Home » News » Ernst & Young System Criticized

Ernst & Young System Criticized

A push by staff members at the Securities and Exchange Commission in USA to temporarily ban Ernst & Young from accepting new clients reflects regulators' concern that the firm has shoddy control systems for catching problems that compromise the independence of its audits.

Agency lawyers filed court papers last week sharply criticizing Ernst for failing to document its business relationships with audit clients and for failing to provide a clear way for employees to raise questions about partnerships between the firm and the clients whose financial reports they evaluate.

Calling the Ernst system “woefully inadequate, internally inconsistent, and under-publicized within the firm,” SEC lawyers wrote that the firm keeps no central records that could easily be reviewed by regulators who want to track Ernst's joint ventures with clients. It also said employees who need to make decisions on independence issues would benefit from such records.

Most of the time, the SEC contended, it's up to consulting partners at Ernst — who make more money if they generate more business — to call attention to deals that could compromise the impartiality of an audit.

Ernst vigorously defended its policies yesterday. “Our people know how to raise the issues, and they did,” said Vice Chair Beth A. Brooke in an interview. “What's really at issue in this case is that the SEC disagrees with the conclusions that we reached.”

Brooke said a panel set up under orders from the SEC to evaluate independence systems at accounting firms gave Ernst a clean bill of health in 2001, calling the firm's system “effectively designed and implemented.” The review spanned six months ending in December 2001. She said that the firm's audits of PeopleSoft Inc. have never been called into question and noted that Ernst has since sold its consulting practice. The court papers filed by the SEC accused Ernst & Young of maintaining an improper relationship with PeopleSoft while auditing the software company's books.

“There is simply no reason to seek” a ban on new clients, Brooke said. “That just on its face is irresponsible.”

Practices in the accounting industry have drawn heightened scrutiny since last year's blowups at Enron Corp. and WorldCom Inc. Industry critics argue that unless independence standards are vigorously followed, accounting firms will not be tough watchdogs because they will be too afraid of jeopardizing other business or will be reviewing their own work. They say accounting firms have a responsibility to make sure even low-level auditors understand the importance of being independent of audit clients.

“Unless the people in the field have a basic sense and understanding of what the independence rules and regulations are, they are not going to be able to maintain the firm's independence because it's more than a need to get approval from some higher level,” said Douglas R. Carmichael, in testimony provided in March at Ernst's trial before an administrative law judge at the SEC. Carmichael appeared as an expert witness for the government.

Carmichael has since been named chief auditor of the new Public Company Accounting Oversight Board. The board will inspect accounting firms that audit publicly traded companies. It also is undertaking a review of professional auditing standards, including those that relate to independence.

The Ernst case dates back to a 1990s-era partnership with PeopleSoft, under which the companies developed software to help international businesses manage human resources, payroll and tax withholding for employees. The SEC sued Ernst last year, charging that the firm broke independence rules by agreeing to share royalties with a client whose financial statements it reviewed, among other practices. Ernst sometimes reaped consulting fees from PeopleSoft that were nearly 300 times as much as audit fees, the SEC said. Ernst sold the software in question three times before scuttling the product in 1999, Brooke said.

An administrative law judge has yet to rule on a request by SEC staffers to impose a six-month ban on Ernst accepting new clients, a move that is rare but not unprecedented. Government sources said a ban is a serious sanction but may have little lasting impact on firms seeking an auditor, since companies review their choice of auditor only once a year. Ernst can appeal the judge's decision to the five SEC commissioners.

In a scalding, 128-page court brief, the SEC said that “widespread independence cluelessness” among Ernst auditors extended to the lead partner on the PeopleSoft account, who “remained totally unaware” of the joint software venture until 1999, “four years into his tenure as PeopleSoft's auditor certifying E&Y's independence.”

Accounting expert and author Dan M. Guy said he believes that audit firms are generally more careful about independence and ethics issues in the new regulatory environment. But cases from the 1990s continue to crop up, he said.

For instance, PricewaterhouseCoopers resolved independence charges last summer by paying the SEC $5 million to settle claims that its investment banking unit entered into improper contingency fee agreements with audit clients, under which PwC would be paid based on the success of deals it arranged. PwC has since disbanded the unit, a spokesman said.

Separately, the SEC sanctioned KPMG last year over its $25 million investment in a money market fund it audited. The agency cited KPMG's lack of internal controls to help put auditors on notice about investments. KPMG neither admitted nor denied wrongdoing.

Leave a Reply