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Lasting legacy

The American accounting profession has worked hard to rebuild its reputation following a number of high-profile scandals, but not all are convinced the evolution is complete.

Lasting legacy
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  • Aleks Vickovich
  • March 03, 2016
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In the well-heeled, tree-lined suburbs of Houston, Texas, the legacy of Enron’s monumental fall from grace still looms large. 2016 will mark the 15th anniversary of the energy giant’s shock filing for bankruptcy, but for the Texan business community, the scars are still fresh.

“It was truly a horrible time for businesspeople in this city,” a local oil and gas executive tells me between sips of Kentucky bourbon.

“To see such prominent members of our community become disgraced like that and even go to jail … well, it was no pretty sight. [It] gave us all a bad name.”

The impact was not endemic to the country’s fourth-largest city. The American accounting

profession also bore the brunt. Having become implicated in the vast fraud underlying Enron’s financial position, Arthur Andersen would be accused of shredding documents and other nefarious activities, leading ultimately to the dissolution of the then ‘big five’ accounting firm.

The media storm that would follow would see the accounting profession viewed through an increasingly negative light, severely straining the relationship between accountants and the public. Speaking with Public Accountant, prominent tax accountant Gail Prather says the fallout was not confined to those Arthur Andersen employees directly responsible for the misbehaviour at Enron.

“Any businesses that were tied to Enron in any way suffered reputational damage as a result and a lot of revenue was lost as well by innocent third parties,” Ms Prather says.

“One of my clients is only just getting back on their feet. “Any [public accountants] who worked with Enron have been even more tainted within the profession and that is really unfair I think given the collusion was right at the top.”

While the Enron-Arthur Andersen saga was almost certainly the most high-profile case of accounting fraud, there were numerous similar cases in the US in the 1990s, including at companies such as Bausch and Lomb, Rite Aid, Cendant, Sunbeam, Waste Management, Superior Bank and Dollar General.

Indeed, a Public Broadcasting Service (PBS) documentary aired in 2002 estimated that accounting industry “failures, lapses or outright fraud” cost investors an estimated US$200 billion in the 1990s.

As a result, the accounting profession as a whole came under considerable scrutiny and became engulfed in a heated debate over the professional and ethical standards and – always controversially – the role to be played by government in all of this.

A fresh pair of SOX

Given the notoriously complex system of political checks and balances laid out in the US Constitution, and the liberty-minded dynamism of its free market business culture, reform never comes easy in Washington.

But like the Dodd-Frank regulations that followed the global financial crisis of 2008-09, the Enron scandal and other high-profile cases of accounting fraud had sufficient teeth – in the form of public outcry – to see new rules passed through the usually slow-moving US Congress.

Officially enacted on 30 July 2002, the Public Company Accounting Reform and Investor Protection Act – which came to be known as Sarbanes-Oxley (or SOX) after bipartisan co-sponsors Democratic Senator Paul Sarbanes and Republican Congressman Michael G. Oxley – was an attempt at a major overhaul of the status quo for American accountants.

Among a number of new regulations, SOX delivered greater oversight powers for company boards and the Securities and Exchange Commission, and enhanced financial disclosure, risk assessment and confidentiality requirements for practitioners and senior management of accounting firms.

Upon signing the bill into law, former president George W Bush proclaimed that the “era of low standards and false profits is over”, describing the act as one of the most significant pieces of financial sector reform in US history.

It also mandated the creation of a new regulatory body, the Public Company Accounting Oversight Board (PCAOB), to oversee and, where necessary, hand down punishments to auditors of public companies.

In comparison to how the accounting profession was regulated previously, there is little doubt SOX reflected a significant change.

However, assessing the effectiveness of the new regulations is more contentious, with stakeholders bitterly divided between those that feel self-regulatory professional standards enforced by the associations are better placed to fix problems in the industry than a statutorily created bureaucracy, and those that feel government intervention must go further still.

In December 2015, PCAOB chairman James R. Doty issued a defence of his organisation’s track record since its controversial inception. “What, you ask, has the PCAOB achieved? I look at three resulting, demonstrated trends,” Mr Doty said.

“As the public has sought to know more about what we see in and think about the audit, auditor conduct has changed; as we have emphasised remediation in our communication to the firms, audit

quality has improved; as audit quality gains credibility from credible regulation, better access to capital accrues.”

Mr Doty went on to provide some statistical evidence supporting the three achievements he points to since the enactment of SOX, including the resolution of 128 enforcement proceedings. But – perhaps appropriately given the American penchant for free speech and its commitment to vibrant democratic exchange – not all members of the accounting profession see things quite so neatly as the regulator has outlaid.

The consulting conundrum

While he believes SOX went some of the way to addressing the problems in the accounting profession, Professor Stephen E. Zeff of Rice University believes there is a significant elephant in the room that remains untouched by the 2002 regulations.

One of the country’s foremost historical scholars studying the accounting profession, Professor Zeff says perhaps the largest concern affecting standards and professionalism stems not from

fraudulent or unethical activity but from the business models inherent in the larger firms.

“My strong concern remains with respect to the great volume of consulting activity performed by the big firms,” Professor Zeff tells Public Accountant in an exclusive interview.

“The margins have narrowed [for these companies] since the 1970s and ‘80s and they have rapidly expanded their consulting services and now perform a great deal of consulting work.

“The conflict exists in that the audit firm partner may be under some pressure to ingratiate himself enough so that the client will purchase additional consulting services, which of course increases overall revenue and profits.”

