Accounting in Crisis

Reform is urgent. Here's what needs to be done

A few years ago, it would hardly have seemed possible: The nation's attention, from the halls of Congress to main street, has been riveted on an accounting scandal, a subject so abstruse it rarely makes the front page. But as the tawdry chapters in the Enron (ENE ) fiasco unfold like some penny dreadful, with explosive revelations of hidden partnerships, shredded documents, and shocking conflicts of interest, it's clear that the fall of Houston-based Enron is in a class by itself.

Everything about this debacle is huge: a $50 billion bankruptcy, $32 billion lost in market cap, and employee retirement accounts drained of more than $1 billion. The lapses and conflicts on the part of Enron's auditor Arthur Andersen are equally glaring. Andersen had been Enron's outside auditor since the 1980s, but in the mid-1990s, the firm was given another assignment: to conduct Enron's internal audits as well. In effect, the firm was working on the accounting systems and controls with one hand and attesting to the numbers they produced with the other. And the ties went even deeper: Enron's own in-house financial team was dominated by former Andersen partners. Then, as the firm began its last, rapid plunge toward bankruptcy, the Andersen auditors began frantically tossing records of their work into the shredder.

For working both sides of the street, Andersen was rewarded richly. In 2000, the firm earned $25 million in audit fees from Enron, and another $27 million in consulting fees and other work. Sure, it's possible that Andersen's auditors blocked all of those connections from their minds and managed still to render an objective opinion, but even former insiders wonder how. "There were so many people in the Houston office who had their finger in the Enron pie," a former Andersen staffer says. "If they had somebody who said we can't sign this audit, that person would get fired."

As shocking as Enron is, it's only the latest in a dizzying succession of accounting meltdowns, from Waste Management (WMI ) to Cendant (CD ). Lynn E. Turner, former chief accountant for the SEC and now a professor at Colorado State University, calculates that in the past half-dozen years investors have lost close to $200 billion in earnings restatements and lost market capitalization following audit failures. And the pace seems to be accelerating. Between 1997 and 2000, the number of restatements doubled, from 116 to 233.

That sorry record has cast doubt on a once honored profession. Auditors have always been in the uncomfortable position of having to judge the financial integrity of the companies that pay them. But in the fast-moving 1990s, with intensifying pressure to produce ever rising earnings and stock prices, Corporate America began to push the accounting boundaries like never before. And auditors were thrust into a new role of enabler. "They began to emphasize too much, being a business partner" to the company, laments Phil Livingston, president of the Financial Executives Institute.

The accounting industry, which largely regulates itself, has steadfastly resisted change, even in the face of repeated audit failures and scandals. That's about to change. The size and scope of the Enron disaster is simply too huge to ignore. Eight congressional committees are investigating or planning hearings on the matter, and legislation is already in the works to force firms to abandon consulting to audit clients or face much stiffer legal liability. Securities & Exchange Commissioner Harvey L. Pitt, who himself has worked for the Big Five, is shaping a proposal for a new body that would remove discipline and investigation of audit failures from the current system of professional peer review. Says Representative John D. Dingell (D-Mich.), the ranking Democrat on the House Energy & Commerce Committee whose hearings begin in early February: "How to make accountants do their jobs will be one of our big interests."

Even after the flameout of Enron, the Big Five accounting firms have yet to acknowledge the need for fundamental change to their independence rules. Instead, in a joint statement issued on Dec. 4, the CEOs of the Big Five focused largely on improving the rules of accountancy. Industry leader James S. Turley, chairman of Ernst & Young, says that rather than an audit failure, Enron "at its core was a business failure." The American Institute of Certified Public Accountants (AICPA) as well as the other big firms declined to comment for this story.

Yet it's hard not to assign blame to the industry's decades-old system of peer review that again showed its ineffectiveness on Jan. 3. That's when Andersen announced that the firm and its Houston office had successfully passed the review conducted by fellow Big Five firm Deloitte & Touche. Amazingly, two weeks later on Jan. 15, Andersen fired its lead Enron auditor and put more Houston partners on leave. "What worries me," says University of Illinois accounting professor Andrew D. Bailey Jr., "is that there's another Enron coming around the bend."

To critics, there is a basic disconnect between the Big Five and the broader public outrage. "The whole culture of auditing is based on disclosure, yet the practices of the industry have defied this in recent years by embracing a fortress mentality," says former SEC commissioner Arthur Levitt Jr. who battled in 2000 very publicly with the industry over his proposal to limit consulting.

Whatever shape the final reforms take, they must reach to the heart of the conflicts that have damaged the auditing profession. As the debate begins, here are seven proposals that could go a long way to re-establishing the public trust:



The Enron disaster has awakened investors to the accounting crisis. Roger C. Hamilton, a portfolio manager at John Hancock Value Funds, managed to unload his 600,000 Enron shares at $14 to $15 last fall before the stock totally collapsed, but he still suffered a substantial loss. Now Hamilton's joining the call for government oversight of the profession: "Then, I think, they would have to play by the rules of the game."

