Don’t Cram Audits Down Investors’ Throats

Oct. 26 (Bloomberg) -- Last month, a Senate investigative panel put a spotlight on how the accounting firm Ernst & Young LLP helped Hewlett-Packard Co. use gimmicks and loopholes to avoid taxes on billions of dollars of profits stashed overseas.

The program involved money transfers through the Cayman Islands, as well as transactions structured to make cash distributions into the U.S. from offshore subsidiaries seem like nontaxable loans. Ernst & Young isn’t just a tax consultant to HP; it is also the computer maker’s outside auditor.

That means Ernst & Young had to opine on whether HP accounted properly for the financial-reporting effects of Ernst & Young’s own tax advice. This dual role -- auditor of the books, plus adviser on how to get around the tax laws -- is allowed under U.S. auditor-independence rules, even though it results in firms auditing their own work. That’s not the worst part, though.

Here we have the U.S. approaching the edge of a fiscal cliff. More than $600 billion of federal spending cuts and tax increases are set to take effect in January unless Congress acts. And it isn’t just politicians who are to blame. Tax avoidance, legal and otherwise, by large multinational corporations is a significant cause of the budget deficit.

It is a classic abusive relationship. Congress made outside audits mandatory for public companies as part of the Securities Act of 1933, guaranteeing accounting firms a lucrative stream of fees. The firms have returned the favor by helping clients bleed the government dry. The notion of “independent” audits is a joke anyway. The client pays the audit firm for its opinion.

Last Straw

The question of whether audits should be mandatory is one I have been chewing on for years. And for me at least, the findings by the Senate Permanent Subcommittee on Investigations, led by Senator Carl Levin of Michigan, were the last straw.

For example, here’s what one Ernst & Young tax adviser, Margie Rollinson, wrote to colleagues on the HP account in a September 2007 e-mail: “Documents and/or workpapers that indicate an intention to circumvent or otherwise abuse the spirit of section 956 could prove particularly troublesome and thus should be avoided.” (She was referring to a section of the tax code.) That should dispel any notion that the Big Four accounting firm was looking out for the public interest.

All the more reason Congress should strip the profession of its government franchise and make outside audits voluntary for public companies. Maybe we can’t stop audit firms from promoting schlocky tax shelters. But at least let’s stop subsidizing them.

Lynn Turner, who was the chief accountant of the Securities and Exchange Commission from 1998 to 2001, has come around to the same view. (Disclosure: I used to work for him at the research firm Glass, Lewis & Co., which we both left in 2007.) Outside auditors have a terrible track record when it comes to detecting accounting frauds and alerting the investing public.

“I just don’t see any other viable road to go down at this point in time,” Turner said. “We’ve tried self-regulation. We tried the SEC as a regulator. And we’ve tried the Public Company Accounting Oversight Board as a regulator. And nothing has worked. So let’s go back to a market solution.”

Here’s what he recommends: End the audit mandate, and require that shareholders be asked to vote on having an audit. He suggests every three years, or sooner when a company switches chief executive officers. If shareholders say yes, the auditor’s appointment by the audit committee would have to go to a shareholder vote each year. Shareholder ratification of auditors currently isn’t mandatory.

The accounting oversight board, which Congress created to regulate auditors and set auditing standards, would collect fees from companies where shareholders have voted for audits. Audit committees would negotiate the fees and notify the oversight board of the agreed-upon amounts. The fees would be paid from the money collected by the oversight board, he said.

Fired, Replaced

If the auditor failed to detect a major fraud or weakness in a company’s internal accounting controls, the firm would be fired and replaced. Additionally, companies would have to provide information to shareholders -- before they vote -- showing key audit-quality indicators, such as the level of experience and turnover among the people doing the audit.

The point is that auditors should have to demonstrate to investors that they are worth keeping around. They also should have incentives to flag suspect behavior by management, beyond their boilerplate opinion letters, which rarely provide insight.

To be sure, there is hardly a groundswell for changing the law. Daniel Goelzer, a member of the accounting oversight board from 2002 until last March, said large companies probably would still hire auditors, while smaller ones, where the risk of errors and fraud may be greatest, would be less likely to. “The audit strikes me as so fundamental that if you want to play in U.S. capital markets, you ought to be required to have one,” Goelzer said.

Robert Moritz, chairman of the Big Four accounting firm PricewaterhouseCoopers LLP and the Washington-based Center for Audit Quality, said audits should remain mandatory because “there is an implicit value to consistency and comparability, rather than a buyer beware system. Audited financial statements provide the capital markets with a means to compare and contrast with a significantly higher degree of confidence.”

Almost 80 years ago, Arthur Carter, then president of the New York State Society of Certified Public Accountants, helped convince Congress that independent audits should be a legal requirement for public companies. During Carter’s testimony on the 1933 legislation, a senator from Kentucky, Alben Barkley, asked: “Who audits you?” Carter replied: “Our conscience.”

It was a bold line. Looking back, the amazing part is that Congress bought it.

(Jonathan Weil is a Bloomberg View columnist. The opinions expressed are his own.)

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