Auditors: No longer shooting the wounded?

Dec. 21, 2004
Companies can benefit by forging a more collaborative working relationship with their external auditors. At the same time, both auditors and their client companies need to keep in mind potential conflicts of interest.

For nine to 10 months of the year, its tempting to ignore the prospect of the annual audit. An audit means probing questions and extra work, and the rewards are not always apparent to the managers and employees who produce the numbers that the auditors examine. Minneapolis-based Honeywell Inc. is benefiting by taking a more proactive approach, says Phillip Billiam, director of corporate reporting and accounting operations with the $8 billion building-controls company. Honeywell management meets quarterly with its accounting firm, Wilton, Conn.-based Deloitte & Touche, to discuss changes occurring both within the company and in accounting regulations. The companies also are linked electronically, so that Honeywells quarterly and yearend numbers are available on a near-real-time basis to its auditors. The result is an enhanced ability to determine the impact of such changes on the financial statements before they occur. For example, when the accounting regulation stipulating that firms disclose diluted earnings per share had yet to be implemented, Honeywell worked with its auditors to determine the probable change to the companys financial statements. Billiams area presented to Honeywells board of directors an estimate of the impact, based on the pre-liminary information available. Knowing about upcoming changes ahead of time also helps Billiam prepare the operating units. For example, companies now are required to capitalize internally developed software according to a strict set of rules -- a change that impacts divisonal profit-and-loss statements. Billiam says his area has been reviewing with operating managers on an ongoing basis the likely impact of the new rule. As a result, managers were not surprised when it was officially implemented. Investors also appear to benefit. Honeywells 1996 annual report received the Gold Award from Financial World magazine and won the Nicholson Award from the National Assn. of Investors Corporation. Many departments within Honeywell contributed to the success of the annual report. However, Honeywells clear presentation of financial information, which resulted in part from the proactive working relationship with the companys auditors, was a key contribution. Honeywells practice of working with its auditors to identify changes and potential problems before they become a reality is a break with the past that is being seen more and more across corporate America. Until recently, auditors have been accused of focusing so much on dissecting historical financial information that their efforts were of little help to those charged with producing the numbers to begin with. Steve Samek, a partner with the Chicago-based accounting firm Arthur Andersen, says this gave rise to the clich, "The auditors are the ones who come in after the battle and shoot the wounded." Today, external auditors still sharpen their pencils and double-check the information that makes its way into a companys financial statements. Indeed, the role of the auditor in verifying historical information remains critical, both to their client companies and to outside parties who rely on the financial statements. However, auditors and their clients are also working to help identify areas before they become problems. To do this, they are looking beyond the financial statements. In recent years, the trend has been "to move much more to the essence of what is happening inside the company," says Jefforie Kvilhaug, principal for manufacturing with the Minneapolis-based accounting firm Larson, Allen, Weishair & Co. LLP. "Even as an accountant, I have to say that a lot of the operating information is more insightful than the financial information." As a result, the audit process today takes a more comprehensive look at risks and weaknesses that an organization faces. The change in focus is similar to much of the process reengineering that is occurring in other areas of many companies, says Robert Neubert, a Detroit-based national director with accounting firm Ernst & Young. The idea is to identify risks that result from the way the company does business and build in proper controls and effective operating procedures from the beginning. In addition, todays audit is increasingly tailored to the companys specific needs. "Rather than come in with a rote audit plan, [accounting firms] are focusing more of their time and effort in the high-risk areas of the balance sheet," says Jim Terrell, vice president and controller with Atlanta-based Georgia-Pacific Corp. He gives an example: Inventory levels often can be a trouble spot for manufacturers. It makes sense for the audit to zero in on this area. As the process changes, some question whether auditors can take on more of a consulting role and still maintain the independence required to effectively perform their auditing responsibilities. The fundamental purpose of an external audit is to provide assurance that an organizations financial statements are presented in accordance with Generally Accepted Accounting Principles, says Judith Sherinsky, technical manager with the American Institute of Certified Public Accountants (AICPA), the New York-based professional association for accountants in the U.S. With everyone playing by the same rules, financial statements should be comparable, and third parties can make informed decisions about investing in or lending money to the organization. Thus, although external auditors are engaged and paid by their client companies, the most immediate beneficiaries of their work are outsiders -- the investors and creditors who rely on the financial statements in deciding whether to put money into the company. That is not to suggest that the companies audited get nothing in return -- quite the contrary. "Basically, the audit reduces the cost of capital by making the financial statements more credible to investors and creditors," says