Enron: Capitalism in a nutshell (Part 4)
Auditors: watchdogs or partners in crime?

by Anna Pha

How can a company's shares be worth over US$60 billion (almost A$120 
billion) and a year later have lost 99 per cent of their value and — 
according to some analysts — be still overvalued? Where were the auditors? 
Where were the regulators?

Enron Corp — once touted as on the way to being the biggest corporation in 
the world, is now the largest bankruptcy case in US history.

"Why did all these people look the other way for so long?", asks Allan 
Sloan writing in Newsweek.

"Money talks or, with Enron, shouts. The company put lots of money in the 
pockets of the people and institutions that were supposed to police it", 
says Allan Sloan, answering his own question.

The thousands of Enron employees and other shareholders including pension 
funds had no inkling of what was going on.

Wall Street loved Enron, Fortune magazine heaped accolades on the 
company and, perhaps most importantly of all, one of the most reputable and 
experienced accounting firms in the world was said to be keeping a watchful 
eye on Enron's books.

Enron paid its auditor, Arthur Andersen, US$52 million a year for auditing 
and other services.

Surely the shareholders had every right to believe Arthur Andersen's report 
that "the financial statements referred to ... present fairly, in all 
material respects, the financial position of Enron Corp. and subsidiaries 
United States"? This statement was a flagrant lie.

According to Allan Sloan's calculations, Enron's debt was soaring by the 
late 1990s. "Enron lost about $2 billion on telecom capacity, $2 billion in 
water investments, $2 billion in a Brazilian utility and $1 billion on a 
controversial electricity plant in India", said Mr Sloan.

"Worse, what a few people knew was that Enron had engaged in billions of 
dollars of off-balance-sheet deals that would come back to haunt the 
company if its stock price fell."

Enron used partnerships and subsidiaries that were "off the books" and 
unknown to shareholders.

Sloan estimates that the JEDI and Chewco partnerships inflated Enron's 1997 
profits by 75 per cent, and over the next three years, by a total of US$396 
million.

When Deloitte & Touche were called in late last year to examine the books 
they quickly drew the conclusion that Enron's profits had been grossly 
overstated and its debts understated for five years. (See previous three 
issues of The Guardian.)

Accounting is big business

In recent years the big accounting firms have undergone a considerable 
transformation, with mergers and rapid growth. They now provide a much 
wider range of services to the big corporations.

Apart from standard accounting, auditing and taxation advice, these global 
businesses advise on mergers, risk management, outsourcing of financial 
management, corporate restructuring (subsidiaries, offshore activities, 
partnerships, etc), and new business models.

Arthur Andersen is the smallest of the Big Five accounting firms, with 
operations in 84 countries. It reported net revenues of US$9.3 billion in 
the year to August 2001.

It was the auditor for the failed Australian insurance company HIH and is 
presently before the courts over its association with the Bond Corporation.

Independent

Arthur Andersen signed off Enron's books as "Independent Public 
Accountants", but Enron paid Arthur Andersen US$25 million for its 
"independent auditing" and US$27 million for other consulting services!

When Arthur Andersen signed the books, saying Enron's practices were "in 
conformity with accounting principles generally accepted in the United 
States", they really were in conformity with practices generally accepted 
in the US.

On average, corporations pay the same auditor similar amounts for non-
auditing work as they do for their auditing.

A survey of 67 firms by the Australian Securities and Investments 
Commission (ASIC) found a similar pattern in Australia.

David S Hilzenrath, staff writer for the Washington Post, said: 
"fees for non-audit services often eclipse those for audits".

He cited KPMG which billed electronics manufacturer Motorola US$3.9 million 
for auditing and US$62.3 million for other services. Ernst & Young charged 
phone company Sprint Corp US$2.5 million for auditing and US$63.8 million 
for other services, and the list continues.

Regardless of the individual integrity of those involved, this situation 
raises a serious conflict of interest.

Where an auditor is providing other services to a company it is auditing, 
it can hardly be said to be independent and it is less likely to be 
critical or do anything that might embarrass management.

Companies may hire or fire an auditor. Consequently, with future career 
prospects and income hanging in the balance, there is little incentive for 
an auditor to publicly expose improper behaviour or "creative" bookkeeping 
being used by the company they are auditing.

The accounting firms even speak in terms of auditing as an "entree" to 
companies to acquire more profitable business with them.

Enron, HIH and a number of the other collapsed companies have brought into 
prominence the practice of corporations employing people who had previously 
audited their books.

This is similar to government officials and ministers taking jobs in the 
corporations affected by the policies they administered. Former Defence 
Minister, Peter Reith's employment as a consultant to firms supplying 
equipment to the navy is an immediate example.

To paraphrase a well known proverb: "Whose books I audit, their numbers I 
sing.

Leaving it to ethics

The question of whether auditors should provide other advisory or 
consultancy services for the companies they are auditing is pretty straight 
forward to most people, especially shareholders and workers. But apparently 
not in the accounting industry.

The Financial Review (17-1-02) quotes the chief executive of the 
Institute of Chartered Accountants (Australia), Stephen Harrison, as saying 
there was no reason to ban auditors selling consulting services to their 
audit clients.

"Clients are addressed through professional ethical requirements and by ... 
company audit committees", said Harrison.

The leading US group representing accountants, the American Institute of 
Certified Public Accountants (AICPA) suggests that the auditor should think 
of himself as a "business adviser" and promote his accounting firm's 
consulting services because "intense competition has reduced the audit to a 
mere commodity that is distinguishable to the consumer only according to 
price."

