Arthur Andersen and Enron - two names that will forever live in

infamy because of the events leading up to and including the debacle of

December 2001, when Enron filled for bankruptcy. These two giants in the
utility and accounting industries, and known throughout the world, took
advantage of not only investors, but also the government and public as a
whole, just so that those individuals involved could illegally increase their
personal wealth. How could the backlash from the actions of the
management of these two organizations have a positive influence in the
accounting industry as a whole? The fallout from Enrons bankruptcy and the
SEC investigation that followed resulted in many changes to the industry to
make standards tougher, penalties harder, and the accounting industry more
reliable. At first glance, these improvements just seem like they are making
more work for the many honest accountants in the industry, who are already
doing the right things. However, this thesis will show how these changes
actually are positive for the industry. In order to do this safety measures that
were in place at the time of the debacle will be shown, the actual events
leading up to the downfall of Enron and Arthur Andersen will be discussed,
the changes that have occurred since the fall through the present day will be
given, the changes that appear to be on the horizon for the accounting
industry will be shown, and finally how all of this will impact the accounting
industry as a whole in a positive fashion will be made clear.
Safety Measures in place Prior to the events.
Prior to the fall of Enron and their accountants, Arthur Andersen, there were
many different types of safety measures in place to help protect the investors and the
public as a whole. These safety measures included Generally Accepted Accounting
Principles (GAAP), Generally Accepted Auditing Standards (GAAS), Statements on
Auditing Standards (SAS), and all professional ethics. The use of GAAP by
accountants is standard protocol. An accountant follows these principles as a matter
of daily routine. According to Several accounting texts, GAAP is identified as a
dynamic set of both broad and specific guidelines that companies should follow
when measuring and reporting the information in their financial statements.
During yearly audits performed by external, independent auditors, checks are
performed to make sure that a business is following GAAP consistently. If they are
not, then the business must show why they are not, and present rationale to
demonstrate that what they are doing is both ethical and appropriate in their specific
situation. This leaves the field open to interpretations of what is appropriate for
different situations. Since interpretations are quite subjective, the American Institute
of Certified Public Accountants (AICPA), added the stipulation that the treatment
must also be applied consistently over time. These rules are in place to make financial
statements as accurate and reliable as possible. Enron took these rules and
circumvented them to allow certain individuals within the company to make money
from the increased investments from stockholders. They did this by bolstering their
balance sheet with inflated asset values, and dispersing their liabilities to subsidiaries
that they just didnt consolidate. Meaning that Enron didnt include these companies
in their financial statement accounts at the end of their fiscal years, causing massive
misstatements. Since these partnerships were, in most cases, wholly owned
subsidiaries or partnerships, they should have been shown on the consolidated
financial statements with Enron. When Enron declared bankruptcy they had $13.1
billion in debt on Enrons books, $18.1 billion on their subsidiaries books, and an
estimated $20 billion more off the balance sheets (Zellner).
While GAAP guidelines relate to how financial statements are presented,
GAAS, on the other hand, are standards set down specifically for the audit cycle of a
company. It tells auditors what tests they should do, and to what extent this testing is
to be done, and what level is acceptable in the audit (Imhoff) Arthur Andersen had a
responsibility to the investors and to the public interest under GAAS. Auditors,
according to GAAS, are to remain independent in both fact and appearance. Meaning
that even if an auditor appears to have a connection with their client, even though they
may not have, they should drop the audit immediately. Anderson took a very active
role in Enrons business through both auditing and consulting. This should have been
enough to make anyone question Andersons independence. They did not execute
their duties independently because of the amount of revenue that Enron was providing
them, not only in audit fees, but also in consulting fees. In 2000, Enron paid
Andersen $52 million, including $27 million for consulting services (Weil). This
amount was enough to make Enron Andersens second largest account in 2000.
SAS constitute the third important safety measure. These statements on
auditing standards are produced to address current issues in the business of
auditing. The American Institute of Certified Public Accountants (AICPA) sets down
these rules. The one that played a predominant role in this incident is SAS 82. SAS
82 was issued in 1997, and it requires auditors to ascertain managements
understanding of the risk of fraud (Jakubowski). This statement also included the
duty to find out if any of the management knew of any fraud being committed against
the company, and added new fraud terminology to the representation letter produced
by management. This SAS was the first to clearly state that auditors had any
responsibility to look for fraud. Up until 1997 it was expected that an auditor would
report fraud if they happened upon it, but they had no responsibility to actively look
for it. This one SAS along with all the others were supposed to protect the public
interest. However, in lieu of the lucrative fees being collected by Andersen from
Enron these were also overlooked. In spite of all of these safety measures the
wrongdoings at Enron went undetected for a long period of time. The major problem
was that of collusion. GAAP and GAAS can not prevent fraud when people work in
collusion to perpetrate that fraud. Therefore, when events like these transpire,
changes are required in an attempt to prevent similar occurrences.
History (Chronology of Events)
The events that led up to the bankruptcy filing in December of 2001, started
long before anyone began to suspect fraud at Enron. Andersens role in the Enron
debacle should have been anticipated. Andersen had two major audit failures just a
few years apart and just a short time before Enron filed bankruptcy. In 1996, Waste
Managements audit reports from Andersen were materially false and misleading
resulting in an inflation of income by over $1 billion dollars between 1992 and
1996. This information came out in an SEC investigation, and led to Waste
Management selling out to another company. In 1997 Sunbeam was found by the
SEC to be using accounting tricks to create false sales and profits, Andersen signed
off on these financial statements even after a partner flagged them. Sunbeam would
later file for bankruptcy (Weber).
