25 March 2002
Barings and Enron provide spectacular examples of a problem that extends to all jurisdictions in which accountants, or more accurately auditors, play a significant role in corporate governance or supervision. England and Wales is one such jurisdiction, and a useful starting point is to remind oneself of the respective statutory duties of directors and auditors.
In terms of accounts and accounting, the directors of a company are responsible for the maintenance of proper accounting records by the company they manage, and for the preparation of accounts showing a true and fair view of the state of affairs and results of that company. This duty is expressly acknowledged as part of a report signed by directors and incorporated in the annual accounts supplied to the company's members.
Auditors, on the other hand, have a duty to investigate whether the accounting records have been kept properly, whether the accounts are consistent with those records and, following the investigation, to report to the company's members on whether the accounts do give a true and fair view of the company's financial affairs. All of this is to be done to the standard of skill and care reasonably expected of a competent auditor.
For a variety of reasons, directors seek to portray their company's results in the best possible light. One reason is, of course, that the directors and the members see it as part of their job; another, no less obvious, is that remuneration has become increasingly performance-based. Annual accounts are a natural yardstick for measuring directors' performance, and consequently a focus for creative attention.
Auditors are expected to operate as a check against both error and, to the extent that it distorts the truth and fairness of the view portrayed by the accounts, creativity. Audit checks involve measuring the reported results against a series of objective standards and either providing comfort that these standards have been met or explaining the nature and extent of any departure. The value of an auditor's report to a company's members is that it may be relied upon as being independent and objective, as well as being founded upon work carried out to the requisite standard of care.
The collapse of Barings and of Enron put in issue the respective responsibilities of directors and auditors, and both examples illustrate the consequences of inadequate internal controls.
Barings is an instance of a group destroyed by inadequate supervision of trading outside authorised limits. The debate is about apportioning blame or responsibility for the consequences of allegedly reckless trading. As between the relevant Singapore subsidiary company and its auditors, the trial of a preliminary issue about the significance of letters of representation from directors to auditors has recently concluded, and judgment has been reserved.
Enron raises different and, at least superficially, more complex questions. Hundreds of non-consolidated affiliates or partnerships, crudely off-balance sheet entities, had been created and used as a parking place for liabilities, reported as significantly in excess of $10bn (£7bn). In Enron's accounts they featured as debtors and investments, appearing to be assets of considerable value to Enron and significant contributors to Enron's revenues, to the extent of some $500m (£351m) in 2000. Thus, reality was the opposite of the appearance.
The controversy is, at least at present, about the legality or illegality of these arrangements and their presentation or disclosure. What is interesting is that despite all the document shredding and negotiations for immunity, there is a serious argument that Enron's practices were not illegal.
The effect on Enron's auditor, Andersen, is reported almost daily in the media. The threatened or issued lawsuits are of staggering proportions, even for class actions. Several high-profile blue-chip audit clients and a significant number of smaller but important clients have changed auditor. Other repercussions of serious damage to reputation are likely to include difficulties in retention and recruitment of staff, the immeasurable loss of future assignments and vulnerability to absorption by one of the remaining big five accountancy firms.
The consequences for auditors and accountants around the world will unfold over years to come. The UK chairman of one of the big five firms has expressed the view that the auditing profession as a whole must be proactive and at the forefront of suggesting and implementing improvements to the system. One step taken by that firm is withdrawal from the provision of internal audit services to external audit clients. Another big five firm is reported as having declined to follow suit on the grounds that no independence issue arises in conducting internal and external audit work.
Other criticisms are made of the provision of consultancy and external audit services by one firm, and of a firm acting as auditor to a particular client after a partner or senior employee leaves to become the finance director or other senior officer of that client.
In the UK, the accountancy profession has a creditable record of working to set high practical and ethical standards. One notable example is the introduction of statements of standard accounting practice (SSAPs) throughout the 1970s and 1980s. Another is the introduction of ethical guidance, which has long recognised the need to guard against undue financial dependence on an individual client or group of companies and the threat such dependence poses to a firm's perceived and actual integrity, objectivity and independence. Of course, the value of standards is in compliance.
The ramifications of Enron will spread far beyond its auditor. Firms may decide, or be required, to split their auditing and consultancy businesses or client base. At the very least, ethical guidance on declining audit appointments where a firm provides other services to a client is in need of revision. Other controls may well be imposed.
Whatever the outcome for auditors, the principle that directors are primarily responsible for the truth and fairness of a company's accounts should remain undiminished, and the lesson that effective internal control prevents this type of collapse will be learnt too late yet again.
Simon Barker is a Fellow of the Institute of Chartered Accountants in England & Wales and a practising barrister at Maitland Chambers