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The US leader of PwC, one of the big the global accounting firm, is discussing a very bruising experience. Dennis Nally, chairman of PwC's US business, is directing his firm's sensitive task of declaring whether audit clients have effective financial controls to prevent fraud and ensure accurate accounting.
PwC had by the end of August reported on the quality of internal controls at 717 companies and issued negative verdicts at 94 of them. It was the first time that PwC had given such verdicts and, Mr Nally, says: "The stress levels between [companies] and their auditors were at an all-time high."
Proof that the process has been bruising is illustrated by Mr Nally's admission that PwC decided to sever ties with a handful of audit clients and that a limited number of companies opted to ditch the firm.
The evaluation of internal controls was stipulated in section 404 of the 2002 Sarbanes-Oxley law on accounting and corporate governance but the requirement only took effect last year. Many public companies have been horrified by the cost of reporting on the quality of their controls.
Companies spent huge amounts on documenting and testing the controls, before management reported on their effectiveness.
The big four accounting firms -- PwC, Deloitte, Ernst & Young and KPMG -- often doubled their fees with audit clients because they must do their own evaluation of the controls. Auditors were accused of going over the top and doing too much testing.
Mr Nally predicts PwC's audit fees will fall this year at companies that must review their controls and he says the reductions will range between 25 and 50 per cent. He insists such cuts are possible because PwC will this year, unlike 2004, be able to combine its audit work on the financial statements and the controls, and so find savings.
He also highlights how the regulators -- the Securities and Exchange Commission and the Public Company Accounting Oversight Board -- issued guidance in May that encourages auditors to use their judgement and only review controls that are deemed significant.
But Mr Nally's optimism about cost savings is tempered by a stark warning to lawmakers and regulators about the impact of new laws and regulations. He says companies are struggling to devote enough attention to future opportunities because they are so preoccupied with compliance matters.
Pointing to the efforts that companies put into dealing with section 404 of the Sanbanes-Oxley law, he says: "How much of those resources could have been devoted to other challenges, other opportunities that drive a business and grow a business?"
Although PwC supports the Sarbanes-Oxley law, Mr Nally argues that the US has to wean itself off its rules based system of accounting and corporative governance. He calls for a mixed model involving principles as well as rules. The principles could set the tone inside companies by stressing the importance of "doing the right thing", although Mr Nally concedes that rules would still be necessary in financial reporting.
Moving to such a model is fraught with difficulty because of the litigious nature of US society. Companies and auditors defend themselves in lawsuits by demonstrating how they stick to the rules, while regulators also use the same regulations as the basis for enforcement actions.
One essential ingredient to achieving change would be the willingness of companies and auditors to exercise greater judgement in their accounting work. They would often have to defend themselves in lawsuits on the grounds that they were consistent with principles rather than rules.
"My profession has to step up and say there needs to be an appropriate balance between principles and specific rules," says Mr Nally, adding that auditors must be prepared to exercise more judgement. "If we don't, I really question what is the ongoing viability of our profession."
Following accounting scandals such as Enron and WorldCom that undermined confidence in auditors, PwC's US business has distinguished itself by making a public pitch to be the progressive voice of the profession. Although it could reassure clients about its heightened commitment to audit quality after the scandals, PwC wanted to be seen to be responsive to the concerns of the public, as well as investors and regulators.
Television and newspaper advertisements over the past two years by PwC have projected images that associate the firm with "doing the right thing".
Mr Nally says: "We really felt there was a real void with how the profession was being viewed." Last month PwC launched advertisements that debate the relative merits of principles and rules in accounting and corporate governance.
Mr Nally argues that some progress has been made in restoring trust in the profession but says "we have got a long way to go". PwC, like other leading accounting firms, continues to be accused of doing shoddy work. PwC plans to appeal against a ruling by a judge last week that it should pay up to $183m for allegedly defective audit work done in the 1980s at Ambassador Insurance, by Coopers & Lybrand, one its predecessor firms.
PwC is also preparing to defend to regulators its audit work at American International Group, the world's biggest insurance company, which was rocked by accounting irregularities in February.
In May AIG restated its accounts for 2000, 2001, 2002 and 2003 after finding multiple irregularities, and shaved 12 per cent off its profits for 2004. AIG said information relating to some irregularities had been withheld from PwC but it does not cover all of the issues contributing to the restatement.
Mr Nally says PwC's audit work was "appropriate". He adds: "To the extent we were not aware of situations, we should not have been expected to be aware."
Before his comments about AIG, Mr Nally claims auditors suffer from an "expectation gap" when it comes to their responsibilities for detecting fraud. Audit practice rules say auditors should obtain "reasonable assurance" that accounts are free from material misstatements including those arising &m fraud. However, regulators are considering imposing new responsibilities on auditors to spot fraud, partly because reasonable assurance has not been defined in existing rules.
Mr Nally says PwC would accept additional responsibilities on fraud if that is what investors want. But he warns that it would mean more work and therefore increased cost, which some investors may baulk at.
He comes back to the Sarbanes-Oxley law and PwC's bruising experience with section 404, and argues for a moratorium on new regulations. "Rather than go down the path of having more changes, more standards, more requirements, why not let those changes have a chance to really work," he says.
Under syndication arrangement with FE
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