Could A Credit Union Use Enron Accounting?

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"I used to work for Arthur Andersen, and I've hired quite a few consultants in my day, but I've never seen anything like this."

Jim Guretzky, president, SAC FCU

The Enron scandal has become a black hole into which auditing firms, CPAs, consultants, Wall Street analysts, investment bankers, TV investment pundits, bond rating agencies, the SEC, the AICPA and even the Bush Administration have been pulled.

With Andersen's felony indictment for obstruction of justice and several other companies' restatements of earnings due to auditing errors, it seems the whole of system of accounting, auditing and consulting services has been called into question.

But can credit unions float above all this? Yes and no, say experts contacted for this story for insights into what the Enron scandal will mean to credit unions. Certainly, changes in auditing rules and new rules governing employee pension plans will affect CU employees and many sponsor companies. But what about other issues? Is there a conflict of interest when a CU auditing firm provides consulting services to that same credit union?

The Credit Union Journal asked that question of leading credit union auditing and consulting firms, along with others who specialize in the field.

"In general, no," answered Douglas Orth, a partner in the firm Orth, Chakler, Murnane and Company, Miami, which specializes in credit unions and has conducted more than 1,000 audit and consulting projects. Orth has worked closely with regulators at all levels of responsibility and has served as an expert witness for the NCUA. "Providing audit and consulting services to credit unions is not unusual."

When doing both, however, Orth believes that any conflict is contingent on the "type of consulting services being provided and the role of the consultant. The possibility of trouble lies when the consultant drifts from providing advisory services to participating actively in management's decision-making responsibility."

Walking A Fine Line

Jim Guretzky, president of SAC FCU, agreed, calling the difference between offering advice and auditing services like "walking a fine line," a line that can become a real conflict, real fast. "And there are some advantages to doing both-like knowing the business- and avoiding the costs of having to change auditors. But if they start making business decisions, like on DP systems, say, they've obviously lost their objectivity and independence."

Barbara Loescher, a CPA and credit union fraud expert noted that "there doesn't have to be a conflict if the firm is large enough, but then, Arthur Andersen was a very large company. Still, if it's not the same group of people performing both jobs, it's minimized."

"This is a fairly common practice," said Constance Lockwood, Chairwoman of the National Association of Credit Union Supervisory and Auditing Committees (NACUSAC). "Credit union auditing firms certainly have more at stake when they derive fees from both auditing and consulting. Even if these firms only provide auditing services, there is the potential for misconduct. For example, management asks the auditors to characterize financial information in a way that may not be totally accurate but allows management to meet their incentive goals."

Orth concurred. "In the Enron example, we may have an instance where the consulting fees were so attractive that the auditors lost their focus on the importance of complying with Generally Accepted Auditing Practices (GAAP) and in particular, the independence requirements," he observed.

When credit unions hire a CPA firm in a consulting capacity, it is usually to do strategic planning, computer system selection and perform executive search services.

"In general, CPA firms are primarily used by credit unions to perform the annual audit and other audit-related services such as compliance reviews, system security reviews, ACH audits, ATM PIN audits, and various levels of internal audit assistance work," said Orth. "At the present time in the credit union industry, there's more money to be made on the audit side of the business versus the consulting side."

If that changes, the dynamic may change with it, unless laws are written to separate the audit function from the consulting side. Former SEC Chairman Arthur Levitt tried mightily to enact that separation, but lost to the lobbying power of auditing companies.

Happy To Have Made Move

Gary Raddon of the Raddon Financial Group in Oakbrook Terrace, Ill., told The Credit Union Journal that his company had set out 10 years ago to get away from the consulting side of the business and move into more of a pure data and data analysis area.

"Fortunately, we got a long way away from it, and I'm glad we did. Here's why: it's labor intensive and you need to provide a value to the client. Face it, there are issues facing credit unions today that a consultant cannot resolve."

"Most CPA firms have consulting divisions, and every year I meet more and more CPAs who claim to be specializing in the credit union industry," observed Loescher, "even though the total number of credit unions is declining."

As not-for-profits, credit union financial statements are less complex and more easily understood by the "average" person or member, which is the great dividing line, of course, to any comparison with Enron.

"The real issue can be not what's in financial statements, but what is left out," said Guretzky, who worked for Andersen in the early 1970s. The company maintains a strong alumni network and he has received correspondence about the firm's efforts to survive and its clients' expressions of continued loyalty. "You need to look behind the numbers. With Enron, it was a disclosure issue. Credit union financials are pretty straightforward, but even that is dependent on which activities in which the credit union is involved. CMOs and tranches are complex, and while CUs are pretty restricted, there are things the 'average man on the street' wouldn't have a clue about."

As an example, Guretzky said that SAC FCU was considering joining the Federal Home Loan Bank. "If we do, we could borrow money there to help us cover risk in our mortgage portfolio. That's basically arbitraging the portfolio. The average member/consumer wouldn't understand that."

The balance here is keeping loans on the books (mortgages) while assuring long-term income and offsetting interest rate risks, he said. "The classic failure of the s&l industry wasn't so much about fraud as volatility in the bond market and poor regulatory oversight," Guretzky noted.

