What Directors Can Learn From the Enron Fiasco
from
March/April 2002
by Colin Leinster
Were the energy giant’s 14 outside
directors criminal, blind, or just dumb? Lynn Turner is content to
leave that verdict to the courts. But he does think that directors
everywhere, and particularly members of audit committees, need to get
tougher with management and auditors if they want to avoid the kind of
legal trouble that faces the Enron board.
Turner, who had been CFO of Symbios, a software manufacturer (now LSI Logic), and a partner at Coopers & Lybrand (now PricewaterhouseCoopers), was chief accountant at the Securities and Exchange Commission from 1998 until last year. These days he’s the director of the Center for Quality Financial Reporting at Colorado State University, where he uses Enron as a textbook case of accounting disaster. His M.B.A. students are “a sharp group of experienced engineering, marketing, information-systems, public-relations, auditing, and financial professionals,” he says. Even so, they display “shock, dismay, and bewilderment by how such a colossal shipwreck could have occurred.” Turner conversed by e-mail with Corporate Board Member editor Colin Leinster.
CBM: What can directors learn from what’s happened at Enron?
Turner: An important lesson is that they should understand the operations and economics of their company, its strategy, and the key performance indicators that give them some idea of how the business is doing. Excellence in corporate governance is critical to the accountability and integrity of any company, and that requires knowledgeable, active, and independent board members.
Outside board members need to be sure they don’t have economic ties to the company or other possible conflicts of interest that might seem to compromise their independence. While directors should not micromanage or second-guess top management, they absolutely cannot shy away from their responsibility to ask the tough questions. And if, after asking those questions, directors are not comfortable with the answers they are getting, then they need to consider whether they should seek outside counsel and advice.
CBM: What danger signs or signals that something was wrong do you think Enron directors missed? Do similar signals exist at other companies?
Turner: There were a number of red flags, and none of them is unique to Enron. They included all kinds of transactions between members of management and outside firms and affiliates, any one of which might provide an opportunity for self-dealing. I can’t tell you how often I have heard that such related-party transactions were negotiated on an arm’s-length basis. The problem is, there is no way you can prove whether they were or not. Directors should consider whether there is a legitimate business reason for the company to enter into any such transaction. If necessary, get outside legal advice, and make sure that all the important terms and details of the transaction are disclosed in plain English in the financial statements and in filings with the Securities and Exchange Commission.
Another red flag is a buildup in off-balance-sheet financing, such as securing debt with leases and special-purpose entities, or SPEs. Investment bankers, lenders, auditors, and other outsiders often help put these kinds of deals together as a way to get around showing debt in the financial statements. There may be legitimate reasons for doing this, but it is often done in order to hide just how leveraged a company is. Ultimately, it is a clear warning that the company is getting overextended. My advice for directors is to request the CFO or treasurer to provide a quarterly summary of all debt, both on and off the balance sheet, along with information on where the cash will come from to service the debt. Finally, get the management team to provide an analysis of the company’s balance sheet so that you can compare various debt-to-equity and liquidity ratios with others in your industry. If there are big disparities, don’t hesitate to ask why.
And derivatives? Now there’s an ugly face we’ve seen in the past, at Procter & Gamble, Kidder Peabody, and Bankers Trust, among others. And these days companies are using ever more complex derivatives to manage all kinds of risk, from the weather to currency fluctuations, and the financial statements should reflect their changing values in a timely fashion. This is not an issue for derivatives that are readily traded. But measuring the value of derivatives and other financial instruments that do not have an actively traded market may be complex. These valuations can also be a way to manage earnings if proper controls are not in place. To avoid such shenanigans, directors should make sure that (1) the company has up-to-date written risk-management policies, procedures, and internal controls and that they’re in place; (2) the internal controls include sufficient safeguards, such as adequate segregation of duties, that prevent any one person in the company from executing improper transactions or doing improper accounting; and (3) the company has established well-reasoned and supportable methodologies that consistently measure the fair values of derivatives and financial instruments. A board would be well advised to ask independent auditors or other experts to assess the company’s policies and controls on this topic.
