• Recent restatement announcements underscore the nexus between audit and control failure and credit risk.
• Restatement risk is likely to persist despite economic improvements. Developments in auditing and increasing complexity in financial markets could contribute to this risk.
• Sectors that may have the greatest risk are those with high levels of financial complexity and/or heavy reliance on estimates.

While I appreciate the contributions to debates on how to improve financial accounting and auditing, I wonder why Fitch said nothing about its failures to warn creditors of potential problems at a variety of corporations.

Consider the report by the Securities and Exchange Commission (SEC) staff to a Senate committee, "Financial Oversight of Enron: The SEC and Private-Sector Watchdogs," dated October 8, 2002. Pages 97-127 of this narrative chastise credit rating agencies (Moody's and Standard and Poor's, as well as Fitch; collectively the SEC refers to them as nationally recognized statistical rating organizations, or NRSRO) for not adjusting ratings prior to the economic meltdown in 2001 and 2002, particularly Enron. Recall that Enron announced on October 16, 2001, a $1.2 billion writedown in stockholders' equity as well as investment losses amounting to about $1 billion. Toward the end of the month, the three rating agencies began to take action. S&P and Moody's downgraded the rating on Enron's debt, while Fitch announced a "watch for a downgrade." The SEC report states that all three organizations kept Enron above investment grade until November 19, 2001, when Enron released its third quarter results. Only when they realized the depth and seriousness of Enron's problems did they lower substantially their assessment of Enron's credit risk.

The SEC staff report claims that NRSROs' "monitoring and review of the company's finances fell far below the careful efforts one would have expected from organizations whose ratings hold so much importance" and "that the credit rating agencies' approach to Enron fell short of what the public had a right to expect…" The SEC staff then cite the following items as evidence for their conclusions: Fitch (and others) did not adequately review Enron's filings, e.g. the infamous footnote 16 in Enron's 2000 10K; Fitch analysts testified that they did not consider the aggressive nature of Enron's accounting procedures; and they did not pursue fundamental information and conducted very little independent verification of management's assertions. Indeed, the SEC staff berates the NRSROs for not understanding their responsibilities to those who rely on their credit ratings.

Section 702 of the Sarbanes-Oxley Act of 2002 required the SEC to conduct a study on the responsibilities of credit rating agencies. After performing this work, the staff of the SEC published its findings in "Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Market" in January, 2003. After repeating many of the shortcomings noted in the 2002 report, the staff examines several policy issues that might improve economic performance. The most important suggestions are to increase the transparency of the ratings process, restrict or eliminate preferential subscriber access to information, and consider the requirement to make credit ratings publicly available at no charge.

This analysis brings us back to the special report issued by Fitch. Given the analysis by the SEC staff, I would have expected at least some acknowledgment that Fitch played a role, perhaps only minor, in the economic meltdown in 2001-2002. I am not looking so much for a confession, but I would like to perceive and understand what Fitch is doing to improve the credit rating process. For example, a simple computation of free cash flow would have revealed significant problems at Enron. No credit rating agency seems to have executed what I think is a fundamental metric when trying to understand the financial condition of a business enterprise. What is Fitch doing today?

Let's get real. Sure, the accounting profession can improve its accounting and its auditing. But it is not the responsibility of the accounting profession to analyze the economic history of a business enterprise and assess its credit risk or its stock price or anything else. The job of corporate accountants is to provide an honest financial report that conveys what has happened to the business entity, and it is the job of external auditors to ensure that this report accurately reflects the situation at the firm. However, it is the responsibility of the investment community to read and analyze these reports before making investment or credit decisions.

During the past few years, credit agencies became too chummy with corporate managers and carried out their work in a shallow manner. It is time to change this, and I hope that Fitch is in the process of cleaning its own house. While I appreciate its suggestions for refurbishing financial reports, I would also like to see Fitch do a better job in analyzing corporate information when it rates corporate debt.

J. EDWARD KETZ is accounting professor at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals, and columnist of The Accounting Cycle for SmartPros.com.