In a corner: Enron's Collapse has left the profession's reputation hanging in the balance. (A Perspective).

"There is a crisis of confidence in my profession," testified Joseph Berardino, Andersen CEO. He was speaking before a congressional panel last December regarding the fall of Enron and the role his firm played. But Andersen is not the only firm likely to suffer repercussions from Enron's collapse--the whole profession is on the line.

Enron is just the latest and largest in a series of accounting-related crises at public companies, including Waste Management, Lucent Technologies, Sunbeam, Xerox and more.

Lynn Turner, former SEC chief accountant, told the New York Times that this rash of accounting-related crises is a "tsunami that's going to destroy public confidence."

Clearly, the profession as a whole must respond to this crisis of confidence. At a minimum, we need to address the following: consulting for audit clients, a rules-based mind-set, risky clients, firm reward structures and peer review.

WHAT THE HECK HAPPENED?

On Nov. 8, 2001, investors learned that Enron was restating its earnings for the past four years for three reasons:

* Three unconsolidated special purpose entities (SPEs) should have been consolidated according to GAAP;

* Audit adjustments passed in 1997 because they were deemed to be immaterial at the time; and

* A reduction in assets and stockholders equity due to reclassifying receivables from stock subscriptions to comply with GAAP.

By Dec. 2, Enron filed for bankruptcy after Dynegy abandoned a bailout of the cash-poor company.

According to Berardino, the restatements of prior information were required because Enron officials had withheld information about one SPE. With the information, the auditors would have required the SPE's consolidation--including its massive liabilities--with Enron's financial statements. Without that information the SPE was not consolidated because it fell below the 3-percent rule.

Berardino also acknowledged that another cause of the SPE restatements was an "error in judgment" by Andersen's own auditors.

Technical reasons for the restatements are often confusing to non-accountants and they can be impatient with the explanations, whether warranted or not. Representative John D. Dingell (D-Mich.), the ranking Democratic member of the Energy and Commerce Committee, told the New York Times, "[Andersen] was either corrupt or incompetent. It's possible they were both."

Unfortunately, a large segment of the public may share Congressman Dingell's sentiments.

CONSULTING FOR AUDIT CLIENTS

Turner also told the New York Times that "Accounting firms have become too dependent on consulting fees from the companies they audit and are unwilling to risk those fees by challenging corporate managers who stretch accounting rules."

The consulting controversy is not new to the profession--it has been debated for at least the past 20 years. In some ways it is similar to the controversy surrounding the "expectations gap" identified by the Cohen Commission in the mid-1970s. The expectations gap described the differences between what the public expected the auditor to do regarding financial fraud, and the auditors' views of their own responsibility to detect fraud.

At least with the expectations gap we seem to have come around--almost entirely--to embrace what the public expected all along: placing fraud considerations at the heart of the audit, rather than just as a side issue. Perhaps now the profession should come around to the public's expectations about consulting for audit clients.

In 1999, the profession came part way in meeting the public's concerns. Then, the AICPA revised Interpretation 101-3 to its independence rules and identified specific consulting-type engagements that, if performed for attest clients, would impair independence.

However, the profession has steadfastly refused to address the issue of quantity. Even if acceptable types of consulting engagements are performed for attest clients, is there a threshold amount above which independence is likely to be impaired?

How can we, as a profession, deny that the appearance of independence is impaired when prominent individuals and the financial press repeatedly tell us that, in their eyes, a problem exists with the sheer size of consulting fees relative to audit fees?

A 2001 study of 563 companies by Andrew D. Bailey Jr., a University of Illinois accounting professor, showed that for every dollar of audit fees, the client paid, on average, $2.69 for consulting services to the same firm.

Some paid much more. Marriott International paid Andersen slightly more that $1 million for audit fees and $30 million for other services. If auditing firms are receiving, on average, almost $3 of consulting for every dollar of auditing, they have four times as much to lose when they tell the client "No."

In 1994, a special blue-ribbon task force of the Public Oversight Board emphasized that auditors should consider the board of directors as their client--not management. They pointed out that the board, and in particular the audit committee, represents the stockholders and are natural allies to help auditors fulfill their public watchdog function. But when a company hires a consulting firm to do consulting, the client is management, and there is a potential for conflict.

According to the February 2001 Andersen memo, "Enron Retention Meeting," Andersen executives discussed problems at Enron, including significant related-party transactions with SPEs used to move debt off the balance sheet. The memo also noted that Enron's fees eventually could total $100 million a year.

Robert Bennett, a Washington attorney representing Enron, told The Washington Post that a week after that meeting, Andersen met with Enron's audit committee and never raised these concerns. "There's no resemblance between the concerns that Arthur Andersen expressed internally in this meeting and the assurances they gave the audit committee that everything was well."

RULES-BASED MIND-SET

There is no question that the present system of promulgating accounting rules is too cumbersome and slow. FASB has been considering revisions to its consolidation rules for 20 years. The rules still are not complete.

