May

The Accounting Profession’s Regulatory Dilemma By Dan L. Goldwasser

By Dan L. Goldwasser

The failure of Andersen LLP to prevent material misstatements in the Enron Corporation’s financial statements has reignited the debate over how the accounting profession can best ensure the accuracy of financial reports. Some critics say the profession must be returned to the “priesthood” by precluding CPA firms from providing any nonaudit services, claiming this would prevent auditors from losing their objectivity. But most CPAs say that would reduce the profession to mediocrity and further reduce audit quality. While we still do not know exactly what went wrong in Andersen’s audits of Enron, change is clearly inevitable and the profession would be well served by developing its own solutions.

Eliminating Nonaudit Services

Limiting CPA firms to audit services will likely help to ensure that audits are performed in an objective manner. Specifically, it would help firms maintain their focus on the audit and reduce the possibility that the opportunity to provide other services to the client would impair their objectivity. Increased audit objectivity is particularly important given that current accounting standards require financial statement preparers and auditors to exercise far more judgment than ever. Before FASB was established in 1973, accounting standards were set by the AICPA Accounting Standards Executive Committee, which was criticized for only adopting standards for which application was readily verifiable. Since becoming the primary source of GAAP, FASB has sought to address this problem and has adopted dozens of accounting standards that employ estimates. For example, Enron had to estimate its future costs in fulfilling uncovered energy contracts and Andersen had to pass judgment upon those estimates. Obviously, the more accounting estimates that are used in preparing financial statements, the greater the degree of audit objectivity required.

Eliminating nonaudit services, however, is not a panacea that will necessarily ensure audit objectivity. Auditors are still selected and compensated by their clients, which means that auditors will always be faced with the threat (whether or not articulated) that unfettered objectivity could result in the loss of the client. Moreover, if a CPA firm is precluded from providing nonaudit services, losing an audit client would have a greater adverse impact than if the firm provided a wider variety of services to a broader client base. Most accountants believe that the overall economic importance of the client to the auditor, not the absolute amount of fees, is what threatens audit objectivity. Nevertheless, if the fees paid by the client are large enough, they will likely affect on the auditor’s judgment, and the $52 million that Enron paid to Andersen appears to have crossed that threshold.

Many advocates of limiting the scope of accounting practices also point to the greater profitability of consulting services, implying that more-profitable services have a greater adverse impact on audit objectivity than less-profitable services. But they are missing the point, because a large engagement involving relatively low-profit-margin services will probably have a much greater adverse impact on audit objectivity than a small engagement that involves relatively high profit-margin services. In short, the total profitability of the engagement rather than the relative profitability of nonaudit services is what threatens audit objectivity. Moreover, the threat is not the nonaudit fees that the firm has received from the client, but rather the possibility of earning such fees in the future. An accountant who hopes to obtain a large nonaudit engagement is in greater jeopardy of impaired objectivity than one who has just completed and been paid for such an engagement.

To be sure, not all nonaudit services have the same impact on audit objectivity. For example, helping a client prepare an insurance claim is less likely to impair the accountant’s independence than advising the client on how to save taxes or maximize reportable earnings. With Enron, Andersen appears to have been instrumental in establishing the special purpose entities (SPE) that Enron used to hide its losses and undisclosed obligations. It is difficult to see how Andersen could have dealt with those entities objectively, having placed its imprimatur on their creation. Similarly, services that entail client advocacy are also likely to skew audit objectivity.

Most accountants resist the idea of banning nonaudit (or nonattest) services, arguing that such services are important for two reasons: First, performing such services ensures that accounting firms will have the full range of expertise necessary to understand their clients’ businesses; such an understanding is essential to an effective audit. This is particularly true with respect to businesses that purchase derivative securities or engage in complex hedging transactions to minimize business risks. Similarly, businesses of all sizes are now highly—if not wholly—dependent on computer technology, and financial statement audits performed without a clear understanding of the client’s computer systems will probably be ineffective. Moreover, by providing a wide array of services to its audit clients, accounting firms have the opportunity to better understand their clients’ operations and thereby perform a better audit. The ability to perform a wide variety of nonaudit services seems critical to the effectiveness of financial statement audits.

Second, the ability to generate additional income from nonaudit services has proved critical to the financial health and viability of the accounting profession. Long before the profession started pursuing most of its current array of nonaudit services, accounting firms were engaged in all-out price wars in an effort to maintain and expand their practices. Clients perceived audit services as simply a requirement, imposed by law or their creditors, that added little or no value to their businesses. The best audit was the cheapest audit. By using a wide array of consulting services to distinguish themselves from the competition, most of the large accounting firms have been able to alleviate some of this price competition. Nevertheless, most clients still regard audit services as providing little or no value, with the result that audit services remain relatively low-profit. They are also, however, relatively high-risk services: A single oversight can cause damages that far exceed the auditor’s available insurance coverage. The potential damages arising out of Enron’s financial misstatements are easily more than 100 times Andersen’s insurance coverage and at least 10 times the value of its assets. Also remember that Andersen must still resolve or pay claims arising out its audits of the Baptist Foundation of Arizona and Global Crossing.