In other words, how can an auditor truly be independent and objective if the firm he or she works for is separately remunerated for advice that is aimed at raising the profitability and revenues of the client company?

Professor Zeff explains that in addition to outright illegal and unethical behaviour, these murky ties between audit firm and client were a related problem in the 1990s that contributed to the profession’s reputational crisis.

“The firms were under pressure to be ‘friendly’ with the people they were engaged to perform independent audits of,” he explains. “That was the concern with Arthur Andersen in particular.”

Consulting is now such an integral part of the larger firms’ revenue base that the scholar predicts should they be forced to choose it would be auditing – which he describes as a far more “essential function” within the practice of accounting – that would receive the chop. Despite this, it has not, according to Professor Zeff, stopped what the academic sees as a general malaise in the auditing function.

“Auditors, now with so many ‘standards’ out around the world, really do little more than tick off a checklist.

“I wonder whether they bring the same thinking game to their work as they used to now that consulting is equal to or greater than the audit function.

“The profession no longer stands up for what it thinks … and that is a great disappointment,” he says. The remaining big four firms have been understandably hesitant to address some of these perceived conflicts – declining, for example, to offer comment for this article – but some commentators intimately acquainted with their operations have spoken out.

Former KPMG international chairman Sir Mike Rake made comments to London’s Financial Times about this topic. “There are dangers in being all things to all people,” he said. Like Professor Zeff, the industry luminary worried that should regulatory pressure force the big firms into an ultimatum that auditing would no longer be a sacred cow.

“If this were to lead to the splitting up of the firms and the loss of multidisciplinary capabilities to large global, sophisticated companies, it would not be conducive to [audit] quality,” Sir Rake fretted.

Auditing alone

Some have suggested the narrow focus of SOX means the PCAOB’s ability to bring about the changes desired by the crafters of the legislation are relatively limited.

While the newly established authorities may have had some success in regulating the auditing function, other professional disciplines within accounting have largely remained untouched, thereby potentially reducing the ability to see behavioural change across the wholeindustry. Ms Prather, for instance, says

the regulations were slightly misplaced in their focus.

Asked if she found the SOX rules overbearing, she replied that, as a tax practitioner, they hardly impacted her practice at all. “The federal regulations focus so narrowly on auditing,” she says. “If anything, I think we need more regulation of tax practitioners.”

So while debates about auditing have consumed the regulatory discourse in the US since Enron, tax accountants meanwhile have been operating in an unsupervised freezone.

“On the assurance side we are subject to peer review and [Inland Revenue Service rules] which don’t have a lot of teeth to regulate people who prepare tax returns,” Ms Prather says. “It actually needs more scrutiny.”

Having said that, practitioners in various states face vastly varying degrees of regulation based on the state-based accounting boards that oversee licensing for public accountants.

In the absence of federal laws governing non-auditor accountants, the professional associations have really led the charge for increasing standards, in conjunction with the state licensing authorities.

However, while continuing education for accountants has been an increasingly important part of the profession – like in Australia – Professor Zeff wonders whether the curriculum is up to scratch.

“The continuing education is often nothing more than ‘how to implement the latest standards’ or an explanation of a new tax law, a new pronouncement,” he explains.

“That does not instil a critical faculty with respect to accounting. They’re just nuts and bolts type things.”

Regulatory roadmap

While it will continue to focus – perhaps disproportionately – on auditors, the PCAOB has not been deaf to the concerns around potential conflicts and seems unlikely to rest on the laurels of previous legislation.

PCAOB board member Lewis H. Ferguson gave a speech to a National Association of State Boards of Accountancy conference in 2012 in which he acknowledged the consulting conundrum and others, albeit with a caveat that he was not speaking officially on behalf of the board.

“There is an inherent conflict built into our system of auditor compensation where the company whose financial statements are being audited hires, fires and pays the auditor,” Mr Ferguson conceded.

“Second, the average tenure of the auditors of the Fortune 100 companies is about 45 years, with some much longer. IBM, for example, has had the same auditor for more than 100 years, and Coca-Cola for 91 years.

“Some have questioned whether tenure of that length by itself, with its implication of a large stream of audit fees continuing into the indefinite future, undermines independence.” In order to deal with these

questions, Ferguson explained that the PCAOB would be embarking on what he expected to be a “highly controversial” project to improve “the auditor’s independence, objectivity and professional scepticism”.

As part of that consultation process, the PCAOB specifically included the contentious issue of term limits and mandatory rotation of audit firms.

However, four years on, change of this kind remains a distant prospect, as the profession and PCAOB board remain split on the issue, despite mandatory rotation becoming law of the land in the comparable market of the European Union. With action being taken across the Pacific and the lasting legacy of scandals past continuing to haunt the profession, it is likely the debates around further regulation will only grow more vocal and heated in the years ahead, especially as the US enters a

presidential election cycle. But while government intervention will probably always play a role in governing professional standards for accountants, there is also something to be said for the very American philosophy of individual responsibility.

While she supports the prospect of sensible regulations, Ms Prather says that in reality these regulatory efforts only have so much impact on her professional conduct since a self-imposed standard already exists.

“From my standpoint the way I do business never changed [with the introduction of new laws],” she explains. “I always held myself to a pretty high standard.”

In addition, she implores foreign observers of the US industry to judge it by the many consummate professionals and not the few unscrupulous operators.

“Just because there was Enron, doesn’t mean we should view the profession like that. In a time of plenty you build a grain silo in order to store the grain for times of less bountiful harvest,” she says “When you do that you always attract rats – but that doesn’t mean you don’t build the silo – you just need to find ways of dealing with the rats.”

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