Stop Playing Games

Legislation Falls Short of Correcting Underlying Problems in Accounting, Audit and Corporate Governance

By Eugene A. Imhoff Jr., the Ernst & Young Professor of Accounting and the Director of the Paton Accounting Center at the University of Michigan Business School

Congress has passed and President George W. Bush has signed into law new legislation designed to address the problems with accounting, auditing and corporate governance.

And although Congress is struggling to find enough Board members who are acceptably "independent", the substantive provisions of this legislation fall far short of what is needed to correct the real underlying problems afflicting our marketplace.

Accounting-related misdeeds and auditing failures have taken down a number of prominent companies, including one of the largest CPA firms in the world. And the carnage may not be over yet.

In part, the problem stems from the fact big CPA firms have focused too heavily on reducing audit costs in order to be price competitive in obtaining new clients.

Cost containment has been achieved by lowering the standards for entry-level hiring, reducing the costly "tests of details" aspect of audits and cutting the number of hours required to conduct audits.

In hindsight, the impact of these changes on the quality and integrity of the financial-reporting system seem obvious. Now, in the aftermath of the 1990s economic boom, concerns about accounting and auditing quality are surfacing with great regularity.

The fundamental contribution of auditors is their independent assessment of the fairness of management's financial statements, which entails verifying those statements conform to acceptable accounting rules, or Generally Accepted Accounting Principles (GAAP). Auditors use these accounting rules to determine whether managers are reporting fairly to shareholders. Unfortunately, all too often, auditors assume that if there is no specific "bright-line" rule to prohibit management from doing what it wants, then the resulting financial statements "fairly present."

Over the years, the role of professional judgment in auditing has been pushed aside. Today auditors are mostly rule checkers.

This situation has evolved in part because auditors have demanded more rules to hide behind. What's more, auditors have shied away from exercising professional judgment or confronting management about questionable or aggressive accounting practices. In most cases, if the practices used by the Enrons of the world are not obvious violations of GAAP, clean audit opinions will be issued.

The financial-reporting environment is also flawed. Managers are rewarded for superior performance through cash-bonus, stock-option and stock-award plans, which are based on accounting results. This practice has made corporate financial statements the focal point of management's wealth-maximization strategy.

Often managers try to mask their wealth-enhancing activities and/or their managerial failures (despite the great transparent maze of accounting rules) by manipulating the accrual-based financial reporting process.

If they find themselves in trouble while perpetuating these window-dressing activities, they can call upon the creative talents of high-priced financial consultants. The role of many of these financial wizards is to develop new, untested financial schemes designed to make managers look like they are achieving results beyond the expectations of shareholders.

Mandate Rotation of Auditors

The proper way to fix the audit industry is not by creating a new oversight board or by forcing the corporate partner in charge of the audit to rotate every five years to another auditor within the same CPA firm. These are weak proposals that do not address the fundamental problems.

In order for auditors to maintain their independence from managers, there must be a mandatory rotation of CPA firms for all major publicly traded companies every three years.

This rotation would encourage auditors to exercise their professional judgment whenever management is observed doing something that could be detrimental to the shareholders, even if it is not an obvious violation of an accounting rule.

Read more about Corporate Governance: Peter Clapman: "We can create a better investment climate" Carl Levin: "Promote a culture of openness, competency and candor" Richard Grasso: "Some have abused the system" B. Joseph White: "Earn the Public's trust"

Moreover, rotating auditors would create a comprehensive oversight of the procedures and judgments employed by the predecessor audit firm. CPA firms would be continuously checking up on one another, so there would be little need for an external oversight board.

Mandatory rotation also would address the revolving-door problem of having auditors perform audits of managers who were formerly fellow auditors themselves. In addition, rotation should do away with low-balling practices by requiring each audit to be priced to make a profit on its own.

Even if an audit were to cost more, there is every indication shareholders would gladly pay for the enhanced quality and integrity of the financial-reporting process.

Many CPAs oppose mandatory rotation because they believe there are greater risks associated with the first year of an audit. However, those risks actually may be associated with low-ball bidding practices and the decline in the quality of auditors used to staff the job.

Professional auditors should and can be effective at auditing. CPA firms must overcome any issues associated with rotation and work to regain public trust and professional respect for the audit industry without the pressure of losing the audit if they stand up to management.