These two major audit failures should have put Andersen on their guard against
another client failure, however the worst was yet to come. Internal memos at
Andersen showed that there were conflicts between the auditors and the audit
committee of Enron. Also included in these memos are several e-mails expressing
concerns: about accounting practices used by Enron. However, the leading partner on
the audit, David B. Duncan, overturned these concerns. Also, there is proof that
Duncans team wrote memos fraudulently stating that the professional standards
group approved of the accounting practices of Enron that hid debts and pumped up
earnings (McNamee). However, because of the relationship between audit and non-
audit fees, Andersens independence was probably flawed (Frankel). During the
fallout of Enrons bankruptcy and Andersens role in it, Andersen began to run an ad
that Andersen would do what was right. In doing this they were trying to rebuild the
consumer confidence in their accounting firm. While Andersen was attempting to
pick up the pieces of their business, Paul Volcker, former Federal Reserve Chairman,
presented a plan for a restructuring of Andersen so that they would have a chance of
surviving this incident. Andersen did eventually agree to the restructuring, but it was
too late to save the firm as a whole (Alexander). Anderson still exists as a company,
although their only reason for doing so is to complete all the litigation against the
firm. They are no longer auditing or consulting. Anderson was the major accounting
influence in this incident, however they were not the main player.
Enrons role started when they emerged as a competing force within their
industry. Enron became more and more arrogant as time passed. They had a banner
in the lobby of their headquarters, which read, the worlds leading company. Many
believe that it was this arrogance on the part of the management that led to the
escalation of the fraud that followed (McLean).

Exhibit 1







Enrons strategy was to have a balance sheet with many intellectual assets, like
patents and trademarks, and that actual assets were bad and should be immaterial
when compared to the intangibles. Most of the debts and tangible assets of the
company were on the balance sheets of partnerships that were run by high-ranking
officials within the corporation (Zellner). With this kind of strategy for business the
company quickly began to falter. Knowing that Enron needed help, a competitor,
Dynergy, offered to buy them out for $10 billion. Then, on October 16, 2001 Kenneth
Lay, ex-CEO of Enron, told the public that Enron would have to decrease
shareholders equity by $1.2 billion. This announcement, along with the November
19, 2001 announcement of a $700 million charge to buy out a note payable, caused
Dynergy to bail out of the deal to buy Enron on November 28, 2001. This proved to
be the defining moment for Enron -- that would cause Enrons management to realize
that Enron had no hope of survival. Finally on December 2, 2001 Enron filed for
bankruptcy (Zellner). In the end Enron fared no better than other companies that
perpetrate this kind of activity. This description is what really happened, but how
these events were displayed to the public is a different story.
In early 2001 Jim Chanos, the person who runs Kynikos Associates, was the
first to say what everyone can now see -- Enron had absolutely no way to earn
money. The parent company had become nothing but a hedging entity for all of its
subsidiaries and affiliates. The operating margin for Enron was way down in 2001, at
2%, from its level in 2000, of 5% (McLean). This kind of a decrease in one year is
unheard of in the utilities industry. Chanos went on to point out how Enron was still
aggressively selling stock, even though management understood that there was very
little to back up the shares that they were selling. Chanos was also the first person to
take notice of and publicly identify the partnerships where Enron was hiding some of
its debt (McLean). Enrons CFO Andrew Fastow ran these partnerships, which would
later become known as the LJM partnerships. These partnerships were recorded as
related parties, but were never consolidated so that the debt never showed up on
Enrons financial statements, as it would have if statements were prepared according
to GAAP (McLean). Thanks to Jim Chanos the public was made aware of what was
going on, and actions have been taken to implement changes to prevent a similar
instance in the future.
Changes
Since these events have taken place, see exhibit 1, many changes have come
about within the accounting industry. Some of these changes originated with the
AICPA and other accounting groups. Still other changes have come from the
government and government agencies or have just naturally evolved with time.
The AICPA made several new Statements on Auditing Standards in response to
the Enron events. The three that appear to be most closely linked to the Enron and
Andersen debacle are SAS 96, SAS 98, and SAS 99. SAS 96 became effective
January of 2002 and dealt with the record retention policies of accounting firms. In
SAS 96 the requirements of SAS 41, which was the first SAS to address record
retention, were reaffirmed. Also several new regulations were added. SAS 96
contains a list of factors that auditors should consider when attempting to determine
the nature and extent of documentation for a particular audit area and procedure. It
also requires auditors to document all decisions or judgments that are of a significant
degree (SAS 96). For example, a decision of a significant degree would be an auditor
approving a client not using GAAP for a portion of their financial statements. These
changes appear to be a direct result of the paper shredding that went on at Arthur
Andersen immediately after the Enron bankruptcy. SAS 98 makes a lot of revisions
and amendments to previous statements. These changes include changes to GAAS,
changes to the relationship between GAAS and quality control standards, and audit
risk and materiality concepts in audits (SAS 98). All of these changes would appear
to be related to problems that were discovered in the Andersen audit of Enron. SAS 99
outlines what fraud is, reaffirms the auditors responsibility to look for fraud, and
reaffirms the necessity to gather all information for an audit (SAS 99). These changes
appear to be in connection to the fact that Anderson did not find any fraud in Enrons
books, where fraud existed. These changes all came from within the AICPA.
Many accounting firms and independent CPAs reacted to these events and
implemented changes in procedure voluntarily. The biggest change that accounting
firms made was a move made by the four remaining members of the big five, KPMG,
Ernst and Young, Deloitte Touche Tohmatsu, and PricewaterhouseCoopers. These
four companies decided to break all ties with Andersen in an attempt to avoid being
dragged down with the selling controversy surrounding the Enron scandal. This
distancing was also due to the major changes mandated to Andersen as a way to get
back on their feet after the scandal broke, and the other firms were afraid that these
changes would be forced on them as well (Schroeder).
This scandal also caused many major companies who had used Andersen as
their auditor in past years to hire auditors to go over past years audits double checking
all of the audit work that could be double checked. This cloud of doubt also extended
to companies that Andersen gave qualified audit reports or consulting advice to. PSC
Inc. is a software manufacturer with increasing financial problems. When Andersen
performed their last audit on the company they raised many questions about the
companys ability to continue to exist as a viable entity (Elstein). Leaders of many
blue-chip firms were very concerned by this scandal, and they met to discuss plans for
future changes. At the end of these meetings, it was decided that a new oversight
committee should be proposed and that these companies were the people to propose
such an idea. This idea would set up a committee sponsored completely by the
SEC. The members of this committee were to be completely independent of the
public accounting firms (Bryan-Low). The oversight committee mentioned was never
instated because the current public oversight committee dissolved itself only a short
time after this proposal was made, as they felt they had let down the community and
the industry. All other changes that would be to come into the accounting industry
would have to be brought in by the government or other outside sources, because the
accounting industry felt that they had changed more than enough to forestall a
reoccurrence of the Enron/Arthur Anderson debacle.
