Washington Post Article:  Part 2
"THE NUMBERS CRUNCH Auditors Face Scant Discipline Review Process Lacks Resources, Coordination, Will," Part 2 of 2 Articles, by David S. Hilzenrath, The Washington Post,  December 6, 2001 ---
http://www.washingtonpost.com/wp-dyn/articles/A64556-2001Dec5.html 

John A. LaBarca was supposed to look out for the investors.

Starting in the mid-1980s, he oversaw the outside audits of JWP Inc., an obscure New York company that bought a string of businesses and transformed itself into a multibillion-dollar conglomerate. The job required LaBarca, a partner at the big accounting firm Ernst & Young LLP, to scrutinize the work of JWP's chief financial officer, Ernest W. Grendi, a running buddy and former colleague.

In 1992, a new president at JWP discovered rampant accounting manipulations, and the company's stock sank. When the numbers were corrected, the 1991 earnings were slashed from more than $60 million to less than $30 million.

After hearing extensive evidence in a bondholders' lawsuit, a federal judge criticized "the seeming spinelessness" of LaBarca.

"Time and again, Ernst & Young found the fraudulent accounting at JWP, but managed to 'get comfortable' with it," Judge William C. Conner wrote in a 1997 opinion. "The 'watchdog' behaved more like a lap dog."

Today, LaBarca is senior vice president of financial operations and acting controller at the media conglomerate AOL Time Warner Inc., where his duties include overseeing internal audits.

The Securities and Exchange Commission filed and settled fraud charges against Grendi but took no action against LaBarca. Neither did the American Institute of Certified Public Accountants (AICPA), a 340,000-member professional organization charged with disciplining its own, or the state of New York, which licensed LaBarca.

LaBarca declined to discuss the JWP case but maintainedduring thetrial that the accounting was "perfectly within the guidelines."

An Ernst & Young spokesman said the firm was confident it upheld a tradition "of integrity, objectivity and trust." Grendi declined comment.

A Washington Post analysis of hundreds of disciplinary cases since 1990 found that, when things go wrong, accountants face little public accountability.

"The deterrent effect that's necessary is just not there," said Douglas R. Carmichael, a professor of accountancy at the City University of New York's Baruch College. That "makes investing like Russian roulette," he added.

In theory, the system has several complementary layers of review. In practice, it is undermined by a lack of resources, coordination and will.

The SEC can bar accountants from auditing publicly traded companies for unprofessional conduct. The agency, however, has the personnel to investigate only the most egregious examples of auditing abuse, officials say. It typically settles its cases without an admission of wrongdoing, often years after the trouble surfaced.

Between 1990 and the end of last year, the SEC sanctioned about 280 accountants, evenly divided between outside auditors and corporate financial officers, The Post's review found.

The AICPA can expel an accountant from its ranks, whichcan prompt the accountant's firm to reassign or fire him. The trade grouptook disciplinary action in fewer than a fifth of the cases in which the SEC imposed sanctions, The Post found. About one-third of the accountants the SEC sanctioned weren't AICPA members and thus were beyond its reach.

Even when the AICPA determined that accountants sanctioned by the SEC had committed violations, it closed the vast majority of ethics cases without disciplinary action or public disclosure.

President Bill Clinton's SEC chairman, Arthur Levitt Jr., a frequent critic of the industry, said the AICPA "seems unable to discipline its own members for violations of its own standards of professional conduct."

The membership group works as a lobbying force for accountants and often battles SEC regulatory efforts.

State regulators have the ultimate authority. They can take away an accountant's license. But some state authorities acknowledge that their efforts are hit-or-miss.

"We only find out about violations on the part of regulants [licensees] in two ways: One, somebody complains, or two, we get lucky," said David E. Dick,assistant director of Virginia's Department of Professional and Occupational Regulation, which until recently administered discipline for the state's accountants.

When the SEC settles without a court judgment or an admission of culpability, state authorities must build their case from scratch, said regulators in New York, where many corporate accountants are licensed.

"You could probably fault both state boards and the SEC for not having worked cooperatively enough with one another over the years," said Lynn E. Turner, who stepped down this summer as the SEC's chief accountant. He added that the agency has tried harder over the past year and a half to share investigative records with state regulators.

As of June, the state of New York had taken disciplinary action against about a third of the New York accountants The Post culled from 11 years of SEC professional-misconduct cases.

While prosecutors occasionally file criminal charges against corporate officials in financial fraud case, they hardly ever bring criminal cases against independent auditors, in part because the accounting rules are so complex. The AICPA's general counsel could recall only a handful of prosecutions.

"From my perspective, this was very hard stuff," said a federal prosecutor who investigated a major accounting fraud. "The prospect of litigating a case against people who actually do this stuff for a living and at least in theory are the world's experts . . . is a daunting prospect."

