Can Andersen Survive the Enron Debacle?
"Saddam Hussein has now agreed to weapons inspections. The bad news is he wants Arthur Andersen to do it." President George Bush, quoted in the Los Angeles Times, January 29, 2002.
The fallout from the collapse of Enron - a Houston-based energy firm whose implosion appears to be traceable at least in part to overly creative accounting methods - has spread far beyond the confines of the companies that dealt directly with it. As investors, regulators and others sift their way through the economic and human carnage, one question has taken center-stage: Did Andersen (once Arthur Andersen), the Big Five professional services firm that was charged with auditing Enron's financial statements and certifying their accuracy, merely fall asleep at the helm? Or did multi-million dollar fees sway its judgment to the point where Andersen ceased to guard the public's interest and instead became a cheerleader for a stumbling giant?
Many of the basic facts of the Enron affair - ranging from off-balance sheet financing methods that kept billions of dollars in liabilities off company books, to special-purpose partnerships that enriched top Enron executives - are not in dispute. But Enron's flameout, as well as numerous cases of earnings misstatements at other companies, are prompting observers to ask whether major changes are needed in the accounting profession to eliminate conflicts of interest between auditing firms and their clients.
The answers to these questions may help to determine whether or not Andersen, for one, can survive without being merged or acquired. In many ways, the firm's reputation has already been tarnished, as President Bush's joke quoted by the Los Angeles Times indicates. In a press conference on January 28, Andersen chief executive Joseph F. Berardino admitted that the firm has begun to lose business in the wake of the Enron scandal.
In some ways, Enron merely adds to questions that Andersen faced earlier. As has widely been discussed - including in an article last year in Knowledge@Wharton - Andersen last year faced charges of fraud from the SEC and agreed to pay $7 million in connection with its audit of Waste Management Inc. (Andersen paid the fine, though it did not admit or deny the SEC's allegations.) In addition, Andersen has been mired in a scandal following the implosion of appliance maker Sunbeam, whose accounts it audited. When Sunbeam collapsed in 1998, Andersen approved a restatement of the company's 1997 earnings from $109 million to $38 million. A recent BusinessWeek article reports that Andersen is now fighting a legal battle to keep these numbers out of court.
Andersen is not the only auditing firm to face charges leading to fines; other Big Five firms also have been forced to restate the earnings of their clients. More broadly, Andersen's predicament forcefully raises questions about the degree of independence that the accounting industry as a whole will enjoy in the future.
Conflicts of Interest?
According to David Larcker, a professor of accounting at Wharton, the issues are somewhat murky. "The real question in Enron's case is whether there was a conflict of interest on Andersen's part," he says. "It's clear that there were problems with Enron, but the door is still open as to whether or not Andersen's consulting activity presented a conflict of interest."
Larcker admits that when an accounting firm's consulting fees from a single client outweigh its audit fees, the "potential exists that when you're negotiating adjustments to the financial statements, you'll come down in favor of the company." But he adds that it's not always a given, and that it's also "not easy to tell" if independence has indeed been compromised.
Former Securities and Exchange Commission Chairman Arthur Levitt saw this issue differently. He believed consulting fees offer an unhealthy temptation to professional services firms that conduct certified audits, and during his tenure at the SEC, Levitt tried to introduce rules barring CPA firms from providing consulting services to their audit clients. Levitt's initiatives were met with a determined lobbying effort by the accounting industry. As Levitt told the New York Times on January 18, he received calls from 10 or 11 senators, warning him that if he did not relent on these regulations, the SEC's appropriations could be cut. "I have never been subjected to a more intensive and venal lobbying campaign," Levitt told the newspaper.
Eventually, Levitt was forced to water down his proposals and he accepted a requirement that made companies disclose the dollar amount of the audit and consulting fees they pay. Despite the backtrack, Levitt's bully pulpit raised enough heat to convince some firms (including Andersen) to spin off their consulting practices into separate entities.
Interestingly enough, the spin-offs may not have created a safe harbor. Published reports indicate that in 2000, for example, Andersen the auditing firm (as distinct from Andersen Consulting, which later changed its name to Accenture), received some $27 million in consulting fees from Enron, compared to $25 million in audit fees from the same client.
