December 2002

The Enron Affair From A Lender’s View

By Neville Grusd

In his most recent State of the Union address, President Bush outlined a 10-point investor protection plan and noted the need to protect investors and employees whose pension plans are damaged by companies that fail. Federal legislators and regulators are hard at work on reforms concerning the oversight of auditors and financial statement disclosures, but no one has mentioned the losses sustained by the creditors of Enron or other failed companies. The only explanation I can come up with is that credit grantors are presumed to be self-sufficient. Most credit grantors, however, rely upon the very financial statements that the President, SEC, and Congress are worrying about. Why aren’t the lending industry and credit community involved in the discussions and recommendations for auditor oversight and financial statement disclosure? Because they have never shown any interest in the subject, never been involved in lobbying for changes with the SEC or government, and, as a result, are ignored.

The Enron–Andersen debacle highlights the recent status quo. Although many audit failures and frauds have gone undetected, in the long run it may have done some good as regulatory authorities and accountants themselves are reexamining their positions. The AICPA stated in its membership newsletter that it is “dedicated to taking whatever steps are necessary to restore public confidence in the capital market system and accounting profession.”

So what can lenders do to protect their interests and ensure that they are relying on accurate financial statements? The areas below need to be addressed.

Rules of accounting disclosures. These rules have been promulgated by FASB, and for public companies the SEC has added certain additional requirements. Over the years, the FASB disclosure requirements have become extremely complex, with many esoteric and detailed rules being added, some as a result of lobbying by interested parties.

One major cause of the Enron collapse was its use of off–balance sheet partnerships to hide losses. These special-purpose entities (SPE) were permitted by current ambiguous rules. Companies stretch the rules as much as possible to gain the maximum advantage for their share price, and their auditors may well be persuaded to follow suit. Accordingly, accounting rules should be written clearly and the general spirit of disclosure should be the accountant’s old doctrine of conservatism. This would encompass the following concepts: recognize income as late as possible, provide for all known liabilities and losses, and disclose all material matters and transactions that could affect the financial condition of the entity.

Former SEC Chairman Arthur Levitt fought public companies for years over “managed earnings.” He pointed out that, not only did some companies overstate earnings in bad years, but there was also a trend to overstate losses and create reserves when share prices were going down anyway. In later years, these reserves would be released to overstate profits to create the appearance that the company was on an upward trend. Many of Levitt’s suggestions were defeated by heavy lobbying of major companies and the AICPA itself.

Lenders should become more proactive in the accounting rule-making procedure. Through the American Banking Association and organizations such as the Commercial Finance Association, lenders should bring existing rules which have caused problems or are thought to be deficient to the attention of FASB, or a successor organization. They should be consulted by FASB to comment on any proposal rules.

Auditor independence. Auditor independence was a major issue in the Enron–Andersen case. It has been argued that, because Andersen received more than half of its revenues from consulting services, this could have influenced its decision-making on the disclosures in Enron’s financials. This caused a flurry of proposed legislation prohibiting CPA firms from providing consulting services to clients and culminated in the Sarbanes-Oxley Act.

Lenders are keenly interested in ensuring that the accountants reporting on their clients’ financials are clearly independent. If a lender knows the client is a major account of the CPA firm issuing its financials, the lender should take the necessary steps to ensure the quality of the financial reporting.

Quality of outside accountant’s procedures. Audit standards are being tightened by the Auditing Standards Board (ASB). The ASB is working to enhance and update the fraud standard and framework for the audit process and to improve audit effectiveness for investors and other users. Auditors have long argued that it is not their duty to look for fraud and that they are not responsible if fraud is not uncovered in the normal course of their audit. The new ASB project will provide standards and guidance to help better identify and analyze risks of material misstatement, whether caused by error or fraud.

The post-Enron discussions have focused on problems arising from audited financials. But what about reviewed financials? It has become common for lenders, even large ones, to accept reviewed statements. Lenders accept these statements because clients argue that an audit is too expensive and because the lender’s competitors are not insisting on an audit. Hopefully, the lending industry will become more responsible in deciding what level of reporting to accept when making larger loans.

Different accounting firms interpret the rules for reviews differently, as was evidenced at various roundtable discussions and panels arranged by the CFA Committee for Cooperation with Accountants. Clearly the accountant has no duty to independently confirm receivables or payables, and does not have to attend and verify the inventory count. The deeper the accountant goes in a review, the more work that may be needed if the results are unsatisfactory. Accordingly, lenders and accountants should discuss the accountant’s procedures, then decide the extent to which the lender’s own field exams should be extended to cover weak areas. In the case of smaller loans, the lender should know or get to know the accounting firm involved to gain confidence in the statements being presented.

One clear result of all the proposed improvements and controls is that the cost of audits will go up. They will no longer be considered a commodity and loss leader to attract consulting work. Accountants will be even more careful with reviews. Higher fees to professionals to do a proper job is a small price to pay for accuracy in financial statements and the possible uncovering of frauds and material misstatements.

Status of accountants. In the past 10 years accountants have pushed to expand their scope into consulting and other business activities. While lenders cannot dictate what accountants should or should not do in the way of other activities, it is clear that lenders should still insist on financial statements being prepared by competent and independent CPAs. It is worth discussing the trend to non-CPA ownership of accounting firms. Lenders have been assured that, when it comes to the attest function, CPAs are independent, but this assertion seems to be more form than substance. While the Enron situation did not involve non-CPA ownership, this nevertheless remains a trend to be watched.

Malpractice litigation. The last thing a lender wants to do is sue an accountant for malpractice. Unfor-tunately, sometimes it is justified and necessary. In these cases the question of “privity” arises. In some states (e.g., New Jersey) it is very clear that there must be substantial communication between the lender and the accountant for the lender to win a malpractice case. As a result, CPAs do not want to talk to or meet with lenders and even refuse to mail financial statements to them.

It seems ludicrous that an accountant who includes a detailed footnote about a client’s borrowing arrangement and a review of compliance with the loan covenants can claim ignorance that the lender was relying on the financial statements to make credit decisions. In some countries other than the U.S., it is clear that third parties who reasonably rely on financials to grant credit can sue accountants for malpractice. If the law were changed to make accountants responsible to lenders for malpractice, accountants would be discouraged from cutting corners. Furthermore, it would promote communication between lenders and accountants, which will ultimately benefit their mutual client.

In the wake of the Enron affair, lenders should become proactive in shaping the rules for accounting disclosures, auditing procedures and auditor independence. In these tumultuous times, the involvement of all parties that rely upon financial statements is vital. Lenders should know their clients’ accountants and, if not satisfied, should insist that the client change to a mutually acceptable firm.

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