Restoring faith in the audit process.

• Author: Hills, Roderick M.
• Position: Financial Reporting

We need to take the fear out of the relationship between the auditor and the board, the fiction out of the financial records, and the weaknesses out of the regulatory system. here is a roadmap to such reforms.

TWENTY-SIX YEARS AGO I sat before this Committee to explain what the SEC was doing about a corporate scandal that caused a public uproar at least as loud as that now directed at the Enron matter. The focus then was on some 400 U.S. companies that were compelled to disclose that they had made bribes or questionable payments to foreign officials to secure corporate favors. Twenty million dollars said to have been given to the Japanese Prime Minister forced his resignation.

In response, the SEC caused the birth of the mandatory audit committee, substantially increased the auditor's responsibility and mandated new internal controls. There should be no doubt but that those steps greatly advanced the cause of good corporate governance. However, the continuing spate of accounting problems makes it clear that much more is needed.

I have no view to express with regard to the question of whether Enron or its auditors violated any existing regulation or law in the presentation of Enron's financial position. The view I do have is that there are substantial weaknesses in our regulatory system. I will identify those weaknesses, suggest steps that can be taken to reduce or eliminate them, and ask that other steps not be taken.

I speak with 32 years of experience with corporate governance: as a former regulator who dealt with those U.S. companies that made questionable payments to foreign officials and with the auditors who failed to cause the disclosure of those payments; service on 17 boards of directors, as a member of 16 audit committees and as chairman of nine such committees. Eight times I have participated in the termination of chief executive officers. Six times we had to report that over $100 million of income had been improperly reported; on one occasion the sum exceeded $3 billion.

These corporate mishaps will continue until we identify and address the very serious weaknesses that our regulatory system has produced and tolerated for far too long.

First, the system itself needs a major overhaul. The head of NYU's Accounting Department, Paul Brown, put it well: "It's the old adage of an FASB rule. It takes four years to write it, and it takes four minutes for an astute investment banker to get around it."

Second, it is increasingly clear that the accounting profession is not able consistently to resist management pressures to permit incomplete or misleading financial statements, and the profession has serious problems in recruiting and keeping the highly qualified professionals that are needed.

Third, the audit committees of too many boards are not exercising the authority given to them or the responsibility expected of them.

Weaknesses: The Financial System

The financial papers produced dutifully each year by publicly traded companies have become a commodity. Companies produce them largely because they are required to do so. Few CEO's regard this work product as having any intrinsic value. Accounting firms compete for business more on price than on the quality of their personnel or procedures.

If a company does take an interest in the structure of its balance sheet and profit and loss statement, it is far more likely to be caused by a desire to be innovative in how they report their profits than in the quality of the auditor's work. They hire bankers and consultants to design corporate structures that will give them a stronger looking balance sheet and, perhaps, keep the profits and losses of related companies off of their financial papers.

For example, news reports are that Enron spent millions of dollars on Wall Street bankers and management consultants to create a corporate structure that apparently had the effect of keeping both debt and losses out of its own financial picture. The audit partner tasked with understanding such a structure is way overmatched. Unless he can find a precise rule or interpretation that frustrates that sophisticated corporate architecture, those Wall Street wizards will prevail.

NYU's accounting department is correct: the existing system, developed over some 70 years by the FASB, the AICPA and the SEC, produces rules at horse and buggy speed while the global economy moves at light speed, developing new and exotic financial instruments and corporate structures.

The ultimate weakness is that the system suffers from too many rules. The system has been so precise so many times in saying what cannot be done that it has created an implication that whatever is not prohibited is permitted. In law school this phenomena has long been known as: "Expressic unius exclusic alterius." This maze of rules has become a challenge to innovative minds to create corporate structures that wend their way through the maze, satisfying all the rules but frustrating the objective of our securities laws.

The sad truth is that the profession has lost sight of the significance of the signature line of the opinions they give to all their clients. That line reads: "In our opinion, the financial statements [prepared by management] fairly present, in all material respects, the financial position of the company."

Today that broad statement means only: "We have looked but have found no material violation of applicable rules and regulations."

Auditors should be more willing to qualify their opinion by saying: "The company has satisfied all the rules but its financial statements do not fairly present its financial position." Today, any auditor tempted to qualify his opinion in such a fashion...