After Enron, what's an audit committee
they were meant to do, Roman Weil told lawmakers, calling for
fewer rules and more backbone.
Roman Weil how to prevent another Enron, and the V. Duane Rath
professor of accounting in the Graduate School of Business tells
a parable about leases. "If a company leases a plane from
another company," he posits, "whose balance sheet should
list the plane?" The company leasing the plane doesn't own
it and won't think to list it as an asset. Then again, because
the lease is long-term the plane's lessor has essentially removed
it from its inventory and turned a profit on it-so why, the leasing
company's managers demand of their accountants, should the plane
sit on its balance sheet?
scans the crammed bookshelves in his small Rosenwald office, nabbing
a three-inch-thick brown paperback titled Statements of Financial
Accounting Standards, part of a three-volume set published
by the Financial Accounting Standards Board (FASB). He flips through
the book, mumbling the arcane titles of various rulings, until
he lands on one made in 1976 to prevent the scenario he related.
In 1990 another rule was made for "synthetic leases,"
allowing a company to enjoy the tax benefits of owning property
while keeping property-related debt off their balance sheets.
"Smart financial managers used the new rule to find their
way around the 1976 rule," he says, "and assets again
disappeared from balance sheets."
rule for synthetic leases has become a common way to keep real-estate
loans off balance sheet. As a result, the financial statements
of blue-chip companies such as AOL Time Warner, Microsoft, and
Cisco Systems-as well as erstwhile blue-chip Enron-have grown
rosy in the glow of seemingly low debt. Enron, like many companies,
kept its loans in off-balance-sheet vehicles known as special
purpose entities (SPE)-the same partnerships at the heart of the
energy giant's collapse. An SPE borrows funds for a building and
then leases the building to the company that set up the SPE.
early March synthetic leases made headlines as PG&E Corporation,
the owner of California's biggest electric utility, announced
plans to reclassify as debt $1 billion in synthetic leases on
three power plants -joining, said the New York Times, "a
score of companies that are examining their accounting to revive
confidence in financial reports after the collapse of Enron."
reviving confidence, Weil's parable concludes, wouldn't be necessary
if the rules hadn't gotten so arcane in the first place. That's
what the professor, who has served on the FASB's advisory committee
and several FASB task forces and has advised the Securities Exchange
Commission (SEC) on accounting matters, told the House Committee
on Energy and Commerce on February 6. Weil, who joined the GSB
faculty the year before earning his Ph.D. in economics at Carnegie
Mellon University in 1966, is the coauthor with Clyde P. Stickney
of Financial Accounting: An Introduction to Concepts, Methods,
and Uses (Dryden Press, 2000), in its ninth edition the standard
text in M.B.A. accounting classrooms.
the early 1980s," Weil said in his testimony, "[when]
an aggressive company's management engages in a transaction not
covered by specific accounting rules, [it] accounts for it as
it chooses and challenges the auditor by arguing, 'Show me where
it says I can't.' The auditor used to be able to appeal to first
principles of accounting"-broadly applicable, commonsense
rules developed in the FASB's conceptual framework when the SEC
formed the group in the early 1980s. But accounting rules have
become increasingly detailed as auditors and the SEC try to stay
one step ahead of aggressive corporate managers who, in effect,
argue, "'Detailed accounting rules cover so many transactions
and none of them covers the current issue, so we can devise accounting
of our own choosing.' And they do," said Weil.
the wake of the Enron collapse, lawmakers feel inclined to call
for more rules to strain the spines of the already-fat brown books.
That, Weil says, is the last thing we need. Where the backbone
is needed, he contends, is in the auditors. "I want accountants
to rely on fundamental first principles in choosing accounting
methods and estimates. I want accountants not to hide behind the
absence of a specific rule. Whatever the detailed rules accountants
write, smart managers can construct transactions the rules don't
cover." He points to a February 19 Financial Times
editorial urging the U.S. to adopt the trim principles set by
the International Accounting Standards Board and used throughout
Europe, emphasizing substance over form.
first principles, however, won't help as long as a company's management
decides which auditor to hire and whether to fire that auditor
if it questions aggressive accounting strategies. "That's
not how it's supposed to work, but it's how it works," says
Weil-not at all companies, but at too many. When in the early
1980s then-SEC chair Rod Hills required the boards of all publicly
traded companies to establish audit committees, he envisioned
a committee staffed primarily by independent board members, responsible
for choosing an auditor and ensuring the auditor does a thorough
job of certifying balance sheets, with shareholders' interests
the driving force. Implicit in this system was that independent
board members be truly independent.
asks Weil, "how independent are independent board members
in reality?" All too often, he answers, "they're the
buddies of the CEO and chairman, and when it comes time to choose
an auditor, management says, 'We want this Big Five accounting
firm,' and so that's who the audit committee hires." As a
result the auditor learns to take its cues not from the audit
committee but from management. The cozy ties of Enron's board
to its management have been well rehearsed. Adding to the problem,
board members-particularly those on audit committees, Enron's
included-are often "financially illiterate," meaning
they don't understand accounting rules enough to know when a rosy
balance sheet shouldn't be so rosy.
do I know they are often illiterate?" Weil asked in a footnote
to his testimony. "Because I teach them in Directors' College
classes where I start with pop quizzes." Head of the GSB's
Director's College, a one-and-a-half-day course for new board
directors, Weil is not alone among accounting experts calling
for a financial-literacy requirement for all audit committee members.
He's working with faculty at the Wharton School of the University
of Pennsylvania and Stanford Law School in a joint venture to
expand the college into a three-day intensive program that graduates
independent directors who better understand what's expected of
them and can recognize suspicious balance sheets.
Weil is one of few voices not calling for legislated limits or
bans on the consulting services that many accounting firms-including
Enron's auditor, Anderson-have provided to clients they also audit.
A true Chicagoan, he believes in taking a regulatory "light
touch." "We need audit committees to exercise the power
the SEC has given them," Weil testified. And the audit committee,
he says, should decide whether the auditor's consulting services
cause a conflict of interest.
and other experts also call for mandatory auditor rotation-five-
or seven-year term limits, with the audit committee responsible
for selecting a new auditor and overseeing the transition. "Let
the auditor know that, no matter what, another auditor will take
over the job in a few years and will have the incentive to expose
a predecessor's carelessness," he says.
also calls on the SEC to "prod" audit committees by
having them report on independent searches to find a replacement
auditor and on their interactions with the auditor after hiring.
"Mandatory auditor rotation, with auditors chosen and beholden
to the audit committee, will solve the conflict-of-interest problem.
Forbidding the auditor from all consulting will not produce high-quality
audits," he says, or prevent "malleable" accounting.
an ideal world, preventing another Enron means trimming down the
rules and getting back to first principles. But in the real world,
Weil believes, requiring audit committees to stand up and be accountable
is the best solution. "We already have regulations empowering
the audit committee to act independent of management," he
told the House. "Now we need the audit committee to act."