Investor lawsuits sometimes lead to multimillion-dollar settlements. But they rarely shed light on the performance of individual auditors because accounting firms generally get court records sealed and settle before trial, limiting public scrutiny.

The accounting firms say they discipline those who violate professional standards, including removing them from audits or terminating their employment.

Barry Melancon, president of the AICPA, said "you cannot look at discipline alone" when assessing accountability in the accounting profession.

The profession's emphasis is on preventing rather than punishing mistakes, he added. Thus, it invests heavily in quality-control efforts, such as periodic "peer reviews" of the paperwork accounting firms generate during audits.

In disciplinary cases, the AICPA's goal is to rehabilitate accountants, not to expel them, officials said. "While it may feel good and it may give somebody something to write about when somebody is disciplined, the most important thing is whether or not this profession does a good job doing audits or not," Melancon said.

The AICPA puts its investigations on hold until SEC enforcement actions and other litigation have run their course, which can take several years.

Acknowledging one of the system's historic weaknesses, the AICPA this year began requiring accounting firms to, at a minimum, supervise senior auditors' work more closely while they are the subject of a pending AICPA ethics case.

"The profession's self-disciplinary process . . . taken as a whole, is reasonably effective in protecting investor interests," the accounting firm Arthur Andersen LLP said in a statement. "As with any system, it can be improved."

A Critic of the SEC

No one has been more critical of the SEC's slow-moving enforcement process than the agency's new chairman, Harvey L. Pitt, a lawyer with long experience defending clients against the SEC.

"If you bring a case six years after a company goes down the tubes, after all of the money has been squandered and dissipated, you are not helping investors," Pitt said.

Pitt is offering leniency in return for prompt cooperation and restitution. He said that could mean forgoing enforcement action in rare cases. But he also said, as violations warrant, "we are going to be every bit as tough as the SEC has ever been, and maybe even tougher."

SEC penalties for unprofessional conduct include temporarily or permanently barring someone from auditing companies whose shares trade on stock markets.

Negotiated settlements remain central to Pitt's enforcement strategy. "There are not enough lawyers in the country for us to hire if we have to litigate all of our cases," he said.

Richard Walker, the SEC's director of enforcement untilearlier this year, said before he left that about 70 SECaccountants were working on about 250 enforcement cases involving accounting and financial reporting, and the agency lacked the capacity to pursue every violation.

"We just simply don't have the resources to do that, so we have to be selective and . . . choose cases that have the greatest importance," Walker said.

But even when the agency focuses on a high-priority case, its actions can send mixed signals. In June the SEC alleged thata former managing partner of Arthur Andersen allowed persistentmisstatements in Waste Management Inc.'s financial reports to go uncorrected,but the agency took no action against him.

The accounting firm and three lower-ranking Andersen personnel settled SECfraud charges, without admitting wrongdoing. The firm agreed to pay $7 million; the individual accountants, a total of $120,000.

Walker said the SEC took no action against the former managing partner, who wasn't identified by name, because the agency didn't think he had the "requisite state of mind" or knowledge.

Asked for comment, an Andersen spokesman replied, "The record speaks for itself."

With or without an admission of wrongdoing, an SEC enforcement action for professional misconduct "is the closest thing as you get to a death penalty in the accounting profession," said Charles D. Niemeier, chief accountant in the SEC's enforcement division.

"If the person is a partner in a Big Five firm, they're gone," and "most major companies would not hire a person in any key position" who has an SEC enforcement action on their record, Niemeier said.

That wasn't the case after the SEC ordered Thomas J. Scanlon, a Price Waterhouse LLP partner, to "cease and desist" from violating securities laws in 1999. The agency found that he knew a W.R. Grace & Co. subsidiaryhad manipulated numbers but failed to insist on proper disclosure.

PricewaterhouseCoopers, as the firm is now known, said the SEC action "speaks for itself."

The order essentially meant that "you don't admit you did anything wrong but you agree that you will not do it again," as Scanlon put it in an interview. Until early this year, Scanlon, now retired, remained the lead PricewaterhouseCoopers partner on the W.R. Grace audit.

Self-Regulator

The accounting profession has long championed its ability to regulate itself, from setting auditing standards to reviewing how well accounting firms follow those requirements. The AICPA, with an ethics division and various oversight committees, stands at the center of that effort.

As early as the 1970s, that effort was under fire. A congressional reportin 1977 called for stronger government oversight of accounting, citing an "alarming lack of independence and . . . dedication to public protection."

The report also noted that the AICPA cleared former Nixon administration official Maurice H. Stans of professional ethics charges after he pleaded guilty to criminal charges in the Watergate scandal. Stans had been president of the AICPA and senior partner of a major accounting firm.

