Daniels Fund Ethics Initiative University of New Mexico http://danielsethics.mgt.unm.
Arthur Andersen: An Accounting Confidence Crisis
INTRODUCTION Arthur Andersen LLP was founded in Chicago in 1913 by Arthur Andersen and partner Clarence DeLany. Over a span of nearly 90 years, the Chicago accounting firm would become known as one of the “Big Five” largest accounting firms in the United States, together with Deloitte & Touche, PricewaterhouseCoopers, Ernst & Young, and KPMG. For most of those years, Arthur Andersen’s name was synonymous with trust, integrity, and ethics. Such values are crucial for a firm charged with independently auditing and confirming the financial statements of public corporations, whose accuracy investors depend on for investment decisions. In its earlier days, Andersen set standards for the accounting profession and advanced new initiatives on the strength of its then undeniable integrity. One example of Andersen’s leadership in the profession occurred in the late 1970s when companies began acquiring IBM’s new 360mainframe computer system, the most expensive new computer technology available at the time. Many companies had been depreciating computer hardware on the basis of an assumed ten-year useful life. Andersen, under the leadership of Leonard Spacek, determined that a more realistic life span for the computers was five years. Andersen therefore advised its accounting clients to use the shorter time period for depreciation purposes, although this resulted in higher expenses charged against income and a smaller bottom line. Public corporations that failed to adopt the more conservative measure would receive an “adverse” opinion from Andersen’s auditors, something they could ill afford. Arthur Andersen once exemplified the rock-solid character and integrity that characterized the accounting profession. However, high-profile bankruptcies of clients such as Enron and WorldCom capped a string of accounting scandals that eventually cost investors nearly $300 billion and hundreds of thousands of people their jobs. As a result, the Chicago-based accounting firm closed its doors in 2002, after 90 years of business. THE ADVENT OF CONSULTING Leonard Spacek joined the company in 1947 following the death of founder Arthur Andersen. He was perhaps best known for his uncompromising insistence on auditor independence, which stood in stark contrast to the philosophy of combining auditing and consulting services that many firms, including Andersen itself, later adopted. Andersen began providing consulting services to large clients such as General Electric and Schlitz Brewing in the 1950s. Over the next 30 years, Andersen’s consulting business became more profitable on a per-partner basis than its core accounting and tax services businesses.
This material was developed by Jennifer Sawayda under the direction of O.C. Ferrell and Linda Ferrell. It is provided for the Daniels Fund Ethics Initiative at the University of New Mexico and is intended for classroom discussion rather than to illustrate effective or ineffective handling of administrative, ethical, or legal decisions by management. Users of this material are prohibited from claiming this material as their own, emailing it to others, or placing it on the Internet. Please call O.C. Ferrell at 505-277-3468 for more information. (2011)
and its emphasis on recruiting and retaining big clients might have come at the expense of the quality and independence of its audits. Thanks to the growth of Andersen’s consulting services. in all material respects. the objective of an independent audit of a client’s financial statements is “the expression of an opinion on the fairness with which [the financial statements] present. at Andersen growth became the highest priority. Throughout the 1990s. Ten years later. As revenues grew.” The primary responsibility of an auditor is to express an opinion on a client firm’s financial statements after conducting an audit to obtain reasonable assurance that the client’s financial statements are free of misstatements. Revenues from consulting surpassed the auditing unit for the first time in 1984. The company linked its consulting business in a joint cooperative relationship with its audit arm. many viewed it as a successful model that other large accounting firms should emulate. Reportedly. a quality crucial to the execution of a credible audit. its audit practice remained the company’s bread and butter. Andersen reaped huge profits by selling consulting services to many clients whose financial statements it also audited. In 1998.2 According to the American Institute of Certified Public Accountants (AICPA). Infighting between the consulting and auditing units grew until the company was essentially split into two opposing factions. hampering the firm’s ability to respond quickly and effectively to crises. Arthur Andersen merged its operational and business systems consulting units and set up a separate business consulting practice in order to offer clients a broader range of integrated services. However. The firm’s focus on growth also generated a fundamental change in its corporate culture. which compromised its auditors’ independence. Those individuals who could deliver the big accounts were often promoted before those people who were concerned with conducting quality audits. concerned over its potential for compromising the independence of audits. one in which obtaining high-profit consulting business seems to have been regarded more highly than providing objective auditing services. then SEC chairman Arthur Levitt publicly voiced these concerns and recommended new rules that would restrict the non-audit services that accounting firms could provide to their audit clients—a suggestion that Andersen vehemently opposed. Nonetheless. this same model eventually raised alarm bells at the Securities and Exchange Commission (SEC). results of operations. competition between the two units for accounts tended to discourage a team spirit and instead fostered secrecy and selfinterestedness. the consulting unit demanded greater compensation and recognition. Although Andersen’s consulting business was growing at a rapid pace. under this arrangement. financial position. Andersen’s consulting business became recognized as one of the fastest-growing and most profitable consulting networks in the world. and its cash flows in conformity with generally accepted accounting principles. who had to decide how to treat questionable accounting practices discovered at some of Andersen’s largest clients. Communication suffered. However. It is important to note that financial statements are the responsibility of a company’s management and not the outside auditor. in 1999 Andersen chose to split its accounting and consulting functions into two separate—and often competing—units. . This lucrative full-service strategy would later pose an ethical conflict-ofinterest dilemma for some Andersen partners.
