NEWS ANALYSIS

Accountants should get 'clean' bill on Pennsy

Rv David Macey

Often times while driving home from work I have to sit in my car at a railroad crossing and wait while a long freight train goes past. Being a railroad buff from my earliest years, I really don't mind these delays and, in fact. I thoroughly enjoy reading the names on all of the freight cars.

One of the names which whizzes by with high frequency is "Penn Central." Every time I see this name, I rannot help but think about the Securities and Exchange Commission (SEC) and the public accounting firm of Peat, Marwick, Mitchell & Co. (PMM). Penn Central is a bankruptcy. Its auditor was PMM.

The Penn Central bankruptcy in June of 1970 was the biggest corporate failure in the history of the world. (approximately $7 billion in assets at the end of 1969) and, as such, raised many complex issues and lawsuits. The SEC and others have brought complaints against PMM on the grounds that PMM should not have given a ! "clean" opinion on Penn Central's 1969 financial statements

A "clean" opinion simply means that the auditor agrees that the financial statements, as prepared by management, meet what is known as "generally acbepted accounting principles." It is most important to realize that the autitors do not prepare the financial statements. The management of Penn Central prepared its financial statements. PMM only certified these statements. Generally accepted accounting principles are not cast in stone like the Ten Commandments. They are highly subjective and a very, very long way from being precisely defined.

A brief and unsophisticated examination of Penn Central's 1969 annual report, the last one it issued, makes one wonder why the firm's failure caught investors by such surprise and, more importantly, why there are so many lawsuits, the SEC's included.

On page 7 of Penn Central's 1969 annual report there are some financial highlights which show that the firm only earned two tenths of one percent (0.2%) on total sales, an absolutely rotten performance for any kind of a company.

On page 14 there is a numeric and pictorial presentation of the sources and uses of funds at Penn Central for 1969. It shows that, of the total funds used in the business during 1969, 82 percent were borrowed and only of one percent came from earnings from operations. Just think about this. How many firms can you name that have to borrow 82 percent of the funds they'

Turning to the audited financial statements, the dala on which PMM gave its "clean" opinion, it can be seen that, as of Dec. 31, 1969, Penn Central had negative net working capital of $207 million. This means that the current debt exceeded the current assets by over $200 million. Not exactly a super liquid position to be in.

Footnote No. 7 to the audited financial statements rontains a tabulation showing the annual principal payments due on the firm's long-term debt for the 19781974 period. The numbers are shown below!

$986 million

Contrast these principal payments (let alone the payment of the interest due on the $2.6 billion of longterm debt outstanding) to the fact that at year end 1969 Penn Central had only $154 million in cash. What more indications of pending cash problems did the world need?

Writing in the March-April 1972 issue of the Financial Analyst Journal, Prof. Paul Dascher concluded that any investor of average intelligence should have easily been able to see the wreck of the Penn Central long before it actually happened. Dascher took Pern Central's 1968 and 1969 annual reports and, using the audited financial statements, calculated 14 simple financial ratios for Penn Central for each of the two years. He calculated these same 14 ratios for nine other large railroads for the same two years. He next compared Penn Central's ratios with those for the other nine railroads and found them to be as different as night is from day. Dascher concluded that the failure of the Penn Central was in the cards for all to see well ahead of the time it actually occurred.

What was PMM supposed to do back in 1969" Print "B-A-N-K-R-U-P-T" in red ink on the cover of the Penn Central report for the benefit of those investors who were either too lazy or too stupid to see all the warning flags?

.

No, PMM had and has no right whatsoever te de any such thing. It is the investors who need to wake up and get with it.

Public accounting firms, PMM included, aren't in the business of certifying the health of any company a a potential investment. It is about time that the SEC took some action to inform investors of what the rea Investment world is all about. Individual investors have heen getting their hands burned for centuries and their ongoing pursuit of profits and lack of knowledge insures that they will continue to get singed.

