BUSINESSWEEK ONLINE : SEPTEMBER 25, 2000 ISSUE
COVER STORY

Accounting Wars
Powerful auditor-consultants are the targets of Arthur Levitt's crusade

It's a pitched battle the likes of which Washington and Wall Street have never seen before. Largely out of the public eye, a morality play is being acted out, and the plot involves power and greed. On one side: Arthur Levitt Jr., chairman of the Securities & Exchange Commission, convinced that greed and arrogance have diverted the accounting profession from its mission of providing sound financial reports for shareholders. To cap his seven years at the SEC's helm, Levitt is determined to halt a wave of auditing failures--breakdowns that have cost investors $88 billion in the past seven years--by ending what he sees as a massive conflict of interest between accountants' duties as auditors and the profits they earn as consultants to the same corporate clients.

On the other side: the Big Five accounting giants, all opposed in varying degrees to the SEC chief's drive. With consulting now contributing 51% of their revenues--and growing three times as fast as their basic auditing business--the Big Five see Levitt's campaign slamming the door on future opportunities. Three of the Big Five are joining with the American Institute of Certified Public Accountants to muster political clout and legal firepower to stop Levitt--a rogue regulator, they say, who's determined to push their profession backward.

The backdrop for this struggle is an industry in turmoil. Accounting firms are rushing on their own to shed their consulting arms, hoping to claim top dollar while the demand to design and install big computer systems--their specialty--is still hot. The largest firm, PricewaterhouseCoopers LLP, notified the SEC on Sept. 10 that it was negotiating to sell its consultancy to Hewlett-Packard Co. ( HWP) in a deal that could net $18 billion (page 52). No. 2 Ernst & Young sold its consulting arm for $11 billion in May, and No. 5 KPMG plans an initial public offering of stock for a majority of its consulting business.

But while they are reducing their consulting, the Big Five don't want to be closed out of the business. Levitt's proposal, they fear, will make it hard to rebuild consulting practices. So business imperatives are shaping the firms' political responses. PWC and E&Y support the SEC in principle, if not in detail, hoping that whatever rules emerge will favor their consultancy sales. The other three--KPMG, Arthur Andersen, and Deloitte & Touche--are fierce opponents.

In this fight, neither side is covered with glory. Levitt's case against consulting is based on anecdotes and a revulsion, shared by his closest aides, to potential conflicts of interest--not on proven cases. The SEC has used inducements and implied threats to try to break down opponents and has stacked public hearings in its favor. But the Big Five, for their part, have a history of dragging their feet when regulators try to open accounting's rulemaking or discipline to public scrutiny--and they're not above using political firepower to protect their turf, either.

The endgame is rapidly approaching. The SEC will finish collecting public responses on Sept. 25 and can then vote to impose Levitt's proposed ban on mixing auditing with consulting. The SEC chief has put out feelers to the Big Five to negotiate but admits he has had trouble getting his calls returned. Opponents are counting instead on Congress--or, if necessary, the courts--to stall Levitt's drive. And delay is key to their strategy: Levitt's tenure as the longest-serving SEC chairman in history will almost certainly end early next year if George W. Bush is elected President. He's not guaranteed to keep his job even in an Al Gore Administration.

But whether Levitt wins or loses, his war on accounting will shape the climate for business and investors for years. A powerful regulator, fiercely convinced he's acting in the public interest, charges that the $70 billion industry--upon which the entire financial system depends for reliable corporate reports--has been corrupted by its search for growth. Levitt's challenge will echo long after he has left Washington. And no one can say whether his campaign will boost investors' confidence--or undermine it by shaking faith in companies' financial reports.

Arthur Levitt has no doubts on that score. At 69, he sees this struggle as the latest crusade--most likely, the last--of his 37-year quest for stronger, fairer financial markets. As a broker, chairman of the American Stock Exchange, and since 1993, SEC chairman, Levitt has fought to break down the old-boy barriers that America's financial institutions erect to protect their profits and freeze out the public. Leading the agency during a bull market that has made stockholders of some 49% of households, he has used his clout to break up Wall Street's cartels, police the Internet's wild investing scams, and bolster the flow of honest, reliable information to investors.

