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By David S. Hilzenrath
Washington Post Staff Writer
Wednesday, December 5, 2001; Page A01

First of two articles

The collapse came swiftly for Enron Corp. when investors and customers learned they could not trust its numbers. On Sunday, six weeks after Enron disclosed that federal regulators were examining its finances, the global energy-trading powerhouse became the biggest bankruptcy in U.S. history.

Like all publicly traded companies in the United States, Enron had an outside auditor scrutinize its annual financial results. In this case, blue-chip accounting firm Arthur Andersen had vouched for the numbers. But Enron, citing accounting errors, had to correct its financial statements, cutting profits for the past three years by 20 percent -- about $586 million. Andersen declined comment and said it is cooperating in the investigation.

The number of corporations retracting and correcting earnings reports has doubled in the past three years, to 233, an Andersen study found. Major accounting firms have failed to detect or have disregarded glaring bookkeeping problems at companies as varied as Rite Aid Corp., Xerox Corp., Sunbeam Corp., Waste Management Inc. and MicroStrategy Inc.

Corporate America's accounting problems raise the question: Can the public depend on the auditors?

"Financial fraud and the accompanying restatement of financial statements have cost investors over $100 billion in the last half-dozen or so years," said Lynn E. Turner, who stepped down last summer as the Securities and Exchange Commission's chief accountant.

The shareholder losses resulting from accounting fraud or error could rival the cost to taxpayers of the savings-and-loan bailout of the early 1990s, he said. Enron investors, including employees who held the company's stock in their retirement accounts, lost billions.

Accounting industry leaders deny they are to blame. They say that the number of failed audits is tiny in relation to the many thousands performed successfully, and that it's often impossible for auditors to see through a sophisticated fraud.

"The industry's record is strong," said Stephen G. Butler, chief executive of KPMG LLP. "I think the fundamental question is: Will you ever get to the point where there are not audit failures? In my view, you won't, just as you won't get to a point where there are no airplane crashes or no automobile crashes, no matter what the safety design or procedures."

The federal government gave the accounting industry the valuable franchise to audit companies that sell shares to the public after the stock market crash of 1929. In return, auditors are supposed to do their best to make sure investors can trust corporate financial statements.

With more than half of the nation's households owning stocks -- directly or through pension or mutual funds -- and a stagnant economy depressing stock values, the investing public has never needed a diligent accounting profession more.

The American system of accounting is still the gold standard for the world. In recent years, the U.S. accounting industry has changed markedly, consolidating into a handful of firms that have become global financial consultants. Known as the "Big Five," Arthur Andersen, Deloitte & Touche LLP, Ernst & Young, KPMG and PricewaterhouseCoopers audit most of the companies whose shares trade on the nation's stock markets.

Licensed professionals are expected to do more than just make sure the numbers add up. They are supposed to check inventory, contact customers and perform other tests before putting their stamp of approval on reports that fairly present the company's financial results.

Increasingly, the way these firms do business is at odds with the accounting industry's public watchdog mission.

• Major accounting firms often make more money from selling clients advice than they do from auditing their books. The accounting firms help businesses pick computer systems, lobby for tax breaks, even evaluate takeover targets. Auditors have been graded and rewarded based on how much other business they win from their audit clients. Arthur Levitt Jr., the former chairman of the SEC, which polices public companies, has argued that such incentives could tempt accountants to go easy on an audit.

• Auditors frequently leave their watchdog positions for jobs at the companies they audit. This career path can encourage auditors to make improper compromises, the SEC has warned. The route is so popular that auditors often find themselves dealing with former colleagues who are now their clients' executives.

• The profession has sought to insulate itself from responsibility for false or fraudulent accounting. When things go wrong, firms typically decline to answer for their work, invoking client confidentiality.

• The system can discourage thoroughness. The fees companies pay their auditors are often set in advance, so the accounting firms' profit margins can diminish as their efforts increase. There are signs that accounting firms are putting fewer resources into audits, using inexperienced staff or skimping on records checks.

These developments compound the more basic, underlying conflict: The auditors are hired, fired and paid by the companies they are responsible for auditing.