What’s the big message from Enron to members of audit committees? Without doubt, Enron has become the poster child for audit committees. And although we shouldn’t prejudge its audit committee—we don’t know if its members asked the tough questions or, if they did, who provided the answers and what the answers were—Enron should definitely sensitize audit committees to a number of issues, if they were not sensitized already. First, each committee member needs to be financially literate enough to understand the company’s financial statements and disclosures. If you don’t comprehend the basic economics of the business and how those economics are affecting the financial statements, ask the CFO to provide some training sessions that will assist you in getting up to speed. Best practices for audit committees include such training sessions for all new audit-committee members.
Every audit-committee member should read Cautionary Advice Regarding Disclosure About Critical Accounting Policies, which the SEC put out last year. I echo the SEC’s sound advice—namely, that you should examine very closely the financial-reporting and accounting policies for all the significant transactions that a company enters into, especially those that are most likely to make or break an earnings estimate for the quarter or year. Audit-committee members should ask both the CFO and the independent auditor if the accounting for transactions, as reported and disclosed in the financial statements, reflects the highest-quality accounting standard that could be used, and if not, why not. To me, this means the transactions are accounted for in a fashion that reflects the true economics of the transaction. For example, if debt could be on or off the balance sheet, it goes on. Similarly, I would ask the audit partner, if he or she was preparing the financial statements, would he or she change any of the accounting policies or numbers in the financial statements? I would also ask both the CFO and the auditor if there were any information that they would want to have disclosed to them if they were considering investing in the company that was not disclosed. The minutes of the audit committee provide a good venue for documenting the response the audit committee receives.
It seems that all too often audit committees find out about problems only very late in the day. That’s true. In recent years, the audit committee has been notified by the independent auditor of material weaknesses in controls, but only after the audit was done and/or problems arose. In addition, I have seen all too many cases where an auditor has identified weaknesses in internal controls that for dubious reasons were not brought to the attention of the audit committee. Unfortunately, the audit committee only found out about them when they surfaced during the course of an SEC investigation. The Financial Executives International, the U.S. General Accounting Office, and most recently the independent Panel on Audit Effectiveness (commonly referred to as the O’Malley Panel) have all argued for greater reporting on internal controls by management. As a result, I would encourage each audit committee to get an annual statement from the CEO and CFO that the company has internal controls and that they are operating effectively. Many public companies now follow a best practice of including such management reports in their annual reports. I would also request that the auditor provide the audit committee with all the comments he might have on the company’s internal controls. The message should be clear: “No surprises here!”
It is important that the audit committee and independent auditor have open lines of communication and a clear delineation that the auditor is working for the audit committee. I would also encourage audit committees to ask the auditor to identify the most sensitive accounting and auditing issues and to describe the steps he is taking to test whether those transactions are properly accounted for and disclosed.
Enron has also raised the issue of companies’ paying fees to audit firms for non-audit services. What’s happening there? It has certainly grabbed lots of press attention. In some cases, non-audit fees have approximated tens of millions of dollars, up to 20 times the amount paid for the actual audit. The big issue is whether any of these extra services impair an auditor’s independence. The O’Malley Panel has recommended that audit committees preapprove such services. The SEC, meanwhile, has encouraged audit committees to consider various criteria the O’Malley Panel set forth that will help directors assess whether such services could impair an auditor’s independence. [The criteria are listed on various SEC websites, including www.sec.gov/rules/final/33-7919.htm.]
Audit committees should become more informed about the nature of the consulting that their audit firms do for the company. Some may be appropriate. A CFO might ask how to properly account for a specific transaction, and it’s good to get the auditor’s input at the earliest possible date. But sometimes an auditor is asked to help structure a transaction in a fashion that will reduce the level of disclosure or transparency to investors, lenders, rating agencies, and others. I have seen accounting firms work with investment bankers to find ways for their corporate clients to get around a particular accounting rule. Audit committees need to ask their auditors if they are involved in any such assignments. If so, the committee members should ask themselves whether the shareholders they represent would consider this auditor to be the unbiased, independent third party he’s supposed to be. I don’t think it takes long to figure out the answer.
