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Arthur Anderson, LLP Case: An Accounting Firm in Crisis

Group 1 for WBC, Vinod Gupta School of Management, IIT Kharagpur

Highlights  Emergence of Arthur Andersen as one of the leading auditing and

consulting firms in the world and a member of the elite “Big Five” Accounting Firms.  The unethical practices of Andersen in the 1990s and deterioration in

the firm's culture hampered its reputation as an independent auditor.  Arthur Andersen's role in accounting fraud at Enron, one of its major

clients.  Criminal charges faced by the firm in the Enron case and how the

Enron case eventually led to the closure of Andersen.

Issues at hand ď‚— Evolution of a large organization on the basis of integrity and

adherence to professional standards. ď‚— The importance of ethics, integrity and professional standards

in the audit business. The need to balance economic and social benefits in corporate decision making

History of Arthur Anderson  The firm of Arthur Andersen was founded in 1913 by Arthur 

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Andersen. During the depression in US in late 1920s, many investors lost faith in companies. Arthur Andersen was instrumental in restoring the faith of US investors in companies based on its integrity and high professional values. In 1979, Arthur Andersen became the world’s largest professional services firm. In 1990s, the firm established itself as a member of the elite “Big Five”Accounting Firms. As of January 2002, Arthur Anderson existed as a private partnership employing approximately 85,000 people and earning nearly $10 Billion in annual revenue.

Early Years: Values of Arthur Anderson  Importance to ethical values and insisted on honest accounting and the  

elimination of conflicts of interest in accounting the firms. Focused on creating a firm with its own set of business standards. Imparted rigorous training to all new recruits to help new recruits imbibe the Arthur Andersen culture, popularly known as the 'Andersen Way. All Arthur Andersen clients across the world received the same quality of work, the same kind of approach to work, and the same caliber people trained in the same way. Leonard Spacek, who succeeded Andersen, continued this emphasis on honesty. For many years, Andersen's motto was "Think straight, talk straight.“ The culture of ethics and honesty was so deeply ingrained that the firm was elected to the Accounting Hall of Fame of Ohio State University in 1953.

Arthur Andersen in 1980s & 1990s  By the 1980s, standards throughout the accounting industry fell as

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firms struggled to balance their commitment to auditing against the desire to grow their flourishing consultancy practices. Andersen established a reputation for IT consultancy in the 1980s. The bulk of its revenues were derived from consulting. Looked out for opportunities for consulting fees from existing audit clients. By the late-1990s, Andersen had succeeded in tripling the pershare revenues of its partners. Andersen struggled to balance the need to maintain its faithfulness to accounting standards with its clients' desire to maximize profits, particularly in the era of quarterly earnings reports.

Who is Enron?  Enron Cooperation was established in1985 as a transporter of natural     

resources through an integrated pipeline network. Seeing the potential profits of hedging activities, the company soon abandoned its traditional business for energy trading. In the 1990s, the CFTC granted Enron permission to run a largely unregulated energy trading business. The firm quickly dominated the industry and became well known among members of the financial and political summary. Enron convinced Congress to exempt them from the regulation of the CFTC and the Securities and Exchange Commission. Enron feared regulation because the company had become a publicly traded hedge fund making its own highly speculative investments.

Relationship-Anderson & Enron  Anderson began auditing Enron in 1985.  Both got close as Enron regularly hired Anderson auditors,

even for positions like CFO & Chief Accountant.  Anderson established permanent office space in Enron’s headquarter.  Anderson took over internal audit function of Enron in 1993 and hired 40 Enron’s employees.  Enron became one of the Anderson’s largest clients with fees over $52 million in 2001.

Anderson-Auditor & Consultant for Enron  Enron was the 2nd largest revenue producer for Anderson.  Half of the fees was earned from performance of consulting

services.  This raised questions about Anderson’s independence in auditing Enron.  During 2000, SEC attempted to force accounting firms to separate their consulting and auditing practices to eliminate possible conflicts of interest.  This was protested by all the Big Five accounting firms.

David Duncan ď‚— David Duncan was the lead partner at Enron. ď‚— As a partner at Anderson, the fees that he personally

generated greatly influenced his compensation.

Anderson’s Audit Failures  Anderson faced audit failures, a few rising from the

company’s largest clients.  Sunbeam, Waste Management, Baptist Foundation of Arizona were few of the failures.  The resulting financial restatement of these failures weighed heavily on the firm’s pocketbook and even more on the firm’s reputation within SEC as an independent auditor.

