AFTER ENRON: THE NEW REFORM DEBATE

STEPHEN BARTHOLOMEUSZ*

I INTRODUCTION
In 1776, Adam Smith, the intellectual father of modern market capitalism,
wrote that:
By pursuing his own interest [an individual] frequently promotes that of the society
more effectually than when he really intends to promote it. I have never known much
good done by those who affected to trade for the public good.1

It is impossible, of course, to know what Smith would have made of the

corporate scandals and collapses of the first years of the 21 st century, but it would
appear the pursuit of individual interest through the 1990s has produced outcomes
that are clearly contrary to, and destructive of, the public good.
The pursuit of individual interest, which in its more intense and less palatable
form might be termed simply as greed, has over the centuries produced periods of
excess and consequent attempts to regulate that behaviour. 2 After the South Sea
bubble in 1720, the formation of new companies was prohibited, in the absence of
specific legislative authority, for more than a century. After the Great Crash of
1929 in the United States, the Securities and Exchange Commission (SEC) was
formed to regulate companies and markets, the Glass-Steagall Act 3 which
separated banks from investment banks was passed, along with a raft of other
legislation designed to prevent such excessive behaviour recurring.
In this jurisdiction, the Poseidon Boom of the late 1960s led, initially in NSW, to
new laws aimed at regulating securities market activity. After the 1987 share
market crash following a decade of increasingly speculative activity by the
entrepreneurs of the 1980s, there was wholesale reform, which included new
corporations and securities laws, more stringent accounting standards, a new
emphasis (with force of law) on continuous disclosure by the Australian Stock
Exchange and a new consensus between regulators, companies, investors and
other interested parties on the constituents of good governance. The evolution of
that consensus, and indeed the progressive updating of corporate law, continues.
None of these reforms, of course, is designed to prevent corporate failure. It is an
integral if brutal element of market capitalism, and one essential to the efficient
allocation of capital, that it provides both opportunities to succeed and to fail. The
legal framework governing corporate behaviour and regulating securities markets
ought, however, to protect investors and creditors from dishonest behaviour by
boards, management and other participants in the public markets for capital. Most
importantly, it ought to ensure that they have sufficient information, of sufficient
integrity and with sufficient timeliness, to protect themselves from either
dishonesty or recklessness.
The string of large and high-profile local corporate failures in 2001 HIH
2002 C o m m e n t : A f t e r E n ro n 2

Insurance, One.Tel, Ansett and Harris Scarfe raises the question of regulatory
failure, as well as serious issues about the effectiveness and/or integrity of the
governance of these companies. With one possible exception, however, there are
no obvious commonalities in the causes of their failure. One.Tels collapse was
due to a fundamentally flawed business model. Ansett failed because it was not
efficient enough, or sufficiently well-managed or capitalised, to withstand the
effects of a vicious price war sparked by new industry entrants. Harris Scarfes
demise was due to longstanding and ultimately unsustainable fraudulent
accounting. Until the Royal Commission inquiring into the circumstances of
HIHs collapse concludes, it is not appropriate to reach absolute conclusions
about the causes of its demise other than to say it would appear that it had, for
some time, consistently and significantly underestimated its liabilities, and under-
reserved and under-priced for risk.
One possible issue of systemic importance posed by the collapses most
substantially by HIHs demise is whether there was audit failure. This is a
critical question, which is as yet unanswered. We know there was some regulatory
failure in the HIH collapse because the Australian Prudential and Regulation
Authority (APRA) has conceded it. Graeme Thompson, chief executive of
APRA, said that with the benefit of hindsight, APRA could have been more
aggressive with HIH and dug more into its financial condition once we had
identified concerns with its operation in the middle of 2000. 4 Subsequently the
federal government has accelerated the introduction, from 1 July this year, of a
new capital adequacy, solvency and prudential framework for general insurers. 5
The stable door has been shut, but only after HIH and more than three billion
dollars of other general insurance losses bolted through it.
The question mark over the quality of the audit functions associated with the
corporate failures is of greater consequence because it links what has happened in
Australia directly to what has transpired overseas, most particularly in the US,
where debate over reforms to the audit function are raging in the wake of a series of
accounting scandals and corporate collapses. The importance of the US economy
and market, and the roles they play in the global economy and financial markets,
ensures that any major reforms in the US will flow through to Australia, despite the
fact that the causes of corporate stress and failure appear to have been quite
different here.

