MARCH 2006 - The past five years have witnessed a widely
perceived ethical breakdown of a trusted fiduciary institution that has
been at the epicenter of a number of financial scandals: the public
accounting profession. Although Arthur Andersen received the most
notoriety, the entire profession was stigmatized. Enron, WorldCom,
Global Crossing, Tyco, and other corporate collapses were widely
seen as a failure of the profession, which is commonly viewed as a
public watchdog of the honesty and accuracy of corporate financial
statements they audit.
The impact of the scandals on investor confidence was striking. In
October 2002, the General Accounting Office (GAO; now the
Government Accountability Office) issued a report on the impact of
nearly 700 financial statement restatements by public companies
between January 1997 and March 2002 due to audit failures and
accounting fraud. Those restatements resulted in an estimated loss to
the shareholders of the restating companies of $100 billion. The report
states that investor confidence in June 2002, one month before the
enactment of the Sarbanes-Oxley Act (SOX), —was at an all-time low
due to concern over corporate accounting practices.“ Monthly surveys
indicated that 91% of respondents agreed that —accounting concerns
are negatively impacting the market“ and 71% agreed that
—accounting problems are widespread in business.“
Viewed from a larger perspective, the conflicts of interest at the
core of the corporate accounting frauds can be characterized as a
corporate governance issue. Corporate governance is monitored by
several gatekeepers, internal and external. The primary internal
gatekeeper is the corporate board of directors. Internal auditors, in-
house legal counsel, and audit committees are other internal corporate
governance gatekeepers. The external influences are many and include
external auditors (i.e., CPAs), government (e.g., the SEC) and
nongovernment regulators (e.g., the New York Stock Exchange),
investment bankers, and security analysts.
When it comes to the reliability of public company financial
statements, however, the reality is that an auditing firm is, by far, the
most competent and best-situated gatekeeper. Corporate directors and
officers are often the source of the accounting irregularities and can
usually negate objections or warnings by other internal gatekeepers.
Regulators are typically too far removed and may lack the necessary
expertise to detect the problem at any given company.
What Led to the Breakdown?
Nonauditing revenue and conflicts of interest. Beginning in the
1970s, client loyalty faded and the auditor-client relationship changed.
Auditing became a low-profit activity as research found that clients
increasingly searched for the lowest prices and the loosest standards.
Yet competition for audit clients rose in the 1980s despite declining
profit margins for auditing, because of the high profitability of the
numerous new consulting and other nonaudit services being offered.
With this enticement, the financial incentives for auditors to become
advocates for their clients‘ accounting practices were stark and
undeniable. A conflict of interests inevitably arose. How audit firms
responded laid the groundwork for the recent scandals.
These new services put pressure on the independence of the
auditors, especially the large firms–and, as the Supreme Court
indicated in the Arthur Young case, independence is the polestar for
auditors. In some cases, the expansion of CPA firms into the new and
highly lucrative nonauditing services for audit clients, sometimes
referred to as horizontal integration, clearly compromised their
objectivity. SEC Chairman Arthur Levitt was a prominent critic of
these arrangements, claiming that —auditors did not want to do
anything to rock the boat with clients, potentially jeopardizing their
chief source of income“ (Take on the Street, 2002).
As the major firms grew through horizontal integration, they
dominated the profession. Former employees went to work within the
industry, amplifying the already significant influence the major firms
had over the accounting institutes, most notably the AICPA. The
hegemony of the major firms led some to believe that the profession
did not have an independent voice (E. Kliegman, —The Demise of the
Profession,“ Accounting Today, Jan. 27, 1999). The startling growth
in nonaudit services precipitated a pervasive perception that public
accounting firms lacked independence from their biggest clients [Zeff,
—How the U.S. Accounting Profession Got Where It Is Today: Part
II,“ Accounting Horizons, 17(4), 2003]. The major firms, who had the
most at stake, vigorously opposed reforms proposed by the Public
Oversight Board to eliminate the growing conflicts of interest arising
from auditing and consulting for the same client.
The unwillingness of the profession to address the problems
created by its conflicts of interests was discussed, in devastating
detail, in a SEC draft report, commissioned by thenœSEC Chairman
Levitt and published by The Wall Street Journal (J. Weil and S.
Paltrow, —Peer Pressure: SEC Saw Accounting Flaw,“ Jan. 29, 2002).