At present the Australian Government is considering a report (the Ramsey 
Report) on these very questions. Enron has added a little bite to the 
debate which the collapse of HIH had already fuelled.

Cosy relationship

Arthur Andersen presents itself as "creating value" for its customers. "Our 
mission is to build relationships and develop innovative solutions which 
help dynamic people and organizations create and realize value."

In response to a question about developing her relationship with the CEO of 
a client, Arthur Andersen's Peggy Smyth said, "A good client relationship 
is like a marriage-in order to thrive you must have trust and mutual 
respect for one another." In other words, trust the statements and 
practices of the company you are auditing?

The Washington Post staff writer David Hilzenrath tells the story of 
a Samuel Greenspan who was retained by carpet cleaning ZZZ Best Corp to 
audit its financial statements.

Greenspan relied on a report by a prior auditor named Richard Evans which 
ZZZ Best's management gave him.

"Had Greenspan checked, he would have discovered that Evans didn't exist, 
the Securities Exchange Commission said. Had he bothered to inspect the 
eight-story building described in the company's second-largest contract, he 
would have learned that it didn't exist either.

"Greenspan never visited any of ZZZ Best's 15 purported job sites, the 
agency alleged when it permanently barred him from auditing public 
companies in 1991."

"I wasn't hired to detect fraud", Greenspan said in an interview. "I was 
hired to do an audit." Greenspan added that he was investigated by AICPA 
and was "exonerated completely".

The chairman of the US SEC Arthur Levitt Jnr, appointed by the Clinton 
administration, raised the alarm over outside auditors joining corporate 
executives "in a game of winks and nods", and made accounting manipulations 
a prime target of SEC enforcement.

Levitt tried to prohibit accounting firms being consultants to the 
companies they audit. Three of the Big Five and AICPA strongly opposed his 
moves. In the end he settled for a requirement that corporations disclose 
how much they pay accounting firms for auditing and other services.

On the ABC's Background Briefing in May 2000, Mr Levitt said that 
the whole process of auditing financial information in modern companies has 
been corrupted by getting too big and diverse.

"Can the audit engagement partner truly be perceived as discharging his 
public duties while trying to sell his audit clients legal advice or 
consulting services", exclaimed Mr Levitt.

But President Bush came to the rescue of the corporations and the 
accounting industry by replacing Levitt with Harvey Pitt, a securities 
lawyer who has represented each of the Big Five and AICPA, including in 
battles against the Securities Exchange Commission.

Pitt promised the industry "a new era of respect and cooperation".

Internal auditors

It is common practice in big corporations for the board to appoint an 
internal audit committee.

Again there are questions of independence. The Investment and Financial 
Services Association, representing the largest institutional investors in 
Australia, has a Blue Book of guidelines which are generally accepted as 
industry standards.

It recommends that company audit committees should be composed of a 
majority of independent directors (i.e. not paid executives of the company) 
— a recommendation that is often ignored.

In the case of the collapsed Harris Scarfe, the three-man committee was 
made up of the Executive chairman of the company, its Secretary and Chief 
Financial Officer and a former partner of Price Waterhouse Coopers.

"An audit committee has a responsibility to ensure the independence of the 
auditors, and to have ex-partners sitting on the audit committee and being 
in a position of a cosy relationship with their old friends seems to me to 
be a very unusual and not a recommended practice at all", said Henry Bosch, 
head of corporate regulation in the 1980s, when interviewed by Four 
Corners (13-5-2001).

There are no laws against such practices-only voluntary industry standards 
and guidelines. Nor is it illegal to donate bags full of money to the 
regulators, politicians and, even to judicial candidates in the US.

Excuses are trotted out: "Everybody does it", "It wasn't illegal", "We used 
standard accounting practices" and so on. These statements are mere cover-
ups for the incestuous, immoral and corrupt behaviour, the fraud and other 
criminal activities that have to some extent been brought out into the open 
by the Enron and other bankruptcies.

Worrying about the system, Levitt recently said that the greatest threat to 
capitalism isn't the anti-globalisation protestors but the loss of faith in 
the system created by the Big Five audit firms and the way they do the 
books for American companies.

Restoring confidence

Such fears have prompted calls for measures to restore confidence in the 
auditing industry.

For a system already in serious economic crisis, the last thing they want 
is a stockmarket collapse, which could well be on the cards if too many 
investors, particularly pension and superannuation funds turn elsewhere.

Since the Enron bankruptcy filing, Deloitte & Touche, Ernst & Young, KPMG, 
Price Waterhouse Coopers, and Arthur Andersen (the Big Five) have been 
frantically trying to restore public confidence in their firms.

But their calls are for a mere cosmetic tinkering to give investors the 
illusion that there are changes. They steadfastly refuse to accept re-
regulation or public accountability of their activities.

None of the changes proposed so far will end the corruption, the fraud, the 
loss of jobs, workers' entitlements and savings and the catastrophe that 
has overtaken many small shareholders. Nor will they change the 
characteristics of the capitalist system.

Enron was touted as the showcase of capitalism and there are many more like 
it on the brink of exposure and collapse.

How far they are forced to make changes will depend on the success of 
campaigns mounted by shareholder organisations, superannuation and other 
retirement funds, trade unions and the smaller businesses that are also put 
at risk.

Globalisation and the growth of monopolies such as the Big Five accounting 
firms that share global domination, mean that when the crashes do occur the 
losses are far more serious and far-reaching in their impact. Many will get 
burnt.

* * *

Next week: How workers were ripped off.