Feigned innocence

Sound accounting rules consistently applied and financial statements audited by professionally qualified, independent auditors in accordance with strict standards of auditing are indispensable in any market economy. Any doubts about the credibility and reliability of the accounting rules, the auditing standards and the integrity of the auditors and accountants involved undermine not only those financial statements and the profession but the entire investment and financial system. It is perhaps not surprising that the profession has responded with feigned innocence ranging from “it can’t happen here” in the UK to it is “really a problem of trust”, “this is not a problem with the accounting and auditing profession” to “Enron is an American problem.”

It is hardly worth pointing out that very recently Marconi (UK), Vivendi (France) and HIH Insurance (Australia) have had problems with their accounts, that all the Big 5 Firms before Andersen operated worldwide and that many of the companies involved operate trans-nationally. Even today as I prepare this article from a hotel room in London, the Times reports that Sodexho, a company which operates in Guyana has launched an attack on its auditors, saying that their “statutory auditors have not been sufficiently vigilant.” Another article also reports that “US investigators have accused Cable and Wireless of entering into secret deals with Qwest and Global Crossing, the stricken telecom companies at the centre of fraud enquiries.”

Naivete

It does the profession no credit trying to claim that nothing is wrong with accounting and that it is the misdeeds of a few practitioners who simply failed to follow the rules. That is at best naivete and at worst an attempt at obfuscation and to mislead the public once again. No less an authority than the Financial Times of London stated quite emphatically recently that “accounting goes to the heart of Enron’s failure.” The accounting profession is now in the dock and the daily fare of accounting scandals is not helping its defence. It has shown itself weak in technical matters, spineless in standing up to CEO’s and eager to sacrifice its integrity for profits. Accounting is one of the few professions which require no minimum university education while its much vaunted ethical standards do not seem to have any firm foundation and are not part of the core curriculum of the leading accounting examinations. The standard and perhaps only serious work on the philosophy of audit is decades old and it is unlikely that many accountants even know about it. Accountants move easily from watchdogs in their capacity as auditors to being the architects of clever deals and frauds as CFO’s and CEO’s.

Different results

The public is led to believe wrongly that accounts signed off by auditors are accurate. Auditors, however, understandably use a sample of transactions in their audit and apply the materiality concept that focuses only on those transactions and balances which can affect the fair presentation of the financial statements. In this way it is possible for significant matters to escape the attention of the auditor. The other relates to accounting policies adopted by the company. Two companies with identical transactions can in fact declare substantially different results both of which may carry an unqualified opinion by the same audit firm.

The reason is that accounting standards allow for financial statements being prepared using different conventions with respect to major balances. For example, fixed assets can be depreciated using the straight line or the reducing balance method. Inventory can be valued based on the last in first out average, and the first in first out bases. One company can capitalise its leases while another may expense its lease payments. Similarly one company may capitalise certain costs while another may write off those costs in the year in which they are incurred.

Accounting standards

Other potential sources of confusion include the situation that different accounting standards govern financial statements in the major market economies. The USA uses GAAP while the international community other than the UK (which has its own standards) applies International Accounting Standards (IAS). You may think that this creates a problem for the auditor whose different offices will sign off on the financial statements prepared under different conventions, but it does not. The offices will have to recognise the different accounting standards underlying the preparation of those statements. It would therefore be highly unusual for accounts prepared under these separate regimes to generate the same results.

Alternative policies

Non-US members of the profession have argued that neither IAS nor UK accounting standards would have permitted the substantial liabilities being kept off the balance sheet of Enron or the exclusion of the millions of dollars worth of option payments to the directors not being charged to the profit and loss account. It is true that the profession in the UK had taken steps prior to Enron to bring their reporting standards in line with IAS and it is likely that those efforts will be accelerated. There are, however, differences some of which suggest that IAS also have their problems. They allow companies to choose between alternative policies on the same issue and in the case of pension accounting “allow gains or losses to be ignored if they do not exceed a corridor of 10% of the greater of the gross assets or liabilities of the scheme.” The USA has so far not announced any specific measures to address the deficiencies in its accounting standards.

Larger issues

But there are even larger issues with accounting which are yet to be resolved. Here are some of them:

Income recognition: Companies still have discretion in the timing of recognition of income and expenses. Enron is certainly not the only failed company to have manipulated its income numbers. Global Crossing leased capacity to other telecoms companies and recognised the income immediately while it treated similar capacity leased from suppliers as capital expenses. Other companies particularly in the computer business treat as sold and therefore recognise as income deliveries to warehouse.

Off-balance sheet items: Companies and not only Enron use off-balance financing to keep liabilities off its books. One familiar example is with respect to lease financing so that a trucking operation or a shipping line may operate trucks or ships that are effectively owned under lease terms but which it does not bring into the books.

Expenditure management: America Online and Waste Management are both alleged to have deferred routine marketing expenses thus inflating profits.

Share Options: The profession in the US has joined with big business in resisting attempts to have the cost of options which is clearly an employment cost being charged in the accounts. This could not happen under IAS or under UK accounting standards.

Disclosure

There is also the critical issue of disclosure of information and readers of these columns will be aware of the open and deliberate practice of leading companies which continue to flout the requirement for disclosure of information required by company law and accounting standards. This column is constantly pointing out the deliberate omission of information on transactions with related parties and on segmental information in the accounts of some of our companies, and it remains a mystery that our auditors can put their names to these financial statements. If they do not know that the accounts do not comply with accounting standards then their professional suitability as auditors is questionable, and if they do know then they are clearly part of the conspiracy to conceal information from the shareholders.

The public interest

Professional accountants in their capacity as auditors must recognize that they have a duty to protect the interest of the shareholders to whom in law they report. No less a person then the CEO of the International Federation of Accountants noted in his presentation to the international assembly of the accountants in the UK that the first duty of the profession is the protection of the public interest. Sadly, it seems that the first reaction of the profession is to cover up and protect its membership rather than use its authority to deal with improprieties thereby preserving its credibility. There is no doubt that because of this desire to preserve the status quo, self-regulation has failed miserably worldwide. This of course has led to the introduction of sweeping legislative changes in the USA to correct the situation.