P-s-s-t ... Wanna buy a good audit?

P-S-S-T...WANNA BUY
A GOOD AUDIT?

$ $ $ $ $

Spotting the BIG FIVE

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March 27, 2008

Report links KPMG to
fraud at New Century

By Reuters, Financial Times

Auditor KPMG either initiated accounting fraud at New Century Financial or stood idly by as the failed subprime mortgage lender committed fraud in 2005 and 2006, an independent report requested by the US Department of Justice shows.

Once the second-largest US subprime lender, New Century filed for Chapter 11 bankruptcy protection last April 2, and was one of the first major casualties of the current US housing crisis, which has roiled global financial markets. It had been one of the largest US providers of home loans to people with poor credit.

The 581-page report by Michael Missal, a court examiner, concluded that New Century “engaged in a number of significant improper and imprudent practices related to its loan originations, operations, and financial reporting.”

KPMG contributed to some of these accounting and financial errors “by enabling them to persist and, in some instances, precipitating the company’s departures from applicable accounting standards,” Mr Missal concluded.

New Century officials were not available to comment on Wednesday.

“We strongly disagree with the report’s allegations,” Dan Ginsburg, KPMG spokesman , said. “We believe that an objective review of the facts and circumstances will affirm our position.”

More than 450 companies and individuals who have filed claims against the Irvine, California-based New Century may be able to sue KPMG for professional negligence based on KPMG’s breach of its professional standard of care, Mr Missal wrote.

“In the post-Enron era, one of the lessons should have been that accountants need to be sceptical, strong, and independent,” Mr Missal said. “You didn’t have any of those attributes here.”

Mr Missal added that creditors might also be entitled to remuneration from New Century officers, whose bonuses were tied to inaccurate financial statements and were sometimes three times what they should have been.

That could result in millions of dollars in recoveries, Mr Missal said.

Mr Missal’s report was submitted to and sealed by the US Bankruptcy Court on February 29. A judge unsealed the report on Wednesday at the request of former New Century employees, who said they could not approve the company’s liquidation plan without more information.

The report details how New Century was “brazen” in increasing its loans and extending them to borrowers who were increasingly unlikely to repay.

The company also lacked internal controls that Mr Missal said were particularly important in a company that dealt with a risky product.

Such controls might have caught “at least seven wide-ranging, improper accounting practices”, most of which were not in accordance with generally accepted accounting principles, Mr Missal said.

These resulted in the company reporting a profit of $63.5m in the third quarter of 2006 when it should have reported a loss, the report said.

The company also reported an increase of 8 per cent in earnings per share during the second quarter of 2006 when it should have reported at least a 40 per cent decline, the report said.

“KPMG contributed to these failings in critical ways,” Mr Missal wrote. “The KPMG engagement team acquiesced in New Century’s departures from prescribed accounting methodologies and often resisted or ignored valid recommendations from specialists.”

Mr Missal said the accounting firm’s most obvious error was suggesting another method for calculating New Century reserves needed to cover potential defaulting loans.

New Century was already underestimating these coming payments when KPMG professionals suggested a new scheme that not only violated the accounting industry’s Generally Accepted Accounting Principles but also exacerbated the situation.

“This is really the origin of the credit crisis,” Mr Missal concluded.

www.ft.com/cms/s/0/df6f0bae-fbb3-11dc-8c3e-000077b07658.html

For more see: KPMG

July 23, 2001

AUDITORS EXPOSED!

Cozy Deals Alleged!

How ‘independent’ are those book checkers?

By Marianne Lavelle, U.S. News & World Report

The numbers arriving in investors’ mailboxes may banish forever their image of accountants as green-eye-shaded drones.

Accounting firms seem neither dreary nor detached now that it is clear, thanks to new federal disclosure rules, how much money they’ve been making from their cozy relations with the very companies they audit.

Only 27 cents of every dollar companies paid their independent auditors last year had to do with the all-important sign-off on corporate financial statements. The rest went for services that the so-called Big Five accounting firms have branched into, from information technology to management consulting. The accounting firms point out there’s nothing illegal about doing other work for auditing clients, and last year the Securities and Exchange Commission lost a bitter battle to prohibit such activity.

Former SEC Chairman Arthur Levitt, as part of his drive against “accounting hocus-pocus,” said regulations were needed to assure investors that auditors had no reason to hide corporate financial woes. But accounting-industry friends in Congress threatened to block the new rules, so the SEC compromised by requiring firms for the first time to disclose what they paid their outside accountants for audit and other services.

Back seat.

“Eye-popping” is how Patrick McGurn of Institutional Shareholder Services in Rockville, Md., a proxy advisory service, describes the numbers released so far.

An SEC analysis of 563 proxy statements filed by big companies this year shows Big Five firms made $5.8 million in nonaudit fees from the average client, while pulling in only $2.2 million for audit work.

“The numbers demonstrate he problems may be larger than were originally thought,” acting SEC Chairwoman Laura Unger says.

The auditor independence issue may take a back seat once President Bush’s choice for SEC chairman, Washington lawyer Harvey Pitt, takes the helm. Pitt, whose name was sent to the Senate last week for approval, has represented the Big Five and questioned the need to rein in consulting work.

For the moment, however, the SEC is active on the issue. Last month, it levied the largest penalty ever against a Big Five firm.

