Question

Arthur Edward Andersen built his firm, Arthur Andersen & Company, into one of the largest and most respected accounting firms in the world through his reputation for honesty and integrity.  “Think straight, talk straight” was his motto and he insisted that his clients adopt that same attitude when preparing and issuing their periodic financial statements.  Arthur Andersen’s auditing philosophy was not rule-based, that is, he did not stress the importance of clients complying with specific accounting rules because in the early days of the U.S. accounting profession there were few formal rules and guidelines for accountants and auditors to follow. Instead, Andersen invoked a substance-over-form approach to auditing and accounting issues.  He passionately believed that the primary role of the auditor was to ensure that clients reported fully and honestly to the public, regardless of the consequences for those clients.

Ironically, Arthur Andersen & Co.’s dramatic fall from greatness resulted from its association with a client known for aggressive and innovative uses of “accounting gimmicks” to window dress its financial statements.  Enron Corporation, Andersen’s second largest client, was involved in large, complex transactions with hundreds of special purpose entities (SPEs) that it used to obscure its true financial condition and operating results.  Among other uses, these SPEs allowed Enron to download underperforming assets from its balance sheet and to conceal large operating losses.  During 2001, a series of circumstances, including a sharp decline in the price of Enron’s stock, forced the company to assume control and ownership of many of its troubled SPEs.  As a result, Enron was forced to report a large loss in October 2001, restate its earnings for the previous five years, and, ultimately, file for bankruptcy in December 2001.

During the early months of 2002, Andersen became the focal point of attention among law enforcement authorities searching for the parties responsible for Enron’s sudden collapse. The accusations directed at Andersen centered on three key issues.  The first issue had to do with the scope of professional services that Andersen provided to Enron.  Critics charged that the enormous consulting fees Enron paid Andersen impaired the audit firm’s independence.  The second issue stemmed from Andersen’s alleged role in Enron’s aggressive accounting and financial reporting treatments for its SPE-related transactions.  Finally, the most embarrassing issue was the massive effort of Andersen’s Houston office to shred Enron audit documents, which eventually led to the demise of the firm.

                                                Enron/Anderson Scandal Key Facts

1.    Throughout Arthur E. Andersen’s life, “Think Straight, talk straight” served as a guiding principle for himself and Arthur Andersen & Co., the accounting firm that he founded.   Arthur Andersen’s reputation for honesty and integrity resulted in Arthur Andersen & Co. gaining status in the business community and growing into one of the leading accounting firms by the time of his death in 1947.

2.    Leonard Spacek succeeded Arthur Andersen as managing partner of Arthur Andersen & Co. in 1947 and continued Andersen’s legacy of lobbying for more rigorous accounting, auditing, and ethical standards for the public accounting profession.

3.    When Spacek retired in 1973, Arthur Andersen & Co. was one of the largest and, arguably, the most prominent accounting firm worldwide

4.    The predecessor of Enron Corporation was a natural gas company created in 1930; steady growth in profits and sales and numerous acquisitions allowed Enron to become the largest natural gas company in the United States by the mid-1980s.   

5.    During the 1990s, Kenneth Lay, Enron’s CEO, and his top subordinate, Jeffrey Skilling, transformed the company from a conventional natural gas supplier into an energy trading company.

6.    Lay and Skilling placed a heavy emphasis on “strong earnings performance” and on increasing Enron’s status in the business world.  

7.    Enron executives used hundreds of SPE’s (special purpose entities) to arrange large and complex related party transactions that served to strengthen Enron’s reported financial condition and operating results.  

8.    Enron entered the year 2001 as the seventh largest public company in the U.S., only to exit the year as the largest company to ever declare bankruptcy in U.S. history (until WorldCom’s bankruptcy in 2002 later claimed the record).

9.    Financial accounting standards played a role in that some of Enron’s questionable accounting strategies were in technical compliance with generally accepted accounting principles (GAAP), despite clearly violating the intent of those standards.

10. Following Enron’s collapse, the business press and other critics began searching for parties to hold responsible. Criticism of Andersen’s role in the Enron disaster focused on three key issues:  the large amount of consulting revenue the firm earned from Enron, the firm’s role in many of Enron’s SPE transactions, and the efforts of Andersen personnel to destroy Enron audit documents.

11.  Andersen’s fall from grace was a result of the firm’s loss of reputation as a result of a long string of audit failures (including Waste Management, Global Crossing, Sunbeam, Qwest Communications, Enron, and eventually WorldCom).   The firm’s conviction on federal charges of obstruction of justice in June 2002 effectively ended the firm’s long and proud history in the public accounting profession.

12. Audit fee revenues from such companies as Enron are very lucrative—Andersen’s audit fee at Enron was about $48 million per year.  It is interesting to note that in 2000,  Andersen earned more from Enron in consulting fees than in auditing fees, with consulting fees of over $52 million.

Question :What are the auditor independence issues surrounding the provision of external auditing services, internal auditing services, and management consulting services for the same client?  

Answer 1

External Auditors are people who look into the affairs of the company for the purpose of vouching their truth and fairnes. The auditors need to remain objective and unbiased in the performance of their work. An auditor performing multiple audit services (including management services) for the same client may seem possible. However,the auditor performing both external and internal services, is already familiar with the company. They know where the company may improve on their weaknesses and shortcomings. At the same time, others may question the auditor’s judgment on whether or not they are acting independently as an external auditor for the same client. There is a tendency to use the information collected during the internal auditing during the external audit work. This leads to a compromise in the objectiveness of the audit. For an auditor, independence is most important and it should be present not just in facts and mind but also in appearance. An external auditor who is providing multiple other services for the same client does not look independent to the outsiders and hence, should not be resorted. Usually, an internal audit is a person/firm who is within the company and understands their flow of work and culture. They know the people and might not hence be able to take a tough decision, if need be. It is also beneficial to have different auditors’ as it will give the company numerous ideas on possible weaknesses and improvements without a fear/threat of fee.

Also, the Sarbanes - Oxley Act of 2002, has the below rules with respect to auditor providing external auditing services, internal auditing services, and management consulting services for the same client-

General Standard of Auditor Independence

The Commission's general standard of auditor independence is that an auditor's independence is impaired if the auditor is not, or a reasonable investor with knowledge of all the facts and circumstances would conclude that the auditor is not, capable of exercising objective and impartial judgment on all issues encompassed within the audit engagement. To determine whether an auditor is independent under this standard an audit committee needs to consider all of the relationships between the auditor and the company, the company's management and directors, not just those relationships related to reports filed with the Commission. The audit committee should consider whether a relationship with or service provided by an auditor:

(a) creates a mutual or conflicting interest with their audit client;
(b) places them in the position of auditing their own work;
(c) results in their acting as management or an employee of the audit client; or
(d) places them in a position of being an advocate for the audit client.

The Commission rules also address specific auditor independence issues, some of which are:

Specific Prohibited Non-audit Services

The auditor is prohibited from providing the following non-audit services to an audit client including its affiliates:

• Bookkeeping
• Financial information systems design and implementation
• Appraisal or valuation services, fairness opinions, or contribution-in-kind reports
• Actuarial services
• Internal audit outsourcing services
• Management functions or human resources
• Broker-dealer, investment adviser, or investment banking services
• Legal services and expert services unrelated to the audit

In addition to the specific prohibited services, audit committees should consider whether any service provided by the audit firm may impair the firm's independence in fact or appearance.

Thus, post the Sarbanes-Oxley Act of 2002, an audior cannot provide the services of external auditing, internal auditing and management consulting to the same client. This is post Enron scandal. To maintain the independence of the auditors.