Baruch Lev Testifies on Accounting's 'Axis of Evil'
In Congressional hearings on the Enron collapse, Professor Baruch Lev of New York University's Stern School of Business gave the House Committee on Energy and Commerce a short but insightful lesson on the “axis of evil” confronting the accounting profession today. When introducing Professor Lev, Committee Chaiman W. J. “Billy” Tauzin said, “If there were a Nobel Prize for Accounting, it would surely have been awarded to Baruch Lev.” If his testimony helps lawmakers navigate through this crisis, he may still get that prize.
How accounting got here
Basically, the Congressmen wanted to know how the accounting profession had gotten to point where Arthur Andersen became known as the “watchdog who never barked.” In response, Professor Lev drew the Committee a diagram of problems and solutions that are axiomatic to the profession. The result was a study in contrasts that demonstrates the distance between where the profession is now and where it needs to go.
- Financial reporting
- Current status: Too narrow
- Future direction: More comprehensive reporting - Auditing
- Current status: Too cozy
- Future direction: More independent assurances - Enforcement
- Current status: Too late and too opaque
- Future direction: Quick response, transparent investigations
How it can be improved
Taking each element one at time, Professor Lev suggested the direction of future reforms:
- Corporate disclosures must become more comprehensive. They must be expanded to better address corporate networks of alliances, partnerships, and joint ventures, as well as unexecuted obligations, intangible assets and risk exposures. “Accounting is very good at recording simple transactions,” explained Professor Lev. “It is terrible at reporting more complex things that are not regular transactions, and it is useless at portraying the risks to which companies are exposed. We need to move to a very broad concept of reporting. It’s a tall order. But it can be done.”
- Auditing must become more independent. The auditing of public companies by external auditors is currently in many cases an “all-in-the-family” affair. Auditors are for all practical purposes chosen by management. They follow standards set by their own trade association, the American Institute of CPAs. And the industry oversight is performed by peer reviews conducted by other auditing firms. The solution is to move along these lines: (a) Allow shareholders to select auditors based on competitive bids for a five-year period. (b) Put a cap on consulting, but don’t eliminate it altogether. (c) Restrict engagement partners from accepting positions with clients without a waiting period of at least one year. (d) Expand the audit report to include an open-ended report to shareholders on various key subjects. (e) Combine the activities of accounting and auditing standard-setters into one independent body.
- The enforcement system must be strengthened. Investigations of audit failures, and this includes restatements as well as bankruptcies, take too long and are too difficult to understand. The solutions are: (a) Create a quick-response investigatory body that will promptly investigate failures – not just “post-mortems” like Enron, but also before-the-fact preventative investigations. This body should not be funded by the accounting profession. One option is to collect 1 penny for every 100 shares traded. This would raise $71 million dollars a year. (b) Make more of the process and results open and available to the public. (c) Require corporate officers to report insider trading activities more promptly.
When asked by Congress why he favored a cap on consulting by auditors instead of a complete ban, Professor Lev replied, “We have to be sensible. I know this is not going to make me popular, but I’m an educator. It’s no secret that it is not very exciting to work for accounting firms. It is extremely difficult to get young, talented, capable, venturesome, intellectually curious people to work for accounting firms.” A key selling point is the opportunity to switch from auditing to consulting and back again. If this opportunity is taken away completely, says Professor Lev, it will make accounting firms “incredibly unattractive,” with the result that the capital markets will not have the quality of work they want and need.
Do you agree?
To get the complete course, you can listen to the complete audio archive of the hearing or download Professor Lev’s presentation. If you have comments, please enter them below or use the feedback button on the bottom of the House Committee’s web site to send them directly to Congress.
-Rosemary Schlank
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More questions to testimony
The presentation is good and might have merit but how can we propose a fix without knowing what went wrong? We are all assuming that from an auditing standpoint Andersen knew every transactions & SPE. We do need better disclosures. The problem surfaces with the complexity of the disclosures. Bottom line is, the average person probably doesn't understand most of the disclosures.
I would question a few of his points:
The "comprehensive disclosures" would be an improvement, but the topics are subjective. Would the subjective and additional information, harm a company's future?
Asking the shareholders to vote on issues as complex as an acquisition is fine and appropriate. This decision is based on facts and figures that can be used to draw a conclusion. Having them pick an auditing firm, by his own admission, would generally be in the control of "well-informed institutional investors". Isn't that as dangerous as the current system? Wouldn't this cause a conflict between auditors and the "well-informed"? Where do the up and coming firms fit into the mix?