"Too often, they operate under the principle that the customer is always right," said Nell Minow, an activist money manager and editor of the Corporate Library, a Web site on corporate governance. "They will give the answer that the customer wants . . . so they can continue to get the fees."

Investment billionaire Warren E. Buffett put it this way in 1999: "Though auditors should regard the investing public as their client, they tend to kowtow instead to the managers who choose them and dole out their pay." Buffett quoted a proverb: "Whose bread I eat, his song I sing."

The new SEC chairman, Harvey L. Pitt, a lawyer who has represented the accounting industry, dismissed Buffett's observation as "a good sound bite" and "a nice thing for people who want to attack a profession to say." What prevents such obsequiousness, he said, is that "if an accounting firm has a reputation for being independent, for being professional and for doing its job, then everybody will flock to that firm."

Robert Kueppers, head of Deloitte's national office, said he and his colleagues know their highest priority: "The culture that I grew up with 25 years here is, your first responsibility is to get the audit done and get it done right."

Last year, an industry panel on audit effectiveness found that "both the profession and the quality of its audits are fundamentally sound."

Accounting firms cite a number of reasons for the rise in corrections. It's tough to apply standards that are nearly 70 years old to the modern economy, they say. And the SEC has made matters worse by issuing new interpretations of complex standards. "The question is not how does this reflect on the auditors," Arthur Andersen said in a written statement. Instead, the firm asked: "How is it that auditors are able to do so well in today's environment?"

In a 1984 ruling, the Supreme Court declared that auditors have an overriding duty to protect the public interest. "This 'public watchdog' function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust," the court said.

The leading industry trade group, the American Institute of Certified Public Accountants (AICPA), encouraged auditors to take a broad view of their role in a 1999 publication titled "Make Audits Pay: Leveraging the Audit Into Consulting Services." The book says the auditor should think of himself as a "business adviser" and promote his accounting firm's consulting services because "intense competition has reduced the audit to a mere commodity that is distinguishable to the consumer only according to price."

The book notes that "conflicts may arise" in asking the auditor to perform two roles that are inherently at odds. "The business adviser is a client advocate," responsible for "acting in the owner's best interests." That is "completely different from the professional skepticism required of the auditor," the book says. But it suggests the conflicts are manageable if the auditor errs on the side of looking out for the public interest.

A case study posted on Arthur Andersen's Web site under "Success Stories" shows how the firm sees itself. As auditor for TheStreet.com Inc., a financial news service, Arthur Andersen said, it helped its client prepare for an initial public offering of stock, develop a global expansion strategy and secure a weekly television show through another client, News Corp.

One of Arthur Andersen's "greatest strengths . . . is developing full-service relationships with emerging companies and then using all of our capabilities to find inventive ways to help them continue to grow," auditor Tom Duffy is quoted as saying.

TheStreet.com chief executive Thomas J. Clarke Jr. said the accounting firm "become[s] a business partner because they're right there with you." He said the auditors answer to a committee of outside board members, not TheStreet.com executives, to provide checks and balances.

Within the accounting business, consulting is widely viewed as more glamorous and lucrative than auditing. The SEC's Pitt said the profession has faced "some difficulties in attracting the best and the brightest."

Among the Big Five firms, U.S. consulting revenue totaled more than $15 billion in 1999 -- about half the firms' total revenue -- the SEC reported last year. That was up from 13 percent in 1981.

The AICPA has described the "certified public accountant" designation as a marketing liability. "The marketplace says the worst thing we have going for us is the 'A' in CPA," Barry Melancon, the trade group's president, wrote in 1998, referring to the word "accountant."

To reflect the variety of services accountants offer, AICPA leaders this fall proposed creating a new credential for "strategic business professionals," and AICPA members have been given until Dec. 28 to vote on the idea.

Fees for non-audit services often eclipse those for audits, according to disclosures corporations were require to begin filing with the SEC early this year. KPMG billed electronics manufacturer Motorola Inc. $3.9 million for auditing and $62.3 million for other services. Ernst & Young billed long-distance phone company Sprint Corp. $2.5 million for auditing and $63.8 million for other services. AT&T Corp. paid PricewaterhouseCoopers $7.9 million for auditing and $48.4 million for other services.

