Uncooking the Books

Financial accounting has one quite simple goal: to
give investors and other
outsiders an honest report on a company's performance and management's
stewardship. Accurate accounting ("transparency") is something that we Americans
preach to other nations as an essential precondition for successful capitalism.

In practice, of course, it's enormously difficult to reduce to a handful of
useful numbers the complex operations, spread over many countries, of a modern
industrial enterprise. But in recent years, that task has been badly skewed by
Wall Street's obsessive focus on short-term results and by an array of
executive-compensation schemes that provide corporate officers huge personal
incentives to manage--that is, manipulate--earnings to meet those market
expectations. The public's primary line of defense has been, now as always, the
auditors, whom we expect to remain not just skilled and diligent but, above all,
independent. Independent of whom? Management, of course. The auditors' real
clients are the boards of directors and the investing public.

That line of defense, however, has proved porous. Accounting firms have come
to see auditing not as a governmental mandate and matter of public trust but,
rather, as an opportunity to garner consulting and other business fees from the
very management from whom they purport to be independent. Auditing has become a
loss leader--one that brings in only 25 percent, sometimes far less, of the Big
Five accounting firms' fees from a large company, thus making them increasingly
likely to bless sham transactions and whatever else it takes to let Wall Street
applaud what in fact is a so-so performance. In the last four years alone, more
than 700 companies have been forced to restate their earnings, thus acknowledging
that their auditors had, for whatever reason, failed to follow the rules.

A nasty set of problems--though remedies have become easier now that Enron and
the like have brought accountants front and center. Here are five easy proposals.

  • Bar accounting firms from performing nonaudit services for their
    audit clients. Not some nonaudit services--all. As in the case of the
    prohibition against owning stock in an audit client, we don't say some, we say
    none.
  • Require public companies to rotate their audit firms every
    five years, so that current auditors would know another firm will soon be lookingover their shoulders. Shareholders would gladly foot the added cost.
  • Replace the accounting profession's ineffective, obscure array of
    overlapping panels with a congressionally mandated system of self-regulation that
    provides the public representation and accountability, the effective discipline,
    and the assured funding that have been woefully missing.
  • Define corporate earnings accurately. In Alice in Wonderland
    accounting, earnings are what I say they are. Consistent and public accounting
    standards are needed so that one company's dollar of earnings can reasonably be
    compared with another's. The Financial Accounting Standards Board already works
    under the eye of the Securities and Exchange Commission, but it needs to be
    insulated from the sometimes blatant industry and political pressures by a more
    independent selection of members and committed sources of funding.
  • Don't let auditors rely on a narrow, technical reading of accounting
    standards. Instead, require them to state whether the client's financials would
    provide a reasonably informed reader with an understandable picture of the
    company's operating results and overall condition. Arthur Andersen could not have
    given that assurance for Enron.

    What is the likelihood of success? It's not clear--until and unless boards
    of directors cease giving executives perverse incentives to seek short-term
    stock gains at the expense of investors and employees. The legislative remedy
    lies with state lawmakers and with Congress. Will Enron give our legislators the
    nerve to enact these reforms? Unless public indignation rises, don't hold your
    breath.

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