The government reacted aggressively when they became aware of the Enron
scandal, and a flurry of legislation and proposals emanated from Congress and the
SEC about how best to deal with this situation. President Bush even announced one
post-Enron plan. This plan was to make disclosures in financial statements more
informative and in the managements letter of representation. This plan would also
include higher levels of financial responsibility for CEOs and accountants. Bushs
goal was to be tough, but not to put an undue burden upon the honest accountants in
the industry (Schlesinger).
By far the biggest change brought about is the Sarbanes-Oxley Act
(Ditman). The Sarbanes-Oxley Act requires companies to reevaluate its internal
audit procedures and make sure that everything is running up to or exceeding the
expectations of the auditors. It also requires higher level employees, like the CEO and
CFO to have an understanding of the workings of the companies that they head and to
affirm the fact that they dont know of any fraud being committed by the
company. Sarbanes-Oxley also brought with it new requirements for
disclosures. These requirements included reporting of transactions called reportable
transactions. These transactions are broken down into several categories, which
impact every aspect of a business. One of these categories is listed transactions-which
are by far the worst. They are transactions that are actually written out in a list, each
one pertaining to one specific situation. Another is transactions with a book-to-tax
difference of more than ten million dollars. There are several others, however these
two will have the greatest effect. Accompanying these requirements are strict
penalties if these transactions are not reported and discovered later. This act will
mean significant additional work for accountants over the next several years.
The GAO (Government Accounting Office), held several meetings revolving
around this scandal and the resulting fallout. One such meeting had David Walker,
Comptroller of the United States, discussing his beliefs as to where serious problems
existed. The four major areas outlined in his discussion were corporate governance,
independent audit of financial statements, oversight of the accounting profession, and
accounting and financial reporting issues (GAO-02-483T). This discussion sparked
the bringing several GAO accountants and heads of business into Congress
committees for advice and to get feedback for proposed ideas. The other large
meeting was held to discuss the Sarbanes-Oxley act that was put before
Congress. Paul Sarbanes, Chairman of the Committee on Banking, Housing, and
Urban Affairs presented the new act to the GAO, in an attempt to allow the members
to see the necessity of the Sarbanes-Oxley act, as well as support it at the
congressional level (GAO-02-742R). These were the two main changes emanating
from the Government Accounting Office.
Another big change that came from the Enron bankruptcy filing was a new
push to separate auditing services from consulting services. Immediately after it
became clear that Andersen had no chance for survival Andersens management
decided to try one last thing to raise some money to settle the lawsuits filed against
them. This last effort was to sell off their consulting service. Several years before the
Enron/Andersen debacle, Andersons consulting arm had forcefully split from the
company because of a lack of distribution of income to partners from the consulting
arm of the business (Toffler). Concordantly, the consulting arm was relatively new to
the company. The buyer of the consulting service would be KPMG, one of the now
big four accounting firms, and they would pay more than $250 million for this
consulting arm (Frank).
For many years the SEC Chairman, then Arthur Levitt Jr., had been calling for
the separation of auditing and consulting services within one company. However big
firms like Andersen would apply their proverbial weight to attempt to show that
consulting did not interfere with an auditors independence. Since the major concern
of Andersens role in the controversy centers on their independence, and because of
the large monetary consulting fees being paid to them by Enron, the push has been
started anew by Paul Volcker the former Federal Reserve Chairman. Realistically,
few think that the big firms will be able to dissuade the SEC from actually
implementing such a rule (Brown). Many companies who use auditors believe that
this is not the answer, because of the fact that it will cause them to hire one firm to do
auditing work, and another to do non-audit work like taxes and other filings
(Solomon). In an attempt to not get damaged by any imminent government action,
many business-including Disney and Apple Computer Inc-have already begun
splitting their audit and non-audit work between different firms. Harvey Pitt, current
SEC Chairman, does not believe that such a drastic change is called for, and instead is
pushing for not allowing external auditors to perform internal audits for companies,
and that all other non-audit work be approved by the SEC and board audit committees
before the work is done (Byrnes). This controversy has long outlasted both
companies involved in the actual debacle, and will continue until specific actions are
taken.
These events have also allowed the world of academia to make many
influential changes to curriculums, without adding or dropping classes. These
changes include a new emphasis on accounting ethics and on special purpose
entities. Ethics have always played an important role in the accounting
industry. However, in recent years ethics education within accounting classes had
fallen by the wayside as audit failures continue to stack up, and accountants are
viewed as at least partially to blame. Several professors of accounting at several
different colleges across the United States have redoubled their efforts to include
ethics in their teachings at every level, from principles to advanced. Special purpose
entities are not something that have been highly discussed in many accounting classes
up to this point in time. However, in light of the tax shelter abuse perpetrated by
Enron, many professors are now finding it necessary to begin to explain these entities
and their uses to their students. The goals of all the curriculum changes are to make
accounting graduates better prepared to confront ethical issues so that events such as
the Enron/Anderson debacle will not be repeated in the future (Wei).
The effects of the Enron/Anderson debacle can even be felt at an international
level as more precautionary measures are taken. In Singapore, there has been a push
to have banks and other lenders rotate their auditors. The controlling government
agency, Monetary Authority of Singapore (MAS), is attempting to make it necessary
for all listed companies to rotate their auditors every five years. The executive
director of MAS, Ravi Menon, said with an extended relationship, auditor firms run
the risk of getting too close to the management of the banks they audit, and begin to
identify too closely with the banks practices and culture (Day). It is this closeness
that caused Andersen and Enron to work in collusion to escalate the fraud that Enrons
management had perpetrated. Several other countries where the remaining big four
practice are now also looking into such restrictions and changes to protect their
citizens. The effects of the debacle are not merely restricted to the United States;
indeed they are felt throughout the business world.
Positive Nature of the Changes
The changes that have been made, are being made, and will be made, all will
have a positive impact on the accounting industry. These changes, some implemented
by accounting companies and agencies, some by the government and governmental
agencies, and others by outside sources, will require more work from accountants, but
will in the long run improve many factors within the industry.
