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.ChangesSince 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 Email Print ShareIn an
opinion piece in theFinancial Times, Harvard Business School
professorJay Lorschargues for legislation to create an independent,
self-regulatory organization to oversee accounting firms. Enron, he
says, is not an isolated incident.byJay LorschIf 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 LORSCHThis 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
betweenEnronCorp.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-DefinitionIn
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 independenceAuditors 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.You can get expert help with your essays
right now. Find out more...The 21stcentury 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 interestDonald 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.Find out how our expert essay writers can
help you with your work...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 independenceDifferent
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).You can
get expert help with your essays right now. Find out more...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
independenceThere 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.Find out how our expert essay
writers can help you with your work...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
independenceCertain 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.You can get expert help with your essays right now. Find
out more...2.7-Regulatory authorities in UK and USAIn 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 UKFollowing 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 USSimilarly 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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