The remainder of this article examines recent developments in the US,

focusing on the Enron and WorldCom collapses. It captures aspects of the current
regulatory debate in the US, and its implications for Australia. In the aftermath of
the corporate failures, two areas requiring reform are the audit function and the
current financial reporting model.

II THE SITUATION IN THE UNITED STATES

The US is experiencing systemic failure in its regulatory framework, which
calls for radical and painful change. The situation is not quite so severe in
Australia. Two important factors underlying the differing experiences of these
two markets are the role each played in the speculative bubbles of the late 1 990s,
and the extent of performance-based compensation used in each country.

A The Twin Booms

The dot-com bubble of the 1 990s had the classical ingredients for a
speculative bubble: the emergence of a radical new technology/opportunity at a
time of loose monetary policy (and therefore easy and cheap credit) which
captured the popular imagination with its promise of both a different future and
the opportunity for fabulous wealth.
Less remarked upon, but of larger dimensions than the dot-com bubble, was an
associated boom in the telecommunications sector as telcos and
telecommunications equipment suppliers scrambled to build the infrastructure to
meet the promised insatiable appetite of the Internet era for bandwidth. The
telecommunications boom coincided with the privatisation and deregulation of
national carriers and markets around the world.
The dot-com bubble started to lose momentum early in 2000 and burst in
March that year. A few months later the telecommunications boom started to
follow suit. Geoffrey Colvin, a Fortune magazine columnist, calculated that the
decline in the market value of the dot-com sector amounted to US$1 trillion,
while the market value of US telecommunications companies fell by US$2.5
trillion.6 That decline is continuing and, given the level of debt-financed
telecommunications over-capacity being experienced around the world, the
effects could take a decade to work through.
The epicentre of the dot-com and telecommunication booms was the US.
Deflation of the twin booms has exposed a level of ugliness in the US corporate
system, and failings in its governance and regulatory structures, which have
shocked investors, regulators and legislators and has had global ramifications. In
contrast, Australia was a peripheral player in the dot-com and
telecommunications bubbles.

B Executive Remuneration
Performance-based compensation has long been a feature of executive
remuneration in the US. Over the past decade or so, as growth-hungry investors
have demanded better performance, the concept of aligning the interests of
executives and shareholders emerged. This alignment was created by the
increased use of executive options and performance incentives as substantial,
sometimes dominant, elements of senior executive remuneration packages. The
notion was that the increased focus of executives on shareholder value and
returns would create mutual benefit.
The popularity of options increased massively during the dot-com era, as the
technology start-ups substituted equity and the promise of eventual wealth for the
cash salaries their business models did not allow. The competition for executive
talent between the old economy and new economy companies inevitably
forced established companies to match the type and scale of remuneration on
offer. Additionally in the US, options are an attractive way to pay executives, as
the accounting standards do not require them to be expensed but, when exercised,
their value is a deduction against corporate tax. 7 Issuing them, as opposed to
2002 C o m m e n t : A f t e r E n ro n 4

paying cash salaries, boosts reported earnings. Alan Greenspan, chairman of the
US Federal Reserve Board, said that the substitution of unexpensed option grants
for cash compensation had added an estimated 2.5 percentage points to the
reported annual earnings growth of the Standard & Poors 500 companies
between 1995 and 2000. 8
Against the backdrop of one of the longer and stronger bull markets in history,
there was an extraordinary escalation in executive remuneration. A Bloomberg
analysis of corporate filings between 31 May 1999 and 31 May 2000 showed
eight chief executives received remuneration of more than US$100 million. The
mostly highly paid, Charles Wang of Computer Associates International Inc,
received US$511 million! Bloomberg found that the average total pay of the 505
chief executives it monitored was US$12.5 million. 9
While share prices kept rising there was little discontent about this largesse,
because corporate executive interests and those of their investors coincided. The
historically high share prices relative to earnings, however, meant that companies
were under extreme pressure to provide superior and consistent earnings growth.
As CEO remuneration increased, their tenure decreased. In Australia, the average
tenure of the Business Council of Australias (BCA) 90 chief executives has,
according to the BCA, fallen from almost eight years a decade ago to 4.2 years. 10

