In a Fortune article three weeks ago, former SEC Chief Accountant Lynn Turner told me that the current accounting and auditing systems we all rely on need wholesale reform.
Since then, there has been a flurry of activity from regulators, who have issued proposals to shore up weaknesses in U.S. corporate accounting and auditing. The Securities and Exchange Commission (SEC) issued a concept release on potential new audit committee disclosures, including possible new requirements for information about how the audit committee actually oversees the company’s auditor. And the Public Company Accounting Oversight Board (PCAOB) issued two new proposals. One could require disclosure of the partner and others involved in a company audit. The second relates to the potential creation and disclosure of what the PCAOB calls “measures that may provide new insights into audit quality.”
Since audits have been required of public companies for 80 years, you’d think that measures of audit quality would already be clear, well established, and tracked. So why is this just now in the works? Given the choice between the stricter accountability of clear metrics and the greater freedom of none, companies, their auditors, and regulators have chosen flexibility.
If you read what gurus advise on how to get ahead in business, you’ll find many argue that childlike truth-telling is, if not the road to disaster, then at best, naive. The common wisdom on how to succeed in big corporations is to master the art of the massage: massage the customer relationship, the supplier relationship, the boss relationship … and the financials.
Occasionally someone who has gone through the fire comes out the other end and now finds it more difficult to fabricate. That’s what former Enron CFO Andy Fastow exemplified earlier this month when he spoke at a Financial Times conference. Bloomberg reported that Fastow told the audience: “I wasn’t the chief finance officer at Enron, I was the chief loophole officer.” He explained that legal wasn’t equivalent to ethical and that massaging was very much in use today in oil and gas and pension valuations and in the ongoing use of special purpose entities. It is easy to dismiss Fastow and pretend this doesn’t happen, when in fact, it is rampant. But what needs to happen for all of us to be brutally honest without the prerequisite of a prison sentence?
Management estimates are at the center of much of the manipulation that occurs in financial reporting. Tom Selling, a member of the PCAOB’s standing advisory group, told me that auditors get in trouble when they opine on management estimates. He recommends auditors be used to verify facts and appraisers opine on the reasonableness of estimates. “If appraisers are used, and there are adequate safeguards to prevent inappropriate management interference, management will have less of an interest in complex accounting, since they won’t be able to manage their numbers any more,” he wrote me in an email. Audit firms might even act as appraisers, Selling says. But would this be better? To avoid problems similar to those that have happened with credit rating agencies’ opinions on Enron, complex bank instruments, and more recently Puerto Rico, working out who controls, oversees, and pays the appraisers would be crucial.
Five years ago, Congress passed the financial reform legislation called the Dodd-Frank Act. Although some might argue that the Act included the kitchen sink, the legislation actually did little to address the financial reporting and audit issues that kept so many people in the dark about the true financial condition of the largest banks and insurance firms.
Why didn’t Dodd-Frank address this critical aspect of the crisis? No one wanted to admit the accounting and auditing systems were still broken. The financial crisis had occurred just five years after the passage of Sarbanes-Oxley and the breakup of Arthur Andersen, one of the “Big Five” accounting firms. In fact, some people have lamented the loss of Arthur Andersen because innocent people lost jobs and the pool of available accounting firms for major U.S. corporations shrunk 20%.
The Andersen case was a milestone. When 10 years ago the Supreme Court overturned the Arthur Andersen obstruction of justice conviction, CNN reported, “Several jurors told CNN after their verdict in the Andersen criminal trial that they had concluded Andersen officials had suddenly ramped up a dormant document destruction policy in October 2001, shredding tens of thousands of Enron-related papers. It was done when Andersen executives acknowledged in memos they were aware of a probable investigation into Enron’s accounting practices.” CNN, at the time, said presciently, “The ruling is a major defeat for the federal government in its aggressive efforts to fight corporate wrongdoing.”
Changing the prevalent practice of following the rules, but not their spirit, won’t be simple. Things have been sour from the start. When the requirement for independent audits was signed into law 80 years ago, auditors said you can trust us, Selling told me. Within five years, one of the largest accounting scandals of the last century erupted, the McKesson & Robbins case involving audit firm Price Waterhouse’s agreeing to not verify the company’s receivables and inventory. According to W.T. Baxter’s history of the case, in the falsified report, the president of McKesson & Robbins wrote that the company suffered from an “oppressive load of Government regulatory measures.”
Eleanor Bloxham is CEO of The Value Alliance and Corporate Governance Alliance (http://www.thevaluealliance.com), an independent board education and advisory firm she founded in 1999. She has been a regular contributor to Fortune since April 2010 and is the author of two books on corporate governance and valuation.