The right stuff: CFOs, auditors & audit committees reexamine their relationships.

($427 billion) YEP, THAT'S RIGHT, A $427 BILLION LOSS. It's the estimated total loss in market value of WorldCom, Tyco, Qwest, Enron and Global Crossing. And it has been the impetus for a thorough reexamining of the client-auditor relationship.

Even before the unanimous passage of the Sarbanes-Oxley Act of 2002, CFOs, auditors and audit committees have been scrutinizing their relationships, looking for best practices that will quell investor fears, stabilize a volatile market and rebuild trust in the profession.

This reexamination has led some companies and accounting firms to take steps toward eliminating perceived conflicts of interest and improving the transparency of financial reporting and the auditing process.

Many public companies have scrutinized their decades-long relationships with their auditors and have determined it is time to select new ones. Others, such as Disney, backed away from giving their auditors consulting work. PricewaterhouseCoopers joined the ranks of KPMG and Ernst & Young and sold its consulting arm to IBM.

THE MARKET'S NOT CORNERED

But change hasn't been limited to public companies. Many privately held companies and nonprofit organizations have changed their financial reporting process.

For example, for the first time in its 92-year history, CalCPA modified the agenda of its annual meeting between its external auditor and audit committee to include an executive session. CalCPA management was excused, which allowed the auditor and audit committee to freely discuss any audit-related matters including internal controls.

This type of open meeting is based on a 1999 New York Stock Exchange Blue Ribbon Committee's guideline for audit committee practices. Even though many public companies did not start following the guidelines until last year, CalCPA felt it should proactively adopt the practice.

"In today's business environment, it's smart for both public and private companies to foster open, unrestricted communication between the auditor and audit committee," says Donna Lekosky, CalCPA director of finance.

In addition, Learning Tree and other public companies such as Rockwell International have gone a step further by including a clause in their audit committee charters about meeting separately with the external auditor without management present.

DIALOGUING WITH AUDITORS

"All companies should have an open, ongoing dialogue with their auditors, especially if there have been new professional pronouncements or changes in the company's business" says Lekosky. "No one wants surprises. I would encourage CFOs to stay in contact with their auditors throughout the year to ensure that everyone is on the same page."

CalCPA's auditor, Dave Ljung, a shareholder with Gilbert Associates, Inc. in Sacramento, agrees that meeting prior to the audit also can give companies a chance to handle problems in advance.

"Some of our clients are taking the initiative themselves and are calling to meet ahead of time," says Ljung. "We've done this historically with CalCPA and are suggesting to clients who have taken a real interest in the process in the past to meet prior to the audit.

"Small to mid-size companies usually meet only once after an audit," says Ljung, "but it makes sense to get the issues on the table early in the game. It's an opportunity for the audit committee to be involved in the planning and to provide input."

This is especially important, because now under Sec. 204 of the Sarbanes-Oxley Act, management must report to the audit committee all "critical accounting policies and practices to be used ... [and] all alternative treatments of financial information within [GAAP]."

It's up to the external auditor to counsel the audit committee on the appropriateness of such practices, because the audit committee is not equipped, nor is it expected to be able to guarantee the quality of the financial statements--that's the job of the professionals.

"For the most part, the audit committee is trying to be diligent in fulfilling its fiduciary duty, and they look to the auditor to inform them of what the issues are and familiarize them with the process in lay terms," says Ljung.

DON'T FORGET THE INTERNAL AUDITOR 

Internal auditors may have difficulty in getting management to listen when they question potential accounting irregularities. To address this issue the NYSE Blue Ribbon Committee included "independent communication and information flow between the audit committee and internal auditor" in its best practices recommendations. If independent meetings were part of the routine, "independent dialogue between the audit committee and the internal auditor should lose its taboo nature and no longer imply treason against management," states the Blue Ribbon Committee.

Had this been the case for Sherrin Watkins at Enron and Cynthia Cooper at WorldCom, would the accounting scandals have been a blip on the radar screen? It's something the whistleblower provision in the Sarbanes-Oxley Act hopes to address.

ROOM FOR WHISTLEBLOWERS

Now internal accounting and administrative staff will have an outlet to report questionable accounting, thanks to the Sarbanes-Oxley Act whistleblower provision. Companies like Pinnacle Entertainment are setting up ethics hotlines to report questionable behavior. And Harrah's already has one in place.

In addition to providing protections for whistle blowers, Mike Donahue, a corporate and securities attorney and partner at Holland & Knight's Los Angeles office, is advising his clients to establish procedures that enable employees to communicate candidly with CFOs and report questionable accounting. "You don't want to be blind-sided," he says, "or embarrassed."

FINDING THE RIGHT STUFF

"One of the elements that contributed to Enron's fall and WorldCom's fraud was a lack of audit committee diligence in asking probing questions and identifying red flags. Inherent in the problem is that most audit committees lack qualified financial experts," says Lekosky.

Under the new legislation, audit committees now must have at least one financial expert on board, and their scope of responsibility in the auditing process has widened.

