Enron Case Study Auditing

In Enron's case, consulting work accounted for slightly more than half of the $52 million that Andersen received in fees in 2000. Even more important, though, was the potential income from consulting, according to John C. Coffee Jr., a law professor at Columbia. ''Enron was a potential market for $50 million or $100 million in consulting fees,'' he said.

Accountants have always been paid by their clients for their role in reviewing their books, and critics have also argued that auditors are increasingly reluctant to alienate a big client that may contribute a significant portion of its revenue. Andersen has acknowledged that Enron was one of its biggest and most desirable clients, something that would give pause to any auditor thinking about challenging the energy concern.

''There's no way that you could have a client which is that huge and important to you and not be tempted to turn your head away from problems,'' said Dan L. Goldwasser, a lawyer who often advises accountants. ''If the audit partner who's on the Enron account lost that account, they were history.''

Many companies also hire former auditors, making the relationships between the accountants and the companies particularly cozy. Enron routinely hired accountants away from Andersen -- as well as from other Big Five firms -- including the company's chief accounting officer and its chief financial officer.

But critics also say that accountants are far less liable today for mistakes in signing off on a company's books than they were a decade ago. Suing accountants in both state and federal courts has become increasingly difficult because of new laws governing securities class-action lawsuits, and a Supreme Court decision has made it harder for shareholders and others to sue a company's auditors, according to Mr. Coffee.

''Over the last 10 years, the legal threat that kept auditors honest has been greatly diminished,'' he said.

The industry has managed to beat back most attempts at greater oversight, including a rule proposed by Arthur Levitt while he was chairman of the Securities and Exchange Commission that would have significantly reduced the amount of consulting work a firm could perform for a client it audits. Among the compromises reached was one to require greater disclosure of fees for audit and consulting work. Many industry observers cynically note that however big the scandal, accountants have emerged largely unscathed.

Accountants have regulated themselves, largely though an entity called the Public Oversight Board. The board was created in 1977, after Senate hearings debating whether the government should have a more active role in regulation.

''There may be questions about the adequacy of the Public Oversight Board, which is an entity that most Americans have never heard of,'' said Richard C. Breeden, a former S.E.C. chairman. ''There certainly have been concerns expressed in the past that it was not adequately funded and did not have the realistic ability to oversee the conduct of audits.''

To ensure the quality of audits, accountants generally rely on peer reviews conducted by one firm of another. Andersen was recently given a clean bill of health by Deloitte & Touche.

''I don't think we should conclude that peer review doesn't have any benefits,'' Mr. Breeden said. ''It's a useful tool, but the question is, is it enough?''

The S.E.C. is already in discussions with the Big Five and the industry association about how to improve the way accountants regulate themselves, according to a commission spokeswoman.

Some members of Congress, including Senator Joseph I. Lieberman, Democrat of Connecticut, are discussing the possibility of greater oversight, in light of disclosures by Andersen. ''Should there be more law with regard to Arthur Andersen?'' Mr. Lieberman asked rhetorically. ''Should there be more law and less self-regulation by the industry?''

Senator Paul Sarbanes, Democrat of Maryland and chairman of the Senate Banking Committee, has scheduled hearings next month on some proposed industry changes.

Critics of the accounting industry have long complained of potential conflicts of interest that prevent auditors from being totally independent and calling for increased oversight. Mr. Levitt, for example, has described the current environment as ''an opportunity to rethink the way the industry is overseen and the way standards are set.''

Though the industry has discussed changes to financial reporting, the Enron collapse may point to a lack of compliance with existing rules, according to Lynn Turner, a former chief accountant with the S.E.C. who is now director of the center for quality financial reporting at Colorado State University. The industry may need a new independent body, akin to the regulatory body of the National Association of Securities Dealers or the National Transportation Safety Board, to address problems like Enron. ''We've got nothing like that in the accounting profession,'' Mr. Turner said.

Many of the big accounting firms declined to comment for this article. The American Institute of Certified Public Accountants, the industry association, has unveiled no specific plans to address concerns about the adequacy of its self-regulation. ''We are obviously as concerned as anybody about the fall out from Enron,'' said a spokesman, noting that the facts surrounding the company's collapse are not yet known.

''We are prepared to make changes where necessary as soon as we could,'' he said.

But many within the industry acknowledge that the problem may be a lack of enforcement of the existing rules. If the rules ''are not being enforced sufficiently, the first thing we need to do is figure out what it would take to get them enforced,'' said Louis Grumet, executive director of the New York State Society of Certified Public Accountants.

It is not clear exactly how aggressive the S.E.C. will be in pursuit of change -- nor is it clear that any such effort would have more success than past efforts to rein in the powerful industry.

Harvey Pitt, the new chairman of the S.E.C., has been criticized for close ties to the accounting industry because he was active in defending the large firms when he was a lawyer in private practice. The two people nominated by the Bush administration to serve as commissioners are also former accounting professionals.

The chairman and commissioners are traditionally from the business arena and are governed by rules that prevent any possible conflicts of interest, according to an agency spokeswoman.

Just yesterday, the S.E.C. censured KPMG, another of the Big Five accounting firms, for improper professional conduct. The S.E.C. said KPMG had violated the auditor independence rules by having a substantial investment in an AIM mutual fund that it had audited. KPMG consented to the order without admitting or denying the commission's findings.

In addition to Andersen, Deloitte and KMPG the Big Five include PricewaterhouseCoopers and Ernst & Young.

Any form of outside regulation would be a challenge to the long-standing practice of accounting firms' policing themselves. That tradition may not survive the Enron debacle, said Arthur Bowman, the editor of Bowman's Accounting Report, an industry newsletter. ''The profession could lose control of this part of its destiny.''

