By John Lorinc
Illustration: Brian Cronin
 CANADA DEEPLY FELT THE SEISMIC SHOCK WAVES FROM THE COLLAPSE OF THE US ENERGY GIANT. THE PROFESSION HAS SINCE TAKEN STEPS TO REASSURE NERVOUS INVESTORS
Investor counsel and veteran shareholder Stephen Jarislowsky doesn't pull punches when speaking about corporate performance. But in the wake of the Enron debacle in the US, the president and CEO of one of Canada's largest money management firms went one step further by banding with several public pension funds and mutual funds to form the Canadian Coalition for Good governance, representing a massive $400 billion in assets and enough shareholder proxies to lay down the law. They're not targeting just dishonest executives and passive audit committees. Boards, he promises, will feel the heat if they rely on compliant external auditors or allow CFOs to produce note-filled financial statements using marginal accounting procedures. "I would like accountants to take an attitude of responsibility and common sense rather than oblige corporations that want to use loopholes. I want accountants to turn out conservative statements," Jarislowsky declares. To those who don't heed the coalition's warning: "We'll go to the corporation and say, 'We have no confidence in you or your auditor.' We are going to be the shareholders who tell the boards, 'You act according to our rules or we'll make changes.' "
There can be little doubt that Canada's accounting professionals, working with securities regulators, have taken heed of the concerns of shareholders like Jarislowsky. "Enron didn't happen in this country," notes David Smith, president and CEO of the Canadian Institute of Chartered accountants. "But the spillover has been here big time."
In the past six months, there has been a series of initiatives designed to shore up investor confidence in Canada, among them tighter accounting standards, tougher professional oversight, and new regulatory measures intended to strengthen the independence and improve the accountability of external auditors. In some cases, the new policies are directly responding to changes in the US, especially the Sarbanes-Oxley Act enacted on July 30, which aims at improving the accuracy and reliability of corporate disclosures by requiring chief executive and financial officers to certify quarterly and annual reports. But in other cases — notably in the area of new standards for auditor independence — the profession had been working on updated approaches even prior to the dramatic December 2001 revelations about Enron Corp. former president and CEO Jeffrey Skilling's now infamous network of off balance sheet subsidiaries. In terms of the industry itself, the Big Four firms have exited the consulting sidelines that were seen to have compromised their capacity to provide disinterested auditing opinions.
Most significantly, though, the Enron fallout has highlighted the fundamental contrast between Canadian and US accounting practice — a stark cultural difference that dramatically illustrates the risks of an excessively rule-oriented system. At the same time, the debate over auditing standards has served to focus attention on the importance of sound corporate governance, professional judgment and the distinct roles of those entrusted with ensuring that audited financial statements provide investors and regulators with an accurate snapshot of a company's books. The result, says Paul Cherry, chairman of the Accounting standards Board (AcSB), "is a greater appreciation of the worth of financial reporting and the damage everyone suffers when you get crummy accounting."
It doesn't seem too long ago that many tech gurus and stock market analysts were contemplating a world in which audited financial statements were a thing of the past. By the end of the 1990s, the boom in the equity markets, the preeminence of options-based compensation, the surge in day trading and extraordinary vitality of the telecom sector all pointed toward a hyper-accelerated environment in which year-old financial information revealed almost nothing meaningful to global investors searching for the next digital supernova. That 24-7 mindset seemed to permeate the accounting industry, which increasingly regarded the audited annual financial statement as a low-margin commodity, and one that would have to take a backseat to high-margin, value-added services such as strategic planning, IT consulting and forensic accounting.
"The pressure on audit fees has been such that audit firms couldn't go in and do a really thorough job," says Professor Royston Greenwood, who heads the university of Alberta's Centre for professional Service Firm Management and is the director of the university's school of business. Like many others have, he observes that Enron has precipitated, among other things, a major shift in the industry because clients "will be willing to pay for more thorough audits. In a sense, it takes the pressure off the accounting firms to cut corners."
By the time the Enron scandal surfaced, this was happening all too frequently, given the extreme pressure on audit service fees. The macro issues are well known: conflict of interest situations where accounting firms or branch offices downplayed client audits in order to maintain lucrative consulting jobs, such as designing IT systems or providing strategic advice to the CEO. The more subtle problems have an impact, as well. Audit teams face extremely tight deadlines and may sometimes be comprised of junior staff who have less experience with questionable internal accounting procedures. Then there's the revolving door dynamic, where a client recruits the audit partner to become controller. In such situations, the auditors may find themselves under pressure from the client to alter the wording of a note that might otherwise put the company's financial statements in a less-than-flattering light.