The report describes how peer reviews of the major firms found
numerous instances of auditing improprieties due to conflicts of
interests that cast serious doubt as to the auditors‘ independence.
Despite the severity of their findings, the reviewing firms always gave
positive feedback in the public parts of the review, including a review
of Arthur Andersen‘s professional standards by Deloitte & Touche
just before the Enron scandal.
The SEC‘s draft report was highly critical of the peer review
process. Beyond simply changing the process of auditor oversight, it
recommended changes in the way accounting and auditing standards
are set. (In this regard, it was an augury of SOX reforms.) But the
SEC‘s project was shelved when Levitt was succeeded as SEC Chair
by Harvey Pitt in August 2001.
WorldCom‘s June 2002 announcement that it had overstated
earnings by $3.6 billion led to the passage of the SOX legislation. The
AICPA and its allies thus tried to weaken the implementation and
enforcement of the law. It was critical for them to find the right person
to head the PCAOB. When it was found that John Biggs, the retiring
head of TIAA-CREF and the initial candidate to head the PCAOB,
might favor the PCAOB‘s writing its own rules (most important, a ban
on consulting services for audit clients), the AICPA lobby and its
allies in Congress and the White House pressured Pitt to rescind the
offer (Levitt, Take on the Street, and R. Kuttner, —So Much for
Cracking Down on the Accountants,“ BusinessWeek, Nov. 18, 2002).
Prior to his appointment to the SEC, Pitt had represented both the
AICPA and the Big Five. He was the principal author of the AICPA‘s
1997 white paper opposing the SEC‘s proposal to severely curtail the
consulting work that accounting firms could do for companies they
audit. This impression was reinforced when he rescinded the PCAOB
offer to John Biggs and instead appointed William Webster, a former
head of both the CIA and the FBI. When Webster‘s involvement with
U.S. Technologies, a troubled company for which Webster had served
as chair of the audit committee, became a front-page scandal, both Pitt
and Webster were forced to resign their respective positions.
Audit partner compensation. The pressure to accept unduly
aggressive and questionable —earnings management“ when a client
was also a source of consulting revenue was reinforced by auditor
compensation policies that rewarded partners who generated the most
business rather than those who delivered the highest-quality audits
(American Assembly, The Future of the Accounting Profession,
2003). In her book about her service at Arthur Andersen, former ethics
consultant Barbara Toffler observed that auditors were punished if
they required a restatement of a client‘s financial reports (Final
Accounting: Ambition, Greed and the Fall of Arthur Andersen,
Broadway Books, 2003). Consulting-oriented compensation systems
further tempted the accounting gatekeepers to forfeit their autonomy.
Reduced auditor liability. Beginning in the 1980s, managers
increasingly used earnings management to meet Wall Street analysts‘
expectations, often with auditor approval (M. Stevens, The Accounting
Wars, Macmillan, 1985). As a result, auditors increasingly found
themselves targets of lawsuits. Thereafter, auditors would approve
aggressive statements if the increasingly complex and prescriptive
accounting rules from FASB were followed to the letter. If the rules
were followed, the financial statements were fair, or alternatively, if
the practice was not prohibited, it was permitted. The now-infamous
special-purpose entities used by Enron to keep liabilities off the
balance sheet were allowed under GAAP.
The major firms obtained Congressional passage of the Private
Securities Litigation Reform Act of 1995, which reduced plaintiffs‘
incentives to sue secondary participants such as auditors (see Zeff,
2003). A sharp increase in the number of earnings restatements
followed in the late 1990s. Restatements by the companies listed on
the NYSE, Amex, or Nasdaq tripled between 1997 and 2001,
according to the GAO. Of the restatements from 1997œ2002, 39%
were attributable to premature recognition of income.
The battle over stock option expensing. For years, an intense
battle was waged over the accounting treatment of stock option
compensation. The widespread use of nonexpensed stock options is
generally thought to have led to inflated stock market valuations,
excessive compensation, accounting frauds, and bankruptcies.
Inasmuch as corporations do not write checks when granting options,
they argued that there is no cost and, thus, nothing to expense.
(Options do have a cost to other shareholders, because once exercised,
they dilute the value of existing shares.) In 1994, FASB considered
the nonexpensing of options to be deceptive accounting, and was
prepared to put out a rule that would require that companies expense
options at their fair market value. But strong lobbying by the business
community and the accounting profession defeated the proposal in
1994 and effectively kept it off the table until the recent corporate
scandals.