Arthur Anderson LLP agreed to pay $7 million to settle charges relating to its mid-1990s work for Waste Management, Inc. The SEC said Andersen helped the huge trash hauler overstate income by more than $1 billion. Noting the $11.8 million in nonaudit fees Andersen got from WMI, Unger calls the case the “smoking gun” proving consulting gigs can compromise independence.

Easy prey.

Whether or not the SEC continues its tough policing, aggrieved investors have seized upon the conflict issue.

PricewaterhouseCoopers (PwC), itself the target of three ongoing SEC investigations, agreed in May to pay $55 million to settle a class-action lawsuit by shareholders of MicroStrategy Inc.

The software maker was forced last year to admit it had been losing millions while telling investors it was profitable. PwC profited from consulting for MicroStrategy and also acted as reseller for some of its software. Like Andersen, PwC denies that its independence has been impaired, but this will not be the firm’s last such legal tussle.

A pending lawsuit by Raytheon Co. shareholders, who lost millions when the defense contractor restated its earnings, may also raise the conflict issue. Nearly 95 percent of the $51 million Raytheon paid PwC last year was for nonaudit services, though Raytheon says much of that was for work it considered audit-related, like tax services.

Such lawsuits are likely to multiply. If an accounting firm was making money from its audit client, “it shows motive,” say an investors’ lawyer. And since firms under shareholder fire are often financially troubled, wealthy accounting giants are attractive prey. . . .

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TWO SETS OF BOOKS

Audits can amount to a tiny share of fees
paid to accounting firms.

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Marriott Intl. - Total Fees: $31,331,300 - Paid to: Arthur Andersen - Nonaudit fees: 96.65%

Sprint - Total Fees: $66,300,000 - Paid to: Ernst & Young - Nonaudit fees: 96.23%

Raytheon - Total Fees: $51,000,000 - Paid to: PricewaterhouseCoopers - Nonaudit fees: 94.12%

Motorola - Total Fees: $66,200,000 - Paid to: KPMG - Nonaudit fees: 94.11%

Gap - Total Fees: $8,245,000 - Paid to: Deloitte & Touche - Nonaudit fees: 93.10%

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OUT OF THE FRYING PAN . . .?

March 2, 2002

MERCK REPLACES OUTSIDE AUDITOR

MERCK & CO., the world’s third-largest pharmaceutical company, has ended a 31-year relationship with its outside auditor, Arthur Andersen LLP, the company caught up in the Enron bankruptcy scandal.

Merck said yesterday that its board of directors has chosen PricewaterhouseCoopers to take over the job this year.

The appointment requires approval by Merck shareholders.

Arthur Andersen did auditing and consulting for Enron, and its reputation has been damaged by the company’s collapse. . . .

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From The Buying of the President 2000, by Charles Lewis and the Center for Public Integrity:

Bill Bradley

Bradley handed out pork to another New Jersey polluter, Merck & Company.

In 1992 he won Merck tariff suspensions that are worth $10 million annually.

In July 1991 New Jersey Citizen Action listed Merck among ten companies responsible for nearly half of the toxic waste dumped in New Jersey....

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For more on PricewaterhouseCoopers, GO TO > > > What Price Waterhouse?

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January 25, 2002

SEC's Top Cop Says Enron
'Not Going To Distract Us'

SAN DIEGO -(Dow Jones)- Investigation into the collapse of Enron Corp. won't stop regulators from pursuing other cases, the top cop at the Securities and Exchange Commission said Friday.

"Enron's not going to distract us," SEC enforcement division director Stephen Cutler said at a Northwestern University legal conference here. He gave the usual disclaimer that his remarks reflect his own views, not those of the SEC.

The SEC began investigating Enron last October, after the Houston energy company announced it had overstated four-and-a-half years of earnings. The SEC later expanded the probe to include document destruction by Enron's outside auditor, Arthur Andersen. A criminal investigation by the Justice Department also is under way, along with investigation by numerous congressional committees.

"People may have a sense that all we care about is Enron," said Cutler.

While he acknowledged the case is getting a lot of attention, he said it won't stop other SEC investigations in their tracks, and promised that in coming months, "you'll be seeing lots of good cases from us."

Connections between SEC commissioners and accounting firms won't stop the agency from cracking down on accounting fraud, Cutler indicated.

Some critics have questioned whether the SEC may adopt a softer touch on accountants given that Chairman Harvey Pitt represented accounting firms in his past law practice, and the newly named commissioner Cynthia Glassman worked for a Big Five accounting firm.

"I think there's a misperception out there about this new commission and its willingness to be tough" in fighting financial fraud, Cutler said.

Accounting cases account for the bulk of the SEC's enforcement actions now. Last year, the agency brought more than 100 cases alleging financial fraud and in case, obtained a record $7 million settlement from Andersen for its role in auditing Waste Management Inc., another big accounting blowup.

Cutler said the fine, the largest ever paid by a Big Five accounting firm, shows that in financial fraud cases, audit firms "will be held accountable" along with audit partners.

Independence is another area getting close scrutiny from SEC attorneys, Cutler indicated. The SEC recently settled a case against KPMG that alleged it violated independence rules by investing in a mutual fund that was an audit client.

"There will be other independence cases to come," Cutler added. He said the agency is concerned when a "web of relationships" or business deals might cloud an auditor's judgment or undermine independence.

