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 :Why do you think audit partners struggle with making tough accounting decisions that may be contrary to their client’s position on the issue?  What changes should the profession make to eliminate these obstacles?

Answer 1

Answer.

Corporate auditing field is a particularly fertile ground for self-serving biases. The audit firm Arthur Andersen’s role in “Enron collapse.” says three structural aspects of accounting create substantial opportunities for bias to influence.

Ambiguity.

Some experts say accounting really is much more of an art than science. For example questions like “What’s an investment? What’s an expense? When should revenue be recognized? The interpretation and weighting of various types of information are rarely straightforward. The accountant can interpret some concepts according to his bias and prejudice.

Attachment.

Auditors try to remain in clients’ good book and are thus highly motivated to approve their clients’ accounts. Under the current system, auditors are hired and fired by the companies they audit, and it is well known that client companies fire accounting firms that deliver unfavourable audits. Individual auditors’ jobs and careers may depend on success with specific clients. Moreover, in recent decades, accounting firms have increasingly treated audits as ways to build relationships that allow them to sell their more lucrative consulting service for big fees.

Familiarity.

The auditors tend towards having good relationship with ongoing clients and their biases will grow stronger as their personal ties deepen. The longer an accounting partner serves a particular client, the more biased his judgments will tend to be.They tend to ignore the faceless investor's interest.

The following changes should the profession make to eliminate these obstacles

1. Auditors must have fixed, limited contract periods during which they cannot be terminated. All fees and other contractual details should be specified at the beginning of the contract and must be unchangeable.

2. The client must be prohibited from re-hiring the auditing firm at the end of the contract. Instead major auditing firms should rotate their client.

3. Audit clients must also be prohibited from hiring individual accountants away from their audit firms at least for five years.

4. Limits the consulting services an auditing firms can provide, otherwise conflict of interest will appear

5. Professional schools should take ethics seriously and cancellation of memberships should consider if serious violation happens.