No one has suggested the financial statements of those companies are inaccurate or misleading.

Rite Aid shareholders alleged that consulting fees figured in KPMG's relationship with the drugstore chain, according to their class-action lawsuit against the accounting firm.

Rite Aid acknowledged last year that it had overstated earnings by more than $1 billion over two years. Audit fees were less than 20 percent of what Rite Aid paid KPMG over a 2 1/2-year period in the late 1990s, the suit alleged.

At one point, the suit alleged, Rite Aid's then-chairman, Martin L. Grass, awarded KPMG consulting engagements worth more than $1.5 million "as a sweetener and to ensure the accounting firm's continued cooperation."

An attorney for Grass said the allegations were "wrong" and "grossly unfair." KPMG was given a contract to address weaknesses in Rite Aid's inventory-tracking system, not to ensure cooperation, lawyer Andrew Weissman said.

KPMG said that it was "victimized by company management" and that the consulting it did for Rite Aid was "insignificant to the overall professional relationship."

The pressures on individual auditors to be "rainmakers," luring new business, as well as to be watchdogs, is apparent from documents in another lawsuit, which was decided in 1996. The case involved Coopers & Lybrand accountant Gregory Finerty's work as auditor for another drugstore chain, Phar-Mor Inc., in the late 1980s. When he didn't bring in enough consulting revenue to please his employer, Finerty's performance review and compensation suffered, the documents showed. "Greg was skipped last year . . . but he got the 'message,' " a superior wrote in one review. The next year, the reviewer added, "he bounced back and . . . cross sold over $900,000 of business."

As Finerty sold more consulting services, his reviews improved. "WOW!!! Greg cross-sold $2.5 million in Special Services to his client," his 1991 review said.

"He penetrated 18 of his 21 clients and sold every service line."

Then, massive accounting fraud at Phar-Mor was exposed. The company filed for bankruptcy protection and its chief executive was convicted of felonies.

In 1996 a jury found that Coopers committed civil fraud. Coopers then settled with plaintiffs for an undisclosed amount.

PricewaterhouseCoopers, formed by the 1998 merger of Coopers and Price Waterhouse, told The Washington Post, "We were the victims of a massive, collusive fraud perpetrated by the former management of Phar-Mor."

Finerty, who is no longer with the firm, declined to comment.

Accounting executives say providing consulting services actually improves audits because it helps an accounting firm get to know a client's business better.

"There is no conflict between the auditor's responsibilities and his calling to the client's attention certain other services that may benefit the client," PricewaterhouseCoopers said in a written reply to questions from The Washington Post.

A document from another lawsuit shows that PricewaterhouseCoopers was still monitoring the amount of non-audit services partners generated last year.

Personnel records of Warren Martin, who oversaw the firm's audits of Virginia software maker MicroStrategy, showed he brought in nearly $3.6 million of "other service line revenues" during the 10 months that ended April 30, 2000, compared with a $2 million target for the year.

PwC said it would not comment on personnel matters.

"CPAs must never forget that the 'P' in 'CPA' stands for public -- serving the public and maintaining their trust," former SEC chief accountant Turner said.

Accounting firms say they have not forgotten their public duty and note they have dropped clients or been fired over disagreements with them. They have also forced clients to publicly correct errors.

Last year, Gene Logic Inc., a Gaithersburg biotechnology firm, fired Arthur Andersen, saying it was disappointed with the outside auditor's level of service and cost. Andersen said in a letter included in an SEC filing that, before Andersen was fired, the accounting firm had told the company it thought it was trying to book $1.5 million of revenue from new contracts prematurely. Gene Logic spokesman Robert Burrows said the revenue disagreement had nothing to do with the auditor's dismissal.

Arthur Andersen said it quickly resigned or refused to accept more than 60 auditing jobs last year after its background checks turned up questions about the integrity of the clients' management.

"There have been innumerable cases . . . where people have stood up and refused to go along with improper conduct," SEC Chairman Pitt said.

Accounting firms say their duty to protect client confidences, based in state law and the profession's code of ethics, prevents them from discussing specific instances where they stood up to their clients and put an end to accounting manipulations.

