This week, we're turning Under the Radar over to the readers. Last week's column quoted a certified public accountant raising questions about the world of corporate accounting and the role of independent auditors of public companies.
Those comments came in the wake of Enron's (ENE) implosion, as many wondered whether the company's auditors, Arthur Andersen, should have known more about the aggressive accounting practices that led to Enron's demise. The accountant claimed the independence of auditors has been compromised by the lucrative consulting practices of the large auditing firms.
Nearly 200 of you -- including scores of CPAs -- responded to my request for comments. Here is a sampling:
Hold Auditors Accountable
As soon as auditors begin to be held accountable, auditing will again function as a watchdog for the stockholders! Let the auditors feel the pain along with the stockholders and we will be able to sit back and watch the fur fly -- fines, penalties, civil suits and lifelong suspension from practice.
In all fairness, though, auditors don't guarantee the accuracy of the numbers, only that the processes that generated them appear to be proper. The public should be educated that an audit report is not a guarantee. Of course, that raises the issue of the Enron board? Where were they?
Just as the investment banking interests polluted the analyst integrity in the brokerage industry, the consulting interests corrupted the auditing function. My read is that you can take an analyst recommendation or leave it. However, an auditor has a fiduciary responsibility to attest to the veracity of financial statements. By overlooking manipulations and material matters that can affect the financial worth of an enterprise, the auditing function has failed and allowed misleading financial statements to go unchallenged. No penalty can be too severe for auditing firms that shirk their responsibility.
The Auditing Conundrum
I was an auditor for many years with a national firm before I moved into the litigation-support arena. I made the move because the work was more challenging and because it was more profitable and thereby was a better career path. That I made this change in the '80s is relevant to analyzing the Enron auditing mess.
I read the comment in your column from a CPA about consulting services driving the audit. While I think this is true, I think it is important to look back and see why this happened. I don't think that there is any doubt that it occurred because, in the late '70s and '80s, the accounting firms turned auditing into a loss leader. The larger firms underbid each other when companies considered changing their auditors to the point where they made little or no money, counting on either raising the fee over time if they retained the client or supplying other services on which they would make money.
The fact that the audits were losing money had several very bad results. First, the auditors looked for ways to do the audits cheaper and cheaper in order to make money. Budget pressures became intense. Second, it made the consulting groups the profitable groups and the groups with clout within the firms. Third, it meant that firms that did auditing were always looking for ways to turn the audit/review/compilation relationship into more so that they could profit from the relationship.
It is the decline of the audit as an important and profitable service (many clients think of the audit as a necessary evil, one which they would do away with if the
or the bank didn't require it) that has led to these spectacular audit failures.
As an additional note, I have worked on litigation relating to various high-profile audit failures. These are always failures of people. Inexperienced, untrained staff are inadequately supervised; senior members of the team are too close to management; slavish adherence to the budget as a priority discourages following up on possible red flags. All of this works if there aren't underlying issues, but puts the audit at risk of failure where there are these underlying issues.
It is also interesting to note that, in Europe, many countries require the auditing firm to do simply that and nothing but that.
Name withheld by request
I understood the comments of the accountant completely. In the 1970s I was determining my career path. My degree was in accounting and I was working for a large financial institution in "information systems." I was deciding whether or not to go for my CPA and work for one of the large firms.
I chose not to because I could see the direction that auditing and accounting were going. I agree with your commentator's statement that "during that time this never could have happened." The auditor in the 70s did the work and uncovered the flaws, errors and fallacies.
Over the years, the large firms' focus on consultancy gradually eroded the disclosure and smoothed over the discrepancies. Minor flaws were corrected (i.e.: the account had to balance to the penny). Major flaws were disguised or smoothed over, without being significantly corrected. I do not mean to imply there was dishonesty, only a shift in focus. I chose not to follow auditing and accountancy because I didn't want to have the rigorous work I would do be lowered to the level of insignificance.
I agree with the need to separate, by law, the practice of "independent" auditing and consulting.
Same Song, Second Verse?
Is this not very similar to the relationship between brokerage analysts and their investment banking departments? The side that gets the biggest fees and then goes on to become most profitable for the firm will dictate the guiding policies of that firm. That's how Morgan and Goldman were able to earn those fat fees -- they had their analysts shilling for them.
People tend not to believe the brokerage firms' opinions anymore, or at least give it a lot less weight than before. But to most anyone you or I talk to about the auditor's final opinion, if a company receives a nonqualified opinion from their auditors, that clean bill of health is almost taken as gospel. The very trust that is placed with these auditors has now been violated. They appear to have put their own self-interest above the rules of their profession. They should lose their licenses, and go to prison. If that is done, I believe these firms will think a little harder before they do something like this again.
Seems a little off to blame the auditing mess on the consulting business. That would be like saying that political campaign contributions might affect a politician's view or vote on a subject. That never happens.
And, that's just the tip of the iceberg. Of course, if you have additional thoughts, please shoot me an email. We'll keep the auditing issue and its impact on investors front and center on our radar.
In the meantime, our radar screen will be focused on Santa's sleigh come Dec. 24, and we wish all of you a very happy holiday!
Christopher S. Edmonds is president of Resource Dynamics, a private financial consulting firm based in Atlanta. At time of publication, neither Edmonds nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send it to