January 2003

Enron and Beyond: What’s the ‘WorldCom’ing to?

By C. William Thomas

In the months following the collapse of Enron and Arthur Andersen—both American icons of success, but apparently motivated more by greed and self-enrichment than regard for the welfare of others—other major corporations have been caught in similar acts that threaten trust in the economy and the integrity of the auditing profession.

The biggest scandal of 2002 took place at WorldCom, which announced in April that its internal auditors had discovered a $4 billion fraud. Unlike Enron, WorldCom’s misstatements were rather simplistic, involving improper capitalization of expenses. In the months that have followed, many other accounting irregularities have surfaced at WorldCom, pushing the estimated total to approximately $9 billion, the largest in U.S. history. Four former WorldCom officials have entered guilty pleas, including former CFO Scott Sullivan who was the chief architect of the fraud. In November 2002, former Enron CFO Andrew Fastow was indicted on 78 counts of fraud. Fastow, like Sullivan, has pleaded innocent to the charges. They and their former superiors at Enron and WorldCom all face protracted civil and criminal litigation for months, and perhaps even years, to come.

The continuing revelations of corporate chicanery and accounting malfeasance have kept the investment community, already skittish from threats of international terrorism and global recession, reeling from the shockwaves. Regulators and prosecutors have opened dozens of investigations, most involving massive financial restatements. Most of the blame has been placed on greedy corporate executives that bailed out huge amounts of cash from corporations by exercising stock options, while corporate profits and market capitalization plummeted. Many situations were tacitly approved by inept or negligent audit committees, as well as by independent auditors. Although many of the companies under investigation were Andersen clients, all of the largest CPA firms were involved in at least one instance. The publicity surrounding these investigations has spurred a lack of confidence in American markets.

The Death of Self-Regulation

In early 2002, dissatisfied with the self-regulation status quo under the Public Oversight Board (POB), then–SEC Chair Harvey Pitt proposed the creation of a Public Accountability Board (PAB) to regulate the accounting profession. He apparently did this after conferring with the AICPA and the heads of the Big Five, but not with the POB. Partly in protest, the POB resigned, effective March 31. Although the AICPA wanted to restore confidence in the auditing profession and its self-regulatory process, too many alleged flaws had surfaced in Congressional testimony during the Enron hearings for this model to continue. To add strength to the arguments against self-regulation, the POB, in its final annual report, issued a white paper recommending replacement of the self-regulatory structure with a legislated body totally independent of the accounting profession that would consider the profession’s input. The POB testified to this effect before Congress. As a result, the SEC and Congress decided that the self-regulatory model had failed, thus clearing the way for a new era of regulation of the accounting profession.

President Bush’s plan for corporate accountability, announced in March 2002, laid out guidelines in three categories, all of which had been issues in the Enron scandal and included in subsequent legislation. The three categories were:

After the WorldCom scandal, Bush somewhat toughened his stance on corporate fraud, calling for doubling prison terms for mail and wire fraud and announcing a Justice Department task force specially created to pursue and prosecute corporate criminal activity. In addition, Bush promised to strengthen laws that criminalize document shredding, strengthen SEC power to freeze improper payments to executives, and increase the SEC’s enforcement budget, among other things.

Each house of Congress passed its own version of reform. The more conservative House of Representatives’ plan, sponsored in the Financial Services Committee by Michael G. Oxley (R-Ohio), was passed in April before the WorldCom scandal broke. The Senate bill, sponsored by Paul S. Sarbanes (D-Md.), specified much more detailed and comprehensive government intervention into accounting regulation than its House counterpart.

At first, it appeared that the Sarbanes bill was losing steam, because the AICPA strongly opposed it and the tougher restrictions it placed on CPA firms. Following the Andersen verdict and WorldCom’s restatement announcement, the Sarbanes Bill passed the full Senate on a unanimous vote of 97-0 on July 15. Amendments to the bill included a toughened package of criminal penalties for executives who defraud investors, as well as a ban on inside corporate loans to officers and directors. In late July, the Dow Jones Industrial Average registered triple-digit losses for seven consecutive days, suffering its largest percentage decline since 1987. Realizing that the free-fall in the markets was partly fueled by lack of investor confidence, the houses conferred and passed the Sarbanes Oxley Act, which was signed into law on July 30, 2002.

The Legislative Solution

Title I of the Sarbanes-Oxley Act creates the Public Company Accounting Oversight Board (PCAOB), independently funded by publicly held companies and overseen by the SEC. The PCAOB’s duties include the following:

The PCAOB’s full-time membership, consisting of five individuals, can include only two CPAs. If the chair is a CPA, he or she cannot have been in public practice for within five years prior to appointment. All firms, including those of foreign origin, that perform audits or participate in any audit report with respect to issuers of publicly traded U.S. securities, must register with the PCAOB. The Board has the power to establish, adopt, alter, or amend auditing, attestation, quality control, and ethics standards used by registered CPA firms. The Act contains provisions that call for PCAOB cooperation with professional groups such as the AICPA, but does not limit the board’s authority to adopt its own rules. The PCAOB is required to make annual inspections of the practices of firms auditing more than 100 public companies, and not less than triennial inspections of others.

The PCAOB will have broad powers, something that the POB lacked. Auditors are required to keep working papers for seven years, and willful violators of this provision face a five-year prison term. The Act authorizes the SEC to recognize any accounting principles established by a standards-setting body that meets specified criteria. This provision allows the SEC to continue its long-standing policy to recognize the FASB as the primary accounting rule-making body, but leaves open the option of employing other entities to promulgate accounting principles should the need arise. The Act directs the SEC to study and report to Congress, within 360 days of enactment, on the adoption of a “principles-based” accounting system. FASB is participating with its own proposal for a principles-based approach to standards setting.