Citing the same client confidentiality requirements, firms generally refrain from giving a public explanation when a financial blowup leaves investors in free fall.

The board of franchising conglomerate Cendant Inc. commissioned an investigation by outside lawyers and accountants of irregularities at CUC International Inc., one of two companies that merged to form Cendant in 1997. The investigators' 1998 report concluded that CUC had inflated operating income by $500 million over a three-year period, and it accused several insiders of participating in the deception.

But the report made no judgments about the company's longtime auditor, Ernst & Young. As a condition of cooperating, Ernst & Young insisted that the investigation remain silent on the question of whether it had violated professional standards, according to a legal brief filed on behalf of investors.

Ernst & Young later paid $335 million to settle with CUC shareholders who had sued it. Two former CUC executives who previously worked for Ernst & Young pleaded guilty to criminal charges.

The accounting firm said it was "the victim of intentional, collusive fraud on the part of CUC's management." The $335 million payment was not an admission of wrongdoing, the firm added, saying such settlements are "sometimes the only realistic option."

The accounting industry has long resisted the idea that auditors should be responsible for exposing fraud.

"We don't want to be in the business of being fraud detectors," Philip Laskawy, who retired in June as chief executive of Ernst & Young, told The Washington Post in the mid-1990s. "What we would like to believe . . . is that you're dealing with honest and reliable people."

A standard adopted by the profession since then requires auditors to assess the risk that fraud is occurring and tailor their audits accordingly.

Since 1995, auditors are also required to notify the SEC if they learn of illegal acts that corporate managers have failed to remedy. Then-SEC enforcement director Richard H. Walker said in a speech last December that the agency received "fewer than five" such notices during the preceding year and fewer than a dozen before then.

Rep. John D. Dingell (D-Mich.), who has sparred with accounting firms before, wondered if the sparse reports meant the auditors are "missing in action." Accounting firms said they expected only a small number of reports, partly because the requirement is triggered only if, in their opinion, an illegal act has "a material impact on the financial statements."

Though investors may interpret an auditor's certification as a sign that financial statements are accurate, accounting firms say their audits are intended to provide only "reasonable assurance" that financial statements are free of "material misstatement."

Over the years, auditors have overlooked a variety of problems and warning signs on the grounds that they were not big enough to be considered "material."

For example, while auditing CUC International, Ernst & Young concluded that after-tax income for one month was overstated by $23 million. But the auditor concluded that the $23 million problem and other discrepancies were not material, according to a report Cendant filed with the SEC. In answer to questions from The Post, Ernst & Young responded generally that even the best audits cannot detect fraud.

Later, after CUC merged with HFS Inc. -- the company behind such famous brands as Avis, Days Inn and Century 21 -- the leadership of the new corporation announced that it had discovered "potential accounting irregularities" and that previously issued auditors' reports "should not be relied upon." The value of the combined company's stock sank by billions of dollars.

The basic requirements of an audit include checking a company's inventory and verifying transactions with a sampling of customers. But professional standards, set by an AICPA board, give accountants broad discretion as to what to do in an audit.

"The auditing standards are so general that, as a practical matter, it's difficult to hold anyone accountable for not following them," said Turner, the former SEC chief accountant.

Even so, a report by an accounting industry review panel last year cited a "gap" between auditing standards and "what actually transpires in practice."

The Panel on Audit Effectiveness, which was led by a former chairman of Price Waterhouse, warned that "audit firms may have reduced the scope of audits and the level of testing." The panel called for heightened testing to better detect fraud.

While accounting firm managers constantly send their auditors messages on topics such as client service, client relationships and profitability, such guidance "often only indirectly infer that quality audit work is an integral part of quality client service," the panel said.

When CFO magazine, a publication for financial executives, surveyed 75 chief financial officers last year, 18 percent called their auditors "extremely thorough," but 23 percent rated them "not thorough enough."

Some industry veterans say audits have become loss leaders -- a way for firms to get their foot in a client's door and win consulting contracts.

Arthur Andersen disagreed, telling The Post that audits are among the more profitable services the firm provides, adding that "lower pricing in some years" is "made up over time."

Indeed, accounting firms say that if the audit becomes more complicated than initially expected, their contracts generally allow them to go back to their clients and adjust the fee.

