Auditors claim to be watchdogs, not bloodhounds

Accountants are under fire after the Worldcom scandal, and it could easily happen here
NIALL BRADY
THE auditor is a watchdog and not a bloodhound. This has always been the profession's last
line of defence when it is caught off guard, and is being trotted out once again following last
week's revelations of an alleged $3.8bn (€3.85bn) fraud at US telecommunications company
WorldCom.

When a corrupt management is hell-bent on inflating profits and deceiving shareholders,

accountants argue that rule books and auditors' questions are unlikely to get in their way.

The Institute of Chartered Accountants in Ireland was quick off the mark as the WorldCom
saga unfolded.

"We must recognise that no rules will work if the individuals charged with observing them are
not committed to the principles that underlie them, " said chief executive Brian Walsh. "It
appears from reports that [WorldCom] suffered from a gross failure of management and
specifically a gross failure to prevent fraud." But with confidence in financial reporting in
tatters after Enron and WorldCom, accountants will have to come up with something better.
If they cannot be relied on to blow the whistle on such serious lapses in corporate
governance, why bother with auditors at all?

"Companies commit fraud but unless we can rely on external auditors to ensure that
accounts are trustworthy, all trust goes out the window, " said Ann Fitzgerald, secretary
general of the Irish Association of Investment Managers. She is also a member the Irish
Auditing and Accounting Supervisory Authority (IAASA) which is being set up by the
government to police the profession after serious lapses in the audits of financial institutions
emerged during the Dirt inquiry.

Few commentators are buying the notion, widely promoted last week by the professional
accountancy bodies, that Enron and WorldCom are purely American scandals that could not
happen here. According to Walsh, the fatal flaw in US accounting is not that there are too
few rules but that there are too many. This prescriptive approach forces companies to follow
the rule book even when they believe that the result distorts their true financial position.

Because we follow the looser UK regime, which is based on general principles rather than
detailed rules, Irish companies have greater flexibility and some, such as Independent News
& Media and IFG Group, have used this freedom to depart from generally accepted
accounting principles (GAAP) when they believe that alternative treatments show a truer
picture of their finances.

But the argument that Irish and UK accounting standards are in some way superior cut little
ice with Niamh Brennan, an accounting professor at UCD and a member of the review group
that advised the government to set up IAASA. She pointed to the example of troubled drugs
company Elan, whose Irish accounts were no better than its US GAAP numbers at revealing
the extent to which earnings may have been overstated.

"Of course it could happen here and it may already be happening for all we know, " Brennan
said. "It's naive and simplistic to suggest otherwise. Why is the Tánaiste establishing the
IAASA if there is not considerable evidence of failings in Irish auditing?" She also believes
that auditors and accountants cannot shoulder all of the blame for failing to pick up on
creative accounting. "Equity analysts also have a lot of questions to answer, " she said.
"They are sophisticated users of financial statements and I can't understand why they don't
spot these things. There seems to be a complicit nod-and-a-wink culture among a large
group of people that allows this to continue." But analysts, just like investors, should be
entitled to take audited financial statements at face value, said Rory Gillen, head of private
clients at Merrion Stockbrokers. "We have to put our hands up too – we could have dug
deeper, " he said. "But we're entitled to rely on audited accounts as a true and fair
representation of financial condition and cash flow." He likened WorldCom's sleight of hand,
where $3.8bn of expenditure that should have been written off against earnings was
incorrectly capitalised as an asset on the balance sheet, to a two-man poker game. While
one card player gains at the other's expense, the total pot of money on the table never
changes.

"In the same way companies are shuffling between the profit and loss account and balance
sheet but no money is being made." he said.

"What should have been going through WorldCom's profit and loss account went to its
balance sheet instead, falsely increasing profit while creating a balance sheet asset that was
worth nothing." Gillen believes part of the solution to today's auditing crisis lies in tackling the
conflicts of interest within the big accounting firms, which make the bulk of their money from
cross-selling consultancy services to their audit clients.

Pressure from US regulators has already led to Ernst & Young and KPMG spinning off their
consulting arms, while PricewaterhouseCoopers has rebranded its consulting unit – under
the much derided moniker Monday – in preparation for a stock market flotation later this
year. But Gillen said these measures do not go far enough; accounting firms would still be
free to provide lucrative tax advice to their audit clients.

"The scandals are now so big they cannot be ignored and the problem won't be solved by a
simple piece of legislation, " he said. "You can get rid of the conflicts of interest that have
affected the independence of auditors but ultimately you have to recognise that accounting
is not an exact science. In a bear market like we have now, when the tide goes out, you
soon discover who's got no clothes on." And with accounting practices under the microscope
as never before, we had better brace ourselves for the spectacle of more scantilyclad
finance directors in the weeks to come.
June 30, 2002

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bloodhounds/