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ACCOUNTING FIRMS TARGETED IN
INSURANCE COMPANY FAILURES

By Joe Frey, www.insure.com

If accounting firms are the financial police for insurance companies, who will police the police? State departments of insurance, that’s who.

Two major accounting firms are taking heat from the New York and Ohio insurance departments for recent insurance company failures. The New York superintendent of insurance, Neil Levin, has filed a lawsuit against PricewaterhouseCoopers LLP, alleging the firm was negligent in its audit of three failed insurance companies that allegedly cost New York residents $100 million.

The Ohio Department of Insurance (DOI) settled a lawsuit for $9.99 million with accounting firm KPMG Peat Marwick for its involvement in the PIE Mutual Insurance Co. insolvency.

The Ohio DOI had alleged that KPMG Peat Marwick “failed to detect that PIE had fraudulently recorded a $58 million asset on its financial statements” in 1996. As part of the settlement, KPMG Peat Marwick admits no wrongdoing.

PIE sold medical malpractice coverage in Indiana, Kansas, Kentucky, Maryland, Mississippi, Missouri, Ohio, Pennsylvania, and West Virginia.

The New York Suit

Coopers & Lybrand, which merged with Pricewaterhouse in 1998, served as financial auditor for Home State Holdings Inc. and two of its subsidiaries, Home Mutual Insurance Co. and New York Merchant Bakers Insurance Co., from 1989 to 1997. The lawsuit alleges that PricewaterhouseCoopers failed to catch “numerous red flags” about the insurers’ financial stability that could have prevented insolvency. They filed for bankruptcy in 1998.

The major transgression the lawsuit alleges is that PricewaterhouseCoopers failed to notify the insurance department that Home State failed to maintain enough cash reserves to pay claims. Home State and its subsidiaries sold auto and homeowners insurance in New Jersey, New York, and Pennsylvania.

The lawsuit also claims that six officers of Home State committed fraud, were negligent, and breached their fiduciary duties.

New Yorkers pick up the tab

Levin is seeking $100 million in punitive damages from PricewaterhouseCoopers to offset the estimated price tag that New York state insurance guaranty funds – which are financed by all policyholders in the state through insurance premiums – had to pay to rescue Home State’s insolvent subsidiaries.

“Had Coopers ... detected and reported the true facts, Merchant Bakers and Home Mutual would have corrected the problems and avoided the insolvency damages alleged,” the lawsuit says.

Steve Silver, a spokesman for PricewaterhouseCoopers, says the lawsuit is totally without merit and his company plans to vigorously fight it.

The Ohio suit

PIE Mutual was Ohio’s largest medical malpractice insurer until 1998, when the DOI seized control of the company because its liabilities exceeded its assets by $275 million. The DOI is currently liquidating PIE Mutual, attempting to pay off the estimated $600 million to $800 million in outstanding claims. The Ohio DOI has recouped approximately $240 million from the sale of PIE Mutual’s assets and the settlement with KPMG.

John Charlton, a spokesperson for the Ohio DOI, says there’s a good chance that claimants will not receive 100 percent of what’s owed them, but he is not sure of the magnitude of the shortfall.

“The guaranty funds have stepped up and have been paying in the nine states in which PIE was licensed,” he says, meaning policyholders in Indiana, Kansas, Kentucky, Maryland, Mississippi, Missouri, Ohio, Pennsylvania, and West Virginia are paying for part of the tab. . . .

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Multidisciplinary Practice: Big Changes Brewing for the Accounting Profession

By Jack Baker, Randall K. Hanson, and James K. Smith

It Won't Be Long Before It Happens

The offering of legal services through multidisciplinary practices (MDP) appears to be moving toward acceptance in the United States. The MDP movement has gained momentum from the American Bar Association Commission on Multidisciplinary Practice's recommendation to allow attorneys to share fees and partner with non-attorneys.

The rule changes would allow accounting firms to employ attorneys that, subject to certain restrictions, could offer a full array of legal services to their clients. Although the ABA House of Delegates voiced strong opposition and deferred voting, the MDP commission was instructed to gather additional information and resubmit the recommendation.

The commission's latest recommendation may have encouraged a number of recent strategic alliances between professional service firms. In addition to approaching accounting firms, law firms have shown an interest in strategic alliances with other professional service firms, such as financial consultants. These alliances are sure to increase the pressure on the ABA to restructure its ethics rules. The ABA recognizes that if it does not write the regulatory rules on MDP, someone else will. . . .

The Unauthorized Practice of Law. The ABA's decision to explore rule changes in the MDP area may result partially from its failed debate in the late 1990s with the accounting profession about the unauthorized practice of law (UPL). (See "CPAs and the Unauthorized Practice of Law," The CPA Journal, August 1998, and "Attorneys and CPAs: Cooperation or Confrontation?" The CPA Journal, June 1999, for background on the difficulties faced by bar associations in prosecuting accounting firms under UPL statutes.)

Not only is the definition of the practice of law elusive in many areas of CPA practice, such as tax, but Federal statutes that may preempt state UPL statutes further cloud the issue. These difficulties may explain why two recent UPL cases against Big Five accounting firms were dropped.

Accounting firms have further complicated the UPL issue by hiring a record number of attorneys. The Big Five now employ approximately 5,000 attorneys, making them the largest employer of attorneys in the United States. Attorneys employed by accounting firms perform many of the legal tasks that accountants are unable or unqualified to do.

