August 2003

Accounting Profession, Heal Thyself: A Matter of Survival
By Ronald M. Mano, Matthew L. Mouritsen, and James G. Swearingen

After the Enron debacle, which followed and was followed by several other cases of apparent audit failure, the accounting profession faced unprecedented scrutiny. When then–SEC Chairman Harvey Pitt recommended a government organization to supervise the accounting profession, the AICPA’s Public Oversight Board voted itself out of existence. In July 2002, the Sarbanes-Oxley bill was passed, mandating the SEC to establish the Public Company Accounting Oversight Board.

There is a great need now for CPAs to step forward and show how serious we are about our own survival. NYSSCPA Executive Director Lou Grumet wrote last year in Accounting Today, “Now is the time for CPAs and their professional societies to lead change and to require higher standards, higher than required by law.” He was right on target.

The CPA profession has the potential to be the single most important player in the financial well-being of the United States of America. On the other hand, if financial statements are not truthful, the auditing profession is worthless. Six actions must be taken if we are to survive as a viable and respected profession:

The Public Is the Client

This is not a novel concept to anyone who has completed a college-level introductory auditing course. We have always been taught that the ultimate client is the public; however, we, as a profession, have not taken this concept to heart. When auditors talk of the client, they almost always refer to the company and the company personnel.

There is nothing new in this proposal. In 1984, in United States vs. Arthur Young (which resulted from Arthur Young’s audit of Amerada Hess), Chief Justice Warren Burger told the accounting profession, “The independent public accountant performing this special function owes ultimate allegiance to the corporation’s creditors and stockholders, as well as to the investing public.”

Strict Independence Is Essential

This profession has always claimed to be independent but has seldom practiced it. Strict independence means that auditors of publicly held companies should not do any sort of consulting for that client. They certainly should not be their outsourced internal auditors. They should not even do tax work for publicly held audit clients. Again referring to United States vs. Arthur Young, Chief Justice Burger said, “This ‘public watchdog’ function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust” (emphasis added).

In this area the profession should, as Grumet said, go beyond what is now required by law. The Sarbanes-Oxley Act prohibits certain types of consulting, not including taxes, but only contemporaneously with the audit. We should also voluntarily prohibit tax work, and these prohibitions should apply to any audit client, regardless of whether it is contemporaneous with the audit. This does not mean that CPAs should not be allowed to do consulting, internal auditing, or taxes; the only restriction should be that they cannot perform them for their own publicly held audit clients.

What about that long-time problem we call “low-balling”? Were the profession to require strict independence, low-balling would end. What rational professional would use an audit as a “loss leader” when no other service revenue is permitted with that client and the client is required by law to be audited?

Two Statements, Not One

Past court cases involving audit failures can teach important lessons. But often, the accounting profession as a whole does not take such case law to heart. One such case is Continental Vending, which was settled in criminal court in 1968. In that case, two partners and a manager of Lybrand, Ross Brothers & Montgomery (now PricewaterhouseCoopers) were found guilty of criminal negligence.

All seven of the other then–Big Eight testified on behalf of Lybrand, supporting the position that the defendants had followed generally accepted auditing standards and that the financial statements were in accordance with GAAP. The judge was not persuaded, and instructed the jury that regardless of what the accounting standards say, the profession must be held to a higher standard than GAAP. The message was that auditors should evaluate the probable effect of disclosures on stockholders’ investment decisions, and if the disclosures are likely to affect such decisions, disclosure is appropriate regardless of GAAP’s requirements. Clearly, the judge was saying that “fairly presented ... in accordance with GAAP” are two statements, not one.

Internal auditing includes the concepts of “condition” and “criteria.” The public accounting profession could learn much from these concepts. Condition is how things exist: the current situation. Criteria is how things ought to be. To determine criteria an internal auditor must analyze the business or situation and must form his own conviction about how it ought to be. The internal auditor does not have a rulebook for this, but must decide what the ideal situation is. In public accounting, auditors have often been willing to put their stamp of approval on the financial statements as long as they could be convinced that the presentation could somehow be shoehorned into GAAP. There was no conviction on the auditor’s part that meeting GAAP was meeting the ideal.

The 1978 annual report of Con Agra, an agribusiness corporation headquartered in Omaha, included an audited report from Coopers & Lybrand (now PricewaterhouseCoopers). The auditors’ opinion was a standard unqualified opinion, thus implying full disclosure. The footnote related to taxes was completely baffling.

A CPA, attorney, and tax professor read the footnote several times and confessed that he did not understand it. He contacted an uncle who worked for Con Agra in the accounting function about the note, and was told “It’s none of your damn business!” Con Agra was presumably attempting to comply with required disclosures but did not want the general public, a non–tax accounting professor, a tax expert, or even a relative to know what it really meant. Coopers & Lybrand had given the financial statements its stamp of approval even though the firm was probably fully aware that they were incomprehensible to anyone who would read them.

That was 1978; this is now. An article in the November 5, 2001, Wall Street Journal, “Andersen Faces Scrutiny on Clarity of Enron Disclosures,” discusses how parts of the Enron annual report are “indecipherable” and quotes Enron spokesperson Karen Denne, who states that if anyone does not understand the financial statements all they need to do is ask. Judging from other statements in the article attributed to Denne, would her response be very similar to Con Agra’s?

