Jumping Ship : Several recent firings of O.C. companies by their outside auditors reflects national trend
The dire news for some companies seemed to roll in all summer.
Comprehensive Care Corp. in Newport Beach was suddenly dumped by its auditor, the Big 6 accounting firm of Arthur Andersen & Co. for what appeared to be no good reason.
Wiz Technology Inc. in San Juan Capistrano got into a nasty argument with its outside auditor, Corbin & Wertz in Irvine, over how to account for certain expenses. The auditor resigned.
HTP International Inc. in Anaheim was rocked by the resignation of its auditor, Jaak (Jack) Olesk of Beverly Hills, who alleged that the company had booked $9.3 million in nonexistent sales. Olesk called the overstatement a fraud.
In the number-crunching world of accountants, resignations are serious matters, with far-reaching consequences for investors, lenders and other creditors, as well as for the employees and the companies.
But the plight of the three Orange County companies is hardly unusual. Nationwide, accounting firms have been ditching corporate clients more and more in the past year. What was once a rare event has become more common.
Pressured by punishing verdicts and a continuing plethora of lawsuits, accounting firms are devising their own ways to limit the risk of getting sued by dumping their riskier clients.
Bloodied badly by the savings and loan debacle and Wall Street finagling of the 1980s and blistered by lawsuits that have since cost them hundreds of millions of dollars, gun-shy accountants now are quick to pull up stakes with the slightest hint that something is amiss.
Big 6 accounting firms, in particular, have been dropping more clients than they have been taking on as part of their intensified effort at risk management. They account for the auditing of more than 90% of the nation’s public companies.
When auditors notify the Securities and Exchange Commission about their resignations, the language is usually vague. A company may no longer fit an accounting firm’s “client profile” or has problems with “internal controls.” An auditor even may have concerns about “management integrity.”
But it all boils down to one thing: Accountants don’t want to go down with a failing client.
Big 6 firms said they paid a total of nearly $1.1 billion in judgments, settlements and legal defense costs in 1993, the latest year for which complete statistics are available. Settlements alone last year cost them $620 million.
Participants in Orange County’s investment pool--which lost $1.7 billion, leading to the county’s bankruptcy last December--hope to pick up a chunk of their loss from KPMG Peat Marwick, the Big 6 accounting firm that audited the county’s records. Investors added Peat Marwick last month to a pending class action.
In the aftermath of the 1980s fiascoes, accounting firms found it cheaper to settle lawsuits than to fight them, said Art Bowman, editor of Bowman’s Accounting Report, an industry trade publication in Atlanta.
“Now they’ve found that an even cheaper way is not to have the client in the first place,” he said.
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They’ve also taken other steps. They have transformed their firms into limited liability partnerships to protect partners’ individual assets from lawsuits. They have focused less on auditing and more on consulting services. And they are backing the Republican Congress’ tort reform legislation, which would limit lawsuits against them.
“Given the litigious environment, we’ve been looking at who our clients are, both current ones and potential clients. It is crucial if we are to reduce risk,” said Philip Peller, managing director of Arthur Andersen’s worldwide audit practice.
The risk of being exposed to a lawsuit seeking damages many times more than auditing fees generate simply isn’t worth it anymore, said Robert Guido, vice chairman for audit services at Ernst & Young, the world’s largest accounting firm.
“Also, we owe it to our other clients to represent honest, forthright clients,” he said.
So large and small accounting firms alike have redoubled efforts to look more closely at current and potential clients. The Big 6 especially have been more cautious.
The major firms cut 27 public clients in the first six months of 1994 but got rid of 60 in the first six months this year, according to Public Accounting Report, an Atlanta trade publication.
The industry’s total resignations grew from 58 in last year’s first half to 99 in the first six months of this year.
Meantime, the Big 6 share of new clients dropped steadily from 51% in 1993 to 46% last year to 40% in the first nine months of this year, according to Accounting Today, a New York trade publication.
“Litigation and liability have become high costs,” said Harold S. Schultz, managing partner of Coopers & Lybrand’s Newport Beach office. “It has to do with shareholders losing money, not with the quality of the audits.”
Many would argue, though, that some so-called independent auditors are aware of problems and are covering them up, a recurring and sometimes accurate theme in litigation.