The state bar associations' primary weapon for combating this development is to charge accounting firm attorneys with violating Model Rules of Professional Conduct (MRPC) 5.4, which prohibits attorneys from sharing legal fees with nonattorneys, forming partnerships with nonattorneys to render legal services, or rendering legal services under the direction of nonattorney employers.

ABA's Proposed Changes to Model Rules of Professional Conduct

The ABA's MDP commission issued its recommendation in support of MDPs in June 1999, proposing that the ABA allow attorneys, subject to carefully defined safeguards, to share legal fees with nonattorneys and provide legal services to clients through MDPs. At the ABA's annual meeting in August 1999, the commission unanimously recommended ethical rule changes in favor of MDP to the ABA House of Delegates, which voted to defer action on the recommendation and instructed the commission to gather additional information and resubmit the recommendation.

The MDP commission defines an MDP as a "partnership, professional corporation, or other association or entity that includes lawyers and nonlawyers and has as one, but not all, of its purposes the delivery of legal services to a client(s) other than the MDP itself or that holds itself out to the public as providing nonlegal as well as legal services."

Under the recommendation, attorneys practicing in MDPs remain subject to the rules of professional conduct, such as independence of professional judgment, protection of confidential client information, and loyalty to clients through avoidance of conflicts of interest. . . .

Strategic Alliances

The problems associated with the MDP commission's recommendation have not slowed down the MDP movement. If anything, it has gained substantial momentum, as evidenced by the number of strategic alliances between law firms and other professional service firms. While the most notable alliances are with accounting firms, some law firms show a willingness to consider alliances with other professional service firms.

The most significant strategic alliance to date is between Ernst & Young and a new Washington, D.C., law firm. Ernst & Young has agreed to supply the law firm with a significant amount of start-up capital and to lease it adjacent office space in a building that Ernst & Young owns. In return, the law firm has agreed to be known as McKee, Nelson, Ernst & Young LLP (MNEY). MNEY will initially focus on tax-related legal work with plans to expand to a full-service law firm.

Philip A. Laskawy, chair and CEO of Ernst & Young, pointed out that while the firm already provides legal services directly or through similar alliances in 40 countries through Ernst & Young Law, this alliance will extend that capability to the United States.

Ernst & Young's alliance with MNEY certainly tests the limits of the current legal ethics rules that prohibit attorneys from sharing legal fees with nonattorneys. Ernst & Young may have selected Washington, D.C., because of its more liberal ethics rules: Washington, D.C., is the only jurisdiction that allows attorneys to share profits with nonattorneys, but it requires the attorneys to remain in control of the firm providing the services.

In addition to the choice of jurisdiction, Ernst & Young has been careful to address the literal requirements of the MRPC. For example, Ernst & Young's Washington, D.C., accounting firm and MNEY are set up as separate entities with separate billing. In addition, Ernst & Young is not involved in the firm's day-to-day management.

Ernst & Young has been assured by outside counsel, a former chair of the District of Columbia's UPL committee, that the arrangement is perfectly allowable under its rules of professional conduct. However, other ethics experts believe that Ernst & Young is trying to see how far it can push the regulators.

Other Big Five firms are also announcing strategic alliances with influential U.S. law firms. In addition to its strategic alliances with the Chicago law firm of Horwood Marcus & Berk and the San Francisco-based international law firm of Morrison & Foerster, KPMG has announced an alliance with members of SALTNET, a network of state and local tax attorneys. KPMG is also expected to announce the hiring of seven international tax attorneys from the firm Weil, Gotshal & Manges, a move that John Lanning of KPMG says "will allow KPMG to take a leap forward in the international tax arena."

PricewaterhouseCoopers has announced an alliance with the Washington, D.C., law firm of Miller & Chevalier, and, perhaps more significantly, the ABA's litigation section has selected the accounting firm as its litigation-consulting sponsor. . . .

Many other accounting firms pursuing arrangements with law firms or attorneys may be keeping a low profile to prevent UPL sanctions. For example, some smaller accounting firms have reportedly hired attorneys as part-time employees with the understanding that their associated legal work will be done outside the accounting firm and billed back. . . .

Jack Baker, PhD, CPA, is an associate professor of accounting and
Randall K. Hanson, JD, LLM, is a professor of business law, both at the University of North Carolina at Wilmington.
James K. Smith, PhD, JD, LLM, CPA, is an assistant professor of accounting at the University of Nevada, Las Vegas.

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CORPORATE AUDITORS UNDER SIEGE

by Daniel L. Berger and Blair Nicholas

In the depths of the greatest financial disaster to ever hit this country, sixty-six years ago Congress passed the federal securities laws in an effort to rebuild investor trust and confidence in the integrity of the financial market.

Trust and integrity are the cornerstones of an efficient financial marketplace, and nothing is suppose to safeguard the market's integrity like an independent accountant's audit of corporate financial statements. This is true because the independent auditor assumes a public responsibility transcending any employment with the corporate client.

The independent auditor's ultimate responsibility is to the corporation's creditors and stockholders, as well as to the investing public. Simply put, if investors cannot trust the auditors to police corporate management, they cannot trust the financial data on which billions of buy and sell decisions are based each day.

This "public watchdog" function demands that the auditor maintain total independence from the client at all times to ensure objective, truthful reporting and complete fidelity to the public trust.

