Auditor's reputation may be tarnished but not fatally so
Will the Akai Holdings scandal destroy Ernst & Young as Enron did Arthur Andersen? It's a question I have been asked many times in the past week.
My bet is, it's unlikely. That's not because the Akai case is any less serious than Enron as a reflection of the auditor's standards. It has more to do with the culture of our market.
Let me refresh your memory about the collapse of Arthur Andersen. In late 2001, US energy giant Enron Corp was found to have kept hundreds of millions of dollars in debt off its books through questionable accounting. The firm collapsed overnight.
While the public questioned the ethics of auditor Arthur Andersen, insiders revealed its employees had illegally destroyed thousands of Enron-related documents and computer records.
Arthur Andersen was charged with obstructing justice in the United States. Even before the trial began, audit clients fled from the firm in droves. By the time a guilty verdict was reached in June 2002, most of its employees had left for competing firms.
In 2005, the Supreme Court overturned the verdict and ordered a retrial on the grounds the 2002 judge was wrong to have told jurors they could convict even if the accounting firm's staff didn't know what they did was illegal. The case was never retried. Yet, to the firm, it no longer matters.
There are striking similarities between the Enron and Akai cases. Like Enron, Akai, which once owned several international brands and boasted annual sales of US$400 million, collapsed overnight in 2000. It had just US$167,000 left.
Like the Enron scandal, the professional standards of auditor Ernst & Young were questioned. The Akai auditor took only a few hours to find out Akai's major buyers never existed.
As in Enron's case, the issue at stake is more than professional negligence. Akai's liquidator claimed more than 80 Akai-related files produced by Ernst &Young had been doctored or faked in 2001. Ernst & Young conceded 'certain documents produced for audits in 1998 and 1999 could no longer be relied on due to [the action of a suspended partner] in early 2000'. It paid a hefty settlement to the liquidator. Police are now investigating the case.
In a business built largely on public confidence or trust, the damage is considerable, even for Ernst & Young, whose name has shown up in more than one fraud case in the past decade.
But in Asia, a tarnished reputation does not necessarily mean death. An audit firm's survival is affected by three things - the clients, the staff and litigation. First, will the clients flee?
None of the firm's blue-chip clients will comment on this. Instead, I polled the financial controllers of five listed firms that have no relationship with Ernst & Young. Only one suggested dumping the auditor. 'You won't risk your own reputation, given the doubts and uncertainty with Ernst & Young,' he said.
The other four saw limited impact from the 'old' case. 'Enron was alive and kicking when the scandal hit, but Akai was a long-forgotten dead cat,' said one from a mainland manufacturer.
'A ghost from the past' has indeed been the pledge of Ernst & Young so far in comforting its major clients over the past two weeks.
Some history first. Despite its image as a 'profession of trust', the accounting industry has a shady past. Hong Kong is no exception, and neither is Ernst & Young's local team.
'In the 1980s and 1990s, the partners were no more than insurance agents manning their own accounts,' said an insider. It was all about the revenue a client brought, not their quality.
Yes, as it is the Asian office of a global firm, rules have tightened up over the years, but the mentality has stayed with the partners from the past.
A top-to-bottom reform did not happen until four of its clients were caught cooking their books between 2002 and 2003. There was a major senior management reshuffle. A handful of veteran partners left and a dozen clients were forced out with a steep fee increase. Annual client review and new control standards were introduced.
'The Akai case is no reflection of our present standard,' said a member of the Ernst & Young global management committee.
This explanation is not entirely satisfactory. The faked document in the Akai case was discovered by the liquidator, not Ernst & Young. And the person involved, who had been promoted from senior manager to partner during the year, was suspended only recently.
But to some, the explanation is acceptable.
'As long as the responsible people have been removed or penalised and the system reformed', that's good enough for the board, said an independent board member of a mainland bank.
There are more pragmatic concerns.
In the case of state-owned listed firms, it is well known that the choice of auditors is rarely a decision that rests purely with management. Unless the regulators have problems with Ernst & Young, there is little initiative to change.
'So far, Beijing has raised no issue with us,' said the Ernst & Young executive.
'If you go one notch up from Ernst & Young, there is the fee issue,' said a financial controller. 'If you go for the non-Big Four, creditors wonder.'
Said another: 'It is a painful exercise to build understanding of a company's business and accounting policies with a new auditor.'
An 'over-rigid' auditing policy is a stronger reason for firms to find a new auditor than a tarnished reputation, two retired auditors say.
Second, will the staff jump ship? The reputation issue and the hefty settlement bill are understood to have weighed heavily on staff morale. But the reality is, there aren't many ships to jump to.
Third, is there more litigation to come? As far as Akai is concerned, this is very much the end. Let's not forget our legal system does not facilitate investors' legal claims. An investor did sue Ernst & Young in another fraud-related case but to no avail.
The Moulin Global Eyecare Holdings case, another situation in which Ernst & Young is accused of failing to notice alleged profit inflation, will soon follow. That will be another prolonged legal wrangle.
As for the Ernst & Young criminal probe, records show no accounting giant has ever been charged, despite high-profile arrests.