Who guards the guards? It's a lot easier to lose trust than it is to regain it, but some new rules aim to help corporations climb back to a higher level of respectability. (New Rules).

In the wake of corporate accounting shenanigans, auditors have come into the spotlight. They may not have an exciting image, but their job of reviewing financial statements and accounting practices is a big one.

As The Economist pointed out in January 2002, "... The capital markets, and indeed capitalism itself, can function efficiently only if the highest standards of accounting, disclosure, and transparency are observed."

So, one of the key places for change is in audit committees, which often are weakened by having corporate managers on them. Experts say it's important for committee members to be independent of the company.

Another problem is that auditing firms often provide consulting services to the same clients they audit, which doesn't lend itself to unbiased reporting. Arthur Andersen Inc., for example, collected audit fees of $25 million from Enron in 2001, but earned more ($27 million) for consulting and other work.

It's also recommended that auditors and their firms be rotated (some say every seven years, some every four). And, although auditors in the past have insisted on self-regulation, some say they should be regulated by an outside organization.

Many observers say what is at the root of recent scandals is more than shameful top management and crooked accounting firms: it is the failure of many boards of directors to make sure everything is running smoothly and legally. Board members are supposed to oversee the work of company managers and protect the interests of the company's owners, the shareholders. But, in several of the recent scandals, directors have often pleaded ignorance of any warning signs that their companies were headed for disaster. J. Richard Finlay, founder of the Centre for Corporate and Public Governance in Toronto, pointed out in a Globe and Mail article that directors of Confederation Life, Royal Trustco, Bre-X, YBM Magnex, and Livent Inc. all claimed to have been shocked when their firms went under. He adds that, "RT Capital, which paid millions in penalties to settle charges of securities-law violations, had a board that never met and at least one director who claimed he did not know he was a director."

Some see the whole mess as a fine example of the age-old contest between greed and trust, experience and ethics.

John A. Campion is chairman of the Toronto office of law firm Fasken Martineau DuMoulin, which specializes in corporate, commercial, and securities litigation and regulation. Seeing corporate directors as key to rebuilding trust in corporations, he says: "In the end, a well-prepared and well-informed director who stands willing to criticize and oppose management is an essential feature of the system."

In July 2002, the Canadian Council of Chief Executives announced plans to establish a new set of its own rules, or code of ethics, to prevent Enron-like scandals from happening. But, as Penny Collenette, former senior adviser to Jean Chretien, writes in a Globe and Mail article in October 2002, "... All professions like the idea of self-regulation, but the past months have proved that there are simply not enough checks and balances in the business world."

Thinking along those lines, the accounting and securities regulators set up the new Canadian Public Accountability Board (CPAB) in July 2002. The Board's job is to supervise, inspect, and discipline Canada's six biggest auditing firms, which do about 90% of public company audits. Within three years the CPAB expects to be examining about 300 smaller accounting firms as well.

At a press conference announcing the creation of the national board, David Brown, chairman of the Ontario Securities Commission, said: "Investors need auditors who can say no. Investors need auditors who will question management, disagree with management, and if necessary reject management's accounting decisions."

In addition to the need for independent and trustworthy external auditors, federal Finance Minister John Manley outlined the areas the government wants to see some action in:

* Corporate governance--Companies must be run in the best interests of shareholders;

* Management accountability--Senior executives should be held responsible for their company's financial statements;

* Financial reporting--Companies must provide complete, accurate, and understandable information;

* Enforcement--People and companies who break the public trust must be punished severely.

SUGGESTED ACTIVITIES:

1. Jeffrey Sonnenfeld, an expert at Yak School of Management, wrote in the Harvard Business Review in September 2002, that the best performing

companies have "extremely contentious boards that regard dissent as an obligation and that treat no subject as undiscussable." Others suggest this approach doesn't necessarily foster the climate of trust and constructive dialogue needed for an effective board. Discuss these two opposing views.