Under the current system of self-policing, it's difficult to figure out who's even in charge. Administered by the AICPA, an industry trade group, is a series of groups that are supposed to monitor auditor independence and audit quality. The Public Oversight Board (POB) is charged with ensuring that the public interest is considered in the oversight of auditors. But the POB relies entirely on the CPA firms for its funding and has no authority to investigate, no subpoena power, and no power to punish infractions. An offshoot, the Quality Control Inquiry Committee (QCIC), investigates the roughly 50 cases of suspected audit failure raised in lawsuits each year. It too has no subpoena power and works entirely from public documents and anything the firms may volunteer. Separately, the AICPA runs a system of peer review. Although smaller firms have occasionally been censured by their peers, no Big Five firm has ever failed a review.

Today, even the industry has conceded that this system needs work. According to Ernst & Young chief Turley, the Big Five are working with the SEC to find a way to modify the peer-review process as well as ways to improve the quality of disciplinary proceedings. "The idea that the whole system is broken is wrong," says Charles A. Bowsher, chairman of the POB. "But with the series of alleged failures in the past two or three years, it needs to be looked at and strengthened."

That won't be enough. In light of the questions being raised about the profession's integrity, there is a rising call that oversight be taken out of the hands of the CPAs. The SEC's Pitt is contemplating transferring both auditor regulation and discipline to a new self-regulatory organization (SRO) staffed and overseen largely by outsiders who would take over the review process. The group's board would be dominated by public members. But this too may fall short if it leaves the setting of audit standards in the hands of the AICPA.

Former SEC chief accountant Lynn Turner wants any SRO to also make its findings public. Turner says a properly functioning auditor SRO would work almost like the respected National Transportation Safety Board. "When an airplane crashes in the morning, that night the NTSB is out investigating, and the airline is right there with them. Within a year they come out with a report on what went wrong and mandate certain things get fixed so it doesn't happen again," says Turner. "That's what our SRO needs to do."

But while it sounds good, creating such a body will be far from easy. First of all, to have real power it requires action by Congress, which in a shortened election year already has plenty of other things to do. How it will be funded is sure to be a topic of long and hot debate. Also, the history of SROs has been far from pristine. While the NTSB is highly effective, an auditor SRO is apt to be more like the National Association of Securities Dealers, which has had a spotty record of regulation, critics say. And any SRO must be set up in such a way, says a former senior official at the SEC, "that the whole system isn't hijacked by the firms. The accounting profession is very creative at taking over every group that's ever tried to rein it in."



What Arthur Levitt couldn't achieve in a year of public hearings, speeches, and backroom bargaining, the Enron scandal may now accomplish. "Ten years from now the auditing profession will look back at that debate on independence and consulting as a missed opportunity," says Jack T. Ciesielski, a CPA and editor of The Analyst's Accounting Observer. "Had they willingly gone along with some changes then, maybe they wouldn't look so bad now."

That accountants have become increasingly dependent on consulting is clear. In 1993, 31% of the industry's fees came from consulting. By 1999, that had jumped to 51%. In 2001, for example, PricewaterhouseCoopers earned only 40% of its worldwide fees from auditing, 29% coming from management consulting and most of the rest from tax and corporate finance work, reports the International Accounting Bulletin. More telling, in a study of the first 563 companies to file financials after Feb. 5, 2001, the University of Illinois' Bailey found that on average, for every dollar of audit fees, clients paid their independent accountants $2.69 for nonaudit consulting. Puget Energy (PSD ), based in Bellevue, Wash., had the greatest imbalance, paying PricewaterhouseCoopers only $534,000 for its audit, but over $17 million in consulting fees. "That's 30 years of audit fees in one year for nonaudit," points out Bailey. Marriott International Inc. (MAR ) had a similar imbalance. It paid Andersen just over $1 million for its audit, but more than $30 million for information technology and other services.

The industry and others argue that conflict of interest is rarely the subject of litigation and that consulting work can provide a better understanding of the company and improve the audit. Still, in many people's minds the rising importance of consulting has contributed to a decline in auditor skepticism. It simply looks bad to have Andersen earning more on consulting to Enron than on auditing.



On September 11, 2001, while the world was glued to the television, Ellen Seidman, director of the Office of Thrift Supervision, testified before the Senate banking committee. Seidman was there to tell the story of the failure of Superior Bank, an Oakbrook Terrace (Ill.)-based savings and loan partly controlled by Chicago's Pritzker family, which had collapsed in spectacular fashion last July. As part of her presentation, Seidman outlined the role of auditor Ernst & Young in the failure of the bank and its write-off of $270 million and argued vigorously for auditor rotation. That would "result in a periodic `fresh look' at the institution from an audit perspective to the benefit of investors and regulators," she said. Ernst & Young blames a large subprime loan portfolio, declining interest rates, and a deteriorating economy for the bank's failure.

Fans of mandatory rotation of auditors argue that scandals like Waste Management, where income was overstated by $1.4 billion, would never occur if the auditor knew that within a few years it would be out and a competitor would be reviewing its work. Opponents say that rotation could create more problems, since new auditors need time to learn about a company. They prefer the current system of changing audit partners periodically but keeping the same firm in place.