“Accountants get sued right and left, and sometimes they deserve it,” said Rick Telberg, editor of Accounting Today. But at the same time, he said, some companies are like “toxic waste” that no auditor should get near.
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Typically, smaller companies, especially high-technology start-ups, and those with troubled operations are being hit hardest by auditor resignations.
The fallout from the bailing out of outside auditors has been shattering to public companies, which are required to file annual audited financial statements with securities regulators.
Stock trading in CompCare and Wiz, for instance, was halted while they obtained new auditors. HTP was delisted altogether, leaving investors to trade in the so-called “pink sheets,” where it costs more money to sell or buy stock.
And HTP, which plans to retain an outside auditor next month, expects to pay more than companies its size normally would pay for the three audits it will need.
“What we see is a long-term trend where smaller, riskier companies can’t get an audit they can afford,” Telberg said. “And there’s no legal aid office in accounting. If you can’t afford one, none will be appointed.”
HTP had to hire a forensic accounting firm just to reconstruct financial information for the 1995 fiscal year, which ended June 30, after auditor Olesk quit and withdrew his audits for the prior three fiscal years.
Auditors rarely find themselves in the situation that Olesk faced in mid-summer.
As part of his routine audit for HTP’s fiscal year, Olesk sent letters to a random number of customers asking them to verify that they had purchased the home entertainment furniture listed in company records. A number of responses came back stating that no such products had been purchased, and the auditor dug deeper.
Olesk said that he went to Paul R. Safronchik, HTP’s chairman and chief executive, but that Safronchik acted “nonchalant” about the nonexistent sales that the company had booked.
Olesk began to worry that the company lacked a proper system of checks and balances--called internal controls. Executives in small companies often wear several hats, and Safronchik also was the company’s chief financial officer, which meant he reported to himself as chief executive.
The auditor decided in early September to resign, an action that triggers the filing of documents with the SEC to notify investors, creditors and others about a change in auditors.
In writing his resignation letter, Olesk figured that he was sending the proper warning signal to regulators and investors. He cited “significant weaknesses” in the company’s internal controls and concerns about “management integrity.”
But when Safronchik challenged both reasons in the company’s SEC filing, Olesk figured he had to spell it out. HTP, he said, booked $9.3 million in nonexistent sales and wanted to show an annual profit of $4 million when it lost $5 million.
“I concluded this was a fraud,” he said in an interview with The Times.
Safronchik has since stepped down from his roles at the company and has told executives that he will resign soon. He couldn’t be reached for comment. The company faces four shareholder lawsuits, and the SEC is investigating.
Last week, HTP admitted that an internal review had found revenue for fiscal 1995, which ended June 30, had been overstated. The extent and nature of the misstated revenue hasn’t been determined yet.
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Olesk’s frankness, which may earn him a lawsuit by the company, has nevertheless been cheered in the industry.
“It’s surprising sometimes how forthcoming auditors have become,” said Robert Burns, a staff attorney for the Securities and Exchange Commission. “We can’t expect auditors to say they found a huge fraud. But they do say that because of discrepancies, they can no longer rely on management. That says a lot.”
The SEC has increased the amount of information that must be disclosed, and Congress’ tort reform bill would require auditors to bring illegal acts to light. “I think the system is about as good as we can do,” Burns said.
Others aren’t so sure, but accounting firms aren’t waiting to get hauled into court to realize that they have to change their ways.
Most firms have set up a system to check on new and continuing clients, not only to assess the risk the firms face but to help them determine if there’s any profit in auditing a particular company.
“We look at a profile of the company,” said Ernst & Young’s Guido. “We look at operations, stability in the markets they serve, the knowledge and background of senior management, their relationships with law firms and financial institutions. If they have predecessor accounting firms, we’re required to talk to them.”
To continue auditing a client, Ernst & Young annually evaluates the client, he said. One factor considered is any prior disagreement on significant accounting issues.
“Just like a client of ours wouldn’t want to deal with certain customers, we may no longer want to deal with certain clients,” Guido said.
Similarly, Arthur Andersen measures a variety of operational and market factors and stresses a need for good internal controls. “The feeling is that the company’s own internal process should detect deviations,” said Andersen’s Philip Peller.
