A number of companies in recent months have dismissed their independent auditors shortly after a material weakness in their internal control over financial reporting was identified. Although such an action might raise eyebrows, David Snyder, vice chairman of the law firm Pillsbury Winthrop Shaw Pittman in San Diego, says “in the vast majority of cases the dismissal has absolutely nothing to do with the material weakness [disclosure].”

RECENT DISMISSALS

In the past two months, more than a dozen companies have terminated relationships with their auditors after a material weakness disclosure was made. Some of the companies did so after several months had passed. But others announced the dismissal within weeks of reporting a failing grade:

CardioDynamics International—Disclosed a material weakness March 30 relating to internal control over financial reporting associated with the company’s accounting for income taxes and determination of allowance for doubtful accounts. Less than a month later, on April 27, CardioDynamics terminated its relationship with its auditor, KPMG. CardioDynamics said the dismissal of KPMG “was the result of … ongoing efforts to improve efficiency and reduce expenses.”

Albany Molecular Research—Identified a material weakness on March 3 relating to the company’s inventory accounting process. Seven weeks later, on May 24, Albany Molecular announced that it was replacing its independent auditor, PricewaterhouseCoopers, with KPMG. The company said, “[T]he replacement is not the result of any disagreements with PricewaterhouseCoopers on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedures which, if they had not been resolved to PricewaterhouseCoopers’ satisfaction, would have caused it to make reference to the disagreements in its reports on the company’s financial statements.”

SPSS—Concluded on April 22 that the company had failed to maintain effective internal control over financial reporting because of a material weakness related to revenue resulting from several deficiencies, including insufficiently documented review of software contracts. SPSS also acknowledged a material weakness dealing with failure to employ personnel with the appropriate level of expertise to calculate, document and review its accounting for income taxes. Less than three weeks later, SPSS dismissed KPMG as its outside auditor and hired Grant Thornton, citing “due consideration of current and future needs.” A press release stated: “SPSS noted its long relationship with KPMG and commended the firm’s professionalism, but said that a new auditing firm would provide a better fit for the company at this time.”

PDI—Announced in a Form 8-K filed on April 22 that it had dismissed PwC as its independent auditor four days earlier. In the same filing, the company disclosed that it had material weaknesses relating to the selection and application of generally accepted accounting principles and the preparation of the consolidated financial statements. The company said, “[T]here have been no disagreements with PwC on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, which disagreements if not resolved to the satisfaction of PwC would have caused PwC to make reference thereto in connection with its reports on the financial statements for such years.”

Other companies to dismiss an auditor in the last two months following an earlier reporting of a material weakness:

Compass Minerals International—Dismissed PwC on May 18; reported a material weakness on Nov. 12, 2004.

Craftmade International—Dismissed PwC on May 19; reported a material weakness on Sept. 28, 2004.

Gulf Offshore—Dismissed Ernst & Young on May 26; reported material weaknesses on March 31 and Nov. 15, 2004.

Hercules—Dismissed BDO Seidman on May 12; reported a material weakness on Dec. 1, 2004.

NorthStar Realty Finance—Dismissed E&Y on May 24; reported a material weakness on Dec. 30, 2004.

MSC Software—Dismissed KPMG on April 28; reported a material weakness on Feb. 16.

Rowan Companies—Dismissed Deloitte & Touche on May 3; reported a material weakness on March 9.

Tengasco—Dismissed BDO Seidman on May 31; reported a material weakness on Nov. 22, 2004.

United Retail Group—Dismissed PwC on May 6. Reported a material weakness on Dec. 20, 2004.

University Bancorp—Dismissed Grant Thornton on May 25; reported a material weakness on Nov. 15, 2004.

Related Resources

Click Here For A Downloadable Spreadsheet of Recent Auditor Changes

Click Here To Review The Latest Internal Control Weakness Disclosures

Snyder

According to Snyder, issues associated with the burdens of Sarbanes-Oxley compliance may be the strongest motivating factor behind a company’s decision to dismiss an auditor or an auditor’s decision to resign. “Auditing fees have gone up dramatically and auditors are narrowing or reducing the number of clients they serve,” he says. “Smaller companies particularly are seeking more cost-effective alternatives. That vastly outweighs any issue of a material weakness.”

Richard Steinberg, the founder of Steinberg Governance Advisors, agrees that switching auditors so close to a material weakness finding isn’t necessarily cause for concern. “If the reason for the change of auditor is based on performance issues—non-responsiveness, insufficient industry expertise, not having the right team involved—it’s certainly understandable. Those things do occur,” he says.

However, if the change “is specifically because the auditor came to the conclusion that the client indeed had a material weakness and management disagreed, that does raise a red flag. If the rationale for the dismissal is simply the auditor is doing high quality work, that’s doing a disservice to all parties,” says Steinberg, who also writes a monthly column for Compliance Week.

He acknowledges that companies wouldn’t necessary come out and say that an auditor was dismissed because of an adverse finding. “There’s no doubt that companies can disguise the reason for dismissal and make it sound more palatable and appropriate than it is. But whether dismissal indeed is appropriate depends entirely on the underlying reason for such action,” he says.

The Right Way Out

Landefeld

Stewart Landefeld, a partner with the law firm Perkins Coie in Seattle, told Compliance Week that companies should keep in mind that “any auditor change will hit the [Securities and Exchange Commission’s] radar—certainly any time an auditor resigns. So call the SEC before hoisting that red flag. Do both yourself and the [SEC] Enforcement Division a favor and make a courtesy call to Enforcement to alert them of the change.”

Landefeld says that the “right way” to dismiss an auditor starts by going back to the governance basics. “It’s your audit committee that needs to make that decision,” he says. “Is the chairperson in the loop? Is the committee as strong and as independent as it needs to be? If you have been thinking of improvements to the committee, can you do that now in anticipation of a tough ‘we may need to make a change—or at least have a bake-off’ decision later this year? Get your 8-K ready and have your committee fully engaged in reviewing that.”

How the company handles the fundamentals “will lead to the cure, and that shows the strength of its underlying governance and disclosure platform,” says Landefeld, noting that companies also need to be concerned about the “pain in the neck factor” of shifting to a new auditor. “The issuer needs to be aware that it will either have to get a future consent from the old auditor, who is now disgruntled, to continue to use its audits for prior periods, or go to the expense of having the new auditor re-audit two additional [prior] fiscal years,” he says. “Sometimes the expensive re-audit is the only choice because, after the material weakness, the old auditor may advise the company that investors can no longer rely on the audit reports previously issued—essentially withdrawing their previously issued audit reports.”

This scenario “is getting increasingly common if the old auditor and the company reach an impasse on an accounting issue or a material weakness disclosure,” Landefeld says.

Martin Caine, a CPA with Wolfe & Company in Springfield, Mass., told Compliance Week that the SOX 404 process “was an ordeal for many companies and, as they went through and talked about issues, there was friction.” He notes that the process was “purposely designed to be somewhat adversarial between the companies and their auditors—it could be most frustrating.”

Caine cites a situation where a company would be looking for guidance about how to go about its internal control review. “Many public accounting firms took the stance that, ‘We can’t tell you anything about that—but if you bring me your answer I can tell you if you’re right or wrong. And if you’re wrong, I have to hold that against you.’ It creates situation where, depending upon how management and their team work through or address those issues, there might have been a lot of situations where egos may have been bruised.”

Many companies might be tempted to avoid doing anything that creates an appearance that an auditor is being dismissed over disagreements resulting in a material weakness disclosure, Caine says. “Those that get negative reviews from their auditors might stick with that [accounting] firm until they work through it rather than raise the red flag,” he says.

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