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The Pwc Scandal Changes Everything

Finance: Accounting

The PWC Scandal Changes Everything

Breaches of auditor independence at PWC could lead to an overhaul of the Big Five

It all started with two letters, one to Coopers & Lybrand, and the other to the Securities & Exchange Commission, accusing Coopers' employees in a Tampa (Fla.) office of owning stock in companies while auditing their financial statements. Those letters set in motion what has become the most massive investigation ever of a U.S. accounting firm. The examination uncovered widespread violations at the world's largest accountant, PricewaterhouseCoopers. And while the SEC-ordered report on the investigation is barely six weeks old, it is already leading to major changes in the U.S. accounting industry.

What has become clear is that auditing and consulting, the mainstays of the business, cannot live comfortably in the same house. PWC is close to announcing a major restructuring that will eventually lead to the sale or initial public offering of its large consulting business, according to a senior partner. PWC insists the restructuring has nothing to do with the widespread violations of auditor-independence rules. But that argument was more compelling before lapses on the accounting side came to light. Besides, such a move would go a long way toward eliminating potential conflicts of interest.

Regulators are putting pressure on the entire profession. The SEC has directed the accounting industry's watchdog, the Public Oversight Board, to investigate seven other major accounting firms. The Big Five are being required to invest in computer systems that will allow them for the first time to track employees' investments in order to guard against conflicts of interest. And other major firms are likely to separate their consulting and auditing businesses in coming months. The reason the SEC wants these changes is simple: Auditors may hesitate to issue tough opinions on companies' financial statements when they are courting consulting business.

What went wrong at PricewaterhouseCoopers? Although many of the 8,064 violations at PWC were technical in nature, the bulk of the infractions broke accounting's most fundamental rule: that partners may not own stock in companies audited by their firm. Half of PWC's 2,700 U.S. partners owned stock in companies the firm audits, according to the report by law firm Lankler Siffert & Wohl done at the behest of the SEC. The report also revealed that 1,885 people at the firm--1 in every 20 employees--committed violations, prompting Lankler Siffert to conclude that PWC has serious structural and cultural problems. The violations went all the way to the top--6 of 11 partners responsible for the firm's independence policies broke the rules, as did 31 of the firm's 43 senior partners, including 4 who had more than 20 violations apiece. Five partners were forced to resign, a sixth is on the way out, and five other managers and staffers were dismissed.

How could a leading firm of PWC's repute get itself into such a mess? "The magnitude [of the violations], to put it frankly, has startled everyone," says Gregg W. Corso, counsel to Chairman Arthur Levitt Jr. at the SEC. The firm's chief executive, James J. Schiro, declined to be interviewed for this story. But in PWC's defense, Kenton J. Sicchitano, its managing partner for firm independence, said during a series of lengthy interviews: "We thought people were taking care of this." Peter B. Frank, another senior partner who worked closely with Sicchitano, said the violations can't be pinned on self-interest, adding: "These are not people who did things intentionally."

PWC says that many of the violations point to problems with the rules themselves. One partner, for example, was cited because his children each had a single share of Walt Disney Co. stock framed and hanging in their bedrooms. Even though Disney was a client, it never occurred to him that this gift from the children's grandparents was a breach of auditor independence. In another instance, partners who had "sweep" accounts at Charles Schwab & Co. found that their idle cash had been moved into money-market funds audited by the firm.

PWC's Sicchitano explains what happened by drawing a picture of a firm facing an ever-more-complicated work environment: "There have been tremendous changes in society with working spouses...a tremendous explosion of direct investment. At the same time of all these external changes, the firms were changing a lot. We have spent all our money on client things. We had not spent on internal things. All of a sudden, we're a big global firm, and we don't have the infrastructure."

