They're Bean Counters, Not Gumshoes

Soon after Phar-Mor Inc. accused two of its executives in early August of embezzling at least $10 million from the drugstore chain, Chief Executive David S. Shapira made sure no one would mistake him for Harry Truman: He blamed the retailers' outside auditors, Coopers & Lybrand, for failing to detect phony financial ledgers and sued the firm. Never mind that Shapira himself caught on only after receiving a tip.

For the accounting profession, lawsuits such as Phar-Mor's are becoming increasingly common. As investors and taxpayers search for scapegoats in the wake of financial debacles, the Big Six accounting firms have come under siege. Last year, they spent nearly $480 million to defend and settle lawsuits charging them with shoddy accounting work--roughly 9% of their domestic audit revenues.

Some of those judgments may be defensible when auditors perform negligently. Yet unfortunately, the public, in its never-ending quest for fail-safe investments, is coming to expect too much from accountants. They aren't, shouldn't be, and really can't be prosecutors looking to root out all fraud and corruption. Their formal role is much more limited: They are hired by management to examine a company's books and records to determine whether management's financial statements abide by generally accepted accounting standards.

`SAVE ME.' By necessity, auditors rely mainly on information furnished by management. They typically visit company facilities, check samples of inventories, and assess a company's internal controls. They make sure depreciation schedules are appropriate and the arithmetic is correct. They see themselves as an ally of management, not its adversary. It's easy to see why: Management pays their fee.

If corporate executives are determined to cook the books to perpetrate some deceptive scheme that, say, shuttles inventory between warehouses, accountants say they can't always detect it. To avoid disrupting a company's operations, they usually schedule such functions as inventory checks in advance with management's cooperation.

Auditors can't be expected to check out every slip of paper and trace the flow of a company's every penny. That would be too time-consuming and expensive for executives to tolerate. "As an auditor, you don't make huge demands of management--that is, if you expect to be the auditor next year," says Howard Schilit, an accounting professor at the American University.

In the case of Phar-Mor, Coopers & Lybrand says it was intentionally misled by company executives. Specifically, Coopers claims Phar-Mor executives altered financial statements. By blaming the accounting firm, "they're saying, 'Save me from myself,' " says Harris J. Amhowitz, general counsel for Coopers & Lybrand, which is countersuing Phar-Mor.

This is not to say that accountants should be excused for failing to spot blatant finagling or for gross negligence, such as ignoring obvious inconsistencies and omissions in financial records. When auditors find fraud, they should be required by law to disclose it to the appropriate authorities. Unfortunately, accountants have often been reluctant to speak up. At times, they've even covered up fraud. As they see it, nothing is to be gained by treating clients like enemies.

EASY PREY. What's more, auditors don't usually make good detectives. According to a psychological study of 1,500 certified public accountants by Babson College professor Larry Ponemon, accountants tend to focus on following rules and lack the intuitive skills to judge the character of their clients' executives. That can make accountants easy prey to hoodwinking.

Despite these limits to the role and competence of accountants, many investors persist in regarding an auditor's unqualified opinion as the equivalent of a Good Housekeeping Seal of Approval against fraud and mismanagement. And sometimes the courts do likewise. U.S. District Judge Stanley Sporkin, in a case involving former thrift executive Charles H. Keating Jr., struck a responsive chord when he asked, "Where were the professionals. . . when these clearly improper transactions were being consummated?"

For all its flaws, there may be no better alternative to the private system. The dismal track record of government thrift examiners during the 1980s suggests that nationalizing the profession would be no panacea. A more prudent approach is that of the California Supreme Court. On Aug. 27, it threw out a suit by investors in Osborne Computer Corp. and ruled that only an accounting firm's client could sue for a negligent audit. More courts need to scale back shareholders' expectations--and access to auditors' deep pockets. They should put the focus of legal assaults on corporate wrongdoing where it usually belongs: on managers who fall down on the job.

Before it's here, it's on the Bloomberg Terminal.