Independent Watchdogs: New Rules Needed for Auditors

Americans aren't known for their long memory, and neither are business journalists, and so it's no surprise that one of the causes of the corporate frauds of the late 1990s and early 2000s -- compromised auditors -- didn't get much attention after a flurry of reforms reforms precipitated by the collapse of Enron and WorldCom. The new rules stipulated that accounting firms could no loger sell a range of services to the same companies they were auditing -- an obvious conflict of interest. Problem solved, right?

Not quite.

A key recommendation of reformers back in the early 2000s was that public companies should have to rotate their auditors every few years, so that overly cozy ties didn't undermine the independence of auditors.

That never happened. Congress decided the issue needed to be studied further, and the GAO released a report in 2003 that was negative about the idea of auditor rotation:

GAO believes that mandatory audit firm rotation may not be the most efficient way to strengthen auditor independence and improve audit quality considering the additional financial costs and the loss of institutional knowledge of the public company’s previous auditor of record, as well as the current reforms being implemented.

Sarbanes-Oxley does require that specific partners rotate off a company's account every seven years, but that was as far as reformers went. The GAO said that regulators should see how successful SOX would be in ensuring independence and return to this issue later. Well now, in the wake of the financial crisis, some powerful regulators are asking whether it's time to revisit the issue of auditor independence and mandate rotation of firms.

Last week, James Doty, chair of the Public Company Accounting Oversight Board (PCAOB), raised this issue in a speech in Pasadena. Among other things, Doty said that PCAOB has, in fact, now studied the issue of auditor independence by reviewing several thousand cases of how auditors have engaged with firms. Along the way, inspectors have identified hundreds of cases of "audit failures."

In one failure, an audit firm let a company cut corners with its books that it had had as a client for 50 years. In another case, it was 98 years. Doty noted that an "audit has value to the public only to the extent that it is performed by a third party who is viewed as having no financial stake in the outcome" and that inspectors had found a "disturbing lack of skepticism" among auditors.

Obviously, it's hard to be objective if the outcome could be losing a client that your firm has had for a century.

Doty didn't mention the case involving Ernst and Young and Lehman Brothers, perhaps the most egregious example of how compromised auditors played a role in the recent financial crisis. As I've described here, E&Y helped Lehman shift tens of billions of dollars of bad loans off its books in ways that misled investors about the firm's financial health. E&Y is now being sued by the New York Attorney General.

Lehman had been a client of E&Y for 35 years. And the accounting giant had billed the firm $150 million since 2001.

Doty said that PCAOB's reviews had prompted it to investigate new approaches for better insulating auditors from pressures to accommodate the wishes of longstanding clients. Establishing rules limiting "auditor tenure" is one such idea.

The PCAOB is now engaged in further study of this idea and no decisions have been made. You can bet that Doty's remarks have set off alarm bells among the big accounting firms and that their lobbyists are girding for war. History shows that this lobby is formidable and often gets its way. Last year, the accounting industry spent $14 million on campaign donations and $15 million on lobbying.

Let's hope that Doty is not only serious about this effort, but ready for a fight. Ensuring auditor independence is one big piece of unfinished reform business from the Enron era.