Where Levitt's plan falls short

What’s the biggest investor loss associated with gaps in financial accounting in U.S. history? No, not Cendant Corp.’s (CD) one-week loss of $11.3bn (£7.77bn), or the Penn Central bankruptcy, or even the $500 billion (£344bn) savings and loan crisis. The crown goes instead to the Nasdaq Composite Index’s 18% drop last March and April–a spill that wiped $1 trillion from investors’ portfolios.

Sure, that debacle was the result of an overvalued technology sector that suddenly confronted reality. Yet there is a connection with accounting. Today’s backward-looking financial statements don’t begin to capture the crucial assets–intellectual firepower, innovative processes, and groundbreaking patents–that underpin New Economy companies. So investors looking for tomorrow’s sources of wealth are flying blind, prey to unsubstantiated information and wild market mood swings. Good accounting can’t cure the market’s volatility, but it can reduce it by giving investors a better fix on companies’ true worth.

CONSULTING BAN

That’s the audit failure that Securities & Exchange Commission Chairman Arthur Levitt Jr. fails to address in his battle royal with the Big Five accounting firms. He is focused instead on errors in traditional financial statements–and whether they are more likely to happen when accountants sell their clients consulting services as well.

But auditors have faced conflicts ever since 1933, when Congress decided that public companies, not the government, would pay for audits. The SEC and the profession must beef up their existing rules to manage those conflicts–an effort for which Levitt has a long and distinguished record of leadership. To improve a system now lacking in checks and balances, the industry should stop resisting his efforts to increase public representation on oversight and standard-setting boards. And it should disclose far more about its consulting jobs and fees so investors can judge for themselves whether an auditor is independent.

Levitt, however, wants to go further and ban accountants from consulting for audit clients. It’s a blunt solution that runs the risk of holding back the new measures needed for the New Economy.

Why? The Big Five say that consulting on information systems and e-commerce puts them on the cutting edge of business. From that vantage, they can start to measure items, such as a company’s customer-service quality, that aren’t on balance sheets even though investors consider them to be crucial assets. They can develop continuous financial statements that provide real-time information instead of historical snapshots. And they can explore ways to audit other measures of value that investors use today–like Web-site traffic and market share locked up by being first with a new technology.

BRAIN DRAIN

The Big Five could still consult under Levitt’s plan. But their inability to consult for audit clients and their affiliates would, they argue, put 30% or more of the consulting market off limits. For a profession that’s already facing a brain drain–from 1996 to 1999, the number of accounting graduates fell by 21%–that raises the risk of driving away talent that is desperately needed. ‘If you’re a young computer whiz, would you go to work for the accountants, where you can only deal with 60% or 70% of the potential clients, or go across the street [to a management-consulting firm] where you can work on any business problem?’ says James E. Copeland Jr., chief executive of Deloitte & Touche, the nation’s No. 3 accounting firm.

The risk is real enough that the Big Five should be allowed to keep their freedom to consult–under stronger rules to protect investors. Audit committees of corporate boards must review and disclose all relationships with their auditing firm–and prove to shareholders that consulting work doesn’t compromise audit independence. Accounting firms must demonstrate to the profession’s overseers that their supervision and pay systems don’t give auditors incentives to cut corners to win consulting jobs and that they discipline auditors who stray. And auditors need more training and clearer standards. A Panel on Audit Effectiveness convened at the SEC’s request recommends, for example, that every audit include ‘forensic-style’ probes where auditors deliberately hunt for fraud in the client’s books.

If the Big Five accepted these steps, the credit would belong to Levitt. It would be a legacy to be proud of: improving today’s audits without slamming the door on accurate accounting for the New Economy.

This article first appeared in Business Week magazine.