Rotation has the advantage of being relatively inexpensive to implement. "It's a wonderful thing," says John H. Biggs, who as chief of pension giant TIAA-CREF selects a new auditor every seven years. "If you want a really good peer review, that's the way to do it. You would break through all of these independence issues very clearly and neatly with rotation."



When the POB began its 2000 review of auditing effectiveness, it brought in a sleuth, Central Michigan University professor Thomas R. Weirich, to do a study of audit failures. In his review of 40 failures that led to government enforcement actions, he found in a number of cases that the Big Five auditors "did not take that extra step, do that extra work" that would have uncovered the problem. In several cases, for example, at companies that generated their bookkeeping journal entries on computer, unusual manual entries would suddenly appear at yearend, massaging the numbers. The auditors, Weirich says, "didn't ask why."

Some say that any auditor should ask that question, but one way to spur their skepticism might be to introduce some forensic auditing techniques into the average audit. Since revenue-recognition issues and the establishment of reserves are two of the most common reasons for earnings restatements, zeroing in on those hot spots could be the subject of such forensic review. The downside? Some fear that "forensic" audits might end up little more than an excuse for auditors to raise their prices.



The June 19, 2001, SEC enforcement action against Arthur Andersen as auditor of Waste Management from 1993 through 1996 paints a damning picture of cronyism at the waste hauler. Besides the fact that Andersen had audited the firm since before its 1971 initial public offering, from 1971 until 1997 every chief financial officer and chief accounting officer at Waste Management had previously been an auditor at Andersen, according to the SEC.

The SEC charges that Andersen audits had begun to pick up irregularities as early as the late 1980s and that in "its original audits for 1993 through 1996, the engagement team had identified and documented numerous accounting issues underlying misstatements that the restatement ultimately addressed." But those discoveries did not prevent Andersen from giving Waste Management's inaccurate financials their blessing. When Waste Management finally came clean in February, 1998, it wiped out $1.4 billion in previous earnings.

Of course, many companies have similar rotation between their accounting staff and audit firms and never run into problems. And there are legal obstacles to limiting people's freedom to work where they like. But there is still the concern that the numbers might not be scrutinized with the necessary vigor when your old partners are adding them up. Henry R. Silverman, CEO of Cendant Corp., a franchising company based in New York, was embroiled in the 1998 accounting scandal at CUC International, a direct marketer Silverman's company had merged with that was later found to have inflated pretax income by $500 million. Silverman has a policy of not hiring people from his auditor, Deloitte & Touche. "It goes to the perception of independence," says Silverman. "It might not have anything to do with reality, but perception becomes reality."



In 1999, an SEC blue-ribbon commission recommended that audit committees be made up solely of independent directors, each of whom should be financially literate, with at least one having accounting or financial management expertise. But when the U.S. stock exchanges moved on the recommendations and adopted new rules for listed companies, they were something else entirely.

Under the New York Stock Exchange rules, directors on the company payroll are permitted, former employees and their families can be allowed after three years, and audit committee members with a "significant business relationship" with the company are also acceptable if the board determines the ties won't interfere with their judgment.

Had the SEC recommendations been adopted verbatim, half of Enron's six-member audit committee likely would have been barred from service. One member has a $72,000-a-year consulting contract with the company, and two others are employed by universities that have received significant charitable contributions from Enron, its Chairman Kenneth L. Lay, and their foundations. "The problem for corporate directors is that a lot of companies are doing what Enron did," says Russell S. Reynolds Jr., chairman and CEO of the Directorship Search Group Inc. "Nobody but maybe the CFO has the slightest idea what the magnitude of the dealings are, and the audit committees certainly don't. It's a hell of a mess." Chairman Dick Grasso says the NYSE will look to the SEC for guidance on any further changes.



Accounting has become increasingly complex just as business has. "Accounting standards have become so complicated that the challenge is understanding the complicated accounting principles rather than understanding the basic aspects of a company," complains a comptroller of a major industrial conglomerate.

To many, the industry standard setter, the Financial Accounting Standards Board, is too slow to respond to change with new rules. It has been considering rules on special-purpose entities--the partnerships that were at the heart of Enron's troubles--for more than 20 years. As the debate on international accounting standards heats up over the next few years, front-and-center should be a drive toward making them clear, pertinent, and timely. In need of urgent attention are clear-cut rules on materiality and how pro forma numbers are tallied and how that relates back to net income. Pitt of the SEC is one who plans to push for an overhaul of FASB. His goal: to get standards made in "months, not decades."

Would all of this have prevented the implosion at Enron? Perhaps not. For all the rules and overseers that may be created in its wake, there is, of course, no substitute for personal integrity. "You're trying to regulate human behavior, and that's going to be difficult at best and oftentimes impossible," says Cendant's Henry Silverman. While it may be impossible to legislate good behavior, a better monitor, the right rules, and some punishment for unethical acts would help. Certainly they would go a long way toward restoring the public's confidence in the bruised auditing profession.

By Nanette Byrnes in New York with Mike McNamee in Washington, Diane Brady and Louis Lavelle in New York, Christopher Palmeri in Los Angeles, and bureau reports

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