"By comparison with Enron's financial statements, credit union financial statements are not complex at all," said Orth. "By last count, I believe Enron had over 900 subsidiary companies that were consolidated within the financial statements of Enron. Our most complex credit union client might have three or four credit union service organizations (CUSOs) that require consolidation with the credit union's financial statements."

Lots Of Eyes, But...

A credit union's financial statements are subject to review by external auditors, internal auditors, NCUA regulators, state regulators and the members of the audit and supervisory committees. With so many sets of eyes, the feeling is that it would be hard not to catch an overt fraud, but it happens. Reading financials can make the eyes glaze over, admit experts, and the expectation of trustworthiness, especially in credit unions, is almost a given.

Credit union financial statements should be understood by average members, said Lockwood. "Credit union auditors not only answer to the credit unions' supervisory/auditing committees, boards of directors and management, state and federal regulators but also to the members. And if you think about it, their audit results are ultimately of interest to the public, since credit unions are insured and backed by the full faith and credit of the U.S. Government."

So, where might a credit union "play" with its financials, in a sense? How might it be done?

"There are numerous ways," explained Orth. "A few examples might include underestimating the amount of loan losses in the loan portfolio, avoiding the recognition of expenses until they are paid, deferring costs over a period of time that doesn't coincide with their period of benefit and many others."

Loescher, who has investigated fraud for CUNA Mutual Group, said she has "seen it all," from phony loans to careless and incomplete documentation. But those "red flags" are involved in individual schemes perpetrated by those intent on defrauding money from the credit union. Guretzky said a trend like increasing loan volume while decreasing the allocation for loan losses should beg the question: Are we making better loans?

"As a supervisory committee member," said Lockwood, "I know there are some things we always look for in audits. One is to compare numbers from the current year with the previous year, looking for significant differences. Another is to be sure that the allowance for loan losses is being properly funded. Another is to have the committee review the credit union's annual expenses."

Risk-Based Exams Seen As Positive

Guretzky believes NCUA's new risk-based-exam program may go some distance toward finding more appropriate ways to deal with troubled loan portfolios by singling out for audit those CUs with a history of losses. "The examiner should look at more than a sampling, and that's appropriate."

"Of course, auditors are trained to look at the high-risk areas of a credit union's financial reporting practices to identify both intentional and unintentional financial statement errors," said Orth. "When it comes to financial statement errors in the credit union industry, I would estimate that 99% of them are unintentional errors and that when brought to management's attention, appropriate corrective action is taken."

There is probably no such thing as what's become known as "aggressive" accounting techniques in the credit union world, according to NACUSAC's Lockwood. "Credit unions are so closely regulated that there is little opportunity to use what might be referred to as 'aggressive' accounting techniques."

Enron officials had a vested interest in pumping up the stock price by keeping losses off the books, but credit union presidents have no incentive to do so. They have no stock options to exercise because credit unions are not publicly traded.

"As a not-for-profit, our focus is on what's best for members. I'm not rewarded by how much money I make for the credit union," said Guretzky. "We're not paid that way. Still, the bigger (by asset size) the credit union is, the higher the CEO's salary is."

"The management and officials of credit unions do not have the incredible financial incentives, including generous stock options, available to many of their peers at SEC companies," said Orth. "Therefore, credit unions are not subject to the same type of financial pressures that today's SEC companies face from shareholders, investment brokers, financial analysts and others. I suspect that CPA firms that audit public companies feel a tremendous amount of pressure from their clients to invoke the doctrine of materiality and avoid accounting adjustments that involve the restatement of the company's reported earnings for any given quarter or calendar year."

But can CUSOs, which are for-profits, adopt aggressive practices for any real gain?

"I don't see very aggressive accounting in CUSOs. In fact, I know some CUSOs that have paid more in taxes than they should have because they were reluctant to adopt more aggressive accounting approaches," Orth said.

Beyond some federal legislation (CU Journal, Feb. 25), what may be the fallout for credit unions of the Enron scandal? Will there be changes in the rules?

The Effect Upon CPAs

"I don't think the Enron scandal will have a major impact on the credit union industry; however, I am certain that it will have an impact on all CPA firms," Orth said. "Anytime there is an audit failure with a public company there will be a trickle down effect to all CPA firms, regardless of whether the firm performs audits of public companies. I am sure that we will see additional rules put into place in an effort to restore the public's confidence in the financial reporting system."

The scandal will also provoke CU officials to ask questions of their auditing firms and supervisory committees.

"A fraud this big tends to jolt everyone awake and makes for vigilance," said Guretzky.

That's good, said Gary Raddon, because as the number of auditing firms decreases, credit unions grow larger and become more dependent upon the outside firms.

"Credit unions will have to take a hard look to assure that firms are reputable. And as CUs become more competitive and increase product lines, especially through CUSOs, they may be subject to more scrutiny going forward. After Enron, everything will be looked at more closely," he said. "The same emphasis put on making original 'buy' decisions will have to be applied to ongoing monitoring and implementation. Too many times, consultant recommendations are accepted and left to flounder. The real value is in the follow-up."

For accountants, however, this scandal cuts both ways. "As a CPA, I am concerned and very disappointed that the conduct of one accounting firm (Arthur Andersen) will eventually have a direct impact on the accounting industry as a whole," said Orth "At the end of the day, what we really offer our clients is our technical know-how and our reputation for integrity."

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