Who Audits the Auditors?
January 17, 2002
The New York Times
By ARTHUR LEVITT
A s four government agencies and six committees of
Congress begin to investigate the Enron failure, it's
important to recognize that this is not just about Enron
and its auditor, Arthur Andersen. We need to look at the
entire system of gatekeepers - auditors, corporate
boards, analysts, ratings agencies, investment bankers,
lawyers and accounting standard-setters - who operate
and regulate our financial markets. The confidence of
individual investors depends on honest, independent
gatekeepers. Sadly, the collapse of Enron shows this
system urgently needs reform.
I know how tough a task this is. When I was chairman of
the Securities and Exchange Commission, we put into
place a number of reforms to improve audits and minimize
conflicts of interest. But we were largely unsuccessful in
persuading accounting firms to separate their auditing
businesses from their consulting businesses and in
convincing the auditing profession to do a better job of
policing itself. Congress and federal regulators should use
this scandal to demand some long overdue changes.
Our financial reporting system - which is supposed to
inform investors about the health of companies - has in
many respects devolved into a numbers game. Companies
can't afford to disappoint Wall Street's earnings
expectations, so they are tempted to push their earnings,
even to the point of deception. And aggressive or
sometimes creative accounting is often overlooked by
auditors preoccupied with the desire to preserve lucrative
auditing and consulting contracts.
At the S.E.C., I advocated imposing significant limits on
accounting firms' performing auditing and consulting
work for the same client, and maybe we should reconsider
those limits. At the same time, we need to establish a
regulatory body, possibly appointed by the S.E.C., to
oversee the accounting profession, particularly the big five
national accounting firms that audit the vast majority of
publicly owned companies. This is the best way to ensure
that auditors are truly independent. Such a panel must
not rely on industry funding. It should be able to set
auditing standards, obtain testimony and documents, and
discipline unprofessional conduct. Its conclusions should
be made public.
We need to strengthen corporate boards. Boards, and
especially directors who sit on audit committees, often fail
to ask management tough questions. Too many directors
fail to see their role as an important public responsibility.
To change this attitude, stock exchanges, as a condition
for listing a stock, should require at least half the
directors on a company's board to be independent. For
example, these directors should not be allowed to take
consulting fees, use corporate aircraft without
reimbursement or receive benefits like corporate support
for their own favorite charities. In Enron's case, at least
three board members would have been disqualified under
a strict test of independence.
The chain of loyalty must change, too. The auditor's
primary loyalty must be to the board and investors.
During my time at the S.E.C., boards were given the
responsibility for hiring, and if necessary for firing, the
outside auditor. In addition, the audit committee, not
company management, should pre-approve any
consulting contracts with the audit firm. Such approval
should be granted rarely, and only when the audit
committee decides a consulting contract is in
shareholders' best interests.
The Financial Accounting Standards Board - a private
organization, supported by corporate contributions, that
sets auditing standards - needs greater ability and
freedom to set new and tougher rules when necessary. Its
decisions on new standards can be agonizingly slow. This
important agency must also be free from Congressional
pressure, which is often applied when powerful
corporations seek to undermine new accounting rules
that might hurt their earnings.
One way to help the F.A.S.B. move faster is to give it
adequate, independent financing. A broad-based user fee
should be assessed not only on publicly traded companies
but also on institutions like mutual funds, securities firms
and commercial banks that do not now support the
F.A.S.B. but that depend on the transparency its
standards provide. The stock exchanges, which in the past
have contributed little, should pay much higher fees.
Some stock analysts willingly overlook dubious accounting
practices because their compensation is tied to bringing
in financial deals to the investment banks for which they
work, not to exposing accounting half-truths. The stock
exchanges, which oversee analyst behavior, need to
finalize a uniform code of conduct that requires analysts
and their firms to disclose clearly all current holdings in,
and investment banking relationships with, the
companies whose shares they rate. Analysts should not be
allowed to trade the stock of any company for which they
have issued a recommendation in the last 30 days.
Credit ratings agencies should show greater
accountability. Because they have quasi-public
responsibilities, they should reveal more about how they
operate. The S.E.C. should also assess their impact on the
markets and consider requesting new authority to oversee
their operations.
Lawyers, who can play crucial roles in revealing or
obscuring financial problems, should review their own
ethics codes. Under the American Bar Association's
ethical standards, lawyers who uncover wrongdoing by
clients cannot report it to the S.E.C. or local authorities.
This inherent conflict needs to be addressed.
The Enron crisis is an opportunity to reinvigorate the
checks and balances in the financial system. Bringing
more transparency to company statements, ensuring the
independence of public-company auditors, ending the
numbers games that companies play and revealing
analysts' conflicts can help restore public confidence in
our markets.
Arthur Levitt was chairman of the Securities and Exchange
Commission from 1993 to 2001.
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