To Levitt, the major blot on that record is a surge in accounting scandals. Big cases--Cendant ( CD), Sunbeam ( SOC), and RiteAid ( RAD)--have grabbed headlines. But the SEC fears those are just a tiny sample. Companies are restating their audited annual financial reports at an accelerating pace: 104 in 1997, 118 in 1998, and 142 in 1999. Such corrections can reflect anything from revised accounting rules to discovery of outright fraud. Whatever the cause, the cost is high. Just nine breakdowns cost investors $41 billion in falling share prices (table, page 160).

SPLIT UP. The trend has convinced Levitt that auditors are relaxing their vigilance and growing cozier with management. And the SEC is developing evidence in at least two cases--Waste Management Inc.'s ( WMI) $3.54 billion writedown of 1992-97 profits and the $55.8 million earnings restatement at high-flying software developer MicroStrategy Inc. ( MSTR)--that accountants' consulting work and financial ties to clients compromised their audits.

Levitt's solution: split auditing and consulting. On June 27, the SEC voted unanimously to issue a proposed rule that would bar accountants from providing a range of consulting services to companies that they audit. Levitt also wants to beef up public oversight of accountants, all with an eye to sending the profession back to its roots as vigorous guardians of investor interests. ''When the public loses confidence in our markets, or when the reliability of the numbers is diminished, the whole system is jeopardized,'' says Levitt. ''The sanctity of the numbers and of their reliability must be there.''

To the Big Five, Levitt's battle cry sounds like a death knell. Without offering proof that consulting compromises auditors' independence, the SEC is proposing a ban that the firms say will cripple their consulting. Accountants insist they can't adequately audit today's technology-driven companies without talented computer, human resources, and management professionals. ''The days of the audit generalist are gone,'' says Robert Grafton, CEO of Arthur Andersen. But those specialists won't stick around, the Big Five contend, if their opportunities are limited by regulatory fiat.

And the limits will extend beyond the firms' current audit clients. Under the SEC proposal, a wide range of businesses that work with accounting firms could be entangled in new regulations. Arthur Andersen, for example, has a joint venture with IBM ( IBM) to help companies install IBM's e-commerce software. The accountants say the proposed rule could make IBM an ''affiliate'' of Andersen--and ban IBM from offering services to Andersen's audit clients, or Andersen from auditing IBM's customers. The SEC says it's rethinking those provisions.

Corporate America, whose accounts are at the heart of this nasty battle, has mixed feelings. Chief financial officers want the freedom to assign work to firms that best understand their companies--and that's usually their auditors. But they recognize the risks: Merck & Co. ( MRK) CFO Judy C. Lewent routes all bids from Arthur Andersen, Merck's auditor, through the board audit committee. Levitt has lined up a half-dozen CFOs to testify for the rule at the SEC's Sept. 13 and 20 hearings--but most of them, like Medtronic CFO Robert L. Ryan, will endorse only portions of the rule.

The Big Five are marshaling reams of evidence against the SEC rule. A study published by Yale University accounting professor Rick Antle last February, for example, concluded that auditing--derided by critics as a loss leader used to get consultants' feet in the client's door--is on average more profitable than consulting. And a blue-ribbon committee appointed at Levitt's urging, the Panel on Audit Effectiveness, has just examined in depth 126 audits by the eight largest CPA firms. Its conclusion: In 25% of the cases where the audit firm also consulted for the client, the mix improved the quality of the audit. In no cases did the group find conflicts.

WAR CHEST. But sweet reason isn't carrying the day for the accountants. So KPMG, Deloitte, and Andersen have unlimbered a massive political campaign. One of their first calls was to Representative Michael G. Oxley (R-Ohio), chairman of the House Commerce Committee's securities panel, which oversees the SEC. He calls the proposed rule a ''Draconian solution to a perceived problem.'' And Oxley isn't alone. Within four weeks of the SEC's rule proposal, 46 members of the House and Senate wrote to Levitt challenging or questioning his plans. They ranged from California New Democrats Calvin M. Dooley and Ellen O. Tauscher to House Commerce Committee Chairman Thomas A. Bliley (R-Va.).

