U.S. media, politians zero in on auditing practices

There is nothing the U.S. media loves more than a nice, juicy scandal. The Olympic figure-skating controversy was tailor-made for them, and Canada got more exposure from it than at any time since Ben Johnson was busted for drugs in Seoul. Of course, the exposure provided by Pelletier and Sale was much more positive.

But after the IOC defused the judging issue with a second gold medal, the U.S. media had to look elsewhere for something to sink their teeth into. They've settled on the auditing scandal surrounding the Enron collapse. It's not as sexy as figure skating, but it certainly has much more important ramifications.

The Feb. 22 edition of USA Today carried a front-page story headlined: "Accounting's role in Enron crash erases years of trust". The lengthy article talks about a "credibility crisis" in the accounting profession, citing issues raised by Arthur Andersen's role in failing to raise warning signals about financial problems within Enron. "Nation howling for changes to make auditors watchdogs, not lapdogs" a second headline read. A number of possible solutions are proposed, from limiting the term of an auditing firm's mandate, in much the same way as the U.S. limits presidents to two terms, to removing potential conflicts of interest by prohibiting companies from using their auditor for other services, such as consulting. The Walt Disney Company has already taken such a step unilaterally.

Make no mistake about it. This is an issue of major importance in a capitalist society. And the problem is multi-dimensional. To pin all the blame on the accounting profession is to miss the bigger picture. Securities regulators in both the U.S. and Canada are going to have to take action on several fronts. Specifically, these are:

Financial analysts. Canada's Crawford Committee missed a golden opportunity to give our country a head start in coming to grips with the potential conflicts of interest between analysts and their employers. As contributing editor Tom Slee has pointed out on several occasions, analysts are often caught between a rock and a hard place. The firm that employs them may have a range of financial ties to companies which they are reviewing, from raising capital to providing lines of credit and investing services. This is big business, with millions of dollars involved. Analysts who ignore the vested interests of their employers do so at the risk of their careers.

It's not as simple as restricting analysts and their families from trading shares in the companies they recommend, which was the thrust of the Crawford Committee's report. The issue runs much deeper than that, and there is no obvious solution. One possibility is the creation of independent equity research companies, whose sole business is unbiased financial analysis. But that represents a huge leap from the current system and there is no guarantee such operations would be economically viable. Another possibility is to forbid brokerage firms from issuing public reports on any companies with which they or related firms have financial dealings. But in a market as small as Canada's, that may be impractical.

As we said, there are no easy answers to this problem. But that doesn't mean we shouldn't start to look seriously for some solutions.

Corporate governance. The issue of the responsibility of boards of directors and the clubbiness that permeates many of them has risen to the surface again as a result of the Enron fiasco, and rightly so. Directors have a responsibility to protect the interests of shareholders - they are the investors' eyes and ears within a company. But events have repeatedly shown they cannot always be relied upon to act in the best interests of shareholders or employees. There are many reasons for this, ranging from withholding of information by management, to lack of time, to unwillingness to rock a comfortable boat, to indifference. Again, the solution is not an easy one, but tougher standards for directors and the inclusion of more outsiders on boards could be a step in the right direction.

Financial reporting. This is the issue that is in the spotlight now, with some of the most trusted names in the business world coming under scrutiny. The Big Five accounting firms in the U.S. have already announced that they will no longer provide certain advisory services to companies they audit, and that is a start in the right direction. But the bottom line is that financial reporting needs to be made more transparent. Analysts and investors must be provided with an accurate and clear picture of a public company's financial fortunes. Right now, the numbers can be manipulated to convey just about any message that's desired.

This means we need tighter accounting standards and tougher rules for data presentation, with teeth to punish violators. If people go to prison because they have deliberately misled the public, so be it. It's a price that must be accepted if we are to restore confidence in a system that looks very shaky right now.

That's what all this comes down to: confidence. Confidence that directors are acting in the best interests of shareholders. Confidence that the financial statements of a company reflect the true picture. Confidence that analysts are using that information to provide unbiased guidance to investors. It needs to be constructed as a solid chain, with no weak links.

There's a lot of work to be done before we will be able to reach those goals. It's time to get started. In the meantime, be cautious and don't take anything at face value.