Elsewhere in the article, apparently unaware of Continental Vending, she tries to defend the quality of Enron’s financial statements by saying, “They comply with reporting requirements.” She continues with this appalling statement: “[I]nvestors who didn’t understand the transactions didn’t have to buy Enron stock.” What a way to justify a lack of full disclosure!

Avoid Conflicts of Interest

In the early 1980s, the courts tried to teach the accounting profession a lesson regarding conflicts of interest. Unfortunately, we seem to have refused to learn. In The Fund of Funds, Ltd. v. Arthur Andersen & Co., Arthur Andersen auditors completed the audit with no problems encountered and issued an unqualified opinion. Shortly thereafter, essentially the same audit team began the audit of King Resources. While conducting that audit, the auditors realized that there was a significant contract between King Resources and Fund of Funds. Undaunted, the auditors continued with the audit and were surprised to find that King Resources had not dealt fairly with Fund of Funds. Now the auditors were caught in a dilemma: They could tell Fund of Funds and likely be sued by King Resources; alternatively, they could refrain from telling Fund of Funds and hope that Fund of Funds would never find out because if it did, it would probably sue Andersen. Andersen decided on the latter option but was unfortunate in that Fund of Funds did find out, sued Andersen, and was awarded the first judgment against a CPA firm that exceeded $50 million.

This case clearly tells us that we must avoid all conflicts of interest in our audits. Obviously, if King Resources had dealt fairly with Fund of Funds, Andersen would not have been in trouble. When the Andersen auditors realized that King Resources had not been fair in its dealings with Fund of Funds, it was already too late. Andersen was caught in a dilemma of its own creation.

As soon as Andersen realized it was auditing both sides of the same transaction, it should have declared itself unqualified to complete the audit. In the legal profession, a lawyer cannot represent both sides of a contract.

The run of CPA firm mergers during the 1980s and 1990s, which decreased the number of national CPA firms, increased the likelihood that another Fund of Funds case would occur.

Refrain from Taking Jobs with Audit Clients

Auditors at the Defense Contract Audit Agency (DCAA), the agency that audits private companies that have defense contracts with the federal government, mainly military contracts, are not allowed to take a job with an auditee for a two-year period after leaving the DCAA.

To enhance the independence in fact of external auditors, it is essential that CPA auditors not be allowed to take employment with auditees for some period of time, and two years seems reasonable. Certainly, CPA auditors should be willing to exercise as much independence as DCAA auditors. Apparently, many accounting personnel at Enron were former Andersen employees. In Lincoln Savings, the Arthur Young partner in charge of that audit took a job with Lincoln Savings less than a month after completing the audit, at a salary four times his previous salary.

The Sarbanes-Oxley Act prohibits “a chief executive officer, controller, chief financial officer, chief accounting officer, or any person serving in an equivalent position” (section 206) to have worked for the auditing firm within the past year. Let’s follow Grumet’s advice and go beyond the law by extending the timeframe to two years.

Cannot Be Fired, Cannot Quit

After the 1929 stock market crash, many people lost their life savings as they saw the value of their investments sink out of sight. Most of those investors had little or no information about the companies in which they were invested. The SEC was established and charged with the responsibility to see that investors were given essential, reliable financial information about their investments. The SEC was also charged with the responsibility to see that the financial information is subject to independent review and audit.

At that time, the SEC lacked sufficient personnel to conduct all of the audits of publicly held entities. Therefore, that franchise was given to the public accounting profession. We became de facto SEC auditors.

Now, consider what would happen if the SEC, rather than CPA auditors, were actually doing those audits.

If the SEC were auditing a company and found disturbing information, could the client fire the SEC auditor? Obviously not. Additionally, could that SEC auditor decide to quit and not complete the audit? Again, obviously not. Therefore, because CPAs are de facto SEC auditors, they should be required to complete the audit once it has begun. They should not be allowed to resign even if there is no prospect of being paid for their work unless they encounter a conflict of interest as discussed above. Remember that the real client is the public. Likewise, regardless of how much the auditee disagrees with the auditor, if the company is publicly held, it should not be allowed to terminate that auditor.

This final proposal could not be enacted by the accounting profession, but would have to be mandated by the SEC. All other recommendations proposed here could be enacted by the profession itself, totally without action by any outside agency or influence.

Desperate Times, Desperate Measures

This is a desperate time for the accounting profession, requiring desperate action. We realize that the proposals presented here would be difficult for the profession. However, if we are to survive government intervention and control that has been imposed on us, or perhaps survive at all, it is essential for us to be willing to bite the bullet and adopt these recommendations, on our own accord if necessary. It is time for the accounting profession to solve its own problems.

Ronald M. Mano, PhD, CFE, CPA, is a professor of accounting, Eccles Accounting Fellow, and department chair; Matthew L. Mouritsen, PhD, is an assistant professor of accounting; and James G. Swearingen, PhD, CPA, is a professor of accounting, all at Weber State University, Ogden, Utah.

Thomas W. Morris
The CPA Journal

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