In Enron's wake calls for reforms: Forensic accountants and critics of the accounting status quo say that changes must be made -- and not just by creating more rules. (Accounting Analysis).

Editor's note: FEI's leadership has maintained that Enron's collapse was largely a failure on the front line of management. Separately, many accounting experts believe that its implosion demonstrates that the auditing function is in serious straits and that changes are imperative.

Accounting problems didn't start with Enron Corp., and Arthur Andersen isn't the only Big Five accounting firm to have had egg on its face -- although, in the case of Andersen's auditing of the now-bankrupt Houston-based energy giant, the smallest of the giant international accounting firms is sporting a Texas-sized omelet.

The flood of allegations of fraud, conflicts-of-interest, Byzantine use of rules and footnotes and the startling revelations of document destruction that have attended Andersen's auditing of Enron has truly put the auditing function in the public eye as never before. To many longtime critics of the accounting industry, the Enron debacle is a sad reminder that audits are capable of hiding weaknesses and propping up companies over long periods -- sometimes with devastating results for employees, shareholders, bondholders, suppliers and other constituencies.

Enron's collapse is also the final piece of evidence to many that the private-sector mechanism for auditing public companies, big and small, is in dire need of an overhaul. The former chief accountant at the Securities and Exchange Commission reckons that auditing troubles have resulted in shareholder losses amounting to a whopping $200 billion in just the last few years.

Industry critics, including former SEC Chairman Arthur Levitt, have long been agitating for wholesale reforms, such as barring accounting firms from consulting for companies that they audit. But many of these critics contend that, even with the raft of investigations into Andersen's accounting practices by Congressional committees, the SEC and the Justice Department -- as well as the staggering array of shareholder lawsuits faced by the professional services firm and Enron itself -- the result will be only marginal change.

"If you're defining the system as requiring additional accounting rules and auditing standards, my answer is that we have more than enough of those," says Howard Schilit, president of the Center for Financial Research and Analysis, a Bethesda, Md.-based organization that provides research reports to institutional investors. "But if you're defining the system as the fundamental way that auditors approach their work, we need a lot of changes.

"Auditors need to speak out when companies are doing things they shouldn't do," adds Schilit, a former accounting professor at American University in Washington, D.C., and author of Financial Shenanigans. "In Enron's case, that meant disclosing all the details of related-party transactions, what the debtors' liabilities hidden in those partnerships were and how they impinged on the company. Disclosing that kind of information would have made the auditors into heroes."

For Andersen, the Enron mess follows two earlier major auditing debacles involving Waste Management Inc. and Sunbeam Corp., for which the firm made settlements with the SEC and shareholders, respectively. And the Chicago-based Andersen is certainly not alone. "All of the Big Five have had major fiascoes," notes Douglas Carmichael, an accounting professor at New York's Baruch College and a stern critic of the accounting industry. "I think there needs to be a shake-up in many areas" to produce meaningful reform.

Names like Cendant, MicroStrategy and Mercury Finance have popped into the headlines in recent years following accounting scandals, and several of the big firms made huge settlements in the early 1990s following the collapse of major banks.

What should be done? Veteran forensic accountants argue that clamping down on the practice of accounting firms' taking lucrative consulting assignments for audit clients should be a top priority. As is well known, Andersen collected $27 million in consulting fees from Enron, more than the $25 million it earned for auditing the energy company in 2000.

"How unbiased or independent are you in auditing a company where you've got millions and millions of dollars coming in [from] outside management consulting fees?" wonders Henry Stotsenberg, managing owner of a CPA firm bearing his name in Tecula, Calif. "That has got to influence a CPA firm doing an audit," he adds. "You don't want to irritate the client."

Moreover, the current system of largely self-policing, industry oversight boards and peer review currently appears inadequate to prevent any future Enrons. SEC Chairman Harvey Pitt is recommending formation by the SEC of a new government panel to review the work of auditors. That is good, as far as it goes, says Baruch's Carmichael, but he believes that Congress must enact enabling legislation for any new agency to have teeth. "It would be nice if Congress didn't have to get involved," says Carmichael, "but the new organization needs statutory authority to subpoena records, depose people under oath and hand out discipline."

Among additional needed reforms, says John Coffee, a professor at Columbia University School of Law and an expert on securities law, companies should be required to change auditors every three years. With so many long-time auditing clients getting into trouble, the usual argument that taking on new and unfamiliar clients every three years can be risky rings hollow, adds Carmichael.

As to the contention that the frequent turnover in auditors is more expensive, particularly if the bidding process were eliminated, Carmichael bluntly says: "Tough -- that's the cost of being a public company." Robert Willens, an accounting analyst at Lehman Brothers, thinks that since the SEC mandates audits of public companies, the bidding process should certainly be changed.

"Auditing is not a very profitable activity," he says, "and many firms make low bids on audits knowing that they'll recoup the money with other services. So auditing firms should probably be guaranteed a reasonable fee -- maybe even some kind of government subsidy."

Another common corporate weakness seen in Enron's implosion, says Carmichael, was the inability of the board of directors' audit committee to act as a watchdog. But that is not really possible, he says, as long as board members are dependent on management and management-hired auditors.

The ineffectiveness of Enron's audit committee has been the subject of a spate of critical articles in major publications. Says Carmichael: "They need their own independent advisers to be really effective. Otherwise, they'll always be at the mercy of the people they're supposed to oversee."

Paul Sweeney is a freelance business writer in Brooklyn, NY.