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Sleeping With the Auditor

Why San Francisco and its outside accountants are a little too close for comfort -- and how it could threaten the city's financial integrity

By Peter Byrne 

With the shocking financial collapse of energy giant Enron Corp. last year, the world learned a dramatic lesson in the importance of an independent auditor. The scandal became a nightmare for the accounting industry, which prides itself on its integrity, when it came to light that Enron's auditor, Arthur Andersen, had publicly diagnosed the energy company as healthy -- even as it privately fretted about damning evidence to the contrary. Andersen, it turned out, had a vested interest in attesting to Enron's health because it was being paid tens of millions of dollars a year in consulting fees by the terminally ill corporation.

The fallout has spread to other companies as well, where supposedly independent auditors have also jumped into the consulting sack with their corporate clients. But even as these conflicts of interest are being exposed in private industry, another aspect of the problem has largely escaped scrutiny: the accounting profession's relationship to its government clients.

In San Francisco, for example, KPMG LLP, a "Big Four" accounting company, has been auditing the city's books for more than 20 years -- at the same time it was pulling down millions of dollars in consulting fees. This conflict of interest, which occurred with the complicity of the city's controller, ignored the basic principles that define auditor independence. For example:

- As a consultant, KPMG sold millions of dollars in accounting software to San Francisco's controller, the official who keeps the city's books. This software, which is riddled with serious glitches, generates the financial statements that KPMG audits.

- KPMG's $140- to $350-an-hour consultants have become semipermanent fixtures at City Hall, where they supervise city employees and participate in policy-making decisions, contrary to the standards of independence.

- KPMG auditors oversaw the creation of financial data in the Assessor's Office that was later audited for accuracy by other KPMG employees.

- The city hired KPMG to investigate a department that has authority over the firm's contracts.

While there is no evidence that San Francisco's books, or KPMG's audits, are inaccurate, the company's dual roles as auditor/consultant and auditor/vendor do call into question its independence -- its ability to remain unbiased and objective, in appearance and in fact, while examining the city's financial statements for truth and accuracy. Last year, the audit company separated its consulting division from the firm, but the process is not complete.

The issues are about far more than appearances and principles. Conflicts of interest between an auditor's watchdog role and its "nonaudit" consulting jobs can undermine the credibility of San Francisco's financial statements, experts say. It could mean that an auditor's "expert" advice may be tainted by self-interest; bookkeeping mistakes, software errors, and accounting frauds could be covered up; wasteful spending could be hidden; and auditors could become responsive to political pressures. Ultimately, bond investors could lose faith in the integrity of the city's financial statements, making it prohibitive for San Francisco to borrow money and pay its bills.

To ensure that the city's books are accurate, and to guard against fraud, San Francisco hires an accounting firm each year to conduct an audit. Auditors spot-check a tiny percentage of the city's financial records for errors or cheating. They peer into the fiscal affairs of big-spending departments, such as the airport or the Public Utilities Commission. Mostly, though, they rely on the client to present them with accurate ledgers that fairly represent the financial position of the city, which they test for compliance with the rules of accounting. It takes about six months to complete the audit, called a Comprehensive Annual Financial Report. KPMG has served as San Francisco's auditor since before 1980.

KPMG reports to the city's controller, Edward M. Harrington, a former KPMG employee, who was appointed by then-Mayor Art Agnos in 1991. Mayor Willie Brown reappointed Harrington last year. As the city's chief accounting officer and internal auditor, Harrington approves more than $5 billion in payments a year, writes the checks, balances the checkbook, and, from time to time, investigates whistle-blower allegations of fraud inside city agencies.

More than any other individual, Harrington is responsible for ensuring that the billions of dollars that flow through the city's treasury do not get diverted, lost, or stolen. As the chief accountant, he is charged with consolidating the financial ledgers of 54 city departments and hiring an auditor to review the data independently, i.e., free from any and all political or economic pressures.

Controller Harrington asked for detailed questions in writing, and then declined to answer them or to comment for this story.

In addition to auditing the books, KPMG provides an array of consulting services to San Francisco -- from selling software to city managers to helping them prepare for the annual audit. In fact, consulting is far more lucrative for KPMG than its auditing services. From 1996 to 2000, the city paid the company $4.5 million for audits and $10.3 million for consulting.

"Audit fees are a loss leader for value added in consulting and software contracts," says Bart Hildreth, a technical adviser to the Governmental Accounting Standards Board, which establishes financial accounting and reporting standards for state and local governments.

Because an auditing firm's chief asset is it reputation, it is vital that the public perceive that it is free of bias and conflicts of interest. Therefore, auditors are bound to avoid even the appearance of a conflict of interest -- whether or not a conflict exists in fact.

The appearance of independence is key, stresses Brett Trueman, professor of accounting at the Haas School of Business at UC Berkeley. "No one can get inside the mind of an auditor, so we must rely upon the outward signs of independence. Even separating auditing from consulting may not go far enough in terms of perception. The danger is that the public will not believe the audited financial statements, and [investors] will stay away from [a government's] bonds."

To preserve the public's confidence, government regulators and the accounting industry evolved two overarching principles during years of acrimonious debate:

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