Burying the past: audit firms have gotten tougher—and board audit committees have, too

Chief Executive, The, April, 2004 by Mike Brewster

When Isolagen, a Houston-based biotechnology company, recently sought to replace its external auditor with a larger, more national accounting firm, the company's board felt the process needed to be as transparent as possible. Isolagen's chairman, Frank Delape, decided the board's audit committee would take charge of hiring the auditors, as specified by new corporate governance laws.

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What ensued was a competitive bidding process that would have been unheard of at a U.S. public company just three or four years ago. Back then, management teams held a hammerlock on the audit relationship. Audit committees were expected to rubberstamp the accounting decisions of CEOs and CFOs. Now at Isolagen, the audit committee, led by its chairman, Henry Toh, took control. In addition to the time-honored practice of accounting firms paying "site visits" to prospective clients' headquarters, Toh visited the prospective accounting firms, interviewing potential audit team members. Isolagen CFO Jeffrey Tomz helped vet the finalists, but the hiring was clearly being done by the audit committee.

As partners from firms such as Grant Thornton and BDO Seidman pitched their services to Isolagen's board, Delape had a front-row seat on two emerging trends: an increased tendency among outside auditors to question management's accounting decisions and a reluctance to get involved in "strategic" discussions. "It was clear that the firms have internalized this new role of being a detective, rather than just a policeman," Delape says. "Everything is reviewed, everything is questioned--which is healthy." Before, he notes, "your auditor was like another counselor: You might go to the auditors for advice on international situations, interpretations of regulations and questions like, 'What's the best way to amortize or depreciate?' They are less likely to get involved in that now."

For CEOs, it's critical to appreciate this new landscape in corporate accounting. Companies' audit committees now serve as a wedge of sorts between management and accounting firms. "Auditors are learning they have a new boss in the audit committee," says Lynn Turner, who served as chief auditor for former Securities and Exchange Commission Chairman Arthur Levitt and now heads the University of Colorado's Center for Quality Financial Reporting.

The Sarbanes-Oxley Effect

Accounting firms have had much to learn since July 2002, when Congress redefined the regulatory landscape with the passage of the Sarbanes-Oxley Act. It was corporate accounting scandals, of course, that spurred the legislation, namely the implosion of Enron and the disclosure by WorldCom that it had overstated revenues by more than $6 billion. Arthur Andersen, then one of the so-called Big Five accounting firms, served as each company's auditor. Andersen was forced to go out of business after being convicted of obstruction of justice in the Enron scandal. The remaining Big Four--KPMG, Deloitte & Touche, PricewaterhouseCoopers and Ernst & Young--fought to put their stamp on Sarbanes-Oxley, but ultimately failed. Now they must live by the new rules.

Judging by recent headlines, one wonders whether the major accounting firms have learned their lesson. When the dairy giant Parmalat was forced to declare bankruptcy in December, it became apparent that its outside accountants, the Italian branches of Grant Thornton and Deloitte & Touche, had engaged in see-no-evil audits of the struggling conglomerate. KPMG found itself in a dispute with the Internal Revenue Service over sales of allegedly abusive tax shelters to corporations and high-wealth individuals. A PricewaterhouseCoopers audit partner was banned from the profession for life in a settlement with the SEC after being accused of issuing fraudulent audit reports of scandal-tarred Tyco International.

But, these scandals notwithstanding, there is increasing evidence that the Big Four are reforming their act. The firms have placed a premium on managing risk at the highest levels by creating new internal checks and balances. Ernst & Young, for example, has created the position of vice chairman of quality and risk management. "We decided the environment changed and we had to evaluate our processes." says Sue Frieden, who holds that title. "I don't want to say I'm everbody's conscience, because everyone here has to do that for themselves. But we needed to evaluate our risk and manage our risk from an enterprisewide standpoint--issues like how we're training our people, whether we're setting the right tone at the top."

As a sign of auditors' new watchdog role, they're often paying longer and more frequent visits with their clients' top managers. As CEO of Yellow Roadway, a $3-billion trucking company based in Overland Park, Kan., that hired KPMG as its outside auditor, Bill Zollars can attest to the trend. "The communication between the senior audit partner and our CFO was always pretty regular, but now there are a lot more meetings between the audit team and myself," he says. "I'm also meeting more with KPMG's Kansas City management team, not just the audit team."