Ethics/Professional Responsibility
Aug. 13, 2002
Pumping Profits
Column by Stephen P. Milner and Dennis McNally - Undoubtedly, most auditors are not involved in any sort of conspiracy with the clients whose financial statements they audit. But absent a conspiracy, how can one explain the series of accounting scandals that are taking place?
Undoubtedly, most auditors are not involved in any sort of conspiracy with the clients whose financial statements they audit. But absent a conspiracy, how can one explain the series of accounting scandals that are taking place?
Some scandals, as with electric and natural gas trader Enron Corp., seem to be a case where the accounting rules themselves need tightening. Recall that Enron involved, among other things, a complex structure of partnerships designed to remove certain liabilities from their balance sheet.
Other scandals, as with telecommunications company WorldCom Inc., seem to be a case where the auditor just plain "missed" something.
To be fair, in the WorldCom case, accounting firm Arthur Andersen did not "miss" $3.8 billion as has been reported. Most of the public assumes that the $3.8 billion was somehow "left off" the financial statements entirely.
What Arthur Andersen allegedly did in the case was to fail to uncover a scheme by WorldCom management to boost earnings by treating some expenditures as capital assets, which were depreciated over several years rather than expensed immediately.
To understand how Arthur Andersen failed to uncover the scheme, one must first understand that categorizing an item as operating expense versus a capital expenditure is not always clear-cut.
To treat an expenditure as a capital asset, it typically must have a useful life longer than a year. While no one would debate the capital nature of office furniture versus supplies, the capital nature of many complex assets in the telecommunications industry, such as "line costs" and "excess capacity," are more uncertain. In such case, management uses its judgment for classification, and the auditor uses its judgment to determine whether to accept the classification.
Assuming there is a scheme by management to boost earnings, at what point has the auditor breached the standard of care if it fails to uncover the scheme? To answer this question, one must understand what an auditor does and does not do, and how audits are performed.
Much to the dismay of the general public, an auditor does not verify every or even most of the transactions of a company. To do so is prohibitively time-consuming and expensive. An audit is merely designed so that an auditor can opine as to whether the financial statements are fairly stated in all material respects in accordance with Generally Accepted Accounting Principles.
All auditors must perform their audits in accordance with Generally Accepted Auditing Standards, but each Big Five auditor (as well as the rest of us) has its own proprietary method for auditing in accordance with Generally Accepted Auditing Standards. Further, each audit is tailored for a specific industry and company.
In the past two decades, auditing has moved substantially away from "transaction-based" auditing to so-called "risk-based" auditing. That is, auditors look less at the numbers and more at management's integrity and the internal controls systems that act as checks and balances.
Assuming management's integrity is satisfactory and the internal controls are good, an auditor focuses on the areas where there are the greatest risks of manipulation or misstatement. Notably, when management integrity and the internal controls are satisfactory, the scope of testing, even in areas of risk, can be reasonably reduced.
With WorldCom, many people, including former WorldCom Chairman Bert Roberts, find Arthur Andersen's failure to uncover the irregularity "inconceivable." To which, former Arthur Andersen partner Melvin Dick countered that the firm relied "on the honesty and integrity of the management of the company."
In other words, Arthur Andersen reduced the scope of its testing because it believed that the management's integrity was high. Assuming the normal background checks were made on management, and that Arthur Andersen did not have any significant reason to believe that management was perpetrating a scheme (which at present is in some doubt), the reduction of scope is not likely a breach of the standard of care.
How Arthur Andersen actually tested the capital expenditures is not public knowledge. Certainly, if the auditor did no substantive testing on the capital expenditures, it would have breached the standard of care.
But, let's assume, for example, that Arthur Andersen tested a sample of the 30 largest transactions and 40 other transactions chosen at random. From what has been reported, apparently the individual transactions comprising the $3.8 billion were not among the largest transactions. So in our illustration, nothing unusual should have surfaced from the first set of samples.
Let's take another example. Assume that WorldCom had approximately $50 billion in capital additions during the year, including the disputed $3.8 billion. In other words, approximately 8 percent of the capital expenditures are in question. We will assume that our random sample has identified some of the dubious capital expenditures. But how much has been identified?
In a perfect world, the statistical sampling would identify approximately 8 percent of the transactions. But in reality, the auditor has no idea whether the few transactions are isolated incidences or whether they are indicative of a more pervasive problem.
What should the auditor do?
At the very least, the auditor will propose an adjustment to move the expenditure from a capital asset to an expense. If the auditor's sample has identified only one or two transactions, it may simply propose the adjustment and question management as to their policies regarding this type of transaction. If management's responses are satisfactory, even if they are untrue, the auditor may be justified in stopping the testing.
In the event that either the sample detects more than just a few questionable transactions or that management's responses are unsatisfactory, the auditor may (and should) increase its scope. Assuming that the new sample identifies even more questionable items, in theory it should stop this portion of the audit and request that management prepare a schedule identifying all similar transactions. Of course, the whole time management likely will be protesting the need for any adjustment (arguing accounting theory regarding their classification) and the need for any schedule.
Management and the auditor may be concerned that time to prepare such a schedule will delay the audit at the risk of the company meeting its statutory filing deadline.
(Remember that in the case of WorldCom it was an internal audit of the capital expenditures that uncovered the purported error. Internal audits are not under any statutory time pressure and can take as long as needed.)
For this reason, management and the external auditor will attempt to develop a reasonable estimate of an adjustment -and if management is trying to bolster earnings at any cost, one can bet that the adjustment will be unsatisfactory.
But, has the auditor breached any standard of care?
Plaintiff's lawyers will be quick to assert that a $3.8 billion restatement by WorldCom is an indication that Arthur Andersen did not meet the standard of care with respect to its audit. They may have a long way to go, however, to prove a breach of the standard, absent evidence showing that Arthur Andersen had reason to seriously question the integrity of management or the internal controls that were in place.
Stephen P. Milner is a certified public accountant and has his master's degree in law. He also is managing partner of Squar, Milner, Reehl & Williamson, a Newport Beach accounting and financial advisory firm. Dennis McNally is principal in the same firm.
Contributing Writer
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