Inside Information: Checks and Balances

Information technology could do many things, but reporting quarterly and annual company performance to shareholders, stock exchanges and regulators was not one of them.

This was information that determined compensation and promotion, not to mention the company’s stock price and future prospects.

Financial reporting involved a myriad of decisions, and decisions were the domain of managers, with all their human limitations and weaknesses.

Given the risk of error or misrepresentation, it made sense to produce and present financial information using a system of checks and balances.

The system that emerged during the 20th century was based on four pillars.

Federal stock market regulators were created by Congress in 1934 to establish and enforce accounting and reporting standards, with jurisdiction over any company seeking to sell stock to investors; business leaders, to maintain corporate books, establish internal controls, and report to regulators and the board of directors; statutory auditors, to verify the information and documents presented by the company, and ensure compliance with regulations; and independent directors of the company, to appoint managers and auditors, set their compensation and assess their performance.

But as with the system of checks and balances in the political arena, checks and balances in the corporate arena were easier to design than to implement.

Especially after federal antitrust laws, enacted by Congress in the early 1980s, were applied to the accounting profession.

After long-standing professional bans on advertising and bidding by accounting firms were overturned by the U.S. Department of Justice, the hitherto genteel and placid world of accounting was turned upside down, and accountants and listeners began a fee rush.

In 1975, non-audit services accounted for an average of 10% of the total revenues of major US audit firms.

In 2000, they accounted for almost half of total income, with dramatic consequences.

Consequences

Audits have always involved potential conflicts of interest, since the company whose books and reports are reviewed by the auditors is also its payer.

The risk of conflicts would only increase if auditors also provided non-audit services.

How diligently would an auditor examine the books of a client who also paid him a lucrative consulting fee?

Energy services provider Enron was the first major company to collapse, in December 2001, wiping out $60 billion in shareholder wealth.

Enron’s reported revenues had increased tenfold in the five years to 2000, even though profits had barely budged.

Enron has accomplished this remarkable feat by accounting for the full value of service contracts as revenue, rather than just commission, as is normally done, and adjusting the value of these contracts daily, using “mark to market” accounting. designed for futures contracts.

Since Enron’s service contracts did not trade on any market, managers could assign whatever “brand” they wished.

Apparently no one, let alone the company’s auditors, has asked why utility contracts are being treated as financial hedging instruments.

With assets of $65 billion at the time of filing, Enron was the largest corporate failure in US history.

The record lasted barely seven months.

In July 2002, telecommunications conglomerate WorldCom filed for bankruptcy after admitting that the $10 billion in profits it had announced for the previous two years actually amounted to $64 billion in losses.

WorldCom had gobbled up more than seventy companies between 1983 and 1999, using acquisitions to manipulate profits.

When regulators clamped down on new purchases, WorldCom resorted to shifting operating expenses from the income statement to the balance sheet to boost profits.

A range of public companies followed Enron and WorldCom into bankruptcy court, wiping out hundreds of billions of dollars in equity.

The litany of accounting and management abuses included fictitious income, hidden expenses, misuse of acquisitions, unsustainable activities, lavish personal loans, and lucrative related party transactions – all seemingly undetected by auditors.

How did corporate executives pull off such an unprecedented fraud?

Lawmakers and regulators have shone a spotlight on the lack of internal controls over executives and conflicts of interest among ostensibly independent auditors.

Internal controls had long been considered important, at least since the stock market crash of 1929, but given the size and complexity of 20th century businesses and the need to control costs, auditors had adopted an “audit risk-based,” whereby they single-handedly reviewed selected areas of business operations for review.

The auditor for Enron and WorldCom was Arthur Andersen’s venerable accounting firm.

Founded in Chicago in 1913 by a famous accountant with a passion for education, who created the first centralized on-the-job training program for accountants, Andersen earned $52 million in fees from Enron in 2000, split also between its audit and advisory divisions. .

On the last day of August 2002, 55 years after Arthur Andersen’s death, the company he had painstakingly built, on the belief that accountants served investors rather than corporate management, relinquished its license practice of accounting and closed its doors, pushed by bitter infighting. between its auditing and consulting divisions, shamed by its association with the biggest corporate bankruptcies in American history, and abandoned by the very clients it had chosen to serve.

The author is a writer and researcher in Dhaka, who previously worked as an investment banker in London and New York