In the aggregate, this history describes a profession that has taken
no substantive steps to resurrect its former image as a trusted public
fiduciary. Despite its role in financial scandals and eroding investor
confidence, it has instead sought to find safe harbors in FASB, GAAP
rules, and liability-limiting legislation.
Reforms. The principal governmental reform vehicle of public
accounting, of course, has been SOX, with its major restrictions on
public auditors and creation of the PCAOB. Auditors are prohibited
from offering eight specific types of consulting or other nonaudit
services to their audit clients. In addition, the lead audit partner must
rotate off an audit every five years. Another restriction seeks to
resolve the —revolving door“ phenomenon by requiring that —the CEO,
Controller, CFO, Chief Accounting Officer or person in an equivalent
position cannot have been employed by the company‘s audit firm
during the one-year period preceding the audit“ (section 206).
All of these measures, however, fall short of more far-reaching and
effective measures. For example, auditors can still provide tax and
other nonprohibited services to audit clients if the audit committee
approves. The SEC had proposed adding tax compliance and planning
services to the list of prohibited services, but backed off after harsh
attacks from accounting firms (J. Glater, —SEC Backs Rules for
Auditors, Revised from Original Plan,“ The New York Times, Jan. 23,
2003). It is also a curiosity why the law allows the PCAOB to grant
specific exemptions from the eight prohibited nonaudit services.
With respect to rotating the lead auditor partners, a more effective
reform would have been to bar the entire audit firm and not just the
lead auditor. The SEC had originally proposed requiring all partners
on the audit team, not just the lead auditor, to rotate every five years,
but, again, backed off under pressure.
If the law is to be effective in preserving and fostering auditor
independence, the rotation periods should be as short as possible and
cover the entire firm. While annual rotation may not be economically
feasible, rotations longer than two years would likely compromise the
—total independence from the client at all time“ mandated by The
United States v. Arthur Young et al. [(1984) 465 U.S. 805].
The ban on former auditors is also inadequate. A mere one-year
ban is insufficient to prevent conflicts of interest. Moreover, there is
no bar on transfers from the auditor to higher-level positions within
the former audit client that are directly below positions such as the
CEO, CFO, and controller. Last year‘s auditor, for instance, can
immediately become an assistant vice president of accounting, wait a
year, and then step up to one of the restricted positions.
The most substantial reform of SOX, and one that largely
overcomes the deficiencies of sections 201, 203, and 206, is the
reinvigorated role of corporate audit committees under the new law.
SOX section 301 requires that an audit committee composed entirely
of independent members of the board of directors be directly
responsible for the appointment, compensation, and oversight of
outside auditors. The audit committee is charged with resolving the
management-auditor financial reporting disagreements that result
from conflicts of interest. The audit committee is independently
funded and must establish —whistleblower“ procedures for handling
complaints, including anonymous submissions by employees.
Furthermore, the committee has the authority to engage outside
counsel and other advisors it deems necessary to fulfill its duties. At
least one member of the audit committee must be a financial expert;
finding qualified individuals who are independent may prove difficult.
SOX clearly made inroads in reducing the potential conflicts of
interests for auditors. But SOX can also be criticized for what it did
not do. Conspicuous by its absence was any attempt to resolve the
options-expensing battle (although that was eventually done by
FASB). And while it removed some opportunities for acquiescing in
accounting irregularities, SOX did not strengthen any deterrence to do
so for those opportunities that remained. Specifically, it left the Public
Securities Litigation Reform Act of 1995 nearly untouched. As long
as a corporate governance gatekeeper has a financial tie to a
corporation, as does an external auditor that also provides nonauditing
services to its client, there will remain the need for a gatekeepers‘
gatekeeper.
This appraisal of SOX‘s ineffectiveness was supported by the
findings of a recent survey of executives from multinational
corporations (J. Whitman, —Sarbanes-Oxley Begins to Take Hold,“
The Wall Street Journal, March 25, 2003):
• Only 9% agreed that SOX —is a good and adequate response to
problems in accounting and reporting.“
• Only one-third agreed that SOX will —restore investor
confidence.“
• Half of finance chiefs and managing directors agreed that SOX
will have —no impact“ at all.
