conflicts of interest.

When the dust settles the accounting firms, for all their grumbling, may end up all smiles. If disposal is required, the partners will receive a nice payout for their consulting business; the consulting arm will be free to raise capital and take stakes in start-up firms; and the auditing arm will not have to look over its shoulder at regulators or face the prospect of still more lawsuits from shareholders who feel that audited reports were a bit more favourable than financial reality suggests they should have been.

Perhaps we are witnessing one of the rare instances in which regulators actually improve things, both for the firms they regulate and for investors.