Who's minding the store? The Enron collapse focuses the spotlight on corporate governance and management processes.

The media has thoroughly dissected Enron's accounting practices and the culpability that Arthur Andersen shared in the dissolution of the firm. But these practices are simply the first element in a series of more substantial problems -- fundamental failures in corporate governance and management practices.

The Enron case provides us with a number of examples of unethical conduct and corporate mismanagement. This is most clearly demonstrated by the manner in which Enron established special purpose entities (SPEs) to keep Enron losses off the company's balance sheet.

SPEs are used legitimately for economic benefits -- to collateralize assets. share risk or obtain more favourable financing They can however be misused to improver reported financial statements.

The external auditors, Arthur Andersen, advised Enron of the requirements for the establishment of SPEs. First, such entities must be managed independently of the company that holds the majority of shares. Second, an outside investor must own at least 3% of the company.

Although advised of these provisions, Enron didn't meet either requirement. The internal audit, also contracted to Arthur Andersen, did not raise any concerns about this. This appeared to encourage the company to set up other SPEs for the purpose of hiding company losses.

The SEC has since announced that outside investment in SPEs will now have to top 10%. But it wasn't the rules that were at fault here; it was organizational relationships and the way people conducted themselves.

The ethical issues are broader than the questionable use of SPEs, of course. Financial guarantees, the way leased equipment was accounted for, how pension liabilities were handled, the valuation of derivatives and revenue recognition have all been raised as issues in the affair. The alleged involvement of Enron, its legal counsel and Arthur Andersen in these matters has received wide coverage in the media, as has the treatment of potential whistle-blowers. Unethical conduct appears to be at the heart of the matter.

Ethics and accountability

Unethical conduct threatens not only a company's reputation, but also that of the whole open market. Without trust, capital availability and market liquidity is threatened.

The problem, of course, is that public companies are part of a market that encourages continual growth and immediate return on investment. To a certain extent, ethics demands that companies not bow to the pressure of the markets for short-term, artificial gain. Enron and other scandals, including those involving Livent and Cinar here in Canada, make it abundantly clear that, in the end, such obfuscation of results only hurts companies.

Encouraging ethical conduct requires a new approach to management and particularly incentive programs. Despite substantial public criticism, the practice of linking the salaries or bonuses of directors to corporate performance continues to be a popular form of remuneration. The obvious potential danger is that this can encourage short-term and self-motivated approaches to management, rather than consistent consideration of investors' interests.

The pressure is there for managers to produce interim and annual reports that demonstrate growth. The question is: is this growth sustainable? This should be the litmus test for remuneration schemes -- sustainable year-on-year growth in profit and shareholder value. Simply rewarding executives for attaining specific goals would also be a straightforward approach to rewarding valuable employees -- goals that encompass not just fiscal benchmarks but also the long-term health of the company. The transparency of this process and proper disclosure of it must also be addressed. There is no reason why this information should be kept from investors.

Fostering a code of ethics and accountability can only help an organization. Transparency in management and open communication between management and employees becomes easier when there is mutual respect and trust. It is a large step toward establishing an effective ethical culture. The common goal of properly leading a company is made clear by such an approach.

At Enron, the common goal appeared to be to mislead the public and investors. This stands in stark contrast to Enron's stated core values of respect, integrity, communication and excellence.

Traditionally, the role of the board of directors is to set and approve strategic objectives and company policies and procedures. The board is responsible not only for dissemination of such policies and procedures, but compliance with them. The board is also responsible for ensuring monitoring of, and compliance with, the laws, regulations and expectations of society. In this regard, the board acts as the ethical conscience of the company.

Governance and management: building competence, fostering independence, and eliminating conflicts of interest

In the Enron case, the board could not fulfill this mandate because, as it was constituted, the board and senior management were intimately connected. Kenneth Lay acted as both chairman and CEO, which, although not yet uncommon, clearly creates conflicts of interest.