The changes implemented by accounting companies and different accounting
agencies will affect only the companies making the changes and the American
companies, and subsidiaries. The three new SAS presented earlier will help to expose
fraud and deception where it exists in a company. They not only make the auditor
work harder to demonstrate more fully that no material misrepresentation exists, but
also require the company to take a more proactive role in their audits and
accounting. These new SASs will help to restore some of the publics confidence in
auditors and businesses.
The move by many businesses to hire new auditors to recheck their past audits,
after Andersens contributing role had been exposed as aiding and abetting the fraud
that existed at Enron, was a wise decision. This allows the public to see that
companies do care that they do not misrepresent their position to the public. It also
creates more work for the accounting industry, which creates job security for
accountants. These changes allow companies to show that even though their auditors
were corrupt; the company itself was fine, thereby restoring public confidence in
publicly traded companies.
The governmental changes had the farthest-reaching effect of all the changes
that would result from the Enron/Anderson debacle. The plan that President Bush
announced would make the penalties stiffer and would make the culpable, high-level
management employees responsible for the workings of the company, something not
yet established in American law. This gives the management of a company a new
impetus to make sure that everything is absolutely correct. Which in turn means that
financial statements should be more reliable than ever before.
The Sarbanes-Oxley Act will drastically improve the accounting industry in
two ways. First it creates a lot more work for many of the public companies. This
additional work means more job opportunities for many accountants and job
opportunity means freedom to tell a client when they are wrong, which in turn makes
audits more reliable. The second way is that it requires tougher restrictions on
internal audits and in judging how well the internal audit is conducted. If the internal
audit is functioning effectively, it cuts down on the volume of work that the auditors
have to do, thus making it easier for auditors to do audits. As well as increasing
reliability on the internal audit, these changes increase the reliability on the financial
statements produced by the companies as well. This increase in reliability will in turn
increase the publics confidence in the accounting industry.
The other changes will have varied levels of effect on the accounting industry,
but will all be positive in nature. The separation of auditing and consulting will move
the accounting industry forward a great distance toward increased credibility. It will
decrease the occurrence of non-independence by auditors. At the same time, this will
allow companies to reap the benefits of having both auditors and consultants. The
accounting industry should again flourish, and businesses will see that once the
consulting firm gets used to working with a company they will work just as well as
the company that they use for audits. This should provide a means of checks and
balances.
The changes in academia will produce a new kind of accountant. The new
accountants will have more training in ethics. This training in ethics will increase the
publics confidence in accountants and the accountants confidence in each
other. Also, accountants will be better prepared to deal with special-purpose entities
which will allow more meaningful and correct accounting procedures to prevail where
bad or antiquated procedures may have been used in the past. This will improve the
reliability and usefulness of financial statements as well as their reliability.
All of the positive changes center on revitalizing the publics ability to trust
accountants as well as the companies in which they invest. Once these bonds of trust
have been repaired, after being so badly damaged as a result of the Enron/Andersen
debacle, the economic world can move forward with confidence and integrity in a new
a positive direction for all people involved.
Conclusion
Executives at Arthur Andersen and Enron did not set out to have a positive
impact on the accounting industry or any industry. They set out to make as much
money for themselves as quickly as possible. They were willing to do whatever it
took to make that money. These thoughtless acts and greed led both companies to an
eventual downfall in bankruptcy. However, the accounting industry reacted by
introducing changes that would, in the long run, improve itself and the economy in
which it exists. The changes that are a response to the Andersen/Enron debacle may
be coming to an end. We are probably seeing the last laws, pronouncements, and
statements that are a direct result of these actions. Still, the changes that have
occurred leave the accounting industry and the economy stronger. Will the industry
ever be perfect? Probably not, but accountants and the world must continue to strive
to make it as functional as it can be. Only by this continued striving can the industry
be good enough to function effectively and even thrive.
























A Cure for Enron-Style Audit
Failures
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In an opinion piece in the Financial Times, Harvard Business School
professor Jay Lorsch argues for legislation to create an independent, self-
regulatory organization to oversee accounting firms. Enron, he says, is not an
isolated incident.

by Jay Lorsch
If companies and regulators are ever to learn from the collapse of Enronand
prevent similar corporate debacles in the futurethey must look more closely at
the relationship between auditors, managers and the company audit committee.
The Enron scandal is not an isolated accounting failure. Over the past five
decades, accountants have changed from watchdogs to advocates and
salespersons. Auditing has become one of a number of services, including
consulting and tax advice, in which accountants "sell" creative tax avoidance and
financing structures. Accountants enable their clients to account for transactions
under generally accepted accounting principles (GAAP) while reducing
transparency and aggressively maximizing earnings and debt.
Creative accounting is part of the competition among auditors that has led to
lower profit margins. As a result, the firms have sought more efficient and
cheaper methods that undermine quality audits.
THE AUDIT COMMITTEE MUST HAVE THE
LEADERSHIP, INDEPENDENCE AND INFORMATION TO
OVERSEE THE AUDITORS AND THEIR RELATIONSHIP
WITH THE MANAGEMENT. JAY LORSCH
This race for profitability and the failure of many auditors to maintain high
professional standards cries out for legislation to create an independent, self-
regulatory organization to oversee accounting firms. Accounting would remain in
the private sector, but the government would be involved, which is critical to
restore confidence. The SRO would have rule-making, supervisory and
disciplinary powers similar to those of the stock exchanges. And, like them, it
would be overseen by the Securities and Exchange Commission. The SRO
board should balance members of the accounting profession with a majority
representing the public interest.
Company boards require less reform and, in general, existing law is adequate.
The main problem lies in the failure by boards to follow procedures that would
hold managements accountable for company performance. This could be
improved by focusing on three areas.
The first is leadership. The independent directors must have a leader who does
not also hold the position of chief executive officer. Where the CEO and the
chairman are the same person, a lead director should be chosen from the non-
executive directors.
The chairman of the audit committee must also be an effective leader. The New
York Stock Exchange requires that members of the audit committee be
independent and financially literate, and that at least one have accounting or
equivalent experience. The audit committee chairman should have this
experience and the leadership to insist on full and complete discussions.
