After Enron, New Doubts About Auditors

Washington Post ^ | December 5, 2001 | David S. Hilzenrath

[liberallarry]

The collapse came swiftly for Enron Corp. when investors and customers learned they could not trust its numbers. On Sunday, six weeks after Enron disclosed that federal regulators were examining its finances, the global energy-trading powerhouse became the biggest bankruptcy in U.S. history.

Like all publicly traded companies in the United States, Enron had an outside auditor scrutinize its annual financial results. In this case, blue-chip accounting firm Arthur Andersen had vouched for the numbers. But Enron, citing accounting errors, had to correct its financial statements, cutting profits for the past three years by 20 percent -- about $586 million. Andersen declined comment and said it is cooperating in the investigation. More.

[liberallarry]

What do the professionals say? I wonder if it would be possible to make private settlements of lawsuits involving accounting fraud illegal? Too much is being hidden.

[Joe Hadenuf]

Enron disclosed that federal regulators were examining its finances, the global energy-trading powerhouse became the biggest bankruptcy in U.S. history.

What a difference a few months makes.

[2ndMostConservativeBrdMember]

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[vrwconspiracist]

Fraud involving collusion is difficult to stop through internal controls, and its detection is beyond the scope of most external audits. With ENRON, they set up/bought entities that GAAP accounting rules do not require to be consolidated, allowing the overall entity to be much more highly leveraged than the financial statements clearly disclosed. They made disclosures re insider/related party trades, but the required format for those disclosures did not clearly communicate the underlying risks (note that some analysts went short ENRON months ago...sophisticated readers of financial statements were able to pick up at least the "smell" of problems). Finally, mark-to-market accounting for derivative instruments and the new rules that allow/require gains on such instruments be booked into current income although the cash will not be received until future periods, if the market doesn't reverse itself, allowed them to "inflate" current income, all again within accounting rules. The FASB should look at the issue of the timing of income recognition on derivative instruments.

[discostu]

I've discussed this one with the accountants around work (we do accounting software so there's a few) and here's how they see it:
Item #1 it's important to remember that the auditing firm Enron used is a subsidiary of their accounting firm. This has been accepted as an OK practice in the past but most accountants consider it the wolf gaurding the hen house. You're supposed to have two different places run your books and audit your books.
Item #2 the auditing firm did recommend correction that we as much as 50% of gross revenue. Enron decided that the amount was immaterial (which is hilarious, no accountant would call 50% of an important number like revenue immaterial no matter what that number was) and did not make the changes. Auditors have no actual power, all they can do is make recommendations. They can (and should have in this case but didn't) file issuances with the accounting boards that a client is not following their recommendations (sort of a formal way of telling the world that it's not your fault these people are going to go to jail). They can also refuse the contract next year (regardless of the length of contract, in the accounting world failure to comply with recommendations is a violation of any contract and allows the auditor to walk away at no loss) if the client has a history of ignoring their recommendations. Niether of those steps were take, at which point you should refer back to point 1.

Over all the auditing process, when followed correctly by both client and auditor, is great. The problem is that when the chicken gaurds the henhouse good practices aren't followed and the auditing becomes a formality and not allowed to function the way it should.

[eno_]

Any bets on the next big one to go down in flames and bad accounting? Computer Associates? Softbank?

[David]

Over the course of the last thirty-eight years, I have been counsel to a number of public companies and have dealt extensively with accountants over matters which were reflected in financial statements, both for public companies and large private companies whose financial statements were often at issue. I am an accountant myself as well as an attorney. After adoption of the ABA policy on "audit letters" (letters from the attorney to the accountant describing certain legal matters which might have an impact on financial statements), I signed all audit letters from my firm to accountants and did so with a view to making technically correct and complete disclosure of exactly the impact of such matters on the financial condition of the company because of my concern about matters reflected here and the goal of keeping my law firm from getting sued for making inaccurate, misleading, or incomplete disclosure of such matters.

In defense of Arthur (Arthur Andersen), they are one of the finest--they have many of the best people; work the hardest; have considerable expertise; and usually do an excellant job. That is in fact true of most of the large national accounting firms--they all hire very good people who work hard and attempt to do good work.