To do so. a judge ruled that Andersen’s consulting arm could effectively divorce the accounting firm and operate independently.S. audit practice. history. employed more than 85. responded that it sympathized with BFA investors but . Problems began when the real estate market in Arizona suffered a downturn. the scheme eventually unraveled. many companies. lost $570 million of donor funds. sending shock waves through the financial markets. The foundation also offered estate and financial planning services to the state’s more than 400 Southern Baptist churches and was one of the few foundations to offer investments to individuals. listing debts of about $640 million against assets of about $240 million. foundation officials allegedly concealed losses from investors beginning in 1986 by selling some properties at inflated prices to entities that had borrowed money from the foundation and were unlikely to pay for the properties unless the real estate market turned around. which allowed the foundation to perpetuate the fraud. Finally. news that Enron had overstated earnings became public. Andersen’s consulting business consisted of about 11. the foundation petitioned for Chapter 11 bankruptcy protection in 1999.3 In August 2000. Andersen. leading to criminal investigations and investor lawsuits against BFA and Andersen.000 people worldwide. Profits from investments were supposed to be used to fund the churches’ ministries and numerous charitable causes. The company paid $110 million in May 2001 to settle claims brought by Sunbeam shareholders for accounting irregularities and $100 million to settle with Waste Management shareholders over similar charges a month later. In the meantime. BAPTIST FOUNDATION OF ARIZONA In what would become the largest bankruptcy of a nonprofit charity in U.000 consultants and brought in global revenues of nearly $2 billion. as a whole. the foundation’s top officers continued to receive six-figure salaries. which Andersen served as auditor. paying interest on deposits that were used mostly to invest in Arizona real estate. a more speculative investment strategy than other Baptist foundations in the state traditionally used. The court later ordered Arthur Andersen to change its name to Andersen Worldwide in order to better represent its new global brand of accounting services. It operated like a bank. By that time. Meanwhile. Andersen named Joseph Berardino as the new CEO of the U. With obligations to investors mounting. Arthur Andersen. following an arbitration hearing. in a February 2000 statement. were forced to restate earnings. a number of them Andersen clients.S. BFA invested heavily in real estate. the Baptist Foundation of Arizona (BFA). His first task was to navigate the smaller company through a number of lawsuits that had developed in prior years. an agency of the Arizona Southern Baptist Convention. Over the following year. was founded in 1948 to raise and manage endowments for church work in Arizona. more than half of the foundation’s 133 employees were laid off. The investor lawsuit against Andersen accused the auditing firm of issuing false and misleading approvals of BFA’s financial statements. in January 2001. BFA. All the while. The following sections describe a few of the cases that helped lead to Andersen’s collapse. The new consulting company promptly changed its name to Accenture the following January. and BFA’s management came under pressure to show a profit. foundation officials allegedly took money from new investors to pay off existing investors in order to keep cash ﬂowing. In what court documents would later dub a Ponzi scheme.
WASTE MANAGEMENT Andersen also found itself in court over questionable accounting practices with regard to $1. reports surfaced that Andersen had been warned of possible fraudulent activity. Losses to Sunbeam shareholders amounted to about $4. and artificially boosting quarterly net income. temporarily inflating revenue through accounts receivable. Waste officials refused to make the corrections and instead allegedly entered into a closed-door agreement with Andersen to write off the accumulated errors . but it advised Andersen that it could earn additional fees through “special work. Sunbeam was forced to amend six quarters of financial statements. Florida-based Sunbeam was the maker of such home appliance brands as Mr.4 billion of overstated earnings at Waste Management.4 stood by the accuracy of its audit opinions. According to SEC documents. and others. Oster. SUNBEAM Andersen’s troubles over Sunbeam Corp. The SEC’s injunction also accused Phillip Harlow. then a partner at Arthur Andersen. reporting. resulting in a loss to investors of more than $6 billion. the company’s senior management aided and abetted others’ violations of antifraud. Waste Management capped the amount of fees it would pay for Andersen’s auditing services. arguing that it was given misleading information on which to conduct the audits. Andersen agreed to pay $110 million to resolve the claims without admitting fault or liability. and accelerating sales from later periods into the present quarter. which involve booking sales months ahead of actual shipment or billing. recording revenue on contingent sales. A complaint ﬁled by the SEC charged Waste Management with perpetrating a “massive” financial fraud over a period of more than five years. Mixmaster. with job losses of about 1.” which outlined entries that needed to be corrected to avoid understating Waste Management’s expenses and overstating its earnings. a federal judge approved a $141 million settlement in the case. of authorizing clean or “unqualified” opinions on Sunbeam’s 1996 and 1997 financial statements despite his awareness of many of Sunbeam’s accounting and disclosure improprieties. Andersen identified improper accounting practices and presented them to Waste Management officials in a report called “Proposed Adjusting Journal Entries. Andersen was named in the case as having assisted in the fraud by repeatedly issuing unqualified audit opinions on Waste Management’s materially misleading financial statements. began when its audits failed to address serious accounting errors that eventually led to a class-action lawsuit by Sunbeam investors and the ousting of CEO Albert Dunlap in 1998. and record keeping provisions of federal securities laws. In August 2002. during nearly two years of investigation. and the firm eventually agreed to pay $217 million to settle the shareholder lawsuit in May 2002.” At first. However. However.700. As a result. The company was also accused of using improper “bill and hold” transactions. In it. According to the complaint.4 billion. Coffee. The firm blamed BFA management for the collapse. Both the lawsuit and a civil injunction ﬁled by the SEC accused Sunbeam of inflating earnings through fraudulent accounting strategies such as “cookie jar” revenues.
more telecommunications firms.9 billion of expenses and had overstated earnings in 2001 and the first part of 2002. Joseph Berardino. 2001. Enron had ﬁled for bankruptcy. After the dust settled. on November 8. alleging that . as a significant opportunity to expand revenues at Andersen. However. While the Enron and WorldCom scandals continued. and investors launched a barrage of lawsuits that sent the telecom into bankruptcy court. Accenture. had improperly accounted for nearly $3. 2002. Investors filed lawsuits against Global Crossing and Andersen. Within a month.000 employees lost their jobs. The result of these cases was that Andersen paid some $220 million to Waste Management shareholders and $7 million to the SEC. Waste Management shareholders lost about $20. prompting both Andersen’s clients and its employees to jump ship. the SEC announced that it was launching an investigation into the accounting of Enron. ENRON In October 2001. News soon surfaced that WorldCom.5 over a ten-year period and change its underlying accounting practices only in future periods. history (six years later. Later investigations revealed that WorldCom’s total fraudulent activities amounted to over $75 billion. Lehman Brothers would top WorldCom when it filed for bankruptcy at the onset of the 2008-2009 financial crisis). The SEC viewed this agreement as an attempt to cover up past frauds and to commit future frauds. Andersen blamed WorldCom for the scandal. as part of its consent decree. Andersen’s new CEO. came under investigation for alleged accounting improprieties. in which the accused telecom companies allegedly exchanged fiber-optic broadband capacity at inflated prices in order to show huge gains. Four Andersen partners were sanctioned. its stock price plummeted.S. Justice Department began a criminal investigation into Andersen in January 2002. one of Andersen’s biggest clients. WorldCom. At the heart of both cases is the issue of fake asset swaps. and an injunction was obtained against the ﬁrm. The auditing firm eventually admitted to destroying a number of documents concerning its auditing of Enron.5 billion and about 11. Andersen CEO Bernardino stepped down by the end of the month. The U. Andersen.S. however. which led to an indictment for obstruction of justice on March 14. The SEC ﬁled fraud charges against WorldCom. which ﬁred its CFO. insisting that the expense irregularities had not been disclosed to its auditors and that it had complied with SEC standards in its auditing of WorldCom. WorldCom’s bankruptcy ﬁling eclipsed Enron’s as the second largest in U. Enron was forced to restate five years’ worth of financial statements that Andersen had signed off on. the accusations of accounting fraud did not end with Enron. Andersen’s largest client. had perhaps viewed the $1 million a week in audit fees Enron paid to Andersen along with the consulting fees it paid to Andersen’s spin-off firm. including Global Crossing and Qwest Communications. After WorldCom restated its earnings. was forced to promise not to sign off on spurious financial statements in the future or it would face disbarment from practicing before the SEC—a promise that it would later break with Enron. accounting for $586 million in losses. pointed the finger of blame not only at its former managers but also at Andersen for failing to find the accounting irregularities. Indeed. TELECOMS Unfortunately for Andersen.
