Auditor Independence

In one of the longest suspensions ever of a major accounting firm,
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io&profile-format-action=incl Ernst & Young LLP was barred for six
months from accepting any new audit clients among publicly traded
companies as punishment for participating in a lucrative business
venture with a company whose books it audited.

The ruling Friday by the Securities and Exchange Commission's chief
administrative-law judge marks the latest sanction of an accounting firm
for violating the agency's auditor-independence rules, which are
intended to ensure that accounting firms remain impartial in their
evaluations of corporate clients' financial statements. The suspension
applies to American or foreign companies whose stock or debt trades on
U.S. markets.

Ernst had fiercely contested the SEC enforcement division's allegations
that it compromised its independence by engaging in a joint venture with
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io&profile-format-action=incl PeopleSoft Inc. at the same time that it
was the software maker's outside auditor, at one point calling the
allegations "outrageous." On Friday, Ernst, the nation's third-largest
accounting firm, said it wouldn't appeal the decision.

The conduct occurred in the 1990s, at a time when accounting firms' fees
weren't disclosed and the prevailing culture within the major firms was
to use audits as a loss leader to generate other, more-lucrative
business with clients.

Three of the four major accounting firms, including Ernst, since have
sold their consulting practices in response to pressure from regulators.
Only Deloitte & Touche LLP continues to maintain a sizable consulting
practice, though it too has come under pressure to part ways with its
consulting business. Nowadays, companies with publicly traded securities
must disclose how much they pay their independent accounting firms for
audit and nonaudit work.

Other questions about Ernst's compliance remain. The SEC's enforcement
division has been probing whether Ernst compromised its independence by
entering a so-called profit-sharing agreement in the 1990s with American
Express Co.'s travel-services unit and by accepting large undisclosed
rebates from AMR Corp. and Continental Airlines Inc. for client-related
air travel. The rebates, reported by The Wall Street Journal last fall,
are the subject of continuing litigation in a Texarkana, Ark., state
court, as well as a Justice Department investigation. Ernst has said it
is cooperating with the government agencies on the matter.

While the suspension of Ernst is unusually lengthy by SEC standards, the
firm won't be required to forfeit any of the nearly $500 million it
received from 1994 to 1999 through its licensing and marketing
agreements with PeopleSoft, under which it installed PeopleSoft software
at other companies. The order by Judge Brenda Murray requires Ernst to
disgorge $1.7 million in audit fees it had collected from PeopleSoft,
plus more than $700,000 in interest, all of which will be paid to the
government.

Ernst also must hire an SEC-approved consultant to monitor future
compliance efforts. Additionally, Judge Murray entered a permanent
cease-and-desist order barring Ernst from future auditor-independence
infractions, the violation of which could subject the firm to
contempt-of-court charges.

Like the other Big Four accounting firms, Ernst has come under harsh
criticism for failing to catch several large accounting frauds, most
recently at HealthSouth Corp., although there has been no indication
that PeopleSoft engaged in improper accounting. PeopleSoft's auditor
today is KPMG LLP.

In a statement Friday, Ernst spokesman Charlie Perkins said:
"Independence is the cornerstone of our practice and our obligation to
the public. We are fully committed to working closely with an outside
consultant in the review of our independence policies and procedures."

The ruling also underscores criticism that the auditing industry today
is too concentrated. The demise of Arthur Andersen LLP in 2002,
following its felony conviction for obstruction of justice in the Enron
case, left only four major accounting firms, down from eight just 15
years ago. "This is a classic example of why four firms are too few,"
said Charles Bowsher, former chairman of the Public Oversight Board,
which had been the accounting industry's top self-regulatory panel
before it disbanded in 2002.

The six-month suspension is unlikely to cause significant harm to
Ernst's financial position. During the last six months of 2003, Ernst
picked up 16 new publicly traded U.S. audit clients, whose combined
audit fees for 2002 were $7.2 million, according to the industry
newsletter Public Accounting Report. Ernst, which sold its consulting
business in 2000, reported $5.3 billion in U.S. revenue for the fiscal
year ended June 30, 2003.

The SEC's staff could have sought an order requiring disgorgement of the
money Ernst received for selling PeopleSoft products, on the grounds
that those payments are the ones that corrupted the integrity of the
firm's audits. Instead, the staff took the less-punitive approach of
asking Ernst to forfeit only its audit fees for the years in question,
which were comparatively tiny.

SEC rules bar accounting firms from entering direct business
relationships with audit clients, except for situations where a firm is
acting as a "consumer in the normal course of business." The requirement
that a public company's financial statements be audited by an accountant
that is independent -- in appearance and in fact -- is a bedrock
principle of the nation's securities laws. In defending its conduct,
Ernst had argued it merely was a consumer of PeopleSoft's products, a
notion Judge Murray flatly rejected.

Calling Ernst's conduct "reckless, highly unreasonable and negligent,"
Judge Murray wrote that Ernst had virtually no systems in place to
ensure compliance with auditor-independence requirements and disregarded
what few internal guidelines it had written on the subject. "This was
not a situation of an isolated mistake or confusion over a complicated,
technical issue," she wrote in a 69-page decision. "These violations
occurred over an extended period. They were committed by professionals
throughout the firm who exhibited no caution or concern for the rules of
auditor independence in connection with business relationships with an
audit client."

Refer to article above (Ernst and young gets SEC penalty fro ties to
client)

Required:

1. A key issue with the SEC in this case appears to center on
"Independence."

Identify why auditor independence is deemed to be so important.

2. The auditor-client relationship identified in the article began prior
to the

Enron scandals. Briefly outline how "independence" issues played a role
in

the demise of Enron's auditor.

3. In your view, what impact will the SEC action have on the reputation
and

future viability of Ernst & Young? What actions do you suggest they
take, if

any, to overcome any damage done to date?

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