Watchdog firm raises regulatory red flags with software.

Regulatory crackdowns are anathema to most of the business world.

But probes such as the Securities and Exchange Commission's current stock option investigations are the bread-and-butter of Audit Integrity Inc.

The Santa Monica-based firm's software digs through financial filings for warning flags on possible restatements, bond defaults and corporate governance transgressions. Audit Integrity evaluates and reports on more than 9,000 publicly traded companies.

"We help our customers, which include auditing firms, insurance companies and investors to identify significant accounting and governance risk," said Jack Zwingli, chief executive of Audit Integrity. "We're basically trying to find the next Enron."

In a sense, Audit Integrity tries to stay one step ahead of agencies like the SEC, which tries to stay one step ahead of companies that are trying to stay one step ahead of the tax and accounting regulations.

Audit Integrity won't divulge any of the firms on its client base, but Zwingli said it includes companies both large and small all over the country.

"Two of the big four accounting firms are our clients and a number of large insurance companies as well," Zwingli said. "Our largest client has about 2,000 separate users. We literally have thousands of investor clients."

The firm's intention is to identify companies that are likely to have regulatory or auditing problems before anyone else spots them.

Before overexpansion and franchisee disputes wracked Krispy Kreme Doughnuts Inc. in 2004, Zwingli had warned its subscribers of potential trouble ahead early on.

"We identified them as being a risk. We identified some patterns of behavior in their accounting that put them at nigh risk," Zwingli said. "In their case, the jury is still out. They had some revenue recognition issues."

Earlier this year, Audit Integrity flagged video game publisher Electronic Arts Inc., as an "aggressive" company.

That characterization is something of a euphemism; it suggests that the firm is pushing the envelope in terms of its accounting practices or corporate compliance.

Electronic Arts, which along with its rival Activision Inc. and several other tech companies in Los Angeles County, is facing a potential SEC investigation into possible backdating of stock options. EA did not return calls seeking comment.

Audit Integrity's monthly Investor WatchList identifies and rates approximately 60 companies each month, 15 per market cap group.

Last month cited some well-known firms for problematic accounting issues, including heavyweights such as CBS Corp., Coca-Cola Corp., Sprint Nextel Corp., Google Inc., BellSouth Corp., Capital One Financial Corp. and Citigroup Inc. None of these firms are under formal scrutiny.

"We look for patterns of behavior that are consistent with past instances of fraud," Zwingli said. "We're not going to accuse people of lying, cheating and stealing, but if it walks like a duck and quacks like a duck, then it's probably a duck. But we just can't say for sure."

Mary Bielaska, an analyst with RSM McGladrey, said Audit Integrity is crucial in shaping her take on complicated firms.

"I use their tool to help me understand the companies I look to do due diligence on," Bielaska said. "What you get is a synthesis of what's out there in the marketplace. That's an excellent service."

Crisis response

Audit Integrity was founded by Zwingli in 2001 as a "direct result" of the accounting disasters with Enron, Global Crossing, WorldCom and Tyco. The firm went commercial in 2003 and has since installed offices are in Los Angeles, New York and San Diego.

Zwingli said that Audit Integrity did, as an exercise, go back and rate Enron. The firm would have been singled out, Swingli said.

"We did have Enron being a very aggressive company, which is our worst rating," he said. "We would have identified Enron. Whether it would have stemmed the tide, I don't know."

Zwingli also said that his firm has found a niche by offering info on accounting and corporate governance combined, since most firms similar to Audit Integrity provide data on one or the other. In the accounting realm, for example, the Center for Financial Research and Analysis specializes in accounting checks. Shareholders Service, GovernanceMetrics and the Corporate Library would get special attention.

He said Audit Integrity is always on the lookout for companies that "manage" their earnings. In other words, "to see if they're making their earnings look better than they actually should be." It has happened since the beginning of time, or at least since the beginning of publicly traded businesses."

Zwingli conceded that a cagey customer could--and that some probably have--conceivably made money on his own company by appearing to conduct "aggressive" accounting practices to draw a report from Audit Integrity that would drive the stock down.

"That's a trick that some of our customers use to do some short selling," Zwingli said.

BY DAN COX

Staff Reporter