From an accountant’s view, The

Enron affair: From an accountant’s view, The

Trager, Michael H

The bankruptcy at Enron Corp., the largest in United States history, will most certainly have a major impact on Enron’s auditors, Arthur Andersen, and most likely the entire accounting profession. This article will focus on Enron’s effect on the accounting profession from this accountant’s point of view.

Two major issues surround the Enron bankruptcy as it relates to accountants. First, Enron used off-balance-sheet partnerships to hide losses. Based on current accounting rules, these special-purpose entities would have been valid mechanisms had they not been owned by related parties to Enron, in many cases employees of the company. The accounting failure was the lack of disclosure of these related-party transactions. Second, the fact that the accounting firm received more than half of its Enron revenue from consulting services gives an appearance of a lack of independence in the audit.

Securities and Exchange Commission Chairman Harvey Pitt has stated that reform of the financial reporting and disclosure system is needed. However, he has said that “…we will not throw out our current system and we will be sensitive to the costs and benefits of any changes.” The SEC will be issuing new rules regarding financial disclosures. These rules will likely require more current disclosures, more comparisons between trend information and historical data, and simplification of filing documents. One area being focused on is the Management Discussion and Analysis (MD&A) where the SEC wants detailed information on corporate asset sales and receivables and on transactions involving related parties. Such reporting would have disclosed information about the losses in related Enron partnerships. In addition, the SEC wants more disclosure about a company’s sources of capital. Mr. Pitt has supported the creation of a private entity that would regulate accountants.

While Andersen’s consulting business for Enron has been a continuing source of discussion by the SEC, Andersen has claimed that the consulting revenue did not affect any of its audit decisions. This may well be true, as the audit itself represented $25 million in fees. However, to the public the appearance of independence is impaired when one firm provides both audit and consulting services. Senator Barbara Boxer of California plans to introduce legislation to bar accounting firms from providing consulting services to companies they audit. The SEC proposed a rule last year to limit the amount of consulting work that accounting firms can do for clients. After heavy lobbying by the accounting industry, the SEC modified the proposal and only required firms to disclose the amount of fees charged for other services.

As accountants, our audits are often looked at as the “seal of approval.” When things go wrong at a company that we audit, third-party users of the financial statements look to the accounting firms as the “deep pockets” to recover their losses. As a result, accounting firms are allocating more time as part of the audit program to review for fraudulent activities. This still does not guarantee that our procedures will uncover a well-hidden fraud, in particular when collusion exists among many employees of a company. Audit procedures consist of samples of records, not the review of every single transaction of a company.

What is likely to happen to Arthur Andersen? The claims are likely to reach up to $30 billion. Andersen’s insurance coverage is probably less than $300 million, according to Mark Cheffers, chief executive officer of AccountingMalpractice.com. Since the company is a limited liability partnership, creditors cannot take the partners’ personal assets. However, partnership assets are fair game. There is likely to be a substantial impact on partners’ income, which could affect a partner’s longevity at the firm. In addition, the desire to become a partner in the firm would be severely limited. It is too soon to tell what effect the litigation will have on other clients of the firm. It is possible that there will be fallout of clients. It is also possible that one of the other Big Five firms may acquire the firm.

Arthur Andersen employs 84,000 people worldwide and reported revenue of more than $9 billion last year. Even considering the huge financial impact on others of the Enron disaster, there is something wrong with the system when one case could totally eliminate a company of Andersen’s size. This would be a case of compounding one disaster by creating another. There is a need for reform in the area of malpractice litigation.

The effects will reach far beyond Andersen. Inevitably, more regulation will raise the cost of doing business, which will raise the costs of audits. In the past, audit fees have been used as loss leaders to generate more profitable consulting work. If the consulting work is limited, audit fees are likely to go up even without stiffer auditing standards and greater disclosures. Stiffer auditing and disclosures will also serve to raise audit fees.

Accounting firms currently have a system of peer review by other accounting firms in order to assure that we are following our own standards. This self-policing is taken very seriously by each firm, but once again does not provide the public with the comfort it requires. In light of Enron, it is being suggested that peer reviews be done in the future by an independent auditing firm.

Another suggestion that has been made is that accounting firms stick to accounting and perform no consulting services, therefore not being tempted to use audit fees as a loss leader for other business. The likely effect of this could be one of two extremes: either audit fees would skyrocket or there would be no firms providing audit services anymore. Neither seems an appropriate solution.

The Enron bankruptcy has once again cast the accounting profession into the public eye. Due to the massive size and effect on so many individuals and companies, it is unlikely that the status quo will continue for the profession. The coming months will provide many challenges to us. These will come from government, the SEC, the public, the courts and from within the profession. It should be remembered that integrity is still one of the watchwords of our industry. We must learn from these events and respond to those lessons.

(This article contains opinions of the author. It does not represent the position of McGladrey and Pullen, LLP.)

Michael H. Trager, CPA, MST, is a managing director in the Philadelphia office of RSMMcGladrey, Inc. He is a member of the Lender Advisory Services team. Mr, Trager is on the Governing Board of the CFA Education Foundation.

Copyright National Commercial Finance Association Mar/Apr 2002

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