act

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William J. McDonough might face the toughest job in the country - convincing investors that corporate accountants wont lie.

McDonough, 6, is chairman of a new board created by Congress to oversee the accounting profession, which over the past two years has been co-conspirator in some of the biggest financial frauds and bankruptcies in history.

At stake are the future of the stock market and the credibility of corporate America. Whether the board, known as the Public Company Accounting Oversight Board, can restore order and faith is not certain.

I view the PCAOB as being fundamental to the process of restoring public confidence, said Arthur Levitt, former chairman of the Securities and Exchange Commission and a senior adviser to the Carlyle Group, a Washington, D.C.-based private equity firm. The restoration in confidence and the reliability of the numbers ... is essential to the primacy of Americas capital markets.




But the early signs are not encouraging.

I am pretty cynical about that entity, said Eric Sussman, a lecturer at the Anderson School at UCLA and a former manager at then-Price Waterhouse. The reality is they may promulgate a few relative standards ... but I have no expectations. At the end of the day, what are they going to do that is really going to make a difference?

The PCAOB can do a lot; it just remains to be seen how firmly they are going to take control of things, said Jack T. Ciesielski, an accounting expert and publisher of The Analysts Accounting Observer. My concern is their becoming another mushrooming bureaucracy that becomes fat and loses its mission.

This is not the first time Congress has created an organization to regulate and oversee an industry that has gone bad. The stock market crash of 1 ruined many investors and wiped out trust in the market.

Congress subsequently created the SEC to protect investors, monitor investment houses and restore confidence.

This time, scandals at Enron Corp., WorldCom Inc., Tyco International and Rite Aid Corp. forced Congress to act. The scandals not only shook investors confidence, but awakened them to the reality that numbers can lie, even after they have been audited.

Congress responded with the Sarbanes-Oxley Act designed to crack down on bad accountants, auditors and corporate executives with new, tough guidelines and stiff penalties.

The legislation also created the oversight board, which has been in operation for 11 months. Under McDonough, a highly respected regulator who headed the Federal Reserve Bank of New York for 10 years, the operation will have about 00 employees, half of them inspectors. To date, it has hired about 4 people, but it has yet to bring aboard a general counsel and someone to head its enforcement group.

McDonough hopes the board can ultimately restore faith in the system. Already, he says, its having an impact.

I think that the fear level is getting higher and therefore it is encouraging people to be more virtuous, said McDonough, in an interview in his sparsely furnished downtown Washington office, which was previously occupied by Arthur Andersen LLP, the collapsed accounting firm.

My impression from talking to lots of corporate managers is that they have gotten the lesson of Sarbanes-Oxley, that the numbers are supposed to be real, that the auditors are supposed to have a far more questioning attitude as they audit the financial statements of companies. I think it is a process that has begun, that the numbers are more believable.

McDonough sees other positive signs. More than 85 percent, or 618 accounting firms that inspect the books of publicly traded companies, have registered with the oversight board so far.

Leading the way

The countrys four largest accounting firms - PricewaterhouseCoopers, Deloitte & Touche, Ernst & Young, and KPMG - voluntarily agreed to be inspected by the PCAOB before they registered. The inspections are under way now.

I think that is a very positive signal, McDonough said. They did not have to be inspected by PCAOB under the Sarbanes-Oxley Act. Our inspections so far are going well.

Next year, the oversight board is scheduled to inspect the eight accounting firms that audit more than 100 public companies. The board will conduct inspections of those firms once a year. It also will inspect small accounting firms that have public companies as clients once every three years.

These inspections are very intrusive, demanding, and we want to really find out if the firms are doing what they say they are doing and what they should be doing under the statute, McDonough said.

He believes the board has plenty of muscle to make a difference. If accounting firms or executives dont comply with its rules, the board can launch investigations, fine firms up to $15 million and bar individuals and companies from the industry.

I have been telling the accountants, You have to win back the confidence of the American people, McDonough said. That is most rapidly and most efficiently achieved if you are really doing it yourselves with us prodding, helping, pushing.