The combination of option-provided incentives, pressure from institutions for

earnings growth and the higher CEO turnover provided, with hindsight, a
destructive combination. It encouraged companies to push the boundaries in their
reporting and the quality of reported earnings fell. A 2001 study by the Financial
Executives International (FEI) Research Foundation found that between 1998
and 2000 there were 464 restatements of corporate earnings, or an average of
more than 154 a year, compared with an average of 46 per year for the previous
decade.11 The most frequent cause of restatements was improper recognition of
revenues. The push to align the interests of executives and shareholders had a
fairly predictable, and quite unhealthy, effect on corporate ethics and practices.
An excess of greed had been introduced, largely unchecked, to the US system.

C Early Moves for Reform

The SEC, concerned about the increasing use of pro forma earnings and
aggressive accounting treatments, increased its enforcement efforts towards the
end of the 1990s. However, despite the growing concern about the quality of
reported earnings and deteriorating corporate ethics, until the Enron collapse
there was no great understanding of the extent of the problem, nor of its
implications.
Arthur Levitt, then chairman of the SEC, campaigned unsuccessfully for better
and tighter reporting standards, the expensing of options, more independent
auditors and more independent sharebroking analysts. The business and
accounting lobbies in the US successfully resisted most of his agenda, although
the major accounting firms reluctantly began spinning off their lucrative
consulting businesses to distance their audit functions from the biggest and most
obvious source of conflicts. Then Enron collapsed and the nature and urgency of
the debate about governance and regulatory structures changed overnight.

III ENRON
A Background12
Enron was created in 1985 from the merger of Houston Natural Gas and
InterNorth, a Nebraska gas company. Enron rode, and evolved with, the
deregulation of the US energy markets through the late 1980s and 1990s. It
became the largest trader of gas and electricity in North America and the United
Kingdom, dominating the markets. It progressively shed its physical assets to
focus on trading and the development of complex derivative products. Over time it
extended its trading activities to create markets for derivative products, including
paper, coal, metals, telecommunications bandwidth and even weather. It was
regarded as the model of a virtual, new-age company and in 2001 was named
The Most Innovative Company in America for the sixth consecutive year in
Fortune magazines annual survey of directors, executives and analysts.13 Over its
15 year history as Enron, its market capitalisation grew from US$2 billion to
US$70 billion. In 2000 it reported operating profits of US$1.3 billion. It was the
seventh largest company in the US.

Last year, however, the US financial media started to focus on the existence of
thousands of complex, off-balance sheet vehicles, largely managed by former
Enron chief financial officer Andrew Fastow. In October last year, Enron
announced a US$618 million third quarter loss and a write-down in shareholders
funds of US$1.2 billion related to the off-balance sheet partnerships. The
vehicles, it appears, were used to hide debt and losses and manipulate profits. As
many of the derivative markets Enron developed were opaque and illiquid, it was
also able to use transactions with the vehicles to establish and inflate the value at
which it would mark-to-market the value of contracts it held. Enrons auditors,
Andersen, were aware of the partnerships and indeed provided advice on their
establishment. In desperation, Enron sought to merge with a competitor, Dynergy,
but the deal fell through and, last December, it was forced to file for Chapter 11
in the biggest bankruptcy in history.
The revelation of the long-term deception Enrons executives had practiced on
US investors and regulators ignited an extraordinary wave of recriminations and
finger-pointing because it said, in embarrassingly visible fashion, that all the
checks and balances that were supposed to be so robust within the US system had
failed spectacularly. There was audit failure of the gravest magnitude; regulatory
failure; cheerleading for Enron by broking analysts who failed to question
accounts which they acknowledged they did not understand; the involvement of
investment bankers, lawyers and institutional investors in establishing and
investing in the Enron partnerships; and the failure of the credit rating agencies.
Enrons investors and employees many of whom held Enron stocks through the
companys pension fund schemes lost massively, while the senior executives
kept hundreds of millions of dollars. Former CEO Jeff Skilling cashed out US$112
million of options in the three years before Enron failed.
Within weeks of Enrons collapse its auditor, Andersen, was also in trouble as it
2002 C o m m e n t : A f t e r E n ro n 6

