Information technology could do many things, but presenting quarterly and annual reports of company performance to shareholders, stock exchanges and regulators, was not among them.
This was information that determined pay and promotion, not to mention the company stock price, and future prospects.
Financial reporting involved a myriad of decisions, and decisions were the realm of managers, with all their human limitations and foibles.
Given the risk of error or misrepresentation, it made sense to produce and present financial information using a system of checks and balances.
The system that emerged over the course of the twentieth century had four pillars.
Federal stock market regulators, were created by Congress in 1934, to establish and enforce accounting and reporting standards, with jurisdiction over any company that sought to sell shares to investors; company managers, to keep the company books, establish internal controls, and report to regulators and the board of directors; independent auditors, to verify the information and documents that the company presented, and to ensure compliance with regulations; and independent company directors, to appoint the managers and auditors, set their compensation, and review their performance.
But as with the system of checks and balances in the political arena, checks and balances in the corporate arena were easier to design than to implement.
More so after Federal antitrust laws, enacted by Congress in the early 1980’s, were applied to the accounting profession.
After long standing professional prohibitions against advertising and competitive bidding by accounting firms were struck down by the US Justice Department, the hitherto genteel and placid world of accounting was turned on its head, and accountants and auditors began a scramble for fees.
In 1975, non-audit services contributed, on average, 10% of total revenues at the top American auditing firms.
By 2000, they accounted for almost half of total revenues, with dramatic consequences.
Consequences
Audits had always entailed potential conflicts of interest, given that the company whose books and reports the auditors reviewed was also its paymaster.
The potential for conflicts would only increase if auditors also provided non-audit services.
How diligently would an auditor review the books of a client that also paid them lucrative consulting fees?
The energy services provider Enron was the first large corporation to collapse, in December, 2001, wiping out $60 billion in shareholder wealth.
Enron’s stated revenues had increased tenfold in the five years leading up to 2000, even though profits had barely budged.
Enron accomplished this remarkable feat by booking the entire value of service contracts as revenue, rather than just the commission, as normally done, and by adjusting the value of these contracts daily, using “mark to market” accounting devised for futures contracts.
Since Enron’s service contracts did not trade in any market, managers could assign whatever “mark” they desired.
Apparently no one, least of all the company’s auditors, questioned why utility service contracts were being treated as financial hedging instruments.
With assets of $65 billion at the time of filing, Enron was the largest corporate bankruptcy in US history.
The record lasted barely seven months.
In July, 2002, telecommunications conglomerate WorldCom filed for bankruptcy after admitting that the $10 billion in profits it had stated for the previous two years was actually $64 billion in losses.
WorldCom had gobbled up more than seventy companies between 1983 and 1999, using acquisitions to manipulate earnings.
When regulators put the brakes on further purchases, WorldCom resorted to shifting operational expenses from the income statement to the balance sheet in order to inflate earnings.
An array of listed companies followed Enron and WorldCom to bankruptcy court, wiping out hundreds of billions of dollars in shareholder equity.
The litany of accounting and management abuses included fictitious revenues, hidden expenses, misuse of acquisitions, unsustainable activities, lavish personal loans and lucrative related-party transactions -- all apparently undetected by auditors.
How did corporate managers pull off such unprecedented fraud?
Lawmakers and regulators turned the spotlight on the lack of internal controls on managers and conflicts of interest among ostensibly independent auditors.
Internal controls had long been understood to be important, at least since the 1929 stock market crash, but given the size and complexity of twentieth century businesses, and the need to contain costs, auditors had adopted “risk-based auditing”, whereby they reviewed only certain, selected areas of company operations for examination.
The auditor for both Enron and WorldCom was the venerable accounting firm of Arthur Andersen.
Founded in Chicago in 1913 by a famously principled accountant with a passion for education, who had created the first centralized workplace training program for accountants, Andersen had earned $52 million in fees from Enron in the year 2000, split evenly between its auditing and consulting divisions.
On the last day of August, 2002, 55 years after Arthur Andersen’s death, the firm he had painstakingly built, on the credo that accountants served investors rather than company management, surrendered its license to practice accounting and shut its doors, driven by bitter infighting between its audit and consulting divisions, shamed by its association with the largest corporate bankruptcies in American history, and abandoned by the very clients it had chosen to serve.
The author is a writer and researcher in Dhaka, who previously worked as an investment banker in London and New York