"Many of these 'new' responsibilities are formalizations of NYSE Blue Ribbon Committee recommendations," says Lekosky, adding that finding people who are willing and qualified to serve on audit committees has been an ongoing challenge for companies. "Now with all the scrutiny, it'll be even more difficult."

Nonetheless, audit committees have an expanded role and will be expected to ask the tough questions, examine the accounting more closely, and maintain their independence.

"Audit committees need to be more proactive in audit planning as well as during the audit engagement," says Dave Wilson, an audit partner with Grant Bennett Associates and CalCPA's Audit Committee chair. "They need to meet with auditors up front to identify areas where high risk is perceived and to work with the auditor to take the appropriate steps."

While the NYSE Blue Ribbon guidelines recognize that audit committees are not comprised of financial wizards, it did recommend that audit committees be familiar with everyone's role in the financial process from management to internal accounting departments to external auditors.

All this should be in writing, the Blue Ribbon committee suggests, and from this understanding, the audit committee will be in a better position "to devise appropriate questions as to how each participant carries out its functions."

TAKING ON FRAUD

Like CalCPA, some public companies started to fortify their audit committees by altering their audit committee charters to include the NYSE Blue Ribbon Committee recommendations. In fact, as early as last December, Los Angeles-based Learning Tree International altered its audit committee charter to include a list of questions or guidelines the audit committee could review to determine if there was a conflict of interest with its external auditor.

All of this was done to encourage more transparency in the audit, and add one more check in the system. "But this puts the onus on the audit committee to identify fraud--something difficult to detect, even for a professional auditor," says Thomas Noce, a partner with Maryanov Madsen Gordon & Campbell in Palm Springs.

"The prime purpose of an audit is not fraud detection. Though traditional auditing is regulated under Statement of Auditing Standards No. 82, which includes a certain number of required steps or procedures to identify fraud or risk factors, it's not intended to uncover fraud. If risk factors are detected, we follow up with identifying controls that might mitigate them or we modify our audit procedures."

PRESSURE COOKER

The audit committee is not the only entity being held accountable. One of the biggest impacts on the auditing relationship has been the requirement for CFOs and CEOs to certify all financial statements. Now, restatements due to "material noncompliance" carry penalties. Additional provisions in the Act also make "misleading the auditor" a punishable offense.

"The certification requirements are causing CFOs and the internal auditing staff to be more careful and diligent, which, of course, is what's supposed to be happening," says Donahue. "It's also one of the biggest problems facing larger companies. The CFO of General Motors can't possibly know what's going on in the corporation's subsidiaries around the world, but that's how fraud arises."

Indeed, the Act is bringing a renewed awareness to CFOs as well as to auditors about their respective responsibilities and about how accounting policies are being followed. It's an awareness that is healthy for business, says Bruce Hinckley, senior vice president and CFO of Pinnacle Entertainment in Glendale. "It continues to define the role of the external auditor and audit committee. The roles are much better defined; the auditor's independence will be strengthened and overall the Act will strengthen the audit process."

IT'S EVERYONE'S RESPONSIBILITY

Certification isn't only for the CFO. At Pinnacle Entertainment, division leaders and financial officers will have to certify financial statements. "We've instituted a number of procedures to conform to the Sarbanes-Oxley Act," says Hinckley. "The challenge is to make certain that people throughout the organization understand the seriousness of the integrity of the financial statements and the company's code of conduct. Integrity of the work is almost as important as the work itself."

Many companies are boosting their internal auditing and accounting staff. Pinnacle Entertainment is evaluating whether it needs more in-house staff to handle the additional certification process. "I'm not sure more resources are the answer," Hinckley says. "It is more critical to have the training for all our employees and to make certain that the way we conduct business is ethical."

REFOCUSING PRIORITIES

A reexamination of professional relationships wouldn't be complete without a discussion of the relationship between corporations and their shareholders.

"The '90s boom lead to a fervent reliance by some investors on earnings per share. Corporate officers felt constant pressure to increase their quarterly earnings. And in some cases, such as with Enron, it seems that incentives for constructing short-term profit pictures without regard to long-term effects were so strong that executives may have given into greed," reflects Lekosky. "In a way, the Enron bankruptcy was a godsend. It drew the profession's--and investors'--attention to a problem that was, in some instances, spiraling out of control."

As a result, Lekosky adds, "It appears the marketplace is responding. There an increased awareness that transparency is far more important than quarterly profits, and it has been the impetus for introspection on the part of corporate officers, their auditors and audit committees. Combine that with the Sarbanes-Oxley Act, and corporate. America has taken important steps toward preventing another Enron."

REPAIRING A BRUISED IMAGE

Certainly the deepest impact of these corporate scandals has been to the auditor's image. Prior to 2001, integrity was never an issue and the profession was viewed as one of the most noble around. Integrity is built into the profession, says Ken Boucher, senior partner with Vilmure Peeler & Boucher.

Can legislation instill ethics and build back confidence in the profession? "It's up to individuals, not legislation," says Boucher.

"There's nothing wrong with our standards. There's nothing wrong with our profession. The whole problem is people following them with integrity. If we'd just remember that every day when we went into work."

Sharon Ross is a freelance writer and editor.