K. Raghunandan, associate professor of accounting at the University of Massachusetts Dartmouth. Two issues become important as the line between auditors and consultants blurs, says Barbara Hackman Franklin, former U.S. Commerce Secretary and president and CEO of Washington-based Barbara Franklin Enterprises, an international consulting and investment firm. The first is the question of whether the audit firm, in also providing consulting work, might become so dependent on a single client that its employees would hesitate to challenge the client when necessary. In addition, when auditors also act as consultants, the risk exists that they could end up reviewing a system or process they helped to implement. Curtis Verschoor, research professor in the School of Accountancy at DePaul University in Chicago, questions just how well auditors can handle the dual roles. "Its the issue of an inability to serve two masters -- the public and the client," he says. Steve Brashear, director of corporate financial reporting with Hewlett-Packard Co. and a former auditor, says attempts by some auditors to seek out consulting engagements can rub him the wrong way. "It reminds me of the dentist telling me that my kids need braces, and it just so happens that the orthodontist is next door to him," he says. Others, such as Paul Danos, dean of the Amos Tuck School of Business Administration at Dartmouth College, Hanover, N.H., argue that the importance of keeping their reputations intact compels auditing firms to act ethically. "If the financial markets dont believe in a firms audit, the firm has nothing," he says. "The likelihood that they would make a sweetheart deal and jeopardize that -- I dont buy it." Just how the issue of auditor independence will be resolved remains to be seen. "Questions [about independence] have been raised and are on the radar screen for the board to consider," says Rick Towers, technical director with the Independence Standards Board. (That New York-based group was developed through discussions between the AICPA and the Securities & Exchange Commission to establish independence standards applicable to audits of public entities.) Audit firms acknowledge the importance of maintaining independence. However, they and their client companies point to shifts in the business environment that have forced a change in approach so that the audits remain accurate and relevant. "I think that the whole audit function used to be more perfunctory," says Hackman Franklin. "Now, auditors have to understand the businesses they are auditing more than they did before." As a result, auditors are spending more time analyzing their clients internal business processes, rather than simply cross-checking numbers. "Auditors have a unique ability to take a look at the organization across all processes," points out Brian Ambrose, Detroit-based partner, KPMG Peat Marwick. For example, the gross margin levels at Ryte-way Industries Inc., a $35 million food manufacturing and packaging firm located in Northfield, Minn., had been fluctuating from year to year. The variances prompted suspicion among management that the numbers were not a true reflection of costs, says controller Diane Bornhauser. The yoyo-like behavior of the numbers also concerned Larson, Allens Kvilhaug, who worked on the firms audit. The 1996 audit was a catalyst for action. Kvilhaug worked with Bornhauser and her staff to obtain the necessary buy-in from the sales, production, and management areas to undertake an activity-based-costing analysis. Recently completed, the new method of accounting appears to reflect more accurately the actual distribution of costs within the company. "I dont think this would have happened without a neutral, outside party," Bornhauser says. In addition to analyzing internal processes, auditors are working more closely with their clients to examine the external environment in which the company operates. "The most important trend of all the big public accounting firms is the risk-assessment approach," says Peter Zurbrugg, who is in charge of accounting policy and external financial reporting for Basel, Switzerland-based pharmaceutical firm Hoffman-La Roche Ltd. "The auditors ask about the risks . . . and the essential happenings. Based on their analysis, the auditors determine their audit strategy." Companies that are going through a period of great change or expansion can especially benefit from an effective working relationship with their outside auditors. Ted French, chief financial officer of Case Corp., says the companys transition from a division of a public company to its initial public offering in 1994 "created a lot of bonding opportunities with our outside auditors." It didnt stop there. During the last two years, the Racine, Wis.-based, $6 billion manufacturer of construction and agricultural equipment acquired 11 companies, eight of which were outside the U.S. The company also entered the equipment-leasing business, a move that generated a number of complicated accounting issues. "I cant imagine doing this without having the auditors involved," says French. "No one wants to be surprised. It always helps to have an independent, objective set of eyes." The audit process will continue to adapt to the major shifts occurring in the business world. The increasing variety of partnering arrangements between companies is one example. Darryl Vernon Poole of the Cambridge Institute for Applied Research notes that a company now can spin off whole functions and departments. For instance, a delivery firm may take over the shipping function for a manufacturer, giving rise to the question: Who audits what? "A $50 million company has the ability to virtualize $20 million in costs," says Poole, chief executive of the Washington, D.C.-based consulting firm. "Thats 40% of the balance sheet." Even as these and other changes take place, one constant remains: the value of a healthy level of objectivity and disagreement between the auditors and the audited. As Hoffman-La Roches Zurbrugg says, "An external auditor is always a good sparring partner."

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