Rules and Regs
Accounting Debacles Spark Calls
For Change: Here's the Rundown
By STEVE LIESMAN, JONATHAN WEIL and MICHAEL SCHROEDER
Staff Reporters of THE WALL STREET JOURNAL
Not long ago, accounting was boring. Today, with controversy swirling around a growing list of companies, it's a hot political and pocketbook issue.
With the profession facing a credibility crisis, a wide array of critics -- from members of Congress to small investors to officials of the big accounting firms themselves -- have begun calling for a major overhaul of the accounting system. "This may be the critical juncture," says Abe Briloff, a professor of accounting at New York's Baruch College.
What should be done? There is little in the accounting industry that isn't on the table. Even though the profession has proven adept at defeating reforms in the past, some major changes now seem inevitable. The industry's current system of regulating itself now seems headed for the dustbin. Auditors who break the rules are likely to find themselves on the end of far stiffer penalties than they now face. Companies soon will be issuing clearer and more detailed disclosures of what they're up to -- both on and off the books. And the issue of who will determine accounting standards promises to be a heated debate occupying Congress, industry and regulators for many months to come.
Here are some major reforms on the table:
Separate the Siamese Twins
Of all the revelations from the Enron Corp. scandal, none has seemed more absurd -- and yet fixable -- than the dual roles played by its auditor, Arthur Andersen LLP. The accounting firm helped structure the very partnerships whose off-the-books treatment it later would approve as auditor, according to Enron. Revelations of the debt carried by these so-called special-purpose entities would later help sink the company.
That wasn't all. Andersen also did a good chunk of Enron's internal auditing -- work that it later approved as the "outside" auditor. In all, the $27 million of extra work Andersen did for Enron in 2000 exceeded the auditing fees by $2 million.
To some accounting professors, this bespeaks a profession that has abandoned the "public" in certified public accounting. Such outsize payments for nonaudit work create the appearance -- if not the reality -- that accounting firms will go easy on the audit to hold on to the more-lucrative consulting business.
Andersen says it doesn't believe its independence as Enron's auditor was compromised. Still, responding to public pressure, the firm this week said it will stop accepting new assignments for certain technology-consulting work or internal-audit work from U.S. clients that are publicly held.
As stock prices tumbled in the past week amid widespread concern about accounting irregularities, several high-profile public companies such as Walt Disney Co. announced they would no longer hire their auditors to do consulting work. All of the Big Five accounting firms chimed in with statements that they also now believe that some kinds of consulting projects don't mix with auditing.
Auditors already are prohibited by the Securities and Exchange Commission from providing certain consulting services, but loopholes remain. They could soon be closed by Congress. The American Institute of Certified Public Accountants has said it won't oppose legislation that adds a ban on auditors performing internal-audit work or technology consulting for their clients, two of the biggest hot-button issues.
But some say the prohibition doesn't go far enough. Mr. Briloff, for example, wants auditors not to perform any consulting work for anybody. "I want them to be the priesthood," he says.
Some critics also would like to bar an outside accountant who audits a company's books from later taking a top finance job at that company. Philip Livingston, president of Financial Executives International, a professional group, favors a three- to five-year ban on the so-called "revolving door" that, for example, placed several Arthur Andersen partners in key financial positions at Enron and vice versa.
"It seems hard for the audit team to maintain their independence if their former bosses are over on the other side," he says. "The worst thing is when you have too many people going from the audit team to the client -- folks think about their career path." Mr. Livingston adds that FEI's board has yet to endorse a prohibition.
New Cops on the Beat
As revelations emerge about the breakdown of the auditing process, lawmakers have begun calling for new independent oversight of auditors. Members on both sides of the aisle have lambasted self-regulation by the accounting industry.
Currently, rule-making and oversight functions are administered by a hodgepodge of mostly industry-sponsored panels. Oversight and discipline nominally have been handled by the Public Oversight Board, with funding from accounting firms. The POB has few weapons in its enforcement arsenal, including a lack of subpoena power and little ability to impose penalties. The American Institute of Certified Public Accountants, the profession's chief lobbying and trade group, sets audit standards and runs a much-criticized program that reviews the quality of firms' audit procedures.
Fixing the system almost certainly must be done through both congressional and SEC action. As a starting point, policymakers are debating the merits of a new oversight organization proposed by SEC Chairman Harvey Pitt, formerly a private attorney who has represented each of the Big Five accounting firms and the AICPA.
Conceding that the accounting industry is facing a "crisis of confidence," Mr. Pitt negotiated with the industry a rough agreement to form a new "private-sector" oversight panel. As envisioned, the panel -- whose board would be "dominated" by non-CPA members -- would have full power to investigate wrongdoing by accountants and regulate auditors.
Chief among criticisms of Mr. Pitt's plan is that it's a repackaged industry self-regulatory group, funded by fees from public companies and accountants. Critics also believe Mr. Pitt shouldn't leave the job of setting audit standards with the AICPA.
More-dramatic changes are also being debated. Ohio Democratic Rep. Dennis Kucinich is drafting legislation that would create a new independent organization that would audit publicly traded companies. The body, operating under SEC authority, would fund itself by charging fees for the audits.
Many lawmakers and accounting experts believe the final answer is a hybrid of Mr. Pitt's plan and others being floated. Former SEC Chairman Arthur Levitt, who led a campaign to clean up accounting fraud and stiffen auditor-independence rules, says it's important for a new oversight body's management and funding to be "totally independent of the industry." Former SEC Chief Accountant Lynn Turner believes a new oversight group should be modeled after the National Transportation Safety Board. The advantages for investors would be that, as the NTSB does with airplane crashes, the new accounting group would communicate with the public, promptly and thoroughly preparing reports on audit failures.
