13 May 2002  Op-Ed

A Cure for Enron-Style Audit Failures

In an opinion piece in the Financial Times, Harvard Business School professor Jay Lorsch argues for legislation to create an independent, self-regulatory organization to oversee accounting firms. Enron, he says, is not an isolated incident.

 

If companies and regulators are ever to learn from the collapse of Enron—and prevent similar corporate debacles in the future—they must look more closely at the relationship between auditors, managers and the company audit committee.

The Enron scandal is not an isolated accounting failure. Over the past five decades, accountants have changed from watchdogs to advocates and salespersons. Auditing has become one of a number of services, including consulting and tax advice, in which accountants "sell" creative tax avoidance and financing structures. Accountants enable their clients to account for transactions under generally accepted accounting principles (GAAP) while reducing transparency and aggressively maximizing earnings and debt.

Creative accounting is part of the competition among auditors that has led to lower profit margins. As a result, the firms have sought more efficient and cheaper methods that undermine quality audits.

The audit committee must have the leadership, independence and information to oversee the auditors and their relationship with the management.
— Jay Lorsch

This race for profitability and the failure of many auditors to maintain high professional standards cries out for legislation to create an independent, self-regulatory organization to oversee accounting firms. Accounting would remain in the private sector, but the government would be involved, which is critical to restore confidence. The SRO would have rule-making, supervisory and disciplinary powers similar to those of the stock exchanges. And, like them, it would be overseen by the Securities and Exchange Commission. The SRO board should balance members of the accounting profession with a majority representing the public interest.

Company boards require less reform and, in general, existing law is adequate. The main problem lies in the failure by boards to follow procedures that would hold managements accountable for company performance. This could be improved by focusing on three areas.

The first is leadership. The independent directors must have a leader who does not also hold the position of chief executive officer. Where the CEO and the chairman are the same person, a lead director should be chosen from the non-executive directors.

The chairman of the audit committee must also be an effective leader. The New York Stock Exchange requires that members of the audit committee be independent and financially literate, and that at least one have accounting or equivalent experience. The audit committee chairman should have this experience and the leadership to insist on full and complete discussions.

These qualities should ensure a strong relationship with the audit partner, who, though working with the management, must understand that his ultimate responsibility is to the audit committee.

The second area for improvement is independence. The audit committee, along with most of the board, must be independent. The NYSE provides a definition of independence that, if complied with in spirit as well as letter, is sufficient.

Furthermore, the auditors must also be independent, with no unrevealed ties to the company. While the Big Five have abandoned consulting, they continue to provide other services. Accordingly, each audit committee should either restrict its auditors to an audit role or publicly disclose the reasons for any other relationship.

Auditors should be rotated every few years to prevent long-term, close ties between the management and their firm. The audit committee should also prohibit the management from hiring audit firm personnel for three years after the person has left the firm. Meetings of the audit committee should start and end with an executive session without the management, and the committee, as part of these sessions, should meet alone with its auditors.

Last, information must be improved. The committee should be supplied with information regarding alternative GAAP methods that would result in different accounting outcomes and with figures outlining those differences. The reasons for the committee's acceptance of the management's and the auditor's recommendations should be disclosed in the financial statements.

The audit committee must also ensure that all analyst and press reports about the company's accounting and disclosures are reviewed. Both the management and the auditor should be required to address negative comments and the committee should decide whether changes are necessary.

Audit committees are the board's vehicle to monitor financial reporting. However, neither the audit committee nor the board is a guarantor and neither has an obligation to ensure perfect accounting or disclosure. They must use reasonable efforts to ensure management and auditors fulfill their obligations.

To accomplish this the audit committee must have the leadership, independence and information to oversee the auditors and their relationship with the management. Without them, the next Enron could be waiting just around the corner.

Excerpted with permission from "The Cure for Creative Accounting," Financial Times, April 10, 2002.