Auditors are giving managers a free reign
Managers use consulting contracts to bring the accounting cops to heal

They say that when the cat's away, the rats will play. If the spectacular Enron collapse is any indication, in many public companies it seems the cat - the auditing profession - has been on an extended vacation. As a result, both U.S. and Canadian managers can get away with murder.

At least that's the view of retired York University accounting professor Al Rosen, president of Rosen & Associates, a forensic accounting firm. "An Enron situation could easily happen here Canadian accounting standards are like a massive Ponzi scheme, and are far weaker than those in the U.S.," said Rosen. "That gives managers more flexibility in presenting their financial results."

In recent years, Canada's chartered accountants, who are sign off on management's financial statements - and who are shareholders' only real check on lax or unscrupulous managers -- have been asleep at the switch.

According to Rosen, there are two reasons for this. The first is that managers are increasingly able use lucrative corporate consulting contracts to bring their auditors to heal. The second, is a little known 1997 Supreme Court of Canada decision, that removed most disincentives to auditors playing ball with the managers they are supposed to be checking up on.

Here's how the game is played. In theory, public auditors are supposed to bypass management, and report directly to the audit committee of the audited company's board of directors. The system is supposed to guarantee that management doesn't unduly influence auditors.

However in practice, managers have developed a variety of subtle and not so subtle ways of getting their auditors to play ball with them. One of the more longstanding tricks has been for CEOs to get pals, golfing buddies or company suppliers appointed to the board of directors, and later to the auditing committee.

But in the last two decades, an even more effective practice has been added to the mix. Managers are increasingly awarding auditing firms lucrative "consulting contracts," for internal audit, taxation and EDP services. These contracts give management an effective leash on the auditors.

The practice works for two reasons. The first is that the audit business is extremely competitive, and many of larger firms don't make big money in their audit divisions. Many accept audit assignments as a loss leader, counting on the consulting contracts to make up the difference.

The situation got so bad that in 1999, according to SEC numbers, only 30 per cent of the larger public accounting firms' revenues were drawn from audit services, down from about 70 per cent two decades earlier.

Although in theory the auditor reports to the audit committee, in practice both he and the managers he checks up on know, that the auditing firm is counting on those consulting contracts to pay out the big-year end bonuses.

According to Rosen, until recently, there was always a threat of a lawsuit from burnt shareholders to ensure that auditors prevented managers from going too far over the line in playing with the earnings numbers.

But in the early 1990s, the U.S. Congress passed legislation making it difficult for shareholders who were mislead by company financial statements to sue the auditors who signed those reports.

Soon after, the Supreme Court of Canada, in the 1997 Hercules v. Ernst & Young decision, issued a ruling that produced a similar effect. According Rosen's assessment the court concluded "that individual investors should not rely on a company's audited financial statements when making stock purchases."

The bottom line is that major public accounting firms rely heavily on the managers they audit, to sign purchase orders that will pay their year-end bonuses. Yet since auditors are not longer worried about being sued, the accounting profession's greed goes unchecked.

Three years ago, former SEC chairman Arthur Levitt made noises about forcing the auditing firms to divest themselves of their consulting practices. There was some movement in that direction. But the big five audit firms pumped huge donations into both Republican and democratic party coffers, and Congress forced Levitt to back off, a move now increasingly recognized as an egregious error.

Canadian regulators are monitoring the situation closely. But since our economy is so closely tied into what happens south of the border, the chances of the any unilateral action against the accounting profession are slim.

That's good news for unscrupulous, lazy or mendacious managers, but bad news for shareholders. Because unlike in private companies, where owners can be frequently seen poking their noses wherever they see something fishy going on, in public companies, shareholders aren't around. They rely on auditors to make sure managers are telling them the truth.

That means with the country's public accountants in their pockets, Canadian managers can pretty much do as they please.

E-mail can be sent to Diekmeyer at: peter@peterdiekmeyer.com

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