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The GAAP in Enron’s accounts

In the name of shedding light on Enron’s affairs, sarcastic and raging politicians on Capitol Hill spent last month haranguing witnesses who veered between the smug and the terrified. The result was gripping entertainment. But the fact is, Enron is capturing the imagination of the world because so much depends on these hearings.

It is no coincidence that the corporate world is suddenly plagued with a rash of restatements and accounting queries. On Wall Street, petrified investors have been rocked by reminders that financials are not all black and white and that the accountants’ job is to creatively play the rules.

Some US public sector organisations, including the Bush administration, now say they may ditch Andersen. The private sector is being more coy, but Financial Executives International, a 15,000 strong association, urged senior members to discuss Andersen with their audit committees.

Whoever is finally blamed for Enron, it is clear that the entire accounting profession, and even corporate America itself, will never truly save face unless the resulting reforms are as far reaching as the crisis is intense.

There are many reform ideas being kicked around but any reasonable suggestion should at least make financial reporting clearer and more reliable. One politician noted that it is impossible to make morality law. This may be true, but perhaps it is possible to create controls that make fraud or conflicts of interest more difficult to hide. The most convincing ideas so far include a vigilant regulator, an improved policing system for the accountancy profession and new disclosure rules for corporates.

The SEC has promised a new oversight body that will break up the profession’s cosy peer review system, while, because of what the Big Five call a “perceived” conflict, they have promised not to offer lucrative consulting services to their audit clients. These ideas have gone down well.

SEC chairman Harvey Pitt also plans to force the disclosure of “unquestionably material information” as soon as a company is aware of it. However, some commentators argue that Pitt’s measures, which many companies already practice voluntarily, should go further and include real-time financial reporting.

Howard Johnson, director of audit at retailer JC Penney and a member of the Institute of Internal Auditors, argues that, in the not too distant future, companies should move to monthly and then continuous reporting in the interest of creating a culture of openness and trust. “Lots of companies don’t have the systems for this right now but it’s going to be practical eventually, maybe in two years,” he says.

Joe Wells, chairman of the Association of Certified Fraud Examiners, agrees. “Right at this moment all companies have the ability to issue real-time financial statements,” he says. “This would allow accountants to audit continuously. If investors could pull up this kind of information in an instant, executives who are predisposed to cooking the books would have less opportunity.”

However, while real-time reporting could answer some of the mounting calls for transparency, it would be a radical departure from current practice, and it is likely to take some time – or even another Enron – before the SEC agrees to it.

Wells’ other reform ideas include director disclosure of private finances to auditors and the addition of fraud detection modules to accountancy degrees. Apparently, only 19 out of 1,000 US accountancy schools currently have this module. In addition he suggests that every audit team should include a fraud examiner.

Other suggestions include the idea that the stock exchange or the SEC – not the company – should appoint the auditors, and the notion that an external organisation should be made available as an outside resource that auditors can consult.

While Andersen’s suggestion that audits should be graded seems to have won favour initially, the other suggestions will have to wait in line, because there are hotter political potatoes that must be dealt with first.

The off-balance sheet special purpose vehicle, of which Enron had about 4,000, is just one item that comes under this category.

The Financial Accounting Standards Board has examined SPVs for 18 months and plans to release a draft update in the second quarter. The rule, which Andersen chief Joe Berardino says he always disliked, allows a company to remove liability from its balance sheet via a SPV if an outside investor owns 3% of that SPV.

FASB’s Tim Lucas, who heads the emerging issues committee could not say how stringent the reform will be, but he predicted that US SPV rules will not be the same as the UK’s. “It wasn’t the intention of the people who put them in place but the rules are being interpreted as a simple 3% of value. It has become one-dimensional,” he said.

FASB is being hassled to speed up its act. Lucas says: “We’re looking for ways to move on but these are hard questions and we don’t get many points when we put out dumb answers.”

Johnson is also concerned that reforms should be careful rather than hasty and reactive. JC Penney has retained KPMG as its auditor since before 1920, so it was surprising to hear Johnson suggest mandatory rotation of audit firms. “There are no sacred cows. Everything needs to be looked at,” he says. “Rotation would be expensive for organisations because it takes time to train a new firm. But it could be worth it.”

The public discussions about corporate governance have not been as focused as those on audit and disclosure. But Bill Bishop, president of the Institute of Internal Auditors, says Enron’s finance committee, audit committee and directors should have been aware of what was happening. Given his role, it is understandable that Bishop is promoting the importance of internal auditors but his focus on “risk, governance and internal controls” makes perfect sense.

According to Johnson, a good internal auditor is close enough to management to find the juice but detached enough to be able to provide the audit and finance committees with good reports. Part of Enron’s problem was that the internal auditor’s role is not regulated. Companies must be able to say internal controls are in place but they are not required to comment on their adequacy. The US does not have an equivalent of the Turnbull report.

“A good internal audit wouldn’t necessarily have stopped Enron,” Bishop concedes, “but if there was more visibility it would have helped. They should have had internal controls and monitoring.”

Enron the movie is already being contemplated in Hollywood – nobody knows the ending yet but everybody is hoping there won’t be a sequel.

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