The same year anAICPA advisory commission called on the trade group "to conduct the profession's disciplinary actions 'in the sunshine,' " but the AICPA rejected that proposal, according to a history by its past president, Wallace E. Olson.

In 1985Price Waterhouse, citing a "crisis of confidence in the auditor's effectiveness," broke ranks with other major firms and called for creation of an SEC-supervised self-regulatory organization "with credible disciplinary authority."

Other big accounting firms were furious. "They couldn't believe that [Price Waterhouse] was selling them out, that here was a firm ready to jump in bed with the enemy," said Wade S. Williams, a former lobbyist for the AICPA and Deloitte & Touche LLP. The proposal died.

Most of the AICPA's ethics work is invisible to the public. When the group finds violations, it routinely resolves cases by issuing confidential letters directing accountants to take "corrective" steps such as courses providing "continuing professional education."

Such private letters have outnumbered by 5 to 1 the suspension or expulsion of members, according to a 1999 AICPA memo to the SEC obtained through the Freedom of Information Act. The memo covered the most recent 108 cases that had been resolved by an AICPA disciplinary panel after SEC action. More extensive data the AICPA gave The Post showed the same pattern.

The AICPA lacks the power to restrict an accountant's practice. But, indirectly, its disciplinary actions can have consequences. If a firm continued to employ a partner expelled from the AICPA, the firm itself could face expulsion, and that could disqualify it from auditing companies listed on the Nasdaq Stock Market and the American Stock Exchange, AICPA officials said.

The Post analysis of AICPA data shows that about 60 percent of the more that 500 members expelled between 1990 and the end of 2000 were ousted automatically, in cases, for example, where they had already been convicted of a crime or stripped of a state license. In more than a quarter of the expulsion cases, members were ousted for refusing to cooperate with AICPA investigations or comply with its remedial orders.

Only about a quarter of the AICPA's disciplinary actions explicitly involved auditing. Others involved such unrelated offenses as failing to file personal tax returns or embezzling from clients.

The main reason the AICPA refrains from disciplining accountants the SEC has punished is that it lacks the power to subpoena evidence, said Norman R. Walker, former chairman of an AICPA disciplinary panel. "Basically we're confined to looking at the [public] record and the information that the [member] is able to provide and willing to provide," he said.

Besides, AICPA officials added, when accountants settle SEC charges without admitting wrongdoing, the enforcement actions don't prove they did anything wrong. The SEC does not share confidential investigative files with the AICPA.

The AICPA allows accountants to put off disciplinary proceedings while other litigation or regulatory actions are pending. The group postpones action because "if we found something, the plaintiff would use it against our member," said Richard I. Miller, the group's general counsel. "We don't think that that's fair."

The postponements have taken an average of nearly three years, and as long as a decade. It has then taken about a year and half, on average, to conclude a case, according to an AICPA memo to the SEC.

An industry review panel led by a former Price Waterhouse chairman reported last year that the profession's disciplinary system "suffers from a number of limitations," adding that AICPA investigations "typically commence and conclude long after the public's memory of the matter has faded."

The case of Samuel George Greenspan shows how long the processcan take.

Greenspan was retained by ZZZZ Best Corp., a California carpet cleaner, to audit financial statements in the mid-1980s. Greenspan relied on a report by a prior auditor named Richard Evans, which ZZZZ Best's management gave him, regulators alleged. But, according to the SEC, the report was a fabrication.

Had Greenspan checked, he would have discovered that Evans didn't exist, the SEC said. Had he bothered to inspect the eight-story building described in the company's second-largest contract, he would have learned that it didn't exist, either, the SEC said. Greenspan never visited any of ZZZZ Best's 15 purported job sites, the agency alleged when it permanently barred him from auditing public companies in 1991.

After Greenspan's audit, ZZZZ Best sold stock, which plummeted when the company was exposed as being rife with fraud.

"I wasn't hired to detect fraud," Greenspan said in an interview. "I was hired to do an audit."

Greenspan said he didn't have the funds to fight the SEC, "but it may be of interest to you that I was also investigated by the American Institute of CPAs and I was exonerated completely." He provided a copy of a 1998 letter in which the AICPA said it found "no prima facie evidence" that he violated its code of conduct and was closing its investigation.

The states of New Jersey and New York, which licensed Greenspan, also said they have taken no disciplinary action against him.

The disciplinary notices the AICPA issues to the public do not include the name of the accountant's firm or the name of the company the accountant was auditing.

A February 1998 report, for instance, listed the names of 15 individuals. It said a trial board had found them guilty of violating the rule that requires auditors to be independent from their clients. Then it concluded, without explanation: "The hearing panel voted there should be no sanctions."