emerged that its staff had shredded tonnes of Enron-related documents. Andersen,
founded by Arthur Andersen in the wake of the 1929 crash with the ambition of
restoring some credibility to company reporting, was one of the Big Five global
accounting firms which dominate international accounting services. Even before
its grand jury indictment for obstruction of justice in March this year, Andersen
was in trouble, with its corporate clients fleeing and its international business
fragmenting as partnerships bailed out. The indictment, which resulted in a
conviction in June, was effectively a death warrant for the firm. More than 600 of
its US clients, representing billings of about US$1.4 billion, have changed
auditors since Enron made its Chapter 11 filing.

B Implications
Post-Enron, much of the focus of the discussion about reforms to the US
system has been on the role of the auditor and on accounting standards. The
Enron experience highlighted the conflicts that have developed within the big
accounting firms as their non-audit income streams have grown. In 2000,
Andersen billed Enron US$25 million for audit services and US$27 million for
non-audit services. With current and former Andersen staff filling most of the key
financial positions within the company, including the CFO and chief accountant
positions, it also highlighted an unhealthy closeness of auditor and client. It also
undermined the US conviction that, in the US Generally Accepted Accounting
Principles (GAAP), it had the best accounting standards in the world.
As some of the emotion in the immediate aftermath of Enrons collapse started
to subside, initial calls for a draconian response to the shortcomings it had
revealed were displaced (with considerable pressure from the accounting and
business lobbies) by a less intrusive consensus. The chairman of the SEC, Harvey
Pitt (who had successfully helped lead the opposition to Arthur Levitts attempted
reforms as a lobbyist for the accountants) advocated the view of the profession
and big business that reforms that led to more regulatory intrusion into the affairs
of companies could lead to loss of efficiency and competitiveness.
Among Pitts suggested reforms was a new private sector oversight body, the
Public Accountability Board, to review accounting firms quality controls and
auditing practices. The Public Accountability Board would include representation
from the firms. Pitt did not propose to restrict the non-audit services firms could
supply their audit clients, nor did he support the rotation of auditors. The
emphasis of his agenda was on improved corporate disclosure, including a US
version of the Australian continuous disclosure regime, and a direction that CEOs
and CFOs should personally sign, and be accountable (liable) for, their
companies annual and quarterly filings. He also advocated a more principles-
based approach to setting accounting standards. 14
In Australia, contemporaneously with the aftermath of Enron, the findings of a
review of auditor independence were released. Written by Ian Ramsay, a director of
the Centre for Corporate Law and Securities Regulation, the review (the Ramsay
report) was commissioned by the federal government after the HIH collapse. 15
Among Ramsays recommendations were that former audit partners should be
prohibited from becoming a director of a company they had audited within two
years of leaving the audit firm; that companies should be prevented from having
as directors an immediate relative of their auditor; that auditors be required to
disclose the dollar value of non-audit work; that they should rotate audit partners
at least every eight years; that Australian Stock Exchange rules should force all
listed companies to have an audit committee and make auditors available to
annual general meetings of shareholders and that a new Auditor Independence
Supervisory Board be created to monitor and enforce ethical standards. The
recommendations emphasised the role of the audit committee and the relationship it
should have with the auditors, as well as self-regulation by the profession. The
Ramsay report was consistent with the evolving, moderating tone of the debate in
the US. Then, however, came WorldCom.

IV WORLDCOM
A Background16
WorldCom, based in Mississippi, was a telecommunications company that
emerged from obscurity during the frenzy of corporate activity in the sector
unleashed by deregulation of the US telecommunications industry. Through a
frenetic series of takeovers 72 over 17 years the company emerged as the
second largest US long-distance carrier and developed the worlds largest Internet
protocol network. At its peak it was valued at about US$180 billion. On 25 June
WorldCom shocked financial markets by announcing that an internal audit had
uncovered what the SEC described in a press statement issued a day later as
accounting improprieties of unprecedented magnitude. 17 The improprieties
involved treating items that should have been expensed as capital items, inflating
the companys reported earnings and cash flows by at least US$3.9 billion over
the five quarters to the end of March 2002. Had the items been expensed,
WorldCom would have reported losses for that period rather than the US$2 billion
of profits it claimed to have earned. The timing of the disclosure may have been a
coincidence but WorldComs auditor, Andersen, was replaced by KPMG in May
2002.

