As we all know, managers write the financial report and thus are ultimately accountable for its contents. Some companies have started issuing "Reports of Management" in which they state things like "Management prepared, and is responsible for, the consolidated financial statements." This responsibility also extends to the disclosures found in the footnotes to the financial statements.

 

Now enters the accountant. According to a recent article in Fortune, a PwC memo sent to Amerco allowed setting up a Special Purpose Entity (SPE) to handle the firm's real estate operations. The applicable accounting rule, EITF 90-15, requires at least three percent of the capital to be raised from outsiders, or else the SPE has to be consolidated by the business enterprise.

 

(The rule has lots of pimples and blackheads. The Financial Accounting Standards Board recently issued a proposal that supposedly improves the EITF, but it too has a horrendous problem with acne. The ridiculous rule along with the foolish incremental improvement only proves that the board has no understanding of dermatology.)

 

The kicker comes when you learn that a senior executive of Amerco provided the outside capital -- and PwC agreed that this arrangement satisfied the requirements of EITF 90-15. Clearly, the partner committed a huge mistake, failing to realize that outside means outside or, in more precise terms, independent means independent. How could somebody with the smarts and the experience to become a partner in a large accounting firm ever believe that a senior executive of a client corporation represents an independent party to that same corporation?

 

A few years later, somebody at PwC realized the error in its ways, confessed the mistake to Amerco, and forced them to consolidate the SPE. Fortune claims that the PwC staff insisted that it was only a balance sheet problem, but some time later it reversed that claim. Amerco had to take a huge hit on its earnings statement, so much so that net income shrunk to only eight percent of its original size. The consolidation led to more debt on the balance sheet, the disappearance of earnings, the drop in the price of its common stock, and the decline in its bond ratings. These problems in turn steered the enterprise into bankruptcy. Question: does PwC have any responsibility to Amerco for its boo-boo?

 

Ethically, the issue is simple. It's like a patient who requires the removal of the left lung and later discovers that the surgeon amputated the right leg. The surgeon did not make a simple mistake, but grossly failed in his or her medical responsibilities. It's like a taxpayer who accepts the advice of a tax adviser to set up some particular scheme, only to discover the wrath of the IRS. Such a doctor or a tax adviser has failed his or her client.

 

So, in good American style, Amerco seeks redress from its assailant by suing PwC for $2.5 billion. How this will end will be left to the courts or perhaps a settlement between the adversaries, but it raises several interesting policy issues for the accounting profession. What is the responsibility of the independent accountant when providing advice to the client? Do auditors compromise their objectivity or their independence when giving counsel to managers with respect either to the recommendation or to the audit? Finally, do we really want managers suing auditors in such instances? While PwC appears negligent, losing $2.5 billion would jeopardize its existence. How few accounting firms will we accept in the industry?

 

While Amerco appears aggrieved, the loss of another accounting firm might lead us down the path to government auditors. On the other hand, maybe the industry is holding that threat over us as a way of asking for lighter penalties.

 

J. EDWARD KETZ is the MBA Faculty Director at the Smeal College of Business at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals.