Rebecca McEnally, Vice President, Advocacy, AIMR

Moderators: John Finnerty, Analysis Group Economics and Fordham University

Betty Simkins, Oklahoma State University

Note: Biographical descriptions of the panelists and moderators are provided at the end of this article.

Betty Simkins: Good afternoon and welcome to this discussion. John Finnerty and I will be serving as moderators of this conference call. Our discussion today will revolve around 6 critical questions/issues related to Enron and Arthur Andersen. We have 3 panelists today: Julia Grant, Bob Jensen and Rebecca McEnally.

Question 1: To what extent should the external auditors be held accountable for the failure of Enron (or any other company for that matter)?

Julia Grant: I would love to address that one first. I think it is really important for non-accountants to understand that accountants can’t make a company fail or succeed. What accountants do is provide information about the position of a company. So accountants are responsible if a company is failing and the accountant fails to communicate that information. The responsibility of the accountant is one of communication, one of understanding of what is going on in the firm. But the accountant is never directly responsible for the failure. The responsibility is about communication for the accounting firm.

Rebecca McEnally: I might broaden that a little a bit, especially where the auditors appear to be serving as management advisors as it appears was the case with Enron There are two failures to consider here. The first is the failure of the company itself, which is the responsibility of Enron’s managers and board of directors. The second is the auditors’ apparent failure to ensure that the investors were fully informed.

What is the auditor’s job? The auditor’s job is to work for the shareholders, to see to it that the information shareholders receive is reported completely, that it is a fair representation of the company’s performance and financial condition, whether the news is bad or good, and that the information is transparent. By transparent, I mean that those who are reading the information have a reasonable chance of understanding how the company is performance.

But there is another issue that complicates the already difficult situation: there is significant evidence that Enron management probably lied to their auditors, to a degree as yet undetermined. So there are numerous complications and failures. No matter how well the auditors do their job, if they have been lied to, we still have a problem.

Julia: That is a fair point, Rebecca, and because the question was worded external auditors, that is where I went. But you know, really the way you went into your answer highlights exactly the issue here. And that is, the company probably, in my judgment, did lie to Anderson the auditor; but that is complicated by the fact that Andersen the consultants were on the other side of that "Chinese wall" probably helping Enron lie to Andersen the auditor, or certainly at least helping Enron create the structures that made their operation so opaque as opposed to transparent. So you really hit on the complexity here. In this case, Andersen the auditor does look like it had a massive failure and it looked like they had several failures. The document shredding, at a very minimum, is something that they have to be held accountable for. But that is Andersen the auditor. What was Andersen the consultant saying to Andersen the auditor to help Enron out? It is very complex for Andersen the firm.

John Finnerty: Also, isn’t there an issue here about whether Andersen was also doing internal auditing? Many of the big accounting firms have provided auditing services to allow companies to outsource, as they put it, the basic auditing functions and in that case the external auditors are really auditing themselves. Isn’t that a dangerous thing to have happen?

Julia: Sure. Absolutely. I think there was even one media report. I forget in which paper, but it would have been the Times or the Wall Street Journal, where Andersen and Enron had these chatty memos talking about how the term ‘audit’ had a different meaning, for them. And they meant it in a nice way – suggesting that this is such a constructive activity where we are all working together. But in fact I guess there is some reason to think that audits should be this arm’s-length, and there should be nothing chummy about it. Certainly Andersen was providing internal audits, they were providing consulting for setting up deals, and then looking at their own navels, so to speak, to evaluate whether that all looked okay or not.

Bob Jensen: I think you can go overboard on blaming consulting and internal auditing on this. What the external auditor needs to do is to know everything possible. The issue is more what the external auditor does with the information it obtains about what is going on. It seems to me that the Houston office (local office) probably knew a whole lot more about what was going on. With three thousand of these SPE’s and so on, you have to begin to sniff out that this stuff is not really for legitimate business purposes, but this is beginning to look more like cosmetic balance sheet stuff. So, also it is clear that Andersen was unlike any other of the big firms. Andersen let the partner in charge run an empire. He did not even have to follow the advice given by central headquarters in Chicago. This was brought out in those internal memos that went back and forth. And so, Andersen created a decentralized operations here where I don’t even think in some cases the central office knew all the stuff that was going on. I think the Houston office probably did, but they did not take the side of the investor in this case. They took the side of the company because there was a million dollar a week audit, which is a huge amount of revenue for the local office. The second thing you have to look at is a kind of a secondary thing with the firms. Andersen gave $5,000,000, I think, at the ordering of Ken Lay, $5,000,000 to Bush’s re-election campaign. It has also spent (all the big firms have) a lot of money trying to influence legislation on the hill, and they are doing so right now with respect to accounting for employee stock options. If you look at the side they are taking, they are taking the side of the client, not the investor in a lot of these instances. So I think the accounting firms should be held accountable for their actions in more of a macro sense. It is clear that they are often siding with the clients and not the investors, and this is something that really bothers me.

Julia: Yes, and that links back to something Rebecca said. I won’t get it quite right. Rebecca alluded to the fact that the auditors are working for the investors and so it is important to point out that, yes, in the theoretical structure they are. But in fact those audit fees are paid by the corporations, and therefore, we see just the activities that Bob talked about. When push comes to shove, the audit firms act in the interest of the people who pay them money.

Bob: This is especially so when it comes to these big clients because the firms just can’t afford to walk away from these enormous clients. Like the auditor for Bank America. Just imagine trying to walk away from that audit. I think what we used to see is that the firms had a lot of clients and they worked in the interest of the investors. Now that they have become so concentrated with large company audits, this is the problem. The problem is not consulting nearly as much and the problem is not internal nearly as much. The problem is dependence on the size of that audit. And pretty soon you got the tail wagging the dog in terms of the client wagging the auditor.

Question 2: Have the financial markets evolved beyond the ability of the accounting profession to keep up with the newest products? How can accountants stay current with the rapid pace of innovation in the derivatives markets?

Bob: First of all, I have been really influenced by the book Fiasco. Fiasco just brought to light the activities of these big investment firms like Morgan Stanley, Lehman Brothers and so on. Their derivatives marketing operation is intended to deceive. That is the basis on which they sell these things. And, they are deceiving the experts in the field - the financial analysts and the buyers of these things, the chief financial officers. So the fact that accountants can’t keep pace is not surprising because the experts in derivatives often can’t keep pace with these tricky deals they put together. So, yes, I think we have lost the ability to keep pace, but I think we are not alone there.

Rebecca: I disagree. This isn’t the same old world, but I would maintain it never was. Markets have been evolving as we all know for thousands of years.

Auditors have several responsibilities. The first is to remain current on market developments. They have been doing this for a long time. The second is to evaluate the trends in market development and educate themselves as necessary. This has been, in my estimation, a major failure.

I have been involved in doing some work in various areas, and I am continually surprised of the lack of attention given to this. A university with which I was associated wanted to institute a required derivatives course for those going into accounting, and the firms themselves said no, they weren’t interested. They told us that if they wanted their staff to know derivatives, they would teach them. As it turns out, only a handful of persons are taught this topic.

Finally--and this goes back decades and decades--auditors have been required to assess their own in-house expertise in evaluating things like the value of chips and the quality of software to determine balance sheet valuations and income statement expenses. If they determine that they don’t have the necessary knowledge, then they are required to acquire the expertise externally or else not render an opinion on the statements. The same principle is applicable here. If they don’t have the knowledge in-house, they have to acquire it. I don’t think we can simply throw up our hands and say, "Well, it is complicated so nobody is responsible." That is just not going to fly

Bob: I think I agree with you Rebecca. I think that the regulators should also begin to focus on how exotic you can make some of these derivatives. If you read some of these contracts now that they are putting together, some of these are incomprehensible to the experts, and that is intended – it is almost like deceptive product marketing – that the basis on which they sell it is their deception.

Rebecca: Well, if the auditors don’t understand it, they can’t give an opinion.

Bob: That I would agree with. The trouble is they can’t find experts sometimes that even know what is going on.

Rebecca: If they can’t render an opinion, they don’t sign off.

Julia: I agree with Rebecca and Bob. But if you don’t understand it, if it is that incomprehensible, then at the very minimum there is some kind of qualification needed in the auditor’s report. "This company has some contracts, and we don’t have a clue what they are." I realize that is not in the standard form of auditor letters. But perhaps it should be. I do think that auditing, particularly for these big companies, these publicly-traded companies, has become an area of specialization too big for any one person. So, yes it is very hard to keep up, but if you are auditing an Enron and they are entering into these types of contracts all the time, I think it is the obligation of Andersen to say, "We have two people and their only job is to stay up on that so that when we issue an opinion, we know what it means, we really understand what is going on." I find it very interesting related to this point about staying current, that the firms didn’t want their students to bother with a course on derivatives. I find it very interesting that the training center in St. Charles is apparently closing. That is a very sad thing, but I think about the outlook five and ten years ago when we all looked around and said, "Wow, the auditing firms are simply teaching their students what they need them to know. Are they ever going to need us as educators because they will teach it on a just-in-time basis." I think there may be a very strong position somewhere here in this discussion for saying, "You know what. We educators should help decide what they need to know. We shouldn’t always just create our curriculum only because the auditing firm says, "Oh, we are not sure they need it." I think this illustrates that of course they need it and of course we should teach it. I am going to take it back and talk about it in my department because it has really clarified for me that by kind of turning it over to Andersen at St. Charles and letting them say, "Well, we will teach them as they need know," some people were not learning enough in time. It is not a good structure.

Bob: I think it is, and I agree with you on that one. The only thing is, there is a very limited amount of technical things we can build into a four- or five-year curriculum. I think the whole thing has to be structured to more of a life-long learning process and a lot of this stuff, and especially in derivatives, begins to take on the aspect of training more than education when you start getting into really specialized contracts. So the whole fault doesn’t necessarily lie with the universities. The fault lies with the structure of saying that once you are a CPA, beyond that you just have to earn CPE credits for which there may not even be tough examinations and other motivations to really learn things well. The problem is, we don’t have a learning structure outside the university that is working very well at the moment.

Julia: It just strikes me that in the university, we are trying to create this infrastructure within an individual’s mind for continuing to learn, so that the students are prepared for the continuing education that they will need to go forward into the future. This particularly is important when we are thinking about a technical area, such as accounting. I am focusing on the one example that has just arisen: the importance of sending an accountant out with some kind of class in options pricing because that is so much an integral part of the world. That just may be a shift we need to make --we are going to send them off with a better infrastructure upon which to build in their continuing education. I think there is much room for strengthening. I don’t think it is the universities’ fault. I think, if anything, the firms are the ones that have assured us that they will teach what is needed.Firms have pushed away a little bit. "Don’t worry about that, we teach that. You take care of whatever it is you do." But I am thinking we could bring more richness into what we do and possibly prepare the individuals better.

John: Do you think some of the accounting firms may be using materiality to avoid their responsibilities? In other words, if you take a particular derivatives contract and look at it in isolation they might conclude that it can’t possibly be material and don’t try to understand it and maybe cast it aside. Maybe by taking individual contracts one at a time, they erroneously come to the conclusion that some part of the derivatives portfolio is not "material" even though if they took the entire set of contracts they set aside, it might be? I am really asking, do you think materiality could be misused here as a way to try to shirk their responsibility to fully understand these contracts?

Bob: I think materiality does do that in practice. In theory, it shouldn’t because you have this whole thing on top that is called representational faithfulness. It is part of the audit, and the representational faithfulness is supposed to take the macro view of all these materiality things. But as the Enron case points out, representational faithfulness just totally failed in that audit and I think it fails in many, many other audits. So this materiality thing is one of the excuses given, but it is certainly not a reason because, in theory, we are supposed to take a macro view on materiality.

Rebecca: The auditing standards do require that materiality be considered with individual items, and in the aggregate as well. So, there is another factor too, and I think Bob would certainly agree on this, that qualitative considerations have to be counted. Frequently, people use the simple rule of thumb if it is 5 percent of something, or whatever, then it is immaterial. That simply doesn’t do. If it is 1 percent management fraud, it is still material on qualitative considerations.

Bob: And especially representational faithfulness enters into materiality when you start dealing in intangibles. What we are finding in some firms, and especially technology firms, is the part that we are auditing and reporting in the financial statements is a shrinking number, and the things left off the financial statements are the more important things for investors. One of the more vivid examples concerns the estimates of the value of the Sabre system for American Airlines, which far exceeds the value of its 700 and some aircraft. Yet the Sabre system is priced at zero on the balance sheet. So, we have to look at those qualitative factors and especially intangibles when we are doing these audits and thinking about helping investors.

Julia: That really gets at another issue that isn’t addressed in any of these specific questions, but I know there are people in this group qualified to talk about it. I am interested in the auditor’s role versus the analyst’s role. So when we start thinking about how we value the Sabre system for American, at least as GAAP has developed, GAAP says, "We don’t know how to do that in any kind of reliable way regardless of the fact that we know it is relevant, so we don’t." I think that the function of professional analysts in our economy is one that at least the market understands. The notions of market efficiency, or market working relatively efficiently, rely on the fact that the people who are trading the big shares understand how to value American Airlines because they know more about this. I am actually very worried that the Enron case also points up a major problem in the analyst’s part of the valuation chain. I am not setting aside the auditor’s responsibility or Enron’s responsibility, but I am adding another layer of responsibility for this group. I believe the market as a whole relies on analysts to take information, even beyond the accounting information, price it, understand the structure of these firms, and understand the pricing. I don’t actually think this seems to happen reliably. Some of my studies have involved analyst’s reports and detailed content analysis. While there are good ones, I would have to say I think that a lot of them don’t have a clue.

Bob: Well, either they don’t have a clue or they are supply side analysts who are really into the marketing end of it and their information is highly biased. I don’t know if you are following what is happening in the Enron case, but Paine Webber has gotten a black eye, Lehman Brothers a black eye, and Merrill Lynch is under investigation by the New York State attorney general. What you are finding is that the analysts really have been essentially lying out their teeth because they are marketing and taking positions on the same thing they are selling to the public - at least the supply side analysts. One more thing, I think the critics who testified before the Senate hit it right on the nose. One said that we really have to focus on this aspect of the problem more so than even the accounting problem.

Julia: I think that while the sell side analysts of course typically issue the reports we have to look at, I am still worried and I realize there has been some feedback as a result of the Enron issue. I am worried about what the buy side analysts are doing because that is where the big chunks of shares are being traded. Those are being traded based on buy side recommendations and those men and women had to be overpricing Enron for a longer time than we wish they would have been. Even if I can’t see their report, the Enron stock price stayed high for too long after the company was already internally deteriorating. So, I don’t think the buy side analysts were doing a good job either.

John: I agree. There is no evidence that indicates that the buy side analysts are any better at ferreting out this information and really understanding company situations than the sell side analysts. There is a lot that has been written about the supposed bias but when you look at the data and the large investment positions of these institutions, that have very sophisticated internal analysts. I agree with you Julia that there also were some mistaken judgments made by the buy side analysts that are quite surprising.

Rebecca: We are stepping off into quite a complex area here. AIMR, my organization, has had a project underway for nearly two years to look at the conflicts of interest in the financial markets that affect the judgments of, primarily, sell-side analysts and what can be done to try to alleviate some of these conflicts.

There are certainly conflicts- the ones that immediately come to mind are between the sell-side analysts and the investment-banking operations. But, obviously, the companies they analyze bring pressure on the analysts for their own purposes, as well. Buy-side analysts and buy-side managers also bring some conflicts to the table. So there are all sorts of things going on and, of course, the companies themselves have their own information.

I will be happy to circulate to the committee a copy of a letter we sent recently to the NASD and the NYSE who presented proposals [now adopted] for trying to overcome some of the conflicts of interest between sell-side analysts and the internal-banking operations and some related issues. Unfortunately, they don’t deal with the company pressures or buy-side pressures.

Betty: One point I want to go back to is, accounting departments deciding what coursework students need instead of the firm deciding it. I thought it was very interesting what Rebecca brought out about the required derivatives course that her university wanted to introduce. It seems to me that the university should decide the coursework.

Rebecca: It was a proposal that we were putting forward. We were moving to the new 150- hour requirement and the question was what would we use the time for? Would we build in an intermediate accounting III or an auditing III or just what would we do? We thought it would be worthwhile to strengthen their finance backgrounds in derivatives and other topics, and so we made some informal inquiries. Would you value this? Basically, the firms said, "No. We will take care of that. Just get them to the entry level and we will take them from there."

If anything, I think the firms tended to prefer a shortened curriculum rather than a longer one. So, there are some institutions that have worked out various arrangements for doing that despite the 150 hours.

Bob: It is the same problem we have in a lot of these other things as well. That is, representational faithfulness. There are terrific finance theories for having SPE’s. There is fairly good accounting theory that SPE’s are needed for better representations of the company. Unfortunately, maybe, but there are a whole lot of tax avoidance things built into SPE’s. For example, synthetic leases where you can put an asset out on lease and still continue to depreciate the asset. The biggest problem you have with this is this representational faithfulness because it can be used for legitimate purposes and probably many times is. But companies begin to take advantage of these for deception. That is where the auditors and auditing rules need to be tightened up with respect to this macro overview. It is kind of like a materiality thing I think. You have to take the macro view of the reason they are doing something. If it begins to smell like deception, that is where the auditing and the accounting rules have to be enforced so they don’t go along with this. Certainly Enron took this to an extreme. 3,000 SPE’s offshore. The auditors had to sniff that out.

Rebecca: AIMR has taken the simple position, but we feel very strongly about it, that debt should not be hidden. First of all, we have held that view for a very long time, going back to the 80s, that all debt should be on the balance sheet. Any non-debt obligation also should be on the balance sheet. Any additional risk exposures should be fully disclosed.

Unfortunately, the tide has gone the other way. The tendency is to say, "Well, the FASB didn’t do their job." We could not disagree more. They tried to do their job but the political pressure went the other way, and they finally had to yield.

This is something I think society as a whole has to consider. Exactly what do they want their institutions to do for them? In the case of accounting, we want, as Bob has indicated, full, complete, and fair disclosure – transparent disclosure. But the only way that you are going to get it with a debt is to have the debt where it belongs – on the balance sheet – and that means all of the debt.

Betty: One thing I want to bring up. When this first came to light with Enron about the special purpose vehicles, it shocked me that all they had to do was to have 3 percent outside ownership to keep it off the books. I talked to other finance professors and we felt like "Well, why is it not a majority ownership?" Why is the outside ownership not required to be 50 percent to keep it off the books? 3 percent? I mean looking at that on the surface, to me it looks like a boon-doggle to begin with.

Bob: Well, first of all, 3 percent of the size of these things can be an enormous amount of money. Secondly, because of the purpose for which they are set up, the debt isn’t always clear. There is risk involved, but some of this is just nonrecourse. For example, suppose your son or daughter just got married and wanted you to co-sign on a mortgage on a house. So you co-sign the note but you know that the down payment is such that the value of the house well exceeds the mortgage balance. It is certainly on your daughter’s balance sheet. I am not sure it is on yours, though, because you are simply co-signing it. So a lot of it depends on the value that is in the SPE relative to its obligations, and whether you are a simply first obligor or second obligor, and so on. So, this concept of risk gets rather complex. But the FASB just raised it to 10 percent. Their raising it to 50 percent would probably eliminate SPE’s, and that could have some bad effects. [Correction: the FASB has considered raising it to 10%, but the document on this has not yet been released and could be changed.]

Julia: In thinking about your example, if I co-sign that mortgage, it will show up on my credit report. That is, as an individual, there is some record that I owe that money. So I am trying to think about that analogy. Saying that somehow under these rules, Enron and other companies are able to act as if they are not responsible for that money concerns me. Now, yes there is a high probability that I am never going to have to pay a dime of it. That is really the issue we have to come grips with. Maybe this is simply a disclosure issue. I don’t love the stock option rule either.

Bob: I would like to use two examples here. This is where Sharon Watkins’ concept of skin comes in. One example is the one I just gave you, where you co-signed a mortgage on real estate and the real estate value exceeds the balance of the debt. So the chances of you having to pay up are pretty slim because in case of default you just sell the property and the property pays off the mortgage. On the other hand, suppose you did the same thing and co-signed a note on your son’s education loan. Now, that education loan is not a tangible thing that can be sold in a foreclosure proceeding. So the concept of your risk varies a great deal and perhaps when there is no skin out there, as there isn’t in the case of your education loan, then perhaps this should be brought on to your books. As Julia I think said, it’s your debt. But in the case of a mortgage where the value of the assets and the SPE exceeds the debt of the SPE, putting this on your balance sheet seems unnecessary and misleading.

Julia: Couldn’t we at least have more detail in the notes? That is, tell me about your SPE and tell me yes, we have a contingent debt obligation related to this 20 million but the assets with skin that cover it are 100 million. That is why it is treated as an SPE and it isn’t on the balance sheet. If Enron had to give us those numbers, we would be in a different place right now.

Bob: I agree. It would have helped a great deal, especially on the trigger points because Enron did not have value in these SPEs. At least they didn’t have hard assets out there. But you have to be also watchful of too much disclosure. You can make full disclosures so full that it is incomprehensible like footnote 12 in the Enron 2000 annual report. They did disclose a lot of things about these SPEs but there was so much and they were so incomprehensible that nobody could make any sense out of it.

Rebecca: I disagree with several points. I don’t think the criterion for putting debt on the balance sheet is whether there is sufficient collateral to cover it if it should go bad. That terrifies me. That would include practically every debt that has any security at all. So I don’t think we want to be on record for saying that kind of thing.

The SPE, as an entity, has been designed, in part, to transfer certain risks and obligations off the balance sheet – to try to make it appear the company doesn’t have those obligations when, in fact, it does. So, what is the problem, other than offending the preparers of the statements, with putting all of the assets on the balance sheet and offsetting them with the related liabilities, as insurers are now required to do?

We have two different rules here for different kinds of companies, but they are essentially the same things. I think all it leads to is total confusion and the occasional collapse. We have seen this same pattern with a number of companies: the shareholders had no idea what was going on until it was too late.

Now, my final point is that there is overwhelming evidence that disclosure is not equivalent to having the information in the balance sheet and income statement. We have run surveys at AIMR on stock options, and other issues, and it is entirely clear that if an item is off the balance sheet and out of the income statement, it is ignored. So, I think it is scary to suggest we can get rid of the problem by pushing the items off the balance sheet, suggesting that we have transferred all of the risk when we haven’t, and not giving us all the information where we need it.

Julia: I agree with a lot of the spirit of what Rebecca just said. However, I do want to bring back on to the table the responsibility of using all information. While I agree with you – and somewhere back in my last chat I said I don’t like the stock option disclosure as it is. I think it is ridiculous, and I am sorry that FASB had to back down due to the political pressure. But the information at least is there, with the Black-Scholes pricing typically given, so that a good analyst can adjust whatever income statement items he or she wants to adjust. I don’t expect my mother, the investor, to go to note 17 and pick that up and do it. But I expect a buy side analyst to eat up note 17 and incorporate it into their pricing and incorporate it in their investment decisions. While I agree with your statement, Rebecca, if there is room for compromise by saying put it in the notes, then I say to the analyst, learn to use the information you are given rather than pretending that if it is not there in those three sheets – balance sheet, income statement, cash flow statement – it doesn’t count. I think analysts have to, they are obligated to, learn to use the notes. I don’t think my mother, as an investor, will probably do that though.

Bob: I think going back to this risk thing though that Rebecca just raised - the problem is she is taking a binary view of risk. You are either obligated or you are not. You know as well as I do that you can have recourse-only obligations. To commingle that with primary obligations can be somewhat misleading and may lead to some bad results in the economy because certain projects just will never be taken on if our recourse risk has to be resolved by making it look like primary debt. For example, your son or daughter may never get to borrow on a house if you don’t want that liability on your balance sheet just because you co-signed.

Julia: If all of us have to put the liability on our balance sheets, I don’t have to worry. I will still get credit for the next thing I want to buy anyway as long as all our borrowing is disclosed.

Bob: But there’s an example I also use in class. Suppose General Electric decides they are going to build a pipeline across part of Africa. Basically, what they are getting for this is they are simply agreeing to the through-put of it. What they are agreeing to, which is the basis for borrowing money for this project, is they are co-signing some of the notes. If the assets themselves of that SPE are sufficient to pay for the debt, then GE can really distort its own operations and would never invest in a pipeline in Africa if it did not have some kind of special way to treat that special project. I just think sometimes a lot of projects are just not going to get invested in if our recourse debt gets commingled with our primary debt. What we need is some more suitable way of reporting risk, other than just a binary on or off the balance sheet.

Rebecca: I don’t buy the argument, Bob, that we risk harming our growth opportunities if we tell it like it is.

Bob: It depends on what you mean by ‘like it is’, though, because there is a recourse obligation as opposed to a primary obligation, and having to put them both in the bag, that just bothers me.

Rebecca: How about Dow Corning? That was a recourse obligation. It nearly took down both Dow and Corning, and the investors should have known it was there. Unfortunately, they didn’t.

Bob: I just think a lot of the SPE stuff though is working as it was intended to today, and I hate to see some of those things destroyed. I just think that our binary balance sheet on or off again is just too simplistic an approach to reporting risk and that we have to report risk more on a spectrum in some way that makes sense, that the nature of the risk is revealed better that way. But a recourse obligation is not quite the same thing as a primary obligation.

Rebecca: The FASB Concept Statement No. 7 does require that companies consider the distribution of probabilities. So there is a provision in the accounting rules, if they are followed, to approach your concern that we may be mixing high-probability risk with low-probability risk.

Bob: Yes. I agree with that. It is just that companies aren’t doing that well.

Rebecca: You have to agree that fair value is a good idea.

Bob: Well, we could get into that. I agree that it is in most cases. But I don’t agree with fair value in the case of held-to-maturity stuff and so on. I think you are creating a lot of distortions in between. It depends on whether you are dealing with held-to-maturity or available-for-sale kinds of things.

Bob: I would like to comment on just the one I consider to be distorted badly, and that is consulting services. The consulting services is a broadened name for a lot of things. But the thing about it is, I think, if the auditing profession had to give up all consulting services, it is going to destroy the auditing business. Down the road, auditing is pretty much going to be a computer operation. It is going to be done by audit box and network systems, and it is not going to be much of a people profession in the long run except for some risk judgments and this kind of thing. But if you take consultancy out of auditing, I think in the long run you are going to destroy the profession as a people profession. Also, I think it is going to destroy the profession’s ability to attract skilled people, qualified people and a lot of things like that. I think that consulting is not the problem. The problem is the size of the audit client – you are going to have the same problem whether they don’t do any consulting at all. If Andersen didn’t do any consulting with Enron, they would still have had the problem of not wanting to drop the client. So, I think the consulting side of this – it depends on the nature of the consulting. We have to look at the specifics, but just saying we are going to drop consulting, I just don’t buy it. I think internal auditing has also been over-boned. If you look at the kind of internal auditing Andersen was doing, it wasn’t as troublesome to me. You have to look at the kind of internal auditing they were doing. The real problem here is the size of the client and the unwillingness of the auditors to look at representational faithfulness rather than just detailed rules like materiality rules.

Julia: To build on some of the ideas there or actually to take a slightly different tack - the interesting issue is audit work independent of consulting. First of all, I think Andersen has to try that route. It doesn’t look like it may work. That remains to be seen. But the interesting thing about trying to decouple them is that, even if we made a rule right now and we all agreed, "Okay, no more auditing and consulting under the same roof", the fact is, auditing by its very nature leads to a very rich and deep understanding of a firm in most cases. As the auditors develop this in-depth knowledge, they learn things and develop themselves. They develop ideas to sell. So even if we all agreed on a rule, what would be interesting would be to say, "Okay, what happens to this new pure auditing profession that we just created when all these auditors are walking around knowing they have great ideas." You know, what we would see is things like McKinsey’s being formed by ex-auditors who have figured out how to sell knowledge to firms to help them out and make money in a different way. That is what we would see. So, it might be a reasonable short-term step just to help manage perception and help to restore confidence in audits. But to think of that as a long-run solution when the very nature of auditing is what leads to consulting knowledge makes that a more problematic solution.

Rebecca: AIMR has stated unequivocally that consulting and audit practices have to be separated, with the possible exception of tax services, which use the same exact data and are simply an extension of the audit process itself. The reason for this position is that we have to have an independent audit if company information is to be relied on in pricing assets in the financial markets. So our concern is for the investors, the users of the information.

