High & Low Finance: A Plot Twist at Herbalife Draws in the Auditors

Herbalife lost its auditor, KPMG, this week after it was revealed that Scott I. London, the partner in charge of the audit until he was fired, had been providing inside information about Herbalife and the shoe company Skechers to a frequent golf partner who was trading on the tips.

The audit firm decided that it would not only resign as auditor at Herbalife and Skechers, whose audits Mr. London also led, but would also withdraw its certification of the old audits, even though it said it had no reason to doubt the accuracy of the reviews. That left the two companies scrambling to find new auditors who will have to reaudit results from recent years, an expensive and time-consuming process.

Skechers presumably will have no trouble getting one of the other Big Four firms — PricewaterhouseCoopers, Deloitte Touche and Ernst Young — to take over its audit. And it seems reasonable to think that KPMG will end up paying the extra costs, since it was the misconduct of its partner that led to the mess.

But it will be interesting to see which firm signs on as Herbalife’s auditor. When an auditor is selected, that firm will be under close scrutiny by the participants in the Herbalife stock market war being fought by hedge funds. That war pits Bill Ackman of Pershing Square Capital Management, who has loudly shorted the stock, against Daniel S. Loeb of Third Point, who bought the shares after Mr. Ackman disclosed his position. Carl C. Icahn, who has an unrelated complaint with Mr. Ackman, has also leapt in to buy the stock.

Financial statements are not at the heart of Mr. Ackman’s argument that Herbalife is an illegal pyramid scheme that will be the target of federal regulators. But he has complained about inadequate and misleading disclosures. It is at least conceivable that an auditor might seek to force additional disclosures.

All audit firms have risk groups that review new business, including the quality of the company to be audited, and that decide that some prospective clients are not worth the risks. It will be interesting to see if any of the other major firms conclude that the risks are acceptable, particularly given that Herbalife’s 2012 audit fee was under $4 million, which is not a large sum to a major firm. If Herbalife turns to a second-tier audit firm, it will be embarrassing to the company.

Then there is the issue of conflicts of interest. Any audit firm that did certain types of consulting work for Herbalife over the last three years might be disqualified, since the new auditor will have to review those periods.

Herbalife’s annual meeting is April 25, and it no doubt would like to have the new auditor on board by then.

Some studies have indicated that financial restatements are more likely when a new auditor is brought in, but the data involved makes it hard to know if there is a causal connection. After all, as a general rule auditors are changed only when either the client or the audit firm is unhappy about the relationship, and a dispute over accounting or even suspicion of management may be at the heart of such a split.

There is no evidence of such a split here. KPMG has been the company’s auditor since before the company went public in 2004, and the two seem to have been getting along fine. If Herbalife’s new auditor does seek to force a restatement, that will be seized upon by advocates of mandatory auditor rotation as support for their argument that auditor independence is inevitably compromised by long tenures of the incumbent firm, and that companies should be required to change firms every decade or so. Such a requirement is fiercely opposed by the accounting industry, but it has been approved by the Dutch Parliament for companies in the Netherlands.

Floyd Norris comments on finance and the economy at nytimes.com/economix.

Article source: http://www.nytimes.com/2013/04/12/business/a-plot-twist-at-herbalife-draws-in-the-auditors.html?partner=rss&emc=rss