Improving Auditors' Effectiveness In A Post-Enron Environment

Originally published March 2002 by the Washington Legal Foundation [17:14 WASHINGTON LEGAL FOUNDATION LEGAL BACKGROUNDER]


The Enron scandal renders it more important than ever for auditors to recognize their potential liability if their clients' financial statements go awry. We suggest ways in which auditors can improve their effectiveness and reduce their liability risk, in the context of improving the entire system of preparing financial statements.

Bases of liability.  Liability of auditing firms primarily arises from class action lawsuits brought under SEC Rule 10b-5.[FN1] Rule 10b-5 prohibits false or misleading statements to investors made with the intent to defraud in connection with the purchase or sale of securities. Civil liability does not arise if an auditing firm does not make a public statement under its own name.[FN2] Thus, as auditors typically do not audit quarterly financial statements or publicly state that they have done so, usually they may not be liable to investors if a company restates (revokes and republishes with materially different numbers) only its quarterly financials.[FN3] However, auditors state in annual reports on SEC Form 10-K that they conducted an audit under generally accepted auditing standards (GAAS), and they opine the company's annual financial statements were prepared in accordance with generally accepted accounting principles (GAAP). These auditor statements have given rise to Rule 10b-5 liability when companies restate annual financial statements. Plaintiffs must prove that the auditors intentionally or recklessly failed to conduct an audit under GAAS or falsely opined that the financial statements were prepared in accordance with GAAP.

Aside from fraud, traditionally, auditors cannot be liable to investors for mere negligence.[FN4] However, they may be liable on this standard to the companies they audit. This claim may be asserted by the new management of a company that restated financials prepared by prior management.[FN5] It also may be asserted by a shareholder purporting to sue on behalf of the company.

Difficult lessons. Suggesting changes requires knowing the problems. But Enron and other high-profile cases do not reveal easy lessons:

  1. This is not a story of high technology companies or the New Economy. Out of the major recent restatement cases (Enron, Waste Management, Sunbeam, Rite Aid, Cendant, Livent, Microstrategy, Lucent), only two involved information technology companies, and neither is an Internet company
  2. Problems do not always arise due to gray areas in GAAP. There were no cutting edge accounting issues involved in such alleged practices as failing to record expenses (Livent), missed quarterly cut-offs (Microstrategy), or phony journal entries (Cendant).[FN6] Even where there are gray areas (as Enron surely will contend), the problem may be not with the decisions reached, but with the lack of disclosure underlying the decisions.[FN7]
  3. Separating auditing from consulting will help, and one of the authors thinks it is critical. However, it surely is not a panacea. After all, the ratio of auditing to consulting fees was almost equal for Enron's auditing firm ($25 million vs. $27 million).
  4. This has nothing to do with the requirement under the Private Securities Litigation Reform Act of 1995 that plaintiffs plead a viable fraud claim before they take discovery. The most damaging allegations in Enron and other noteworthy cases were not ferreted out by post-lawsuit discovery allowed under lax pleading standards. Courts should continue to apply the Reform Act to accounting fraud allegations.[FN8]
  5. If financial fraud exists, it is not for a lack of deterrence. There is ample evidence that the government regards this as a serious matter.[FN9] And notwithstanding the absence of aiding and abetting liability (under Central Bank), auditors remain targets for fraud lawsuits and huge settlements.

What's left? Clearly, most finance professionals and corporate executives are not corrupt. Perhaps, however, some corporate actors, structures, and practices have lost sight of the seriousness of purpose required to prepare prudent financial statements and accompanying shareholder disclosures. Especially given the increasing complexity of transactions, this task requires accounting expertise, practical business knowledge, and, above all, a commitment to honorable values. These resources and qualities must be provided by outside auditors, corporate finance professionals, management, and Board of Directors and their Audit Committees.

What auditors can do. What can auditors do to provide the expertise, knowledge, and honorable values required to prepare prudent financial statements and disclosures? As we write, auditing firms and others are proposing reforms. Here are just some of our suggestions:

  1. Auditors must heighten their awareness of their independent role. Auditors are not hostile to management. However, other persons are the main customers of audited financial statements: the shareholders, as represented by the Board and its Audit Committee; the SEC; professional peers; and other stakeholders such as employees and lenders. Auditors must treat these persons as their key constituents, if for no other reason than maintaining professional dignity and values. Thus, for example, auditors should bring any and all issues to the Audit Committee, regardless of their relationship with management; and be firm in insisting that the ethical implications of accounting and disclosure decisions be kept in mind.

2. In Enron and Sunbeam, auditors allegedly changed their opinions, notwithstanding their knowledge of the facts, between the time they approved revenue recognition on controversial transactions and the time of the respective restatements.[FN10] The obvious lesson here is prudence: auditors should think carefully before making a judgment that they may have to revisit later. To insure prudence, auditors should consider the effects of disclosure. Assume that others will reach an opposite conclusion on issues that can go either way, and that these dissenting judgments will be disclosed. Would the auditor still be willing to support his judgment? If he would, he should increase his level of attention to the disclosure of the issue in the MD&A and notes accompanying the financial statements.