“We’re looking harder at clients and we have better tools to measure them with,” he said. “That’s not necessarily indicative of a change in the moral fiber of America.”
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But companies that pose high risks of failure or exposure to lawsuits “will have greater difficulty over time in getting accounting firms to do work,” Peller said. Much of the risky business already has shifted from the Big 6 to local and regional accounting firms, he said.
When an auditor quits with a remark that a company no longer fits its “client profile,” it could mean that the audits simply aren’t generating enough revenue for the accounting firm. But more often, it means the company is in financial difficulty or is likely to be in trouble soon.
That’s what happened at struggling Comprehensive Care Corp., the managed-care company that was a darling of Wall Street in the 1980s, when its revenue soared to nearly $300 million.
Newport Beach investment banker Chriss W. Street joined the board two years ago and became chief executive officer the following spring.
Within a year, Street settled $59.3 million worth of debts for less than $10 million and refocused the company on its much neglected managed-care business.
A big share of the credit for engineering the new plans went to CompCare’s accounting firm, Arthur Andersen, which not only audited CompCare’s annual results but also provided management advice for its restructuring.
So executives were shocked and upset in May--as they readied a public offering to raise much-needed cash--to learn that Andersen was dumping the company as a client.
At a hastily called meeting with the accounting partners on the audit, Street heard the now-familiar chorus.
“We were told the decision was made from higher up and was part of Arthur Andersen’s desire basically to weed out problem customers, customers that they felt had some kind of risk,” Street said. “They were afraid of getting sued.”
Andersen acknowledged as much in subsequent statements, saying it took the step to reduce its risks and pointing out that “Comprehensive’s historic performance speaks for itself.” The firm wouldn’t comment further on specific cases.
CompCare quickly retained Ernst & Young. As a company whose shares trade on the New York Stock Exchange, Street said, CompCare needed a Big 6 accounting firm to provide the sense of security demanded by its shareholders.
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Disagreements about how to account for certain sales, expenses or other financial matters have long been the basic reason accountants give for dumping clients.
The Irvine firm of Corbin & Wertz resigned in late June from auditing Wiz Technology Inc. in a dispute over an accounting method that turns expenses into assets, resulting in increased revenue.
The American Stock Exchange, where Wiz shares are traded, brought in Arthur Andersen to straighten out the matter. The company decided not to take advantage of what is called capitalizing expenses, but designated certain costs as unfinished inventory.
The 4-year-old software developer wound up hiring Coopers & Lybrand as its auditor.
The accounting firm maneuvers have been watched with bemusement by lawyers who represent swindled investors, like those who lost $285 million in the 1989 collapse of Lincoln Savings & Loan in Irvine.
“You can’t just close your eyes and look the other way,” said Ronald Rus, an Irvine lawyer who represented investors in the Lincoln case. “It’s better for auditors if they disclose everything. Either you’re the public watchdog or you’re not.”
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The Big 6
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U.S. revenue Number of Accounting firms (in billions) SEC clients Arthur Andersen & Co. $3.3 2,120 Ernst & Young 2.5 2,267 Deloitte & Touche 2.2 2,030 KPMG Peat Marwick 2.1 2,174 Coopers & Lybrand 1.8 1,401 Price Waterhouse 1.6 2,801
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Source: Public Accounting Report, August, 1995
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Auditor Angst
Most changes in auditors stem from companies dismissing outside accountants. But auditors, led by the Big 6 firms, are increasingly ditching their clients as they seek to reduce their risk of getting sued:
* Total auditor resignations
1st half, 1994: 58
2nd half, 1994: 75
1st half, 1995: 99
* Big 6 resignations
1st half, 1994: 27
2nd half, 1994: 40
1st half, 1995: 60
* Total number of auditor changes
1st half, 1994: 376
2nd half, 1994: 383
1st half, 1995: 435
Source: Public Accounting Report, Atlanta
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Shrinking Big 6
The nation’s six largest accounting firms have been losing their market share of auditing clients as they step up resignations and refuse to take on some new companiess. Here is their share versus all other certified public accountants:
* 1993
Big 6: 49%
Local firms: 51%
* 1994
Big 6: 46
Local firms: 54
* 1995 (Through September)
Big 6: 40
Local firms: 60
Source: Accounting Today, New York