Can you give any examples of close escapes that other boards may have had from Enron-like disasters? “But for the grace of God, it could have been me” is a phrase I have heard over and over again during my 25 years in the accounting profession. The SEC has a caseload of 200 to 250 companies at any point, many of which have had to restate their financial statements. Any of their boards fortunate enough to avoid litigation will have had a close escape.
What does the Enron collapse mean to auditors and their reputation? There is no question that auditors have lost the trust and confidence of many shareholders. This isn’t just because of Enron, either. There’s been a constant parade of companies—Cendant, Waste Management, Xerox, Lucent, Rite Aid, WR Grace, Sunbeam, Micro-Strategy, and many, many more—where auditors dropped the ball.
Auditors are going to have to make fundamental changes in how they do their audits. The O’Malley Panel recommended two years ago that certain forensic auditing procedures be required and that many, if not all, of the current auditing standards be reconfigured to provide greater detail and specificity in the procedures that must be performed. Auditors also need to recognize that many financial frauds continue to involve improper revenue recognition, establishment of “cookie jar” reserves, and large, unusual nonrecurring adjustments.
But there’s been no real progress in setting new auditing standards that would result in auditors’ working more effectively. In fact, even existing accounting and disclosure standards and requirements are often ignored. At Waste Management, the SEC noted that the auditors identified certain problems, but instead of asking for corrections in the financial statements they went ahead and gave their “clean” report anyway.
The fundamental lesson here is that we can have all the accounting rules one can write, develop new ones for SPEs or valuing derivatives, and require greater disclosure of key financial metrics or related-party transactions. But in the end, none of that will matter if the CEOs and CFOs play the numbers game and cook the books and if the auditors don’t stir the pot enough to figure out what’s being cooked and whether it is edible by investors and the markets. The way we do audits needs to change and change quickly, before the next disaster befalls innocent victims.
How should shareholders feel about auditors? If you mean “Is the current oversight of the accounting profession working?” the events of recent years dictate that the answer is no. The profession vigorously lobbied Congress and the SEC 25 years ago for the system of self-regulation that we now have, and it has turned out to be far too self-serving. Interestingly enough, the profession has taken a much more proactive approach in Britain. Faced with public criticism as a result of frauds involving the Maxwell empire, BCCI, Barings Securities, and others, it drafted a framework for a new regulatory-oversight mechanism. Some of the key elements include an oversight board called the Foundation and four separate boards. One reviews the work of auditors and the other boards. Two others set standards for audits and auditor independence, and the fourth is a disciplinary body. The eight or so members of the Foundation all come from outside the accounting profession, representing the Bank of England, the National Association of Pension Funds, and the like. The other boards either exclude accountants entirely or at least those currently in practice. We need to have a similar system in the U.S.
Do you expect to see more Enrons? History has told us the answer is yes. I think there is a large iceberg out there.
What should directors do if they’re unsure of what’s really going on? First, I would encourage them to spend some time onsite with management and company personnel. One thing I learned was, it was difficult to get your hands around an issue when the issue was a thousand miles away. Don’t be afraid to ask a lot of questions. As both a CFO and an audit partner, I had greater respect for the audit-committee and board member who had the fortitude to ask questions, as opposed to the one who sat silent and contributed little to improving the company. I know some of the questions I was asked put me to the test and no doubt enhanced some of my decisions. More important, it was always easier to work with an informed board member as opposed to one who was uninformed.
If, at the end of the day, directors were still unsure and uncomfortable with what they were seeing or hearing, I encouraged them to seek legal advice. Keep in mind that the board has an important role as the overseer of corporate governance. Sometimes seeking outside counsel is simply something that has to be done.