How do the Big Five get such quick response? With campaign cash. The accounting profession has given $11 million to candidates' war chests in this election cycle--$8.2 million of it from the Big Five and the AICPA. All but three of the 46 letter-writers gets support from the industry. Senator Rod Grams (R-Minn.), who will chair Sept 28 hearings on the SEC rule in the Senate Banking Committee's securities subcommittee, has received some $56,000. Senator Spencer Abraham (R-Mich.), in a tight race to save his seat, has gotten $109,000.

If necessary, the accountants will call in those chits. One House GOP aide says several lawmakers are prepared to amend the SEC's fiscal 2001 spending to forbid the agency to implement the anticonsulting rule. But that's a high-risk strategy. Levitt can count on help from the Clinton White House, which can do a masterly job of embarrassing the GOP Congress in such yearend budget battles.

That leaves Plan B: a race to the courthouse. Arthur Andersen has hired David Boies--architect of the Justice Dept.'s so-far-successful lawsuit to break up Microsoft Corp. ( MSFT)--while the AICPA and other opponents have hired Washington powerhouse Gibson, Dunn & Crutcher LLP. ''Arthur Levitt has been a great chairman,'' says Gibson Dunn partner John F. Olson, ''but in this case, the commission is using a sledgehammer when it ought to use a scalpel.''

Levitt isn't bothered by such criticism. He takes seriously his duty to build confidence in the markets--and to pound away at groups he feels are undermining investors. He is especially proud that on his watch, millions of Americans have flocked to the stock market, many for the first time. But he also feels a heavy responsibility to protect new investors from market sharks.

BULLY PULPIT. Possibly his biggest such triumph came in 1996, when he censured the National Association of Securities Dealers, which owns the Nasdaq Stock Market, for failing to police its own members. An SEC investigation found that for years, Wall Street dealers had colluded to keep spreads between buy and sell prices on Nasdaq shares artificially wide to let dealers profit at investors' expense. Nasdaq dealers had to pony up more than $1 billion to settle the case. Levitt dictated radical changes to the NASD and its stock exchange--and since has pushed for new trading rules in all stock markets to promote disclosure and competition.

Levitt didn't stop there. He has forced disclosure on the secretive and antiquated municipal-bond business, saving millions for both investors and cities and towns. He has used his pulpit to prod Wall Street to end compensation practices that put brokers into conflict with their customers. He has changed the disclosure rules on mutual funds to help investors figure out management fees. More recently, Levitt pushed through a controversial rule aimed at preventing companies from disclosing information to analysts before they let ordinary shareholders in on the news.

The common theme in Levitt's career as a regulator: independent public oversight. In financial markets, investors must rely on overseers to protect their interests. History shows that those guardians often become tools of the brokers, money managers, or accountants they're supposed to watch. Only the SEC, in Levitt's view, can force them to be independent and to focus on the public interest. ''To Arthur, the ultimate failure would be for the SEC to turn a blind eye when overseers are captive of their industry,'' says a former longtime aide.

Protecting the public is an imperative that was bred in Levitt. He was raised in Brooklyn, N.Y., by parents who shared their brownstone with his mother's Orthodox Jewish parents. His father was custodian of the state's teachers' retirement fund and later was Comptroller of New York for 24 years. Arthur Sr. taught Levitt the importance of acting in the public interest, but his mother, Dorothy, shaped his outlook. A schoolteacher with a Depression-era mentality, she had an obsessive fear of losing her pension because of mismanagement by fund trustees. That, says Levitt, ''left a deep impression.''

As a retail broker from 1963 to 1978, Levitt realized that small investors are reluctant--even fearful--of challenging the market's conventional wisdom or the recommendations of a broker. Many of his initiatives, including an early move to require plain English in SEC rules, have been aimed at translating the language of stock and bond markets for ordinary people. In seven years as chairman, Levitt has held dozens of town hall meetings with investors. ''We don't have the resources to protect these people,'' he says. ''We've got to give them the information so they can protect themselves.''

Clear, honest information depends on the independence of CPAs, who are charged with auditing the financial reports of companies that offer their stock to the public. Independence means CPAs cannot audit their own or their partners' work: An auditor whose firm keeps a company's books can't be counted on to flag embarrassing errors in those numbers. More broadly, an auditor must not have any financial stake in the health, or even survival, of a client company. Indeed, in 1933, when Congress first required public financial reports, lawmakers debated whether audit fees would taint auditors' independence.