B Implications
If Enrons collapse and the circumstances surrounding it raised suspicions
about the integrity of the US financial reporting framework, WorldCom seemed to
confirm them. Its disclosures galvanised and changed the debate over reform.
Where previously the business and accounting lobbies appeared to be succeeding in
their effort to minimise the extent of the reforms and their impact, after
WorldCom the prospect of substantial reform strengthened sharply. President
George Bush said that he was deeply concerned about accounting practices in
the US and said the administration would fully investigate the issue and hold
people accountable. 18 In the US, a reform bill sponsored by the chairman of the
Senate Banking Committee, Paul Sarbanes, had been floundering. The Public
Company Accounting Reform and Investor Protection Act of 2002, 19 introduced
to the Senate on 25 June, had met fierce opposition from business and
Republicans. It proposed the creation of an independent regulatory board, with a
majority of members from outside the accounting profession, to oversee auditors
2002 C o m m e n t : A f t e r E n ro n 8

and audit standards; it would prohibit auditors from offering consulting services
to audit clients; it would insist that audit committees, comprised of independent
directors, would become responsible for selecting and overseeing auditors; it
would force executives to disgorge bonuses and other incentive payments if there
was subsequent disclosure of audit error; it would make it an offence for an
executive or a director to mislead or coerce an auditor and it would direct the
SEC to devise rules to address conflicts of interests faced by stockbroking
analysts.

That latter proposal relates to charges that analysts recommendations have

been influenced by the investment banking relationships their firms had with
corporate clients. A leading US investment bank and broking firm, Merrill Lynch,
paid a US$100 million fine and undertook to introduce policies to insulate its
analysts from the influence of its investment banking division in May after an
unprecedented inquiry and legal action by the New York State Attorney-Generals
office. That office is investigating at least five other big investment banks.
Securities analysts have been blamed for not questioning Enrons accounting
before its collapse and for the absence of objectivity during the dot com boom,
where their firms generated massive fees from arranging the initial public
offerings of shares in companies they promoted through their research.

V THE AFTERMATH: CONSEQUENCES FOR

AUSTRALIA
In Australia, as in the US, the most intense focus of the debate post-Enron,
WorldCom and the local corporate failures has been on corporate disclosure and
the role of auditors. It is evident that regulators around the world have concluded
that the critical issue raised by the Enron and WorldCom episodes is the failure of
the current financial reporting model and, in particular, a lapse in audit standards.
Modern capitalism has spawned massive, international corporations operating in
ever more complex environments and accessing increasingly sophisticated capital
markets. To safeguard the interests of investors, a complex framework of
regulation and oversight has been developed: a system which relies on the
veracity and quality of financial reporting and, in particular, the assurance
provided by the audit process. Confidence in corporate accounts is the most
important prerequisite for the economic system to function. That confidence was
undermined by Enron, WorldCom and the host of restatements of corporate
earnings flowing out of the US. Not surprisingly, therefore, the largest part of the
reform effort is directed at the accounting profession. Most of the measures
mooted are aimed at reinforcing the independence of auditors from corporate
management and ensuring the integrity of the audits.

