Fiddling the books

By Frances Martin

Monday 1st July 2002

The Enron scandal has weakened investors' trust in our companies and their accounts. If corporates and accounting firms are going to win that trust back, more needs to be done than assuring shareholders it couldn't happen here.

Deception, suicide, billions of dollars up in smoke. There's nothing like a financial scandal to titillate the appetite - except, of course, if you're caught up in its wake. Though the recent Enron debacle happened thousands of miles from our shores, shock waves are lapping the ankles of New Zealand companies and accounting firms, along with the country's regulators.

For those who need reminding, Enron was the US energy trading giant that went spectacularly bust in December after its auditors, Arthur Andersen, apparently failed to notice that management were seriously cooking the books. It seems Enron's accountants were strenuously "managing" earnings, partly by hiding debts in off-balance sheet vehicles.

Questions have since arisen about whether Andersen's ability to spot these dodgy practices was affected by the fact it also did lucrative consulting work for Enron. In the wake of the energy giant's collapse, the New Zealand accounting profession has been quick to reassure Kiwi investors our companies wouldn't get away with that kind of carry-on.

US accounting standards are rule-based, while New Zealand's are principle-based, says Nick Main, managing partner of Deloitte Touche Tohmatsu. That means any accounting mechanism is examined for its substance, not just its ability to fit the rules. "If it barks like a dog, we call it a dog - even if it's got a cat on the label," Main says. So, if a Kiwi company tried using an Enron-style off-balance sheet mechanism, chances are the substance test means its dirty linen would end up back on the balance sheet.

Does that mean Kiwi investors can rest peaceful at night, smug in the knowledge our audit regime is watertight? Not exactly.

Enron's bankruptcy has made funds managers more sceptical about trusting audited financial accounts, according to BT Funds Management chief investment officer Craig Stobo. Analysts traditionally value companies using these accounts. "[Enron] has shown that you can't rely on the numbers, even when they've been audited," Stobo says. Post-Enron, BT has stepped up efforts to test its numbers - particularly when it comes to things like goodwill, extraordinary items, cash-flow and, of course, off-balance sheet items.

Yes, Kiwi companies regularly use these, says Macquarie Financial Services senior investment analyst Arthur Lim. Selling assets, then leasing them back, is the most common sleight-of-hand used here to get debt off the balance sheet, Lim says. Chief financial officers also have scope to "manage" earnings, and they make use of it, he says. Legitimate adjustments to things like depreciation, inventory values or bad debt provisions can influence a company's results by up to 5%.

Still, Lim says the relatively simple nature of most Kiwi companies and our high levels of disclosure mean the use of profit-smoothing and off-balance sheet items isn't likely to get out of hand here. "They're easier to analyse and easier to audit than US companies, which often have a multitude of businesses running in many countries."

Auditing the auditors

Maybe the rules are okay, but what about the rule enforcers? As in the US, New Zealand accounting firms regularly do tax and other consulting work for companies whose books they audit. This consulting work can be very lucrative. A survey by the US Securities and Exchange Commission found firms earned nearly three times as much from consulting as auditing.

The work is keenly sought - in fact, Unlimited knows of two New Zealand accounting firms that have offered discounts on audit work in the hope of getting a foot in the door with a new client likely to be offering some consulting contracts later on.

Accountants absolutely reject suggestions they should be stopped from doing auditing and consulting work for the same company. The practice does not create an inherent conflict of interest, they say. "Our firms essentially trade on their reputation and objectively. No firm I know would compromise that for any relationship," insists PricewaterhouseCoopers partner Warwick Hunt. This view is supported by Victoria University's Professor Keitha Dunstan, who says there's no evidence that providing non-audit services compromises an auditor's independence.

Despite this, the big four accounting firms have suggested reforms aimed at shoring up investor confidence in their craft. Among other things, they want auditors to report to non-executive directors, and for the Securities Commission to play a role in the appointment or replacement of auditors. Currently, companies pretty much have a free hand to dump auditors that won't sign dodgy accounts. It isn't easy to do, though, because the change must be made public and the ensuing publicity is likely to be unpleasant. Getting the Securities Commission involved would reduce management's ability to intimidate auditors with the threat of sacking. Having auditors report to independent directors, rather than management, would be another way to reduce this intimidation.

Other proposals include making it mandatory to swap the partners in charge of an audit at least every seven years, thereby lessening the chances of auditors and management becoming too friendly. Some accounting firms are also recommending telling shareholders about consulting services also provided by the auditor.

The changes, which are relatively minor, may be an attempt to head off pressure for stricter rules to be imposed on the profession. The Ministry of Economic Development is taking a keen interest in the inquiries into Enron and HIH, a failed Australian insurer that was also audited by Andersen.

The ministry has briefed Commerce Minister Paul Swain on the issues but says there's still a lot to come out of the inquiries about what happened and why. Still, it says New Zealand is unlikely to lead the pack on any regulatory reforms, partly because we don't want to get out of step with our main trading partners.

For now, at least, it seems regulators are happy to give accounting firms breathing space to come up with their own initiatives for rebuilding investor confidence in audits. Just how long they'll maintain this relaxed approach largely depends on whether the profession comes up with credible changes or just some public relations window-dressing, aimed at protecting their money-spinning consulting businesses.

Frances Martin
frances.martin@paradise.net.nz

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