2. One of accounting firm Arthur Andersen's arguments in favour of doing both auditing and consulting work for its clients was that they had to promise glamorous and highly-paid consulting work to attract bright, creative, young people into their profession. However, some observers say that auditing needs thorough and suspicious minds, not creative geniuses. Discuss.

DEFINITION

A Company's Audit Committee is appointed by the Board of Directors and is responsible for recommending the selection of external auditors to the Board, receiving, reviewing, and forwarding to the Board the annual financial report of the external auditors, and generally dealing with other financial matters that arise.

Most corporate governance experts define independent directors as those without a financial or personal link to the company for which they are acting, making them more willing to challenge company management.

FACT FILE

CFO, a sister magazine of The Economist, conducted a survey in 2002, which found that auditors had challenged practices at 38% of respondents in the previous year, but that in 57% of cases, the company persuaded the auditor to accept the questionable practice.

Websites

Canadian Council of Chief

Executives--http://www.ceocouncil.ca/English/flash.htm

The Corporate Library (U.

S.)--http://www.thecorporatelibrary.com/

Investor Responsibility Research

Centre (U.S.)--http://www.irrc.org/

Office of Superintendent of

Financial Institutions--http://www.cpab-ccrc.ca/-/index.html

RELATED ARTICLE: American crackdown.

According to a Globe and Mail study released in October 2002, which looked at corporate governance practices at 270 Canadian companies, most would not be able to meet tough new U.S. standards for independence of boards of directors. Many don't even meet existing voluntary guidelines set by the Toronto Stock Exchange, which recommend companies should have majority independent boards and fully independent audit committees. The Globe study found that 20% of companies have a majority of related directors, 43% of audit committees include related directors, and 58% of companies have related directors on their compensation committees. Related directors were defined as immediate family members of management, those who provided professional services to the company (such as lawyers, accountants, bankers, and consultants), and former executives of the company, or executives of a parent company. In the United States, the Sarbanes-Oxley Act became law in July 2002 to clean up that country's auditing process. Under the Act, a new five-member board will oversee auditors, accounting firms are not allowed to offer other services to companies whose accounts they audit, and directors sitting on companies' audit committees (who choose the firm's auditors) must be independent. But the Act is far from popular. According to one report it was nearly "strangled at birth." Accountants persuaded legislators to ditch the idea of companies rotating their auditors every five years. Others say that the Act has irregularities itself that are a result of it being drafted in a rush.

Still, under the Act, the senior executives of all 14,000 firms listed in the United States, including those based overseas, had to take an oath in August 2002 that their financial reports and statements contain no untruths and omit no material facts. (Critics say there are a few loopholes to wriggle through fairly effortlessly though, such as having to prove that any dodgy accounting was done willfully or knowingly.)

Other countries are taking a look at their corporate practices with the aim of tightening up existing guidelines too. In Britain, for example, two government-sponsored reports issued in January 2003, called for corporate boards and their audit committees to become more independent of top company officials.

The recommendations of both reports are expected to become part of an existing code of corporate practices by July 2003. But, the guidelines are milder than those established in the U.S.: they allow companies to purchase services other than auditing from the firm that audits its books, they do not require the mandatory rotation of auditors. And, Britain still thinks guidelines and peer pressure are the way to go rather than strict rules. Companies that don't comply with the guidelines are expected to explain why in their annual reports.

Germany and France, Europe's two biggest economies where unions are strong and workers get seats on corporate boards, are taking a closer look at corporate behaviour too. In 2002, Germany produced its first corporate-governance code, to be reviewed once a year. And, France also has launched a review of best corporate-governance practice.

RELATED ARTICLE: Rules versus principles.

One of the biggest accounting issues raised by Enron's collapse has been accounting standards--specifically the rules-based Generally Accepted Accounting Principles (set by the Financial Standards Board) used by American companies versus the principle-based International Accounting Standards (set by the London-based International Accounting Standards Board) used in Europe. American companies rely less on broad principles than on precise, detailed rules. Some say the rules are too detailed and too easy to get around. In general, what standard-setters want is for companies to be forced to reveal the economic reality of their company operations, not the fantasies that result from accounting tricks.