THE ENRON COLLAPSE AND AUDITOR INDEPENDENCE: Why The SEC Should Go Further In Regulating Accounting Firms >

The collapse of the energy trading firm Enron has focused attention on the issue of auditor independence - again. Memories and news cycles are short, so readers may be forgiven for forgetting that we've been here before.

Only two years ago Arthur Levitt, then chairman of the Securities and Exchange Commission, championed the cause of auditor independence. Throughout the 1990s, accounting firms began to offer consulting services along with traditional auditing services to their clients, and discovered that often, the consulting work was the more profitable. Levitt argued that the two services were incompatible: auditors must be independent of their clients, and consulting enmeshed them in their clients' business in ways detrimental to that independence.

The accounting industry vigorously opposed new regulations. At the time, Harvey Pitt was one of the leading members of the securities bar: he had worked for all the major accounting firms, including Enron's, Arthur Andersen, and he had been a key player in drafting regulations that governed accountants. Pitt's role today is rather different: he is Levitt's successor as chairman of the SEC. But his position is unchanged. Auditor independence is a favorite cause in newsrooms and Congressional hearing rooms, but not at the SEC.

Chairman Pitt maintains that auditor independence is not the problem. Why not?

SEC Regulations That Require Companies to Use Accountants

Courtesy of the Securities and Exchange Commission, which regulates and polices the securities industry, the accounting profession enjoys a unique place in our economy. A company can offer securities to the public without employing a single lawyer, underwriter, or investment banker. Not so, however, when it comes to accounting firms.

SEC regulations require any company that offers securities - meaning, effectively, any major American company - to have independent, certified accountants sign off on their publicly available financial statements. Although a company and not its auditors is ultimately responsible for the information it discloses (or declines to disclose) to the public, independent auditors have long played a critical role in protecting investors. By applying widely accepted accounting principles to their clients' books, auditors are supposed to verify that what a company wants to report as profits are actually that, and that what a company doesn't want to call debts are nonetheless known.

This is, needless to say, a highly lucrative franchise. Think of it this way. When it comes to lawyers, Microsoft can choose what to handle inside its own legal department, and what to send off to outside law firms. Presumably, it will try to choose the most efficient way to address its legal problems.

But Microsoft has far fewer options when it comes to accounting, because the law requires that much of the work be done by outside companies. In the name of protecting investors, the law skews the market for accounting services toward outside accountants. Inevitably, the prime beneficiaries of this thumb on the scales are the outside accountants.

The accounting firms are well aware of the value of their franchise. They speak endlessly of their role in safeguarding the integrity of America's markets. Their main industry body, the American Industry of Certified Public Accountants, helps both to regulate the profession and to protect its lucrative position at the nexus of America's capital markets.

The New Consultants: Accounting Firms

The 1980s saw an explosion in the consulting business. Management professionals, instead of going to work for individual companies, set up shop as management experts. By doing so, these individuals made far more money than they would have made had they simply joined management at a company. Business school graduates, who are usually good at following the money, increasingly went to work for consulting firms (and investment banks) as opposed to individual companies.

Accounting firms got into the act, too, in a big way. They began by offering consulting services for what they knew best - financial systems. But the businesses boomed, and soon Arthur Andersen and others were major consultancies working across the full range of American businesses.

Recent Changes: Pressuring the Accounting Firms to Divest Consultancies

The combination of accounting and consulting practices attracted the attention of the SEC during the Clinton Administration. Using the bully pulpit of the Commission, Chairman Levitt brought enormous pressure to bear on the accounting firms to divest themselves of their consultancies. Arthur Andersen, for example, spun off Andersen Consulting; most of the majors acted similarly.

But the accounting firms did not go quietly. For example, following a wave of accounting firm mergers, the SEC discovered massive violations of the investment rules that prohibit accountants from investing personally in their clients. Chairman Levitt asked the AICPA's regulatory body, the Public Oversight Board, to investigate and to commit resources to policing the investment rules. AICPA's initial response was energetic, but before the investigation was completed, AICPA pulled the plug, withdrawing all funding and support from the POB's efforts. While the accounting firms spun off consulting firms, they still maintained considerable consulting business.

