Business Risk and the Auditing Industry: The Enron Example
By Wayne R. Landsman and Douglas A. Shackelford

he auditing profession is a key reason that the United States enjoys the most well-developed capital markets in the world. Auditors provide shareholders, lenders, employees, customers, suppliers and policy-makers with assurance that the financial information provided by companies is reliable.

During the past months, the auditing profession has received unprecedented attention. Andersen's audit of Enron is front-page news, a place where auditors seldom find themselves. As part of the fallout from the Enron-Andersen story, many are suggesting sweeping changes to the structure of the entire auditing profession, notably the requirement that audit firms divest their business and tax advisory services.

Whether sweeping changes are necessary is subject to debate. What is not subject to debate is that Enron went bankrupt because its business failed. The auditors did not cause the failure. If Enron's financial statements, which Andersen audited, misled investors, then Andersen should and will suffer financial loss. This is a risk that auditors understand.

Our research suggests that Andersen might not have fully appreciated another risk associated with the Enron audit. Even if Andersen is fully exonerated, it likely will suffer substantially simply because it was the auditor of a major company that went bankrupt. This guilt by association is what auditors call "business risk."

When a company fails, auditors face both financial and reputational loss, even if they conducted an audit correctly. Financial damages arise because auditors provide one of the few remaining sources of cash, so-called "deep pockets." Reputational damages can be even greater than the financial costs associated with a bankruptcy because that association erodes an auditor's brand.

We have a longstanding interest in how auditors handle this risk of association. As part of a research project, we interviewed the CEO or the head of the auditing practice for each of the Big Five firms. One firm (not Andersen) provided us with detailed confidential information about their fees for 422 audits.

Our research shows that auditors can identify clients that pose a business risk of litigation, reputational impairment and regulatory sanctions, e.g., large companies with substantial financial or business risks, aggressive accounting practices and suspect management. On these high business risk audits, auditors work even longer hours and use more experienced personnel. This likely reduces the risk of the audit failing to detect an error in the financial statements. However, expanding the audit scope cannot prevent a business from bankruptcy and the resultant costs associated with being a bankrupt company's auditor. Yet, our research suggests that auditors do not charge higher fees on high business risk audits. Thus, one lesson of Enron is that auditors need to reassess their business risk exposure. If auditors decide to continue their relationships with risky clients, then they should learn from Enron and substantially increase their fees to compensate for the risks of association with a bankruptcy.

Alternatively, the auditors may conclude that no fee justifies association with a possible Enron and resign the audit. Imagine if a year ago Andersen had concluded that the business risk of Enron was prohibitively high and resigned the audit. Suppose Andersen's competitors had agreed that no fee was enough to accept the Enron audit. Without an audit, Enron would have faced an immediate crisis because U.S. security laws require an audit for a firm to trade its shares publicly.

However, no large U.S. company has ever failed to find an auditing firm that was willing to conduct its audit. Each year audit firms drop scores of clients because they judge the risk of retaining the client as too great. Amazingly, another firm is always ready to assume the risks. This ultra-competitiveness has contributed to the position in which Andersen now finds itself.

If the auditing industry refused to provide audits to excessively risky clients, then large, high-risk American companies would understand that delisting from the New York Stock Exchange or the NASDAQ was a possibility. To attract auditors and remain publicly traded, companies would rein in their affairs. This market discipline could have protected Andersen from its current debacle.

We believe that auditors must re-examine their business practices of client selection and audit pricing if they are to re-emerge as a stronger profession.

A version of this article appeared in The News & Observer. Contact Landsman, KPMG Distinguished Professor of Accounting and associate dean of the PhD Program, at (919) 962-3221, ; Shackelford, associate dean of the Master of Accounting Program and Meade H. Willis Professor of Taxation at (919) 962-3197,