If it means that we have to change the way we do the audit and correctly price those audits, which is another issue that hasn’t come up yet, then that is what we have got to do. But we have reached a crisis of confidence and trust in the financial markets right now. If you recall, and I know you do Julia, the whole requirement for auditing of a company’s financial statements began with the collapse of the financial markets in 1929 and the depression that followed. When there was zero confidence in the markets, firms could not raise capital. One of the proposals that was put forward, one of the very first, in fact, when the SEC was first created, was that there had to be an independent oversight of the company’s preparation of its financial statements and that the auditors should do this job. Rather than placing that responsibility in the government itself, they designated the auditors as their agents, effectively, for overseeing the quality, completeness, and transparency of the information produced. Over time the role of the auditor has eroded and their allegiance to the shareholders has eroded. So now I think in order to restore this trust and confidence, we are going to be forced to return to the independent auditor as an auditor and not as a provider of a portfolio of services.

Julia: I do agree with you. I think it is interesting that you point that out because, of course, there were a couple of very high profile firm failures -- Kreuger and Toll come to mind-- that actually were the kind of final precipitating events for the 1933 and 1934 acts. We were pretty sure we had all that resolved and that these things wouldn’t happen again. Of course, every 10 to 20 years or so, I am not enough of an historian to know for sure, but the fact is we have some high profile failure because people get smarter, people figure out ways to get around the rules, and some people decide they want to get around the rules. I agree with you about the need to restore the confidence. I worry in all of this about the underlying role that some sort of notion of ethics, overall ethics (or lack thereof), plays in all of this – whether we are talking about the Enron executives, whether we are talking about the Andersen partners, or whether we are talking about the analysts who were analyzing things they didn’t understand and acting like they understood them. I would love to ask all of the players how did they feel in their gut because I would love to understand whether there was a way to somehow achieve some better ethical decision-making. Regardless of the rules, regardless of the regulatory structures we set up, we know that people will push those boundaries. People will look for ways around the edge, and unethical people will do that and push it in ways that finally will lead, every so often, to dramatic and dreadful outcomes. That is a human nature issue. We have been facing that on a regular basis since 1933 and 1934 when we thought having independent auditors would resolve it all. I am worried about that because we have imagined every so often that now we have got the rules right, now it is all fixed, because we finally wrote the rules right this time. We are always going to be faced with new problems.

Rebecca: The code of conduct is an interesting issue – the AIMR has a code of ethics and standards of professional conduct to which all of our members are required to subscribe. In fact, our members have to attest in writing each and every year that they have, in fact, abided fully by the code of ethics and standards of professional conduct. And we are continually working to improve these standards as time goes on.

Julia: Well, I think I have addressed this, at least indirectly. It has to do with whether there is some better regulatory structure, right? I think I have made myself somewhat clear on that. I am sure there are ways we can change the regulatory structure to try to address the things that we know people have already done. I think that just setting up another board is just another layer. We can reform FASB, but I agree with Bob Jensen, I think it was Bob earlier, who said, "Hey, FASB has tried." I agree. I think FASB has tried. We are not going to come up with a structure governed by the SEC that is immune to political pressures. In fact, I gave a talk recently, and in the question-and-answer period, I said something about trying to remove this from politics and one of my questioners said, "Okay, that is an unrealistic goal" and it is. There are going to be political issues. So just setting up yet another SEC private board may be the right thing to do to help with perception right now. It may be a very good thing to help regain the confidence in the capital market. Will it solve the problem for the long-term? No, it won’t.

Rebecca: To a large extent, I agree with Julia. I am responding to the question as stated. Do we think the SEC should put in place a private board? I don’t think the SEC should do it. We think that there should be some private sector oversight body. The problem right now is we don’t have such a body. We have the AICPA, but that is the professional organization that has as it members the auditors. So, they’re in a difficult position to serve also as an independent and unbiased oversight board serving the needs of shareholders as compared to auditors.

Rebecca: As for reform of the FASB, I think that this question has come up simply because there were those who chose to deflect the responsibility for Enron from the auditors and from Enron to somebody else, and we don’t think that is appropriate. Now, could the FASB make some changes? Certainly. And, in fact, the Financial Accounting Foundation proposed some changes. A few weeks ago, AIMR’s Financial Accounting Policy Committee responded to the proposals. So, yes, we hope they will continually consider what they are doing and how to do things better, but I don’t think the Enron problem lies with the FASB.

JULIA E. S. GRANT, PH.D., is an Associate Professor of Accountancy and Associate Dean for Graduate Programs at the Weatherhead School of Management, Case Western Reserve University. Dr. Grant received her bachelor’s degree from the University of Arizona and her MS and PhD degrees from Cornell University. She was on the faculty of Ohio State University prior to joining the Weatherhead School of Management in 1991.

Dr. Grant has frequently been invited to speak publicly about the issues surrounding the Enron situation, as well as other corporate reporting problems. Her research interests include developing a greater understanding of how to effectively use financial information about a firm. These interests have led to several research projects examining the reports of financial analysts and the disclosure policies of corporations. She also has published several papers applying game theoretic social dilemma settings and their effects on group and policy outcomes.

