Enron: could it happen here?

Andersen, Enron’s auditor, is facing widespread probes into its objectivity after it was revealed the energy giant had conducted numerous off-balance sheet transactions and its auditor had received $27m (£19m) in non-audit fees from its client last year.

However much the profession continues to protest its objectivity, the public – particularly investors – continue to question how a firm can retain its impartiality when it is also selling high value non-audit services to its audit client.

Just two years ago the profession faced an arduous time over auditor independence at the hands of the Securities and Exchange Commission, the main US financial watchdog. Under then chairman Arthur Levitt, the SEC undertook a comprehensive review of the relationship between auditors, the services they provide and their clients. The probe followed the discovery that rules on employee ownership of shares in audit clients had been broken by PricewaterhouseCoopers.

The return of Arthur Levitt
Levitt has now risen again. Last week he slammed the big accountancy firms by calling for a new regulatory regime for auditors in the wake of the collapse of Enron.

Levitt, whose own efforts to tighten regulation in the accounting profession were largely thwarted by the US corporate lobby, said that accounting firms could not be trusted to regulate themselves. ‘There is no present significant oversight of the profession: I don’t think the accountants can do it on their own. I think they’ve been insensitive to the importance of the public interest,’ he said.

In November 2000 new rules were published in the US requiring public companies to disclose in annual statements the non-audit services provided by their auditor.

US accountancy firms were also told to meet strict disclosure conditions if they wished to provide certain non-audit services that the SEC believes impair auditors’ independence.

Now, like then, the big accountancy firms rallied together.

When the SEC announced it was to investigate Andersen over Enron, in a rare turn of events the Big Five rivals banded together and pledged to address financial reporting issues laid bare by the energy company’s collapse.

Cracks in the Big Five union
Since then cracks have appeared in the Big Five union. Nevertheless Andersen’s dilemma will have serious repercussions for the profession in the US and already it appears Levitt’s words have been heeded.

Harvey Pitt, the new SEC chairman, last week outlined a stricter regulatory framework to be made up primarily of non-accountants. He admitted the US financial reporting system of disclosure had ‘long needed improvement’ and made it clear Enron had revealed the ‘inadequacies’.

His concern focused on the view ‘disclosures are made not to inform but avoid liability’. The SEC will review the role of corporate governance and company audit committees among others.

Seasoned observers are talking of horses and stable doors. And for all those former and current employees at Enron who invested their life savings in the company, the news will leave a bitter taste.

Implications for the UK
But these are measures for the US and, while engrossing, experts here are concerned about the implications for the UK.

To allay suspicious of similar faults to the US, the UK’s main professional body, the ICAEW commissioned an investigation of its own. The findings, published at the end of 2000, concluded that the existing regime is effective.

Despite that the UK’s new independent regulatory body, the Accountancy Foundation, has found it necessary – now that the full implications of Enron’s collapse are becoming clear – to undertake a review of auditor independence and make the issue its top priority this year. What conclusions will emerge from this are unclear.

But before doomsayers begin predicting wholesale change for the UK, it is crucial to note important differences with the US.

UK auditors and international standard-setters say UK rules, because they are based on judgement and do not wait for new rules to emerge, are tighter and adapt more easily to new scenarios. It is this that makes many in the British profession believe further measures to safeguard auditor independence are unnecessary here.

A fundamental problem with audits
One of the biggest problems for auditors, as PwC head of assurance Rodger Hughes told Accountancy Age this week, is that good audits cannot be made public because of client confidentiality constraints.

‘It’s the auditors’ lament,’ says Hughes. ‘We have required the replacement of directors, chairmen and finance directors. I regard those as major successes but we can’t tell you about them. They have to be secret because of client confidentiality.’

PwC’s UK managing partner Kieran Poynter, echoes that view. ‘It’s very frustrating,’ he says.

Half the battle is a lack of public understanding of the audit process, something the firm is determined to change.

Another argument against a clampdown on auditor independence has been that it would put firms at a competitive disadvantage if they were not allowed to offer their audit clients certain non-audit services.

Indeed, in statements to the SEC, some of the Big Five argued that offering both audit and non-audit services to clients enhanced their understanding of a company’s business and therefore their work was of a higher quality.

Changing views on audit
That view appears to be changing since the Enron collapse, not only in the UK but also in the US, with the SEC’s promise last week to establish a framework to police the profession. With changes to regulation underway, the only thing that remains to be decided is what form of ethical standards should be adopted. The Enron collapse will be ample proof for many that the US rule-based approach is deeply flawed.

The way forward may have been provided by the International Federation of Accountants, which recently issued its updated code of ethics with a major focus on auditor independence. The code was broadly welcomed by UK accountants, not least because it has adopted a framework that the profession here hopes the US will move closer towards.

The new code emphasises that independence is a state defined by IFAC as ‘the state of mind that permits the provision of an opinion without being affected by influences that compromise professional judgement, allowing an individual to act with integrity, and exercise objectivity and professional scepticism.’

But this principle is dependent on all auditors possessing a high level of integrity and strength of character. Something that is very difficult to demonstrate for the benefit of outsiders.

The principle is backed up by a further caveat – ‘independence in appearance’ – defined as ‘the avoidance of facts and circumstances that are so significant that a reasonable and informed third party, having knowledge of all relevant information, including safeguards applied, would reasonably conclude a firm’s, or a member of the assurance team’s, integrity, objectivity or professional scepticism had been compromised’.

This is easier to measure. And these are the questions regulators in Europe and the United States have to answer. And soon.