However Arthur, like all of the large public accounting firms, faces an irreconcilable conflict of interest. Their primary public mission is to attest to the reliability of financial statements published by the company. Their principal profit activity is getting people to hire them both to expertise the financial statements and more important from a financial point of view, to give advice concerning tax, business and financial matters. They can't do both. Because to get hired, they often are required to compromise the disclosure they ought to require companies to make in order to get the company to hire them and keep retaining them.

What needs to happen is for the SEC to change the rules to effectively mandate the creation of accounting entities to expertise financial statements which entities have no other relationship with the enterprise for whom they are signing. I doubt that is likely to happen--again, because both the Commission and the accountants have incestious relationships and are both significantly influenced by the business establishment that does not want to make real complete full disclosure of its financial condition in the first place.

[Republicanus_Tyrannus]

I work with Discostu, and there is one initial correction I have to make. Their consulting firm (guys that design & monitor processes and accounting systems software) is the "independent" and "spun off" portion of Arthur Andersen. It's called Andersen Consulting. I put the "independent" in quotes because the opinion of nearly all of the accountants in my acquaintance is that AC is definitely NOT independent.

Discostu was quite right how stunned and disbelieving accountants are when faced with the statement from Arthur Andersen that 50% of revenue was "immaterial". This is beyond stupid.

Now, it may have to do with the combined balance sheet - I will have to look at it (plus have a heavy re-read of consolidated financial statements, pooling v. purchase method, etc ). I always hated consolidation, by the way. Anyway, they should have issued a qualified or adverse opinion - which they didn't.

There's going to be a few junior partners in Arthur Andersen with no certifications, no job, no future, and no money after this fiasco. If you screw up like this, you don't get to keep your certifications and no one will hire you.

[aculeus]

Their principal profit activity is getting people to hire them both to expertise the financial statements and more important from a financial point of view, to give advice concerning tax, business and financial matters.

Andersen has a rep of pushing for consulting services (tax especially) much more than other audit firms. Having had too much experience with them (as a client) I hope they suffer for the Enron fiasco.

[eno_]

You make a reasoned defense, but it falls short:

You can play by the rules and still get burned. Call it a lack of strong-enough ethics, or call it a lack of risk management in terms of how close you get to the line, but don't use it as an excuse.

There are many business environments with very weak regulation. Busiensses have to know how to handle these risks without a regulatory short leash.

[liberallarry]

"the auditing firm did recommend correction that we as much as 50% of gross revenue. Enron decided that the amount was immaterial (which is hilarious, no accountant would call 50% of an important number like revenue immaterial no matter what that number was) and did not make the changes.

Discostu was quite right how stunned and disbelieving accountants are when faced with the statement from Arthur Andersen that 50% of revenue was "immaterial". This is beyond stupid."

When I read this I have to pinch myself to make sure I'm awake.
The worst part is knowing that at the trial someone is going to spin this to make it look reasonable, and only professionals will know the truth.

[spudsmaki]

Auditors have no actual power

Auditors have ENORMOUS power, IF they choose to wield it. In their opinion of the audit, they can qualify, hedge, state reservations, and in general call the financial summaries a figment of Pro Forma results. It's the equivalent of a credit report. That is, if the auditor chooses. Too often, they don't.

Pro Forma means "without the bad news we don't want to tell you about." Auditors shouldn't be signing off any summary containing that statement, but they do.

Today Enron, tomorrow LTV Steel, next year Ford. Happy investing.

[bluetoad]

Like all publicly traded companies in the United States, Enron had an outside auditor scrutinize its annual financial results. In this case, blue-chip accounting firm Arthur Andersen had vouched for the numbers.

The Whole Auditing Process for Corporate America Has Been Flawed for the Past 20 Years or More.

01. Arthur Andersen is just one of the Big 5 (There use to be 8) Accounting Firms Doing the Auditing.
02. Arthur Andersen (any Big 5 Accounting Firm) is paid to give companies a clean bill of health financially that’s their job, and everyone in Corporate America knows it.
03. Arthur Andersen has a sister company Anderson Consultant which seem to get a kick back on contractors and temporary workers (usually paid over +$100/hr for menial tasks i.e. MS Access Querys) for companies that need extra help with the books.
04. Most Auditors or are young college graduates with accounting degree who recenely passed there CPA exams with less than 5 years of experience who do the work and are usually the most confused people you ever met about the company being audited.
05. Virtually no Auditor knows any business but accounting.
06. Every Accountant has a different way of categorizing accounts so they always recommend something, usually menial.
07. These people will believe any thing put in front of them. If it’s on the computer, It must be TRUE!!!


