Arthur Andersen’s Troubles

Once the largest professional services firm in the world and arguably the most respected, Arthur Andersen LLP (AA) has disappeared. The Big 5 accounting firms are now the Big 4. Why did this happen? How did it happen? What are the lessons to be learned? Arthur Andersen, a twenty-eight-year-old Northwestern University accounting professor, cofounded the firm in 1913. Tales of his integrity are legendary, and the culture of the firm was very much in his image. For example, “Just months after [Andersen] set up shop in Chicago, the president of a local railroad insisted that he approve a transaction that would have inflated earnings. Andersen told the executive there was “not enough money in the City of Chicago” to make him do it.”1 In 1954, consulting services began with the installation of the first mainframe computer at General Electric to automate its payroll systems. By 1978, AA became the largest professional services firm in the world with revenues of $546 million, and by 1984, consulting brought in more profit than auditing. In 1989, the consult-ing operation, wanting more control and a larger share of profit, became a separate part of a Swiss partnership from the audit operation. In 2000, following an arbitrator’s ruling that a break fee of $1 billion be paid, Andersen Consulting split completely and changed its name to Accenture. AA, the audit practice, continued to offer a limited set of related services, such as tax advice.

Changing Personalities and Culture

Throughout most of its history, AA stood for integrity and technical competence. The firm invested heavily in training pro-grams and a training facility in St. Charles, a small town south of Chicago, and developed it until it had over 3,000 residence beds and outstanding computer and class-room facilities. AA personnel from all over the world were brought to St. Charles for training sessions on an ongoing basis. Even after the consulting and audit operations split, both continued to use the facility. Ironically, AA was the first firm to recognize the need for professional accountants to study business and professional accounting formally. In the late 1980s, AA under-took a number of programs to stimulate that formal education, including the development of ethics cases, the creation of an approach to the resolution of professional ethical problems, and the hosting of groups of 100 accounting academics to get them started in the area. Most had no formal ethics training and were uncertain how to begin ethics teaching or even if they should. It is likely that AA’s farsighted policies are responsible for the genesis of much of the professional ethics education and research in accounting that is going on today. What happened to the AA culture that focused on integrity and technical competence? What changed that would account for AA’s involvement in the major scandals noted in Table C2.2 as the audit firm that failed to discover the underlying problems? Some observers have argued that a change in AA’s culture was responsible. Over the period when the consulting practice was surpassing the audit practice as the most profitable aspect of the firm, a natural competitiveness grew up between the two rivals. The generation of revenue became more and more desirable and the key to merit and promotion decisions. The retention of audit clients took on an increasingly greater significance as part of this program, and since clients were so large, auditors tended to become identified with them. Many audit personnel even looked forward to joining their clients. In any event, the loss of a major client would sideline the career of the auditors involved at least temporarily if not permanently. For many reasons, taking a stand against the management of a major client requires a keen understanding of the auditor’s role, the backing of senior partners in your firm, and courage. The pressure for profit was felt through-out the rest of the audit profession, not only at Arthur Andersen. Audit techniques were modified to require higher levels of analysis and lower investment of time. Judgment sampling gave way to statistical sampling and then to strategic risk auditing. While each was considered better than its predecessor, the trend was toward tighter time budgets, and the focus of the audit broadened to include development of value-added non audit outcomes, suggestions, or services for clients. Such non audit services could include advice on the structuring of transactions for desired disclosure outcomes and other work on which the auditor would later have to give an audit opinion. According to discussions in the business and professional press, many audit professionals did not see the conflicts of interest involved as a problem. The conflict between maximizing audit profit for the firm and providing adequate audit quality so that the investing public would be protected was considered to be man-ageable so that no one would be harmed. The conflict between auditing in the public interest with integrity and objectivity that could lead to the need to roundly criticize mistakes that your firm or you had made in earlier advice was considered not to present a worry. In addition, the conflict between the growing complexity of trans-actions, particularly those involving derivative financial instruments, hedges, swaps, and so on, and the desire to restrain audit time in the interest of profit was thought to be within the capacity of auditors and firms to resolve. The growing conflict for auditors between serving the interests of the management team that was often instrumental in making the appointment of auditors and the interests of shareholders was recognized but did not draw reinforcing statements from firms or professional accounting bodies. Some professional accountants did not understand whether they should be serving the interests of cur-rent shareholders or future shareholders or what serving the public interest had to do with serving their client. They did not understand the difference between a profession and a business.

