Schooled by Scandal

The enactment of the Sarbanes-Oxley Act in the US, together with a plethora of initiatives to shake up accountancy and auditing in Europe, might have been expected to win the accountancy profession a reprieve from scandal. News this month of material weaknesses in internal controls at Adecco, the world's largest temporary employment agency, suggests otherwise.

Coming after scandals at Ahold, the Dutch supermarket group, and Parmalat, the now notorious Italian food and dairy group, this latest upset at Zurich-based Adecco carries a disturbing echo of Enron and other scandals that shook confidence in the integrity of reporting in the US.

Is there a discernible pattern in these European corporate crises? Perhaps only in the loose sense that all three raise questions once again about the quality of audits conducted by the global accounting and professional services firms. Parmalat, where €4bn disappeared from the coffers of a Cayman Islands subsidiary amid allegations of forgery and wider fraud, is spectacularly bust and Calisto Tanzi, its jailed founder who is under investigation, could come to be regarded alongside some of the biggest miscreants in corporate history.

At first sight, it seems to be a one-off, with some characteristically Italian features. Unlike the US scandals where managers at Enron, WorldCom, Global Crossing, HealthSouth and numerous others were cooking the books in an attempt to maximise the value of their stock options, Parmalat was about the response of one entrepreneur to his deteriorating financial circumstances. He appears to have siphoned money into private family businesses.

Yet Parmalat, like Enron, was also involved in the use of opaque special purpose vehicles. As Britain's Financial Services Authority warned this week, there are important issues about the responsibility of investment banks in peddling these complex structured finance arrangements to corporate clients. Both Parmalat and Enron raise ethical questions about whether banks should facilitate off-balance-sheet arrangements that disguise economic reality and deceive shareholders.

It is too early to know what damage has been done at Adecco, where publication of the results has been postponed because of its accounting problems in the US. Yet it seems likely that, as with Ahold, the company will remain solvent and continue to trade, even if questions have been raised about the impact of failures of internal control on its banking covenants. If there is a pattern in the experience of these two companies, it is that they were both acquisitive and had been busy with takeovers in North America, where the accounting flaws emerged.

The US, with its very open market in corporate control, has been a graveyard for the strategic aspirations of countless European companies. In most cases, as at Marconi, this has simply been the result of expensive, ill-judged or poorly financed acquisitions. But managing acquisitions at a distance is also a serious challenge. At Adecco, as with Ahold, there appears to have been a clear failure of control (see below).

It is noteworthy that Adecco's auditors up to the 2001 financial year were the Swiss arm of the Arthur Andersen global network. When the Swiss firm was absorbed into Ernst & Young after Andersen's worldwide, post-Enron break-up, the Andersen partner on the Adecco audit, Mike Sills, continued to be responsible for the audit in 2002.

At Adecco and Ahold, the emphasis placed on internal controls by the Sarbanes-Oxley Act may well have caused external auditors to apply greater rigour to this aspect of their audit. Under section 404 of the Act and the Securities and Exchange Commission's subsequent rules, company managements are required to assess the effectiveness of internal control over financial reporting. Management's conclusions then have to be recorded in the annual report and accounts.

The Public Company Accounting Oversight Board, created by the same Act, has now proposed that there should be a separate audit of a company's internal controls, performed in conjunction with the audit of the financial statements. This would include making a judgment about the effectiveness of the audit committee. Any material weakness in internal control, for which the PCAOB's definition is exacting, would prompt an adverse auditor's report. Serious sanctions could apply.

For many large European companies registered with the SEC this tough new regime affects the current financial year if it ends on or after June 15. It also opens a significant transatlantic gap. The UK Combined Code, for example, requires a broader review of operational controls and risk management systems as well as the financial controls that are the more narrow focus of Sarbanes-Oxley. But UK boards have only to report that they have carried out the review.

Against this challenging background, auditors have been weeding out risky clients or raising fees to reflect the risks better. And they are probing more deeply. It seems odds-on that more news of weaknesses in internal controls will emerge at other companies registered with the SEC, as the demands of Sarbanes-Oxley bite.

