Accounting Who's Counting?

By THOMAS McCARROLL

On paper, Miniscribe certainly looked like a highflyer. The Colorado-based company's financial statements in the mid-1980s painted it as a vigorous, healthy computer-parts maker with a bright future. But an internal investigation drew quite a different picture. The probe uncovered massive fraud by senior managers, who shipped boxes of bricks labeled as disk drives and counted them as sales. Investigators blamed executives for the company's cooked books, but bondholders also sued Miniscribe's auditors, Coopers & Lybrand, for conducting faulty audits. In February a jury stunned the accounting profession by ordering C&L to pay damages of $200 million. It was the largest judgment ever levied against an accounting firm.

Coopers & Lybrand is not the only auditing firm being dragged into court these days. From the Big Six firms, which ring up a quarter of the industry's $46 billion in revenues, to the bean-size outfits that operate in storefronts and home offices, the accounting profession is facing the most serious liability crisis in its history.

All told, U.S. accountants now face 4,000 liability suits -- double the number in 1985 -- and more than $15 billion in damages. In the past year, the six largest firms alone have paid more than $300 million to settle such suits. At the same time, legal expenses and insurance rates are zooming. The financial burden is so pressing that it is driving many firms out of the riskiest lines of business and pushing others out of business altogether. Says Mark Carr, editor of Public Accounting Report, an industry newsletter: "The magnitude of the suits and the potential risks pose a great danger for even the largest firms. It's a crisis, and it's a big crisis."

Roughly two-thirds of the litigation stems from the epic savings and loan scandal. Accounting firms, along with lawyers and others, face thousands of lawsuits by investors and government regulators, including the Federal Deposit Insurance Corporation. Accountants' financial liability in S&L cases could exceed $9 billion, not counting compensatory damages. Last week Ernst & Young agreed to pay $63 million to settle claims that its negligence helped S&L honcho Charles Keating Jr. defraud some 23,000 investors in Lincoln Savings & Loan. The settlement came two weeks after the largest U.S. accounting firm, Arthur Andersen, paid $22 million for fraud claims arising from the same S&L collapse.

Accounting firms can expect to be sued in connection with many of the past decade's financial scandals. A notable example: the collapse of the Bank of Credit & Commerce International, which investigators shut down last July after it was found to be a virtual supermarket of illegal services. American firms Ernst & Young and Price Waterhouse are being investigated for their part in managing B.C.C.I.'s books; both could face suits. Coopers & Lybrand is coming under similar scrutiny for its role as auditor for the media tycoon Robert Maxwell, who apparently looted some of his companies in the months before his mysterious death at sea. Deloitte & Touche stands to be hit with hundreds of liability suits by policyholders whose investments were put at risk by the failure of Executive Life Insurance.

The case against accountants revolves primarily around their function as auditors, which accounts for 60% of the profession's revenues. An additional 23% comes from tax planning and the remainder from consulting work. After examining a corporate client's books, auditors usually issue a letter intended to adorn the company's financial statement and certify that the statement is free of errors that could distort the company's fiscal picture. The note often includes the auditor's opinion of the company's business risks. But, cautions Dennis Beresford, chairman of the Financial Accounting Standards Board, the profession's chief rule-making body: "The auditor's signature is not the Good Housekeeping Seal of Approval."

The problem is that many investors think it is. If something goes wrong, they tend to blame the auditor as well as the company's top officers. The common assumption is that auditors should be among the first to know whether a company is failing or even defrauding investors. To be sure, accountants can be found negligent and held liable if their own work is sloppy. A 1989 report by the General Accounting Office on failed thrifts, for instance, found many cases where auditors simply failed to provide independent verification of management claims that problem loans were collectible.

Responsibility for spotting outright fraud, though, is another matter. Says John Hill, assistant professor of accounting at Indiana University: "No audit is going to uncover cleverly disguised fraudulent schemes concocted by management." In the strictest sense, auditors are not required to look for fraud -- but controversy rages about what they should do when they stumble upon it. Rather than inform on clients, auditors usually prefer to drop the account quietly. When that happens, the client must file form 8-K with the Securities and Exchange Commission, explaining why the auditor resigned. But details of the disagreement are typically fudged and played down.