3. Auditors should support systems that increase the probability of identifying irregularities:

a. Insist that companies have written policies and procedures for all aspects of accounting and transaction processing, as well as an ethics statement. Most Finance personnel are familiar with written policies from their professional training, and this task will stimulate their professional interest in keeping up with current accounting topics.

b. Demand the right to access to all documents needed for an audit, and to personnel at all levels and divisions of the company. This is a good litmus test to insure that the client recognizes the seriousness of preparing financial statements. And after an auditor has asked for documents, he should ask if there is any document that he should have requested but did not do so.

c. Encourage companies to provide representation letters (i.e., letters stating that the signatory is not aware of any transactions in violation of company policy or accounting rules) from all levels and business units of the company. Increasing the number of reports increases the probability that someone will report a problem if it exists. The same logic dictates that auditors obtain from as many of a company's customers as is practicable confirmation of material contracts and the absence of undocumented terms that would preclude revenue recognition.

d. Do not decline to further investigate a potential problem, or acquiesce to an improper accounting treatment of a particular item, based on materiality thresholds only (i.e., on the theory that the monetary value of the dispute is insignificant to the financial statements or balance sheet).

e. Document the investigation of all issues (and retain all documents). This will assist in defending against the claim that auditors recklessly failed to conduct a GAAS audit by ignoring "red flags" signaling trouble.

4. One author strongly advocates that companies change auditing firms every 3-5 years. This would encourage auditors to be prudent so as to avoid second-guessing by their successors. It also would stimulate competition, and hence improvement in auditing standards. If auditing firms counter this reform, they will have an greater duty than ever to justify their tenure by ensuring that all auditors on an engagement are trained in the nuances of the client's business and the accounting issues that may arise. Auditors then must tailor their audits or quarterly financial reviews to those risks. For example,

a. Any instance in which the company sells to a customer and buys from the same customer should invite extremely close attention, and a bias on the side of more disclosure.

b.If a large percentage of a company's revenue-generating activities occur at the ends of quarters, auditors should directly observe business at the quarter end.

c.Companies should recognize the risks to the independence of the finance function when finance personnel report to local business managers, not functionally through the Finance Department. If a company insists on the former structure (particularly in foreign divisions), the auditors must devote particular attention to their audits.

5. Unfortunately, auditing the balance sheet (as distinguished from the income statement) has atrophied. The Enron experience should correct this trend.

Some may object that these steps will require auditors to adopt an adverse stance towards their clients. (They also may require companies to pay for more auditors and greatly improve their finance staff, systems, control disciplines, and documentation.) We think that wise companies will understand and facilitate auditors doing their jobs (as many companies with which we are familiar do). It makes sense to reduce the risk of incurring the tremendous cost of a financial restatement by paying auditors to render their best independent professional advice, based on a complete factual record. This will reduce the chance of an error occurring in the first place; and if a problem nevertheless occurs, reliance on an auditor's informed advice may provide a defense to securities fraud liability.

What companies can do. Auditors are important, but companies prepare financial statements What can they do prepare prudent financial statements and disclosures?

The SEC's emphasis on the "tone from the top" is a good start.[FN11] Having senior management committed to integrity and prudence makes a tremendous difference, although it does not insure that there will not be problems. It is particularly important for management to understand the role of the finance function (both internal and external). Accounting, like all aspects of management, adds shareholder value, and finance personnel perform other important tasks such raising capital.

But management should not regard confuse finance with the revenue-generating business of the company. A chilling allegation in Sunbeam is that when the CEO noted that the company's financial statements had missed Wall Street forecasts for 5 consecutive quarters, he chastised the former CFO, "And you delivered these numbers? How could you in good conscience have done that? How could you have supported those forecasts?"[FN12] In "good conscience", how could a CFO not do that? Accountants don't create financial results, they just report them.

Another good initiative is improving Audit Committees. This reinforces the seriousness and attention that must be paid to financial statements and disclosures. It also may allow for broader changes. It is not beyond imagination that some companies may choose to have their finance personnel report directly to the Audit Committee, so as to increase the finance function's independence.[FN13] Indeed, some companies may outsource their accounting function entirely, foreclosing even the appearance of manipulating results in order to benefit management.

The SEC now requires Audit Committees to have at least three independent directors, all of whom must be financially literate and one of whom must be a financial professional; and a written charter. These are steps in the right direction,[FN14] but more can be done:

  1. Qualification standards should not be satisfied by directors with purely academic experience; practical business experience also is needed.
  2. Charters should be written with a bias towards increasing responsibility, not avoiding it.
  3. Committees should function with a bias towards holding more rather than fewer meetings. This applies to Boards of Directors, too; the Audit Committee is an agent of the Board, not a substitute for it.
  4. Committee members must recognize that their ultimate constituency is the shareholders and other stakeholders. Thus, they, like auditors, must insist that the company prepare prudent and honorable financial statements and disclosures. Here, it is absolutely crucial that the directors protect finance professionals who may be pressured to do otherwise. The shareholders, in turn, must compensate Board members commensurate with their important responsibilities.
  5. It's dangerous for companies to let internal finance capabilities, systems and disciplines atrophy in the belief that the outside auditors will fill the gap at the year end audit. To forestall this, Committees should grade internal finance departments on professional standards, metrics and disciplines such as the speed in preparing financial statements, the number of errors, and the degree of analytical commentary. We think that most finance professionals will welcome the involvement and guidance of a competent and active Audit Committee.
  6. Committees should monitor compliance with the written ethics statement on a quarterly basis.
  7. Committees should consider engaging an outside firm as advisers on an ongoing basis. This often occurs after an issue has become acute; why not an ounce of prevention beforehand?
  8. Committees should ask the auditors if they were given the full access to people and documents required for their audits. In turn, the auditors or some other party should review the Audit Committee's effectiveness.