Ethical behavior in an organization is guided by the ethical culture of that organization, by any relevant professional norms and codes, and particularly by the “tone at the top” and the example set by the top executives. Also, presumably, the selection of the CEO is based partly on the choice of the values that an organization should be led toward. Joe Berardino was elected AA’s CEO on January 10, 2001, but he had been partner in charge of the AA’s U.S. audit practice for almost three years before. He was the leader whose values drove the firm from 1998 onward and probably continued those of his predecessor. What were his values? Barbara Ley Toffler, a former Andersen partner during this period and before, has provided the following insight: When Berardino would get up at a partners meeting, all that was ever reported in terms of success was dollars. Quality wasn’t discussed. Content wasn’t discussed. Every-thing was measured in terms of the buck…. Joe was blind to the conflict. He was the most aggressive pursuer of revenue that I ever met.

Arthur Andersen’s Internal Control Flaw

Given this “tone at the top,” it is reason-able to assume that AA partners were going to be motivated by revenue generation. But if too many risks are taken in the pursuit of revenue, the probability of a series of audit problems leading to increasingly unfavorable consequences becomes greater. That is exactly what happened. Unfortunately, the leaders of AA failed to recognize the cumulative degree to which the public, the politicians, and the SEC were angered by the progression of AA audit failures. If they had recognized the precarious position they were in, the AA leadership might have corrected the flaw in the AA internal control that allowed the Enron audit failures to happen. AA was the only one of the Big 5 to allow the partner in charge of the audit to override a ruling of the quality control partner. This meant that at AA, the most sensitive decisions were taken by the person who was most concerned with the potential loss of revenue from the client in question and who was most likely to be subject to the influence of the client. In all of the other Big 5 firms, the most sensitive decisions are taken by the person whose primary interest is the compliance with generally accepted accounting principles (GAAP), the protection of the public interest, and the reputation of the firm.

On April 2, 2002, the U.S. House Energy and Commerce Committee released a memo dated December 18, 1999, from Carl Bass, a partner in AA’s Professional Services Group in Chicago, to David Duncan, the AA partner in charge of the Enron account. That memo asked for an accounting change (believed to be in regard to SPE transactions) that would have resulted in a $30 million to $50 million charge to Enron’s earnings. In February 2000, Bass emailed Duncan to object to the setting up of an LJM partnership because he indicated that “this whole deal looks like there is no substance. “On March 4, 2001, Bass wrote that “then-chief financial officer Andrew Fastow’s role as manager of special partnerships compromised deals Enron made with the entities. Duncan overruled Bass on the first issue, and Bass was removed from Enron audit oversight on March 17, 2001, less than two weeks after he questioned Fastow’s role in Enron’s SPEs. In any other Big 5 firm, Duncan would not have been able to overrule a quality control partner on his own. History might have been different if a quality-focused internal control procedure had been in place at AA rather than one that was revenue focused.

 

Arthur Andersen’s Apparent Enron Mistakes

The previously presented “Enron Debacle” discussion covers in detail many of the questionable accounting transactions, legal structures, and related disclosures that AA reviewed as auditors of and consultants to Enron. Without repeating these in detail, it is possible to provide the following summary of significant issues that AA could be questioned about in court proceedings: • AA apparently approved as auditors and consultants (and collected fees for the consulting advice) the structure of many SPEs that were used to generate false profits, hide losses, and keep financing off Enron’s consolidated financial statements and that failed to meet the required outsider 3% equity at risk and decision control criteria for non-consolidation.