Corporate governance experts, however, point out that boards bear the lion's share of the responsibility for lapses in judgment or a failure to ensure independence of the audit process. Chris Bart, CA, and professor of strategic management at McMaster University's DeGroote School of Business in Hamilton, argues, for example, that auditors must be allowed to meet privately first with audit committees to discuss questions arising from the financial statements, and only then invite the CFO or the president to respond to queries or answer for certain accounting practices. And then there's outright malfeasance, which is what occurred with Enron and WorldCom.
"We can create rules and procedures until we are out of breath," Bart says. "If people are dishonest, they'll always find a way around them." He recalls receiving a key piece of advice from a commerce professor during his training. "There's no defending against a client who is intent on fraud. Your best defence as an auditor is to assure yourself that you're dealing with a reputable client. We've lost sight of that. [Enron] is a call to arms to rediscover its roots as a profession."
The reforms to date fall into three categories: accounting standards; professional oversight at both the provincial and national level; and audit independence. Since the summer, the AcSB has begun the process of upgrading accounting standards on three of the most controversial issues that have materialized since Enron melted down: the treatment of special purpose entities; the recognition to expense stock options; and fuller disclosure of guarantees, including in interim financial statements. The profession is also pushing regulators to promulgate tougher disclosure standards for management discussion and analysis reports.
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Audit committee charters
"Audit the audit committees." That's Chris Bart's solution to the governance aspect of the crisis in investor confidence created by the scandals at Enron and WorldCom. Audit committees have come under close scrutiny in the past year, and there are growing calls for strict reforms, such as ensuring that members are both financially literate and have a clear measure of independence from management. But Bart, a professor of business strategy and innovation at Hamilton's DeGroote School of Business, wants to see boards go a step further by adopting formal procedures, or charters, to guide the oversight work of their audit committees. In other words, no more rubber-stamping.
Such charters — which have been adopted by US companies such as The Dow Chemical Co., Intel and Raytheon — lay out the committee's responsibilities and the nature of its members' qualifications. These charters may also include policies on the hiring of external auditors, procedures for dealing with management-auditor conflicts, and rules setting out the sorts of nonaudit work that can be performed by the external auditor. Some can encompass up to 40 requirements, including those that say the committee should routinely review its own performance.
Bart argues that both the charter and the audit committee's self-evaluation should be published in the annual report and that an oversight body, like the newly formed Canadian Public Accountability Board, be given the authority to conduct random checks to see if all the principles set out in a company's charter are being adhered to. And that, fundamentally, is a governance issue. As Bart says, "We have to provide greater assurance that the financial statements have been appropriately approved." |
SPEs have received the majority of the attention in the US because Enron depended so heavily on such vehicles to hide billions of dollars in debt. Canadian CAs are more than familiar with the tactic of establishing SPEs to mitigate tax payables or to securitize credit-card debt, and the new guideline is a bid to provide consolidated information that is even more comprehensive. The AcSB had considered an SPE standard prior to Enron, but decided against issuing what Cherry describes as a "band-aid solution" because there wasn't enough evidence about the financial impact of SPEs. The new draft guideline will require reporting corporations to identify the "primary beneficiary" as well as the nominal owner, and explain how these determinations are made. The new draft standard, in the words of one equity analyst, "really clarifies the principles that already existed."
At the same time, there's been less political fallout here over SPEs because canadian corporate pension funds are barred from owning more than 5% of the company's own stock — a policy that protects employees from the sort of personal financial exposure that befell Enron's thousands of workers when the company collapsed. As Fred Snell, chief accountant for the Alberta Securities commission, says, "There's a lot of SPEs in canada, and the disclosure has been OK here based on experience with Alberta reporting issues."
Denis Durand, a partner in Jarislowsky Fraser's Montreal office, feels the options accounting question, in fact, is more pressing for domestic investors, particularly in light of the meltdowns of Canadian high-tech giants such as Nortel Networks and JDS Uniphase, both of which provided extensive options-packages for their top executives. "The accounting challenge is to find a consistent basis for evaluation."
For years, many accountants and investors such as Warren Buffett have questioned why options were not accounted as a compensation expense on the financial statements (see "Accounting politics, US-style" on page 25). And the canadian accounting profession has been criticized for not acting more aggressively on the options issue.
