Auditors Targeted for Blame As Disclosure System Fails. (Wall Street's Safety Net - Who Can You Trust?).

AUDITORS -- those people responsible for verifying the accuracy of public company financial statements -- have become among the primary scapegoats for what's wrong with the U.S. financial disclosure system.

The auditors' response: Duck for cover until the system can be fixed.

Multiple calls to the L.A.-area offices of all Big Five accounting firms, which handle most public company audits, were not returned last week.

One exception was a brief comment from Natalie Webb, spokeswoman for Deloitte & Touche. "I spoke with my boss and, unfortunately, at this time we are not speaking on that topic," she said.

Soon after the Enron Corp. implosion, a rare joint statement was issued by the chief executives of all Big Five firms.

"Working together, our five firms are committing our attention and resources to evaluate and chart a course to address issues important to investors," the Dec. 4 statement reads. "We are developing specific recommendations to the SEC for improved disclosure guidance... and will work with the profession to submit these recommendations by the end of the year."

Any number of other parties -- the Securities and Exchange Commission, Financial Accounting Standards Board, National Association of Securities Dealers and others -- are likewise hammering out fixes to what most now agree are structural flaws in the auditing system.

The FASB alone has two projects underway, according to Chairman Edmund Jenkins.

One is aimed at clarifying how companies report results from off-balance-sheet partnerships, such as those that wiped out $1.2 billion in Enron equity. The other effort is aimed at improving the reporting of financial performance to "make the use of pro forma numbers less necessary in the eyes of companies and investors," Jenkins said.

Conflict of interest

But William Lerach, a partner at Milberg Weiss Bershad Hynes & Lerach LLP who represents investors in class action lawsuits, scoffs at the notion that systemic flaws are to blame. Instead, he cites what he calls a conflict of interest stemming from accounting firms offering both consulting and auditing services.

"Supposedly 'independent' accountants are routinely violating independence rules while pocketing lavish consulting payments that outweigh their audit fees many times over -- creating powerful incentives for these watchdogs' to accommodate their corporate clients," Lerach asserted in a position paper.

Outright collusion between auditor and client is extremely rare, however, several sources agreed.

"It's not like the client is saying to the auditor, 'Look, this is criminal, we know, but we'll give you $50,000 to keep it quiet,'" said Irving Einhorn, a West L.A. attorney who specializes in defending auditors. "It's a subtle pressure on issues that are not black and white."

A more prevalent reason auditors find themselves in hot water is that accounting firms sometimes assign inexperienced, lower-pay people to conduct major portions of public company audits.

"Accounting firms tend to spread their senior people too thin," said one financial services professional. "They're taking auditors who are fresh out of college and giving them an inordinate amount of responsibility, with an amount of oversight that's not sufficient."

Paying the price

The result: major penalties against Big Five accounting firms.

Arthur Andersen, which is accused of doing a shoddy job on Enron's financials, this year alone has settled $75 million in shareholder claims on Waste Management Inc.'s audit and $110 million on Sunbeam Corp.'s meltdown.

It's no secret that the U.S. audit system's "flaws" long have been exploited by some public company executives to cast their companies' financials in the best possible light, even if that meant shading the truth.

Such scenarios regularly put auditors under pressure to fudge, especially if the client also generates big consulting fees for the audit firm.

"When sticky issues come up, very often you'll see the senior audit partner knuckle under," said Einhorn, who was Pacific Regional Director of the Securities and Exchange Commission from 1984 to 1989. "It's part of the culture -- a client asks you to do something close to the line, there's another audit firm out there that will do it if you don't, and your future with the (audit) firm is riding on keeping that client happy."

The larger the client, the greater the pressure on the audit team to comply with the client's wishes. Because Los Angeles-area public companies are usually small and mid-sized outfits, they don't have sufficient clout to pressure a Big Five audit team.

"(Big Five auditors) are certainly not going to take any risks for the smaller companies, so (investors) can be comforted in that," said one senior finance industry executive.

Beyond that, being audited by a Big Five firm is still viewed by many in the investment community as a seal of approval.

RELATED ARTICLE: Auditor Red Flags,

Indications that a public company's audited financial statements may be suspect.

* Auditor resigns, possibly signaling that it was pressured to sign off on questionable financial assertions.

* Public company uses auditor other than one of the Big Five accounting firms.

* Inordinately large portion of auditing firm's total business is derived from one client company.