Stiffening the auditors’ backbones (written with Bryan Carsberg)

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The debacle of Enron has shaken core assumptions about auditors and auditing . A new accounting standards body needs to be appointed to maintain the integrity of corporate reporting.

Enron and Andersen have turned auditing intofront-page news. Political attention has focused on the possible conflict of interest when the same firm provides both audit and consultancy services. But this is not the fundamental problem. Prohibition of dual roles would not remove the pressures on auditors. The essential conflict of interest is in the audit process itself.

So long as the auditors of a company are, in practice, chosen by the executives of that company, and the principal relationship is between the auditors and the finance director, it is very difficult for auditors to maintain objectivity.

If policemen were selected and paid by burglars, we would not expect the job to be well done; and even the brightest student will hesitate before seeking out the toughest examiner. Independent audit committees have a role to play. But the members of an audit committee usually lack resources, capacity or inclination to probe into the detail of the figures. Nor would the problem be solved by requiring rotation of auditors. An individual or a firm that establishes a reputation as a difficult auditor is much less likely to be chosen at the next rotation.

Enron is not a one-off problem, unlikely to recur, but an extreme manifestation of a general issue. Competition between auditors makes it hard for them to be too critical. Furthermore, accounting standard-setters, as currently organised, cannot provide a complete solution. In most countries, including Britain, accounting standards are set by boards dominated by currently practising auditors and finance directors.

Even in the international and the US boards, where almost all members work full-time and observe independence rules, attempts to toughen accounting standards find it hard to win acceptance from a constituency in which the leading accounting firms and their finance director clients weigh heavily. Think, for example, of the continuing battle over the treatment of share options.

The evolution of accounting standards would be difficult enough without these political pressures. But the financial world becomes ever more complex and new forms of contract constantly emerge – some for good commercial reasons, others with the principal purpose of enabling companies to massage their financial reporting. In any event, accounting standards bodies today only determine principles – they do not supervise implementation. The quality of corporate earnings appears to be lower today than it has been for many years.

The haemorrhage of clients from Andersen shows that the market does, to some extent, work. Even burglars who hire their own policemen will find these individuals less compliant if their associates and colleagues must also obtain work from honest citizens. And the good student will not want a completely supine examiner, because no one will attach much value to his marks.

But competition still produces a race towards the bottom, even if it does not normally lead all the way down. During the dotcom madness, analysts and investment banks abandoned scepticism in the face of competitive pressures. In US higher education, grade inflation has become rampant as colleges vie for applicants and instructors seek to attract students to their courses.

One option might be to recognise that maintaining high standards in reporting by the corporate sector is a public function, not a private one, and so break the link between the finance director and the auditor. Auditors would rotate – and be appointed by, and ultimately be accountable to, securities exchanges or governments rather than the company itself.

The trouble is that regulating the appointment of auditors would not be enough. It would have to be supplemented with regulation of fees and prescription of the content of audits. It would necessarily become intrusive and inefficient. It would amount to nationalisation of auditing and this would be a poor solution.

The best approach is to have a free market in audit and consultancy services, as at present, combined with a new kind of statutory regulation of the audits themselves. This regulation might best be undertaken by an accounting standards body whose responsib-ility was not just for accounting standards but for the standards of accounting. Such a body could be developed from existing accounting standards boards, no doubt with some constitutional changes, inter alia to secure greater independence.

The new regulatory function would be quite different from that of audit’s existing disciplinary bodies. As with bank or educational regulators, the audit regulator would investigate regardless of whether a complaint had been made and the fact of an investigation would involve no stigma. Such a body would have the duty of examining a sample of audits before the financial reports were published.

Auditors and finance directors could be cross-examined about questionable accounting treatments, and obliged to provide information about future commitments and other contracts in derivatives, joint-venture arrangements, revenue recognition, measurement of intangible assets, allowance for impairment of assets and other devices that can be used to boost profits, or to disguise them.

Experienced audit practitioners generally know well what the questionable areas are and, when working for the regulator, would put their fingers on the difficulties most of the time. The regulator would have the power to require additional disclosures in financial reports. People under examination would face penalties for giving information dishonestly. Most importantly, the incentives facing both auditors and their clients would change. Independence on the part of auditors would become a competitive advantage, not a competitive problem.

The new role we propose would give invaluable background for recognising those issues that should be dealt with in new standards. The object is not to name and shame but to use the threat of naming and shaming to give auditors the backbone to stand up to their clients. It is to restore the ethos of public service and public obligation that has been eroded as accounting has moved from liberal profession to competitive business: the ethos that seems to have been sadly deficient in Andersen’s Houston office.

John Kay is an economist. Sir Bryan Carsberg was secretary-general of the International Accounting Standards Committee, 1995-2001

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