Consequently, any accounting firm forced to restrict its practice to audit services would be extremely unattractive to investors and employees. In fact, one factor that prompted the AICPA to embark upon its global business credential project was survey data that showed the accounting profession’s ability to attract future employees depended greatly on continually providing a variety of business consulting services.

Reconciling the Scope-of-Practice Dilemma

Because both sides are right, the profession and its regulators must find a way to reconcile these two seemingly conflicting views. An apparent solution is to proceed along the path suggested by former SEC Chairman Arthur Levitt: Prohibit accounting firms from offering audit clients those services that tend to impair audit objectivity. Firms would be free to continue to offer those services to nonaudit clients and thereby maintain their expertise in a wide variety of business disciplines, their attractiveness to present and future employees, and their relative profitability. This solution presupposes, however, that the consulting practices of accounting firms can remain viable without servicing the firm’s audit clients, and that accounting firms would retain their consulting practices under such circumstances. It also assumes no detrimental impact to clients as a result of filling their consulting service needs from other sources.

To be sure, an accounting firm would have great difficulty in establishing a business consulting practice of any scope if it could not service its audit clients (much less the full spectrum of its attest clients). With no possibility of providing such services to their existing client base, few accounting firms would even bother to try. Moreover, consulting practices already established by many small and mid-size firms might be liquidated. Thus, a rule that precludes only the rendering of consulting services to audit clients would probably be fatal to consulting practices within most small and mid-size firms.

The results would probably be less dire for the Big Five and some second- tier firms whose substantial consulting practices may be able to survive on their own. Accenture (formerly Andersen Consulting) has clearly established this.

A consulting practice that splits off from its parent faces less of a challenge than one that chooses not to go it alone and is forced to give up much of its clientele. Whether Accenture could thrive if it had to give up all of its clients that remain clients of Andersen LLP is an unanswerable question. Thus, former Chairman Levitt’s proposal may very likely be unviable.

Also unknown is whether the large firms would even want to keep their consulting divisions if they could not service their firm’s audit clients. Faced with this issue, Ernst & Young and KPMG chose to sell their IT consulting groups, and PricewaterhouseCoopers is looking for a buyer for its IT consulting operations. These entities have far greater value if they can continue to service at least a large portion of their existing clients and not be limited in their efforts to acquire future clients. Even if it were economically feasible for a Big Five firm to retain its consulting practices in the face of a prohibition against rendering consulting services to audit clients, it seems unlikely that any would want to.

Even if the Big Five firms were to maintain their consulting practices in the face of a ban on servicing audit clients, no one knows whether such a prohibition would achieve the desired results. The Big Five have a history of cooperating with each other, and undoubtedly they would find it in their best interest to refer consulting business to each other. The possibility of benefiting from a cross-referral might also impair auditor objectivity.

A rule prohibiting nonaudit services would also adversely impact the clients served by the accounting profession, including governmental and nonprofit entities. Accountants can often spot problems and potential problems in a client’s operations that the client has not yet noticed. Accounting firms that offer a host of consulting services have a positive incentive to look for ways of improving their clients’ businesses and to offer their services in helping their clients to achieve greater efficiencies. If accounting firms are precluded from offering nonaudit services, they will have less incentive to help clients improve their operations, especially if operational changes may make the audit more complex. While the impact of this factor is difficult to assess, U.S. businesses were able to overcome significant competitive disadvantages in the world markets during the 1990s, a period of growth for the consulting practices of U.S. accounting firms. Therefore, adopting a prohibition against providing nonaudit services to audit clients could unintentionally hamper business growth.

Because no one knows whether the net effect of eliminating nonaudit services would be positive or negative, a less radical approach seems prudent. Indeed, this is ultimately what the SEC did in 2000 when it opted not to ban all nonaudit services and to require disclosure of the dollar amount of nonaudit services that a company’s outside auditors provide. We still cannot fully assess the results of those new regulations, but some facts are emerging. The large accounting firms are providing substantial nonaudit services to many of their clients, and in many cases their fees from nonaudit services are significantly greater than from audit services. It also seems clear that the SEC’s failure to adopt a total ban of nonaudit services did not eliminate the stimulus for the large accounting firms to sell their consulting practices, because both PricewaterhouseCoopers and KPMG chose to proceed with the dispositions of their IT consulting practices even after the SEC’s new independence standard was adopted.