Continue reading the main story

THE mess just keeps spreading. Two months after Enron filed for Chapter 11, the reverberations from the Texas-based energy-trading firm's bankruptcy might have been expected to fade; instead, they are growing. On Capitol Hill, politicians are engaged in an investigative orgy not seen since Whitewater, with the blame pinned variously on the company's managers, its directors, its auditors and its bankers, as well as on the Bush administration; indeed on anybody except the hundreds of congressmen who queued up to take campaign cash from Enron. The only missing ingredient in the scandal—so far—is sex.

The effects are also touching Wall Street. In the past few weeks, investors have shifted their attention to other companies, making a frenzied search for any dodgy accounting that might reveal the next Enron. Canny traders have found a lucrative new strategy: sell a firm's stock short and then spread rumours about its accounts. Such companies as Tyco, PNC Financial Services, Invensys and even the biggest of the lot, General Electric, have all suffered. Last week Global Crossing, a telecoms firm, went bust amid claims of dubious accounts. This week shares in Elan, an Irish-based drug maker, were pummelled by worries over its accounting policies.

All this might create the impression that corporate financial reports, the quality of company profits and the standard of auditing in America have suddenly and simultaneously deteriorated. Yet that would be wide of the mark: the deterioration has actually been apparent for many years. A growing body of evidence does indeed suggest that Enron was a peculiarly egregious case of bad management, misleading accounts, shoddy auditing and, quite probably, outright fraud. But the bigger lessons that Enron offers for accounting and corporate governance have long been familiar from previous scandals, in America and elsewhere. That makes it all the more urgent to respond now with the right reforms.

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Uncooking the books

The place to start is auditing. Accurate company accounts are a keystone for any proper capital market, not least America's. Andersen, the firm that audited Enron's books from its inception in 1985 (it was also Global Crossing's auditor), has been suggesting that its failings are representative of the whole profession's. In fact, Andersen seems to have been unusually culpable over Enron: shredding of incriminating documents just ahead of the investigators is not yet a widespread habit. But it is also true that this is only the latest of a string of corporate scandals involving appalling audit failures, from Maxwell and Polly Peck in Britain, through Metallgesellschaft in Germany, to Cendant, Sunbeam and Waste Management in America. In the past four years alone, over 700 American companies have been forced to restate their accounts.

At the heart of these audit failures lies a set of business relationships that are bedevilled by perverse incentives and conflicts of interest. In theory, a company's auditors are appointed independently by its shareholders, to whom they report. In practice, they are chosen by the company's bosses, to whom they all too often become beholden. Accounting firms frequently sell consulting services to their audit clients; external auditors may be hired to senior management positions or as internal auditors; it is far too easy to play on an individual audit partner's fear of losing a lucrative audit assignment. Against such a background, it is little wonder that the quality of the audit often suffers.

What should be done? The most radical change would be to take responsibility for audits away from private accounting firms altogether and give it, lock, stock and barrel, to the government. Perhaps such a change may yet become necessary. But it would run risks in terms of the quality of auditors; and it is not always so obvious that a government agency would manage to escape the conflicts and mistakes to which private firms have so often fallen prey. As an intermediate step, however, a simpler suggestion is to take the job of choosing the auditors away from a company's bosses. Instead, a government agency—meaning, in America, the Securities and Exchange Commission (SEC)—would appoint the auditors, even if on the basis of a list recommended by the company, which would continue to pay the audit fee.

Harvey Pitt, the new chairman of the Securities and Exchange Commission, is not yet willing to be anything like so radical. He has been widely attacked because, when he acted in the past as a lawyer for a number of accounting firms, he helped to fend off several reforms. Yet he now seems ready to make at least some of the other changes that the Enron scandal has shown to be necessary (see article).

Among these are much fiercer statutory regulation of the auditing profession, including disciplinary powers with real bite. Hitherto, auditors have managed to get away with the fiction of self-regulation, both through peer review and by toothless professional and oversight bodies that they themselves have dominated. There should also be a ban on accounting firms offering (often more profitable) consulting and other services to their audit clients. Another good idea is mandatory rotation, every four years or so, both of audit partners—so that individuals do not become too committed to their clients—and of audit firms. The most effective peer review happens when one firm comes in to look at a predecessor's books. The SEC should also ban the practice of companies' hiring managers and internal auditors from their external audit firms.

In search of better standards

Then there is the issue of accounting standards themselves. Enron's behaviour has confirmed that in some areas, notably the treatment of off-balance-sheet dodges, American accounting standards are too lax; while in others they are so prescriptive that they have lost sight of broader principles. Past attempts by the Financial Accounting Standards Board to improve standards have often been stymied by vociferous lobbying. It is time for the SEC itself to impose more rigorous standards, although that should often be through sound principles (including paying less attention to single numbers for earnings) rather than overly detailed rules. It would also be good to come up with internationally agreed standards.

Although audit is the most pressing area for change, it is not the only one. The Enron fiasco has shown that all is not well with the governance of many big American companies. Over the years all sorts of checks and balances have been created to ensure that company bosses, who supposedly act as agents for shareholders, their principals, actually do so. Yet the cult of the all-powerful chief executive, armed with sackfuls of stock options, has too often pushed such checks aside.

It is time for another effort to realign the system to function more in shareholders' interests. Companies need stronger non-executive directors, paid enough to devote proper attention to the job; genuinely independent audit and remuneration committees; more powerful internal auditors; and a separation of the jobs of chairman and chief executive. If corporate America cannot deliver better governance, as well as better audit, it will have only itself to blame when the public backlash proves both fierce and unpleasant.

This article appeared in the Leaders section of the print edition

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