STUMBLING DOWN THE AUDIT TRAIL
New Roman">The Sunbeam affair will probably make readers wonder how confident they can be in the quality of audits in general. They are right to be concerned.
Abundant evidence has emerged over the years of corporate managers leaning on auditors to paint as rosy a picture as possible. The following examples convey the magnitude of the problem:■ Following a downward restatement of results for the second through fourth quarters of 1993, Woolworth launched an internal investigation by a special committee of its outside directors. The committee’s report quoted the company’s auditor as saying that the retailer’s management had repeatedly pushed for reporting “another good quarter.” Several employees told the committee that it was a company “tradition” to record a profit, however small, in every period. The former controller of Woolworth Canada said that in pursuit of that objective, he was instructed to send corporate headquarters first-half 1993 numbers that bore no resemblance to the actual results. He added that he was told to keep track of the discrepancy and offset it in the second half of the year by underreporting that period’s performance.23 The committee concluded that “senior management failed to create an environment in which it was clear to employees at all levels that inaccurate financial reporting would not be tolerated.”24 On the contrary, the committee found, otherwise capable and conscientious financial staff people evidently concluded that such behavior was acceptable.
■ In 1997, National Auto Credit’s auditors warned the board of directors that the company’s internal accounting controls were inadequate.
Supposedly, the finance company, which had previously been obliged to restate downward by $9 million the profit on the sale of its rental car business, corrected the shortcomings. A short time later, however, the auditors received information from some current or former employees of the company that cast doubt on the validity of the financial statements. Concluding that management was untrustworthy, the auditors resigned. A committee of three of National Auto Credit’s outside directors investigated and found “substantial competent evidence”25 that the auditors’ mistrust of management was well grounded. The committee advised the full board to suspend the company’s top management and recommended that chairman and majority shareholder Sam J. Frankino place his stock in a voting trust. Frankino responded by appointing two new directors, who voted with him and the company’s president to reject the special committee’s report. The outside directors resigned following their defeat.■ In 1989, the auditor of California Micro Devices’s cited “material internal control weaknesses” and urged the manufacturer of computer chips to replace Chief Financial Officer Steven J. Henke. The company responded by switching Henke to the treasurer’s slot. He later testified at a criminal trial that contrary to what his resume stated, he had not majored in accounting, but had taken only one course in the subject and received a D. A new auditing firm took over in 1990 and found that contrary to the preferred practice of having outside directors serve on the board’s audit committee, in Cal Micro’s case the panel included Chairman Chan Desaigoudar, who owned 45.7% of the company’s stock. On August 4, 1994, Cal Micro’s stock plunged by 40% after the company wrote off nearly half of its accounts receivable. The following month, Cal Micro’s financials received a clean opinion, but it soon became apparent that the auditors had missed a massive accounting fraud.
An internal investigation disclosed that one-third of fiscal 1994 revenue was spurious. According to Wade Meyercord, an outside director who helped to uncover the fraud and took over as chairman, the fakery included fictitious sales of nonexistent goods to imaginary companies. A Cal Micro staffer testified that the outside auditor assigned inexperienced employees “fresh out of college” to the job. One of the novices asked a bookkeeping question so elementary that it gave rise to a running joke among Cal Micro accounting officials. Imitating cartoon character Elmer Fudd, they asked one another, “What’s wevenue?”26In theory, the audit committee of the board of directors serves as an additional line of defense in the struggle for candid financial reporting. This added protection does not invariably guarantee the integrity of the financial statements, however. In a study of financial frauds that came to light between 1987 and 1997, the Securities and Exchange Commission found that the audit committees of many of the companies involved met only once a year or so. Some had no audit committees. In one of the few encouraging notes of recent years, the SEC has imposed a “financial literacy” requirement on audit committee members. This might seem too obvious a criterion to necessitate a specific regulation, but readers should bear in mind that O. J. Simpson once served on the audit committee of Infinity Broadcasting Corporation.27