In some cases. According to former employees.000 and agreed to stop auditing public companies by August 31. and ultimately laid off more than 7. A senior executive allegedly removed Bass from the Enron account due to his complaints. Another factor may have been Andersen’s partners’ limited involvement in the process of issuing opinions. however. Soon after Volcker came on board. the company seemed to stray from the high ideals set forth by company founder Arthur Andersen. a jury found Andersen guilty of obstruction of justice related to the Enron case. Andersen auditor Carl Bass expressed concern over Enron’s use of derivatives and off-the-balance-sheet partnerships. the number of partners stagnated. CORPORATE CULTURE AND ETHICAL RAMIFICATIONS As the details of these investigations into accounting irregularities and fraud came to light. making it the first accounting firm to be convicted of a felony. As it grew. was free of all charges. its spin-off consulting unit.6 Global Crossing had artificially inflated earnings and that Andersen had violated federal securities laws by issuing unqualified audit opinions on Global Crossing’s financial statements. Qwest. The company paid a fine of $500. 2000. the company began selling various business units. One of the reasons for this confusion in its corporate culture may have been the inexperienced business consultants and untrained auditors who were often ignorant of company policies. Andersen had been trying to negotiate merger deals for its international partnerships and salvage what was left of its U. it appeared that Arthur Andersen may have even taken action to discourage employees from raising the red flag regarding questionable accounting practices. By the time Arthur Andersen made a wide-scale effort at reform. including $950 million in relation to the swaps and up to $531 million in cash sales of optical capacity. Evidence during the proceedings revealed that as early as 1999. Andersen hired former Federal Reserve Board chairman Paul Volcker to institute reform and to help restore its reputation. On June 15. although the consulting firm . Andersen was indicted for obstruction of justice in connection with the shredding of Enron documents.S. operations. which avoided bankruptcy court. essentially shutting down the business. though it knew or failed to discover that they contained material misstatements. Employees were rewarded for the amount of money they brought into the company rather than for acting with integrity. The problem also appears to be Arthur Andersen’s corporate culture. 2002. Accenture. the corporate culture had become highly competitive. admitted to using improper accounting methods and was forced to restate profits for 1999. 2002. it became apparent that Andersen was more concerned about its own revenue growth than the source of the revenue or whether its independence as an auditor had been compromised. As the company grew. and 2001.000 employees in the United States. However. Audit teams had great discretion in terms of issuing financials and restatements. Global Crossing ﬁled for Chapter 11 bankruptcy protection and ﬁred Andersen as its auditor. In February 2002. amid a mass exodus of clients and partners and the resignation of Berardino. There is also evidence that Andersen had limited oversight over its audit teams and that such visibility was impaired by a relative lack of checks and balances that could have identified when audit teams had strayed from accepted policies. it was too late to save the company. During the investigations.
