The collapse of energy giant Enron has underscored a strong need to clean up America's financial markets. While congressional committees pore over documents in an effort to find out who was responsible for Enron's sudden descent into insolvency, regulatory agencies are considering changes to the way companies audit and report financial results. The stakes are high. The Enron debacle has already cost investors around the world billions of dollars. The losses will be higher still if confidence in U.S. capital markets is allowed to erode further.
Prague, 13 February 2002 (RFE/RL) -- U.S. regulatory authorities are proposing measures to improve corporate accounting standards in the wake of the unfolding Enron scandal.
The head of the federal Securities and Exchange Commission (SEC), Harvey Pitt, has proposed creating an independent oversight board that would monitor the major accounting firms for accuracy and reliability. The board -- composed of accountants and other financial professionals -- would have the power to impose penalties.
The accounting profession has come under strong criticism for the failure of auditing firm Arthur Andersen to foresee the failure of its client company Enron, the biggest corporate bankruptcy in U.S. history.
Texas-based Enron collapsed just weeks after Arthur Andersen approved its corporate accounts. The bankruptcy cost investors billions of dollars and sparked a crisis of confidence in the country's financial markets.
The U.S. has the world's biggest financial markets and attracts substantial investment from around the world. The U.S. is often held up as a model for other countries to emulate when regulating their own markets.
In a speech to the SEC on 17 January, Pitt pointed out that "accounting firms have important public responsibilities." He said the U.S. cannot afford to have an accounting system, such as the present one, that "facilitates failure rather than success."
Arthur Bowman, the editor of the respected industry watchdog publication "Bowman's Accounting Report," says the new oversight board would replace the current "peer review" system whereby the five biggest accounting firms review each other's work. The peer review system has been criticized for being too soft on the accounting firms.
"The SEC has said it wants to create an oversight board, independent of the [accounting profession]. Currently, the [accounting] profession has its own oversight board and does 'peer reviews' -- one firm reviews another firm's quality control standards," Bowman says. "Chairman Pitt wants to establish this independent board that would have its own staff that would do these reviews and quality control standards."
Accountants play a crucial role in any healthy market economy. When accountants audit a company's books, they certify that the accounts meet all legal requirements for reliability and can be trusted by creditors and investors. When those numbers are suspect, that trust vanishes.
The Enron scandal has roiled financial markets around the world as investors have dumped shares of companies that -- like Enron -- have complicated or suspicious accounts. Some investors have even gone so far as to question whether the huge increase in U.S. corporate earnings over the past decade -- which fueled a historic rise in stock prices -- was in fact simply an accounting illusion.
The SEC is considering other reforms to the accounting profession. One radical proposal would have the exchange on which a company is traded, such as the New York Stock Exchange, for example, pay for a company's auditing services, and not the company itself.
Proponents of the idea say it would eliminate the conflict of interest when a company pays for an auditor's services yet the accountant is expected to produce an objective evaluation of that company's books. Enron, for example, paid Arthur Andersen $25 million in 2001 for its audit.
Bowman says that when an auditing firm receives $25 million for an audit, it's unrealistic to expect it to be objective: "When fees like that are being exchanged, it appears that no one can be independent."
Another reform under consideration involves prohibiting accountants like Arthur Andersen from offering companies both auditing services and general business consulting services at the same time. Such consulting services make up a growing component of accounting firms' revenues.
In the same year that Enron paid Arthur Andersen $25 million for an audit, it paid $27 million to Arthur Andersen's consulting unit for business advice.
Supporters of the practice say it saves money for the client and, ultimately, shareholders. Detractors, however, point to a conflict of interest. An auditor's obligation is to the general public. Consultants, on the other hand, serve solely the interests of the client.
The major accounting firms are now taking steps to separate -- and in some cases sell off -- their consulting units to avoid this conflict.
