Auditing the Auditors

One professor's study proposes a way to rate the work of accounting firms. The method may not be perfect, but he may well be on to something

Buying a car? Umpteen periodicals and Web sites will rate new models for you. Picking a college for your kid? Rankings galore. Heck, if your kid isn't even born yet, you can get reviews of how well the obstetricians at your local hospitals do their job. But what if you want to buy stock in IBM (IBM )? How well does its auditor, PricewaterhouseCoopers, do its job? Is Deloitte & Touche, Microsoft's (MSFT ) auditor, risky? Who's more trustworthy, Ernst & Young or KPMG?

These are uncomfortable questions for the Big Four accountants. Yet for investors, they have become unavoidable. And they're vital if you're on a public company's audit committee. Trouble is, no one has been able to offer many answers. Now, Ross Fuerman, an accounting professor at Suffolk University in Boston, has released research into audit firms' relative riskiness (table). His aim: to monitor and publicize auditors' performance and so improve it. "We can appeal to the moral, ethical, and altruistic impulses of public accountants," Fuerman notes, "but these impulses are lacking in many auditors."

This, needless to say, is controversial stuff. I sent copies of Fuerman's recent paper to each of the firms it names. (Full disclosure: Among the paper's references, it cites a BusinessWeek Online article of mine from January.) Without commenting directly on Fuerman's research, an Ernst spokesman said the firm "has a strong track record of fostering long-term client relationships, while maintaining our independence--a critical measure of our performance." Greg Weaver, partner in charge of Deloitte's audit practice, noted that Arthur Andersen's ranking above Deloitte's undercuts the study. "It's unbelievable," he said. Other firms declined to comment publicly, but some privately questioned Fuerman's methods. And Peter Moizer, a University of Leeds accounting professor whose work on auditor reputation is cited by Fuerman, called his approach "very cavalier."

So, don't hurry off to your broker with Fuerman's results. Yet I think this guy is on to something. A 49-year-old former practicing lawyer and certified public accountant, Fuerman since 1994 has researched the role of accountants in securities litigation. His latest work looks at 476 private suits brought from January, 1996, to November, 1998, plus any ensuing regulatory actions or criminal cases. Fuerman next scored the outcome of each suit. For example, if a case did not name the auditor as a defendant, Fuerman gave the case a "0" score. If the auditor was named but made no settlement, the case got a 200. And so on, up to 1,600 if an auditor pleaded guilty or was convicted in a criminal case, the most severe of nine outcomes.

Did relative riskiness by Fuerman's measure bear a relationship to investors' returns? To find out, Fuerman examined total returns on stocks in companies audited by each of the firms. While noting his analysis did not indicate that stock-market returns were actually caused by a given level of auditor riskiness, he did see a decided correlation: Stock in companies audited by firms with lower risk scores yielded higher total returns over the five years ended last November.

There is plenty to debate in Fuerman's paper. Some question whether litigation results say anything meaningful about an audit. Firms often settle cases just because it's economical. And underfunded regulators may not pursue some egregious cases. Yet as I see it, Fuerman has carved out a worthwhile new research tool. It needs to be refined, but it does offer new insight into an unplumbed investment risk.

Will auditing firms keep standing purely on their reputations? They had better not. The other day, I stopped at the library for Abraham Briloff's 1981 book, The Truth About Corporate Accounting. As I checked it out, the librarian looked me dead in the eye. "Are you sure you want to read this?" she asked. "You probably don't want to know the truth."

By Robert Barker

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