Russia's World-Class Accounting Games

Investors say abuses are rife, and pressure is building on regulators to step in to ensure that vital capital isn't scared off

By Paul Starobin

It's the financial scandal of the moment in Russia. A government watchdog organization, Russia's Audit Chamber, is investigating the auditing of energy titan Gazprom by PricewaterhouseCoopers, apparently spurred at least in part by a BusinessWeek article highlighting shareholder criticism of the auditing (see BW, 2/18/02, "Gazprom: Russia's Enron?").

The agency has already suggested that Gazprom, which is 38% owned by the Russian government, replace PwC as its outside auditor. The energy company is now organizing a tender to select an auditor for its 2002 accounts. PwC, which has been signing off on Gazprom's books since 1996, may lose the job.

Shades of Enron? The PwC-Gazprom controversy may sound familiar to anyone following the woes of the Houston energy company and its auditor, Arthur Andersen. But, in fact, such problems in the largely unregulated relationship between auditors and companies in post-Soviet Russia run much deeper and are far more common than anything known in the U.S.


  Russian regulators now must act quickly to establish tough uniform standards ensuring that auditors serve the interests of shareholders, not management. Without such requirements, responsible shareholder capitalism is unlikely ever to flourish in Russia, leaving the country bereft of vital investment capital.

Gazprom is hardly the only company that may be failing to disclose sufficient information to shareholders. Russian oil giant Lukoil, audited by KPMG, another U.S. Big Five firm, also doesn't adequately report transactions with businesses apparently connected to management, according to Moscow fund manager Mattias Westman, director of Prosperity Capital Management. KPMG says Lukoil's books are audited according to generally accepted accounting principles, but investors like Westman remain skeptical. "Big U.S. investment funds stay away from Russia because of lack of confidence in disclosure," he contends.

Another Russian oil giant, Yukos, has shown that tightening financial controls can give a company a major boost. Back in June, 2000, as part of a package of reforms to improve corporate governance, Yukos set up an audit committee headed by Jacques Kociusko, managing director of Paris-based Kajis. Since then, the company's share price has skyrocketed by 850%.


  However, most companies have simply ignored calls by Russia's Federal Securities Commission for voluntary action. The reason? All too many are still headed by managers who cling to the view that the enterprise is an engine to generate wealth for themselves.

Indeed, the central allegation by Gazprom's minority shareholders is that PwC became a captive of the management of former CEO Rem Vyakhirev. Critics say Vyakhirev scuttled attempts by minority shareholders to have the Big Five's Deloitte & Touche review PwC's auditing of ties between Gazprom and Itera, a Moscow gas producer. Critics suspect that Gazprom management was using Itera as a front for the transfer of billions of dollars in assets. Under pressure from Gazprom managment, PwC agreed to conduct its own review of Gazprom-Itera ties. Gazprom declined to comment.

That's why several reforms are crucial. Most important, the PwC-Gazprom matter flags the need for publicly held Russian companies to establish mandatory, full-fledged audit committees, headed by independent directors, to supervise the outside auditor. That's standard practice in the U.S. This would complement steps to improve corporate governance adopted last year by Russia's legislature, the Duma, including a measure that gives boards of directors the right to dismiss a company's CEO at any time.


  Tougher rules are also needed to police the selection and payment of auditors. A recent review of Russian auditing practices by the Paris-based Organization for Economic Cooperation & Development (OECD) found that some Russian companies use so-called pocket auditors -- firms run by cronies of the managers who help cook the books to enable companies to evade taxes and disguise asset-stripping.

To combat such practices, Russian law should require companies to disclose the criteria by which an outside auditor has been chosen, as well as the fees paid to it for auditing, consulting, and any other work. As the OECD is recommending, false statements should be punishable by Russia's Federal Securities Commission. It would also help to require that the lead auditor on each account be rotated periodically.

Of course, outside auditors such as PwC and KPMG shouldn't be made scapegoats for every manner of corporate misdeed. In a Feb. 27 full-page advertisement in the Russian business daily Vedomosti, PwC responded to criticism by pointing out that auditors often recommend improvements in corporate governance to clients but are not responsible for deciding whether such reforms are adopted. That's fair enough: In the case of Yukos, Chairman Mikhail B. Khodorkovsky credits PwC, its auditor, with playing a helpful role in implementing shareholder-protection improvements.

Nor are auditors at fault for the murkiness in Russia law in many key areas. Changes are needed to tighten legal definitions of related parties and improve disclosure, says Roger Munnings, the KPMG partner in charge of the Moscow office. However, auditors are losing credibility, in Russia and elsewhere, for good reason: They too often seem willing to keep accounts at all costs. It's high time for the lawmakers and regulators to step in.

Starobin is BusinessWeek's Moscow bureau chief

Edited by Thane Peterson

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