In the meantime, new financial instruments, transactions and entities--such as SPEs--emerge and evolve. The old accounting rules simply don't seem equipped to handle the new complexities.

Early last December, the Big Five accounting firms announced that they were developing specific recommendations to the SEC for improved disclosure guidance related to several Enron problem areas. But there can never be enough rules to cover every situation and clients cannot be allowed to hide behind the letter of technical standards to deliberately mislead investors.

The public expects auditors to use professional skepticism to critically examine the client's handling of key transactions and insist the client report them "fairly." A real profession must do more than mechanically apply rules.

Rule 203 of the Code of Professional Conduct says as much. "If, however, the [financial] statements or data contain ... a departure [from GAAP] and the member can demonstrate that due to unusual circumstances the financial statements or data would otherwise have been misleading, the member can comply with the rule by describing the departure, its approximate effects, if practicable, and the reasons why compliance with [GAAP] would result in a misleading statement."

FASB's Tim Lucas pointed out to the Los Angeles Times, "the problem is that as soon as we draw a line, the people who design [SPEs] will figure out how to structure them to be on the side of the line they want to be on." He was referring to the 3-percent rule allowing certain SPEs to remain off balance sheet.

A large part of Enron's November restatements was due to SPEs that failed to meet that test. But as Allan Sloan argued in Newsweek, "Even if [the SPEs] had met the 3 percent rule, the result would still be outrageously misleading."

Another cause of the November restatements was that Enron included $51 million of audit adjustments passed in 1997 as immaterial. Had they been booked they would have reduced 1997 reported earnings from $105 million to $54 million. Those adjustments would have reduced earnings by almost 50 percent. How can anyone argue that amount is immaterial?

In his testimony, Berardino said Andersen looked beyond net income to "what accountants call 'normalized income."' In other words, Andersen considered Enron's income from prior years, when earnings were much higher.

Stephen Zeff, an accounting professor at Rice University, told The Washington Post, "a cynic would say that someone was looking for a way to make something that was otherwise material not material."

And that is the problem with a rules-based mentality: Someone always will try to bend the rules and find the loopholes. The public expects more of the profession. They expect the auditor to demand financial statements that truly "present fairly." They expect the auditor to tell the truth as he or she sees it, and to use professional skepticism and a public watchdog mentality when performing the audit.

The rule-based mentality, taken to an extreme, might explain why Andersen employees destroyed documents after the SEC requested information from Enron. Apparently, the shredding didn't stop until the day after the SEC subpoenaed Andersen. Did whoever ordered the shredding really think that Andersen's lack of a subpoena would make the destruction permissible or appropriate?

RISKY CLIENTS

If the reports are true, Andersen should have known better! By al accounts, Enron's executives pushed the limits and were, according to Fortune, arrogant and greedy. According to a Los Angeles Times report, Enron's own attorneys, Vinson & Elkins, acknowledged that Enron's accounting treatment of certain key transactions was "creative and aggressive."

In a 1999 report, Andersen executives Andrew Flaig and Gloria Chang cautioned the firm's hospitality industry clients about the following warning signs of financial fraud: "Inadequate leadership at the top, weak internal controls, autocratic senior management, collusion among accounting employees and aggressive accounting policies." The warning signs, in Enron's case, were clear. Auditors must factor in such warnings when planning and executing their audits.

FIRM REWARD STRUCTURES

All firms emphasize, both in written directives and oral messages during staff training, that auditors must do contentious work to protect the public interest. But sometimes the firms' reward structures send an opposite message.

Dan Goldwasser, a lawyer who often advises accountants, told the New York Times, "There's no way that you could have a client which is that huge and important to you and not be tempted to turn your head away from problems. If the audit partner who's on the Enron account lost that account, they were history."

Indeed, when was the last time an audit partner was rewarded for losing a significant account because they insisted on a certain accounting treatment? More typically, a good part of partners' compensation may be based on how much new business or consulting fees they generate.

PEER REVIEW

All accounting firms that audit SEC clients undergo peer review. There is no doubt that the peer review program has resulted in improvements to many firms' systems and procedures. But it is not enough.

No Big Five firm has ever received anything but a clean peer review opinion. Nevertheless, those same large firms have spent an inordinate amount of time and money on what certainly appear to be audit failures.

WHAT'S NEXT?

In January, the SEC and AICPA announced that a new self-regulatory organization is in the works. For such an SRO to be effective it must act timely and have subpoena powers when investigating possible disciplinary situations. If its hands are tied until after civil litigation is complete, its disciplinary actions will be anti-climactic and their impacts will be meaningless. The devil is in the details.

It is too soon to tell if the new SRO will have teeth and be effective. But for the sake of the public interest and the profession's future, we all better hope so.

Mary Beth Armstrong, Ph.D., CPA, is a Professor of Accounting at Cal Poly, San Luis Obispo. She is also a member of CalCPA's Committee on Professional Conduct and a frequent ethics instructor.