The SEC also seeks to encourage plain language financial statements and pro forma accounting. These worthy goals will prove difficult to execute, particularly as the broad liability at issue requires the type of "lawyerly" attention to disclosures that some have decried.[FN15] Other SEC initiatives have been off target. For example, one author decries the SEC's critique of "channel stuffing" as contrary to case law and justifiable business prerogative; the other author decries the complete abandonment of pooling accounting for mergers as contrary to accounting principles.

Conclusion. Hopefully, Enron will remind auditors, directors, finance professionals, and senior management that seriousness, prudence, and honorable values are their own reward, and also will be rewarded by investors.


[1] 17 C.F.R. § 240.10b-5, promulgated under Securities Exchange Act of 1934 §10(b), 15 U.S.C. § 78j(b).

[2] Central Bank v. First Interstate Bank, 511 U.S. 164 (1994) (no private aiding and abetting liability); Wright v. Ernst & Young LLP, 152 F.3d 169, 175 (2d Cir. 1998) ("If Central Bank . . . is to have any real meaning, a defendant must actually make a false or misleading statement in order to be held liable . . . ."). The SEC, however, may pursue auditors for aiding and abetting a client's false financial statements.

[3] See Tricontinental Indus., Ltd. v. Anixter, No. 01 C 5526, 2002 WL 84622 (N.D. Ill. Jan. 22, 2002) (no claim where auditors did not certify any annual financial statements before plaintiffs' stock purchase; no duty for auditors to disclose company's alleged irregularities in quarterly financial statements).

[4] Since the seminal case denying such liability, Ultramares Corp. v. Touche, Niven & Co., 255 N.Y. 170, 174 N.E. 441 (1931) (Cardozo, C. J.), there has been a slow expansion of the scope of potential liability. See Bonhiver v. Graff, 311 Minn. 111, 248 N.W.2d 291 (1976) (contending that Ultramares has been weakened over time).

[5] Thus, Cendant sued the auditors of a company it acquired, CUC, for negligence, breach of contract, and breach of fiduciary duty, even though the auditors already had paid $500 million to settle the related investor class action lawsuit. In re Cendant Corp. Sec. Litig., 166 F. Supp. 2d 1 (D. N.J. 2001).

[6] See also ZZZZBest (bringing auditors to phony restoration sites to support claim that company had entered into restoration business); Miniscribe (shipping bricks and recording them as sales of disc drives); Media Vision (recording sales of computer boards while the components were en route from Asia).

[7] See Lynn E. Turner, Speech by SEC Staff: The State of Financial Reporting Today: An Unfinished Chapter III (June 21, 2001) ("The lack of such disclosures in the Waste Management, Sunbeam, and W.R. Grace cases contributed to an inability of investors to understand and analyze the companies' reported results."). All speeches cited herein are available on the SEC Internet site.

[8] See Shirli F. Weiss and David Priebe, Financial Fraud Lawsuits: The Case For Stricter Judicial Scrutiny, Washington Legal Foundation Critical Legal Issues Working Paper Series No. 104 (Aug. 2001).

[9] See Lynn E. Turner, Speech by SEC Staff: Quality, Transparency, Accountability (Apr. 26, 2001) (listing prison sentences from 2 to 30 years given to 7 CFOs, and potential 5-115 year sentences awaiting 4 other CFOs).

[10] See, e.g., John A. Byrne, Chainsaw 349 (1999) (alleging that Sunbeam Controller "sat dumbfounded through the process as auditors . . . disapproved many of the accounting transactions [they] had previously okayed.").

[11] See Lynn E. Turner, Speech by SEC Staff: The Investor's Bill of Rights (June 18, 2001) (calling for "management - from the board of directors on down - that fosters a corporate culture of integrity, honesty and adherence to the spirit as well as the letter of the law" and "who foster a corporate culture in which people don't cut corners just so they can report favorably on the achievement of individual or corporate goals.").

[12] Byrne, Chainsaw, at 3-4.

[13] Thus, Enron's problems may have surfaced sooner had the "whistleblower" sent her memorandum to the Audit Committee, not just the CEO and outside auditors.

[14] It would been a stronger step had the SEC stuck to its original proposal to require three finance professionals; consider what this would have meant to Enron.

[15] See Turner, The Times, They Are a-Changing (praising audit committee report that "doesn't read like a report written by a corporate attorney to be read by a plaintiff's attorney.").