In a long-running lawsuit, Calpers, the giant pension fund for California public employees accused Arthur Andersen of doing such a superficial job auditing a finance company that the "purported audits were nothing more than 'pretended audits.' "

Andersen assigned a young, inexperienced auditor "who has candidly testified he did not even know what a Contract Receivable was, then or now," consultants for Calpers wrote in a September 2000 report prepared in support of the lawsuit.

Andersen didn't test any of those accounts while the unpaid balances soared, and it failed to recognize that a substantial amount was uncollectible, the report said.

Andersen declined to comment on the case, which was settled confidentially.

Just as government officials often take jobs in the industries they are responsible for regulating, outside auditors often go to work for their clients.

The AICPA board of directors in 1993 proposed a cooling-off period before lead auditors could go to work for their clients, but the SEC last year decided that approach "unnecessarily restricts . . . employment opportunities."

Investors in MicroStrategy lost billions of dollars, at least on paper, when the Northern Virginia software company announced in March 2000 that, contrary to years of audited financial statements, it had been losing money rather than making a profit.

Months before the correction, while serving as senior manager on the MicroStrategy audit, a PricewaterhouseCoopers accountant sought a job as chief financial officer of a MicroStrategy subsidiary, according to a report filed by plaintiffs in a shareholder lawsuit against the accounting firm. The report cited an Aug. 6, 1999, e-mail from the auditor to a MicroStrategy executive, saying, "As we discussed I would really appreciate the opportunity to have a shot at the CFO spot in the new company."

PricewaterhouseCoopers said this had "no impact on the quality or integrity of the audit." The accounting firm denied wrongdoing and said it agreed to pay a $51 million settlement "to avoid the further costs and uncertainties of protracted litigation."

Few cases illustrate the potential conflicts in the accounting business as vividly as the one involving Arthur Andersen and Waste Management.

Many investors may not realize they were victims because they held Waste Management stock indirectly, through mutual funds and retirement plans. Lolita Walters, an 80-year-old retired New York City government employee who suffers from diabetes and a heart condition, can count what she lost -- more than $2,800, enough money to pay for almost a year of prescription drugs.

"I think it's unconscionable," Walters said of Andersen's role.

According to the SEC, Andersen lent its credibility to Waste Management's annual reports even though it had documented that they were deeply flawed.

Waste Management eventually admitted that, over several years, it had overstated its pretax profits by $1.4 billion.

In a civil suit filed in June, the SEC accused Arthur Andersen of fraud for signing off on Waste Management's false financial statements from 1993 through 1996. For example, during the 1993 audit, the SEC said, the auditors noted $128 million of cumulative "misstatements" that would have reduced the company's earnings, before including special items, by 12 percent. But Andersen partners decided the misstatements were not significant enough to require correction, the SEC said.

An Andersen memorandum showed the accounting firm disagreed with the approach Waste Management used "to bury charges" and warned Waste Management that the practice represented "an area of SEC exposure," but Andersen did not stop it, the SEC said.

An SEC order noted that, from 1971 until 1997, all of Waste Management's chief financial officers and chief accounting officers were former Andersen auditors. The Andersen partner assigned to lead the disputed audits coordinated marketing of non-audit services, and his compensation was influenced by the volume of non-audit fees Andersen billed to Waste Management, the SEC said.

Over a period of years, Andersen and an affiliated consulting firm billed Waste Management about $18 million for non-audit work, more than double the $7.5 million it was paid in audit fees, which were capped, the SEC said. Andersen said some of the non-audit work was related to auditing.

Andersen, which continues to serve as Waste Management's auditor, agreed to pay a $7 million fine to the SEC, and joined with Waste Management to settle a class-action lawsuit on behalf of shareholdersfor a combined $220 million. Andersen did not admit wrongdoing in either settlement.

"There are important lessons to be learned from this settlement by all involved in the financial reporting process," Terry E. Hatchett, Andersen's managing partner for North America, said in a statement after the SEC action. "Investors can continue to rely on our signature with confidence."

Staff writer Sandra Sugawara and researcher Richard Drezen contributed to this report.

Tomorrow: The accountants' accountability