In the mid-1990s, says Brian Gibson, senior vice-president of the Ontario Teachers' Pension Plan Board, the "US accounting authority, the Financial Accounting Standards Board, backed away from forcing companies to include option costs on their income statements in the face of stiff political opposition from corporations, particularly those in the technology industry. After five years of study, the [CICA] adopted the FASB rule virtually unchanged."
But market watchers also acknowledge that figuring out the value of an option is less than straightforward, primarily because the cost is a moving target that depends on the value of the stock both at the time when the option was issued and when it's exercised. And there's no consensus on the appropriate accounting treatment. "To me, expensing options might almost be more confusing," says Tom Lunan, a CA who is a vice-president and a chartered financial analyst for BEST investment Counsel in Toronto.
Both Lunan and Durand observe that the lavish executive options packages of the late 1990s may have provided simply too much incentive for senior executives to manage the stock price, either with lots of good-news press releases or the establishment of SPEs to artificially inflate operating profits by moving assets off the balance sheet. "It's a bigger problem than just the accounting treatment of options," says Lunan.
Beyond these new standards, however, looms a more fundamental question. Smith points out that Canada's principle-based accounting culture has proven more resilient to scandal than the rule-based system in the US, where the accounting handbook is literally thousands of pages long. US regulators have clearly indicated they would like that dynamic to change by implementing such measures as requiring CEOs to sign off on financial statements. (Canadian regulators have stopped short of such accountability measures, and many domestic observers see such gestures as more symbolic than substantive.) US Securities and Exchange commission chairman Harvey Pitt has called on the US profession to move toward a more principle-based approach. Many canadian chartered accountants see that as a monumental shift. "It's an open question as to whether the SEC can move to principle-based regulation," says David Leslie, chairman and CEO of Ernst & Young.
Cherry says much of the accounting literature in the US exists because of the profession's response to specific queries from companies such as Enron, but observes that the net result is a dense thicket of rules that are often contradictory and incomplete. However, while the profession recognizes that more rules actually exacerbate the problem, the onus is now on controllers, audit practitioners and audit committees to prove that the principle-based Canadian approach remains inviolable — primarily by placing the emphasis squarely on mainstream interpretations.
"It's not marginally acceptable accounting principles," says Toronto CA Charles Smedmor of Smedmor & associates. "It's generally accepted accounting principles."
The move away from technical interpretations will be a "very healthy development," says Jim Turner, senior partner in the securities law practice of Torys LLP. But, he adds, "It's going to be a much more difficult judgment call for professionals like CAs. We can't just take a technical interpretation without doing a public interest analysis. The auditors have to ask fundamental questions. It's going to put more pressure on them than they have seen in the past."
Still, some securities regulators warn that the principle-based approach isn't without its flaws. "It's not a slam dunk one way or the other," says the ASC's Snell. "In the past few years, there have been lots of financial minds finding ways of getting things off the balance sheet and finding subtle ways around the rules, and that's when the abuse begins." But, he adds, "I've also run into a lot of situations where it's nice to have a very specific rule to fall back on."
To date, financial analysts say it's still a bit early in the reform process to detect direct evidence of the new ethos. But, as Canadian telecom analyst Stuart Isher-wood, CA, comments, "You would presume [external auditors] are being more careful." Jarislowsky's coalition intends to go well beyond presumption. ontario Teachers' Pension Plan, for example, is calling on regulators to insist on better and faster reconciliations between pro forma earnings and reported earnings, which represent the basis for a huge volume of retail trades.
"What I would like to see," Jarislowsky says, "is a far simpler financial statement that people can understand. It should be plain language. It should be understandable. Let's get back to basics. Not loopholes. Not fancy banking deals. Minimal notes. That's what I'd like to see."
