Checking Up on the Auditors : Accounting Firms Face Pressure to Do Their Job Better

The Big 6 accounting firms of Ernst & Young, Arthur Andersen & Co. and Deloitte & Touche are among the prime defendants in civil lawsuits arising out of the 1989 collapse of Lincoln Savings & Loan in Irvine.

Last week, another of the nation’s Big 6 accounting firms, KPMG Peat Marwick, became the latest target of the much-vaunted crackdown by federal savings and loan regulators on such professionals as accountants and lawyers.

Peat Marwick is accused of a conflict of interest because a partner in charge of auditing a San Francisco thrift took out $1.7 million in loans from that thrift over the last five years. The accountants involved with Lincoln are accused of negligence in preparing financial statements for the S&L; and its parent, American Continental Corp. in Phoenix.

Across the nation, accounting firms are under a microscope as the government and investors who lost money seek compensation from deep-pocketed professional companies for alleged wrongdoing.

And the plaintiffs are winning big. Regulators are expected to collect more than $40 million in a pending settlement with Ernst & Young over its audits of Lincoln.

With the industry under pressure, the profession is looking for better ways of auditing firms--especially financial institutions--and ferreting out negligence and fraud, and of better informing the public about companies’ financial affairs.

Waymond Rodgers, assistant professor of accounting at UCI’s Graduate School of Management, has been studying how commercial lending officers make decisions on whether to fund loans and what techniques could be used to improve those decisions. He is also looking at accountants who audit financial institutions to find ways to improve their effectiveness.

In an interview with Times staff writer James S. Granelli, Rodgers talked about the problems the profession faces today and some of the solutions.

Q. Do independent auditors have a more difficult job with banks and savings and loans than with other industries?

A. They would probably have somewhat of a more difficult task in that banking is the most regulated industry in this country. That’s mainly because the biggest area to audit by outside auditors is the loan portfolio, or, more specifically, the loan loss reserve. I was a commercial lending officer at one time, and I can tell you that quite a few loans that are made are based on qualitative features. Those qualitative features are often based on the managerial ability of the company that you’re loaning the money to.

Q. In other words, you’re looking to the character of the borrower, to a great extent, to determine if that person is reliable and will repay the loan?

A. Yes, exactly. What auditors, especially those who have not had experience as commercial lending officers, are looking at is certain factors that will perhaps suggest that the company borrowing money is a good bet or bad bet to repay the loan. Now, even though auditors may spot certain borrowers who are somewhat questionable in terms of the company being able to pay back its loan, they report their findings to a committee that consists of both the auditors and the clients--in this case, the top officials of the bank. At this point, certain negotiations take place. For instance, certain loans that the auditor may have classified as doubtful to be paid back, the bank officers have a chance then to question whether the auditors are properly classifying that loan.

Q. How independent are independent accountants if the result of their auditing stems from a negotiation with company executives?

A. They’re very independent. If the auditors don’t have enough information to change their mind about classifying a loan, then the client has the opportunity to provide some more information or insight about that particular borrower. This doesn’t happen only in banking. It happens with other companies as well. That’s pretty normal.

Q. But considering the large fees that accountants get for auditing, are independent auditors really independent or are there conflicts between their duties and their meal tickets?

A. I would say that the fees generally do not have any relationship with auditor independence. That is, even though some of these fees are very high, auditors still have a legal relationship with the client’s board of directors that requires them to do the very best within their ability to audit that firm.

Q. To continue getting those fees, though, they have to continue a relationship with that company over the years. At what point is there concern that the auditor becomes too close to a company and begins to adopt the company’s view of things rather than an independent view?

A. That does not necessarily happen. Auditors abide by a set of generally accepted auditing standards, and the way they approach an audit is predicated on these auditing standards. The program they use to audit companies is somewhat independent of the fees they charge or the length of time they’ve been auditing the firm. In fact, I would say that the longer they audit the firm, the better off they are in terms of understanding certain nuances of the firm. They can tailor that audit program to the specific firm.

Q. You’d probably get a lot of argument from the people who were bondholders in American Continental about whether the accounting firms were really independent.

A. Well, this doesn’t necessarily apply to the Lincoln/American Continental case, but there are instances where accountants are pressured internally into not doing a thorough job. They have to complete audits within a certain time period, and that’s tied to profitability. If an audit team stays close to the hours budgeted for a particular company, the accounting firm makes a bigger profit. If they take more time, the profit is smaller.

Q. What duties does an auditor owe to a company, to the shareholders, to the investing public and to the public in general?

A. The Securities Act of 1933 established that in terms of the auditors’ liability for ordinary negligence, the onus is on the company and the accountants to show that the audit fairly represents the financial condition of the company. And the Securities Exchange Act of 1934 has provided a watchdog regulatory agency, the Securities and Exchange Commission, to enforce the 1933 act. However, today, auditors realize their potential liability for ordinary negligence has extended beyond their clients. Third parties, such as lenders or even potential investors, can in some cases successfully litigate against auditors. Court cases in California and about half the states in the past several years have emphasized that auditors’ liability is not only to their client but to the third party as well.

Q. Does the accountant have a duty to look for fraud?

AIn fact, there have been two generally accepted auditing standards adopted in 1989 to deal with irregularities as well as to detect illegal acts by companies. The first deals with errors and irregularities of the companies. Errors pertain to material misstatements, unknown to the client, that may affect the judgment of someone reading that statement. Irregularity indicates that the client is doing something intentional, perhaps window-dressing figures, or even fraud. There is a statement, a guideline, a blueprint, so to speak, that auditors must follow in order to try to uncover those errors and irregularities. The second standard states that it is the auditor’s responsibility to detect and report illegal acts by the client.