Boards Ill-Equipped

The state licensing boards hold the most power over accountants, but many are ill-equipped to police the profession. "There are a number of state boards that just don't have the financial resources to take on big firms," said Dennis Spackman, past chairman of the National Association of State Boards of Accountancy (NASBA).

For the most part, "the state boards of accountancy are ineffective," said Lloyd "Buddy" Turman, who is executive director of the Florida Institute of Certified Public Accountants, a professional society.

Members of the accounting industry backed legislation in Virginia this year to create a separate state agency for the supervision of the state's 14,000 accountants and remove that function from a department that oversees a variety of professions.

Gov. James S. Gilmore III (R) vetoed the bill, arguing that, "to avoid conflicts of interest, regulatory agencies cannot be dedicated to individual professions." The legislature overrode Gilmore's veto.

Ellis Dunkum, a retired PricewaterhouseCoopers partner who is chairman of the Virginia state board, said the new agency, which operates on a smaller budget, is more efficient because its staff can concentrate on being knowledgeable about one set of regulations.

In Maryland, Dennis Gring, executive director of the state board, said he spends most of his time monitoring the state's 14,000 active accountants. He said he also works for boards regulating foresters, precious metal dealers, sports agents and heating and ventilation contractors.

The AICPA has urged state licensing authorities to let it investigate disciplinary cases on their behalf, partly to avoid duplication of effort. Four states -- Illinois, West Virginia, Rhode Island and Connecticut -- have accepted the group's offer, at least in principle.

AICPA disciplinary notices often give the licensing authorities in Connecticut "our first inkling" of a possible problem, said Michael T. Kozik, staff attorney for the Connecticut board. The board's staff consists of a director, three clerical workers and himself part time -- when he isn't handling election-law matters for the state, Kozik said.

Under the Connecticut-AICPA cooperative agreement, which has been used in only one or two cases, the group shares the results of its investigation and the state makes its own decision, Kozik said. In complicated cases, "it saves us the time and the expense of . . . hiring experts," he said.

The state of New York, which had the most accountants sanctioned by the SEC, as of June had disciplined 17 of 49 New York accountants The Post culled from more than a decade of SEC enforcement actions.

New York regulators said they lack legal authority to discipline accountants who engage in misconduct as corporate officers rather than independent auditors. When an accountant licensed in New York is suspected of committing offenses in another state, New York may wait until the other state investigates, said Daniel Dustin, the board's executive secretary.

California regulators disciplined a large majority of the accountants licensed there who were sanctioned by the SEC, though it wasn't unusual for the penalty to be probation.

The association for state accountancy boards maintains a national database of the disciplinary actions its member boards take. But, like a federal database of sanctioned physicians, it is not accessible to the public.

The database was created for state boards to consult when reviewing license applications from accountants already certified in other states. Denise Hanley, NASBA's director of information services, said members of the public can get information about individual accountants from state boards.

A spokeswoman for the District's board, which supervises 1,100 accountants, said it hasn't revoked an accounting license in the past 15 years. Maryland's Gring said records show nine CPAs lost their licenses since 1990, with a 10th about to be made public. Nancy Taylor Feldman, executive director of the Virginia board, said two licenses have been revoked this year.

Liability Limited

Like other professionals, accountants can be sued, and there have been a series of large settlements involving Big Five firms in recent years. But the industry has lobbied hard and successfully to limit its liability.

Sometimes, even when courts find that auditors knowingly misrepresented a company's finances, damages aren't awarded.

In the JWP case, for instance, LaBarca's firm, Ernst & Young, paid $23.4 million to settle with shareholders -- which the judge called "an extravagantly expensive education in auditing ethics."

But a group of insurance companies that lost about $100 million on JWP bonds has come up empty so far.

When the outside auditors confronted JWP management on accounting questions, Judge Conner wrote, "Grendi almost invariably succeeded in either persuading or bullying them to agree that JWP's books required no adjustment."

"Part of the problem was undoubtedly the close personal relationship between Grendi and LaBarca," who trained together for the New York City Marathon, the judge wrote.

In its defense, Ernst & Young argued that LaBarca and his associates were ultimately convinced that JWP's accounting positions were reasonable or that the earnings overstatements were so small as to be immaterial, the judge wrote.

For all his criticism, Conner found that the accounting distortions were not the reason JWP defaulted on its bonds. In legal jargon, he found no "loss causation."

The insurers have appealed. Lawyers who represented Ernst & Young cited their victory in a law journal article titled "Loss Causation: A Defendant's Secret Weapon." Such arguments, they noted, "can brush aside even the most difficult set of facts against a defendant."

Database editor Sarah Cohen, staff researcher Richard Drezen and research assistant Eddy Palanzo contributed to this report.

© 2001 The Washington Post Company