Having the shareholders involved with the fees that the firms receive is a good one. Why not allow the shareholders to decide whether the firm can do audits as well as consulting services? Let them decide.Setting caps on consulting fees is against all capitalistic principles. Caps can be a very dangerous thing!
If an auditor wants to work for a client, what should that person do for a year? What company would hire the auditor if the intension were to work for a year and then leave? Should the auditor deceive the temporary company?
Wouldn't keeping the Financial and Audit groups separate allow for better standards? The two groups have different mindsets in approaching the goal.
Why do we need another body checking the financials? Isn't that the job of the SEC? Wouldn't creating another agency cause more governmental roadblock, costly delays, and confusion between agencies?
Tax shelters and fraudulent reporting go hand-in-hand
I am a retired IRS agent. I have two masters degrees and am now a practicing CPA.
As an agent, I saw the big five actively promoteand structure near-fraudulent corporate tax shelters and not disclose anything about these arrangements to the shareholders. The mentality of stretching the law and playing games with IRS and other regulators has misled the big five into the attitude that "anythinggoes."
I respect a CPA as an advocate for his client, just as an attorney represents his clients, guilty or not guilty. However, when a CPA or attorney begins to sell "sham" shelters, advocasy ends and fraud begins.
I have seen the accounting profession go from a skeptical "watchdog" to a business cheerleader. The overzealous accounting profession has become a condom for business to screw investors and government.
Unfortunately, we need the SEC to oversee the accounting profession NOW. Even the FASB pronouncments on GAAP have become suspect. For example, the recent FASB re: no goodwill amortization immediately increases book income for all companies. Yet, nothing has really changed - goodwill does not live in eternity. Even the tax law (IRC section 197) gives goodwill but a 15-year life. This FASB prouncement allows greater discretion of management to write-off goodwill whenever it is in their best interest. But another game to be played later when taking a "big bath" will be forgotten when next year results report without the "big bath" of goodwill written off.
responses to Prof. Lev
I've always wondered why the entity requiring the audit - the SEC or, for small companies, lending banks or "outside" shareholders - doesn't choose the auditor and manage the audit relationship.
I've been in auditing for about 5 years, right out of college. The whole time I've been doing it, for two firms, the attitude has been that auditing is a loss leader to "get the consulting work." Management within the firms has promoted the idea that auditing is dull, boring and an exercise in paper-shuffling, that we all put up with in search of more interesting and lucrative work. Not surprisingly, staff at both firms agrees.
I'd feel a whole lot better about the work I do if I knew that the banks and outside investors were able to get the best audit possible. I've been hampered by attitudes of "client service" rather than those of "do the best audit possible." If the real stakeholders chose the audit firms and we worked for them, the real clients, I believe the profession would be much better off.
In regard to Mr. Goia's comment about consulting caps being against capitalistic principles, I'd have to ask how unlimited consulting fits in with the "independent auditor" concept. Lying - committing fraud - is also against capitalist principles, and for Andersen to say they're independent in thought and deed when they get three times their audit fees in consulting work, which we all know is more profitable, is an outright lie. When auditors work for the audited companies rather than for the users of the financials, they're not independent, and to say they are is a crime and a shame.
Give Middle Managers a Vehicle to Report Fraud
More disclosure, stronger independence rules and faster enforcement would not have stopped the Enron fraud. While I agree with much of what the professor says, the whole Enron issue boils down to a lack of management integrity and no facility for middle managers to voice problems. It is now coming out that the Enron executives managed through intimidation. Those that saw the faults in the accounting system tried to voice concerns but really had no one to speak with that could take appropriate action, except for the CEO who appears to have ignored the warnings. The only option for managers with integrity is to resign which does not help the company, shareholders or employees if the fraud continues. The managers that close the books each month, prepare the financial reports, review customer and vendor contracts, and others who go about doing their jobs properly know right from wrong. Give those middle level employees a vehicle to report alleged fraud without fear of intimidation or retribution, even if the allegations later prove wrong. This puts a system of checks and balances in place on management integrity that does not exist today. Senior managers will then begin to play by the rules.
