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:

  1. 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.”
  2. 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.
  3. 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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