February 4, 2002	Monday	Ziqa’ad 20, 1422

WHEN AN economic or financial bubble bursts and companies built on dodgy foundations are being blown over by the wicked wolf, one question is always asked: where were the auditors?

Sometimes auditors become scapegoats for investors and lenders who failed to assess risks or fell foul of the likes of Robert Maxwell. More often, the question is well asked. The hefty fees charged by the Big Five (British) accountancy firms are inflated by premiums to meet liability claims from company liquidators. The latter are also partners in the Big Five firms. Even accountants insist that they are themselves blameworthy. Why are they getting it wrong?

Enron’s collapse has triggered furious debate in America on the practices of accountancy firms, the relationship of auditors to their client companies and the accounting rules that they enforce. Helpfully, we had a similar debate in Britain more than a decade ago, after a series of sudden, spectacular company failures such as Atlantic Computers and BCCI. In these cases, as with Maxwell and Enron, the company was rotten at the core. Others were hit by employee fraud or fair-weather financial structures.

The most positive outcome was a powerful new Financial Reporting Council to set and enforce accounting standards. Sir David Tweedie, the lively Scot who started its Accounting Standards Board, transformed the UK accounting rules from being easily fudged to being highly robust.

The new UK financial reporting standards enforce transparent treatment of the off-balance sheet financing vehicles that were used to puff up Enron’s reported results. These devices eventually destabilised the company.

The American business had twice resisted a similar reform. With luck, the US Securities and Exchange Commission will now sign up for the evolving rules of the International Accounting Standards Board, which Sir David now leads with his usual zeal.

The most disappointing conclusion of the UK debate was that investors and creditors should not rely on the auditor’s opinion. Investors used to scan the audit report to see if it consisted of two lines claiming that the accounts showed a true and fair view. If there was more, it was a red signal that made investors read carefully, even if what followed was complex.

Now the audit report is a page of querulous, back-protecting verbiage, but no more communicative. Accountants admit that audit is liable to miss major boardroom fraud. Forensic auditing would cost much more, they claim. But no auditor that values its name should take on a dodgy character like Robert Maxwell unless they adopt a forensic approach.

Auditors should never sink into a client/servant relationship with the finance director. Still less should they become cronies. Independence is lost where an auditor depends too much on the fees, as when a small firm has a couple of big clients. The size of the audit firm should relate to the size of the company, not least because big names send juniors to handle small audits.

Investors should be wary when the auditor joins the company as finance controller. This features too often in companies that have controversial accounts. If the auditor goes native non-executive directors should insist on a change of audit firm.

Lucrative consultancy work, including basic matters such as tax planning, often depends on winning and keeping the low-profit audit account. Andersen, Enron’s luckless auditor, earned more consultancy fees than audit fees from the company. So far, the remedy has been disclosure. There will now again be pressure to separate audit from other work to ensure independence. This would also cost more, though not as much as the alternative of rotating audit firms at short intervals, and not as much as boardroom pay.

Separation would rarely make business sense: there are more links than barriers between audit, due diligence, financial systems design and tax consultancy. It may still be a price that is worth shareholders paying.

Rather than rush into bureaucratic rules, however, let the market test reform. Investors big and small should lobby some boards to experiment with dedicated auditors reporting only to non-executive audit committees. And more auditors should experimentally resign when they do not like how a company is being run or accounted for. It might win friends.

When the auditor, the shareholder’s policeman and guardian of probity, is found shredding the evidence, then something has to change.—Courtesy, The Times.