In addition to numerous executive education seminars and programs, her teaching responsibilities have included the core accounting course in the MBA program, a doctoral seminar on financial reporting issues, and undergraduate courses in introductory and intermediate financial accounting.

ROBERT E. JENSEN, PH.D., is the Jesse H. Jones Distinguished Professor of Business Administration at Trinity University. Dr. Jensen has a Ph.D. in accounting from Stanford University (1966). He was formerly the Peat, Marwick, Mitchell & Co. Professor of Accounting and Department Chairman at The Florida State University (1978-82), the Nicholas M. Salgo Professor of Accounting at the University of Maine (1968-78), and Associate Professor at Michigan State University (1966-68). He also worked as a CPA for Ernst & Ernst in Denver, Colorado (1959-61). He has lectured extensively both inside and outside the United States and has been an invited speaker at over 350 colleges and universities. Dr. Jensen has an extensive website containing information about Enron and other fraud related topics (http://www.trinity.edu/rjensen).

Professor Jensen has spent two years in "think-tank" research on the campus of Stanford University. He was named recipient of The University of Maine Presidential Research Award in 1976. Dr. Jensen has won a number of teaching awards including: American Accounting Association's Outstanding Accounting Educator Award (2001), Outstanding Professor Award from the Minority Business Association at Florida State University (1982), and Outstanding Professor by the Graduate Business Student Association at the University of Maine (1978). In August 1988, he was elected to a two-year term as Academic Vice President of the American Accounting Association. He was the 1989/90 Vice President of the South Texas Chapter of the Financial Executives Institute and became its President for the 1990/91 term. His publications are mainly devoted to research papers and monographs. His major interest in teaching and research in recent years is the future of education in the electronic classroom without walls via computer networking.

REBECCA MCENALLY, PH.D. is Vice President of Advocacy in the Professional Standards & Advocacy Division at AIMR. Dr. McEnally taught in the accounting department at Boston University prior to joining AIMR. She has extensive professional experience in academia and industry. Dr. McEnally is an authority on auditing, accounting, and disclosure issues.

JOHN D. FINNERTY, PH.D., is a Principal of Analysis Group Economics based in New York. His areas of specialization include valuation, calculation of damages, and litigation support for matters involving derivative instruments, securities class actions, securities valuation, securities fraud, solvency analysis, and closely held corporation valuation disputes. He has testified as an expert in valuation, as well as other financial matters, in federal and state court and in arbitration and mediation proceedings. He has also testified as an expert in bankruptcy court concerning the fairness of proposed plans of reorganization.

Dr. Finnerty has spent his entire career in the financial services industry having previously worked for Morgan Stanley, Lazard Frères, McFarland Dewey, Houlihan Lokey Howard & Zukin, and most recently, as a Partner in the PriceWaterhouseCoopers Financial Advisory Services Group’s Dispute Analysis & Investigations practice. He is a nationally recognized expert in securities valuation and has published extensively in that area, including nine books and more than 60 articles and professional papers. His most recent books include Corporate Financial Management and Principles of Financial Management, published by Prentice Hall, and Debt Management, published by Oxford University Press in fall 2001.

For the past 14 years, Dr. Finnerty has also served as Professor of Finance at Fordham University. Dr. Finnerty received a Ph.D. in Operations Research from the Naval Postgraduate School, an M.A. in Economics from Cambridge University, which he attended as a Marshall Scholar, and a B.A. in Mathematics from Williams College. Dr. Finnerty is also an Editor of FMA Online, a former Editor of Financial Management, and a member of the editorial boards of three other financial publications.

BETTY SIMKINS, PH.D., is an Associate Professor of Finance at Oklahoma State University. She has a Ph.D. in Finance from Case Western Reserve University, an MBA from Oklahoma State University, and a B.S. degree in Chemical Engineering from the University of Arkansas.  She teaches Cases in Corporate Finance, Energy Finance, and Corporate Finance.  In September 2001, she received the Regents Distinguished Teaching Award, the Outstanding OSU MBA Faculty Award, and The Merrick Foundation Teaching Award. Her research interests include financial and energy risk management, international finance, board monitoring and diversity, finance pedagogy, and research productivity and influence. She has published in The Journal of Finance, Financial Management, and the Journal of International Business Studies, among others.

Dr. Simkins is the Executive Editor of FMA Online and currently serves on the board of the Eastern Finance Association. She is serves on the FMA Publications Committee and the FMA Website Committee and has served on the FMA Long Range Planning Committee and NASD e-Brokerage Committee.  She is the former Finance Editor for the Journal of Applied Business Research (JABR), and currently serves (or has served) on the editorial boards of the Journal of Financial Education and Financial Practice and Education (past board member). Prior to obtaining her Ph.D., Dr. Simkins worked for Williams, Inc. and Conoco, Inc. the areas of corporate financial planning, research and development, and process engineering.