A The Role of Auditors

Best practice before Enron was a governance structure which gave an audit
committee comprised of independent directors the power to hire, fire and monitor
auditors. That will now become common practice, perhaps legislated or imposed
by stock exchange listing rules. In June 2002, the New York Stock Exchange
(NYSE) issued a report on corporate accountability and listed standards which
proposed changes, and new standards, for corporate governance and disclosure
practices by companies listed on the exchange. 20 Among the key
recommendations were that the role and authority of independent directors should
be increased, and that the definition of independence should be tightened. Audit,
nomination and compensation committees should consist solely of independent
directors. Further, the audit committee should have sole authority to hire and fire
auditors and approve any non-audit work by the auditors. In addition, the chief
executives of the companies should have to attest to the accuracy, completeness
and understandability of information presented to investors. The NYSE
recommendations reflect a broader consensus that allowing auditors to be chosen
by, and report to, the management who also pay them is asking for trouble.
A more contentious issue is the extent to which provision of non-audit services
by auditors should be limited. According to an Australian Securities and Investment
Commission study, non-audit fees account for about 50 per cent of the total fees
paid to auditors. 21 The accounting profession says, with some justification, that
completely prohibiting auditors from providing non-audit services will not only
damage the firms financially and reduce their appeal to potential employees, but
also reduce the level of technical expertise within firms and therefore their
competence to conduct audits. On 23 May, the two major Australian accounting
professional bodies the Institute of Chartered Accountants in Australia and
CPA Australia released a New Australian Standard for Audit Independence. 22
The standard, which will become mandatory on 31 December 2003, bans the
provision of non-audit services where, in conducting an audit, a firm could be
required to check its own work.

The new standard also requires the rotation of audit partners for listed
companies every seven years, and a two year waiting period before a retired
auditor can become a director of a company they audited. In common with the
Ramsay report, the accounting bodies shied away from proposals that would
introduce mandatory rotation of audit firms, as opposed to audit partners.
Rotation of firms was off the agenda in the US until WorldCom but is now again
being seriously discussed. Accounting firms argue that the first two years of an
audit are a learning experience for the auditor after which the audit process
becomes increasingly valuable to the client and its stakeholders. Mandatory
rotation would reduce the quality of audits and increase their cost, particularly as
not all firms have the same level of expertise in all sectors of corporate activity.
There is sufficient validity to this argument to ensure that, if mandatory rotation
were introduced in any of the major jurisdictions, the period of incumbency
would be quite lengthy.
There are two obvious benefits from mandatory rotation of firms: without
unlimited tenure firms would be less vulnerable to influence or corruption by
their clients and they would work in the knowledge, shared by their corporate
clients, that the quality of their audits would eventually be reviewed by their
successor. It may not be possible to legislate against bad audits but it ought to be
possible to reduce the risk of audits being corrupted by a firms commercial
2002 C o m m e n t : A f t e r E n ro n 10

ambitions or its relationship with management. Tougher rules on conflicts,

distancing of auditors from management through a strengthened role for the audit
committee and some form of firm rotation would strengthen the audit regime.
The Treasurer, Peter Costello, in June announced a review of audit regulation
and corporate disclosure which will incorporate the findings on auditor
independence indicated in the Ramsay report.23 These issues will be addressed in
the next phase of the governments Corporate Law Economic Reform Program
(CLERP).

B Accounting Standards
If the role of auditors is under severe scrutiny, so too are the accounting
standards on which their work is based. Ordinary investors may believe that an
auditors role is to attest to some form of objective truth about a companys
financial position. In reality, and in law, it is to confirm that the accounts are
drawn up in compliance with the accounting standards of the jurisdiction.
Until Enron, the US GAAP were regarded as the most stringent and robust
accounting framework in the globe, at least by US regulators and investors. US
standards have, over the years as companies and auditors have sought greater
certainty, developed into a complex, highly prescriptive, black-letter set of rules. In
Australia and the UK, accounting standards, while still detailed and sometimes
extremely complicated, tend to more akin to statements of principle and rely on a
philosophy of substance over form. Black letter rules, as Australian investors and
legislators discovered in the 1980s, invite loopholing.

Former US Federal Reserve Board chairman, Paul Volcker, said that while
most of the accounting profession in the US still believed the US had the best and
most comprehensive standards, everything is on the table, including the style
[in] which accounting standards are set out whether the emphasis is on matters
of principle or detail. 24 Volcker is chairman of the trustees of the International
Accounting Standards Committee Foundation. With the International Accounting
Standards Board (IASB), the Foundation was created last year to include the
UK and US in the attempt to create international standards acceptable to all the
major capital markets. Australia announced in 1996 that it would harmonise its
standards with the international standards produced by the IASBs predecessor
organization, the International Accounting Standards Committee. 25 It is ironic that
the collapse of one of Americas corporate icons has produced the greatest
opportunity to convince the US to embrace the concept of international
accounting standards. The European Commission last year proposed legislation
that would see the European Union adopt the IASB standards from 2005. 26 There
are obvious benefits for companies and financial markets, and probably
regulators, if there is consistency between accounting standards within the major
markets.

