Investors' New Worry: "Auditor Risk"

Before buying a stock, these days you better consider which accounting firm is doing the company's books

By Robert Barker

Thank heaven for Arthur Andersen.

You may think I'm nuts, given the hellfire now licking at the once-venerable Chicago-based accounting firm that signed its name to the annual financial audits of Enron (ENRNQ ). But in the stock market, every edge counts. And the Andersen situation is offering investors a fresh edge.

Call it "auditor risk." Investors long ago learned to weigh a bunch of different threats to the value of their shares. Some financial-services stocks suffer "interest-rate risk": When rates go up, their stocks tend to go down. Or take overall "market risk," such as the plunge in value that took down most every stock when trading resumed post-September 11.

To the list of things every thinking investor should consider, I'm now adding auditor risk. It's as simple as this: No investor can make an informed decision about a stock without reading the company's financial statements, and financial statements are only as good as the firm auditing them. If you have worries about the auditing firm, you could have worries about the stock market value of the companies it audits.


  What role Andersen played -- and if it has any responsibility -- in the Enron debacle is still being sorted out. But at the very least, Andersen's handling of Enron's books has raised a number of questions, and investors now have reason to wonder about Andersen audits of other companies' financial statements.

True, the firm would not be the only Big Five accountant to have messed up. Just last week, the Securities & Exchange Commission censured KPMG for having made investments in a money-market fund for which it was supposedly serving as an "independent" auditor. KPMG consented to the SEC's findings without admitting or denying them.

Other firms, such as Ernst & Young and PricewaterhouseCoopers, also have had problems. (Come to think of it, an opportunity is waiting for an entrepreneur who can sort out which auditing firm is least worrisome.)


  Yet Andersen seems to have had more than its share recently, given the high-profile nature of the Enron matter. In addition to that mess, Andersen has had recent dealings with the SEC involving audits that had to be redone at Waste Management (WMI ) and Sunbeam (SOCWE.OB ).

Last May, Andersen agreed -- without admitting liability -- to pay $110 million in damages to Sunbeam stockholders for an audit that had to be redone. Then, weeks later, came Waste Management.

"Without admitting or denying the allegation or findings, Andersen agreed to the first antifraud injunction in more than 20 years and largest-ever civil penalty -- of $7 million -- in an SEC enforcement action against a Big Five accounting firm," the government announced. It added, "Andersen further agreed to be censured under the SEC's rules of practice. The SEC concluded that Andersen's Waste Management audits were materially false and misleading and that Andersen engaged in improper professional conduct."


  Now, Enron. Is it fair to single out one firm as potentially risky? No, not entirely. You might say it's guilt by association -- wondering about all Andersen audits, and other Andersen clients, simply because of the connection between Andersen and Enron.

That hasn't stopped the Connecticut attorney general's office from asking its state accountants board to look into the possibility of revoking the licenses that let Arthur Andersen work for corporations in the state.

Neither is the stock market always fair. Based on Enron's misleading financial statements, the market did not value the company fairly at $35 a share last August. Just before being banished from the New York Stock Exchange, the stock traded at 67 cents. Over the counter, it's now 37 cents.


  What's indisputable is that an intelligent investor's first job is to note every perceivable risk. That's why I decided to see which other big companies use Andersen for their audits.

To do so, I searched the most recent annual reports and proxy statements of the 30 most valuable companies by market capitalization in the Standard & Poor's 500-stock index. You can see the results in ). Of the 30 and their respective auditors, you'll see four use Andersen: Abbott Laboratories (ABT ), American Home Products (AHP ), Merck (MRK ), and Oracle (ORCL ).

Should investors in these companies be worried? Andersen did not return my call for comment. Neither did Oracle, although CEO Larry Ellison declared on CNBC last week: "I'm a big fan of Arthur Andersen." The other big Andersen clients, all of whom were contacted, weren't anxious to discuss the relationship.

A spokesman for Merck told me that Andersen "has rendered much excellent service" to the drugmaker for many years. He added that this year, as in the past, the audit committee of Merck's board will review how well Andersen is doing and leave it to shareholders at their annual meeting in April to decide whether to rehire Andersen.


  Seems reasonable enough. But if I were on that audit committee, I would be weighing whether Andersen's reputation is now so damaged that a prospective investor would regard Merck's financial statements with something less than full faith. The question for corporate audit committees: Has Andersen lost so much credibility that an audit with the Andersen name could potentially suppress the price of a company's stock?

For shareholders, I have this modest proposal: Check your most recent proxy statements to see who the auditors are. Next, check the proxy to see how much the companies are paying the accounting firm for services above and beyond the audit.

In Enron's case, Andersen's audit fees of $25 million in 2000 were outstripped by the $27 million it charged for other consulting work, including -- get this! -- risk management.


  That's no anomaly. Look at General Electric (GE ), the world's most valuable company. GE's last proxy reported that it paid KPMG $23.9 million in 2000 for its audit. It was further reported in the proxy statement that GE also paid KPMG a total of $79.7 million in 2000 for a variety of other services, from consulting on computer systems to tax preparation to advice on mergers. KPMG collected more than three times as much money from GE for its consulting work as for its audit.

No one is accusing KPMG of stinting in its role as an auditor on behalf of the board, with ultimate allegiance to GE shareholders. GE's audit committee explicitly noted that it had "considered whether KPMG's provision of nonaudit compatible with KPMG's independence." The directors concluded that KPMG's independence remains intact.

Again, fair enough. But this is precisely the kind of imbalance that holds the potential for conflict of interest and can raise eyebrows.

If you're an investor, here's my advice: Don't close your eyes or hold your breath waiting for Corporate America, the Big Five, the SEC, or even Congress to protect you. Instead, do yourself a favor. When you consider all the risks in your portfolio, open your eyes to the newest one -- auditor risk.

Company Symbol Auditors
General Electric GE KPMG
Microsoft MSFT Deloitte & Touche
ExxonMobil XOM PricewaterhouseCoopers
Wal-Mart Stores WMT Ernst & Young
Citigroup C KPMG
Intel INTC Ernst & Young
IBM IBM PricewaterhouseCoopers
American International Group AIG PricewaterhouseCoopers
Johnson & Johnson JNJ PricewaterhouseCoopers
Cisco Systems CSCO PricewaterhouseCoopers
Verizon Communications VZ Ernst & Young
Merck MRK Andersen
AOL Time Warner AOL Ernst & Young
SBC Communications SBC Ernst & Young
Home Depot HD KPMG
Coca-Cola KO Ernst & Young
Royal Dutch Petroleum RD KPMG
Philip Morris Cos. MO PricewaterhouseCoopers
Tyco International TYC PricewaterhouseCoopers
Procter & Gamble PG Deloitte & Touche
Bristol-Myers Squibb BMY PricewaterhouseCoopers
Bank of America BAC PricewaterhouseCoopers
Oracle ORCL Andersen
Abbott Laboratories ABT Andersen
Eli Lilly & Co. LLY Ernst & Young
American Home Products AHP Andersen
Viacom VIA.B PricewaterhouseCoopers
Fannie Mae FNM KPMG

Barker covers personal finance in his Barker Portfolio column for BusinessWeek. His column appears every Friday, only on BusinessWeek Online

Edited by Patricia O'Connell

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