Where the buck really stops

In some ways it is comforting to be working in a profession which is suddenly the centre of media attention, having been previously ignored. Following the Enron saga and the instant demise of Andersen, the spotlight has been on the role of audit and auditors. There is, of course, a danger that, as usual, the real culprits will remain unaffected and unscathed.
Let us look at Enron and the factors which allowed the company to collapse. The truth is that for a very long time (principally) American investors have believed that it is actually possible to get something for nothing. Aided and abetted by investment advisers, both private investors and institutional shareholders have believed that it was possible for the stock market to outperform the economy. Ever more excessive valuations were placed on dot-coms, telecoms and other sectors perceived to be the future. Add to this the tendency to reward chief executives with stock options (of course at the cost of dilution of the other shareholders - but no one was supposed to notice), and you have a potent incentive for the whole industry to hide the bad news and to hype up performance.

What then is the role of the auditor? Typically it is to protect various interested parties by reporting on the true and fair view of historical data. Now accounting is not an exact science, and many areas (particularly valuations) are open to interpretation. Historically, the profession has been self-governing, and moral pressure from peers has been sufficient to curb excesses. In recent years, regulators (and in particular the US SEC) have sought to try to codify the practise of accounting. Now this is a dangerous thing, as you introduce the concept of form over substance where strict compliance with the regulation is all that the regulator can impose. The US has some of the most detailed accounting standards which unfortunately were insufficient to stop Enron from hiding the results and liabilities of controlled subsidiaries. The SEC itself has for years insisted that audit reports be unqualified, which seriously limits the scope for auditors to raise concerns over the future performance of audited companies.
What lessons have been learned, and could the same happen again in the US and elsewhere?

Starting with the last point, it is my humble opinion that an Enron was far less likely to happen elsewhere. First, most economies which have been going for more than just a century and a half have a single legislative system better able to deal with fraud and deception. The truth is that the US legal system is based on a number of models, principally the German system of codification and the UK system of equity. The two are not compatible and lead to a completely different mind-set. Hoping as the US did that a detailed code (in this case accounting standards) could be supplemented by the application of common sense and fair play just does not work.
As a knee-jerk reaction, the US has passed the Sarbanes-Oxley Act. This seeks to significantly reduce perceived conflicts of interest by banning the auditors of listed companies from providing a whole range of other services. The idea is that the auditor will be more objective in reaching his opinion. To those of us brought up in Europe where most countries have always imposed stringent conflict of interest regulations, the act reads as if the US is only now waking up to this issue. More fundamentally, it is hard to see what the act hopes to achieve. If auditors in the past lacked objectivity because another part of the firm was an adviser to the client, then this suggests a far deeper problem than one which can be cured by legislation. I do not, however, believe this to be the case. The fact is that for a long time now regulators have been more than happy to abrogate all responsibility to auditors without giving them the tools to do a proper job.

There is quite rightly an "expectations gap" between what auditors actually do and what the public thinks they should do. The time is right for a public debate on the role of audit, and whether this should include the right of the auditor to draw attention to inherent business risks and whether the audit should also cover the basis on which the share price does or does not reflect likely future performance. Clearly, if public expectations are to be met, the cost of audits will rise dramatically. Overregulation of the profession will not achieve anything in itself. A review of the function of audit will. And more importantly, market regulators have to start taking an active role and will in the future have to support the conclusions of auditors even at the cost of market liquidity and performance.
In the next few articles I hope to look at these issues in some detail, particularly as they relate to Poland. In the meantime, the new US act imposes strict compliance and registration criteria on auditors of foreign subsidiaries of listed US companies. A very interesting concept of the territorial extent of US law. And there I was thinking that Poland was about to join the European Union!!!

Andrew Kinast is the managing partner of Grant Thornton Poland.