GOING EASY. After World War II, as business grew more complex, consulting practices were born. Critics warned that consulting could impair audits: Auditors would have an incentive to go easy on clients, either to win more contracts or to prove that their colleagues' advice was successful. But fears were muted when consulting contributed only a small fraction of the industry's revenues.

That all changed in the 1990s. Where 1993's Big Six earned just 32% of revenue from management consulting, 1999's Big Five got 51% of their income from such services. The share earned in auditing and assurance services dropped from 45% to 30%, according to Public Accounting Report, an Atlanta newsletter. Tax preparation and advice provided 19% of 1999 revenues.

Fueling consulting's growth: a series of economywide management initiatives, from the late-'80s reengineering boom to Y2K repairs and, most recently, Internet-based systems for everything from supply-chain management to customer service. Meanwhile, the number of public companies hiring the Big Five for audits grew only 1% from 1993 to 1999. So while Big Five audit revenues rose 9% a year, the SEC calculates that management-consulting fees surged at a 26% rate--quadrupling during the six years.

The trend alarms some CPAs. Eli Mason, ex-president of the New York State Society of CPAs and senior partner at New York's Mason & Co., frets that auditors are crossing an ethical line: ''How can the independent accountant state that his audit report was prepared in conformity with accepted standards when he may be reviewing some of his own services?''

In 1998, Big Five firms began to sense that the boom could be ending. The market for big internal management information systems--the accounting firms' specialty--peaked as clients swarmed to put their businesses on the Web. KPMG, for one, reckoned that its $3 billion consulting arm would have to retool and grow to $10 billion within three years to remain a player. But the firm--like its competitors, a partnership--can't sell stock in itself. So KPMG could not use stock to acquire other firms or to dangle stock-option riches before young dot-com wizards.

BOYCOTT. Besides, KPMG needed the money a spin-off would bring. To stem partner defections, it had promised those who stayed until retirement an increasing share of the firm's future profits. CEO Stephen G. Butler wanted to replace that retirement scheme with a 401(k)-style defined-contribution plan. But the old plan was still seriously underfunded and in need of funds from a spin-off. So in mid-'98, Butler sought SEC approval to spin off KPMG's consultants through an initial public offering. KPMG would retain nearly 50% of the stock.

Levitt wasn't about to sign off. The SEC chief charges that the Big Five had fought his every move ''almost from the day I came here.'' He was still smarting from a three-year struggle to establish the Independence Standards Board to shape the profession's rules. Levitt wanted an ISB dominated by investors and academics. But when the board was launched in 1997, accountants or their allies held most of the seats. Levitt boycotted the ISB's first meeting.

KPMG's spin-off plan went to Lynn E. Turner, newly appointed as the SEC's chief accountant. A Coopers & Lybrand audit partner for 20 years, Turner looks and acts the part of a jolly man--unless he's talking about his profession's performance and ethics, which he feels are sinking fast. ''You see these numbers they missed and wonder, 'How did anyone sign off on that?''' he says.

Turner rejected the KPMG spin-off plan in December, 1998. The SEC felt KPMG was retaining too much of the spin-off's stock. But the talks had caught the attention of other firms. When Ernst & Young CEO Philip A. Laskawy approached Levitt about selling his consultancy, the SEC chief saw an opening to divide consulting and auditing at all Big Five firms. Levitt had another weapon: A 1998 probe at PricewaterhouseCoopers' Tampa office had found that employees were buying stock in companies they audited--flouting the most basic standard of independence. PWC CEO James J. Schiro agreed to scrutinize the portfolios of PWC's partners and managers. When the report came out in January, 2000, it documented 8,000 violations. Half of the firm's partners had conflicts--averaging five apiece. The other four firms charged into the boardrooms of PWC's clients, trying to grab a share of the No. 1 firm's $2.3 billion audit business.

Levitt and Turner, backed by SEC Enforcement Div. Director Richard H. Walker, had their own use for the scandal. Last spring, they called in the other four firms and told them: Investigate your own employees' investments, or we'll do it for you. And quit stalling on new rules to limit consulting.

