A cure for Enronitis?

Providing non-audit services does not vitiate the independence of auditors

Readers of newspapers may justly feel that they have had their fill of articles on Enron and Arthur Andersen "" an embarrassement de richesse to the point of giving them indigestion.

In the process, Enron of course but the accounting profession also has been castigated ruthlessly and the latter have few, if any, defendants. It is perhaps worthwhile, even in the middle of this avalanche of barbs from every direction, to step back a little in order that in trying to adopt the numerous, no doubt well intended, suggestions for purifying the accounting professions and in particular, auditors, the baby is not thrown out with the bathwater.

To begin with, there is still a pervasive misconception about what it is that auditors are required to do. Put simply, they are asked to express an opinion on whether a set of accounts present "a true and fair view". This ancient, time honoured phrase has never been defined, but informed readers of auditors' opinions have a good consensual understanding of the meaning. Auditors do not, of course run the businesses whose accounts they audit, nor do they prepare the accounts.

The principles adopted for the accounting treatment of various transactions are also determined by those managing the business, no doubt with the concurrence of the auditors, but in the framework of the vast amount of pronouncements on the subject by the professional institutions all over the world.

Since auditors express a professional opinion based on a certain set of facts in the background of existing circumstances, they are on this point at par with other professionals exercising similar opinions on their own subjects "" a doctor giving a diagnosis, say, or an architect deciding that a certain structure will stand up (interestingly, there is a recent report in The Economist that a building designed and built by the famous American architect, Frank Lloyd Wright had developed dangerous cracks and subsidence and has had to be propped up externally). Auditors, like other professionals, are liable if they have not exercised their duty of due care and diligence and have done insufficient work on which their judgement is based "" but not only because their judgement itself proves to be wrong.

The test, broadly speaking, is how much work would a reasonably competent professional person consider it necessary to do to arrive at a judgement.

In the Enron case, no attempt has yet been made (though no doubt this will come during the hearings of the civil suits for damages) to examine whether enough work was done to be able to express an opinion.

There has also been criticism of the long and complicated notes to the accounts and the fact that US GAAP is so circumstantial, that it was possible to omit the consolidation of numerous "special purpose" entities "" the "form over substance" argument.

Without defending the voluminous and obscure notes to the accounts in which information in financial reports is only too frequently buried (and not only in the US!) it is possible to ask ourselves what the normal reaction of the managers of a business is when told that though the accounting principles and pronouncements of the country allow a certain treatment or presentation, in order to reveal the substance, a different treatment or presentation must be followed.

It is of course possible for auditors to refuse to sign an auditors' report or an unqualified report if they have an overwhelming conviction that revealing the substance is so vital for the readers of the financial statements that following the form would be totally misleading.

It is possible that such a situation did in fact exist and this will be revealed in the Civil Suit hearings "" however, Enron collapsed because it was unable to pay its liabilities as they fell due and this may have happened whether the special purpose entities were consolidated or not, though lenders may have become less generous at an earlier stage.

There are also allegations of fictitious income having been generated through these infamous entities. What we need to bear in mind in the heat and dust of the collapse and the shredding of documents, is that these complex matters have yet to be investigated, though there is little that can be added at this stage to the reports of the criminal indictment against Andersen for obstruction arising out of destruction of documents.

Numerous helpful suggestions are pouring in like a flood from every quarter regarding regulation of the auditing function of the accountancy profession. A concern widely expressed and bolstered by the concurrence of Arthur Levitt, the previous Chairman of the SEC relates to the provision of non-audit services by auditors to audit clients, which, it is argued has a tendency to vitiate independence. There are a number of things to be said about this.

First, no evidence has ever been produced to show that an audit failure has actually resulted from lack of independence caused by the same firm rendering non-audit services to the audit client.

Arthur Levitt admitted this and though it is not fashionable to say so, in the instance of Enron, no one has tried to prove that an audit failure (assuming it took place) occurred because of the provision of other services by the auditors. This is an ex-hypothesi conclusion, with no empirical evidence.

Second, it is by no means true that auditors, because of their audit relationship, automatically get other work. In most medium to large companies, much of the non-audit work is awarded on a competitive basis.

Third, quoted companies have audit committees and are already in a position to introduce whatever safeguards they wish. Paul Volcker has recommended for Andersen the structure of a firm carrying out audit work and nothing else.

Similar proposals, differing in degree, are being discussed widely. Such a structure will, if it is to succeed, need to ensure that firms are able to have networks to serve global or country-wide companies, keep abreast of technological developments and find ways of providing challenging and fulfilling careers to attract and retain high calibre people who will need suitable remuneration as well as the scope for professional development and diversity of work.

The Indian Institute of Chartered Accountants in an outburst of righteous activity has, without any public discussion or debate already activated rules which limit the amount of fees that a firm of chartered accountants can earn from non-audit work for audit clients that are listed or have a turnover exceeding Rs 50 crore. How can the premise be proved that up to 100 per cent of audit fees for non-audit work retains the auditors' independence, but 100.1 per cent does not? Why should unquoted companies with a turnover less than Rs 50 crore be excluded? Does the auditor in these cases remain independent even if the non-audit fees are 500 per cent of audit fees?

Fees for "representation before any authority" are excluded from the definition of non-audit fees' for this purpose, when such representation is precisely the kind of activity that could theoretically compromise independence since the auditor has to take the side of the audit client in the course of advocacy. Changes in the accounting standards and audit practices are certainly called for.

A measured, reasoned response to events will produce the appropriate long term framework for strengthening the hands of auditors, ensuring the protection of interests of various stakeholders and implementing the desired level of disclosure and discipline. Quick fixes are perhaps attractive but surely not the best option.

In closing, it is pertinent to remember that until October 2001, Enron was the darling of the investors, both retail and wholesale, the lenders, the analysts, the credit rating agencies, the stock markets, the management experts and (most of all?) the media.

The praise heaped on Enron's management, its business model, its adaption of technology, its profit record, the performance of its shares on the exchanges was not only fulsome but quite extraordinary.

Did none of the people singing this paean make money when the share was rising to $85. Did their audiences or the stockholders believe that these opinions were impartial, independent and "expert"? Was a duty of care and ethical behaviour owed to the readers (some of whom may have acted on the opinions expressed)? What, one may legitimately ask, happened to the judgement of all of these commentators and players in the drama? One thought which emerges from all the coals of fire now being heaped and the outraged moral postures taken all round is that the ancient love of human beings for blood sports is alive and well.