The importance of this independence requirement was well summarized by the Supreme Court of the United States in United States v. Arthur Young & Co., sixteen years ago when it stated, "Public faith in the reliability of a corporation's financial statements depends upon the public perception of the outside auditor as an independent professional . . . . If investors were to view the auditor as an advocate for the corporate client, the value of the audit function itself might well be lost."

Accordingly, it is not enough that the audit quality is maintained and that the numbers are accurate, it is also critical that public investors ― the users of corporate financial reports ― know that the auditors are acting objectively and independently in their role as the public's financial cop.

The American Institute of Certified Public Accountants Code of Professional Conduct describes the principle of "objectivity and independence" by mandating that: "a member should maintain objectivity and be free of conflicts of interest."

The application of this common-sense idea could not be simpler: Independent auditors who are engaged to judge the fairness of management's financial statements should avoid all conflicts of interest that would impair their judgment or create the appearance of an impairment. Indeed, these independence requirements are particularly critical today as public pension funds, as well as individual investors, are fueling the bull market by investing a healthy portion of their portfolio in the securities market.

This huge increase in investment activity in securities, so crucial to our national prosperity, only intensifies the basis for the core values of the independent auditor ― objectivity and independence, honesty and integrity, commitment to quality and professional expertise ― in the preparation of corporate financial statements.

Independent Auditors Under Fire

At the same time auditor independence requirements are becoming increasingly crucial, the auditing profession has come under fire as a recent Securities and Exchange Commission ("SEC") report cited more than 8,000 violations by PricewaterhouseCoopers ("PWC"), the world's largest accounting firm, of one of the basic rules of ethics of audit firms: You don't hold investments in a company audited by your firm.

The SEC report estimated that eighty-six percent of PWC's 2,700 audit partners had at least one ethical violation. Among the more serious violations, PWC's accountants owned stock in companies audited by the firm, took out loans from clients audited by the firm, had spouses or other relatives who worked for a client, and managed family trusts that held investments in a client.

In a letter to his partners, PWC's Chairman, Nicholas G. Moore and Chief Executive James J. Schiro, called the SEC's investigation's findings "embarrassing to our firm and to all of us as partners." SEC Chief Accountant Lynn Turner called the SEC's report "a sobering reminder that accounting professionals need to renew their commitment to the fundamental principle of auditor independence."

At the SEC's request, the Public Oversight Board, an agency created by Congress to keep watch on auditors, will now examine the accounting practices of ten accounting firms, including major auditing firms such as Ernst & Young, KPMG Peat Marwick, Deloitte & Touche and Arthur Anderson. In recent times, however, corporate auditors have been guilty of more than just violating fundamental conflict-of-interest rules, they have been at the center of nearly every recent financial scandal.

Judge Friendly of the Second Circuit in United States v. Benjamin , noted three decades ago: "In our complex society the accountant's certificate . . . can be instruments for inflicting pecuniary loss more potent than the chisel of the crowbar."

Judge Friendly's words have been borne out, as independent auditors have been held responsible for the outright manipulation and inflation of public companies' earnings to boost stock prices, despite the auditing firms' claims that they departed too early, arrived too late, or for some other reasons were not knowledgeable about the huge financial frauds that have recently rocked our nation's securities market.

For example, in In re Waste Management Securities Litigation , Arthur Anderson paid $70 million; in Cendant , Ernst & Young paid $355 million; and in Informix Ernst & Young paid $32 million ― all to resolve securities fraud actions where there were egregious irregularities with the financial statements of these publicly traded companies and the auditors were at the epicenter of the financial fraud.

As United States District Court Judge Stanley Sporkein, former enforcement chief of the SEC, aptly questioned in presiding over the litigation concerning the Lincoln Savings financial collapse: "Where were these professionals . . . [referring to the auditors] when these clearly improper transactions were being consummated? Why didn't any of them speak up or disassociate themselves from the transaction?"

While owning stock in a client is an obvious example of why a corporate auditor would refuse to "speak up," it also provides an example of part of a larger problem: the fundamental principle of total independence has been severely jeopardized as accounting firms in recent years have become multi-dimensional professional service conglomerates.

The Metamorphous of The Auditing Profession: The Watchdogs Become the Puppies of Management

In the 1970s, accounting firms like Ernst & Young and PWC functioned largely as independent auditors. Business consulting was merely an offshoot of traditional accounting and auditing ― a way to derive more income from the same base of clients. But the consulting business took off beginning in the mid-1980s, when consultants from large auditing firms won over the trust of corporate chief financial officers and landed huge technology consulting projects.

Today, corporate accounting firms view auditing as a low-profit, low-growth service of diminishing importance, and have instead focused their resources on the more profitable and faster growing non-audit services, including business consulting, tax consulting, human resources consulting, and corporate finance consulting. As a result, non-audit consulting fees have increased as a percentage of the largest accounting firms' revenues from 15% in 1978 to 24% in 1990 and to 38% in 1996.

This explosion in growth and demand for non-audit services has resulted in auditing firms "lowballing" their quoted auditing fee (whereby firms offer big reductions in their audit fees), in order to more easily leverage themselves into the companies to cross-sell the firm's more profitable non-auditing services, usually on a no-bid basis. For example, in 1991, PWC won a contract to audit Prudential after offering a discount of almost 40% off its original quote.

