Investigations
After Enron, what's an audit committee to do?
>> What they were meant to do, Roman Weil told lawmakers, calling for fewer rules and more backbone.

Ask 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?

Weil 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."

The 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.

In 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."

But 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.

"Since 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.

In 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.

Embracing 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.

But, 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.

"How 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.

Meanwhile, 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.

He 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.

He 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.

In 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."
- S.A.S.

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