Audit Failures – Arthur Andersen
A report written for Mark Billings, Brenda Porter and those interested in the failure of one of the largest firms
of the 20th century.
UNIVERSITY OF EXETER
April 30, 2012
Authored by: Daniel Biles, 600026422
Executive Summary
In a small report such as this one, it is impossible to cover all of the reasons why Arthur
Andersen LLP failed in its duties to the public and ceased to be the largest of the ‘Big 5’
accounting firms. Here, the practice of document shredding is examined with reference to the
collapse of Enron in particular. The loss of independence due to a rapid expansion and
increase in services is suggested to be a factor, as well as the deterioration of the business
culture in general.
Contents
1. Introduction……………………………………………………….………………….2
2. Audit Failures………………………………………………………………………...2
2.1 Document Shredding…………………………………………………...………….2
2.2 Priorities – Keeping Clients vs. Independence……………………………..…….3
2.3 Business Culture……………………………………………………………….…..4
3. Conclusion…………………………………………………………………………….5
4. References…………………………………………………………………………….6
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“We believe in integrity, respect and always speaking as one firm. We believe in maintaining
a passion for excellence in people, service and innovation. And we believe in demonstrating a
commitment to personal growth through training and development. In fact, these values are
minimum standards for anyone within our organization. Each has roots in the thinking of
Arthur Andersen himself. And each guides us toward a brighter future ahead.” Arthur
Andersen LLP value statement (pre 2002) [1] [2]
1. Introduction
Arthur Andersen LLP (AA) was once known as a company whose core, most important value
was integrity. Arthur Andersen himself only stood for the highest of standards, strongly
believing that his sole responsibility was ensuring investors received accurate information. In
later years, it seems that this integrity and focus was replaced by a need to please corporate
management, to ensure that AA’s lucrative services (including non-audit services) were
retained by satisfied companies with high (reported) profits.
As a result of this loss of independence (and with hindsight, fairly predictably) AA was
accused of undertaking fraudulent audit services for companies such as WorldCom, Enron,
Sunbeam-Oster, Waste Management Inc, amongst others. AA was seen as a company ‘too
big to fail,’ it was one of the ‘Big 5’ accounting firms, yet these accusations proved to be the
catalyst for huge changes to the audit profession and inescapable repercussions for AA. This
report will look at how and why these practices were performed, undetected, for so many
years and for so many companies.
2. Audit Failures
2.1. Document Shredding
Before the collapse of Enron, there were clear indications of impending trouble, and when the
Securities and Exchange Commission (SEC) began an informal investigation, Dave Duncan
(the engagement partner for Enron) was reminded of AA’s new document handling policy.
(This policy allowed ‘secondary’ documentation to be destroyed, i.e. anything not supporting
the audit opinion, in case of impending litigation. It had been created a year and a half
previously and, according to various documentaries and reports, was used on a smaller scale
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in other cases such as Sunbeam-Oster).[3] In the Enron case, AA continued destroying
documents even after the SEC had requested accounting records for Enron, and only ceased
this practice after a subpoena was issued. Before the subpoena, almost two tons of paper was
destroyed, along with 30,000 emails and computer files. This document shredding was a
significant factor in AA’s subsequent indictment for ‘obstructing an official proceeding of the
SEC.’ [4]
In the UK now, ‘ISA 230: Audit Documentation’ requires adequate documentation to provide
evidence of the audit opinion and reasons for it, and that the audit was conducted in
accordance with ISA’s and relevant laws/regulations. As a direct response to AA’s practices,
ISA 230 also includes a section requiring a timely (within 60 days) assembly of the final
audit file (a process involving the deletion of redundant documentation, documenting any
relevant information not already recorded and signed off on completion checklists etc.). After
this the auditor is not permitted to get rid of any documentation before the applicable
retention period (usually 6 years). [5]Also the Sarbanes-Oxley Act enabled punishment of
anyone who alters, destroys, conceals etc. any document with the intent to influence any
investigation.
Clearly, the shredding of documents at AA has had lasting effects on the audit profession and
there has been no notable repeat, largely due to the new regulations enacted. Whilst there was
no specific law preventing the destruction of these ‘secondary’ documents, it has been
suggested that in the Enron case, the SEC investigation was foreseeable and therefore the
document shredding was against the law. However, foreseeable or not, such a large scale
operation should surely have sent alarm bells ringing much earlier than it did.
2.2 Priorities – Keeping Clients vs. Independence
Auditors are required to be objective (offering opinions without bias, compromise and
conflicts of interest) and independent, both in mind (acting with integrity, objectivity and
scepticism) and in appearance (where a reasonably informed third party would not conclude
that independence has been compromised). As stated previously, Arthur Andersen would not
tolerate a compromise of his high standards of independence. Soon after AA’s formation, he
refused to sign off on a large rail company’s incorrect accounts, despite the possibility of
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losing a major client, and this is what is expected from all auditors in similar situations.
