Arthur Andersen, USA

Made By- Vinita Taneja

Introduction• Arthur Andersen, founded as a partnership in 1913, became one

of the premier accounting firms of the late twentieth century, boasting a strong reputation for diligent audit and accounting work.

• Despite the series of consolidations that swept through the industry during the 1990s – which turned the “Big Eight” global accounting firms into the “Big Five” – Andersen remained independent. During this critical period the firm’s business focus started shifting from auditing to consulting and advisory services.

• Consulting services were more lucrative than traditional audit and accounting business, hence management’s desire to build the practice; indeed, the firm’s audit services became in some ways a “loss leader” as consulting revenues outpaced auditing revenues by a three to one margin during the 1990s.

• As the dual business focus grew stronger, the partnership reorganized itself into two separate, though still related, units: Andersen Worldwide. was created as the partnership holding company of Arthur Andersen and Andersen Consulting.

• As the consulting unit turned into a powerful revenue engine, tensions between the auditing and consulting units began mounting; in fact, as a separation between the two appeared increasingly inevitable the audit group began forming client consulting relationships of its own, many of them based on tax structures and advice.

• In early 2000, after a decade of escalating conflicts, Andersen Consulting broke away as an independent unit (renamed Accenture); after legal wrangling, the courts ordered the consulting unit to pay the audit group for splitting away. However, instead of approximately US$15 billion in cash the audit group was expecting, it received only US$1 billion, putting immediate pressure on the audit unit’s revenues and presence (the core unit went from being the largest audit/consulting provider in the world to the fifth largest auditor in the United States).

CASE SUMMARY• As Arthur Andersen attempted to rebuild its business operations it began

focusing more heavily on revenue growth than audit quality. In some cases it chose not to abandon companies that favored aggressive accounting treatment so as not to lose lucrative consulting/audit client accounts. In addition, the firm apparently lacked proper internal checks and balances to guard against conflicts of interest that were building within the consulting/ audit business.

• During the latter 1990s, the firm’s audit client roster came to reflect a growing number of high-risk clients. Bernardino, who became CEO in January 2001,21 created a risk profile of its 2500 audit clients when he was in charge of the US audit practice. Nearly 50 of those were classed as maximum risk and 700 as high risk.

• Maximum risk clients, in particular, required special attention because of their financial/structural complexity, aggressive accounting stance, and/or low creditworthiness. Despite their maximum risk status, Andersen never applied overly stringent audit standards; had it done so, subsequent financial reporting problems, lawsuits/fines, and reputational problems might have been avoided

• Although Andersen went through many difficult situations during the latter part of the 1990s, and compiled a poor record on some of its audit work, its downfall came through its relationship with Enron and the extensive work it did for the company over a multi-year period.

• Enron was one of Andersen’s key accounts, generating large accounting and consulting fees; by the start of the new millennium Andersen was earning US$1 million a week from. While the audit unit reviewed Enron’s financial statements, the consulting division was instrumental in helping establish many of Enron’s SPEs and tax “plays”. Some of Andersen’s Enron-related problems began as early as 1997, when the firm began signing off on audits, despite suspicious findings.

• For instance, in February 2001 several audit partners expressed concerned about the company’s aggressive practices; rather than investigate the matter, one senior auditor was removed from the account and local Houston partners responsible for the Enron relationship were permitted to overrule more conservative audit recommendations. As the Enron investigation unfolded in the aftermath of the company’s October 2001 earnings release, Andersen’s management agreed to assemble Enron documents for the SEC’s own investigation into SPEs.

• However, instead of delivering the documents to the SEC, Andersen partners, led by chief Enron relationship manager Duncan, commenced a thorough and systematic destruction of valuable documents. Only when Andersen was officially served by the SEC were audit team members told to stop their shredding activities.

• In January 2002, approximately one month after Enron’s bankruptcy filing, Andersen’s management admitted that it had destroyed a large number of Enron documents after the SEC investigation had already started. Duncan and several associates were fired, but CEO Bernardino and other executives denied any criminal wrongdoing; in fact, Bernardino claimed to be unaware of Enron’s situation until the scandal was in its latter stages.

• In March 2002 the US District Court charged Andersen with obstruction of justice in the matter of “wholesale destruction” of Enron documents. The partnership hired respected former Federal Reserve chairperson Volker to create an independent oversight board, but the effort yielded no results. Bernardino stepped down as CEO in a final attempt to try to avert further actions against Andersen.

• At this point many began to question the future prospects of the firm, which led to a further exodus of clients and employees. By June 2002 Andersen’s client roster had shrunk considerably, and only 10,000 employees remained at the company. Andersen went to trial shortly thereafter and, after six weeks of proceedings, was found guilty of obstructing justice, causing the SEC to ban the firm from further audits of public companies.

• The judgment spelled the end of the partnership. While Andersen’s base of intangibles – such as knowledge/intellectual property, ethics, goodwill, and reputation – was already in a precarious state prior to the trial, the SEC ban destroyed what little remained of the franchise.

• Andersen’s audit team felt such disclosure could be “misleading,” and reflected that belief in an interoffice memo, but Enron proceeded nonetheless. The Andersen lawyer then urged Duncan to delete any language related to the word “misleading.” The jury ultimately believed she had demonstrated criminal intent in making the recommendation. Although a number of Andersen’s competitors examined the firm to determine whether any part of it could be salvaged, all opted to pass, believing the liabilities and reputational damage were simply too great. Andersen filed for bankruptcy in late 2002, turning the Big Five into the Big Four.

Governance Flaws• The firm was severely conflicted on some client accounts,

simultaneously providing audit, accounting, and consulting services, often receiving millions of fees from different divisions of a given company Following the split with its consulting arm, Andersen’s executives were focused almost exclusively on rebuilding a new consulting business and generating revenues, to the detriment of the quality and independence of its audit business.

• Andersen’s executives failed to control properly the behavior of senior audit partners and internal lawyers, who displayed considerable lapses in judgment, responsibility, and ethics.

• Andersen’s audit work deteriorated steadily over the years, to the point where auditors were unable or unwilling to spot repeated financial errors or challenge aggressive interpretation of accounting rules at client companies. The technical capabilities within the audit group appear to have weakened.

• Despite classifying accounts as high or maximum risk, the firm was not particularly careful in handling these “special cases”; it did not regularly apply additional examination procedures or reviews.

• Local partners responsible for managing client relationships were, in at least some instances, given the authority to overrule the advice of the firm’s own auditors and specialists.

• Certain auditors were conflicted, rendering bad opinions or ignoring problems in order not to jeopardize their chances of eventually working directly for clients.

• The firm lacked a robust crisis management program through which to defend its reputation and intangibles. By the time executives attempted to control the damage, it was far too late to salvage goodwill.