Still, nearly half of the violations occurred because PricewaterhouseCoopers employees or their spouses held shares in companies audited by PWC. In most cases, employees were not actively working on those companies' financial statements. Later, at the SEC's behest, PWC built a $15 million state-of-the-art computer system that compares senior employees' portfolios with lists of the firm's clients to spot infractions. On Feb. 1, the industry's trade group, the American Institute of Certified Public Accountants, said that it will require other Big Five accounting firms to invest in similar systems.

For PWC, fallout from the reported violations continues. It faces a civil-racketeering lawsuit filed in the U.S. District Court in New Jersey. And PWC had to resign as auditor from four companies, including Pediatrix Medical Group Inc., a Fort Lauderdale manager of physicians' practices, as well as inform 52 more clients that PWC audit partners, tax experts, and other professionals were not fully independent of them. PWC insists none of the violations harmed clients' financial statements or filings. DEEPER PROBLEM. None of PWC's problems might ever have come to light had it not been for the two "poison pen" letters, as PWC's Frank calls them, sent to Coopers & Lybrand and the SEC in late 1997, shortly after Coopers & Lybrand and Price Waterhouse announced plans that September to form the world's biggest accounting firm. The letters prompted the firms to start an internal review. Then, in February, 1998, the SEC notified them that it was investigating.

The initial allegations about Tampa struck Sicchitano, Frank, and others who knew about them as insignificant. A 35-year veteran of Price Waterhouse, Frank didn't suspect a wider problem: "We've never had a problem," he said. In their view, this was a Tampa problem, a Coopers problem, an isolated incident.

On July 1, 1998, the two firms merged, creating a company with 140,000 employees worldwide. The merger also introduced huge potential conflicts by marrying the client bases of the firms. Combined, they would audit nearly 3,000 public companies, mainly American, thus putting them off-limits as investments to partners. Employees were given a month to dispose of all investments that were prohibited--and a further three weeks to confirm that they had done so.

While PWC was sorting out its own independence issues, the SEC was turning up evidence that there were deeper problems in Tampa. Just how serious they were became evident on Nov. 5, 1998, when PWC's Schiro sent out an internal memo saying that two partners and a manager connected with the business there had been asked to resign. Schiro, a member of the Independence Standards Board, a professional rule-making body, added that the firm took such issues seriously. The next day, PWC did a check of its own. It asked its 1,200 audit partners to answer two questions: Do you own stock in a client you have audited? And do you know of any auditor who does? To the firm's relief, all of the answers came back "no."

Clearly, auditor independence was a big issue at PWC in the fall of 1998. Yet the recent allegations by semiconductor-maker Emcore Corp. of Somerset, N.J., raise the question about whether all of the firm's partners took the matter seriously--particularly the rule that no partner may own shares in a client. Emcore alleges in a lawsuit filed in the U.S. District Court that Schiro and eight other PWC partners caused a costly delay in its secondary-stock offering last year because they owned 140,000 shares in the company while PWC did a key audit of 1998 financial statements. PWC moved to dismiss the suit, which Frank P. Barron, PWC's outside counsel, says is nothing more than an attempt to embarrass PWC and Schiro. The partners, he says, were all Price Waterhouse employees who bought into Emcore in the mid-'80s, and it was Coopers that had been Emcore's longtime auditor. Schiro owned 165 shares that were labeled "restricted." That meant that the stock was not a liquid investment that Schiro could have easily disposed of by the July 31 deadline set for employees affected by the merger. Barron said Schiro transferred the shares, worth about $1,600, to his daughter in August, 1998, and they were sold by December of that year, to comply with independence rules.

An amended Emcore complaint, filed on Feb. 4, also says that partner Lennart Lindegren exercised 233 warrants to buy additional shares of Emcore in December, 1998, just before the firm signed off on the audit. Lindegren said through a PWC spokesman that his shares were restricted, too. He said that when he asked Emcore's chief financial officer about the best way to dispose of them, he was advised to exercise the warrants, which he did, and then sell the shares. Lindegren says he donated the proceeds to a university.