I believe this is part of what happened to Enron. Every Thing was on the Computer…
Seen it happen for 20 years.

[discostu]

That's true and further down in my post I do indicate some of the things they can do. What I mean is that, other than filing reports with 3rd parties, the auditors can't do the kind of stuff that companies really fear. When I talk about power in this sense think "send people to jail", I'd kind of like it if auditors could sic the SEC or FTC on somebody for ignoring their recommendations, as it is they can do a lot and if they do the things they can do they can make it very hard on you (try finding an account when your auditors have filed pro forma on you, none of the good ones will work for you after that) but it doesn't have the kind of teeth I'd like to see.

[discostu]

Actually I think they'll have a hard sell making that a defense, speaking as some one who isn't really an accountant by has been learning to think like one im/materiality is one ofthe hardest concepts to grasp; we have clients that just don't get it. The fret over something that will be +/- $20 every month and will probably even out over the year to +/- $40 or maybe even out entirely and they think it's huge so then we have to put really dumb changes in the system so they can make sure it's never off, which actually dramatically increases their work and their potential for error; but they don't want to hear it.

To the outsider if something in the books is wrong it's wrong and needs to be fixed, they can't grasp the idea that you expect some things to be wrong the question is HOW wrong. I can't see any way you could explain im/materiality to a layman jury that's not going to be inclined to believe the concept in the first place, and find a way to explain that 50% of gross revenue is immaterial. All the prosecuting atourney has to do is say this: So if your neighbor put up a fence and it took half your yard would you consider that immaterial? That will shut down that defense instantly. This is going tobe really interesting to watch.

[discostu]

Oh you sound like me three years ago, then I got to know accounting and found out I was full of it.

01. Arthur Andersen is just one of the Big 5 (There use to be 8) Accounting Firms Doing the Auditing.
Anderson is one of the big 5 that do most of the big account auditing, this is true to that point. By no means to the big 5 do all the auditing in the country, there are only a few hundred companies in this country big enough for the big 5 to even care about, the majority of the money that flows in this country is never looked at by any member of the big 5.

02. Arthur Andersen (any Big 5 Accounting Firm) is paid to give companies a clean bill of health financially that’s their job, and everyone in Corporate America knows it.
No, the job of auditors is to make sure the books are right. The way our accounting system is designed failing companies can be very profitable (has to do with asset depreciation mostly), and people do find out eventually if a company was really no good inspite of what the books said (the way we track stuff in America companies tend to actually look less stable than they really are). Because AA and AC have an incestuous relationship things started getting messed up. But again, if you look at the record AA recommended some serious changes to both the record and accounting practices at Enron but were ignored. The fault here is that AA then didn't turn around and file the auditing paper work an auditor should file when their recommendations are ignored.

03. Arthur Andersen has a sister company Anderson Consultant which seem to get a kick back on contractors and temporary workers (usually paid over +$100/hr for menial tasks i.e. MS Access Querys) for companies that need extra help with the books.
The relationship that probably contributed heavily to the troubles. On this you are quite correct.

04. Most Auditors or are young college graduates with accounting degree who recenely passed there CPA exams with less than 5 years of experience who do the work and are usually the most confused people you ever met about the company being audited.

Auditors are generally fresh out of college with little experience, they tend NOT to have their CPAs though; you can't even test to be a CPA until you've worked under a CPA for 4 years, so it's nearly impossible to find a CPA with less than 5 years experience. Auditors are not supposed to know about the company being audited, that's why auditing is done by outsiders. Auditors are supposed to look at the books, do some sample testing to make sure that what happened in the company was properly recorded in the ledger, when it isn't (there's always problems) they are to recommend repairing transactions to fix the problem and new accounting methods so they don't have to fix the same problem next year. If they are ignored the smart auditor will (this is where things went terribly wrong in the Enron case) file some forms with FAASB and/ or other organizations (I forget who all with) saying that this client doesn't listen to his auditors. This does thre things: if the client gets busted it saves the auditors butt, if the auditor doesn't want to put up with that client anymore it gives him a way out of the contract regardless of the other terms in the contract, and it tells other auditors and accountants that they might not want to work for this client. In the full analysis AA not filing this paperwork when Enron ignored their recommendations is really what caused this entire situation.

