Accounting Ethics (and fraud)

Postings by Art Berkowitz on ethics and fraud. Most of them are serious, but sometimes we also need to have a little fun.

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Location: Orange County, California, United States

Art Berkowitz, C.P.A. is an author, speaker, and consultant from Orange County, California. He writes ethics, fraud, and accounting courses (CPE) for accountants and other financial professionals. Art has also written a weekly online column for The Wall Street Journal and a book on the Enron debacle. To order any of his self-study courses go to

Wednesday, June 29, 2005

Can We Really Have Independent Auditors?

The issue and problems surrounding auditor independence and objectivity will continue as long as auditors are paid by their clients. Whether the audit fee is $25 million as it was with Enron or $25,000 for a private company audit, the independence of the auditing firm could be impacted by the importance of the fee (either real or imagined) to the engagement partner, the firm's managing partner, or the firm itself.

As of yet, no one with any clout has been willing to take up the debate... and yet there are viable alternatives that deserve to be discussed.

The subject of who pays for accounting services was the leadoff section in chapter 4 of my book, Enron: A Professional's Guide to the Events, Ethical Issues, and Proposed Reforms. In it, I summarized three of the most feasible alternatives for paying for auditor services. I called for a national debate on the subject.

That was three years ago. Perhaps with the KPMG and E&Y lawsuits hanging over the accounting profession (Auditors: Too Few to Fail), now could be the time for such a public debate.

Each alternative has its pros and cons. Some of the highlights are summarized below. For a more complete analysis, you can email me at or read my book.

The "user pays" alternative looks to the user of financial statements for payment. For public companies, the theoretical difference between this alternative and what we have now should be small. Stockholders, represented by an independent audit committee and board of directors, hire the auditor and oversee the relationship. Unfortunately in practice management is often the one that actually makes that decision. The good news is that Sarbanes-Oxley is having a positive effect at many companies in the way auditors are chosen. For private companies this alternative would result in a major change in the way auditors are hired. Banks, bonding companies, and other users would directly hire the auditor.

The "pooled funds" alternative would require a group of companies to pool their funds. The auditor would be selected by an independent entity and the fee would be negotiated. Only the independent entity could hire or fire the auditors. This should result in a more independent selection process, but critics contend that a whole new set of bureaucracy and problems would develop.

The "government auditor" alternative would totally change the auditing function to a regulatory one. There are strong advocates and opponents of this alternative who are often influenced by their perspective of the proper role of government. The relationship between company and auditor would change. Critics contend that an adversarial relationship would be the result and the quality of audits would actually decrease.

Clearly there is still much to discuss. But with the recent scandals and their effect on the capital markets, the need for a public debate on the topic of independence and the payment of auditor fees should be clearer now than ever before.

Tuesday, June 28, 2005

The Innocence of Arthur Andersen? Nothing Could be Further from the Truth

There seems to be some rush from former Arthur Andersen members and some others in the accounting profession to declare the recent ruling by the U.S. Supreme Court in overturning the conviction of Arthur Andersen in the obstruction of justice conviction for Enron as a declaration of their innocence. NOTHING COULD BE FURTHER FROM THE TRUTH.

In fact, the more we have learned, the more that should have been prosecuted.

Remember, Arthur Andersen had begun as one of the most stalwart, conservative accounting firms in the country, by a man who at the age of 27, had chaired one of the most prestigious accounting departments in the academic world at Northwestern University. The firm grew at a rapid pace to become one of the Big Eight accounting firms because people believed that the firm, and the members who worked for the firm, POSSESSED THE HIGHEST INTEGRITY.

They were prosecuted and fell, not because of Enron, but because they had forgotten everything that Arthur Andersen stood for. I do not question whether the judge in the obstruction case exceeded his authority in the instructions he gave the jury. I leave that for legal debates in law school and for future text books. I do question any connection between overturning the conviction of Arthur Andersen, the firm, with any concept of innocence.

Because what the FIRM did at Enron was just the tip of what they did at WorldCom, Waste Management, Sunbeam, Global Crossing, and Baptist Foundation of Arizona. What the FIRM did at Enron was an assault on every honest accountant in the profession. It was not just a breakdown by a few individuals, but an entire firm that had encouraged aggressive behavior by their partners and employees in order to maximize profits.

No other firm gave their partners the right to override their national technical department when issues of integrity arose.

No other firm shredded documents in anticipation of a SEC order – not at one office, but at several.