fees and a place to tell of wrong doing
I have been working 13 years in accounting, from external auditor to internal accountant of a publicly held entity. I have seen bad accounting and fraud. The bad accounting I try to fix. Fraud, I would try to bring to someones attention. Supervisors, President, Board, Auditors and yes the SEC, if its publicly held. If the situation is such that the transactions are above you, QUIT! Ask yourself if you want to be a part in anyway? Watkins screamed for over a year. Too bad it was all internal. I guess she had no friends at Andersen or didn't have the address to the SEC.I have stepped away from two companies that were committing fraud. One public one private. The public one, it appeared that the board might have been involved and I was not able to draw a straight line to finger anyone. As pressure from above mounted and I could go no further, I quit. The private company was much more interesting (the fraud) and I basically built various roads that pointed to questionable information and left the day before an important meeting. Needless to say information was found and people were caught.
Now to the fees. Setting fees or services is against a firms right to due business. Independence is not an issue that should be taken lightly nor should be set by some arbitary body. Lets have shareholders involvement. Lets them decide their faith. The goal is to protect the shareholders from another debacle.
One of the fingers that is being pointed is to Fees and other services. I guess we won't find any companies that have qualified opinion and high nonaudit fees?
The shareholders, as owners, should have the final say in what services a firm can and can not do. Not some board nor Government. What is the difference if a firm comes in and, in the process of an audit, finds a material misstatement in the current financials, proposes the correcting entry and everyone agrees to post it versus hiring your auditors in the beginning so that it is done correctly the first time. Wouldn't this give the owners, managers and anyone else who uses the financial a better picture? Or is it better to wait for the year-end audit to discover that the past 12 months were wrong? My vote is do it right the first time.
Andersen dropped the ball, looked the other way, what every you want to call it. They screwed up. To accuse all firms that do audits and other services as greedy people is just as wrong.
Fraud can be committed at any time and place. I learned that fruad is hard or near impossible to detect if their is collusion. I would love to see the safe guards between the auditors and the other firms and management.
Oh by the way, I don't do audits, I rather leave that for the big boys that could afford the losses. I actually do accounting and information services. I just hate the thought of the Government making a decision for that should be made by the owners of a company.
Why Auditing Isn't Attractive
As a government auditor I have audited private sector businesses for over 25 years. I have found this activity challenging, stimulating and rewarding. I am certain the same can be as true in public accounting.
As a government auditor, I am not under any price pressure. True, I have to be able to demonstrate I add value to the public and there is the usual underlying "political" environment to deal with, but overall, the government audit serves a useful function and can be independent. We do not do any consulting work and our compensation is fixed.
It seems for public accounting to return to its former high level of credibility, it could learn some lessons from the government sector. I think the profession (I'm speaking of the auditing profession) needs to stop trying to be all things to all people. This can only occur if compensation and "non-audit" services are rationalized. Stengthen the public accountants authority and provide better compensation so they don't have to continually chase the proverbial "brass ring". Eliminate or closely regulate "non-audit" services and the profession will be back where it should be with its image and public trust restored.
Thomas Goodfellow, CPA
Let's hold off on Lev's Nobel Prize
I doubt if professor Lev has spent a day working in public accounting. I found it to be quite stimulating. His ideas to overhaul the accounting profession are certainly provocative (e.g., he would have us add value to Microsoft's balance sheet for their internally generated goodwill), but hardly useful. Without a doubt, there are many reforms that the profession could use. However, just like the airlines are doing stupid things (e.g., frisking little old ladies) to give the appearance of more control, the accounting profession will probably have to go through some useless hoops before the perception problem goes away.
Response to M. Fennema
I doubt if M. Fennema has ever spent a minute reading any of Lev's work. Prof. Lev has spent much of his life attempting to improve the way we measure and report business assets and performance. If we had implemented some of Lev's metrics, I wonder if Enron would have even happened in the first place. I hope our world's best minds keep working to improve the financial reporting process, much as Lev has done thus far, so that we never have to experience another Enron.
Too many rules to begin with
In 1982 Miller's Comprehensive GAAP Guide weighted 1.64 pounds. The 2001 version weights 3 pounds. Eighty-three percent more, and it stoped nothing. If it weighted what the IRS code does, would it make people honest? We have to remember the old saying: If you have integrity, nothing else matters. If you don't have integrity, nothing else matters. My old college professior would have flunked me if I did what they did at Enron.