which established new guidelines and direction for corporate and accounting responsibility. In 2005. While some experts believe that the Supreme Court’s ruling was strictly based on technical issues rather than whether Andersen was guilty of obstruction of justice. stiffer penalties for violators. The act was created to combat securities and accounting fraud and includes provisions for a new accounting oversight board. the Supreme Court threw out Arthur Andersen’s obstruction of justice conviction. the fact remains that Andersen may not have gone out of business if this ruling had been made available during the trial. For the accounting profession. However. Although there may be different reasons for this trend. Studies conducted after the passage of Sarbanes-Oxley indicated that the number of public companies that became private jumped 30 percent in a 16month period. . restricts accounting firms’ abilities to provide both audit and non-audit services for the same clients. some businesses worry that these reforms may not have been given enough forethought and cost-benefit consideration for public corporations that operate within the law. They also helped spur a new focus on business ethics. The Supreme Court did not rule on whether Andersen’s shredding was wrong. the lives of many thousands of Arthur Andersen employees not involved in accounting fraud were affected by all of the events associated with this case. A federal jury originally found the company guilty of obstructing justice by “corruptly persuading” workers to shred documents related to alleged improprieties by Enron. the Supreme Court said the jury instructions diluted the meaning of “corruptly” to the point that it could have covered the type of innocent shredding that companies do each day. smaller businesses have cited the cost of compliance that Sarbanes-Oxley imposes on public companies as one of the considerations in privatization. accounting consultants and many business executives believe that the quick rush to destroy Arthur Andersen’s accounting and auditing business may have had a negative effect on competition and the cost of auditing for all public corporations. Congress passed the Sarbanes-Oxley Act of 2002. and requires periodic reviews of audit ﬁrms. Table 1 discusses some of the components of the act.7 remains reluctant to mention its origins and association with Andersen: nowhere on Accenture’s Web site is the word Andersen to be found. Unfortunately. Arthur Andersen’s involvement with so many accounting fraud cases could have caused regulatory agencies to overreact. the case revolved entirely around the adequacy of the jury instructions at the company’s trial. Sarbanes–Oxley emphasizes auditor independence and quality. Looking back at this event. rather. and higher standards of corporate governance. driven largely by public demands for greater corporate transparency and accountability. IMPLICATIONS FOR REGULATION AND ACCOUNTING ETHICS The string of accounting scandals of the early 21st century sent many Andersen clients to bankruptcy court and subjected even more to greater scrutiny. In response. and the number of private companies choosing to go public hit an eight-year low in 2003. However.
reduce the Scope of Auditors. it did not prevent the 2008-2009 financial crisis. Although it has been nearly a decade since the disaster. the scandal still resonates with lawmakers. Carl Bass had his CPA license revoked by the Texas State Board of Public Accountancy in 2010 along with another former auditor of Enron. activities only likelihood of compromising Prohibited Activities good audit for more revenue Section 203: Audit Partner Rotate partners assigned to “Partner in Crime” Rotation client. Although regulators were hopeful that Sarbanes-Oxley would prevent similar scandals in the future. The board claimed that the two men did not follow accepted accounting practices in their 1997 and 1998 Enron audits. provides allow investigators to review Act of 2002) whistle-blower protection work of auditors Section 1102: Tampering with Persons acting to corrupt or Others from attempting to a Record or Otherwise destroy evidence liable for interfere in an ofﬁcial Impeding an Ofﬁcial extended prison term investigation Proceeding Table adapted from Mandy Storeim. not the company investigate and prevent companies from publishing misleading statements Section 303: Improper Removes power from company Withholding of information Inﬂuence on Conduct of Audits personnel from auditors by making this illegal Section 404: Management Gives auditor a voice outside of Information slipping by the SEC Assessment of Internal the audit to attest to policies and stakeholders by giving Controls demonstrated by the company more visibility to the ﬁrm Title VIII: Corporate and Makes it a felony to impede Destruction of documents. There is also much debate over whether the Arthur Andersen/Enron scandal actually changed anything. November 13. who work for the giving board power to board. 2002. For . so fresh eyes see work relationships papers Section 204: Auditor Reports to Auditors must report to Powerlessness of auditors by Audit Committees committee. Several financial institutions used accounting and financial tricks to inflate earnings and engage in risky financial practices. BG660 Final Project. Andersen LLP: An Assessment of the Company’s Dilemmas in Corporate Crisis. will Criminal Fraud (Accountability federal investigation. The pair challenged the decision in court. Despite being touted as a hero among accounting professionals for his early recognition of the problems at Enron. Colorado State University.8 TABLE 1 Sarbanes–Oxley Act Intended to Prevent Accounting Misconduct SARBANES–OXLEY ACT WHAT IT DOES WHAT IT COULD PREVENT Section 104: Inspection of Verify that financial statements Use of questionable/illegal Registered Public Accounting are accurate accounting practices Firms Section 201: Services Outside Restrict auditors to audit Improper relationships. THE ACCOUNTING FIELD TODAY Arthur Andersen is the perfect example of how a company that appeared impenetrable to failure could be so completely destroyed. The effects are still being felt by Arthur Andersen employees today.
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