No other firm tried to justify at their trial a training video where partners told new staff that it was O.K. to shred documents until the firm received a formal subpoena, although their own internal documents expressly forbid it.

No other firm ignored repeated warning from the SEC as to their lack of management control.

The NCAA issues the death penalty to athletic departments when they have determined that the university has lost institutional control. Arthur Andersen, the FIRM, had lost institutional control.

What Arthur Andersen did to the accounting profession will take years to overcome. But perhaps what Enron and Arthur Andersen did for (or to) the investing public with the passage of Sarbanes-Oxley may take even longer to reestablish the balance in what the public wants and needs and accountants are able to deliver in a reasonably economical fashion.

Wednesday, June 01, 2005

Public Interest Meets Turf Wars and Self-Interest

The high profile of the corporate scandals might lead some people to believe that opposing corporate reforms would be bad for their health. But when self-interest and personal power are at stake, even such clear issues as promoting transparency and corporate ethics have trouble bearing the weight.

The Public Company Accounting Oversight Board (PCAOB) was established by Congress to provide independent oversight over the preparers of financial information and the professions that help ensure their integrity. So when the PCAOB issues new standards to protect the public from overly aggressive corporate executives, one would think that everyone except the crooks would be rallying ‘round the flagpole.

Well, not quite!

You see, Congress specifically gave the PCAOB authority only over financial statements issued by publicly-held companies.

Are there others? Sure.

Banks want to make sure the companies they lend money to are being truthful. So do bonding companies who ensure the integrity of most contractors… and partners who might not be involved in the day-to-day activities of the company.

You get the idea. There are plenty of others who would like to be sure that the financial information they receive is truthful and clearly presents all of the information they need to know (what has become known as transparency).

So what is the problem?

Well, that’s where the turf war comes in.

The American Institute of CPAs, a professional organization of the CPA profession, was not overly thrilled about seeing a good chunk of their authority whisked away in the name of integrity. In fact, they looked downright incompetent during the Congressional hearings, since most of the scandals had taken place during their watch. Not that they were responsible for the corporate executives who secretly paid themselves hundreds of times the compensation that they had been receiving just a few years earlier or for the auditing firms like Arthur Andersen that decided that bottom line profits were more important than the integrity they had sworn to uphold. But somehow Congress and the public got this idea that people who had a personal self-interest in the outcome of the controls might not be the best people to be in charge of the regulatory process.

In May 2004, the non-independent AICPA issued a “white paper” to remind CPA firms that they were the boss when it came to nonpublic financial statements. In June, the PCAOB issued a series of questions and answers under heavy pressure from …well you decide.

Here are some examples:

If a CPA firm adopts the stricter standards of the PCAOB and refers to those standards in an audit report of a non-issuer , does the auditor represent that he or she has complied with the Commission’s auditor independence requirements? NO

Does a reference to the “auditing standards of the PCAOB” or to “the standards of the PCAOB” in an auditor’s report on the financial statements of a non-issuer imply that the non-issuer is subject to, or otherwise complied with, some or all of the provisions of the Act and other securities laws or the Commission’s rules and regulations? NO.

Does inclusion of a reference to the Board’s standards in an auditor’s report on the financial statements of a non-issuer cause the audit to become eligible for review as part of the Board’s inspection? NO.

If a non-issuer elects to have its financial statements audited pursuant to the Board’s standards, must it also have its internal control over financial reporting audited pursuant to the Board’s Auditing Standard No. 2, “An Audit of Internal Control Over Financial Reporting Conducted in Conjunction with an Audit of Financial Statement”? NO.

So much for turf wars, what about the self-interest?

Congress was very careful during the Congressional hearings on the scandals to remain neutral in the area of accounting standards. They recognized that an independent body, the Financial Accounting Standards Board (FASB) had been established several years earlier to ensure that experts in the field who had “no axe to grind” would be in charge of issuing the rules covering accounting standards. They recognized that many of the problems included in the Income Tax Code were the direct result of partisan pressures and political self-interest. Now the reasons for the independent body are becoming clear again.

Although experts from across this country and around the globe have clearly stated that financial statements that do not include stock options as a cost of doing business are a distortion of the concept of transparency and the integrity of financial statements, some members of Congress have put their political self-interest ahead of the principles they espouse. Interestingly, some of the supporters of the measure to restrict what the independent FASB is permitted to do, include pro-consumer advocates like Senator Barbara Boxer, who is up for re-election in a state that has influential high-tech companies that use stock options and oppose the new FASB rules.

Reprinted from July 2004 press release

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