The Case for Auditor Independence

The case for auditor independence is straightforward. Auditors are paid to tell clients how to account for their money. In an era when companies face extraordinary pressure to report ever-increasing profits, and markets severely punish those who don't, auditing independence is vital: investors need to know they can rely on financial statements.

Auditors, of course, are paid by their clients. Theoretically, if Arthur Andersen won't let you book your latest contract the way you want to, you can fire them and hire Ernst and Young. But there are real barriers to shopping for auditors. First, it makes investors nervous. Second, because auditing is ongoing, there are huge costs associated with axing one set of auditors and inserting another. Finally, there are not an endless number of accounting firms that can handle America's largest and most profitable companies. Changing auditors is hard, and so companies have an incentive to listen when their accountants bring bad news.

But what if the accountants have a lot more at stake than their accounting fees? Traditional accounting is, compared to consulting, less and less profitable. Consider: in 2000, half of Arthur Andersen's fees from Enron (approximately $50 million) came from consulting work. This is especially striking given that we are talking about Arthur Andersen - not Andersen's consulting business, which is now independent. Even after Arthur Andersen spun off its consulting firm, it was still generating huge revenues from consulting work.

The Intricacies of Auditors' Independence

Everyone agrees that auditors need to be independent. The question is how to ensure independence without unnecessarily hamstringing other economic activity. There is not enough evidence, yet, that consulting is uniquely responsible for the recent well-publicized auditing failures. In the infamous case of Microstrategy, whose stock collapsed from a high of $330 per share to around $3 per share in the wake of earnings restatements, the accountants did not appear to have a significant consulting relationship with the company. Nonetheless, they signed off on financial statements that were largely works of fiction.

The market may end up punishing Arthur Andersen and other malefactors well enough. Already the papers are reporting a "brain drain": Andersen employees are looking for work elsewhere. And companies may decide that Andersen is too tainted to serve as their auditors.

Nonetheless, the SEC's current response is insufficient. The accounting profession is, as noted above, in possession of a fabulously valuable franchise: every publicly traded company has to use them. If accountants want to keep this license to make money, it is not unreasonable to impose structural limits on their other businesses.

And the SEC cannot simultaneously reject calls for structural changes and insist that it does not need more resources to enforce existing law. The SEC is notoriously cash-starved: its investigators are poorly paid and the turnover rate in the Enforcement Division is astronomical. There is no substitute for the SEC - as AICPA's performance on the POB's investigation into the investment rules amply demonstrates.

Furthermore, there are several practices that are especially problematic. First, linking auditors' pay to consulting fees seems like the most straightforward sort of conflict. The press has widely reported that Andersen's accounting partners received bonuses in proportion to how much consulting work was done. Those arrangements should be flatly illegal: auditors can't be in the position of selling consulting services.

There is also a specific problem with the type of consulting that Andersen did for Enron. One type of consulting that most of the major accounting firms continue to do themselves relates to the accounting and information systems for their clients. Andersen, for example, helped set up Enron's internal accounting procedures. Indeed, when the SEC under Levitt proposed limiting this type of consulting, Enron's chairman wrote Levitt a well-publicized letter in which he praised Andersen's work in setting up the very procedures that contributed to Enron's subsequent collapse.

On one level, of course, this type of consulting make sense. Accounting firms know a lot about accounting; they ought to be good at telling companies how to set up their own internal procedures. The problem, of course, is that such work vitiates the notion of independence. Auditing is supposed to provide a second set of eyes. But if Andersen created Enron's accounting procedures and trained its people, how can it also step back and review those procedures critically? At that point, criticism would be tantamount to an admission of incompetence or worse.

It may not be time, yet, to tell America's accountants that they can't make money by serving as consultants. But at a moment when confidence in publicly-available financial information has been weakened, it's surely time to closely examine, and limit, any activity that contributes to that weakening. Confidence is a matter of perception, and so the standards of evidence should be correspondingly low. Confidence in the markets is far more important than the right of wealthy accountants to make even more money than they already can.