Development of Crisis in Anderson 2001 Annual Retention Meeting  Anderson was aware of serious risks involved in the audit of Enron.  An Anderson memo dated February 6th, 2001 outlined the discussion of 

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Anderson executives regarding the retention of Enron as a client. Enron’s private partnerships involving related party transactions allowed Enron to keep the partnership losses off of its books, due to loop hole in accounting standards. For the same reason, if partnership incurred any debt, it was not shown on Enron’s balance sheet. Enron also had possible conflict of interest arising from CFO Andrew Fastow’s control of several of these partnerships and the compensation he received from them. Despite issues, Anderson concluded that the financial statement of Enron was presented fairly for 2000.

Enron Restates Earnings  In October 2001, Enron announced its third-quarter results for 2001.

The third-quarter results included a loss of $638 million, a $35 million write-down due to losses on its partnerships, and a decrease in shareholder's equity by $1.2 billion.  This announcement led to a sharp decline in the stock price of Enron (40%). Following this, suspecting Enron of financial misappropriations, the SEC launched an investigation into Enron's financial dealings in late October. The investigation revealed serious accounting misappropriations by Enron between 1996 and 2001.  In November 2001, Enron restated its financial statements for the years, 1997 to 2000 and for the first two quarters of 2001, and reported a loss of $586 million for that period. According to reports, Enron had huge accumulated debts on account of its dubious financial dealings with its partners and had even traded its shareholders' equity...  On December 2, 2001, Enron filed for Chapter 11 bankruptcy after Dynegy terminated the merger on November 28, 2001.

 October 12, 2001: A day after SEC

announcement, David Duncan called an urgent meeting to organize the expedited effort to destroy Enron-related documents. January 10, 2002: Anderson CEO admitted that the firm destroyed documents relating to the Enron audit. January 15, 2002: Anderson partner, David Duncan was fired by the firm and 3 other partners at the Houston office were placed on leave. In March 2002, Arthur Andersen, was indicted by the US Department of Justice on charges of obstructing the course of justice in the Enron case. Despite the auditor’s attempts to salvage its relationship with Enron, Anderson was officially released of its duties on January 17, 2002.

They [Andersen] can never clear their name. In the court of public opinion, they have been tried, convicted and hanged. After WorldCom, there was just nothing you could say." - Lynn Turner, Former Chief Accountant, SEC (US)

Aftermath 1/2  In August 2002, Andersen Worldwide, the parent company of the

US-based Andersen, agreed to pay claims worth $60 million to Enron shareholders and creditors (against claims of over $25 billion).

 Andersen Worldwide stated that it was not responsible for

Andersen (US) that operated as an independent division.

 In October 2002, Andersen received the DOJ verdict: the firm was

given the maximum court sentence (in such cases) of five years probation on its US operations and a $500,000 fine for altering evidence of its Enron work...

Aftermath 2/2 Many partners formed new companies or were acquired by other consulting firms. Examples include:  MarketSphere Consulting

 SMART Business Advisory and Consulting  Perot Systems  Huron Consulting

 Protiviti  True Partners Consulting  Navigant Consulting

 WTAS, LLC (Wealth and Tax Advisory Services, LLC)

Anderson in 2010  Andersen has not returned as a viable business even on a limited scale.  There are over 100 civil suits pending against the firm related to its

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audits. Its reputation was so badly tarnished that no company wanted Andersen's name on an audit. It began winding down its American operations after the indictment, and many of its accountants left to join other firms. The firm sold most of its American operations to KPMG, Deloitte & Touché, Ernst &Young and GrantThornton LLP. From a high of 28,000 employees in the US and 85,000 worldwide, the firm is now down to around 200 based primarily in Chicago. Most of their attention is on handling the lawsuits and presiding over the orderly dissolution of the company. Arthur Andersen LLP has not been formally dissolved nor has it declared bankruptcy. Ownership of the partnership has been ceded to four limited liability corporations named Omega Management I through IV.

The Debate on the Role of Auditors ď‚— In 1990s, the audit firms tended to become business consulting

firms which also did auditing. This shift in focus from auditing to consulting had a negative impact on the business of audit firms.

ď‚— As most of the audit firms were partnership firms, they lacked the

leadership necessary for coping with rapid growth. The partnership model did not suit the expanding consulting business model. It resulted in a lack of proper span of control as all partners had equal control over the firm. This in return resulted in lack of effective communication channels that led to huge gaps in communication between the partners working on various projects.

Arthur Andersen, LLP: An Accounting Firm in Crisis  

Case Study: Arthur Andersen, LLP: An Accounting Firm in Crisis

Arthur Andersen, LLP: An Accounting Firm in Crisis  

Case Study: Arthur Andersen, LLP: An Accounting Firm in Crisis