• AA failed to recognize the GAAP that prohibits the recording of shares issued as an increase in shareholders equity unless they are issued for cash (not for notes receivable).
• AA did not advise Enron’s audit committee that Andrew Fastow, Enron’s CFO, and his helpers were involved in significant conflict-of-interest situations without adequate alternative means of managing these conflicts.
• AA did not advise the Enron Audit Committee that Enron’s policies and internal control were not adequate to protect the shareholders’ interests even though AA had assumed Enron’s internal audit function.
• Many transactions between Enron and the SPEs were not in the interest of Enron shareholders because:

1. Enron profits and cash flow were manipulated and grossly inflated, misleading investors and falsely boost ing management bonus arrangements.
2. Extraordinarily overgenerous deals, fees, and liquidation arrangements were made by Fastow (or under his influence) with SPEs owned by Fastow, his family, and Kopper, who was also an employee of Enron.

• AA apparently did not adequately con-sider the advice of its quality control partner, Carl Bass.
• AA apparently did not find significant audit evidence or did not act on evidence found, related to the following:
• Erroneous valuation of shares or share rights transferred to SPEs
• Side deals between Enron and banks removing the banks’ risk from trans-actions such as the following:

1. Chewco SPE Rhythms hedge
2. Numerous prepay deals for energy futures even though AA made a presentation to Enron on the GAAP and AA requirements that precluded such arrangements

 

Why Did Arthur Andersen Make These Apparent Mistakes?

The term “apparent” is used because AA’s side of the story has not been heard. The so-called mistakes may have logical, reasonable explanations and may be supportable by other accounting and auditing experts. That stated, these apparent mistakes may have been made for several reasons, including the following:

• Incompetence, as displayed and admit-ted in the Rhythms case
• Judgment errors as to the significance of each of the audit findings or of the aggregate impact in any fiscal year
• Lack of information caused by Enron staff not providing critical information or failure on the part of AA personnel to ferret it out
• Time pressures related to revenue generation and budget pressures that pre-vented adequate audit work and the full consideration of complex SPE and pre-pay financial arrangements
• A desire not to confront Enron management or advise the Enron board in order not to upset management, particularly Fastow, Skilling, and Lay
• A failure of AA’s internal policies whereby the concerns of a quality control or practice standards partner were over-ruled by the audit partner in charge of the Enron account; AA was the only one of the Big 5 accounting firms to have this flaw, and it left the entire firm vulnerable to the decision of the person with the most to lose by saying no to a client
• A misunderstanding of the fiduciary role required by auditors

 

Because AA has now disintegrated, it is unlikely that the cause of specific audit deficiencies will ever be known. How-ever, it is reasonable to assume that all of the causes listed played some part in the apparent mistakes that were made. A review of additional cases of failure where AA was the auditor, such as the Waste Management and Sunbeam failures that may be found in the digital archive at www.cengage.com, reveal that AA’s behavior was strikingly similar to that in the Enron debacle. In each case, AA appears to have been so interested in revenue generation that they were willing not to take a hard line with their clients. AA personnel apparently believed that there was no serious risk of default and that, over time, accounting problems could be worked out. At the very least, AA’s risk assessment process was seriously flawed. Also, when AA’s client had a combined chairman of the board and CEO who intimidated or was willingly helped by his CFO, neither additional professional accountants working for the corporations nor other nonaccounting personnel who knew of the accounting manipulations raised their concerns sufficiently with AA or the Audit Committee of their board of directors to stimulate corrective action. This lack of courage and understanding of the need and means to stimulate action left AA, the board, and the public vulnerable.

Shredding Enron Audit Documents: Obstruction of Justice

The final disintegration of AA was not caused directly by the Enron audit deficiencies but rather by a related decision to shred Enron audit documents and the conviction on the charge of obstruction of justice that resulted. This charge, filed on March 7, 2002, raised the prospect that if AA were convicted, the SEC would withdraw AA’s certification to audit SEC registrant companies.9 That would preclude those large public companies that needed to be registered with the SEC to have their shares traded on U.S. stock exchanges (the New York Stock Exchange [NYSE] and NASDAQ) or raise significant amounts of capital in the United States.

