by Lee Berton
Is accounting an exact science? The audit of Enron, which collapsed and sent shivers through the United States economy and stock market, certainly proves that it is not.
Andersen, Enron's outside auditor, blames the accounting and auditing models and other shortcomings of the capital-raising mechanism for missing the pervasive holes in Enron's operations and financial reporting.
And outside auditors along with Andersen have long cited the so-called principles of materiality for avoiding the reporting of every little financial wiggle. But the courts and legislators have, on occasion, offered another point of view: If there is a possibility of fraud, then every little financial transaction is important.
Materiality once involved 5 percent of profits, assets or what have you. Now, with increased public scrutiny, it can (and should) mean informing the investor if any skullduggery is suspected, no matter what the amount.
Ted O'glove, the former editor and writer of "The Quality of Earnings Report," which years ago forecast the problems of IBM before any other analyst saw it coming, feels that materiality is a crutch that auditors should shed.
He feels that there will always be accounting scandals under generally accepted accounting principles because it permits companies "to be aggressive, middle-of-the-road and liberal, all under the same set of guidelines." He adds: "It's an open invitation to hide all sorts of problems - and the auditor is tempted to go along with the scams."
With this Enron scandal again focusing public attention on the question, "Where were the auditors?" the spotlight of regulators and Congress will again shine on the accounting profession. And no matter what the size of the accounting firm, the scrutiny will certainly not help accountants maintain their reputations, which are so necessary to their professional stature.
O'glove asserted that all financial analysts are "held hostage to the companies they look at." But he feels that accountants could do a better job as auditors if they would just probe deeper into corporate operations. "Look at all the layers, the off-balance-sheet transactions, the total amount of debt and whether it is growing too quickly and whether the income is being front-end loaded," he said.
Douglas Carmichael, former vice president of auditing for the American Institute of CPAs and Wollman Distinguished Professor of Accounting at Baruch College, in New York, feels that the fall of Enron has many lessons to offer the accounting profession.
"Here are some the questions that auditors should always ask themselves," he said. "Do outside special purpose entities have real economic substance? Who really controls them? If a client is setting up hedges and swaps, are they really working? Are receivables really legitimate and is there any possibility that they are spurious?"
Carmichael said that auditors should pay attention to all red flags and realize that "no client is worth bending the rules for." He feels that the Enron case will "hurt the reputation of the accounting profession and that of Andersen, itself, as the outside auditor."
He felt that current steps to keep auditors independent of clients, such as rotation of the engagement partner every seven years and peer review every three years "are not working effectively." He maintained that auditors need backbone, better judgment and higher ethical standards to avoid being tied in with client companies that "cook their books."
Some supporters of the accounting profession have sometimes blamed rogue partners of big accounting firms for wearing blinders. But the Securities and Exchange Commission has eliminated the Independence Standards Board, because it didn't do its job, because it moved too slowly or because it hid behind the shield of litigation fears.
Carmichael cited numerous audits, that he feels didn't do the job: Microstrategy, Jamaica Water & Power, Businessland and Waste Management. All have called into question whether auditors can and will blow an early whistle if the client is recognizing spurious profits.
Years ago, this writer looked into the audit of MiniScribe, a company that shipped bricks to its warehouses to create profits, and found that there are many auditors at lower levels in big accounting firms who want to stop financial fraud. But they can be overruled by their superiors and are told to keep quiet about what they have learned. Or they are brainwashed into believing that certain lapses are not material to the financial report.
It was a sad lesson for the entire accounting profession. But as one philosopher once asked: "Are accountants doomed to repeat the mistakes of the past?" The outcome of deliberations by regulators and Congress and many court suits and the reaction of the profession itself to the Enron debacle may, one day, provide us with some answers.
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