No Accounting
Where’s the ethics?

By Paul A. Rahe, Jay P. Walker Professor of History at the University of Tulsa.
February 12, 2002 9:35 a.m.

n 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.