Ernst & Young Violated Auditor Rules, SEC Alleges

The accounting profession, already reeling from the Enron Corp./Arthur Andersen scandal, suffered another hit Monday as federal regulators alleged that Ernst & Young violated rules designed to keep accountants independent from the companies they audit.

The Securities and Exchange Commission said Ernst & Young compromised the independence of its audits of PeopleSoft Inc. by entering a business venture with the software company.

The issue of auditor independence is among those at the heart of the Enron affair, which has raised questions about Enron’s longtime accountant Arthur Andersen having done both auditing and lucrative consulting work for the company.

The SEC’s action came as the Senate Banking Committee postponed--in the face of heavy Republican and industry pressure--a vote on legislation that would impose restrictions on accounting firms’ ability to do consulting work for their audit clients.

Monday’s action was the second time the SEC has brought an auditor independence action against Ernst & Young. The firm settled a 1995 action by agreeing to comply with independence guidelines.

Ernst & Young said it was “surprised and disappointed” by the SEC’s charges Monday and disputed the allegations.

Like embattled Andersen, Ernst & Young is a Big Five accounting firm. As Andersen has lost a stream of corporate clients and has sold chunks of its business to rivals in recent weeks, Ernst & Young has absorbed many of Andersen’s overseas operations as well as operations in Virginia, Maryland and Pittsburgh.

In an administrative proceeding, the SEC said that Ernst & Young was auditing the books of PeopleSoft at the same time it was developing and marketing a software product in tandem with the company. Ernst & Young engaged in the dual activities from 1993 through 2000, according to the SEC.

The SEC said that the product, named EY/GEMS for PeopleSoft, incorporated some components of PeopleSoft’s proprietary source code into software previously developed and marketed by Ernst & Young’s tax department.

The SEC alleged that Ernst & Young tried to gain a competitive advantage by putting the source code into its product and agreed to pay PeopleSoft royalties of 15% to 30% from each sale of the product.

The SEC ordered that a hearing be held on the case before an administrative law judge within 60 days to determine whether sanctions should be imposed on Ernst & Young.

“Our conduct was entirely appropriate and permissible under the profession’s rules,” New York-based Ernst & Young said in a statement.

The firm said its marketing arrangement with PeopleSoft didn’t affect the software company or its shareholders.

The charges were approved by a single SEC member, Isaac Hunt, because Chairman Harvey Pitt and Commissioner Cynthia Glassman recused themselves, SEC spokeswoman Christi Harlan said.

It’s “highly unusual, if not unprecedented” for a single commissioner to vote on an SEC case, former SEC general counsel Simon Lorne said.

Pitt, who has been criticized for meeting with former clients who are under SEC investigation, represented Ernst & Young while a lawyer in private practice. Glassman worked at the firm as an economist.

SEC Chief Accountant Robert Herdman, who was a senior partner at Ernst & Young, also recused himself from the investigation, Harlan said.

Ernst & Young said it carefully considered its consultants’ actions before they were taken, concluding that such arrangements were common and permitted under accounting rules.

In a similar case, the SEC in January censured another Big Five accounting firm, KPMG, for allegedly violating the auditor independence rules. The agency said KPMG invested $25million in a mutual fund at the same time it was auditing the fund’s books. KPMG invested the money in the AIM mutual fund in May 2000 and kept that account open through year’s end, according to the SEC.

KPMG, which was not fined, agreed to the SEC’s censure without admitting to or denying the allegations. The firm also agreed to take measures to prevent future violations.

The SEC adopted the independence rules in November 2000 after a bitter fight between the accounting industry and Arthur Levitt, then SEC chairman. He and others worried that accountants in some cases had become too cozy with the companies they audited, threatening the integrity of financial reports and undermining investor confidence.

The rules identified nine services as inconsistent with auditor independence, including bookkeeping, financial systems design and implementation, human resources and legal services.