The board is created to protect the interests of investors from the foibles of management. At Enron, this wasn't possible. Along with the obvious conflicts of interest, too much trust was put in management's effectiveness and there was incompetence either through a lack of awareness or understanding of the important role the board is meant to play.

There has to he a clear separation of the board from senior management to make the board effective. It also requires directors who are committed and diligent. This means that directors should serve on one or a very limited number of boards so they have the time to dedicate to committees and board meetings. It also requires that they have an intimate knowledge of the industry and are financially literate. Each should have a substantial personal investment in the company and be known as independent thinkers who can offer insight to the governance process. New directors must fully understand their responsibilities.

The audit committee, of course, has a pivotal role in cases where accounts appear to be doctored. The Enron audit committee has been criticized for failing to act when U.S. accounting rules were exploited to suggest a better performance than was actually experienced.

It is essential to have a high level of financial expertise to manage the auditing process. With this expertise should come an ability to pinpoint risk factors and measure them against the key business interests of the company to see that management isn't taking more risks than its shareholders and good governance in general would allow.

And again, it is essential that such a committee be completely independent of senior management. If the audit committee includes management representation, already it is hobbled by potentially problematic self-interest. This is another area where Enron was remiss.

The ethical culture of Enron comes into question again when you consider the fact that four whistle-blowers came forward and were roundly ignored or transferred to avoid a confrontation. Sherron Watkins, for instance, went directly to Kenneth Lay, who had Enron's legal firm look at her concerns. As the legal firm was also clearly intimately implicated by the scandal, the firm announced that they found no substance to Watkins' claims. She also noted that she did not go to the board for fear of losing her job.

To avoid such a situation, a clear path to the board has to be available to employees who feel that something is amiss. This may come in the form of an ethics committee, but it needn't be so specific as long as an ethical culture exists. An ethical culture provides a framework for employees so that they know when it is appropriate to go to the board with concerns about the company's operations. The board has to be so constituted that it can respond appropriately in the interests of the shareholders and the future well-being of the company.

Directors now face many challenges to improve the way they manage their relationship with senior executives of the company and employee input into operations. This doesn't mean that inherent distrust should be encouraged, but rather that directors not be afraid to challenge management's directions or decisions. To do so requires a broad understanding of the company's business model, financial literacy and an adherence and focus on corporate culture and ethics, as well as a consistent concern for the company's reputation.

Transparency: accurate financial information, communication, and disclosure

With the Enron collapse clearly in mind, this is an ideal time to establish national, high-quality, common accounting standards to ensure that reported financial information is consistently correct. Regardless of what form these take, it is still up to management and particularly the audit committee to see that they are followed. And it is important that any regulation come from the profession, rather than through government. Effective principles will be key to making accounting information more transparent.

The audit committee has to work with management to set the proper tone at the top of an organization -- to make clear that only the highest quality financial reporting is acceptable. They must also ensure that management is involved in the review of key accounting policies and financial reporting decisions.

Communication is essential in this process. The audit committee and auditors should maintain a healthy dialogue with management on key issues and strive for the most transparent accounting and disclosure.

Any estimates and judgments that are made should be supported by reliable information and the most reasonable predictions available. This practice must be consistent in each reporting period. If there are still concerns, these should be raised with the external auditor.

The disclosure of subjective measurements should be more substantial than was the case in the past. The focus should always be on transparency. If business decisions are based on economic reality rather than accounting goals, it shouldn't be difficult to explain these issues to shareholders. And, again, it's important to remember that the reports are for the shareholders.

There is no question that many people are culpable for the problems that arose at Enron. Company directors and managers, auditors, banks, analysts, regulators and standard-setters must work together to correct the serious deficiencies raised by the Enron situation. Already many companies have come clean about questionable accounting practices they've used in the past year. Xerox and IBM are prime examples. But this is not enough on its own.

It is essential that everyone in business use the impetus that has been created by the Enron scandal to make lasting, sustainable changes to their governance and management processes, and to foster an ethical culture. This will be critical to restore investor confidence and re-establish market stability.

R.W. Dye, CMA, FCMA, LLD is the president and CEO of CMA Canada.