These qualities should ensure a strong relationship with the audit partner, who,
though working with the management, must understand that his ultimate
responsibility is to the audit committee.
The second area for improvement is independence. The audit committee, along
with most of the board, must be independent. The NYSE provides a definition of
independence that, if complied with in spirit as well as letter, is sufficient.
Furthermore, the auditors must also be independent, with no unrevealed ties to
the company. While the Big Five have abandoned consulting, they continue to
provide other services. Accordingly, each audit committee should either restrict
its auditors to an audit role or publicly disclose the reasons for any other
relationship.
Auditors should be rotated every few years to prevent long-term, close ties
between the management and their firm. The audit committee should also
prohibit the management from hiring audit firm personnel for three years after the
person has left the firm. Meetings of the audit committee should start and end
with an executive session without the management, and the committee, as part
of these sessions, should meet alone with its auditors.
Last, information must be improved. The committee should be supplied with
information regarding alternative GAAP methods that would result in different
accounting outcomes and with figures outlining those differences. The reasons
for the committee's acceptance of the management's and the auditor's
recommendations should be disclosed in the financial statements.
The audit committee must also ensure that all analyst and press reports about
the company's accounting and disclosures are reviewed. Both the management
and the auditor should be required to address negative comments and the
committee should decide whether changes are necessary.
Audit committees are the board's vehicle to monitor financial reporting. However,
neither the audit committee nor the board is a guarantor and neither has an
obligation to ensure perfect accounting or disclosure. They must use reasonable
efforts to ensure management and auditors fulfill their obligations.
To accomplish this the audit committee must have the leadership, independence
and information to oversee the auditors and their relationship with the
management. Without them, the next Enron could be waiting just around the
corner.
HOUSTON -- Big companies and their outside auditors
often have close relationships, but few become as cozy
as the ties that developed between Enron Corp. and
Arthur AndersenLLP.
Questions are being raised about whether they were so
tight that they hindered Andersen from scrutinizing
Enron's books as thoroughly and independently as it
should have.
Indeed, the distinctions between the dozens upon
dozens of Andersen workers assigned to the Enron
account and Enron's own workers were so blurred that
many at the energy-trading company's headquarters
here couldn't tell the difference.
Andersen auditors and consultants were given
permanent office space at Enron headquarters here and
dressed business-casual like their Enron colleagues.
They shared in office birthdays, frequented lunchtime
parties in a nearby park and weekend fund-raisers for
charities. They even went on Enron employees' ski trips
to Beaver Creek, Colo. "People just thought they were
Enron employees," says Kevin Jolly, a former Enron
employee who worked in the accounting department.
"They walked and talked the same way."
Many Andersen accountants in Andersen's Houston
office, one of its biggest, eventually became Enron
employees as the energy-trading company sharply
increased its hiring of Andersen workers in the late
1990s. While other companies also hire talent from their
auditors, so relentless was Enron's hiring that Andersen
in the late 1990s grew uncomfortable and discussed
solutions, including capping the number of people who
could be hired, said a current Enron employee and a
former Enron employee.
Neither Andersen nor Enron will say how many
Andersen employees were hired away. An Andersen
spokesman declined to comment on such a cap, saying
only that "it's not an issue that is addressed in one of our
standard agreements" with a client. Enron spokesman
Mark Palmer says he was unaware of a cap.
See full coverage of Enron's downfall.
Andersen's close ties to Enron raise a conflict-of-interest
issue, says John Markese, president of the American
Association of Individual Investors. Noting that the
Andersen-Enron relationship evolved into an informal
alliance, an unusual arrangement for a Big Five
accounting firm to have with a client when it is supposed
to keep watch on the books, Mr. Markese notes, "All that
closeness goes a long way toward breaking down
barriers of independence."
Andersen, while conceding errors in judgment in its
handling of the Enron account, has defended its work,
saying that Enron in some cases didn't provide Andersen
auditors all the information they needed. Enron fired
Andersen last week, days after Andersen officials
disclosed that the firm's employees destroyed
documents related to Enron's financing arrangements.
Andersen has drawn fire for signing off on accounting
practices related to Enron's partnerships, which allowed
Enron to keep debt off its balance sheet and has made it
the subject of a federal investigation. Another problem,
critics say, is that auditors are reluctant to question their
big clients' books too much because they earn such
large fees, not just for the auditing work but for nonaudit
services, such as consulting.
Enron paid Andersen $27 million for nonaudit services,
including tax and consulting work, compared with $25
million for audit services, making Enron one of its biggest
clients. "We would marvel at the amounts of money we
were spending" with Andersen, says a former Enron
analyst, whose job was to streamline costs.
Also, documents show that Andersen executives
believed Enron's fees to the firm could eventually total
$100 million a year, which would have made the energy
trader Andersen's biggest client by far.
Ties between Enron and Arthur Andersen stretch back to
the late 1980s but became especially close in 1993 when
Enron hired the accounting firm to undertake its internal
audit. While that made some Enron employees uneasy,
they became even more troubled by the hiring of
Andersen employees, among them Richard Causey,
Enron's chief accounting officer, and Jeffrey McMahon,
the company's chief financial officer.
"It was like Arthur Andersen had people on the inside,"
says Judy Knepshield, formerly director of accounts
payable at Enron. "The lines became very fuzzy."
Andersen's Houston office, which employs some 1,400
people out of the firm's total of 85,000 world-wide, was a
sort of farm club for Enron. The Andersen employees
wore Enron golf shirts, former employees say, and
decorated their desks with Enron knick-knacks.
David Duncan, the Andersen partner in charge of the
Enron account, was a Texas A&M University graduate
and recruited heavily from A&M for Andersen's Houston
office. Many of the recruits landed jobs on the prestigious
Enron account and were often hired by Enron itself,
current and former employees say. In addition to
graduating from Texas A&M, Mr. Duncan sits on the
advisory council for the university's accounting
department. The tight-knit crowd of A&M graduates
"would take care of each other," says one former Enron
employee.
Mr. Duncan last week was fired by Andersen after
revelations that he directed the document shredding; Mr.
Duncan's attorneys have denied that he did anything
wrong.
