Investors' New Worry: "Auditor Risk"

By Robert Barker Thank heaven for Arthur Andersen.

You may think I'm nuts, given the hellfire now licking at the once-venerable Chicago-based accounting firm that signed its name to the annual financial audits of Enron (ENRNQ

). But in the stock market, every edge counts. And the Andersen situation is offering investors a fresh edge.

Call it "auditor risk." Investors long ago learned to weigh a bunch of different threats to the value of their shares. Some financial-services stocks suffer "interest-rate risk": When rates go up, their stocks tend to go down. Or take overall "market risk," such as the plunge in value that took down most every stock when trading resumed post-September 11.

To the list of things every thinking investor should consider, I'm now adding auditor risk. It's as simple as this: No investor can make an informed decision about a stock without reading the company's financial statements, and financial statements are only as good as the firm auditing them. If you have worries about the auditing firm, you could have worries about the stock market value of the companies it audits.

A LEDGER OF PROBLEMS. What role Andersen played -- and if it has any responsibility -- in the Enron debacle is still being sorted out. But at the very least, Andersen's handling of Enron's books has raised a number of questions, and investors now have reason to wonder about Andersen audits of other companies' financial statements.

True, the firm would not be the only Big Five accountant to have messed up. Just last week, the Securities & Exchange Commission censured KPMG for having made investments in a money-market fund for which it was supposedly serving as an "independent" auditor. KPMG consented to the SEC's findings without admitting or denying them.

Other firms, such as Ernst & Young and PricewaterhouseCoopers, also have had problems. (Come to think of it, an opportunity is waiting for an entrepreneur who can sort out which auditing firm is least worrisome.)

"IMPROPER PROFESSIONAL CONDUCT." Yet Andersen seems to have had more than its share recently, given the high-profile nature of the Enron matter. In addition to that mess, Andersen has had recent dealings with the SEC involving audits that had to be redone at Waste Management (WMI

) and Sunbeam (SOCWE.OB

).

Last May, Andersen agreed -- without admitting liability -- to pay $110 million in damages to Sunbeam stockholders for an audit that had to be redone. Then, weeks later, came Waste Management.

"Without admitting or denying the allegation or findings, Andersen agreed to the first antifraud injunction in more than 20 years and largest-ever civil penalty -- of $7 million -- in an SEC enforcement action against a Big Five accounting firm," the government announced. It added, "Andersen further agreed to be censured under the SEC's rules of practice. The SEC concluded that Andersen's Waste Management audits were materially false and misleading and that Andersen engaged in improper professional conduct."

GUILT BY ASSOCIATION? Now, Enron. Is it fair to single out one firm as potentially risky? No, not entirely. You might say it's guilt by association -- wondering about all Andersen audits, and other Andersen clients, simply because of the connection between Andersen and Enron.

That hasn't stopped the Connecticut attorney general's office from asking its state accountants board to look into the possibility of revoking the licenses that let Arthur Andersen work for corporations in the state.

Neither is the stock market always fair. Based on Enron's misleading financial statements, the market did not value the company fairly at $35 a share last August. Just before being banished from the New York Stock Exchange, the stock traded at 67 cents. Over the counter, it's now 37 cents.

ANDERSEN'S OTHER CLIENTS. What's indisputable is that an intelligent investor's first job is to note every perceivable risk. That's why I decided to see which other big companies use Andersen for their audits.

To do so, I searched the most recent annual reports and proxy statements of the 30 most valuable companies by market capitalization in the Standard & Poor's 500-stock index. You can see the results in this table). Of the 30 and their respective auditors, you'll see four use Andersen: Abbott Laboratories (ABT

), American Home Products (AHP

), Merck (MRK

), and Oracle (ORCL

).

Should investors in these companies be worried? Andersen did not return my call for comment. Neither did Oracle, although CEO Larry Ellison declared on CNBC last week: "I'm a big fan of Arthur Andersen." The other big Andersen clients, all of whom were contacted, weren't anxious to discuss the relationship.

A spokesman for Merck told me that Andersen "has rendered much excellent service" to the drugmaker for many years. He added that this year, as in the past, the audit committee of Merck's board will review how well Andersen is doing and leave it to shareholders at their annual meeting in April to decide whether to rehire Andersen.

A MODEST PROPOSAL. Seems reasonable enough. But if I were on that audit committee, I would be weighing whether Andersen's reputation is now so damaged that a prospective investor would regard Merck's financial statements with something less than full faith. The question for corporate audit committees: Has Andersen lost so much credibility that an audit with the Andersen name could potentially suppress the price of a company's stock?

For shareholders, I have this modest proposal: Check your most recent proxy statements to see who the auditors are. Next, check the proxy to see how much the companies are paying the accounting firm for services above and beyond the audit.

In Enron's case, Andersen's audit fees of $25 million in 2000 were outstripped by the $27 million it charged for other consulting work, including -- get this! -- risk management.

OPEN YOUR EYES. That's no anomaly. Look at General Electric (GE

), the world's most valuable company. GE's last proxy reported that it paid KPMG $23.9 million in 2000 for its audit. It was further reported in the proxy statement that GE also paid KPMG a total of $79.7 million in 2000 for a variety of other services, from consulting on computer systems to tax preparation to advice on mergers. KPMG collected more than three times as much money from GE for its consulting work as for its audit.

No one is accusing KPMG of stinting in its role as an auditor on behalf of the board, with ultimate allegiance to GE shareholders. GE's audit committee explicitly noted that it had "considered whether KPMG's provision of nonaudit services...is compatible with KPMG's independence." The directors concluded that KPMG's independence remains intact.

Again, fair enough. But this is precisely the kind of imbalance that holds the potential for conflict of interest and can raise eyebrows.

If you're an investor, here's my advice: Don't close your eyes or hold your breath waiting for Corporate America, the Big Five, the SEC, or even Congress to protect you. Instead, do yourself a favor. When you consider all the risks in your portfolio, open your eyes to the newest one -- auditor risk.

Company

Symbol

Auditors

General Electric

GE

KPMG

Microsoft

MSFT

Deloitte & Touche

ExxonMobil

XOM

PricewaterhouseCoopers

Pfizer

PFE

KPMG

Wal-Mart Stores

WMT

Ernst & Young

Citigroup

C

KPMG

Intel

INTC

Ernst & Young

IBM

IBM

PricewaterhouseCoopers

American International Group

AIG

PricewaterhouseCoopers

Johnson & Johnson

JNJ

PricewaterhouseCoopers

Cisco Systems

CSCO

PricewaterhouseCoopers

Verizon Communications

VZ

Ernst & Young

Merck

MRK

Andersen

AOL Time Warner

AOL

Ernst & Young

SBC Communications

SBC

Ernst & Young

Home Depot

HD

KPMG

Coca-Cola

KO

Ernst & Young

Royal Dutch Petroleum

RD

KPMG

Philip Morris Cos.

MO

PricewaterhouseCoopers

Tyco International

TYC

PricewaterhouseCoopers

Procter & Gamble

PG

Deloitte & Touche

Bristol-Myers Squibb

BMY

PricewaterhouseCoopers

Bank of America

BAC

PricewaterhouseCoopers

Oracle

ORCL

Andersen

Abbott Laboratories

ABT

Andersen

PepsiCo

PEP

KPMG

Eli Lilly & Co.

LLY

Ernst & Young

American Home Products

AHP

Andersen

Viacom

VIA.B

PricewaterhouseCoopers

Fannie Mae

FNM

KPMG

Barker covers personal finance in his Barker Portfolio column for BusinessWeek. His barker.online column appears every Friday, only on BusinessWeek Online