|By A.D. Freudenheim||
21 January 2002
As the details of the Enron Corporation disaster continue to unfold, so too do the pieces of information suggesting complicity between Enron's senior management and the company's accounting firm, Arthur Andersen. Although in the case of Enron it is unclear exactly who may be guilty of what, one tangential - but highly relevant - discussion that has been sparked concerns the overall role public accounting firms play in American capitalism.
At the moment, the regulations under which American accounting firms operate are not as tight as they might have been; Arthur Levitt, the Clinton-era Chairman of the Securities and Exchange Commission (S.E.C.), tried for several years to pass regulations designed to prevent conflicts of interest in this industry. The crux of these regulations was to bolster the concept of "independence," which in the abstract allows accounting firms to act honestly and with no (financial) motive other than to provide an accurate bill of health to its client and its client's shareholders. For instance, existing regulations prohibit partners in these auditing companies from owning stock in (or even conducting certain business with) a company audited by their firm. Levitt sought to expand these types of regulations to ensure greater independence, for example by limiting an accounting firm's ability to sell other, non-audit services to clients.
The regulations never passed, and with the election of President George Bush, and Bush's selection of Harvey Pitt to be Chairman of the S.E.C., the S.E.C.'s focus on tightening the rules of the accounting industry largely vanished. Pitt, who had previously been a lawyer representing these firms, seems not to have agreed with his predecessor's views on the possible conflicts of interest, or the potential for damage - to the market, or to shareholders - by accounting firms gone wrong. However, by my estimation, it was not that Pitt and his colleagues did not understand the problems that could arise in a case like Enron's. Rather, it is more likely that they made an assessment of the risks and decided that in the broad view of successful businesses, it would be financially unhealthy for both corporations and their auditors to be dishonest in the ways we are now seeing. It was an almost Darwinian approach, more extreme than the general principle by which the free markets operate already: only the best will survive. (And the S.E.C. and members of Congress were encouraged to take this view by the not-insignificant lobbying power of the auditing firms themselves.)
What Pitt's perspective missed is the reality of why the industry needed regulation in the first place: those most likely to be hurt by corporate failures are not the leaders of the business, who will probably bail out before the ship sinks, but the investors whose money helped finance the corporation being audited. The regulations Levitt sought were not designed simply to protect against short-term cheating, but to help guarantee the long-term health of publicly-owned companies, and thus the securities markets themselves.
Now, with the Enron collapse in full view - and following on the heels of other notable problems, like allegations of fraud at Waste Management, Inc. - regulation is back on the table, and new proposals are being floated, by Chairman Pitt and others. But the circumstances of American capitalism have not changed overnight, and neither have the motivations: to make money. Thus what new regulations will undoubtedly will have to address are the possible penalties for mismanagement, which seems an impossible task. After all, Enron shareholders are estimated to have lost more than $60 billion dollars with the failure of the company - what S.E.C.-imposed punishment can possibly make up for that kind of loss? Fining the leadership of Enron and Andersen combined will not enable a payback to the shareholders who lost money.
Under the current set of regulations - which are tighter than the accounting firms want, and not tight enough to prevent another Enron-style disaster - the audit industry now lacks an adequate sense of the consequences of its actions. These firms, which exist as partnerships owned by their own managers, are too important to the process of global business truly to feel the pain of any one management error. When problems arise, partners are fired, work teams are shifted - but the process of ditching an accountant, after many years of happy work together, is not a hasty one for most large companies. Make no mistake, it is a solidly entrenched industry, and despite the scale and importance of the Enron disaster, the real impact of this mess will be felt rather slowly. Therefore, instead of devising new regulations to address outsiders' concerns about the industry, Mr. Pitt and his colleagues at the S.E.C. should push the accounting industry in the other direction, away from the limited partnerships which have existed for so long. The accounting firms should be allowed, maybe even forced, to become public companies.
One obvious benefit of this would be to allow their wealth to be dispersed more broadly throughout the marketplace. The other, more important factors are ones of risk and openness: as public companies, the accounting firms would be forced to disclose more information about their management on a regular basis; shareholders, representing the public market, would have the ability to shape not only the direction of the firm but also have some say in its value. Imagine if Arthur Andersen was public today; a sell-off of shares in a publicly-held accounting firm could be financially devastating to many, but the circumstances provoking it might also never have arisen. In a publicly-held company, every issue from executive compensation to conflicts of interest would be more open to examination, if not to the public than at least to investors.
In the U.S. and elsewhere, the long-held belief has been that this model will not work, that too many potential conflicts of interest exist in an open marketplace to allow auditing firms to go public. That model of independence, however, presupposes adequate restraints on the auditors, with appropriate incentives for good performance and with more-than-appropriate penalties for misdeeds. These incentives, positive and negative, are no longer realistic - think of the $60 billion dollar Enron loss mentioned above - yet the broad public that participates in the securities marketplace is largely unaware of the importance and trust placed in auditors - and of their potential for failure. Only by changing the dynamic, by making the public aware of the risks from a poor audit and by exposing the auditors themselves to such risks, is the situation likely to change.
Disclosure: I worked at KPMG
LLP and KPMG Consulting
for roughly 2 1/2 years. However, I am not an auditor,
and can claim no in-depth knowledge of the broader
aspects of the audit business.
Copyright 2002, by A.D. Freudenheim.
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