by Paul B.W. Miller and Paul R. Bahnson
We don’t know about you, but we started getting questions from non-accounting friends and colleagues more than a year ago that ran something like this, “So, are there any more companies like Enron and WorldCom out there? Are they the only ones or are others lurking?”
As we saw it, the tragic erosion of independence and the universal fixation on financial reporting form over substance meant that these companies were only the tip of the iceberg. Of course, our dire view has been affirmed time and time again, as scandal after scandal has paraded across the public consciousness.
Our prediction was also affirmed by Andersen’s disappearance, or at least its dissolution and its osmotic re-absorption into the other Big Five firms.
All this is background to what we now see as other really, really big problems that could very well bring down others in the Final Four. More on that later.
Let’s focus first on the case of HealthSouth, which hit the news last fall with rumblings about insider trading by chairman Richard Scrushy, who sold 2.5 million shares shortly before bad news began to come out. Within weeks, allegations of Medicare fraud were followed by disclosures that the company’s revenue recognition activities were under investigation.
HealthSouth management apparently kept quarterly earnings up by crediting sales for amounts that were inflated above what insurers would reimburse. Because it took months to process medical claims, the ruse was not detected until it collapsed under its own weight.
The smoke hasn’t completely cleared yet, but the fraud has been estimated at $2.5 billion, nothing to be sneezed at even by Enron and WorldCom standards. No fewer than 11 former officers of the company have pled guilty, including three different chief financial officers.
Meanwhile, Scrushy has been fired, taken the Fifth Amendment, been caught making incriminating statements to one of those CFOs who was wearing an FBI wire, sued his board of directors, and demanded immunity prior to testifying before a congressional committee.
In the end, another seemingly great company has gone down the drain.
Ernst & Young has also begun receiving attention because of recent disclosures about its pathetic activities as HealthSouth’s external auditor. Granted, it can be difficult to penetrate cleverly executed fraud when management conspires with the intent to deceive. Still, we wonder how $2.5 billion of fake revenue can escape detection.
Uncovering the fraud was made more difficult by the fact that the audit committee was in hibernation, holding meetings at the frenetic pace of approximately once each year.
The real secret may lie in the old magician’s technique of distracting the audience away from the hand that is performing the trick.
In this case, we think that Ernst & Young was distracted by Scrushy’s idea of having the firm perform “Pristine Audits.” As reported in the press, Ernst was hired to have its staff members show up at 100 percent of HealthSouth’s locations unannounced, carrying checklists with 100 non-financial items like these: Are the magazines in the waiting area neatly stacked? Are the ceiling tiles clean or water-stained? Are the toilets sanitary and functional?
The ostensible purpose of the Pristine Audits was to ensure compliance with policies designed to promote repeat business. Ha! We suspect that the real purpose all along was to compromise E&Y’s independence through a huge fee for what was, fundamentally, nonsense work. After all, almost anyone could have performed these inspections Ñ why not just hire retired drill sergeants who are accustomed to inspecting latrines?
We find that these Pristine Audits flunk our sniff test for four reasons.
First, what could the managers at E&Y have been thinking? Imagine the impact on the E&Y audit staff’s morale when they learned that they would be checking water closets.
Suppose you had studied accounting for pensions, leases and taxes for five years, joined Beta Alpha Psi, slaved through internships, bought a new interview suit and passed the CPA exam. How, then, would you react when you were ordered to go check out the client’s loo? (We’ll be happy to hear directly from any of our readers who had to plunge into the plumbing.)
Second, the press revealed that E&Y received $1.2 million for the Pristine Audits. That’s a lot of money to flush down the drain.
Third, the same story reported that the real financial audit fees were only $0.8 million. This imbalance suggests that E&Y management’s judgment could have been all clogged up. After all, if you were the real audit partner, would you want to risk losing that $1.2 million over something like a measly little revenue recognition issue?
Fourth, the proxy statement reportedly included the $1.2 million among the audit fees paid to E&Y instead of among the non-audit fees. When challenged, the HealthSouth spokes-person (we wonder who is left to be spoken for) stated that management relied on Ernst for the allocation. E&Y replied only by saying that it stood by its treatment. We think that you’ll agree there is a need for some heavy-duty room deodorizer.
Is there a bigger picture here beyond our crass, even dumb, bathroom humor? Of course there is.
Even though we have previously accused the so-called leaders of our profession (the managers of the Final Four and the American Institute of CPAs) of being in pathological denial, we have to admit that we, too, underestimated the desperate situation that public accounting is now in. As we start to shed our last bits of denial, our fears are becoming more focused.
E&Y is not the only one in hot water, so to speak. In addition, PricewaterhouseCoopers is now sweating bullets over a $2.5 billion lawsuit over alleged major errors in the Amerco financial statements and Securities and Exchange Commission filings, not to mention its Tyco problems. KPMG is also fighting hard to keep from being sucked under by Xerox and disclosures of its highly questionable tax shelter schemes.
Perhaps in the best shape of this wretched quartet is Deloitte & Touche, relatively untouched but on the hook because of its long association with Adelphia, the Rigas family’s private sandbox.
Finally, no one should overlook the AICPA’s top management’s trouble from the inside and outside for its failure to maintain both the appearance and the reality of the profession’s independence and integrity.
Some people have raised the question of whether the profession (as we know it) can possibly survive by overcoming these massive failings. We have started to believe that it is already in its death spiral, despite new vision statements that are dismissible because they are offered up by totally discredited and otherwise unbelievable leaders.
Thus, we think that the real question to be debated is what new profession is going to replace the old one and serve the public, the economy and the capital markets by promoting the publication of truly relevant and reliable financial information. We seriously challenge the status quo belief that the old firms and the institute can somehow be salvaged out of the mess they have made.
Perhaps the best solution is the one that has been totally unthinkable up until now: A governmental agency that would be responsible for auditing all public companies.
If you gag on that thought, welcome to the club; however, we challenge you to come up with something more realistic that allows that distasteful solution to be avoided without assuming a magical transformation of the big firms.
The answer certainly is not going to be found in professionals who release public statements about their renewed commitment to ethics, while sending their best and brightest to inspect rest rooms.
The hole that has been dug is deep. Perhaps the best solution is to just fill it in, forget the Final Four and the AICPA, and move on to something new that has at least a chance of working.
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