PCAOB Enforcement; EBITDA Tweaks; More

Auditing regulators have issued their first enforcement action in relation to a Big 4 accounting firm, barring an already fired KPMG auditor from any other public company auditing for one year.

The Public Company Accounting Oversight Board has barred Susan Birkert, a 27-year-old former KPMG auditor, from associating with accounting firms registered to audit public companies. Birkert was an auditor with KPMG from 2002 to 2006 and is accused of making a stealth stock purchase in a company she audited in violation of auditor independence rules.

According to the PCAOB order issuing the disciplinary action against Birket, KPMG acted on an anonymous tip to learn that Birkert wrote a $5,000 check to a former coworker with instructions to purchase stock in Comtech Telecommunications Corp. on her behalf. At the same time, Birkert was a member of the audit engagement team for Comtech.

KPMG investigated internally, advised Comtech of its findings, and fired Birkert, the PCAOB order says. Birkert is forbidden from associating with any accounting firm registered with the PCOAB. She can apply for reinstatement after one year.

“KPMG learned of the employee’s discussion of a possible stock purchase through its internal compliance process,” firm spokesman George Ledwith says. “KPMG advised Comtech of the matter on Nov. 30, 2006. We also quickly informed the [Securities and Exchange Commission] of the situation and terminated the employee.”

While the enforcement action is the first to hit the ranks of the Big 4 accounting firms, critics of the PCAOB enforcement process say the Board should be working on more substantial cases by now. Created as part of the Sarbanes-Oxley Act of 2002, the PCAOB has taken disciplinary action less than a dozen times and never against a major firm.

Woodbury

“It’s hard to get excited about a lower-level employee being sanctioned by the PCAOB for being stupid and purchasing stock of an audit client,” says Pat Woodbury, managing director at FTI Consulting and a former PCAOB staffer in the enforcement area. “I’m still waiting for the first PCAOB sanction against a firm, or partners and managers of a Big 4 firm, relating to their conduct of an audit.”

In a separate enforcement action, the PCAOB revoked the registration of Oregon accounting firm Timothy Steers Corp. and barred its sole owner, Timothy Steers, from associating with a registered audit firm for two years. The PCAOB said Steers violated PCAOB auditing standards on two separate audits in 2003, failing to exercise due professional care or skepticism and failing to obtain competent audit evidence to support an opinion.

Study: Companies Should Review EBITDA-Based Contracts

Companies should perk up to looming changes in lease accounting and begin reviewing debt covenants and compensation agreements heavily tied to a common non-GAAP metric: earnings before interest, taxes, depreciation and amortization, or EBITDA.

That’s the advice from the Georgia Tech Financial Analysis Lab, which studied the likely effect of expected changes in lease accounting rules for companies that employ leasing extensively and use EBITDA as a basis for debt and compensation agreements.

The Financial Accounting Standards Board and the International Accounting Standards Board are revising accounting rules regarding how companies account for leases. Currently, a series of bright-line tests define the difference between operating and financing leases; that drives companies to structure leases so they are classified as operating leases and consequently not reflected on the face of financials statements.

FASB and IASB have pledged to rewrite the rules to assure lease obligations are more plainly stated. As part of the comprehensive, long-term look at leases, the boards expect to publish a document reflecting preliminary views in late 2008.

Mulford

Charles Mulford, accounting professor at Georgia Tech and director of the financial analysis lab, says a change in lease accounting rules to bring leases into the financial statements would affect EBITDA calculation, thereby also affecting agreements based on EBITDA. The lab studied a sample of companies that make significant use of operating leases and that use EBITDA as a basis for establishing debt agreements with lenders or as a basis for establishing compensation agreements with key executives.

The study, titled “Lease Capitalization, Financial Agreements, and EBITDA,” found that when it adjusted EBITDA for the effect of converting rent expense to a capital lease cost for a sample of 25 major companies, it increased EBITDA by an average of 17.2 percent. “Capital lease treatment increases interest expense, depreciation and amortization, but it replaces rent expense in the EBITDA calculation, in the income statement,” he says. “EBITDA increases by the amount of rent expense when you capitalize a lease.”

The difference would likely have a significant effect on related debt or compensation agreements, Mulford says. Although a change in rules is likely well into the future, Mulford said companies should look at EBITDA-based agreements now because many of them are long-term agreements. “We need to have some agreement on how we’re going to measure EBITDA when this accounting change takes place,” he said. “Certainly for any new debt agreements or compensation agreements, it’s not too soon to be thinking about it.”

Mulford acknowledges EBITDA is not a formula prescribed by Generally Accepted Accounting Principles, so there are no hard rules about how to calculate it. While it’s not a metric of great significance to shareholders, it is seen by lenders and by compensation committees as a meaningful metric of operating performance. “I don’t like EBITDA, but I think it has a place in certain situations,” he says. “The epitaph has been written on EBITDA, and it lives on.”

IAASB Proposals on External Confirmations, Experts

The International Auditing and Assurance Standards Board is seeking comment on two proposals to address concerns about the use and reliability of external confirmations as audit evidence and to establish stricter requirements when an auditor uses an expert to obtain audit evidence.

The IAASB said the standards are meant to enhance audit quality by enhancing the quality of information from external sources. Third-party confirmations, for example, have sometimes proved to be less reliable than expected, IAASB Chairman John Kellas said in a statement. And auditors will increasingly rely on third-party valuation experts as fair value accounting becomes more important in financial reporting, he said.

In proposing International Standard on Auditing 505, External Confirmations, the Board considered whether to mandate external confirmations, but stopped short of an explicit requirement, says Alta Prinsloo, deputy director of the IAASB. “The IAASB has concluded that making external confirmation requests mandatory would conflict with the audit risk model, may not improve audit quality, and would suffer from significant operational disadvantages regarding the international context in which the ISAs are applied,” Prinsloo says.

Proposed ISA 620, Using the Work of an Auditor’s Expert, emphasizes the need for auditors to evaluate the objectivity of experts from fields other than accounting or auditing whose work is relied on to reach an audit conclusion. The proposal “clarifies that internal experts are subject to the firms’ system of quality control and that, while such a system can assist the auditor, the auditor cannot rely on internal experts simply because they are part of the firm,” Prinsloo says.

As proposed, ISA 620 would set out more detailed requirements and guidance around using the work of experts than equivalent U.S. standards, Prinsloo says. The requirements of proposed ISA 505 are more consistent with existing U.S. auditing standards, she adds.

The IAASB is a global standards setter for the auditing profession under the auspices of the International Federation of Accountants.