To have teeth, the disciplinary panel must have subpoena power. How a new panel will be funded will be hotly debated. Federal funding seems unlikely.
Reforming the Rule-Makers
To some critics, the road to reform passes through a corporate campus in Norwalk, Conn. There, the Financial Accounting Standards Board, a private-sector body that's funded largely by the accounting industry itself, sets standards for the financial statements that investors must rely upon.
If some legislators have their way, the board would be history. Tuesday, two members of the Senate Banking Committee, Democrat Christopher Dodd of Connecticut and Republican Richard Shelby of Alabama, signaled they believe that the task of setting accounting standards should be left to the federal government.
What's wrong with the current standard-setting process? For starters, the public meetings at which rules are discussed usually are sparsely attended. The board and advisory council that oversee it are dominated by members of the accounting industry. When outsiders are present, they tend to be finance executives at corporations that stand to benefit from favorable decisions, or accounting professors whose endowed positions are financed by Big Five accounting firms.
The board has long been criticized for producing rules too complex for most investors to reasonably understand. The board's newest standard on the financial contracts known as derivatives, for instance, is 804 pages. To critics, the board's members have been too slow to address festering problems and too quick to cave in on critical issues when pressured by big corporations and members of Congress acting on their behalf.
Two cases in point: For two decades, the board has been deliberating the issue of when companies should be required to consolidate onto their balance sheets the debt of certain subsidiaries. But amid objections by companies that would have to disclose they carried more debt than they report to their shareholders, the board's members have become endlessly bogged down over crafting a definition for when one company "controls" another.
On the issue of how to account for stock options used to compensate employees, FASB board members long have unsuccessfully pushed for options to be counted as expenses on companies' income statements. As such, they would depress earnings. That explains why many companies opposed the rule, which FASB scrapped under congressional pressure in 1995.
If there's one systemic flaw that colors nearly every aspect of accounting literature nowadays, it's this: Over the past three decades, the standard setters have moved away from establishing broad accounting principles aimed at ensuring that companies' financial statements are fairly presented. Instead, they've moved toward drafting voluminous rules that may shield auditors and companies from legal liability if technically followed in check-box fashion. But taken together, those rules can produce financial statements that present a distorted picture of economic reality.
The FASB's chairman, Edmund Jenkins, says he believes that accounting standards should be left to the private sector and that the board is trying to streamline its procedures. "I think except for the stock-option issue, we've been successful in resisting pressures," Mr. Jenkins says.
Opening the Books
Shedding more light on companies' finances today would help eliminate many future problems, say advocates of greater corporate disclosure.
Regulators already have warned companies they need to more completely disclose key details in financial statements filed with the SEC. For instance, they're pushing for more detail on transactions between companies and their affiliates or executives.
They also want to force more disclosure in news releases. A growing number present their earnings on a "pro forma" basis, "as if" certain expenses didn't exist. Pro forma earnings can be misleading, because the exclusions typically are considered normal business expenses under generally accepted accounting principles.
Long reluctant to tackle the problem for fear of running afoul of First Amendment protections for free speech, the SEC finally spoke up in December. It warned companies that they could face civil-fraud lawsuits for touting misleading numbers; the regulators said companies must fully explain how their pro forma results are calculated.
Investors aren't demanding more transparency only from companies. There is also growing demand for greater transparency from auditors -- and even the SEC. The commission's files are full of correspondence between companies and SEC accountants that shed light on the aggressiveness and propriety of corporate accounting practices. But the SEC's Freedom of Information Act division is so backlogged and riddled with bureaucracy that requests for information routinely take months to complete, leaving market-moving information stored away in filing cabinets collecting dust.
As for auditors, last year marked the first time that companies were required to disclose the amount of fees they paid their independent accounting firms for nonaudit services. Yet the required descriptions of those services remain vague at best. That leaves the public unable to determine how much a company paid for routine tax work -- as opposed to how much it paid the auditor to structure an off-balance-sheet partnership containing billions of dollars of hidden debt.
The major accounting firms, including Arthur Andersen, also are floating an idea under which auditors would issue more detailed opinion letters. Rather than simply giving qualified or unqualified certifications of companies' financial statements, an alternative would be to rank companies on their levels of conservatism or aggressiveness and explain to readers how their clients' approach to accounting affects the companies' financial statements.
Stiffer Discipline
What do the accounting profession's top disciplinary bodies do when an accounting fraud is revealed?
They can't do much -- at least not right away. Disciplinary actions generally are left to the American Institute of Certified Public Accountants. The institute's policy is to wait until all pending litigation and government investigations are completed before taking any action. That process can take years. Even the institute -- and its former attorney, Mr. Pitt -- say the current process isn't effective.
While the AICPA is fairly responsive when it comes to disciplining members convicted of crimes, such as drug offenses, it's far less aggressive at pursuing auditors that helped clients cook their books. That's also been true of U.S. attorneys, who rarely pursue large white-collar crime cases like accounting fraud because of their daunting complexity and the difficulty of proving criminal intent. SEC fines don't pose much of a deterrent now, either. Consider the SEC's $7 million fine against Arthur Andersen last year over its botched audits of Waste Management Inc. In the settled complaint -- in which Andersen neither admitted nor denied wrongdoing -- the SEC accused the firm of committing financial fraud by certifying financial statements that it knew were false and misleading. The commission's public-relations arm touted the fine as the largest against an accounting firm in U.S. history. But that $7 million was less than 10% of the $79 million that Waste Management paid Andersen in 2000 for audit and other services.
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