By the time Prudential dropped PWC as its auditor last year, PWC's annual consulting fee was more than 300% greater than PWC's annual audit fee. What is the reasonable investor to think when an auditing firm certifies a company's financial statements as complete and accurate, yet the auditing firm is generating three times its auditing fee from providing business consulting to the same company?

Clearly, the independence of the auditor is contaminated, the auditor is more reticent than ever to disagree with corporate management on financial reporting issues, and the credibility of an industry which is suppose to be free of potential or actual conflicts of interest is diminished. Auditing the Auditors

As business consulting services continue to grow at a rapid clip in this Internet age and auditing firms continue to direct more of its resources toward providing non-audit services to its clients, the issue of auditor independence will only intensify. In fact, Lynn Turner, chief accountant for the SEC, recently advocated that public companies should disclose all business links with outside auditors so shareholders can better evaluate possible conflicts of interest.

Ms. Turner stated that "given the explosion of these [non-audit] services, it's time for the public to know" and urged that mandatory disclosure of possible conflicts of interest should be required by the Independence Standards Board, a self-regulatory organization, or a new SEC rule. Clearly, someone needs to watch the watchdog.

The SEC's willingness to raise tough questions about conflicts of interest has been rewarded by the recent separation of auditors' consulting arms. PWC recently 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. Similarly, following the SEC's report exposing PWC's ethical violations, Ernst & Young sold its consulting arm to Cap Gemini, a French computer-services company.

The SEC should keep the heat on auditing firms to divest or at the very least, come up with some reorganization scheme that protects shareholders from actual or potential conflicts of interest.

Independence and integrity have always been the bedrock of the accounting profession and, in order to inspire investor confidence in the integrity of the American financial market, the auditor must remain independent.

– Daniel L. Berger can be reached at dlb@blbglaw.com and Blair Nicholas can be reached at blair@blbglaw.com.

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TO SPOT SOME MORE OF THESE COZY NESTS,

JUST DROP BELOW.

Arthur Andersen LLP - A “Big Five” accounting firm still praised by some for its “Outstanding Integrity”!

May 17, 2002

Ex-Andersen Partner Kept Enron Papers

Associated Press

HOUSTON – A former Arthur Andersen partner who illegally shredded documents related to Enron Corp. testified yesterday that he preserved several potentially embarrassing records.

David Duncan, who pleaded guilty to obstruction of justice charges in April, said he kept records related to allegations of questionable accounting practices brought last August by Enron Vice President Sherron Watkins.

“I believe I retained (documents) relevant to the Watkins allegation matter in a separate folder,” Duncan told attorney Rusty Hardin in a second day of cross-examination at Andersen’s obstruction trial.

Andersen claims neither the firm for Duncan broke any laws and that Duncan took the plea deal under threat of extensive prison time.

In his questioning yesterday Hardin focused on the important documents that survived the shredder in an effort to show the jury there was no conspiracy to cover up auditing work on Enron’s books.

Among the documents Duncan retained was a memo from fellow Andersen partner James Hecker, who took a call from Watkins in August. In the call, Watkins relayed her worries about Enron’s accounting of so-called “Raptor” entities and rumors of side deals that might have jeoparized the veracity of Enron’s financial statements.

The memo, detailing the conversation with Watkins, was titled “Smoking guns you can’t extinguish.” Duncan dismissed the title as nothing more than sarcastic wit.

Also preserved were copies of Watkins’ complaints, which she shared with former Enron Chairman Kenneth Lay. A review by law firm Vinson & Elkins later dismissed many of Watkins’ concerns.

Obstruction carries a maximum sentence of 10 years, but prosecutors can recommend Duncan, 43, be sentenced only to probation.

If Andersen is convicted, it could be fined up to $500,000 and face probation for five years. It also could be fined up to twice any gains or damages the court determines were caused by the firm’s action and would be barred from auditing publicly traded companies – likely putting the firm out of business.

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May 16, 2002

Kamehameha uses Enron firm in audit

By Jim Dooley, Honolulu Advertiser

The beleaguered accounting firm Arthur Andersen, on trial in Houston for obstructing justice in the federal investigation of Enron Corp.'s collapse, was paid $2.1 million last year to help audit Hawai'i's largest nonprofit organization, the $6 billion Kamehameha Schools, according to the organization's tax return, made public yesterday.

Eric Yeaman, chief financial officer of Kamehameha Schools, was an Arthur Andersen employee, working as "internal auditor" of the schools, when the Kamehameha trustees decided to hire him for the CFO post in July 2000.

Arthur Andersen has continued to serve as internal auditor and provides other services to Kamehameha Schools. The company will receive a slightly lower sum this year than the $2.1 million it was paid last year, according to Yeaman and to the tax return.

Yeaman said he has a conflict of interest in dealing with Arthur Andersen and "leaves the room" when there is any discussion at Kamehameha Schools about a business transaction with the accounting firm.

Hamilton McCubbin, chief executive officer of the schools, said the Honolulu office of Arthur Andersen has demonstrated "outstanding integrity" in its dealings with Kamehameha Schools.

The internal auditing contract with Arthur Andersen expires this summer, and the schools plan to hire their own internal auditing staff rather than rely on an outside company for the work, McCubbin said.

But an outside firm will be needed to help in that transition and to provide independent expertise when needed by the internal auditing staff, McCubbin said.