Andersen ultimately became troubled by the number of
employees it was losing to Enron, Enron employees and
former employees say. When the company unveiled its
so-called new power project in 2000, for example, it hired
all 35 of the Andersen consultants who had helped
develop the model, former employees say.
But the hiring between Andersen and Enron worked both
ways. In 1993, when Andersen took over Enron's internal
audit operation, 40 people moved from the company's
payroll to Andersen. Also in the early 1990s Enron's
Thomas Chambers, the energy trader's vice president of
internal audit, left Enron to run the Andersen group
assigned to Enron's internal audit.
A former Andersen employee now at Enron says the
attitude was that rivals would handle an account of
Enron's size similarly, so there wasn't a reason to raise
issues. "Another auditor would have done the same thing
anyway," the employee says, "So what's the point of
losing all that money?"
2.1-Definition
In auditing profession "Auditor Independence" has traditionally no precise
definition and academic literature also seems very unclear (Altman, 1984).
Altman (1984) stated that both AICPA and SEC have neglected the necessary
attempts to provide precise definition of auditor independence and end up with
having lengthy rules.
Generally, independence issues are discussed by different parties such as
investors, scholars and regulators. They all have different objectives and
expectations which makes independence a debatable issue. Therefore, there
is no common acceptable definition of auditor independence exists in the
academic literature (Ketz, 2006).
Most definitions of auditor independence reflect the significance of
integrity (willingness to express truthful opinion) and objectivity (ability to
overcome biases) as the main feature of auditor independence (Dunmore and
Falk, 2001). Independence "in fact" (or actual independence) and "in
appearance" (or perceived independence) is two types of auditor independence.
Auditors ability to make objective and unbiased audit decisions and his/her
state of mind is defined as "actual independence". On the other hand
"Perceived independence" refers to the publics perception towards the audit
profession (Dykxhoorn and Sinning, 1982 cited in Bakar, Rahman and Rashid,
2005).
2.2-Importance of auditor independence
Auditors are believed to work on behalf of company shareholders in order to
ensure that financial statements are representing "true and fair" view
(Cosseratt, 2004). This is to ensure that the capital invested by the
shareholders is in the safe hands (i.e. not misused by the company directors
or management).
There is sufficient amount of academic literature available which emphasises
on the significance of auditor independence. For example, Bakar et al (2005)
stated that auditor independence is fundamental to the public confidence in
the auditing profession as well as in financial reporting. Similarly, Gul (1989)
stated that perceived independence has generated a sufficient amount of
debate and controversy and a source of much concern.
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The 21
st
century corporate frauds such as Enron (discussed later) and other
recent audit failures have highlighted the importance of auditor independence
as a global issue (Yang et al, 2003). These failures also raised the questions
about the quality of financial reporting (IAS, 2002). This has led audit
profession to look more closely in this problem and develop certain policies
and procedures, which in turn can minimise the potential for non
independence. Due to globalisation and economic development most of the
capital invested in companies is by the investors around the world. Therefore,
the assurance provided by the auditors about the reliability and credibility of
financial statements more useful to them for decision making (Bode, 2006).
2.3-Conflicts of interest
Donald et al (2002) have defined a conflict of interest as "a situation in which a
person has a private or personal interest sufficient to appear to influence the
objective exercise of his or her official duties as, say, a public official, an
employee, or a professional (p.68)". Many users of the financial statements
fears that financial information provided by the management is biased in
nature.
This apprehension gives rise to conflict of interests among these users and
management of the company (Cosserat, 2005). Therefore, the assurance
from independent auditors ensures different users groups that information is
neutral and not manipulated by the management.
Different researchers have identified different "Conflicts of Interest" and also
provided the recommendations to tackle this problem. Goldman and Barlev
(1974) identified three types of "Conflicts of Interest" that affects auditor
independence. These "Conflicts of Interest" pressurises auditors not to
produce audit report in accordance with developed professional standards
and code of ethics. Under "Audit-firm conflict", management and shareholders
both have similar interest, where both the parties want auditors not to disclose
any facts and evaluations concerning their wishes.
Because they think that these facts can affect future investment as well as
creditors decisions for loan grant. Under "Shareholders-Management conflict"
management tries to put pressure on auditors to produce a more favourable
report in order to impress shareholders. This is because shareholders
normally evaluate managements performance by looking at auditors report.
Finally, under "Self interest- Professional standard conflict" auditor may find
himself in a situation, where they may get any financial benefit by violating the
professional standards. This conflict of interest can also be seen in Enrons
case, where Arthur-Anderson (Enrons auditor) was paid $52m for conducting
audit and non-audit services, and with a fear of losing such a client Anderson
represented the facts as Enron was wanted them to do(The Economist, 2002,
Cited in Bakshi, (2004)).
OConnor (2006) stated that several attempts or reforms to reduce conflict of
interest and improve independence are still proven inconsistent. He
recommended that control of audit must be in the hands of shareholders
rather that audit committees. By implementing this action two benefits will be
achieved, firstly, reduction in audit cost and secondly, reducing the chances of
conflict of interest among different users.
Moore et al (2006) conducted research on US auditing system, in order to
identify the causes or factors that give rise to conflicts of interest. They used
two different theories, namely "moral seduction theory" and "issue cycle
theory" were stating different predictions. The "moral seduction theory"
predicts that the decision taken by the auditors are influenced by the social
and economic pressures, and "issue cycle theory" predicts that special
interest groups will undermine the audit industry reform efforts.
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They concluded that the recent reform efforts to improve audit quality in US
are insufficient because these efforts have failed to identify the underlying
conflicts of interest. Conversely, Nelson (2005) stated that it is important to
understand the affect of the reforms before implementing further changes.
He stated that the recent reforms are based on the probability that the clients
pressurises auditors and creates misstatement in the financial statement, and
are also based on the probability of audit detects the statement and auditors
resist pressure from their client. Therefore, identification and finding simple
solutions for factors giving rise to conflicts of interest is more important rather
than making new rules that complicating the whole system.
