First Executive tax bill makes talking auditors hard to find.

First Executive tax bill makes talking auditors hard to find

Where were the auditors?

Why didn't the annual reports of First Executive Corp., which were audited by Deloitte & Touche for 1989 and Price Waterhouse for 1990, clearly disclose the enormous potential tax liability of more than half a billion dollars?

Those questions about the two Big Six accounting firms remained open last week after recent calamities afflicted First Executive and its principal operating subsidiary, Executive Life Insurance Co., both based in Los Angeles.

"You would think some sort of disclosure would have been made," declared Gale L. Case, newly elected president of the 10,000-member Los Angeles Chapter of the California Society of Certified Public Accountants. "In hindsight it should have been pretty obvious to everyone, but maybe it wasn't then," said Case, a partner of Ozur Andersen & Radder, a Beverly Hills accounting firm.

To be sure, Price Waterhouse, which signed off on the '90 report on March 27, 1991, did caution about a number of other items including waving the red flag about whether First Executive could "continue as a going concern."

Indeed, just 15 days later California Insurance Commissioner John Garamendi put Executive Life under regulatory control, saying it was in "hazardous" financial condition. That presumably related to the giant-sized writedowns the insurer took in its portfolio of high-yield, high-risk junk bonds last year, not tax liabilities.

However, the Internal Revenue Service on April 19 filed a federal tax lien with California's insurance commissioner and secretary of state on all the property and rights to property belonging to Executive Life. The filing claimed back taxes, interest and penalties owed IRS aggregating a thumping $643.4 million as of April 18, 1991, for the three years 1981-83.

That amount breaks down to: $115.23 million for '81, $133.55 million for '82 and $394.60 million for '83, according to the IRS filing. Put another way, the filing represented $249 million sought in back taxes for the three years and $394 million in penalties and interest through April 18, 1991.

However, the meter continues to run on the penalties and interest, compounding the amount already claimed as the clock ticks away, an IRS spokesman said. He further suggested that the amounts claimed relate only to unpaid taxes indicated by IRS audits for the 1981-83 period and that other amounts may be claimed after IRS audits are completed for years subsequent to 1983.

Thus, the $643.4 million already claimed by the IRS may be only the tip of an iceberg that could sink Executive Life and the hopes of its thousands of annuitants and insureds, not to mention investors in First Executive. Commissioner Garamendi previously reported Executive Life has 170,000 life insurance policies and 75,000 annuity contracts in force in 46 states.

Policy prevents the IRS from discussing a taxpayer, but a Garamendi spokesman said the commissioner believes the federal claim against Executive Life stems from a 1989 Supreme Court decision concerning Colonial American Life Insurance Co. The decision, though, affected taxation of all insurance companies (not just Colonial) engaged in re-insuring policies.

Instead of deducting certain re-insurance costs in the year incurred, as much of the insurance industry had been doing, the court decision required such costs be deducted from taxable income over a period of years. However, insurance companies using the accelerated, one-year method were allowed to make certain adjustments in 1989 filings that would limit liability for back taxes under the court decision.

Should a company not make those adjustments then, all tax amounts owing for prior years could be levied. The IRS apparently concluded Executive Life did not make the required adjustments for '89 and therefore filed a lien for back taxes, penalties and interest, the agency spokesman suggested.

The Garamendi spokesman said the commissioner had been unable to determine whether First Executive/Executive Life had made the "escape hatch" filing in '89 to limit liability for back taxes. Deloitte & Touche and Price Waterhouse partners here refused to say one way or the other.

Whether the IRS claim will be upheld in court, of course, is unknown at this time, and the tax agency indicated it will not take any further action against Executive Life until granted approval by a California court.

Yet the question remained of why a potential tax liability of this enormous size was not clearly disclosed in First Executive's Form 10-K annual report in either the company's financial statements or the auditors' letters.

Susan Kanter Leonard, a Price Waterhouse tax partner specializing in the L.A. office's financial services sector, saqid she could not discuss the financial statement without permission of the client, and she had been unable to obtain that.

However, Leonard asserted: "We believe the statements (in First Executive's 10-K) reflect all the tax liabilities the company is likely to be responsible for. We're very comfortable with the financial statements."

She termed the IRS claim "outlandish." Leonard contended it is standard IRS practice for the agency to jump in with farfetched tax claims in order to muscle its way to the head of the line of creditors after bankruptcy is declared.

"You can put two and two together," she declared, "and see Price Waterhouse has no liability."

While declining to do sums, a Century City partner of a major law firm agreed that it, indeed, is standard IRS practice to highball back-tax claims in bankruptcy cases. He recalled that the IRS had made a gargantuan tax claim against the now-defunct brokerage house Drexel Burnham Lambert after it had filed for Chapter 11 bankruptcy protection and a federal judge put the tax agency "in its place."

Robert Garland, Deloitte & Touche's L.A. managing partner, carefully noted his firm had not been First Executive's auditor since June 1990 and never had prepared that client's tax returns. However, he continued, his firm believed the financial statements for 1989 were "reasonable" at the time of audit, and the firm continues to believe that.

Moreover, Garland stressed, his firm has not been advised by the successor auditor, Price Waterhouse, that it found anything different in going over the audit work performed by Deloitte & Touche. He, too, insisted he could say nothing further without permission of the former client, which he did not have.

Unless the questions regarding the auditors are put to rest quickly in this now celebrated case, the California Board of Accountancy well could jump in as it did against Ernst & Young in another celebrated auditing case. That one related to the "unqualified opinion" of the '87 audit of Lincoln Savings & Loan Association and its parent, American Continental Corp., headed then by the now notorious and indicted Charles Keating Jr.

After Lincoln employees peddled to their depositors junk bonds issued by American Continental, federal regulators seized the S&L for being insolvent, and the parent promptly went into the chapter. The state board accused an L.A. partner of the firm of agreeing to improper recognition of about $62 million in profits on real estate transactions, without which Lincoln and its parent would have reported a pretax loss approximating $36 million.

Ernst & Young, as part of a settlement with the state board, agreed to pay $1.5 million toward the Board's Enforcement Program. Part of those funds will be used to help the board pursue other cases against licensees "regardless of size of firm or engagement," Executive Officer Carol Sigmann emphasized.

Yet another hazard for Price Waterhouse and Deloitte & Touche: The two are likely to be sued by Executive Life policy holders and annuitants if the IRS tax claim halts or reduces their payments.

It is standard procedure for strike suit attorneys to sue anyone and everyone around, especially any national accounting firms that may be involved because they are perceived to have "deep pockets." Except that in the case of Laventhol & Horwath, it may be recalled, that national accounting firm's pockets turned out to be not that deep, and the firm filed for bankruptcy after claims exceeded $100 million.