Regarding the accounting treatment of stock options, in 2004
FASB proposed a rule mandating the expensing of stock options. And
the opposing forces, including the public accounting industry, again
mounted a counterattack through proposed Congressional legislation.
This time, however, the proposal survived and took effect in June
2005. The new rule did not mandate a method for expensing use, but
nearly 300 public companies had already voluntarily decided to
expense options when the standard took effect [C. Schneider, —Who
Rules Accounting,“ CFO 19(10), 2003].
Proposals
If dissatisfaction with public accounting ethics and practices–
influenced in no small part by the public image projected by the
profession–crosses the threshold of tolerance in the investing
community, new restrictive or punitive legislation would be possible.
For example, SOX could be amended to preclude auditors from the
most lucrative consulting services for audit clients. Additionally,
auditor liability for accounting fraud or other irregularities could be
expanded.
But remedies imposed by legislation and regulation have innate
limitations. They can, for example, be financially onerous or
otherwise impracticable. Ideally, needed remedies could be fashioned
by the auditing profession alone or in conjunction with the regulatory
body. Recently, the 103rd American Assembly of Columbia
University convened to consider the future of the profession in light of
its current problems. There were 57 individuals from the top ranks of
business, government, academia, and the accounting profession. Their
report (2003) makes certain recommendations addressing the
following issues.
One recommendation seeks to restore the importance of the quality
of audits by establishing different systems of compensation incentives
for audit partners. Emphasis should shift from rewarding those who
generate new business and the cross-selling of nonaudit services to
those who perform top-quality audits. The Assembly suggests that the
PCAOB verify the quality of audits.
Another recommendation seeks to disabuse financial-report users
of the common misconception that a proper audit can determine with a
high degree of precision whether management has accurately
portrayed a company‘s finances–what the Assembly refers to as —the
illusion of exactitude.“ While this reliance may have been more
defendable for traditional companies, in a knowledge-based economy,
a large percentage of corporate assets are intangible, requiring
estimates and assumptions. Valuation of these assets inescapably
involves management subjectivity, and the auditor‘s review requires
judgment rather than the formulaic application of rules.
To shatter the —illusion of exactitude“ with regard to financial
statements, the report recommends the adoption of a variety of new
reporting formats and new attestation standards for auditors. Auditors
would continue to use the current wording to vouch for concrete,
nonspeculative items, such as historical costs. But for speculative
items that don‘t have usable historical costs or reliable market prices,
a more limited attestation standard regarding procedure could be used;
for example: —The corporation‘s judgments regarding estimated fair
value used a clear and seemingly reasonable process.“ The auditor‘s
statement would not attest to the estimate itself. Some values may be
presented as a range of numbers, like management forecasts. The
overall goal is greater financial-statement transparency.
The logic behind this recommendation is sound. Whether
government, investors, or creditors would accept it is another matter.
It shifts the burden of making new and subtle distinctions to the users
of financial statements. Recognizing that the adoption of new
reporting formats and varying CPA attestation standards may create
uncertainty and unpredictable reliance, the report also recommends
reduced auditor liability. The caveat is that although a tradeoff of
greater transparency for reduced liability is also reasonable, it would
not, on that basis, conduce renewed investor confidence, which, in the
current climate, is the overarching immediate objective.
The last recommendation is the most obvious, most essential, and,
perhaps, most elusive. It is simply that the Big Four should reassert
the prominence of ethics and professionalism. The American
Assembly‘s report exhorts them to —maintain a culture in which the
only acceptable behavior is the most ethical.“ This was once self-
evident, but has become obfuscated. Before the scandals, Arthur
Andersen had long been recognized as the gold standard among CPA
firms for integrity and high standards. Its self-destruction is a
metaphor for the tarnished image of a once proud profession and a
clarion call for rededication to its primary, fiduciary role.
The Image of the Profession
The appearance of a public accountant‘s independence from client
manipulation is of critical significance to investor confidence. Yet
notwithstanding recent financial scandals that have tarnished its
reputation, the profession has done little to restore that confidence.
Rather, its overall performance bespeaks a continuation of acting in its
clients‘–and its own –financial interests, instead of the public
interest. If the profession is to avoid public condemnation–and,
perhaps, restrictive new remedial legislation or regulation–it would
be well served to return to its previous emphasis on ethics,
professionalism, and independence from client influence.
Franklin Strier is a professor in the accounting and law
department at California State University Dominguez Hills, Carson,
Calif.