2.4 -Arguments against independence
Different authors have identified the different threats to auditor independence;
however there are commonly five threats to auditor independence are
identified. These are self-interest, self-review, advocacy, familiarity and
intimidation threat (Cosserat, 2004). Alleyne et al (2006) stated that auditors
are watch dogs for public and it is their responsibility to evaluate the
materiality and probability of each threat. "Having mutual interest" and "acting
in the capacity of the management" are two familiar concepts included in the
prior mentioned threats. Therefore, auditors must not favour their clients
interest and must not act as a managerial decision makers.
Hussey (1999) stated that growing importance to non-audit fees and
increasing competition among auditors are main factors affecting
independence. He has also mentioned Familiarity threat i.e. development of
informal relationships between company directors and auditors. He concluded
that Familiarity threat is present in both public and private companies.
Therefore, it is worthwhile to concentrate on selection and appointment
process and auditors term of office to ensure that threat is kept at minimum
level.
Recent professional and regulatory initiatives have been implemented
restricting non-audit services in US and elsewhere with a claim that these
services affect independence "in fact" as well as "in appearance" (Ruddock et
al, 2004). In academic literature, researchers have also concluded that how
non-audit services impair audit independence. For example, Ruddock et al
(2004) conducted research on non-audit services and earning conservatism in
order to see how much they impair auditor independence.
They concluded that independence "in fact" is less likely to improve with
recent legislature intervention restricting non-audit services; however it is
more likely that independence "in appearance" may be improved. Similarly,
Hay et al (2006) conducted research on 200 New Zealand companies in order
to see the level of non-audit services affecting independence.
They also found that level of non-audit fees might give indication of lack of
independence "in appearance" but independence "in fact" is not affected by
the level of non-audit fees. Therefore, there is sufficient evidence available in
academic literature which states that independence "in appearance" is
affected by the level of non-audit fees rather than independence "in fact".
Another factor which affects the auditor independence is the Size of the audit
firm. As stated by Nicholas and Smith (1983) that the larger the size of the
audit firm, the greater the auditors independence. The reason behind this
factor is that the large audits firms are capable of resist more pressure from
client as compare to small audit firm (cited in Bakar et al,2005).
On the other hand Goldman and Barglev (1974) states that competition
among large size audit firms can challenge this assumption audit firms ability
to resist pressure from clients. This point can be seen in Arthur Anderson and
Enron case (cited in Bakar et al,2005).
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Hemraj (2002) stated that it is the auditors responsibility to ensure that to
recognise the real and apparent threat in order to retain independence. Some
of the threats he identified were being indebted, receiving recurring fee,
accepting directorship or owning shares, accepting goods and services from
client Company.
The academic literature is full of researches conducted on identification of
potential threats affecting independence. However, it is also full of researches
conducted on explaining different ways of safeguarding auditor independence.
As stated by Moizer (1997) that there are some existing and suggestive ways
also persist in order to improve auditor independence. The following section
highlights some of the ways recommended by different researchers to
improve independence.
2.5-Argument for independence
There are certain statutory provisions exist in order to safeguard the auditor
independence such as the Company Act 1985 in the UK (Dunn, 1996).
However, over the years different recommendations have been re-issued
such as audit-rotation, peer-review, prohibition of other services, audit
committees and Company law reform (Byrne, 2001). There is a common
perception that mandatory audit rotation is helpful in improving independence.
For example, Bakshi (2004) stated that the most obvious advantage is that
auditors would be less vulnerable to managements pressure because they
would know that they will be replaced after certain time period. As a result,
this will improve independence along with reduction auditor-management
conflict of interest.
This perception has been criticised by many researchers over different
periods. For example:
Church and Yhang (2006) compared the benefits of a system which require
audit rotation to one that does not. They concluded that overall benefit is very
sensitive to the cost associated with biased report, start up cost, rotation
period and time span. On the other hand it can only be achieved if start-up
and biased report cost is high, the rotation period is long. Jackson et al (2008)
also stated that mandatory audit firm rotation will not improve audit quality.
This is because cost on both auditor and the client, rotation cost, cost related
to early stages of auditor client relationship. They also concluded that rather
than mandatory audit firm rotation other initiatives are more likely to have
greater impact. In 2003, a survey was carried out by Accountancy age where
all major auditing firms in the UK were against the idea of audit rotation
(Accountancy age, 2003). However, currently in the UK, under APBs Ethical
Standard ES (3), no one should serve as engagement partner on the audit of
a listed company for more than five years.
One further suggestion is peer review where audit work done by one audit
firm is reviewed by another audit firm in order to ensure the audit quality
(Moizer, 1997). Russell and Armitage, (2006) stated that this is the
professions responsibility to make peer review disciplinary rather than
educational and corrective. The standard should also contain the penalties in
order to provide benefits to the entire profession.
Regulators and stakeholders worldwide have recognised the non-audit
services as potential threat to auditor independence (Sori & Karbdhari, 2005).
Researchers have also proved that non-audit services (see; Ruddock et al,
2004 & Hay et al, 2006) impair independence in appearance. Therefore,
regulators in USA (under SOX) and elsewhere have put restriction on auditors
to carry out non-audit services. Bakshi (2004) claimed that this prohibition on
services will not only safeguard independence but it will also reduce the
problems associated with conflicts of interest.
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Bakshi (2004) stated that in some cases such as banks and other non-profit
organisations, appointment of auditors is decided by the independent
authorities. Similar procedures can also be adopted for the companies listed
on the stock market. Auditing and accounting standards are also useful for
auditor independence when prescribed procedure is followed under similar
circumstances.
Another recommended method to safeguard independence is the formation of
audit committees by the regulators worldwide. Sufficient amount of research
has also been conducted in order to see affect of audit committee on auditor
independence. For example, Sori et al (2007) revealed that the activities such
as audit committee meetings, report in annual report and determining audit
have great amount of affect on auditor independence.
Similarly, in another paper on Malaysian capital market, Sori and Karbhari
(2006) concluded that presence of active audit committee is successful in
maintaining or improving independence. This gives a clear cut indication that
stakeholders have faith in the audit committees which as a result enhance
communication between management and auditors. The following section
discusses why and how the recent corporate failures make the auditor
independence issue more debatable in current corporate world scenario.