In early 1999, the SEC decided that PWC's opinion on Emcore's financial statement wasn't independent, which forced Emcore to hire another auditor, Deloitte & Touche, get its 1998 statement reaudited, and delay its stock offering by three months. The suit seeks unspecified damages. The SEC won't comment on the Emcore case. But in general, say officials, ownership by partners in an audit client is a violation of independence rules whether shares are restricted or not.

After the investigation in Tampa, lasting nearly a year, the SEC on Jan. 14, 1999, issued an order that became the basis for the massive review that would turn up the 8,000-plus independence violations. The SEC's findings were serious: In one instance, a tax associate owned stock in a company for which he prepared financial statements used in securities filings. In 31 other cases, partners and managers owned stock in auditing clients.

Without admitting or denying the findings, PWC agreed to set aside $2.5 million for education on independence. Also, it agreed to invest in the new computer system to track every partner's and manager's investments. In the past, PWC, like all big firms, simply asked employees to review ethics rules and sign an annual statement saying they are in compliance--no one had to disclose the contents of his or her portfolio. And though it called the Tampa violations "aberrant," PWC agreed to let an outside consultant review how closely all of its U.S. employees were following independence rules.

The review, starting in March, 1999, turned into a massive undertaking. PWC had to collect data on nearly 39,500 U.S. employees, back to June, 1997. With law firm Lankler Siffert supervising the review, PWC began by e-mailing employees, asking them to list any violations of which they were aware over the period--and warned that if they failed to do so, they could be charged with making a false statement. Despite the warnings, a random sample of 200 of the firm's 2,700 partners revealed that 77.5% of them failed to report at least one violation that they had committed. That could in part be explained by the complexity of the rules. Even Frank and Sicchitano were stunned to learn that they had several violations despite the large amount of time they spent working with the SEC and sorting out the firm's independence problems.

Even so, Lankler Siffert found that the bulk of the violations resulted from breaking the most basic rules of all. Fully 37% of the violations were direct employee investments in clients--and an additional 11% were direct investments by their spouses. While the Price Waterhouse and Coopers merger accounted for nearly half the violations, 4,367 were not merger-related. The lawyers' report notes that most often, people simply forgot to check the firm's lists of prohibited investments or didn't figure out how to do a complete check. Yet the report also reaches the damning conclusion that others at the firm "appear to have made little or no effort to comply with the rules."

Clearly, PWC's partners are exasperated by those rules. While the firm insists that it will follow them, Frank may have voiced the firm's truest view when he said in an interview: "We're not here to tell you the rules are wrong, but they are." The SEC is showing a new willingness to update some of the more onerous restrictions, particularly those on mutual-fund ownership and family conflicts, which have forced many partners to leave PWC when their spouses wound up working in a significant position at a client company. And partners' parents, children, and other relatives have been forced to give up investments.

So how big a threat are lapses in auditor independence to the integrity of companies and markets? For all the weight the SEC has placed on the issue, none of the recent spectacular financial blowups at such companies as Cendant, Sunbeam, or Rite Aid can be traced to an auditor with a financial interest in the company. In PWC's case, it insists that the violations didn't compromise their clients' financial statements. Still, a number of companies were subjected to costly inconveniences because they were forced to hire new auditors.

Furthermore, many accounting professionals and industry watchdogs are bothered by what they see as PricewaterhouseCoopers' stunning complacency about the rules. "There's no excuse for what happened," says a CPA who oversaw independence policies at another Big Five firm. Some observers even liken what happened to jury nullification--a conscious rejection of the system and its rules.

Certainly, PWC's travails in coping with professional ethics contain a number of ironies. It is hard to believe that PricewaterhouseCoopers--which specializes in selling sophisticated technology and computer-systems advice--would have turned up violations if it had audited its own system for monitoring independence. And it is hard to believe that a firm littered with specialists who routinely steer clients through arcane tax laws somehow found the independence rules too hard to follow. Soon, it will be possible to see whether PWC is an isolated case or emblematic of problems plaguing the entire profession.By Pamela L. Moore in New YorkReturn to top

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