Many lawmakers want to change that practice. Democratic Congressman Ron Wyden of Oregon wants to force accountants to blow the whistle on lawbreaking clients. In 1990 Wyden introduced legislation that would have required auditors to report to the SEC any client found engaging in fraud. Though it passed the House, the bill failed to clear the Senate. Says Wyden, who plans to try again this year: "They're called certified 'public' accountants because they're accountable to the public. But accountants are not living up to their public duty. If they find wrongdoing, they have an obligation to come forward."

Wyden and others lay a large part of the blame for the S&L crisis at the door of the accounting profession. "Accountants didn't cause the S&L crisis," says Wyden. "But they could have saved taxpayers a lot of money if they did their jobs properly and set off enough warning alarms for regulators."

The accounting profession sees itself as a scapegoat in the S&L crisis. Says J. Michael Cook, chairman of Deloitte & Touche: "The equation that an S&L failed, it had an audit, so the audit failed -- that just doesn't add up." Industry leaders complain that they are being targeted by government regulators seeking to deflect blame from their own mistakes and by investors looking for rich firms to make good their losses. "People come after the auditors because they're usually the only ones with money left standing," says Philip Chenok, president of the American Institute of Certified Public Accountants (A.I.C.P.A.).

The industry's crisis has already toppled some stalwarts. Laventhol & Horwath, the big Philadelphia-based firm, filed for bankruptcy last year after it became the target of several lawsuits stemming from its auditing and consulting work. L&H had paid more than $50 million in claims before folding. Another major failure could be imminent, some analysts believe. The average Big Six firm has total capital of nearly $3 billion, but in light of recent damage awards, even that amount could be eroded. Of the Big Six, Ernst & Young may be the most exposed because of its focus on the financial industry. The ^ New York City firm audited about one-fifth of all recently failed banks and S& Ls.

Firms are also paying the price in the form of higher legal expenses and climbing insurance rates, which together can eat up 25% of a firm's profits. The typical Big Six firm spends an average of $30 million a year to defend itself against lawsuits, twice as much as five years ago. Insurance premiums are also rising, up at least 15% last year, to about $5,300 for the average Big Six accountant. Increasingly, however, insurers are refusing to offer any coverage at all to accounting firms because the risks are too great and uncertain. Insurers have no way to measure the risks of insuring some financial-services audits because problems usually remain uncovered until several years after the audit. Where 15 firms offered audit insurance about five years ago, only three or four still do, including Crum & Forster. In response, accounting firms are abandoning the riskiest clients, most notably financial-services companies. Goldstein Golub Kessler, a midsize New York City firm with more than 1,500 clients, says it will no longer perform audit work for banks, credit unions or insurance concerns. KPMG Peat Marwick, the fourth largest accounting firm, is also turning away high-risk cases, says Michael Conway, the partner in charge of professional practices. "We're being very selective about which clients we accept."

Accountants won't be the only ones who will pay, say analysts. As large firms retreat -- the Big Six currently handle the audits of 90% of FORTUNE 500 companies -- industries that require the most careful audits could be left without accountants or with lower-quality auditors. "Financial markets could grind to a halt if auditors stop certifying books," warns Rick Telberg, editor of Accounting Today, a New York City newspaper. "Investors are not going to invest unless they see that stamp of approval."

The profession is instituting a series of reforms designed to prevent future legal shocks. In January 92% of A.I.C.P.A. members voted to organize in forms other than partnerships, which saddle individual partners with maximum liability risk; most want to switch to general corporations. The plan needs approval from all 50 states. The group's members also voted overwhelmingly to maintain a long-standing policy that bars members from volunteering confidential client information to government agencies, making it even more unlikely that accountants will squeal on clients unless subpoenaed.

To some extent, the increased litigation has served to make accountants more vigilant. But the reforms so far have failed to slow the avalanche of lawsuits. More litigation is bound to increase the cost of doing business for accountants, which in turn will mean higher costs for the companies they serve and for customers down the line. And if that drives the best professionals away from the areas where they are needed most, it would be a heavy price to pay for America's obsession with lawsuits as the way to solve all problems.