But he warned that he will not hesitate to use his broad powers.

We do not need to be hanging accountants in public to show how tough we are, he said. On the other hand, if they richly deserve being hanged in public, we will hang them in public. Its for them [to decide].

Despite the tough talk, experts arent sure the new organization will be able to force auditors to change their behavior. They argue that greed still prevails and that pressure on accounting firms to generate profits is just as strong as before.

Others complain that auditors are too inexperienced to detect complicated or simple fraud and the multitude of interpretations of accounting rules makes it easy for companies to bend them to suit their needs.

I think they have a humongous job on their hands, said Lynn E. Turner, a professor at Colorado State University and the former chief accountant at the SEC. To get the job done, they are going to have to avoid compromises and be tough and tenacious.

A troubling issue is whether accounting firms will continue to push their employees to sell lucrative consulting services while downplaying their auditing business. Some firms have been accused of easing up on audits so they wouldnt lose consulting arrangements.

Culture of greed

Turner believes a culture of greed persists in corners of the accounting profession.

The board must be able to take forceful action against those people who still havent gotten the message, and who believe they remain above the law, if it is to accomplish what Congress intended it to, Turner said. An important task ahead for the PCAOB is getting the partners in the auditing firms to understand that their number one, two and three priorities must be making sure that the investing public is getting what it needs in the way of financial statements.

Other experts are concerned that auditors are too young and inexperienced and can easily be duped by corporate accountants who want to hide problems. The typical auditor is in his 0s, studied accounting in college and has no practical experience, Sussman said.

Maybe their big job was flipping Whoppers, he said. We are going to ask them to audit a company that makes routers? They wouldnt know a router if it hit them.

To compound matters, some companies have overseas operations and the audit must be done quickly.

Those are serious and inherent flaws, Sussman said. Until they are able to attract, recruit and retain the right type of people to do audits, you can regulate until Haleys comet makes an appearance and you are not necessarily going to prevent restatements, prevent fraud and so forth.

Young, inexperienced auditors are no match for corporate accountants who want to deceive. But some of the schemes were simple and should have been detected, experts say.

WorldCom used a basic accounting slight-of-hand to inflate profits. The giant long-distance provider often had to pay competitors fees when its customers needed to make calls using their telephone cables. Instead of booking the fees as expenses, WorldCom classified them as assets on its balance sheet, driving expenses down and profits up.

Sure sounds like they [auditors] werent scrubbing the balance sheets too well, Ciesielski said. It wasnt subtle. It was like using a sledgehammer to doctor the financial situation. It wasnt like they set up offshore entities.

But some companies employed more sophisticated techniques.

Adelphia Communications Corp., the bankrupt cable company, which sued its accounting firm, reportedly kept two sets of books. Enron Corp. created off-balance-sheet partnerships whose debt was hidden from investors. Tyco ordered companies that it was acquiring to use all the cash they could muster to pay off suppliers. When the deal was finalized and Tyco and the newly acquired company reported numbers, the low cash position ballooned, making it look as though cash flow was surging.

Another problem McDonough faces is with the basic rules of accounting. While the board will write auditing standards, it has nothing to do with how accounting rules are created. That is the job of the Financial Accounting Standards Board, an independent organization in Norwalk, Conn.

The concern is that FASBs rules are open to too much interpretation and companies and accountants can manipulate them to meet needs, experts said. The profession uses rules-based accounting standards, which give accountants specific steps to follow as if they were baking a cake.

It allows you to be clever and look for loopholes, said David Nolte, a principal at Fulcrum Financial Inquiry, a Los Angeles, Calif.-based forensic accounting firm. People who are inclined to reverse-engineer can structure a transaction that takes advantage of these so-called tight rules.

McDonough acknowledges there are problems with the current approach. He said the rules for how companies should account for hedging transactions and derivatives are 800 pages alone.

You certainly dont need 800 pages, he said.

No matter what changes he makes, or how much power the board enjoys, the battle to clean up the accounting profession and restore faith in financial America might never be won.



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