U.S. academic advocates vigilance in corporate governance and auditing

Australian and U.S. governments are being pressured to regulate higher standards of corporate governance and quality accounting and auditing, in the wake of the Enron and HIH Insurance collapses.

“These failures and current litigation against Enron’s accountants Arthur Andersen underscore that systems are not perfect,” said one of the world’s leading academic experts in auditing, Professor Jere Francis.

“They are a wakeup call. Enron may be simply another dot com failure of irrational exuberance where the stock price was overvalued relative to the value of the company. There’s a cycle of these failures occurring every 10 to 15 years.”

Professor Francis, who is KPMG Distinguished Research Professor at the University of Missouri-Columbia, recently visited the UQ School of Business for discussions and to give seminars for the Centre for Business Forensics, which will be launched on July 1.

He said in the case of the multi-billion dollar Enron Corporation, the only legal charges have been made against its accounting firm, Arthur Andersen, for shredding drafts of Enron-related documents which Arthur Andersen claimed were superfluous. Enron, a $60 billion company, generated U.S. $52 million for Arthur Andersen, more than half of which was for the sale of consulting services. Many Arthur Andersen clients have deserted the firm since the indictment.

Professor Francis said there was potential for conflict of interest with respect to the auditor`s primary role when a firm which audited financial reports also sold consulting services to that firm. “When auditors start to think of themselves as being in a business relationship with their clients they are not as sceptical,” he said.

“Auditors convinced themselves that the audit was another consulting service which created value for their clients. Arthur Andersen earned $25 million from their audit fee but a further $27 million from consulting for Enron.

“It’s human nature with a big and important client to succumb to pressure to go along with the client who has a budget bigger by factors of hundreds than your own. But no client is too important to walk away from if you value your reputation. The bottom line is the auditor is not there to be a buddy.”

There was also difficulty for auditors in investigating accounts of very large conglomerates, such as Enron, which had 4000 subsidiaries and other affiliates, and was the seventh largest U.S. company in revenues, with a larger budget than many countries. The size of the company begged the question how effectively the board of directors could keep tabs on the businesses.

“Corporate governance is like policing — it’s a deterrent that keeps honest people honest,” Professor Francis said.

“One of the lessons from Enron is that when you put a lot of money on the table you can tempt people. The culprit was stock options linked to company performance which created incentives for executives to maximise the value of the firm. These options were typically held for three years and created 10s of millions of dollars for executives providing large incentives to keep the stock prices moving up and to continue to meet performance targets.”

Enron shares traded at a 52-week high of U.S. $54.95. This week they traded at 17 cents, exemplifying how the market punishes firms which do not perform to expectations.

Professor Francis said what was unclear was whether Enron did anything technically wrong. “In accounting, a lot of things are not black of white. There are many grey areas which Enron used to advantage to keep earnings growing and the stock market pleased with their growth. They turned every dial to get earnings coming down the faucet.

“The system in Australia is the same, and when a company issues stock options to executives they are not recorded as an expense to the company.”

He said U.S. accountants were resisting calls for the Government to revisit how stock options were taxed and accounted. One solution might be to give executives stocks instead of stock options, and to lengthen the holding period for longer terms.

There has been criticism of the activities and behaviour of some U.S. CEOs and other notable insiders who sold large numbers of shares just before dramatic declines in their companies` share prices.

Professor Francis said one of the big lessons from Enron was that it was important to pay executives well, but not make them multi-millionaires.

Another challenge was to find independent directors prepared to do their jobs well, with a sceptical viewpoint at corporate meetings. In the Enron situation, members of the board of directors were also given stock options, creating a potential conflict of interest. Four directors sold these options for $5 million in the year before Enron’s collapse.

Media: Further information, contact Professor Colin Ferguson of the Centre for Business Forensics, telephone 3365 6631 or email Professor Jere Francis: Francis@missouri.edu