Insist on ‘no surprises’


By COLIN LEINSTER

IN the second of a two-part article, Lynn Turner, the Securities and Exchange Commission’s (SEC) former chief accountant, provides some answers to a few questions on the Enron fiasco. 

 

Q: What’s the big message from Enron to members of audit committees? 

A: Enron has become the poster child for audit committees. And although we shouldn’t prejudge its audit committee – we don’t know if its members asked the tough questions or, if they did, who provided the answers and what the answers were – Enron should definitely sensitise audit committees to a number of issues, if they were not sensitised already. 

First, each committee member needs to be financially literate enough to understand the company’s financial statements and disclosures. If you don’t comprehend the basic economics of the business and how they are affecting financial statements, ask the CFO to provide some training sessions. 

Every committee member should examine closely the financial reporting and accounting policies for all significant transactions in the company. Committee members should ask both the CFO and the independent auditor if the accounting for transactions, as reported and disclosed in the financial statements, reflects the highest standard that could be used, and if not, why. 

This means the transactions are accounted for in a fashion that reflects the true economics of the transaction. I would ask the audit partner if he or she would change any of the accounting policies or numbers in the financial statements. 

I would also ask the CFO and the auditor if there were any information they would want if they were considering investing in a company that was not disclosed. The minutes of the audit committee provide a good venue for documenting the response. 

It seems that all too often audit committees find out about problems only very late in the day; material weaknesses in controls are highlighted by the independent auditor only after the audit was done or problems arose. 

In many cases, the audit committee only found out about problems when they surfaced during the course of an SEC investigation. 

The Financial Executives International, the US General Accounting Office and most recently the independent Panel on Audit Effectiveness (commonly referred to as the O’Malley Panel) have all argued for greater reporting on internal controls by management. 

I would encourage each audit committee to get an annual statement from the CEO and CFO that the company has internal controls and that they are operating effectively. Many public companies now follow a best practice of including such management reports in their annual reports. 

I would also request that the auditor provide the audit committee with all the comments he might have on the company’s internal controls. The message should be clear: “No surprises here!” 

It is important that the audit committee and independent auditor have open lines of communication and a clear delineation that the auditor is working for the audit committee. I would encourage audit committees to ask the auditor to identify the most sensitive accounting and auditing issues and to describe the steps he is taking to test whether those transactions are properly accounted for and disclosed. 

 

Q: Enron has also raised the issue of companies paying fees to audit firms for non-audit services. What’s happening there? 

A: In some cases, non-audit fees have amounted to 20 times the amount paid for the actual audit. The big issue is whether any of these extra services impair an auditor’s independence. 

The O’Malley Panel has recommended that audit committees pre-approve such services. The SEC has encouraged audit committees to consider various criteria that will help directors assess whether such services could impair an auditor’s independence. 

Audit committees should become more informed about the nature of the consulting that audit firms do for the company. 

A CFO might ask how to properly account for a specific transaction, and it’s good to get the auditor’s input at the earliest possible date. But sometimes an auditor is asked to help structure a transaction in a fashion that will reduce the level of disclosure or transparency to investors, lenders, rating agencies and others. 

I have seen accounting firms work with investment bankers to find ways for their corporate clients to get around a particular accounting rule. Audit committees need to ask their auditors if they are involved in any such assignments. If so, the committee members should ask themselves whether the shareholders they represent would consider this auditor to be the independent third party he’s supposed to be. 

 

Q: What does the Enron collapse mean to auditors and their reputation? 

A: There is no doubt that auditors have lost the trust and confidence of many shareholders. This isn’t just because of Enron, either. There’s been a constant parade of companies –Cendant, Waste Management, Xerox, Lucent, Rite Aid, WR Grace, Sunbeam, Micro-Strategy – where auditors dropped the ball. 

Auditors will have to make fundamental changes in how they do their work. The O’Malley Panel recommended two years ago that certain forensic auditing procedures be required and that current standards be reconfigured to provide greater detail in the procedures. Auditors also need to recognise that many financial frauds continue to involve improper revenue recognition, establishment of “cookie jar” reserves, and large, unusual adjustments. 

But there’s been no real progress in setting new auditing standards that would result in auditors working more effectively. Even existing accounting and disclosure standards and requirements are often ignored. 

We can have all the accounting rules one can write, develop new ones for SPEs or valuing derivatives, and require greater disclosure of key financial metrics or related-party transactions. In the end, none of that will matter if the CEOs and CFOs play the numbers game and cook the books, and if the auditors don’t stir the pot enough to figure out what’s being cooked and whether it is edible by investors and the markets. 

 

Q: How should shareholders feel about auditors? 

A: If you mean, “Is the current oversight of the accounting profession working?” the answer is no. The profession vigorously lobbied Congress and the SEC 25 years ago for the system of self-regulation that we now have and it has turned out to be far too self-serving. 

The profession has taken a much more proactive approach in Britain. Faced with public criticism as a result of frauds involving the Maxwell empire, BCCI, Barings Securities and others, it drafted a framework for a new regulatory-oversight mechanism. 

Some of the key elements include an oversight board called the Foundation and four separate boards. One reviews the work of auditors and the other boards. Two others set standards for audits and auditor independence, and the fourth is a disciplinary body. 

The eight or so members of the Foundation all come from outside the accounting profession, representing the Bank of England, the National Association of Pension Funds, and the like. The other boards either exclude accountants entirely or at least those currently in practice. 

 

o This interview is extracted from “What Directors Can Learn From the Enron Fiasco” by Colin Leinster in Corporate Board Member (March/April 2002). For more information, call MIM Customer Service at 03-2165 4611 or visit our website:

www.mim.edu. 

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