Gaynor: Keeping a leash on the watchdogs

By BRIAN GAYNOR

The spectacular collapse of Enron, once the seventh largest company in the United States, has highlighted the role of auditors and the amount of non-audit work they undertake for client companies.

Andersen, Enron's auditor, has been castigated for allowing the company to report false profits and for systematically shredding documents after the Securities and Exchange Commission had started an investigation into the company's collapse.

Andersen's woeful performance is partially attributed to the huge amount of non-audit fees it received from Enron. In 2000 Enron paid Andersen $US27 million for non-audit work and $US25 million in audit fees. It is extremely difficult for auditors to remain independent when they receive huge non-audit fees.

Former SEC chairman Arthur Levitt tried to ban auditors from doing non-audit work, but his proposal was defeated after extensive lobbying by the Big Five accounting firms.

After the Enron collapse the Big Five have decided that they will no longer do non-audit work, a move that will have huge implications for the industry.

Payments to auditors, for both audit and non-audit work, should also be a topic of debate in New Zealand yet the subject is never raised at company meetings.

The issue is becoming increasingly significant because a number of our largest listed companies are now paying huge fees for non-audit work and this could compromise the independence of their auditors.

Last year eight listed companies paid more than $1.5 million to auditors and the 15 largest fee paying companies forked out a total of $36.5 million.

Nearly $26 million, or 71 per cent of the total, was for non-audit work.

Non-audit fees are becoming increasingly important. Audit fees paid by the 15 companies have risen from $10.3 million to $10.6 million over the past two years but payment for non-audit work has increased from $16.8 million to $25.9 million.

Directors are keeping their audit fees in check, but payment for non-audit work has risen dramatically.

In the latest year, KPMG received $13 million from the 15 companies, PricewaterhouseCoopers $12 million, Deloitte Touche Tohmatsu $6.8 million, Ernst & Young $3 million and Andersen $1.7 million.

KPMG made 78 per cent of its income from non-audit work and PricewaterhouseCoopers 76 per cent.

An auditor's independence can be compromised if it challenges creative accounting treatments and the client company threatens to terminate its contract. In this situation the auditor will be under enormous pressure to sign off questionable accounting treatment if it receives large non-audit payments and these fees are closely aligned to the audit mandate.

Telecom (PricewaterhouseCoopers), Fletcher Building (KPMG), Fletcher Forests (PricewaterhouseCoopers and KPMG), Sky City (PricewaterhouseCoopers), Tranz Rail (KPMG), UnitedNetworks (Deloitte Touche Tohmatsu) and Infratil (KPMG) all pay a high percentage of their fees to auditors for non-audit work.

Can these auditors be truly independent?

Would they stand their ground and risk losing their mandate or condone substandard practices to protect their non-audit fees?

The lesson from Enron is that executives with large shareholdings use creative accounting to maximise profits and auditors earning large non-audit fees are poor watchdogs.

New Zealand companies argue that it is appropriate to use auditors for several projects, including restructurings, acquisitions and due diligence. Last year Telecom's non-audit fees were for work related to the Kiwi Share, due diligence on prospective acquisitions, reorganisation of accounting segments and the AAPT purchase in Australia.

Fletcher Building says that all its non-audit payments last year were for audit work associated with the Fletcher Challenge break-up and a large proportion of the non-audit fees for Fletcher Forests were associated with the same process.

But the big question is why are auditors commissioned to do this work when plenty of other organisations are capable of advising on mergers, acquisitions and restructuring?

Fisher & Paykel undertook a major restructuring last year, yet its non-audit fees were low because the group used independent advice.

Expansion-oriented companies should take outside advice because acquisitions create huge scope for creative accounting, and it is important that auditors are completely independent of this process.

The huge level of non-auditing fees in New Zealand does not necessarily mean that companies are at risk because the board of directors, particularly the audit committee, also plays an important role.

The audit committee, made up of non-executive directors, should have several individuals with inquiring minds and extensive accounting experience. It also helps if they have had first-hand experience of creative accounting.

We are fortunate in this regard because the excesses of the 1980s have not been forgotten.

An issue related to this topic was raised at DB Group's annual general meeting on Tuesday when David Sadler, aged 70, and John Cronin, aged 74, stood for re-election. A shareholder objected on the basis of their age but it is important that every board has a mixture of experience and youth.

Mr Sadler has a background in finance and accounting and another director Sir Colin Maiden, who is 68 and chairman of DB's audit committee, has had extensive experience of shonky accounting policies.

Sir Colin was a director of Fisher & Paykel when Equiticorp took a major shareholding in the 1980s and he now goes through every issue with a fine toothcomb.

It is important that a board has a number of directors with experience of wayward accounting practices but at the same time the majority of independent directors should be under 60.

The problem in the United States is that economic conditions have been so good for so long that directors and auditors have become lazy and complacent. Ireland has also experienced unprecedented prosperity and has also allowed lax standards to develop. It is now paying a high price as the Irish Stock Exchange has fallen 17.2 per cent since December 31 because the country's two largest companies have had audit related problems.

The market capitalisation of Elan, the pharmaceutical manufacturer, has plunged from $36.5 billion to $11.2 billion since the end of last year after a profit downgrade and concerns over its creative accounting policies.

Allied Irish Bank's market value has fallen from $24 billion to $21.7 billion after the announcement of a $1.8 billion foreign exchange trading loss.

The bank's monitoring problems developed during a two-year period when the non-audit fees paid to PricewaterhouseCoopers rose from $0.8 million to $12.1 million and audit fees increased from $4 million to $5.2 million.

The collapse of Enron will have major implications for the accounting profession, and auditors in this country will not be immune.

Shareholders will become more proactive over fees paid to auditors and restrictions will be placed on the amount of non-audit work that auditors can do.

This could lead to the break up of the Big Five accounting firms.

These developments are long overdue because the huge growth in non-audit income has compromised the independence of auditors, and Enron's stakeholders are now paying a huge price for this unsatisfactory development.

* bgaynor@xtra.co.nz