DARK SIDE. The firms balked. When Levitt is stalemated, he reaches for the phone and schedules a speech. He booked one at New York University for Apr. 11--and turned up the pressure. Big Five executives say they were stroked and cajoled. But the talks had a dark side, too: Chief accountant Turner plainly warned that firms that didn't launch investment probes would be investigated head-to-toe by the SEC's Enforcement Div. And Big Five executives say that Walker told two firms that if they cooperated with the probe, he could assure the SEC's Corporation Finance Div. that their clients' financial reports wouldn't need extra scrutiny. To the CPAs, this was a threat to turn their clients against them. Walker denies making threats. Instead, he says he told the firms that cooperation would win them a safe harbor for minor violations.

Despite the growing rancor, the two sides found they could negotiate on investment rules. By mid-June, the Big Five agreed to examine their employees' portfolios, using streamlined rules that free most employees to invest in a client company if they're not directly involved in that client's audit.

But no deal could be reached on consulting. In part, the firms' stiff opposition was buying time: If the SEC rule is completed before the firms spin off their consulting arms, the new limits could force the accountants into a fire sale and slash their return. That could deprive thousands of partners of hefty payoffs and more secure retirements. But the concerns went deeper. The AICPA, led by KPMG partner Robert Elliott, was convinced the rule would damage small and medium-size firms and was stirring them to fight Levitt.

Talks finally broke down in a frosty confrontation at Deloitte's midtown Manhattan headquarters on June 20. A week later, the SEC put its proposal to split auditing and consulting on a fast track.

At the SEC meeting where the rule was issued, Commissioner Isaac C. Hunt Jr. put his finger on the proposal's greatest weakness: ''We haven't had any'' cases based on audits compromised by consulting. Enforcement chief Walker replied: ''There are a number that we're looking at.''

GO-BETWEEN. Indeed, Walker's securities cops are moving heaven and earth to establish that link in two recent cases. One involves MicroStrategy Inc.'s restatement of three years of financial reports, which cost shareholders $10.4 billion in a week. There the SEC is investigating numerous financial ties between the software company and its auditor, PWC, which was a reseller of MicroStrategy software. The probe, says a source familiar with the case, involves allegations that the two companies sought to cover up their financial ties by using a third party as a go-between. Both companies deny the charge.

The Waste Management case involves many of the same charges that arose in a shareholder class action against the Houston-based garbage hauler. WMI and Arthur Andersen, its auditor of 30 years, agreed to settle the suit last year for $220 million without admitting wrongdoing. The allegations include a revolving door between the auditor and WMI's executive suite, and hefty consulting fees: An SEC source says WMI's consulting fees were five times what it paid for auditing. Arthur Andersen says consulting and auditing fees were about equal. Waste Management declined comment.

The case also involves cross-selling of consulting services by the audit team. When Andersen landed consulting contracts, a former employee says, auditors shared in the bonuses. Such financial and personal conflicts, says one SEC source close to the case, resulted in auditors accepting flimsy excuses for WMI's accounting practices, such as stretching out depreciation of equipment and landfills to inflate profits. The game ended in 1997 when newly installed CEO Robert S. Miller announced a pretax charge of $3.5 billion against earnings as far back as 1992. Investors lost $859 million in market value in the week after the restatement--just part of an eventual $26 billion loss.

Will a few cases convince the SEC--and Congress and the courts--that consulting and auditing should be separated? Levitt is confident: In seven years at the SEC, he has never lost a vote, despite the other commissioners' sometimes libertarian impulses. Still, he owes that record in large part to his ability to find compromises that avoid confrontations. Even in this jihad, Levitt is sending signals that the proposed rule can still be reshaped. He has put out feelers to the heads of the three recalcitrant firms. But so far, they are not talking.

But Levitt says he'll never give up his drive to make the accountants accountable. Even if Congress or the courts tie his hands, he'll take to the road to publicize what he believes is a gross failure to protect the public interest. ''They can't stop me from speaking out,'' he fumes. The tenure of the most aggressive securities cop in history might end soon, but he vows to carry on this final crusade until the day his successor's furniture arrives.

By Mike McNamee, Paula Dwyer, and Christopher H. Schmitt in Washington and Louis Lavelle in New York

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