Q. Reported to whom?

A. It depends. If the illegal act is performed by the treasurer or president or some top officer, then the auditor will report the act to the client firm’s board of directors. If it’s the board that has performed the illegal act, then the auditor is well advised to contact his own attorney.

Q. How often does an accountant really find illegal activity?

AIt’s a very small amount. I would say that for those auditors who perform a very good audit, these fraudulent activities should pop out. It’s darn near impossible for auditors to catch every illegal act by the client.

Q. What about catching any illegal act?

A. Yes, auditors have caught clients engaged in illegal acts. If they’re doing a good audit, they should pick up an illegal act, if one has been committed. Auditors have discovered, for example, computerized banking fraud, check-kiting and lapping, which is where the client will take one customer account that has been paid on and apply the payment to another customer account to make it look as if the account is a good one.

Q. How is the average citizen able to read an audited financial statement and determine whether a financial institution is likely to fail?

A. There are 12,860 banks, quite a few of which are not audited. For those that are audited and are given a clean bill of health, the auditors did a very good job and those banks are performing quite well. There is a very small number of so-called problem banks. A recent study done by Veribanc Bank Rating Service indicated the problem banks on their list dropped to 301 from 314. So if you look at it from a broad picture--that is 12,860 banks of which 300 are problem banks--you’re dealing with a very small percentage.

Q. Enough problems, however, to bankrupt the federal deposit insurance fund.

AYes, they’re recapitalizing the Federal Deposit Insurance Corp., but that is due to other problems not related to audits made by CPA firms.

Q. But is there any effort by the industry to present financial statements that are understandable to the average person?

A. Yes, there is a great deal of work being done to try to get financial statements more user-friendly. In fact, there are certain research foundations that are funded exclusively by the Big 6 auditing firms, like the Peat Marwick Mitchell Foundation, which has given several million dollars to research and improve auditing techniques. The bottom line is to find a way to report information in such a way that makes it more user-friendly.

Q. What is the biggest issue facing auditors today?

AI would say coming up with a better audit. We need to improve decision-making techniques, to improve auditors’ understanding of certain clients and to report the client’s operation and financial position as reflected by the numbers.

Q. Why is that issue more important now than it was 10 or 15 years ago?

AI would say it was always important. But it’s my opinion that auditors are being placed increasingly in the position of defending the way they audit, especially since they now may be liable to third parties led by class-action lawyers looking for deep pockets. Part of the problem today is that we are in a more litigious environment. If there’s any money to be found by a shareholder looking to recoup his lost investment, there are attorneys out there who will try to advocate that cause. Now that’s not to say that happens all the time. Surely, there are some cases where the auditors did not do a thorough audit . . . and should be held liable.

Q. Are you saying that the state of litigation in the last few years has spurred the industry into reviewing both its ethical and procedural standards more closely and to tighten them up?

A. Well, I would put it in a different light. I would say that due to the court rulings that have come out in the last several years, there has been an emphasis on third-party rights, as opposed to fiduciary relationships between the CPAs and their clients. Auditors are responding to those issues. This could be said about auditing in most industries that have gone through changes.

Q. Is there anything else the profession is doing today to correct these problems?

A. Yes. There are several things they are doing. One is selecting their clients more carefully, looking for those who work in industries that the auditors have knowledge about. For example, many auditors are not seeking S&L; or even bank clients unless they have a good knowledge of the banking industry and banking law. That’s being stressed quite heavily. Auditing firms also are making sure they follow generally accepted auditing standards. There are, for example, peer group reviews in which other auditing firms look at the way a particular accounting firm audits. And, as I mentioned earlier, there have been certain reporting standards that outline what auditors must do in order to perform a sound audit.

Q. Are there other issues the accounting profession faces beyond the litigation and the S&L; crisis?

A. Yes, I would say that one of the biggest issues auditors are facing and will face in the future is the big explosion of computerized information. Putting information on computers opens the possibility for misstatements of information and irregularities or illegal acts. It’s very difficult for one person or several people to try to understand or process the amount of information that computers can generate. So auditors are continually trying to upgrade their knowledge on how to audit this kind of information. One thing the auditors have done of late is to develop so-called expert systems that help guide them through audits. In fact, Coopers & Lybrand has a very well-known expert systems package that they use.

Q. How much faith can the public put in audited financial statements?

A. If you look at it from a strictly statistical point of view, you would have to conclude that most audited financial statements by Big 6 firms are reliable. Studies have shown that most audited statements are very reliable. Banks, which are the biggest users of specially audited financial statements, rely on them in making loans. Investment bankers rely on them in advising clients. Audited financial statements are used as a basis for a company’s future performance. Also, in the savings and loan and banking industries, there are federal and state auditors who do a very detailed audit of these institutions. In the case of the Lincoln Savings & Loan problem, some of the problems must be shared with the government in that the federal auditors did in fact find some irregularities. However, due to downward pressure by certain political entities, these auditors were not able to put Lincoln onto a problem list.

Q. They were not able to push corrective measures?

A. Exactly. Now bear in mind that the federal auditors work in conjunction with the independent auditors. They share information, and this, of course, improves the auditing process. So in some cases, if you have top regulatory agencies making policy statements that say, ‘Look, this is a sound institution,’ the independent auditors are relying on the federal professionals who are very adept at auditing from an internal perspective or from the federal government’s perspective. When you have breakdowns in that system, it could lead to a bad audit or it could short-circuit auditing procedures in gathering information about such things as loan portfolios. At Lincoln, outside auditors relied on certain documented information that they believed was legitimate.