Issue #6
February 2002
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The Real Enron Secret by Gerry Krownstein Columnists, politicians and industry experts have all spent the past months decrying the venality and incompetence of Enron management, the nonfeasance of Enron Directors, and the conflicts of interest engulfing Enron's outside auditors, Arthur Andersen. The fact that the auditors and the SEC fell down on the job has rocked the US capital markets; in order for these markets to work and work well, there must be confidence that company reports are accurately prepared and that the information that the investing public uses to evaluate potential purchases and monitor the health of its holdings is truly reflective of reality. If this information is corrupt, the entire market system collapses.
Unfortunately, Enron is unusual only in the degree to which corporate management has dispensed with any pretense of obeying the rules. The scary thing is not that Arthur Andersen was in bed with this gang of thieves; the scary thing is that our structures for ensuring accurate reporting, that is, outside auditors and regulatory overview, as they are currently constituted, are systemically incapable of doing what the public assumes they do.
The public assumes that it is the auditor's job to detect fraud. Not so. The public assumes that the SEC reviews the corporate filings mandated by law and regulations for accuracy. Again, not so. The SEC has only a minimal review staff; most companies go for years without any meaningful regulatory scrutiny. The SEC will notice if reports are not filed, but the SEC rarely reviews, in detail, the content of those reports.
Outside auditors review a company's records and attest that the quarterly and annual reports the company issues "fairly represent" the actual financial state of the company. In reality, the auditors of a large corporation doing a complex business often barely understand how that company makes a living. All of the material they review is provided by the company itself; interpretations that make that information meaningful are often supplied by the company as well. The auditing profession grew up in the era of hard-goods manufacturing, retailing of tangible items, and extraction of raw materials, with a little bit of banking and brokerage thrown in. Physical counting of inventory, checking the books for arithmetic, and some common sense and industry knowledge sufficed to make audit opinions meaningful. Irregularities stood out more, and diligent auditors pursued these when they stumbled across them. Today, for many large companies (and for many smaller "new economy" companies as well) the old techniques are inadequate to ensure that an audit opinion means something.
Today's companies are increasingly multi-national; they are in many (often unrelated) businesses at once; their assets are increasingly intangible, often third order abstractions with no physical reality that can be seen, smelled and counted; they often do deals where profit and loss depends on the definition of "is". What's a poor auditor to do? The situation scares everyone.
The suggested remedies (divestiture by auditing firms of their consulting operations; tightening of rules governing the functions and responsibilities of outside directors; changes to accounting guidelines governing partnerships and off-balancesheet financing; rotation of audit firms to enhance auditing independence and accountability) are helpful, but do not attack the real problem. Enron has exposed the dirty secret of our entire financial structure: that is, it is not impossible to do an audit right, given proper rules and training; it is merely too expensive. No audit firm ever does an adequate audit of large modern corporations because the audit fees would be astronomical. The auditors couldn't charge such fees, and their clients wouldn't pay them.
In an honest attempt to overcome this distressing fact, audit firms have increased their reliance on computerized audit techniques and such labor-saving investigatory devices as statistical sampling of fundamental corporate data. The savings generated by such techniques have kept audit costs down somewhat, but not enough. The resulting crisis of confidence in the transparency of our corporations threatens our whole economic system. What can be done, given the all-too-real economics of the situation?
First, international structures must be created to assume responsibility for data flowing from multi-national companies. Second, we must revise our definition of a domestic company to recapture control over entities that are US owned and controlled, but nominally domiciled abroad. Third, and most important, we must recognize that ensuring the quality of the representations made by our largest companies (and those smaller companies occupying a critical position in our economy) is vital to our national economic health, and as such is as much a governmental function as protection from foreign enemies or maintenance of food and drug purity. It is up to the federal government to absorb the costs needed to supplement the efforts of private auditing firms with a periodic truly thorough audit of these economy-critical companies; an audit that is designed to detect fraud and misrepresentation. Once the cost problem is resolved, the accounting profession will develop the techniques and guidelines to achieve the goals of accuracy and transparency. The budget for these super-audits will be large, but way smaller than the economic cost of a single Enron.
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