An advocate for overhauling US standards is Joe Berardino, former CEO of

Andersen. Berardinos view is that US accounting rules and literature have
grown in volume and complexity as we have attempted to turn an art into a science. In
the process, we have fostered a technical, legalistic mindset that is sometimes more
concerned with form rather than the substance of what is reported. 27
 He describes the current financial reporting system as having been created in
the 1930s for the industrial age, at a time when assets were tangible and investors
sophisticated and few, and highlights the need to move to a more dynamic and
richer reporting model. 28 This appears to be occurring in the US, with the SEC
mandating more frequent disclosure of material events and better explanation of
critical accounting policies.

C Options for Reform

In striving for a more effective reporting model, a more radical approach than
that of the SEC could involve eliminating audits altogether, and making boards
and management solely responsible (and liable) for their companys reporting.
Alternatively, it could be worthwhile reconsidering the role and the approach of
auditors. In todays environment of global markets and global companies, it
seems perverse that we place such reliance on an annual statement of assurance
from an auditor which says nothing more than that the accounts concerned
themselves simply a snapshot of a moment in the companys year comply with
accounting standards. Given Australias concept of continuous disclosure (one the
US is introducing), the auditor could be involved in a continuous audit, providing
some level of assurance that the basis of any disclosure is sound.

If that were too radical or costly, it would be a relatively straightforward matter

to require auditors to produce more meaningful audit statements. These could
identify the key accounting issues within the financial statements, particularly
any which have provoked significant discussion with the board and/or
management, and discuss the implications of using a different treatment. A
similar requirement could be made of the audit committee.
Additional possibilities for reform include a positive obligation on auditors,
and perhaps company officers, to inform the audit committee and the authorities
of any suspect or unusual transaction. Auditors should also be available to their
real employers the client companys shareholders to answer questions about
the accounts at annual meetings. That might require granting them some qualified
form of privilege.

VI CONCLUSION
Periods of excess stress test the integrity of markets, their participants and the
safeguards that are supposed to discipline their behaviour. They make the points
of vulnerability within those safeguards more visible. Enron, WorldCom, HIH and
the other corporate scandals that have emerged over the past year are not novel
every lengthy speculative boom is eventually characterised by a level of
unsustainable optimism and greed that encourages recklessness and chicanery. No
doubt that will be as true for the next boom as the last.
The recent US experience has, however, caused questioning of the practice of
aligning the interest of management and shareholders and the structure and
quantum of the rewards available. The architecture of the so called shareholder
value model of governance appears badly flawed and almost designed to produce
Enron-style disasters. It would appear that the pressure to perform in the near term,
2002 C o m m e n t : A f t e r E n ro n 12

when coupled with massive incentives for short-term performance, produces a

destructive mix. Investors, particularly institutional investors, may have had
unrealistic expectations of the ability of companies to deliver superior growth
continuously, creating an environment where executives were almost encouraged
to find ways to make it appear they were achieving the unachievable. It will not be
easy to withdraw from executives the largesse of the form and scale they have
become so accustomed to.
Redirecting incentives towards more reasonable and productive outcomes is a
priority of any post-Enron reform. Another is upgrading the quality and credibility
of corporate disclosure. Had the audit function performed better under pressure;
had securities analysts, funds managers, ratings agencies and other professional
market participants been more diligent or less complicit; perhaps we would have
seen less damage inflicted on investors, employees, market confidence and the
US brand of market capitalism.

In any event, Enron and subsequent disasters and HIH in Australia have
indicated that the current reporting model and the audit function associated with it
are, if not broken, then malfunctioning. There is an opportunity to think more
creatively and laterally about how to devise a model better suited to the demands of
this century and the needs of this centurys users of company accounts.