Don't blame Penn Central on PMM. Put the blame where it belongs... on the investors who in they looked but, per usual, utterly failed to see.

David Macey is a lecturer in fname at Northeastern University.

By NEIL ULMAN

Staff Reporter of THE WALL STREET JOURNAL

BOSTON-Peat, Marwick Mitchell & Co. got a qualified opinion from a special committee investigating its audit practices at the insistence of the Securities and Exchange Commission.

The committee report, based on 14,000 man hours of peering through Peat Marwick records and over the shoulders of its accountants, concluded that the firm's "prescribed policies, procedures and practices are comprehensive... effectively communicated and... . appropriate."

But the committee also "pointed out a significant number of instances of noncom. pliance with prescribed policies and procedures," plus what it considered some weaknesses in Peat Marwick practices. These include some alleged cases of deficient documentation and allowing audited clients to get by with "numerous omissions of or deficiencies in disclosures" required by accounting principles or SEC rules. The omissions and deficiencies didn't "affect the overall fairness of the financial statements" involved, the report said.

The committee's review was carried out as part of a 1975 settlement between Peat Marwick and the SEC. The settlement had barred Peat Marwick from accepting most new, publicly held clients for six months. At the same time, the SEC had released stinging criticism of Peat Marwick's practices in auditing five clients, including Penn Central Co., that had all experienced financial collapses or profit reductions.

In its report, the committee said that so much time had elapsed since the original five cases cited by the SEC that it didn't think it was practical to comment on whether Peat Marwick's subsequent changes in quality control were.directly responsible to problems in those cases. It did say that it deemed "appropriate" Peat Marwick's responses to deficiencies that the committee review uncovered.........

Review Procedures

To carry out its review, the committee zeroed in on 13 of Peat Marwick's nearly 100 U.S. offices and a single audit in each of 10 additional offices. Noting that "documen tation is tangible evidence of audit work performed. the committee cited some problems in this area. "We noted a significant number of instances where documentation wasn't present or didn't comply with firm standards."

For example, when auditors discuss clients' improper payments with top management, the discussions should be documented, the committee noted. But, "such documentation wasn't prepared in a significant number of (cases) where the requirement was applicable, although we were gen-. erally advised that such discussions had taken place," the committee said.

In one of many comments published as an integral part of the report, Peat Marwick noted that it "is in process of updating its internal literature . . . relating to improper payments." The firm also suggested that the newness of improper payments as "an emerging audit concern" may have contributed to less than satisfactory documentation.

Other Criticism

The committee also criticized Peat Marwick for lack of evidence of communication with other auditors in situations where the accounts of a related party may have been material to work Peat Marwick was performing. Peat Marwick promised to stress compliance with its requirement for written communication in the future.

The committee further criticized Peat Marwick's failure to show any proof that its reliance on clients' internal auditors wasn't "a substitute for, rather than a supplement to, the firm's work." The report particularly noted a lack of evidence that Peat Marwick supervised and tested the work of internal auditors checking up the effectiveness of computerized accounting controls.

Peat Marwick said it revised its audit

manual in April 1976 to include "a substantial expansion of the discussion of the use of internal auditors."

In filing the 31-page report, the committee noted that it was limiting Its comments to recommendations for modifications in Peat Marwick policy and comments on noncompliance with prescribed procedures and policies. "We haven't commented on the many policies and procedures of the firm that we considered to be satisfactory and those prescribed policies and procedures for which we considered compliance to be satis. factory," the report said.

The committee comprised five accoun tants and a nonvoting attorney selected from a list acceptable to the SEC staff. The five accountants were Donald J. Bevis, a retired partner of Touche Ross & Co.; J. Michael Cook, a partner of Haskins & Sells; Paul Lambert Jr., a partner of Lambert & Jones; Ralph F. Lewis, editor and publisher of Harvard Business Review, and Marvin L. Stone, a partner of Stone, Gray & Co. The attorney was Arnold Bauman, partner of Shearman & Sterling.