Make Board Members Independent

No matter what is done to correct the ills of the audit industry, bigger problems with the corporate-governance system will persist and continue to cause more failures unless those problems also are remedied. In too many instances, corporate boards are aligned with the interests of corporate management and do not adequately represent the shareholders.

Frequently, the current or former CEO chairs the corporate board, handles the nomination of new board members and effectively controls the agenda and persona of the board.

To make matters worse, many of the directors who sit on corporate boards are not capable of evaluating financial information in depth, and they may be compensated with stock options whose value is heavily dependent upon future financial performance.

Four things could be done to address current corporate-governance weaknesses. First, the CEO or any other past or current top manager should be prohibited from acting as the chairman of the board of directors at any publicly traded firm. Second, outside directors should not be allowed to hold stock options in the company.

Third, a subcommittee of outside directors should be established to nominate new board members who act independently of management. Fourth, a continuing-education requirement, encompassing 30 hours per year of corporate-funded coursework from an accredited program of study, should be made mandatory for all board members.

These changes may make it more challenging to find qualified people willing to sit on corporate boards. However, the remedies could go a long way toward enhancing the independence and competence of the board of directors and compelling them to properly represent shareholder interests. .

No serious improvements to the audit industry and corporate governance will occur if the total responsibility for instituting reforms is left in the hands of Washington politicians who struggle to staff the new oversight board months after its approval.

The American Institute of Certified Public Accountants and the Securities and Exchange Commission or the stock exchanges themselves should take the lead in initiating changes to improve the quality and integrity of our system of financial reporting and governance.

And the rating agencies and security analysts also should become more organized and proactive at stimulating substantive changes to bring about important long-term improvements.

In short, America's capital markets are afflicted by problems in accounting, auditing and corporate governance that have undermined the quality and integrity of financial reporting. Only by making serious and substantive changes at all organizational levels across the board can the American business community move forward into an orderly marketplace.

A Timeline for Accountability

• 1700-1799 - The Industrial Revolution stimulates the formation of capital markets and the separation of owners and managers. Owners voluntarily hire independent auditors, but publicly owned corporations have no requirements for auditing and are guided only by the financial reporting rules of the stock exchanges until well into the 20th century.
• 1933-1934 - After the 1929 Crash, Congress attempts to renew public confidence in the financial markets by passing the Securities Act of 1933 and the Securities Exchange Act of 1934, establishing the Securities and Exchange Commission (SEC).
• 1937 - The SEC begins issuing financial-reporting standards and requires all publicly traded corporations to have an annual independent audit, attesting to the fairness of management's financial reports to shareholders and noting any deviation from the acceptable rules of accounting and reporting. Elected shareholder advocates form corporate boards of directors to oversee managers and protect shareholder interests.
• 1939 - The American Institute of Certified Public Accountants (AICPA) forms the Committee on Accounting Procedures (CAP) to help establish accounting principles.
• 1959 - CAP is replaced by the AICPA's Accounting Principles Board.
• 1974-1976 - Congressional investigations target the public accounting profession's lack of independence, particularly the practice of serving as both independent auditors and management consultants. CPA firms weather the storm and recognize the strategic advantage of developing their high-margin consulting practices. Corporate mergers stimulate growth within the CPA firms.
• 1973 - The Financial Accounting Standards Board (FASB), an independently funded, full-time standard-setting organization, is created, placing America at the forefront of the worldwide development of accounting standards.
• 1980-90 - Major CPA firms develop strategies to attract a bigger client base and to provide full-service consulting to clients in every industry. AICPA rule changes permit CPA firms to advertise, thereby stimulating open competition, cost cutting and low-ball bidding. Through massive consolidation, the Big 8 CPA firms become the Big 5. Auditing is turned into a commodity
• 1999 - The SEC supports the findings of the 1998 "Blue ribbon Committee on Improving the Effectiveness of Corporate Audit Committees," a joint effort of the New York Stock Exchange and the National Association of Securities Dealers.
• 2001 - Enron's collapse and subsequent corporate meltdowns unleash a public outcry and congressional action against accounting abuses and corporate malfeasance.
• 2002 - Congress passes the corporate-governance and accounting-oversight bill, which is signed into law by President George W. Bush.