[6]
However, with the expansion of the business, and increasing pressure on generating
revenue, the main objective switched to making sure that clients (and more importantly,
revenue) were retained. Clients scared of the repercussions of losing an auditor, such as a
poor reputation and falling stock price, experienced a shift to an environment where they
could dictate their needs to auditors who were scared of losing their custom.
Independence may have been compromised by the offering of non-audit services. However,
this dual role of an auditor compromises independence in 4 ways. Firstly, a self-interest threat
may arise due to the high non-audit fees, and the auditor’s reluctance to lose the client. A
self-review threat may also arise if the auditor audits, for example, an internal control system
which they had consulted on. A management threat arises if the auditor makes decisions on
behalf of the management, and can cast doubt over the distinction between client and auditor.
Finally, an advocacy threat could arise as the auditor supports the client’s views/position.
[5]
At AA, the most prominent seemed to be the self-interest threat, as a result of top
management requiring revenue as a bottom line performance measure. Until 1989, the
Andersen Consulting arm of the business (now Accenture) contributed 40% of AA’s revenue.
The Sarbanes-Oxley Act, as a consequence, specified prohibited practices to restrict the nonaudit fees received by firms.
2.3 Business Culture
AA’s value statement claimed that the heart of the business was integrity, as its founder had
wanted. However, before its ‘near death,’ the culture of the business seemed to have
completely changed. Starting with recruitment, the focus was seemingly on graduates who
would adapt to and follow the rules, rather than those who would challenge what they thought
was wrong. [3] [6]
Rather than for personal and professional development, training was seen as a way to ensure
everyone conformed to the same approach (a fair motive for a company with good business
practices as AA once had, but in this case, as has been highlighted, this may have just turned
into the blind following of poor instructions).
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In most large businesses, employees are able to thrive in a competitive atmosphere, ensuring
everyone is performing at a high standard. At AA, it has been suggested that social
psychological theories (including obedience under authority and loss of identity in crowds)
may have had an influence on employee behaviour. [7] [8]Would these employees have
mindlessly signed off on clearly misleading statements, or commenced shredding countless
working papers, if they were willing to challenge their management, or if they had to make
the decision themselves? In this sense, the ‘speak as one firm’ part of the value statement was
satisfied, in a twisted and unintended way. Perhaps a minority believed in what was
happening, but it would be extremely disturbing if everyone at AA thought what was
happening was right for the business, the shareholders and stakeholders of the companies
who they were supposed to protect.
3. Conclusion
The above value statement has a clear focus on being trustworthy, providing excellent
service, developing employees and following the ideals of Arthur Andersen. Strangely it
could be argued that most of these had been worked towards. There was certainly a view
from the outside of integrity, of respect, and the firm did speak as one. The service was seen
as top quality, resulting in AA becoming the largest of the Big Five. Training was seen as
essential, and employees were forced to move ‘up or out.’ This was how the picture was
painted to the outside, and with a thin layer of truth, no-one dug deeper to find the mess
behind. Arthur Andersen’s key ideas were represented, but they were blurred, and perhaps an
afterthought to the desire to be competitive, to keep clients happy, and to create revenue for a
ship that was, supposedly, too big to sink.
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4. References
[5]
Porter, B. Simon, J. Hatherly, D. (2008) Principles of External Auditing, 3rd edition,
Chichester: John Wiley & Sons, Ltd.
[1]
Waygood, T. Bringing Values to Life. Available:
www.dixeyhenderson.com/downloads/motivaction.pdf. [23 Mar 2012]
[2]
Lemanski, T. (2011) The Role of Core Values in Business Strategy and Leadership.
Available: www.vista-development.com/ws/core_values.htm. [23 Mar 2012]
[4]
Kinsler, J. (2008) Arthur Andersen and the Temple of Doom. Available:
www.swlaw.edu/pdfs/lr/37_1kinsler.pdf. [29 Mar 2012]
[3]
Squires, S. Smith, C. McDougall, L. Yeack, W. (2003) Inside Arthur Andersen: Shifting
Values, Unexpected Consequences. Financial Times (Prentice Hall)
[6]
Vaz, B. Arthur Andersen - The Giant’s Fall. Available: www
bcvaz.in/vision/arthur_andersen.htm. [4 Apr 2012]
[7]
WUSTL. (2003) Deep psychological contracts formed between employees and employers
can result in acts of revenge, ‘crimes of obedience.’ Available:
news.wustl.edu/news/Pages/114.aspx [5 Apr 2012]
[8]
Buttross, T. Schmelzle, G. Rao, H. (2011) Ethical Decision Making by Management
Accountants: An Empirical Examination of Obedience Theory. Available:
papers.ssrn.com/sol3/papers.cfm?abstract_id=1787613 [5 Apr 2012]
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