BUSINESS: Accounting Firms Open To Scrutiny

Waste Management Inc., Houston, has filed suit in federal district court seeking unspecified "compensatory and punitive damages" from several former officers of Eastern Environmental Services Inc., Mt. Laurel, N.J., and some 20 unnamed individuals "who may have conspired with, aided or assisted" these officers.

The suit, which stems from Waste Management's 1998 purchase of Eastern, alleges that the officers perpetrated a fraud to lure a buyer to acquire Eastern at an inflated price. Additionally, the lawsuit charges the defendants with unlawfully enriching themselves, breaching their fiduciary duties and wasting corporate assets.

Specifically, the complaint alleges that Eastern officers acquired dozens of small waste firms and, through "systematic accounting fraud," caused Eastern's operating performance to be regularly and materially overstated. Moreover, the defendants are accused of misrepresenting Eastern's financial condition by creating and submitting fraudulent financial and accounting statements to the Securities and Exchange Commission (SEC).

The statements, the suit alleges, contained false and misleading financial information, including overstated earnings, assets and merger costs, inflated earnings from manipulation of reserves, and undisclosed accounting policies that did not meet generally accepted accounting principles.

Initially, no members of Eastern's audit team were named as defendants. As the story unfolds, however, some of the so-called "John Doe" defendants may have participated in the pre-merger financial review.

Outside auditors are routinely summoned to give company books a clean bill of health. Take the case of a team from Coopers & Lybrand which, after auditing publicly listed California Micro Devices Corp., (Cal Micro) Milpitas, Calif., gave thumbs-up to the company's writing off half of its accounts receivables. Several weeks later, it became clear that auditors had overlooked wholesale accounting fraud - at least a dozen instances of accounting tricks by company employees to buoy up the stock price. The sleight of hand included posting bogus sales to fictitious buyers for non-existent products.

Now, it's the auditors who need a thorough check-up. The SEC, which is best known for punishing dishonest brokers and stock market finaglers, is considering action against the principal Coopers & Lybrand auditors that would bar them from signing off on public company audits.

The accused partner and manager "conducted the audit in a vacuum, recklessly ignoring [an] unmistakable red flag," according to the SEC administrative complaint. The auditors' lawyer insists that his clients followed the rules and did their jobs properly. For its part, Coopers & Lybrand, now known as PricewaterhouseCoopers (PwC), New York City, has declined to comment on the Cal Micro case.

The wave of accounting snafus should warn investors and would-be company purchasers about inherent shortcomings in the auditing process. For one thing, auditors usually don't go through the very costly process of scrutinizing every number in financial statements during annual audits. Instead, audits merely test samples of company transactions to make sure the overall numbers are accurate.

The auditors' attorney says the SEC is trying to hold his clients to a high standard of auditor conduct that did not exist at the time of the Cal Micro audit. Indeed, not until 1998 did the SEC toughen the standard for reckless auditor conduct - and only after a federal appeals court faulted the agency for relying on a vague rule.

Reckless auditor conduct has been a punishable offense for more than 20 years, the SEC says. Indeed, says Douglas Carmichael, who writes auditing textbooks and teaches at Baruch College, New York, accepted auditing practices always have forced auditors to "keep their eyes open."

As if alleged auditing mistakes weren't enough of a problem for PwC, a government report issued in January charged the firm with more than 8,000 violations of auditor independence rules. "The report is a sobering reminder that accounting professionals need to renew their commitment to the fundamental principle of auditor independence," said Lynn Turner, the chief accountant at the SEC, which ordered the study.

SEC regulations prohibit accountants from owning any stock or options in companies their firm audits. The rules also cover the financial affairs and employers of auditors' spouses. In January 1999, the SEC formally censured PwC for conflicts violations and engaged an outside consultant to conduct a thorough review that culminated in the report.

Such violations could lead to legal claims against PwC by companies involved in mergers. Allegations could include fraud, negligence and other breaches of professional duty, particularly where an acquiring company relied on PwC audits of a target firm with which PwC had impermissible links. If the target's financial statements turned out to be misleading, the acquiring firm might attempt to build a case against PwC for fraud by introducing evidence of documented violations such as those disclosed in the SEC report.

Without responding directly to the report, PwC notified its partners in January by letter that "at no time was the objectivity or integrity of any PwC audit compromised." The firm claims to have instituted new systems and procedures to uncover violations and discipline offenders.