HBSWK Pub. Date:
May 13, 2002 In an opinion piece in the Financial Times, Harvard
Business School professor Jay Lorsch argues for legislation to create an
independent, self-regulatory organization to oversee accounting firms. Enron,
he says, is not an isolated incident. ***** If companies and regulators are ever to learn from the
collapse of Enron—and prevent similar corporate debacles in the future—they
must look more closely at the relationship between auditors, managers and the
company audit committee. The Enron scandal is not an isolated accounting failure.
Over the past five decades, accountants have changed from watchdogs to
advocates and salespersons. Auditing has become one of a number of services,
including consulting and tax advice, in which accountants "sell" creative
tax avoidance and financing structures. Accountants enable their clients to account
for transactions under generally accepted accounting principles (GAAP) while
reducing transparency and aggressively maximizing earnings and debt. Creative accounting is part of the competition among
auditors that has led to lower profit margins. As a result, the firms have
sought more efficient and cheaper methods that undermine quality audits. The audit committee must have the leadership, independence
and information to oversee the auditors and their relationship with the
management. This race for profitability and the failure of many
auditors to maintain high professional standards cries out for legislation to
create an independent, self-regulatory organization to oversee
accounting firms.Accounting would remain in the private sector, but the
government would be involved, which is critical to restore confidence. The
SRO would have rule-making, supervisory and disciplinary powers similar to
those of thestock exchanges. And, like them, it would be overseen by the
Securities and Exchange Commission. The SRO board should balance members of
the accounting profession with a majority representing the public interest. Company boards require less reform and, in general,
existing law is adequate. The main problem lies in the failure by boards to
follow procedures that would hold managements accountable for
company performance. This could be improved by focusing on three areas. The first is leadership. The independent directors must
have a leader who does not also hold the position of chief executive officer.
Where the CEO and the chairman are the same person, a lead director should be
chosen from the non-executive directors. The chairman of the audit committee must also be an
effective leader. The New York Stock Exchange requires that members of the
audit committee be independent and financially literate, and that at least
one have accounting or equivalent experience. The audit committee chairman
should have this experience and the leadership to insist on full and complete
discussions. These qualities should ensure a strong relationship with
the audit partner, who, though working with the management, must understand
that his ultimate responsibility is to the audit committee. The second area for improvement is independence. The audit
committee, along with most of the board, must be independent. The NYSE
provides a definition of independence that, if complied with in spirit as
well as letter, is sufficient. Furthermore, the auditors must also be independent, with
no unrevealed ties to the company. While the Big Five have abandoned
consulting, they continue to provide other services. Accordingly, each audit
committee should either restrict its auditors to an audit role or publicly
disclose the reasons for any other relationship. Auditors should be rotated every few years to prevent
long-term, close ties between the management and their firm. The audit
committee should also prohibit the management from hiring audit firm
personnel for three years after the person has left the firm. Meetings of the
audit committee should start and end with an executive session without the
management, and the committee, as part of these sessions, should meet alone
with its auditors. Last, information must be improved. The committee should
be supplied with information regarding alternative GAAP methods that would
result in different accounting outcomes and with figures outlining those
differences. The reasons for the committee's acceptance of the management's
and the auditor's recommendations should be disclosed in the financial statements. The audit committee must also ensure that all analyst and
press reports about the company's accounting and disclosures are reviewed.
Both the management and the auditor should be required to address negative
comments and the committee should decide whether changes are necessary. Audit committees are the board's vehicle to monitor
financial reporting. However, neither the audit committee nor the board is a
guarantor and neither has an obligation to ensure perfect accounting or
disclosure. They must use reasonable efforts to ensure management and
auditors fulfill their obligations. To accomplish this the audit committee must have the
leadership, independence and information to oversee the auditors and their relationship with the management. Without them, the next
Enron could be waiting just around the corner.
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