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Accounting politics, US-style
There is little doubt that the Sarbanes-Oxley Act, which was passed earlier this year by US Congress, has the potential to dramatically change the face of financial reporting and auditor oversight. Its provisions include new rules for auditors, conflicts of interest and the very efficacy of the rules-based system that represents the tangled foundation of public accounting in the US. But the politics of reform isn't always a pretty sight. Driven by the Enron/WorldCom scandals, the new legislation represents something of an about-face for many of its backers, including prominent US politicians such as Senator Joseph Lieberman. Back in the mid-1990s, US politicians and business lobbyists trained their guns on accounting rules when the Financial Accounting Standards Board came forward with a standard recommending that stock options be fully expensed on financial statements. That proposal, which was backed by FASB's long tradition of extensive consultation and deliberation, turned into a major political target. With the stock markets roaring along on the fuel of option-based incentive packages, many US politicians had absolutely no appetite for challenging Wall Street or, indeed, Silicon Valley, which generated so much of the options themselves. It turned into a game of brinksmanship, with legislators threatening to pull the plug on FASB altogether. The standard was finally withdrawn. "The tenor of the debate was disgusting," recalls the CICA's Paul Cherry. "It was vicious and relentless on the part of business and a significant portion of the Congress."
Everyone now understands the immense financial consequences of not fully costing stock options. And as it happens, some of those who vehemently opposed FASB's options standard in the mid-1990s are backing Sarbanes-Oxley. It's a bit of political inconsistency that's been detected by the Wall Street Journal. "I think our approach is better," says Cherry, citing the high degree of consensus about accounting and auditing issues among members of the profession, issuers, regulators and other stakeholders. |
On July 17, Canada's chartered accountants, the Canadian Securities Administrators and the Office for the superintendent of Financial Institutions announced the first in a series of major structural reforms intended to shore up the integrity of Canada's financial accounting system. The Canadian Public Accountability Board (CPAB) was established "to ensure the independence and transparency" of the system by creating a way of imposing sanctions on auditors and audit firms that fail to protect the public interest. The board will have contracts with all firms that audit publicly traded companies and a national inspections unit that will essentially police audit practices and conduct annual inspections. It will also have the power to issue reprimands or censure, call in provincial accounting bodies to investigate problems and supervise problem firms.
The 11-member board will be comprised primarily of senior securities regulators and is required to have at least seven non-CAs as members.
That move came hard on the heels of a movement by the provincial institutes/ ordres to take steps to open up their own oversight capacity. In June, the Institute for Chartered Accountants of Ontario an nounced the establishment of a disciplinary oversight board, the result of a two-year-long review of the ICAO's professional conduct system. As with the CPAB, a majority of its members will come from outside the profession. Its mandate will be to keep tabs on the ICAO's professional conduct committee, the board of review and the discipline and appeal committees.
"Overdue" is how Snell describes the advent of the CPAB. "It will result in more effective practice reviews," he predicts. The establishment of these new bodies, adds Turner, will mean auditors will be "looking over their shoulders. I assume the regulators feel that the [profession's] oversight process has not been working properly."
Indeed, the addition of the CPAB doubles the annual budget of the entire professional inspection system to about $6 million. "The increased quality control reviews are a good thing," says E&Y's Leslie.
The CICA's David Smith, however, rejects the suggestion that the accounting profession has lost its ability to self-regulate. But, he adds, "We should be willing to open our doors to public oversight." Individual accountants seem to agree: "Having capable and qualified lay representatives [on these boards] contributes to the process being transparent and supportable by all the stakeholders," says Smedmor. "If [an accounting practice] can't be explained to a knowledgeable lay person, then it's not going to fly."
But the most closely watched structural reform of all will be the CICA's new standard for auditor independence, which was released for comment in early september, just days after Ontario Securities Commission chairman David Brown embarked on the process of developing new securities regulations in response to tougher US auditor rules. Those rules speak directly to the sorts of non-arm's length relationships that dramatically undermined Arthur Andersen's ability to provide investors with an objective analysis of Enron's murky financial condition. As Turner observes, "There's no question that Sarbanes-Oxley has fundamentally changed the business of accounting for the major firms."
The proposed rules target five types of potential threats facing auditors: self-review — when auditors assess their own work; self-interest — when auditors stand to benefit from some financial interest in the client; advocacy — when a practitioner promotes the client's interests; familiarity — when the audit team is too close to the client; and intimidation threat — when the auditor's independence is compromised by actual or perceived threats from the client.
Echoing some of the key provisions in Sarbanes-Oxley, the new rules call for five-year partner rotations, a prohibition on financial ties between audit team members and client firms, as well as strict limits on how firms perform nonassurance services for audit clients, including an outright prohibition on routine financial statement preparation, valuation services, actuarial advice, internal audits for listed entities with more than $50 million in assets, hardware or software systems design, legal services, certain recruiting services and corporate finance activities that "create an unacceptable advocacy or self-review threat."