Since these clients represented the bulk of AA’s U.S. and foreign accounting practices, if convicted, AA would be effectively reduced to insignificance unless a waiver could be arranged from the SEC. The SEC, however, was very angry about the Enron audit deficiencies, particularly in view of the earlier similar cases involving the AA audits of Waste Management and Sunbeam. In regard to the Waste Management debacle, “The commission argued that not only did Andersen knowingly and recklessly issue materially false and misleading statements, it failed to enforce its own guidelines to bring the company in line with minimally accepted accounting standards.” As a condition of the $7 million fine paid in June 2001 settling AA’s Waste Management audit deficiencies, AA had agreed to rectify its audit inadequacies, and the SEC believed that AA had not honored this under-taking. Consequently, since AA’s behavior in the Enron debacle was so similar, the SEC provided only a temporary and conditional waiver, pending the outcome of the trial.

The conviction was announced on Saturday, June 15, 2002, but many large clients had already transferred their work to other large audit firms. Some boards of directors and CEOs thought that AA’s reputation was so damaged by the Enron fiasco that they no longer wanted to be associated with AA or that such an association might weaken their company’s ability to attract financing at the lowest rates. The outrage of the public was so intense that other boards could not face the lack of credibility that continuing with AA would have produced with their share-holders. Still other boards realized that if AA were convicted, there would be a stampede to other firms, and their company might not be able to make a smooth transition to another SEC-certified audit firm if they waited to switch. By the time the conviction was announced, only a small percentage of AA’s largest clients remained. Even though AA’s chances of acquittal on appeal were considered by some observers to be good, AA was a shell of its former self and was essentially finished as a firm in the United States and ultimately around the world.

The chain of events that led to the shredding of some of AA’s Enron audit documents begins before Enron decided to announce a $618 million restatement of earnings and a $1.2 billion reduction of equity on October 16, 2001. An SEC investigation was launched into Enron’s accounting on October 17, and AA was advised on October 19. However, AA had advised Enron that such an announcement was necessary to correct its accounting for SPEs and, on October 9 as the eight-page indictment states, “retained an experienced New York law firm to handle further Enron-related litigation.” Eleven days later, the subject of shredding was dis-cussed as part of an emergency conference call to AA partners, and shredding began three days after that.

Shredding was undertaken in AA’s Houston office, as well as in London, Chicago, and Portland. “According to the U.S. government, … the destruction was ‘whole-sale,’ with workers putting in overtime in order to get the job done.” “Tonnes of paper relating to the Enron audit were promptly shredded as part of the orchestrated document destruction. The shredder at the Andersen office at the Enron building was used virtually constantly and to handle the overload, dozens of large trunks filled with Enron documents were sent to Andersen’s Houston office to be shredded.”

At the trial, AA argued differently. AA’s lawyer attempted to clarify the purpose of Chicago-based AA lawyer Nancy Temple’s email of October 10 to Michael Odom of AA’s Houston office. In that email, she wrote that “it might be useful to consider reminding the [Enron audit] team that it would be helpful to make sure that we have complied with the policy which calls for destruction of extraneous and redundant material. “This lack of relevance, of course, was difficult to prove after the documents in question had been destroyed. Essentially, AA contended that “the order to follow the document retention policy was an innocent effort to organize papers, emails and computer files and eliminate extraneous material.”

David Duncan, however, testified against AA. He had been fired from AA (where he had been the partner in charge of the Enron audit) on January 15, one day after he met with the U.S. Justice Department. He said, “I obstructed justice . . . I instructed people on the [Enron audit] team to follow the document retention policy, which I knew would result in the destruction of documents.”

The jury deliberated for many days, emerged, and was sent back for additional deliberations. Ultimately, AA was declared guilty. Although AA planned to appeal, it agreed to cease all audits of public companies by the end of August. Ironically, AA’s conviction turned on the jury’s view that the shredding was part of a broad conspiracy, and that rested on testimony that was reread to the jury, indicating that an AA memo (or memos) was altered. The acts of shredding alone were not enough for conviction.

