Breakdown Seen in Audit Oversight

As Xerox Corp. became the latest company to play corporate America’s “Who’s Cooking the Books?” game Friday, investors are asking what has happened to the auditors, board members and other watchdogs of the nation’s corporations.

Xerox said Friday that it improperly reported $6.4 billion in revenue over a five-year period by prematurely booking revenue from some sales and leases. On Tuesday, WorldCom Inc., the nation’s second-largest long-distance telephone company, admitted that it wrongly booked $3.9 billion in routine expenses as capital expenditures over the last five quarters, greatly inflating its income.

Both of these cases and multiple other financial scandals over the last year required the participation of a corporation’s chief financial officer and usually the senior executives to alter the books or to hide important information. But seldom is knowledge of improper accounting limited solely to one or two individuals who orchestrate the scheme.

The problem is whether underlings will jeopardize their careers to blow the whistle on top executives and whether outside accountants will risk losing clients by objecting to questionable accounting.

“You have to worry when the chief executive and the audit committee of a company’s board of directors give the chief financial officer so much power,” said Lynn Turner, former chief accountant at the Securities and Exchange Commission.

“The CFO can create a culture where people who challenge him for doing wrong will end their careers,” said Turner, who heads the Center for Quality Financial Reporting at Colorado State University.

Accounting experts say it is possible but unlikely that WorldCom CFO Scott D. Sullivan acted unilaterally when he booked $3.9 billion of ordinary expenses as capital expenditures, actions that now make him a target of a Securities and Exchange Commission probe.

“It is a big enough number so that more people than just the CFO had to know,” said John C. Coffee Jr., a white-collar crime and securities expert at Columbia University’s law school.

Theoretically, Sullivan could have directed staff to log the expenditures into the company’s accounting and then made the final decision to mark them as capital expenditures as he compiled the balance sheet and financial statements.

However, it’s likely that at least one other person and possibly more were aware of the improper accounting and either participated or chose not to challenge it, accounting experts say.

Ed Muller, the former chief executive of Edison Mission Energy and an audit committee member on the boards of two public companies, is not surprised that board members missed the incorrect accounting treatment.

“An audit committee meets four or five times a year,” Muller said. “They discuss the major issues raised by management, the outside and the internal auditors, but they are not making entries or poring through the books. The big problem is that the perpetrators were the staff.”

The error was discovered only after John W. Sidgmore, who replaced longtime WorldCom Chief Executive Bernard J. Ebbers in April, asked an internal auditor to conduct a special review of the company’s books. Coffee said Arthur Andersen, WorldCom’s auditing firm, also should have detected the irregularities.

“What are you paying them for if they can’t detect $3.9 billion in errors?” Coffee said. “Either they are innocent and useless because they can’t catch huge errors, or else they participated by looking the other way.”

The WorldCom debacle will make little difference to Andersen, which already is in the process of dissolving after its conviction on a criminal obstruction-of-justice charge.

Although WorldCom’s misstatement of expenses could have been limited to just a handful of people, the Xerox case represents a more widespread policy by the financial accounting staff, Coffee and Turner said. That’s because Xerox staff members would have had to search sales activity each quarter for ways to recognize revenue prematurely.

“They would have looked for contracts they could say are binding even though they might be no more than a salesman’s handshake with lots of ways for the client to get out,” Coffee said.

That process allowed Xerox to book $6.4 billion before they were firm contracts from 1997 through 2001.

Xerox will now reverse $1.9 billion in sales and lease transactions.

Both of these cases, as well as accounting and other financial scandals at Adelphia Communications Corp., CMS Energy Corp., Dynegy Inc., Enron Corp., Qwest Communications International Inc. and Tyco International Inc., point to a breakdown in the checks and balances system between an audit committee, the outside auditors, the internal auditors and management, said Nell Minow, a shareholder advocate and corporate governance expert.

“The board of directors is at ground zero in the corporate meltdown we are seeing now,” Minow said.

Xerox, for example, has faced questions about its accounting for years but continues to have longtime, entrenched board members sitting on its audit committee.

“When you have problems with your accounting, the first thing you should do as a board is ask what is wrong with the audit committee and you bring in people who know what they are doing,” Minow said.

Inattentive board members also played a key role in the Enron bankruptcy and the problems at Tyco, where recently deposed CEO L. Dennis Kozlowski faces criminal charges that he evaded paying $1 million in taxes for artwork.

Minow said the Tyco board approved a contract for Kozlowski that exempted being charged with a felony as a firing offense.

“Why did they approve that? Their first call should have been to the law firm when they saw that,” Minow said.

Muller agrees that although boards won’t always catch fraud, they should be more skeptical and analytical about what’s going on at their companies.

For example, William T. McCormick Jr. resigned as chief executive of CMS Energy last month after the disclosure of $5.2 billion in sham energy trades.

These transactions, in which traders bought and sold electricity without profit or loss, were designed to inflate revenue to give the company an appearance of growth.

“The board should have started asking questions when they saw revenue shoot up but there was not corresponding growth in profits,” Muller said.

Regardless of who is at fault, individual investors are concluding Wall Street has little credibility.

“I am not a happy camper with the stock market,” said Alex Centurioni, a 76-year-old Temple City investor who lost $20,000 in the Tyco scandal. “People don’t want to take chances investing now because they are worried about all the big companies that faked their numbers and what will come next.”