Who’s Watching The Watchdogs? In The Wake of Enron: A Survey of State Accounting Board Membership and the Need for Reform

Executive Summary

“There are government agencies that purport to regulate CPAs to some degree, but if you look behind the agency to the identity of the people who are controlling this profession, you will see that those people are largely CPAs making decisions that benefit and protect the CPA profession, rather than the public at large.” —Julianne D’Angelo Fellmeth, Center for Public Interest Law ¹

Conflicts of interest and lack of independent funding have doomed both the national and state level accounting oversight systems in the United States. The state accounting boards and the network of overlapping, mostly self-regulatory federal accounting overseers act as classic “captive” regulators, serving management instead of serving investors and taxpayers. In 1984, the U.S. Supreme Court famously called accountants “public watchdogs,” yet while no one watched the watchdogs, they became lapdogs. ²

The current Enron-Arthur Andersen debacle is illustrative of larger problems in the accounting oversight system. Despite a pattern of more frequent and more serious failed audits since the savings-and-loan failures of the 1980s that left the landscape littered with half-built shopping centers and emptied the pockets of taxpayers and small investors alike, bad auditors and bad audit firms just keep on auditing without threat of significant penalties for inaction or bad action. ³

This report examines potential conflicts of interest in the 51 (50 states and the District of Columbia) state agencies with regulatory authority over accountants, known as the state boards of accountancy. It finds complicity between the boards’ lapdog bite and their overwhelming dominance by accounting insiders.

The report also reviews national oversight of the accounting industry. In the noteworthy cases where the well-intentioned Public Oversight Board, a national self-regulatory organization, attempted to assert any independence from the industry, well-funded industry lobbying campaigns defeated its efforts to improve oversight.

Enron collapsed in a wave of accounting scandals in November 2001 after restating its balance sheet to include previously unreported losses. Enron’s auditor, Arthur Andersen, signed off on Enron’s financial statements every year, despite the fact that Enron was using fraudulent partnerships to conceal huge losses. Had Andersen blown the whistle on Enron’s accounting practices when the first fake partnership was set up, Enron partners would not have been able to continue to set up more partnerships to conceal more losses.

The accounting discrepancies associated with the Enron scandal were not an isolated incident. Although the Enron accounting failure has captivated the media, the noted securities law expert John Coffee has said the only thing exceptional about Enron was its failure was “larger.”⁴ Enron’s, and other, failures are indicative of the sort of accounting that is practiced when there is no significant fear of consequences. Enron’s auditors, Arthur Andersen, operated in an atmosphere where they had more to gain by approving Enron’s slippery accounting tricks than by conforming to accounting standards. The government regulatory agencies had no complaints about Arthur Andersen to respond to and the self-regulatory peer review process of the accounting industry was not likely to result in negative consequences.

Congress and several states are considering enacting accounting reform legislation. Among the principal goals of the best reform proposals is the establishment of independently-funded, majority-public-member accounting oversight boards. ⁵ Without ensuring that independent oversight agencies watch the watchdogs, we cannot prevent future accounting disasters that will cost investors, taxpayers, employees and retirees more untold billions.

¹ Julianne D’Angelo Fellmeth, Center for Public Interest Law, Comments to Assembly Committee on Business and Professions. Hearing on Accounting Practices and Corporate Audits: Protection of Consumers, Employees, and Shareholders, 19 February 2002.

² U.S. vs. Arthur Young, 1984

³ See “Bad Audits, Not Deep Pockets: Illustrations of Failed Audits By The Big 6,” The State PIRGs and Public Citizen, 1993, for a detailed analysis of some of the S&L audit investigations. http://enronwatchdog.org/PDFs/bad_audits.pdf

⁴ See testimony of professor John Coffee before Senate Commerce Committee, 18 December 2001.

⁵ See http://enronwatchdog.org/newsroom/index.html for state PIRG testimony and press releases in support of reform proposals in California and New York.