Arthur Andersen will be free to bid for that work, he said.

Once the fourth-largest accounting firm in the world, Arthur Andersen has lost clients steadily in the wake of the Enron scandal. In addition to the criminal trial now going on in Houston, Arthur Andersen has been named in a class action lawsuit filed by Enron shareholders. The firm has been selling offices and assets around the country, and could face bankruptcy in the near future, according to news reports.

The Kamehameha Schools tax return shows net assets of more than $4 billion. A wholly owned subsidiary, Kamehameha Activities Association, filing a separate return for the first time, listed assets of more than $2 billion.

The schools, which educate children of Hawaiian ancestry, spent $139 million of its operating budget on program services, and another $53.9 million in school construction and repair, according to the tax filing.

The construction expenses were mainly incurred building two new campuses, one on the Big Island and the other on Maui.

McCubbin said the schools are now spending about $20,000 per student on the Neighbor Islands, compared with $13,000 per student at the main campus on O'ahu.

The tax return also reveals considerable turnover in top employees at the huge institution.

Four former executives of Kamehameha Schools/Bishop Estate are listed among the highest-paid executive personnel, but the numbers include their severance pay.

They include Nathan Aipa, former chief lawyer for the schools and later acting chief administrative officer. Aipa, now in private practice, was paid $413,620 for the tax year ended June 30, 2001.

Former Kamehameha tax director Gilbert Ishikawa was paid $271,610; Rodney Park, former administrative/planning director, received $260,023; and former appraisal director Kenneth Teshima was paid $214,627.

McCubbin is the highest-paid executive now on payroll at Kamehameha Schools, receiving $321,026 plus $28,585 in expense account allowances.

Chief Investment Officer Wendell Brooks, who also has left the institution, was paid $300,000. Yeaman was paid $224,532. Mike Chun, acting chief education officer, was paid $188,718.

Executive salaries are considerably higher now than they were before years of turmoil culminated with the departure of all five of the institution's trustees two years ago.

Trustees used to be paid about a million dollars each. Last year they were paid between $122,000 and $49,500, depending on whether they served in the job a full year.

Board chairman Robert Kihune received the top salary of $122,000, because he was one of the acting trustees who carried over to full-time status. The same is true of trustee Connie Lau, who was paid $100,500, according to the return.

– Reach Jim Dooley at jdooley@honoluluadvertiser.com or (808) 535-2447

For much more on the Kamehemameha Schools’ connection, GO TO > > > Aloha, Harken Energy!

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< < < FLASHBACKS < < <

May 16, 2001

‘Chainsaw Al’ Accused of Fraud . . .

The New York Times

Albert J. Dunlap, the former chief executive officer of Sunbeam Corp., directed an accounting fraud in which he was aided by a partner of Arthur Andersen, the firm that audited Sunbeam’s books, the Securities and Exchange Commission charged yesterday.

Dunlap, best known for ruthless turnaround plans that usually involved slashing jobs, saw his memoirs become a best-seller.

Sunbeam’s stock leaped nearly 50 percent the day he was hired to run the company in 1996. But the SEC suit, filed in U.S. District Court in Miami, said the Sunbeam turnaround directed by Dunlap was a sham.

“This case is the latest in our ongoing fight against fraudulent earnings management practices,” said Richard H. Walker, the commission’s director of enforcement.

Sunbeam, now in bankruptcy reorganization, settled related administrative proceedings filed by the SEC, accepting a cease-and-desist order barring further violations of securities laws. It did not admit or deny the allegations.

But Dunlap, along with four other former top executives of the company, and Phillip E. Harlow, the Andersen partner who was in charge of auditing Sunbeam, said they would fight the charges. . . .

Dunlap, in a statement released by his attorney, called the charges “totally false,” and added, “I am outraged that the SEC has chosen to bring these baseless charges against me.”

Less likely to be outraged are the thousands of Sunbeam employees who were cut from the payrolls by the man known as Chainsaw Al. He became a corporate star in the 1990s, making tens of millions of dollars for himself as he dismissed thousands of employees in the name of efficiency. . . .

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19 June, 2001, UK

Top accountant fined $7m

One of the world's top five accountants has been fined for allegedly fiddling the books of a US firm.

Arthur Andersen failed to stand up to company management and betrayed their allegiance to the investing public.

by Richard Walker, US Watchdog

The US Securities and Exchange Commission alleged that the accountants had filed false and misleading audits of the US firm Waste Management, North America's biggest rubbish-hauler.

Without admitting or denying the allegations, Arthur Andersen has also agreed to an injunction that means it will face stiffer sanctions for future violations.

This is the SEC's first fraud case against a big five accounting firm.

Bad for PR

The firm is hoping that the payout will finally sweep the embarrassing episode under the carpet.

"This settlement allows the firm and its partners to close a very difficult chapter and move on," said the accountants in a statement.

"The allegations underlying the settlement are limited to one client and reflect work that is in some cases more than seven years old," it added.

The four audit partners involved are barred from doing accounting work for public companies between one to five years.

Investor protection

Arthur Andersen was in charge of Waste Management's books from 1992 to 1996 and issued audit reports that are alleged to have overstated revenue by more than $1bn.

Publicly traded companies are required to hire an accounting firm to go through their books using accepted accounting principles.