05. Virtually no Auditor knows any business but accounting.
While true this is completely meaningless. You don't have to know anything about any business to tell if the books are right. Books are books are books. The basic concepts of accounting have been around for a few hundred years and the rules are the same pretty much across the board (even across types of accounting (financial, cost, fund) most of the rules are universal).

06. Every Accountant has a different way of categorizing accounts so they always recommend something, usually menial.

Yes and no and so what. Most of the things that count have a universal categorization. Cash is an asset, money coming in is a revenue, money going out is an expenditure, debt is a liability. There are some complicated things that can be hard to figure out (contra assets, they still make my head hurt) but when in doubt you can always check your lefts and rights. That's one of the nice parts about the system, the only stuff where it could get confusing are on opposite sides of the equation. Sometimes it's hard to tell if something is a revenue or an asset, but if you guess wrong your transaction won't balance and you'll know you screwed up; same kind of thing with liabilities and expenditures. As for the actual account numbers, yeah everybody's is different but as long as the system actually makes sense nobody really cares, and making sense usually revolves around clustering, so long as all your assets start with the same digit (etc. etc. through the other account types) nobody cares. And if your auditor is actually talking about your account codes he's probably trying to make work for himself (unless they're not clustered, in which case do what he says).

07. These people will believe any thing put in front of them. If it’s on the computer, It must be TRUE!!!
And at this point is when you start to sound like an idiot. The job of the auditor is to believe NOTHING that is put in front of them. The assumption an auditor makes walking into a client's sight is that the books are a mess, nobody knows what's going on, and it's his job to save them from themselves. He assumes neither misfeasance (honest mistake) nor malfeasance (criminal intent) (that assumption gets made by a Certified Fraud Investigator, these are the Rangers of accountancy), but he does assume things are fubar. And auditors believe people more than they believe computers. They know that when people make transactions that person is probably an accountant and therefore should know what they're doing. When a computer makes transactions that computer was programmed by a non-accountant and therefore clearly the computer is confused and likely in error.

Auditors have it hard enough without people like you picking on them. They've got the least interesting job in accounting (not a particularly exciting profession to start with), and they're low man on the totem poll in the entire profession. The reason people with so little experience are pushed into accounting is simple: they're still pure and untainted. At least that's the theory, that fresh out of college these guys are still well steeped in theory and not as willing to accept shortcuts. Shortcuts are what make for bad books and that's the stuff auditors are trying to catch. And, when everybody does their part (listen to the auditors recommendations, file the right paperwork when the client ignores the auditors) the system works great and has worked that way for a very long time (a lot more than the 20 years you talk about). Unfortunately sometimes folks get too hungry for the bottom line and they don't do their part. But notice that even when that happens the auditors have provided all the papertrail needed to show that Enron screwed up and knew they were screwing up (if nothing else the auditors told them they were screwing up). Give credit where credit is do.

[bluetoad]

Auditors have it hard enough without people like you picking on them.

You poor smuck, I just call 'em the way I seen 'em for 20 years...

[bluetoad]

When a computer makes transactions that computer was programmed by a non-accountant and therefore clearly the computer is confused and likely in error.

And one more thing...

It's not that the company’s computers make a mistake. It's that the company computer makes a mistake in the company’s favor and decide NOT TO FIX IT BE BECAUSE THE “BOOKS” LOOK BETTER and the auditors couldn't find it, if there paints were on fire...

[bvw]

Eliminate the SEC and let the market dictate it's own policy and policing. Corruption can't ever be eliminated but it can be checked.

No person in the SEC because he/she is not personally at risk or benefit of a securities transaction is as proper or capable of assuring market integrity. Indeed, as government employees and agents, the SEC is indeminified and immune from its mistakes and the consequences of its actions. That is, the SEC has AIDs, a perpetual third-wheel at the party, yet without liability it is prone to infection with little remedy. It is a corrupting influence, even when it is not itself corrupted because it provides a best a false security and stands in the way of more aggressive private remedies.

[discostu]

There's no such thing as a mistake in the companies favor. If the mistake says there's more money in the company than there is they'll over reach and incur debt they can't afford (like what happened to Enron). If it says there's less money then they're undervalued. Billing mistakes if known and ignored are fraud, people go to jail for that.

Of course I don't expect you to listen. Since your entire answer to my long and well reasoned post was to call me a shmuck and not even spell it right. Oh well, sucks to be you.