NEWS INDEX Archives 2004 June

Sarbanes-Oxley Act fails to address corporate accounting flaws, scholar says

Mark Reutter, Business & Law Editor
217-333-0568; mreutter@uiuc.edu

6/28/04

CHAMPAIGN, Ill. — Far from imposing an unreasonable burden on corporate America, the Sarbanes-Oxley Act has not tackled the core accounting conflicts that led to investor losses at Enron, WorldCom and other companies, according to an expert at the University of Illinois at Urbana-Champaign.

As the second anniversary of its enactment approaches, Sarbanes-Oxley “presents a potpourri of largely missed opportunities regarding the relationship of auditors and their clients,” writes Richard L. Kaplan, an Illinois law professor who has taught accounting issues for lawyers. “Coming at a historic moment for the U.S. securities markets, it addressed important problems but adopted weak solutions … At base, it is not clear that these half-hearted approaches will accomplish all that much.”

Corporate lobbying groups such as the Business Roundtable have been calling the act too harsh and burdensome. In a recent speech, John Thain, the head of the New York Stock Exchange, argued that the costs associated with Sarbanes-Oxley might scare U.S. and foreign firms from investing in the United States.

Such complaints are off the mark, according to Kaplan’s article published in the Journal of Corporation Law, because the legislation does not effectively curb the ingrained culture of “auditor coziness” that can result in financial manipulation of public companies and scare away investment dollars in the long run.

This culture is summed up, Kaplan wrote, in the “joke about the corporate official interviewing two accounting firms and asking each of the partners, ‘How much is two plus two?’ The first firm’s partner said ‘four,’ but the second firm’s partner replied, ‘What number did you have in mind?’ The second firm won the client.”

What makes this joke especially pungent is that auditors don’t just answer to their clients. They are legally responsible for acting as a public watchdog in certifying the accuracy of financial statements issued by public corporations. This requirement demands, according to the U.S. Supreme Court’s 1984 decision, United States v. Arthur Young & Co., that “the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust.”

Sarbanes-Oxley’s response to auditor coziness was to bar the lead partner of an auditing firm from overseeing the same corporate account for more than five years. This period is “simply too long in today’s fast-paced business world,” Kaplan argued.

What’s more, the law places no rotation restrictions on the auditing firm itself. With unlimited tenure at the same company, the auditing firm will invariably “identify with its client, substitute trust for skepticism and brag about the client to prospective clients.”

Federal securities law should require public corporations to switch auditing firms every few years, Kaplan argued. “Then the new partner would feel comfortable challenging the work done previously.”

The Illinois scholar, himself an accountant who worked for a major auditing firm, also faulted the narrow prohibitions against accountants offering non-audit services to a client. The biggest loophole permits auditing firms to provide tax compliance and planning services to a company they “independently” audit.

Because tax compliance and planning require an accounting firm to act as an advocate for a client, one of the core elements of auditor independence is violated, Kaplan said.

“Consider, for example, an accounting firm that advises its audit client to classify certain expenditures in a way that minimized the client’s current-year tax expense. If the Internal Revenue Service subsequently challenges this classification scheme, what role will the accounting firm then play? The corporate client will quite naturally expect the accounting firm to defend the client’s action … Can the accounting firm really provide a dispassionate analysis of the expenditure classification scheme that the client adopted because of the accounting firm’s recommendation?”

If the auditing firm cannot make an independent judgment, then the client’s balance sheet liability for taxes owed will be understated, perhaps dramatically, to the investing public. Kaplan therefore recommended that Congress put tax advice on the list of prohibited services.

Assessing why billions of dollars of fraudulent transactions went undetected by auditors until Enron and WorldCom collapsed, Kaplan noted a recent study, which found that “modern auditing has focused too much on the information systems that a client uses to generate financial information and too little on a direct testing of the underlying transactions.”

This mindset of following arcane rules rather than spot-checking for potential fraud has been validated by “generally accepted accounting principles” (GAAP) promulgated by a private organization, the Financial Accounting Standards Board.

GAAP needs to be thoroughly reviewed and reformed, according to Kaplan. In fact, paving the way for such reform could have been the greatest achievement of the Sarbanes-Oxley Act.

But instead of overhauling GAAP, a move that was vigorously opposed by the accounting profession, Sarbanes-Oxley skirted the issue, authorizing a study of the costs and feasibility of moving to a “principles-based accounting system.” How Congress would react to the findings of such a vague study was left unspecified.

“Perhaps the next legislative effort will be better, but comprehensive opportunities to address [complex accounting] issues do not arise that often,” Kaplan concluded. “If the audit process is to fulfill the high expectations that U.S. securities laws assign to it, things must improve.”

His article is titled, “The Mother of All Conflicts: Auditors and Their Clients.”