In today's financial climate, auditors' reports have about as much credibility as buy recommendations from Wall Street analysts. Last year there were 156 restatements to correct corporate earnings reports, up from 104 in 1997, according to the Securities & Exchange Commission. They cost investors an estimated $31.2 billion in market value. The question "where were the auditors?" is asked more and more.
It's being asked now of Deloitte & Touche, which certified financials of Pre-Paid Legal Services Inc. The company announced on June 28 that SEC accountants insist it correct its books. A restatement could erase half the earnings Pre-Paid reported in the last two years and three-fourths of its net worth. The stock fell 20% the next two weeks. The controversy erupted in November with a report by Off Wall Street, a research service catering to short-sellers.
At issue is Pre-Paid's practice of deferring the expense of commissions it pays now. The gambit boosts current earnings and creates an asset that's whittled down later as the expense is recognized. Pre-Paid says it complies with generally accepted accounting principles (GAAP) and logically aligns the expense with future revenue. Deloitte approved the practice after a previous version was squashed by the SEC. Pre-Paid had switched its auditing to Deloitte in 1994, replacing PriceWaterhouse, after the SEC refused to allow it to issue new securities unless it quit the deferrals.
WIGGLE ROOM. "You can interpret GAAP any way you want," says Melanie Lawson, financial analyst at Pre-Paid. Deloitte even backed Pre-Paid's financials in April after the SEC began investigating in January. Citing professional restrictions against discussing clients, Deloitte declined comment, but noted that the issue is not resolved.
GAAP may be open to interpretation, but Deloitte is risking its credibility. "It is unbelievable that once challenged by the SEC, they maintain this is justifiable," says Douglas R. Carmichael, accounting professor at Baruch College. The SEC has taken a dim view of deferring expenses as assets in other cases. In a March speech, SEC chief accountant Lynn E. Turner said the tactic is one of four "key ingredients that have gone into cooking the books" in recent years.
Pre-Paid's case seems part of a trend where auditors help clients report what they want while technically complying with GAAP. "Auditing has become a compliance exercise," says Paul B. Miller, accounting professor at the University of Colorado at Colorado Springs. Trouble is, accounting firms have slashed prices for audits, making them loss leaders for selling consulting services. They forget that the goal of audits is to ensure companies present results forthrightly and earn investors' trust and a lower cost of capital. Until accountants take that to heart, investors and companies alike will pay the price.
Henry covers finance and markets.
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