2.6-Recent corporate failures affecting auditor independence
Certain corporate failures and scandals such as Energy giant Enron,
WorldCom and Parmalat further heated up the issue related to auditor
independence. Enron was the American energy giant formed in mid 1980s
and was the seventh largest in the USA in terms of revenue (Elliott & Elliott,
2007). Enrons disastrous diversification strategy was failed to generate
revenue or recover the money invested in projects such as water,
telecommunication and energy.
Therefore, in order to generate billions of dollars, Enron employed series of
schemes to manipulate the financial statements (Kroger, 2004). During that
period questions were also raised on the integrity and independence of
Enrons audit firm Arthur-Anderson. In a speech Andersons CEO said that
"faith in our firm and in the integrity of the capital market has been shaken"
(page, n.d.). He admitted that his firm was involved in the honest errors (i.e.
known errors) in the financial statements (Hermes, n.d.).
Enron exploited the loophole in the US GAAP i.e. revenue recognition under
Statement of Financial accounting Concept (SFAC) 5. This concept states that
revenue should not be recognised until it is earned or realised. By virtue of
this loophole Enron reported $23.4m of profit in a deal with Quaker Oats and
including revenue of $110m in financial statements even before the trading
began (Greer and Tonge, 2006).
Bazerman et al (2002) stated that biasness is normally present where
relationships with the client have been formed and scope of decision making
exist (Cited in Greer and Tonge, 2006). In this case auditors will make
judgement with the approval of client, hence affecting their integrity and
independence (i.e. Arthur-Anderson).
Similar scandal also occurred in EU i.e. Parmalat in Italy where $4.7bn hole
was found in their annual accounts. Many were held responsible for this
including auditors such as Grant Thornton International and Deloitte. It was
argued that Deloitte was failed to determine that 38% of Parmalats assets
were held in a fictitious account (Greer and Tonge, 2006).
Because of these scandals many changes have been implemented by the
regulatory bodies around the world mainly in the UK and USA. The following
section will provide the auditing regulation in the UK and USA with relation to
auditor independence. However, the detailed reforms in both countries will be
discussed in next chapters.
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2.7-Regulatory authorities in UK and USA
In the UK, audit profession regulation includes provisions to govern auditor
independence. These provisions are contained in Company act 1985, Auditing
standards and Guidelines in order to strengthen the appearance of
independence (Dunn 1996). Under the Companies Act 1985 auditor have the
right to access companies books of accounts during the course of audit
(Vanasco et al, 1997). Furthermore over the years amendments have also
been made in Company Act 2006 with relation to auditors rights and
responsibilities (Morse, 2007).
Auditing Practices board (APB) has issued certain Ethical Standards which
deals with the matters related to auditor independence. These Ethical
Standards are compiled with the EUs European Commission
Recommendation (Morse, 2007). These Ethical Standards are not part of the
regulation but these are necessary for the auditors when doing the audit work
and are based on the integrity, objectivity and independence of the auditors
(ICAEW, 2008).
On the other hand US have rule-based approach towards auditor
independence. There are three main regulatory bodies in US are The
American Institute of Certified Public Accountants (AICPA), The Public
Company accounting Oversight Board (PCAOB) and The US Securities and
Exchange Commission,(SEC).
The AICPA is responsible for issuing codes of professional conduct and
Ethics ruling on independence (ICAEW, 2008). The SEC rules have replaced
the old functions of ISB and created new rules on auditor independence.
The Sarbanes Oxley Act 2002 created the PCAOB which is responsible to
oversee auditors action to protect the interest of investors and public (ICAEW,
2008). Vasacco (1997) stated that USA and UK independence standards are
the same; however one major difference related to independence is that in the
UK auditors are allowed to perform certain book-keeping functions. The
following section gives the overview changes made in both countries after
Enron failure. However, these changes are discussed in detail in the
upcoming chapters.
2.8-Post-Enron reform in the UK
Following the Enron collapse the Co-operative Group of Audit and accounting
(CGAA) was set up by UK Government in 2002. During that period auditor
independence frameworks adequacy was the key concern for the CGAA.
Fearnley and Beattie (2004) stated that the APBs responsibilities were
extended with relation to auditor independence i.e. they are now responsible
for setting up auditor independence standards.
Furthermore, in order to manage the relationship between company and the
auditors, audit committees need to play a leading role. Fearnley and Hines
(2003) stated that the main change with relation to audit rotation was also
implemented. These were the key partner should rotate every seven years
and engagement partners should rotate every five years. UK is already ahead
in matters related to auditor independence as compare to other European
Countries.
This can be seen in the EU Eighth Directive principle, under which audit firm
or statutory auditors must not make any decisions on behalf of their client and
must be independent. Whereas UK has already established principles and
rules, and ethics in order to tackle this issues (Downes, 2006).
2.9-Post-Enron reform in the US
Similarly in the US Sarbanes Oxley Act (SOX) was passed by the US
Congress with an aim to regulate the governance of firms. Cohen et al (2007)
stated that the prime reason of SOX was to reinstate investors confidence in
capital markets after the Enron collapse. In SOX sections 201-209 deals with
the issues related to auditor independence (Moeller, 2005). Along with the
intended benefits, however, SOX is criticised by many authors.
For example, Ribstein (2005) stated that future corporate scandals may not be
prevented by implementing SOX (cited in Cohen et al 2007). In their research
on economic consequences of SOX, Cohen et al (2007) found that after SOX
value of the option grant is decreased as compare to the increased salary and
bonus compensation. This shows that firms are shifted to bonus awards
policies resulting in lesser incentive compensation for CEOs.
Tackett et al (2004) conducted research on SOXs ability to reduce the
chances of audit failure in public listed companies. They concluded that
provisions such as increased criminal penalties and restriction on audit-client
consultation are helpful to reduce the chances of audit failure. On the other
hand provisions such as mandatory use of audit committees and creation of
PCAOB are less likely to reduce the chances of audit failure.
This is because of any hidden biasness and operational shortcomings entail in
these provisions. Many believe that the impact of SOX can also be seen in
other countries too. For example, Herz and Gurr (2006) found that this US
legislation is affecting financial reporting in South East Asian countries. They
concluded that SOX in these countries appears to be a mechanism. This is
resulting in worldwide reform movements towards increased corporate
responsibility and improved financial reporting.


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