This ensures that potential investors are not misled by false accounts when considering whether to buy stocks and shares.

The SEC said that Arthur Andersen and its partners had betrayed their allegiance to shareholders and the general public.

"We will not shy away from pursuing accounting firms when they fail to live up to their responsibilities to ensure the integrity of the financial reporting process," warned Richard Walker, head of the SEC.

For more, GO TO > > > Nests Along Wall Street

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November 13, 2001

Andersen Could Face SEC Sanction,
Suits Over Enron Accounting Error

Bloomberg News

HOUSTON -- Arthur Andersen may face U.S. Securities and Exchange Commission sanction and shareholder lawsuits because it certified Enron Corp. financial reports that the company disavowed last week as inaccurate, legal and accounting experts said.

Andersen, the world's fifth-largest accounting firm, served as Enron's outside auditor for more than a decade. Last week, the company reported that it overstated earnings by $586 million over 41/2 years, inflated shareholder equity by $1.2 billion because of an "accounting error," and failed to consolidate results of three affiliated partnerships into its balance sheet.

Enron restated its financial reports as the company suffered a cash crisis triggered by disclosure of the cut in shareholder equity and the start of an SEC investigation.

"I'd be very surprised if the SEC didn't go after Arthur Andersen," said Alan Bromberg, securities law professor at Southern Methodist University.

Andersen partner David Tabolt has said the firm is cooperating with a special committee of Enron's board of directors appointed to investigate the accounting problems.

Lynn Turner, who was the SEC's chief accountant for three years until he resigned in August, said Enron and Andersen ignored a basic accounting rule when they overstated shareholder equity.

Explaining the equity reduction last week, Enron said it had given common stock to companies created by Enron's former chief financial officer in exchange for notes receivable, and then improperly increased shareholder equity on its balance sheet by the value of the notes.

"What we teach in college is that you don't record equity until you get cash for it, and a note is not cash," said Turner, who is now director of the Center for Quality Financial Reporting at Colorado State University.

"It's a mystery how both the company would violate, and the auditors would miss, such a basic accounting rule, when the number is $1 billion."

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January 17, 2002

Anderson, trying to curb damage,
vows to changes practices, policies

Some suggest company’s future may be in doubt

By Dave Carpenter, Associated Press

CHICAGO – Arthur Andersen LLP accelerated damage-control efforts yesterday, running full-page ads in national newspapers to try to limit blame in the Enron debacle to its Houston office and promising an overhaul of its practices.

But as Andersen’s lead auditor in the case met with congressional investigators in Washington questions remained about whether involvement in the document-shredding scandal extended to executives at Andersen’s Chicago headquarters.

A series of disclosures involving Andersen’s role in Enron’s demise has hurt the accounting giant’s stellar reputation, raising speculation it may not survive the controversy as an independent company.

Experts say the company’s short-term future may depend on what investigators discover in probing what top managers knew and when they knew it.

In the advertisement published yesterday, Andersen CEO Joseph Berardino touted actions taken by the company on Tuesday: Andersen’s lead partner on the Enron account, David Duncan, was fired; three partners who worked on the assignment were put on leave; new leadership was put in charge of the Houston office; and four partners were stripped of management responsibilities.

“In the near future, Andersen will announce comprehensive changes in our practices and policies that we believe will reaffirm confidence in the independence and quality of our work,” the ad read. . . .

The efforts at damage control appeared designed to isolate the problems to the Houston office, which handled the audit of the collapsed energy-trading company.

But Berardino left open the possibility that executives at headquarters might be implicated, saying Tuesday that “we’re not quite sure yet” whether wrongdoing reached higher into the accounting firm than the auditors now being disciplined. . . .

Particularly at issue are special partnerships formed by Enron that enable it to add several hundred million dollars from off-the-books transactions to publicly stated earnings, and at the same time hide big debts. . . .

In other action, an energy company sued Andersen, accusing it of fraud and negligence in Enron’s collapse.

Attorneys for Samson Investment Co. in Tulsa, Okla., filed the civil suit Tuesday, saying Samson and other companies “justifiably relied on the financial audits” for their natural gas purchase contracts with Enron but those audits were “grossly misleading.”

The lawsuit requests class-action status on behalf of more than 100 unnamed companies and seeks unspecified damages.

Andersen is already named in more than 30 lawsuits filed on behalf of Enron shareholders who saw their holdings plummet in value after the company’s stock plunged to below $1 in December. . . .

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January 18, 2002

Failed Enron Energy Company Dismisses Its Accounting Firm

Lawyer cites auditor’s order to shred papers

By H. Josef Hebert, Associated Press

WASHINGTON – Enron Corp. fired accounting firm Arthur Andersen yesterday amid growing evidence that its auditors had serious questions about Enron’s financial practices but did nothing to correct them.

“We’re very troubled about the destruction of the documents, and we’re very concerned about the accounting advice we got,” said Washington attorney Robert Bennett, who is representing Enron.

Bennett said Enron informed Andersen of the dismissal yesterday afternoon. Joseph Berardino, Andersen chief executive officer, acknowledged Enron’s decision. . . .

The firing came as congressional investigators pressed the accounting firm for more documents concerning Enron’s business activities. . . .

SEC Chairman Harvey Pitt did say that the commission will reserve its harshest punishment “for anyone who lies or obstructs (an SEC) inquiry.&