It's still not clear whether Arthur Andersen violated any laws in its handling of the Enron audit. Enron executives are suspected of manipulating the company's financial statements to hide losses in a bid to inflate the company's stock price, then selling off the inflated stock at a profit. The stock collapsed as news of potential fraud began to leak out. The company declared bankruptcy a few weeks later when it could no longer raise money to pay its debts.
It's not yet known whether Arthur Andersen simply failed to notice the irregularities on Enron's financial statements or took an active part in committing fraud. Several congressional committees are now looking into the matter, but a final determination is still weeks, if not months, away.
It's not clear how much information these congressional committees will uncover.
Former Enron Chairman Kenneth Lay appeared yesterday before the Senate Commerce Committee, one of the groups looking into the Enron collapse. But instead of testifying, he chose to exercise his right under the Fifth Amendment of the U.S. Constitution that protects individuals from incriminating themselves. Lay, who may face criminal charges for his involvement in Enron, said he chose not to testify based on advice from his attorney.
"I've [wanted] to respond to the best of my knowledge and recollection to the questions you and your colleagues have about the collapse of Enron. I have, however, been instructed by my counsel not to testify based on my Fifth Amendment constitutional rights," Lay said. "I am deeply troubled about asserting these rights, because it may be perceived by some that I have something to hide. But after agonizing consideration, I cannot disregard my counsel's instruction."
Lay became the fifth Enron executive, plus a senior auditor at Arthur Andersen, to seek protection under the Fifth Amendment.
Arthur Andersen's chief executive officer, Joseph Bernardino, appeared on 5 February before the House of Representatives Subcommittee on Financial Services. Unlike Lay, Bernardino opted to speak. His testimony, however, was vague and may prove to be of little value.
When asked by subcommittee Chairman Richard Baker whether the Arthur Andersen audit accurately reflected Enron's financial state, Bernardino said he did not know. He said several questions remain unanswered.
"Mr. Chairman [Richard Baker], in hindsight we could look at what happened, and I regret to tell you that I can't answer your question with authority because there are several unanswered questions. What did people know? When did they know it? And as I testified last time, everyone's talking about the off-balance-sheet liabilities, but they had to move. Enron had to move assets off the books with those liabilities. And one of the big questions I have -- I don't have an answer to -- [is] when did those assets go bad?"
Another controversial reform being considered involves controlling the activities of stock analysts. Analysts typically work for brokerages or investment banks. Their job is to recommend to investors whether or not to purchase a given stock.
Analysts from the biggest brokerages or investment houses exert a strong influence over the value of a stock. A good word from a respected analyst can boost the price of a stock 10 percent or more on a given day. Similarly, a poor review can knock the price down by the same amount.
New rules would prevent analysts from owning stocks that they recommend. They would also try to restrict the practice, now common, of analysts touting stocks held by their own banks or large customers.
But analysts are skeptical that the measures -- on their own -- will clean up American's financial markets.
Anais Faraj at Nomura Securities in London says that not only are new rules needed, but also the investing culture needs to change. He says regulators need to instill what he calls a "culture of compliance" among the country's corporate managers, accountants and banks.
"It's really two things. It's about strengthening compliance. Any time there's a 'bull market' [a rapid rise in stock prices], compliance [with regulations] goes out the window. And it's about making sure that companies present their results in a consistent manner year on year so that you can make comparisons," Faraj says.
Accounting watchdog Bowman is more emphatic. He says it's simply wrong to place the blame for Enron on accountants alone. The entire system, he says, is rife with abuse.
"But also we have securities dealers who are 'pimping' stocks [misrepresenting stocks in order to sell them at a high price]. We have corporate executives who are being rewarded for driving stock prices up -- and not necessarily creating long-term values in the company," Bowman says. "So there are all kinds of factors here -- not just 'where were the auditors?'"
Bowman says many companies employ the same questionable practices -- such as shifting debt to partnerships outside of the company -- that got Enron into trouble. He says Enron simply abused the rules. Many are now saying it's time to change some of those rules.