Endnotes
* Associate Editor (Business) and daily business columnist for The Age (Melbourne).
1 Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (first published 1776, 1952
ed) 194.
2 For a general discussion of the history of corporate regulation, see, eg, Harold Ford, Robert Austin and Ian
Ramsay, Fords Principles of Corporations Law (2001) ch 2.
3 Banking Act of 1933, Pub L No 7366, 48 Stat 162 (1933).
4 Evidence to Senate Economics Legislation Committee, Parliament of Australia, Canberra, 5 June 2001, 237.
5 G e n e r a l I n s u r a n c e R e f o r m A c t 2 0 0 1 (Cth).

6 Geoffrey Colvin, When Scandal isnt Sexy, F o r t u n e (Chicago), 10 June 2002, 56.

7 Financial Accounting Standards Board, Statement of Financial Accounting Standards (SFAS) 123:
Accounting for Stock-Based Compensation (1995).
8 Alan Greenspan, Corporate Governance (Speech delivered at the Stern School of Business, New York
University, New York, 26 March 2002).
9 Graef Crystal, Eight CEOs Make the $100 Million Club: Bloomberg Pay Survey Bloomberg News wire
service, 22 June 2000.
10 Hugh Morgan (Speech delivered at the Melbourne Mining Club lunch, Grand Hyatt Hotel, Melbourne, 13
June 2002). This speech was reported in Ian Howarth, Life Too Short For Mining Chiefs, Australian
Financial Review (Sydney), 14 June 2002, 64.
11 Financial Executives Research Foundation, Quantitative Measures of the Quality of Financial Reporting
(2001), <http://www.fei.org/download/QualFinRep-6-7-2k1.ppt > at 16 August 2002.
12 See generally, Enron <http://www.enron.com/corp/pressroom > at 16 August 2002.
13 Ahmad Diba and Lisa Munoz, Whos Up, Whos Down, F o r t u n e (Chicago), 19 February 2001, 64.

14 See below Part V(B) for a discussion of the principles-based approach.

15 Ian Ramsay, Independence of Australian Company Auditors: Review of Current Australian Requirements
and Proposals for Reform Report to the Minister for Financial Services and Regulation (2001),
 <http://www.treasury.gov.au/contentlist.asp?classification =14&titl =Publications > at 23 July 2002.
16 See generally, WorldCom <http://www1.worldcom.com > at 16 August 2002.
17 Securities and Exchange Commission, SEC Statement Concerning WorldCom (Press Release, 26
June 2002), <http://www.sec.gov/news/press/2002-94.htm > at 18 July 2002.
18 Office of the Media Affairs, President Promises WorldCom Investigation (Press Release, 26 June
2002), <http://www.whitehouse.gov/news/releases/2002/06/20020626-2.html > at 16 August 2002.
19 S 2673, 107 th Congress (2002). This was enacted on 30 July 2002: S a r b a n e s - O x l e y A c t o f 2 0 0 2 , Pub L
No 107204, 116 Stat 745 (2002).
20 New York Stock Exchange, Report of the New York Stock Exchange Corporate Accountability and
Listing Standards Committee (2002), <http://www.nyse.com/pdfs/corp_govreport.pdf > at 22 July 2002.
21 Australian Securities and Investments Commission, ASIC Announces Findings of Auditor Independence
Survey (Press Release 02/13, 16 January 2002), <http://www.asic.gov.au > at 18 July 2002.
22 The Institute of Chartered Accountants in Australia and CPA Australia, Professional Statement F1:
Professional Independence (2002),
<http://www.cpaaustralia.com.au/01_information_centre/10_audit/1_10_0_f1_draft.asp > at 10 September
2002.
23 Peter Costello, Review of Audit Regulation and Corporate Disclosure (Press Release, 27 June 2002),
<http://www.treasurer.gov.au/tsr/content/pressreleases/2002/034.asp > at 18 July 2002.
24 Paul Volcker, Accounting in Crisis (Speech delivered at the European Commission, 6 March 2002),
<http://www.iasc.org.uk/docs/speeches/020306-pav.pdf > at 30 August 2002.
25 Australian Accounting Standards Board, Policy Statement 6, International Harmonisation Policy (1996).
26 Regulation (EC) No 1606/2002 of the European Parliament and of the Council of 19 July 2002 on the
Application of International Accounting Standards [2002] OJ L 243, 1.
27 Joe Berardino, Enron: A Wake-Up Call, Wall Street Journal, 4 December 2001, A32.
28 Ibid.