Title II of the Act strengthens standards for auditor independence, prohibiting registered firms from performing eight specific nonaudit services concurrently with auditing:

In addition, a blanket provision prohibits other services deemed by the board to impede independence. Nonaudit services, not specifically excluded, must be approved by the audit committee of the issuer’s board of directors, unless the service is less than 5% of total fees. All approved nonaudit services must be disclosed in the issuer’s annual report. The Act also requires lead and reviewing partner rotation every five years, as well as timely reporting to the issuer’s audit committee of critical accounting policies, alternative accounting treatments and ramifications, and copies of all communications with management, including audit adjustments. The Act also requires a one-year waiting period before a CPA in public practice may go to work for a client in the capacity of CEO, CFO, controller, or other equivalent position. A separate section commissions a GAO study and report to Congress (within 360 days) on the effects of mandatory rotation of registered audit firms among issuers.

New Corporate Responsibilities

Title III of the Act focuses on corporate responsibility. It—

Under the Act, attorneys with knowledge of securities violations are required to report those violations to the CEO within 180 days. Funds received from fines against offenders of these provisions will be deposited into a fund and used to partially reimburse investor losses.

Title IV of the Act includes enhanced financial disclosures in annual reports of public companies, such as all material adjustments recommended by the auditor, all material off–balance sheet transactions, and the presentation of pro forma information that reconciles with GAAP.

The SEC has one year to study and report to Congress on the impact of off–balance sheet transactions, including the use of special-purpose entities (SPE) on the transparency of financial statements of public companies. Issuers are also required to include an assessment and report on internal controls, certified by the independent auditor, in their annual reports.

Title V of the Act gives national securities exchanges one year from enactment to adopt rules to address conflicts of interest that can arise when securities analysts recommend equity securities. It also prohibits investment firms from retaliating against analysts that criticize clients of the firm.

Title VI increases the SEC budget, lengthens the statute of limitations for investor lawsuits on securities fraud to five years from date of discovery, broaden the ability of whistleblowers to sue the company, and prevents officials facing fraud judgments from using bankruptcy to escape liability.

The Act carries stiff criminal penalties:

SEC’s Reluctant Reformer: Harvey Pitt

Harvey Pitt was appointed to succeed Arthur Levitt as SEC chair in hopes that he could help resolve some of the deep differences that have arisen between the SEC and the accounting profession. During his time as chairman, circumstances changed drastically. Democrats, and even a few high-ranking Republicans in Congress, questioned whether Pitt possessed the objectivity required, considering his previous legal representation of the Big Five. Yet, Pitt appeared to take ever-tougher stands against the accounting profession.

Pitt proved that the SEC could move within its existing authority to enact certain reforms without the benefit of legislation when he ordered CEOs and CFOs of companies with more than $1.2 billion in revenue to issue, by August 15, written sworn statements attached to their filed reports that they had read the report; that, to the best of their knowledge and belief, the report was true in all important respects; and that the report contained all information about the company that a reasonable investor needed to make in-formed decisions.

Harvey Pitt made a fatal mistake in late October, when he appointed William Webster, former head of both the FBI and CIA, as the first chair of the PCAOB. Shortly afterward, the press revealed that a publicly held company of which Webster had been audit committee chair was under SEC investigation for accounting improprieties. Furthermore, it was shown that Pitt and SEC Chief Accountant Robert Herdman knew of the charges at the time of Webster’s appointment but failed to inform other SEC commissioners. Pitt was pressured to resign, which he did on November 8, followed closely by Herdman. Webster announced that he will step aside as PCAOB chairman before the panel’s first official meeting on January 6. On December 10, the President named William Donaldson, co-founder of investment banking firm Donaldson, Lufkin & Jenrette and former chair of the New York Stock Exchange, the new SEC chair. Under his leadership, the SEC is expected to name a new PCAOB chair soon. In the meantime, the integrity of the financial regulatory process still suffers from the blunders made in the formation of the PCAOB, the very organization that was designed to help the process recover lost credibility.

Not Over Yet

Most anyone would agree that the Enron–Andersen incident has forever changed the face of the accounting practice in the United States. The impact of the scandal on world opinion of U.S. markets has been devastating. Loss of confidence in U.S. markets has caused the dollar to fall to its lowest level in almost three years, slowing the flow of foreign investment. The leadership of the American business and accounting community are partly to blame for a significant loss of reputation. Whether it can ever totally be regained remains to be seen.

As a result of proposed reforms, the U.S. economy will likely become even more highly regulated than it has been in the past. This will result in higher costs for audits and public oversight, which will have to be borne by registered entities and their shareholders, increasing the cost of capital for U.S. businesses. These changes are necessary, however, in order to restore confidence in American markets.

In capitalistic enterprises, two very strong motivating factors operate: greed and fear. For effective control of the unscrupulous few, fear of the consequences of getting caught must outweigh the greed for short-term gain. The Sarbanes-Oxley Act of 2002 raises the price for unscrupulous conduct. The former officers of Enron, WorldCom, and other companies that perpetrated such scandals are just beginning to answer for their misdeeds. In the meantime, businesses and individuals will bear the cost of greater oversight through higher professional fees and lower corporate profits. Hopefully, in the long run, reform measures will restore confidence in U.S. financial markets and the public accounting profession.

C. William Thomas, PhD, CPA, is the J.E. Bush Professor of accounting in the department of accounting and business law at Baylor University in Waco, Tx.
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