The activity behind those numbers illustrates the difficulty in trying to strip away the accounting function from the consulting one. The very term "consulting" appears to cover a wide range of activities, including tax preparation and other services that a company's outside auditor is uniquely qualified to offer. This latticework of financial and professional services means that even if "separation of audit and consulting" initiatives like Levitt's - and similar shareholder proposals launched by a variety of institutional investors - are successful, they could get bogged down in such issues as determining just what constitutes "consulting," and what consulting services are appropriately executed by auditors.
In fact the distinction need not be foggy, according to Robert E. Mittelstaedt, Jr. the vice-dean of executive education at Wharton. "When an audit firm provides consulting services, it can create the appearance of a conflict of interest," he observes. "While we can expect to hear calls to eliminate even an appearance of a conflict, it does make sense for the audit firm to provide some consulting services, like tax advice."
One reason why firms like Andersen pursue opportunities to provide consulting services is that these can represent a source of revenue that would be lost after the consulting division has been spun off. "Andersen Consulting used to drive an amazing sum of money into our firm, but after the spin-off, Andersen audit partners were still looking to drive incredible revenues and profit per partner," says a former Andersen senior manager who joined the firm right after college. The CPA, who is now with another Big Five firm, told Knowledge@Wharton that "Enron was one of Andersen's largest clients, and the partners were reluctant to walk away from that kind of money."
The former Andersen executive says that a common practice, called "audit by talk," may have contributed to lapses in judgement in Enron's case, as well as others, regardless of what firm performed the audit. "During an extended relationship audit partners tend to get comfortable with the top management of their clients," he says. "Ongoing talks with, in this case, Enron's CFO, may have made the audit partner comfortable with transactions that appeared to be on the edge of acceptability, and would have been shown to have been out of bounds if documentary evidence had been closely examined. So you may have simply had a client who wasn't being forthright, and an auditor who may have relied on the client too much."
So perhaps the accounting problems that have plagued Enron and a long list of other companies can be traced, in part, to the pressures placed on auditors: The drive for revenues that makes an audit firm think twice before walking away from an audit, and the tradeoff that occurs when an engagement partner tries to balance the accuracy of an audit (which means reviewing and testing transactions) while keeping costs down.
"We're not cops," says the former Andersen manager. "We can't examine every shred of evidence in an audit, especially when we're dealing with a large client. Instead we try to examine a representative sample, which means there's a certain amount of judgement involved."
Mittelstaedt acknowledges this, noting that, "The real problem is that large enterprises have grown exceedingly complex, doing business in countries around the world. When regulators ask an auditor to certify that everything's in line, the team will consider materiality. Something may be out of bounds, but it's possible that no one will notice."
But Mittelstaedt makes it clear that he's not ready to absolve the CPAs just yet. "Audit firms may be crossing a line when they take on strategic and operational assignments for their audit clients," he says. "They may be taking on a role of general management consultant, opening themselves to conflicts of interest, in appearance if not in fact. One thing is certain - the reputation of CPA firms has been tarnished."
Mittelstaedt, who sits on a number of corporate boards, says that some Andersen clients are now concerned about their association with the Big Five firm. "They're worried about what investors and others will think when they see their financial statements were audited by Andersen," he comments. "The audit firm may lose business, and could get wiped out financially by lawsuits."
In public statements, Andersen's Berardino has said his company understands that "...there are many questions still to be answered. We will answer them. We will cooperate with investigators. We will be accountable. And we will make the changes needed to maintain confidence in our firm."
Berardino's confidence aside, the defections may have started. A front-page article in the January 29 edition of the Wall Street Journal noted that longtime Andersen clients, including Delta Air Lines, had either already severed their relationship or had launched a search for a new auditor.
In the end, will regulations that require more transparency about the relationships between auditors and their clients be required to protect investors? Or will the free market initiate steps to reduce the likelihood of another Enron-type meltdown? Mittelstaedt, for one, believes that the Enron situation requires tougher measures.
"Putting some senior executives in jail and stripping them of personal assets would wake up a lot of people and get them to be more careful," he says. "It would encourage respect for regulations and corporate governance, and the penalties would show that we're serious about enforcing them." At Enron, the audit committee, for example, knew what was going on when it exempted the company's CFO from ethical guidelines and let him profit from Enron partnerships. "They knew what was going on and they did it anyway, in violation of their responsibility," says Mittelstaedt.
Time will tell whether executives at Andersen too - especially those responsible for shredding documents the SEC was looking for - will face such tough measures.
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