The SEC’s new independence rule has also motivated corporate audit committees to become more involved in the decisions about whether to retain their companies’ outside auditor as a provider of consulting and other nonaudit services. Some audit committees have chosen to eliminate the practice. Presumably, a company that makes this choice has decided that financial statement reports issued by a firm with minimal impairments to its audit objectivity are worth more than those issued by firms with numerous threats to audit objectivity. This realization can only inure to the benefit of the accounting profession, lending credence to the proposition that audit services, like consulting services, are indeed value-added services and should not be viewed simply as a required cost of doing business. One disappointing aspect of the current regulatory debate is that it bears little or no relationship to the problems that led to the financial misstatements published by Enron and Andersen. While all of the facts have yet to emerge, apparently Andersen subverted its good judgment in an effort not to jeopardize its relationship with a very large and profitable client. Yet none of the recommendations for rectifying this sad experience address the issue of the economic importance of the client to the partners in charge of an audit. The SEC also ignored this issue when it created its new independence rules in 2000. Moreover, that rule-making episode effectively destroyed the Independence Standards Board (ISB), which was well on its way toward dealing with this issue. If any action is taken, it should be to resume the efforts of the ISB in dealing with this long-ignored issue.

Enron’s false reports also appear to have been the result of weaknesses in at least two different accounting standards, one dealing with special purpose entities and the other addressing the recognition of income with respect to uncovered futures contracts. One can argue whether Andersen should have done a better job of reviewing Enron’s computations of its profits from its futures trading activities, but the seemingly obvious conclusion is that there is no proven way to accurately predict profits on uncovered futures contracts; as a result, such profits should be recognized only when realized. The primary fault seems to lie with the accounting principles, not with Andersen’s efforts to audit Enron’s estimates of its future costs. (According to recent disclosures, Andersen realized belatedly that Enron’s cost estimates were understated, but chose not to act.) Equally problematic were the rules about when financial statements of SPEs must be consolidated. Those rules require the audit firm to ascertain the ownership of an entity not covered by the firm’s audit. Thus, the audit firm is being asked to verify what is inherently unverifiable. Although FASB is attempting to streamline its procedures, those reforms do not seem likely to cure the problems underlying Enron’s false financial reports.

Equally troubling is the possibility that Andersen encouraged Enron to take advantage of weaknesses in the accounting standards that facilitated hiding its losses in off–balance sheet entities. Although the accounting profession is generally quick to discipline accountants that violate professional standards, it has no ethical prohibitions against encouraging the abuse of professional standards, even though an accounting firm owes its primary duty to the readers of its reports. It is the very purpose of ethical standards to go beyond what is legally required, in an effort to distinguish the members of a professional organization from other licensed practitioners. By placing its ethical standards on a par with the legal requirements, a professional organization jeopardizes one of its primary missions. This important lesson has been overlooked.

It is also disheartening that, despite Andersen’s many audit failures over the last three years, we see no indication that either the AICPA or a state board of accountancy has initiated a disciplinary proceeding against Andersen. Equally disheartening is the lack of public outrage over this void in the regulatory scheme. Indeed, one would search almost in vain for any such disciplinary proceeding against any accountant employed by the Big Five during the past decade, notwithstanding the current furor about rampant audit failures and independence violations. Therefore, one can easily appreciate why an Andersen partner may have been willing to ignore certain accounting indiscretions by Enron, comforted by the knowledge that no disciplinary actions would be brought unless the matter reached the attention of the SEC. Accordingly, if regulatory reform is to be visited upon the accounting profession, it should include disciplinary processes capable of addressing transgressions by members of the large firms.

Finally, the Enron experience underscores the need for improved audit procedures (as opposed to audit standards). After every audit failure involving a public company the accounting profession seeks to determine whether the existing audit standards adequately addressed the problem. Typically, there is a cry for more detailed audit requirements, if not for the accounting profession to assume a greater degree of responsibility for financial statement reporting. These efforts appear somewhat misguided, because the problem seems to lie with the want of audit techniques and technology rather than audit standards. Today’s public companies have grown so large and complex that accounting firms are hard pressed to audit more than a minute portion of the client’s transactions and are equally hard pressed to understand the relationships between transactions. The accounting profession therefore must make a considerable investment in devising computer programs and other devices to identify and verify potentially problematic transactions. Without such a capability, financial statement audits of large corporations will be more akin to an exercise in insurance underwriting than an audit of financial transactions.

Along with the devastating losses that Enron’s collapse has caused, the company’s demise also points out numerous weaknesses in the structure of financial audits and the accounting profession. My hope is that the profession and its regulators will heed those lessons and not simply engage in rhetoric over regulatory reforms that have public appeal but little practical merit.


Dan L. Goldwasser, Esq., is a partner of Vedder, Price, Kaufman & Kammholz in New York City and devotes most of his practice to advising and defending CPA firms. He is currently the ABA cochair to the National Conference of Lawyers and CPAs.

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