The growing number of earnings restatements over the past few years might suggest auditing firms have lost their way, although they're not about to admit it. Instead, they shift blame to the reporting system itself, calling it antiquated and "unresponsive."
That might be true, but it doesn't excuse the major offenders. After all, if the accountants are not accountable, what's to stop another disaster like
( ENE) from happening again?
The deterioration in accounting standards has become increasingly pronounced in recent years, as evidenced by a study conducted earlier this year by Financial Executives International Research Foundation. The survey found that 464 companies had restated their earnings in the last three years, more than in the prior 10 years combined.
Most people understand, if not condone, the accounting chicanery that goes on within companies as they try to make their earnings look as attractive as possible. But the fact that the watchdogs of the industry put their stamp of approval on these practices has raised more than a few eyebrows.
In a press release Tuesday, the big five auditing firms said they are committed to studying how to improve financial reporting in the wake of the collapse of energy trading giant Enron. But in an op-ed piece in
The Wall Street Journal
CEO Joseph Barardino made it clear that he believes outdated accounting rules are at fault.
The remarks were seen by some as self-serving, although at least one accounting expert agrees with the general sentiments.
"My thesis is that 'modern GAAP accounting' was developed in the '30s. So a system that evolved in a world where there was time to digest and analyze data is now used in a world where there is no such time," said Jeff Brotman, adjunct professor of accounting at University of Pennsylvania. "With much more complex transactions, and rules to cover them, this 'GAAP gap' gets much worse."
It's true that rapid changes have taken place in the marketplace over the last few years. The Internet boom created scores of companies with new business models that accounting firms were generally unfamiliar with. Enron itself tried to convince Wall Street it was a dot-com, transitioning from a regulated natural gas provider to an Internet infrastructure company.
Accountants "were used to boring audits on companies they understood. As new businesses were created they were not flexible at figuring out the changes," said Howard Schilit, an accounting specialist at the Center for Financial Research and Analysis.
Still, many experts and most investors are unforgiving. They contend that if auditors don't understand the rules of the game and can't adapt to changing market conditions, they should get out of the auditing business.
"It's like going to a doctor for an operation," said Schilit. "The doctor botches the job and then says 'I'm sorry, it was too complicated.' If you took on the responsibility and got paid for it, you have to be responsible when things go wrong."
It's impossible for any auditing firm to analyze every detail of a company's financial statement. But flagrant violations of basic accounting principles have become more visible now that the
Securities and Exchange Commission
has cracked down on the industry.
For instance, Andersen signed off on Enron's financial results, even though the company kept losses from certain limited partnerships off the balance sheet. The letter of the law may not be completely clear on this issue, but it's also hard to see how removing large chunks of debt from a firm's financial statement wouldn't obscure results.
Andersen failed to adequately explain Enron's dealings in its statements, according to some experts. The upshot: a $1.2 billion reduction in Enron's shareholder equity and a $1 billion charge in the third quarter.
Back in 1998, Andersen was also responsible for another accounting blunder at
( WMI), which resulted in a $7 million civil fine. The SEC said Andersen "knowingly or recklessly issued materially false and misleading audit reports on Waste Management's annual financial statements." In addition, Andersen agreed to settle a shareholder lawsuit for $220 million without admitting wrongdoing.
Other accounting firms have also failed investors.
Deloitte & Touche
blessed the results of
even though the company booked $42.2 million in revenue that never materialized. Meanwhile,
signed off on the results of
, despite the fact that the firm booked revenue in three quarters in 1998 and 1999 based on contracts it did not complete until after the quarters had ended.
Restatements R Us
The list of accounting irregularities goes on and on. This year,
( EMBX) are among those to have restated results.
Some suggest that auditors have relaxed their vigilance in recent years because of their growing reliance on consultancy fees.
"It doesn't take a full imagination to picture scenarios in which a degree of diligence might not be as great," said April Klein, professor of accounting at New York University's Stern Business School.
Andersen received $25 million in auditing fees from Enron but another $27 million in consulting fees last year. Andersen also received hefty fees in its dealings with Waste Management. According to an SEC official, Waste Management's consulting fees were five times what it paid for auditing.
Still, attempts to separate the audit and nonaudit businesses have so far proven fruitless, as many accounting firms contend that consulting work allows them to better understand their clients, and that this actually improves the quality of the audit.
In fact, most attempts to really alter the financial reporting system (that Andersen's CEO claims is at fault) have been opposed vigorously by the accounting industry.
To be fair, most accounting firms do a good job most of the time. But that's little comfort to those investors who have been misled and lost billions as a result.