At Parmalat there are several lessons relating to audit, including one that currently features nowhere on the regulatory agenda. It concerns the loose confederal nature of the big global accountancy firms and the standards they are capable of maintaining on a global basis.

In Parmalat's case, two firms were involved. Grant Thornton, in the second tier below the big four, used to be the main Parmalat auditor. In 1999 new Italian legislation requiring regular rotation of audit firms led to the appointment of Deloitte & Touche. Yet Grant Thornton continued to perform the audit of some Parmalat subsidiaries, including that of Bonlat in the Cayman Islands.

In 1999 subsidiaries owning 22 per cent of the Parmalat group assets were examined by auditors other than Deloitte. By 2002 this had risen to 49 per cent. So Deloitte was relying heavily on other auditors including Grant Thornton's Caymans practice, which accepted a verification letter, seemingly from the Bank of America, confirming that Bonlat held nearly €4bn in cash and investments in an account at the bank.

The scandal started to unfold late last year when Bank of America denied the existence of the account. The auditors are believed to have sent their request for verification through Parmalat's internal mail instead of following the standard audit practice of sending the letter independently.

The Italian legislation on auditor rotation is ostensibly tougher even than Sarbanes-Oxley, which requires the rotation only of audit partners rather than firms. Yet it was clearly flawed, since it failed to address the problem of the group auditor's responsibility for audits of subsidiaries conducted by other firms. And there has long been a question over whether audits conducted by members of the global accounting networks maintain consistent standards in offshore tax havens such as the Cayman Islands, in developing countries and even in parts of the developed world.

Within the networks, member firms are usually legally separate, with local ownership and management. This reflects the insistence of most governments and regulatory authorities that accountancy and audit be carried out by national firms controlled largely by local professionals. For the locals, membership of a big network brings obvious business benefits. They are, in effect, franchisees of powerful global brand names. And the big global firms benefit because they can claim to offer a global service to big multinational corporations.

The snag is that it is hard to enforce global auditing standards in such loose confederations. And they are not subject to any global regulation. This has led to complaints from institutions such as the World Bank that rely heavily on the big firms' accountancy services and audit judgments in developing countries and transition economies. The concern is that the firms have franchised their names like the McDonald's burger chain, but without its quality control.

In response to criticism the firms have taken measures including the introduction of global training programmes and codes of conduct and compliance, along with tighter rules on conflicts of interest. But enforcement is heavily reliant on the agreement of local firms. The only real sanction for a departure from global standards is expulsion from the network, which is how Grant Thornton dealt with its Italian firm when confronted with Parmalat. It was no doubt conscious of the speed with which Andersen disintegrated once clients observed the horror stories at Enron and WorldCom.

Similar questions about global standards arise over the role of Deloitte & Touche. David Cairns, a former secretary-general of the International Accounting Standards Committee, the predecessor of today's International Accounting Standards Board, points out that Parmalat claimed in its 2002 group accounts that its accounting principles were in line with established international accounting standards as well as Italian standards.

Yet this appears not to be so. According to Mr Cairns, Parmalat failed in its acquisition and merger accounting to apply fair values to assets and liabilities of acquired companies. It carried some of its equity investments at cost rather than fair value. And he believes that some off-balance-sheet items should have been on the balance sheet.

In all these points, the Parmalat accounts were at odds with international standards. Yet the Deloitte audit report says nothing about the assertion of compliance with international standards made in the body of the Parmalat accounts. It merely refers to compliance with standards required by Consob, the Italian securities watchdog. For Mr Cairns and many others, the use of an international brand name by an audit firm should mean, at the very least, that the audit has been carried out in accordance with international auditing standards.

A final problem concerns the big firms' business model. For while under companies legislation and case law they are usually required to be appointed and paid by the shareholders, in practice they are beholden to the managers of the companies they audit. From around the 1970s managers demanded more value from their auditors, who responded by offering a broader range of consultancy services. This confusion about the identity of the real client persists today, despite the post-Enron regulatory backlash. As with everything that relates to business culture, it will take both time and the requisite desire to secure change.

Too much blame should not be attached to the auditing fraternity. If the quality of audits has been disappointing at Enron, Parmalat and elsewhere, it is partly because those who use the capital markets, especially institutional investors, have under- valued the audit function. Many of the techniques of modern investment encourage them to do so.

