Findings: Firstly, Enrons Board of Directors failed to fulfil its fiduciary duties towards the

corporations shareholders. Secondly, the top executives of Enron were greedy and acted in
their own self-interest. Thirdly, many of Enrons employees witnessed the wrongdoings of
Enrons top executives, and quite a few whistleblowers came forward. Lastly, Enron outsourced
external auditing for its internal audit function instead of establishing a functionally internal
audit mechanism and its external auditor acquiesced in the application of questionable
accounting and fraudulent financial reporting.
Enron and auditing
The lessons from Enron
After the energy firm's collapse, the entire
auditing regime needs radical change
THE mess just keeps spreading. Two months after Enron filed for Chapter 11, the
reverberations from the Texas-based energy-trading firm's bankruptcy might have
been expected to fade; instead, they are growing. On Capitol Hill, politicians are
engaged in an investigative orgy not seen since Whitewater, with the blame pinned
variously on the company's managers, its directors, its auditors and its bankers, as
well as on the Bush administration; indeed on anybody except the hundreds of
congressmen who queued up to take campaign cash from Enron. The only missing
ingredient in the scandalso faris sex.
The effects are also touching Wall Street. In the past few weeks, investors have
shifted their attention to other companies, making a frenzied search for any dodgy
accounting that might reveal the next Enron. Canny traders have found a lucrative
new strategy: sell a firm's stock short and then spread rumours about its accounts.
Such companies as Tyco, PNC Financial Services, Invensys and even the biggest of
the lot, General Electric, have all suffered. Last week Global Crossing, a telecoms
firm, went bust amid claims of dubious accounts. This week shares in Elan, an Irish-
based drug maker, were pummelled by worries over its accounting policies.
All this might create the impression that corporate financial reports, the quality of
company profits and the standard of auditing in America have suddenly and
simultaneously deteriorated. Yet that would be wide of the mark: the deterioration has
actually been apparent for many years. A growing body of evidence does indeed
suggest that Enron was a peculiarly egregious case of bad management, misleading
accounts, shoddy auditing and, quite probably, outright fraud. But the bigger lessons
that Enron offers for accounting and corporate governance have long been familiar
from previous scandals, in America and elsewhere. That makes it all the more urgent
to respond now with the right reforms.
Uncooking the books
The place to start is auditing. Accurate company accounts are a keystone for any
proper capital market, not least America's. Andersen, the firm that audited Enron's
books from its inception in 1985 (it was also Global Crossing's auditor), has been
suggesting that its failings are representative of the whole profession's. In fact,
Andersen seems to have been unusually culpable over Enron: shredding of
incriminating documents just ahead of the investigators is not yet a widespread habit.
But it is also true that this is only the latest of a string of corporate scandals involving
appalling audit failures, from Maxwell and Polly Peck in Britain, through
Metallgesellschaft in Germany, to Cendant, Sunbeam and Waste Management in
America. In the past four years alone, over 700 American companies have been forced
to restate their accounts.
At the heart of these audit failures lies a set of business relationships that are
bedevilled by perverse incentives and conflicts of interest. In theory, a company's
auditors are appointed independently by its shareholders, to whom they report. In
practice, they are chosen by the company's bosses, to whom they all too often become
beholden. Accounting firms frequently sell consulting services to their audit clients;
external auditors may be hired to senior management positions or as internal auditors;
it is far too easy to play on an individual audit partner's fear of losing a lucrative audit
assignment. Against such a background, it is little wonder that the quality of the audit
often suffers.
What should be done? The most radical change would be to take responsibility for
audits away from private accounting firms altogether and give it, lock, stock and
barrel, to the government. Perhaps such a change may yet become necessary. But it
would run risks in terms of the quality of auditors; and it is not always so obvious that
a government agency would manage to escape the conflicts and mistakes to which
private firms have so often fallen prey. As an intermediate step, however, a simpler
suggestion is to take the job of choosing the auditors away from a company's bosses.
Instead, a government agencymeaning, in America, the Securities and Exchange
Commission (SEC)would appoint the auditors, even if on the basis of a list
recommended by the company, which would continue to pay the audit fee.
Harvey Pitt, the new chairman of the Securities and Exchange Commission, is not yet
willing to be anything like so radical. He has been widely attacked because, when he
acted in the past as a lawyer for a number of accounting firms, he helped to fend off
several reforms. Yet he now seems ready to make at least some of the other changes
that the Enron scandal has shown to be necessary (see article).
Among these are much fiercer statutory regulation of the auditing profession,
including disciplinary powers with real bite. Hitherto, auditors have managed to get
away with the fiction of self-regulation, both through peer review and by toothless
professional and oversight bodies that they themselves have dominated. There should
also be a ban on accounting firms offering (often more profitable) consulting and
other services to their audit clients. Another good idea is mandatory rotation, every
four years or so, both of audit partnersso that individuals do not become too
committed to their clientsand of audit firms. The most effective peer review
happens when one firm comes in to look at a predecessor's books. The SEC should
also ban the practice of companies' hiring managers and internal auditors from their
external audit firms.

In search of better standards
Then there is the issue of accounting standards themselves. Enron's behaviour has
confirmed that in some areas, notably the treatment of off-balance-sheet dodges,
American accounting standards are too lax; while in others they are so prescriptive
that they have lost sight of broader principles. Past attempts by the Financial
Accounting Standards Board to improve standards have often been stymied by
vociferous lobbying. It is time for the SECitself to impose more rigorous standards,
although that should often be through sound principles (including paying less
attention to single numbers for earnings) rather than overly detailed rules. It would
also be good to come up with internationally agreed standards.
Although audit is the most pressing area for change, it is not the only one. The Enron
fiasco has shown that all is not well with the governance of many big American
companies. Over the years all sorts of checks and balances have been created to
ensure that company bosses, who supposedly act as agents for shareholders, their
principals, actually do so. Yet the cult of the all-powerful chief executive, armed with
sackfuls of stock options, has too often pushed such checks aside.
It is time for another effort to realign the system to function more in shareholders'
interests. Companies need stronger non-executive directors, paid enough to devote
proper attention to the job; genuinely independent audit and remuneration committees;
more powerful internal auditors; and a separation of the jobs of chairman and chief
executive. If corporate America cannot deliver better governance, as well as better
audit, it will have only itself to blame when the public backlash proves both fierce and
unpleasant.