The CICA's draft standard doesn't address two key areas included in the new US rules, and also identified by OSC's Brown, who, in his capacity as chair of the council of governors of the CPAB, made a call for comments on how to improve the regulatory framework. One is the issue of audit firm rotation, which is to be studied by the US comptroller general, and the other involves conflicts of interest arising when any of the senior officers of an issuer had worked for the audit firm less than a year prior to the release of its audited financial statements. Nor are there measures that would limit accounting firms from providing tax-planning services to audit clients. That omission prompted some sharp media criticism soon after the draft standard was released. As one Globe and Mail commentator wrote, "When the consultant who created the tax structures is also the auditor who reviews them, there is a clear appearance of conflict. Indeed some issues that could have been classified as tax matters were critical in Enron's failure."
Leslie sees both the CICA draft standard and the Sarbanes-Oxley provisions as striking the right balance in terms of maintaining independence and objectivity. To some extent, the new rules confirm what's been happening on the ground, as the remaining big firms exit the consulting side of the business in the wake of the Arthur Andersen collapse. E&Y actually sold its consulting practice to Cap Gemini in May 2000 and stopped providing internal auditing services to audit clients last spring. Leslie doesn't believe the rules go too far. "Is the baby being thrown out with the bath water? I don't think so."
It's not a universally held view within the profession, however. Smedmor agrees there should be limits on auditors providing consulting services. But, he adds, "Any limitations should exclude auditors' services to upgrade and improve their clients' accounting records and systems. If the auditor has worked until 11 p.m. on that client's books because of poor accounting records, then that auditor is uniquely qualified to fix the problems. Bringing in someone else wouldn't be the best way to solve the problem. You have to have the guys who sweated over it."
Even the investor side of the market has its skeptics, including Jarislowsky. "The accounting profession is in total willingness to do almost anything. Every one of the big firms must have skeletons, so they're very receptive." But he believes the solution lies in greater shareholder vigilance and the threat of retribution, not added regulation. "My own feeling is that the more laws you have, the more expensive the process becomes and the less you accomplish."
Quite apart from the theoretical debate about the efficacy of the new independence rules, accounting firms now will be examining their internal process in order to better comply with the fact that basic standards of good practice have now been codified, alongside explicit guidance. Take partner rotation: E&Y, for example, implemented this approach before the Enron scandal hit. But at Grant Thornton LLP, which has a large audit practice, the firm must begin to devise a system for incorporating the rotation procedure into its audit practice. Vancouver-based Don Thomson, GT's national director of professional standards, says the problem is dealing with the issue of partner expertise.
Under an audit rotation system, it may be a challenge to find incoming auditors with the industry knowledge or background about a particular client's own quirks. "They do not have the history and they do not know where the potential pitfalls are," Thomson says. The firm intends to use its debriefing process to facilitate knowledge transfer, as well as a systematic way of transmitting important information — such as key corporate contacts — from auditor to auditor as a means of migrating to the new compliance approach.
But what is clear, too, is that there are fresh opportunities for accounting firms opening up as a result of the tighter rules. Like most accountants, Thomson knows his firm's clients have been poring over the newspapers all summer, studying the steady stream of unsavory revelations from the US. Everyone has seen the list of disgraced CEOs, the news clips of arrests and the clarion calls for sweeping reform from major commentators. Says Thomson: "They're concerned about quality, auditor independence, corporate governance."
A growing number of clients, he says, are now asking for advice on how to make the changes in their own governance and financial reporting systems. "A lot of this would have been viewed as good practice in the past," he says. "What we've added [as a profession] is significant guidance and oversight."
Stepping back from the nitty-gritty of the policy debate, Prof. Greenwood believes that what is happening represents nothing less than a sea change in the dynamics of the accounting profession and its relationship to the largest players in the industry.
As in many other sectors, the old assumption about a company being too big to fail has once again proven false. It's a signal event: "How," Greenwood asks, "does a profession that's geographically bound control these gigantic firms? In the past, the balance of power has shifted away from the profession, in the direction of the globally integrated international accounting firms."
The pendulum is swinging back, in his view, and the Big Four now need the approval of the profession in a way that wasn't nearly as apparent a year ago, when governance was still an abstract topic for forums and business ethics courses. "The profession is taking itself much more seriously," says Greenwood. "What Enron has done is recast the landscape."
John Lorinc is a freelance writer based in Toronto. |