A growing share of both bond and equity markets is given over to index-tracking. Those who invest in an index have no interest at all in what the auditor has to say about the companies in which they invest. Once companies feature in the indices, as Parmalat did, they can rely on the automatic support of non-judgmental investors.

The growth of credit rating has a similar impact. As more people rely on rating agencies, fewer monitor company balance sheets. This may help explain why Parmalat was able to continue raising money from bond investors despite having a deficiency of net tangible assets attributable to shareholders in its balance sheet and ostensibly maintaining large cash balances that could be expected to yield less than its cost of new borrowing.

Also relevant is the growing perception that asset allocation is a far more important determinant of investment performance than stock picking. That, too, devalues the role of the auditor since it subordinates the company to the class of asset that investors choose.

The overall message, if there is one, is that auditors are becoming tougher in response to a more demanding regulatory environment, but that the big firms' global networks are imperfect and mistakes are still being made.

At a more fundamental level, these scandals serve to underline the way that the culture of the accountancy profession and the techniques of modern investment management have not helped the auditor's role as guarantor of the integrity of the numbers on which the capitalist system relies.

...........................................................................................................................................

Distance may bring dangers

While Adecco has been frustratingly unforthcoming about the extent of the financial damage resulting from its accountancy troubles, it has been explicit about the nature of the failures of internal control.

According to the board's statement on January 16, material control weaknesses relating to Adecco Staffing North America included flaws in such areas as IT system security, accounts receivable and reconciliation of payroll bank accounts.

Several issues were uncovered that affected revenue recognition, including lack of systematic documentation of agreed rates and hours, and billing errors that were not identified in timely fashion and corrected. There was also a lack of segregation of duties in the branches, which increased the likelihood of undetected errors.

The question is how so many flaws could have been allowed to accumulate and whether they existed before the last audited financial year, which ended on December 29, 2002.

No one could argue that the three-man Adecco audit and finance committee lacked technical expertise. The chairman, Conrad Meyer, is a professor of accounting, control and risk management at the University of Zurich, as well as being chairman of the Neue Zürcher Zeitung newspaper and of Basel-based ATAG Asset Management. Among other posts, he sits on the board of the Prince of Liechtenstein Foundation.

Philippe Foriel-Destezet was a founder of Ecco, the French recruitment concern that merged with Adia, the Swiss group controlled by Klaus Jacobs, to form Adecco in 1996. So Mr Foriel-Destezet could not have been in a better position to understand the fundamentals of the business.

The third member of the committee, Andreas Schmid, an experienced businessman, is a former chief executive of Klaus Jacobs' family holding company, Jacobs AG, and of the big Swiss chocolate group, Barry Callebaut. He is chairman of two Switzerland-listed companies, Kuoni Reisen Holding and Unique Flughafen Zurich.

This was not, in Anglo-American corporate governance terms, a properly independent committee. But with Mr Foriel-Destezet still owning 18.3 per cent of the company in 2002 and the Jacobs Group continuing to hold 16.3 per cent, the governance was closer to an owner-manager model than to one of dispersed ownership. Mr Foriel-Destezet had a greater incentive than anyone else to ensure that Adecco's finances remained sound, and suffered the biggest loss when the shares plunged 35 per cent on the day of the announcement about flawed accounting.

There was, then, a clear failure to maintain control over far-flung foreign subsidiaries. That is not unusual. Managing foreign acquisitions at thousands of miles' distance is a much tougher proposition than many investment bankers would have managers believe. And in the post-Enron, post-Sarbanes-Oxley world, failures of internal control have assumed heightened importance.

A striking feature of Adecco was that, while the business became increasingly global, with more than a quarter of revenues in 2002 coming from North America, the small audit and finance committee remained resolutely European, as did the Adecco board.

There may be a wider message for business here. The corporate world is on a steep learning curve in adapting to the globalisation of investment and the accident rate with foreign takeovers has been high. Where boards remain essentially national while the business becomes multinational, the risks of a failure to understand foreign market conditions and to exert proper control over foreign subsidiaries will inevitably be great.