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an interview in early January, Harvey Pitt told Barron's
that "there is nothing rotten in the accounting profession."
This is the sort of nonsense one would expect to hear from a lawyer
paid fabulous sums to tell whoppers on behalf of the big auditing
firms — which, of course, is precisely what Harvey Pitt was,
before George W. Bush asked him to chair the Securities and Exchange
Commission. That Pitt could make such a statement now, in the wake
of the Enron debacle, suggests that he still thinks he works for
Arthur Andersen. It's a great misfortune for all of us if he doesn't
understand that he now represents a new client — the American
people — for there clearly is something rotten going on, and
if the government does not do something about it we will all pay
a very heavy price.
To begin with,
let's leave aside Enron and Arthur Andersen — where there is
good reason to suspect outright fraud. The odds are good that some
Enron executives and Arthur Andersen auditors are going to end up
in the hoosegow. It is highly unlikely that those who set out to
shred all the evidence will get off scot-free. In the United States,
we have institutions in place to deal with and deter out-and-out
crookedness.
The deeper
problem is that we don't have institutions in place to deter accountants
from using every legal trick in the book to misrepresent
the financial well being of the companies they audit. In fact, when
they come up against the Fortune 500, auditors have every incentive
to cook the books. Of course, in theory, auditors work for investors
and not for the managers of the companies they audit. After all,
they perform a public function. The law stipulates that publicly
held corporations be audited at regular intervals and that the results
be made available to the general public. For this reason, the auditors
are never hired by management. Instead they are nominated by and
report directly to the audit committee of the company's board, and
their selection is, in fact, contingent on the approval of the company's
stockholders. Their task is to report — to the current stockholders
as well as to the wider public of potential stockholders —
on the company's financial condition.
Those who audit
the so-called small caps generally perform more or less as they
are supposed to. But those who audit larger corporations quite frequently
perform other services for those corporations as well, helping them
keep track of the taxes they owe and advising the company on a great
many other matters as well. It's easy to see why such an arrangement
is convenient: A company's auditors come to know it very well. No
one else is better equipped to do its taxes and to do consulting
work.
The trouble
is this: The auditors are not hired to do this other work
by the auditing board. As is only natural, they're hired by and
report to management. And this work is quite commonly more lucrative
than the work the accounting firm does in auditing the company.
There is, then, a conflict of interest, for those who have been
hired to give the public an honest appraisal of the company's financial
well being also work for the very people whose handiwork they've
been hired to appraise. The relationship between a company's auditors
and its managers ought to be an adversarial relationship, but the
managers of large firms have it in their power to reward auditors
who do their bidding.
All too frequently,
then, as one would expect, a company's auditors and its managers
are — not to put too fine a point on it — as thick as
thieves. All too often the auditors don rose-colored glasses, massage
the numbers, and thereby hype the company's stock. Even when everything
they do is strictly legal, their purpose is essentially fraudulent:
They put the most positive spin possible on the numbers they report.
It's no accident that, as the consulting business of the big accounting
firms has grown, we have had scandal after scandal. One cannot think
of Arthur Andersen without recalling Sunbeam, Waste Management,
and Enron — and Arthur Andersen is by no means peculiar. In
recent years, company after company has had to "restate"
its earnings. What was once an unusual incident has become quite
commonplace. To put it bluntly, the auditors are cooking the books.
There is no
point here in discussing professional ethics. Nor is there any reason
to join the editors of the Wall Street Journal in lamenting
the general decline in morality. They may well be right, that is;
but in the United States, there have always been scoundrels and
rogues, and it has never been our policy to put our trust in the
goodness of human nature. Our government is based on a separation
of powers, reinforced by a system checks and balances, that presupposes
that human beings are liable to corruption. We hold frequent elections;
we divide governmental responsibilities among federal, state, and
local governments; we encourage a freedom of the press that borders
on license; we set up a legislative branch as a watchdog over the
executive and an executive branch as a watchdog over the legislators;
and we have a judiciary independent of both — all because we
believe that no one can be trusted with absolute power, and because
we suspect that in politics, popular vigilance encourages good behavior.
The same principles
can easily be applied with regard to the accounting profession.
The firms that audit publicly held companies ought to do that and
nothing else. There should be no chance that the individual accountants,
or the firms to which they belong, could ever be hired to advise
or work for management in any capacity whatsoever. Moreover, they
ought to be made liable for the work that they do. When there is
an earnings restatement, those responsible should be made to compensate
those whom they have misled.
Commercial
societies, such as our own, operate on trust — not on trust
in any given individual or organization, but on trust in the system
as a whole. We buy stock; we buy bonds; we deposit our savings in
banks or put it in money-market funds. We allow others to put our
money to work on the presumption that we have been given the information
we need to accurately gauge their prospects for financial success.
When we lose money, it ought to be our own fault — it ought
to be because we have misjudged, not because we have been misled.
If Harvey Pitt does not act to eliminate the perverse incentives
that characterize the accounting profession today, if auditors cease
to be watchdogs for investors and to an ever-increasing degree become
the lapdogs of management, there will come a time when American
investors lose faith in the system and start to do what citizens
of less well-governed countries have done all along: stuff their
money into their mattresses, instead of investing it in stocks and
bonds so that entrepreneurs can put it to work for the benefit of
all. Or if, even after the Enron scandal, Harvey Pitt really wants
us to believe that "there is nothing rotten in the accounting
profession," it may well be because the current chairman of
the SEC is part of the rot.
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