Accounting scandals leave corporate world with little option but to instigate change

We are in a situation where a company thinks it is better to cover up than toface up, writes Joe Carr

Last October, Enron; this week, WorldCom; and now Xerox. In between, probably another 30 corporate problems that only get covered in the inside pages of the business papers. Is this a poisoned market system in its death throes? Are all companies corrupt? Is it all the fault of accountants and auditors?

The specifics of WorldCom - all of the facts, figures and human reasons behind the story - will be analysed, debated and dissected over the coming weeks and months. However, it concerns me that when all of this discussion and allocation of blame is done with, we are very likely to find that we have not addressed the fundamentals.

Collapses like these will continue to be repeated unless we address the question of why they occur. There are a number of issues to be considered in looking at this question. Each has its place and requires considerable debate, but the focus of this article is primarily on the auditing profession and its role.

We must first ask ourselves why companies feel pressured to smooth, massage and, ultimately, misreport their results. The answer, simply, is that the consequences of reporting results below expectation are too difficult for some managers to handle. The combination of unrealistic corporate strategy, a very demanding market mechanism and the unreasonable desire for wealth has left us in a situation where a company thinks it is better to cover up than to face up.

The markets continue to demand increased growth, quarter after quarter, year after year. The availability of virtually real-time reporting has shortened our perspective to months, when the realistic business model typically runs in cycles of five or seven years. The system abhors failure, even where that failure is in fact a reasonable level of profit. All of this has the capacity to produce misleading financial statements.

What of the auditors? Were the watchdogs asleep? The auditor should be in a position of trust, charged with providing an objective unbiased view on the financial statements. What is now apparent is that, caught up in a culture of massaging the market, some of the watchdogs became lost in the play.

The auditors lost perspective. They failed to see (and I am not referring here solely to the auditors of companies that have experienced the financial equivalent of significant trauma) that what was being presented was, in essence, divorced from reality. As a profession we must face up to these facts.

The profession of auditing is in real danger of being rendered irrelevant by its failure to address the needs of its market. Audit has succumbed to commercial pressures, as clients squeeze fees for a service that they do not perceive as contributing to profitability.

Many of the major audit firms have shifted focus from the traditional core competencies to more profitable activities.

The result? An inevitable deficiency in the relative level of intellectual and technical auditing skills brought to bear in an increasingly complex business world? Auditing is about making the link between what happens in the real world of electric cables, computers and car sales, and what is reported in the financial statements so beloved of analysts and the market.

The essence of auditing should be about understanding business, and clarity of analysis and communication. Lose sight of these fundamentals and the profession is dead. The question then might become what, if anything, can replace it? Who will protect the shareholders and the markets?

Audit still holds a position of primacy in accounting firms in Europe, particularly those firms that owe their origin and ethos to European ideals. In France, joint audits are the norm for all public- interest organisations, providing protection against the loss of objectivity and independence.

I am not suggesting that the European and US systems are completely different or that one system is all right and the other all wrong. Nor am I suggesting that everything is rosy in the European garden. However, in finding a solution, the European experience has a significant contribution to make.

In the Republic we have already been over this ground. In the wake of the DIRT Inquiry, the Committee on Public Accounts raised a series of questions with respect to the future operation of auditing. These questions included the possible appointment of joint auditors, the rotation of audit firms every five years and the development of conflict-of-interest prohibitions and rule changes.

These issues were examined by the Review Group on Auditing, which largely found that significant changes to the status quo would leave the State out of step with the rest of the international business community. One suspects that they were conscious, in particular, of the Securities and Exchange Commission (SEC).

Mr Harvey Pitt, SEC chairman, commenting on the auditing profession, recently said that, as a consequence of deficiencies in our auditing system, it was patently clear that "we're experiencing a significant loss of investor confidence in public companies, their audited financial statements and the accounting profession".

And that was before the WorldCom story broke!

In Europe, auditors must work to repair their tarnished image. That will require a realistic diagnosis. In the Republic, through the review group, we have already done just such an analysis. While some change occurred, many of the solutions contemplated at that time were found to be unpalatable. It is surely now time to look again. We have the wherewithal but do we have the will?

Joe Carr is managing partner designate of Chapman Flood Mazars chartered accountants and a member of the international executive of the Mazars group, an indigenous European audit and accounting firm.