The jury was reported as concluding that: Duncan eventually pleaded guilty to one count of obstruction and testified on the government’s behalf, but jurors said afterwards that they didn’t believe his testimony. Instead, the jury agreed that Andersen in-house attorney Nancy Temple had acted corruptly in order to impede the SEC’s pending investigation. One of Temple’s memos was a response to an email from Duncan about Enron’s third quarter earnings statement. Enron wanted to describe a massive earnings loss as “non-recurring,” but Duncan advised Enron against using that phrase. Temple’s memo advised Duncan to delete any language that might suggest that Andersen disagreed with Enron, and further advised Duncan to remove her own name from his correspondence, since she did not want to be called as a witness in any future litigation stemming from Enron’s earnings announcements.

On October 16, 2002, AA was fined the maximum of $500,000 and placed on five years’ probation. AA appealed out of principle, even though only 1,000 employees remained. Interestingly, on May 31, 2005, the U.S. Supreme Court overturned the conviction on the grounds that the “jury instructions failed to convey the requisite consciousness of wrong-doing” that AA personnel needed to think they were doing wrong rather than right to be convicted. The U.S. government must decide whether to retry the case. Unfortunately, the Supreme Court’s ruling came too late for AA.

Lingering Questions

Within a few months, arrangements had been made for the AA units around the world to join other firms, but not before many staff had left, and not all those remaining were hired by the new employers. A firm of 85,000 people worldwide, including 24,000 in the United States, was virtually gone.

Was this an appropriate outcome? Perhaps only 100 AA people were responsible for the Enron tragedy, but 85,000 paid a price. Will the reduced selection of large accounting firms, the Big 4, be able to serve the public interest better than the Big 5? What if another Big 4 firm has difficulty? Will we have the Big 3, or are we now facing the Final Four? Will fate await other individual AA partners and personnel beyond David Duncan or by the American Institute of Certified Public Accountants through the exercise of its code of conduct? Will a similar tragedy occur again?

Emerging Research

These questions and others have stimulated the accounting research community to investigate them. Conferences are being held, and research articles are appearing.

One of the early studies, by Paul R. Chaney and Kirk L. Philipich, titled “Shredded Reputation: The Cost of Audit Failure,” provided insights into the impact of AA’s problems on its other corporate clients and their investors. On January 10, 2002, AA admitted shredding Enron’s documents, and in the ensuing three days, the stock prices of most of AA’s 284 other large clients that were part of the Standard & Poor’s 1,500 Index fell. Over that time, these stocks dropped an average of 2.05% and lost more than $37 million in market value. This was the largest movement observed for the four critical information events tested. The other events were November 8, 2001, when Enron announced its restatements; December 12, 2001, when AA’s CEO admitted AA made an error; and February 3, 2002, the day following the release of the Powers Report, when AA hired former Federal Reserve Chairman Paul Volcker to chair an independent oversight board to shore up AA’s credibility. Volcker later resigned when it became evident that AA was unwilling to embrace significant changes.

Additional research studies have examined many aspects of the conduct of the directors, executives, lawyers, and accountants involved in the Enron, AA, and World-Com tragedies. In addition, the roles of regulators, of directors, and of professional independence have come under scrutiny. These studies are to be found in many aca-demic and professional journals as well as the popular business press. In particular, useful articles can be found in the Journal of Business Ethics, Business Ethics Quarterly, Journal of Accounting Research, Contemporary Accounting Research, Journal of Research in Accounting Ethics, and Business Week.

 

Questions

 

1.What did Arthur Andersen contribute to the Enron disaster?

2. Which Arthur Andersen decisions were faulty?
3. What was the prime motivation behind the decisions of Arthur Andersen’s audit

partners on the Enron, WorldCom, Waste Management, and Sunbeam audits: the public interest or something else? Cite examples that reveal this motivation.

4. Why should an auditor make decisions in the public interest rather than in the interest of management or current shareholders?

 

5. Why didn’t the Arthur Andersen partners responsible for quality control stop the flawed decisions of the audit partners?
6. Should all of Arthur Andersen have suffered for the actions or inactions of fewer than 100 people? Which of Arthur Andersen’s personnel should have been prosecuted?
7. Under what circumstances should audit firms shred or destroy audit working papers?
8. Answer the “Lingering Questions”