ENRON’S TENTH ANNIVERSARY: ARTHUR ANDERSEN’S AUDIT FAILURES AT ENRON AND ELSEWHERE

Arthur Andersen was not a hapless bystander when Enron’s managers committed their accounting frauds, nor was it a duped auditor, nor an innocent victim of the media.  Perhaps it was a scapegoat as all the large firms have engaged in audits of less than stellar quality, but that does not excuse its poor performance at Enron.  In this essay we explore audit failures by Arthur Andersen not only at Enron but also at other business entities during this time period.

 In the previous column we explored the “Context for Andersen’s Audit Failures” by describing the immense changes in the accounting profession during the decade or so prior to Enron’s collapse.  Several large accounting firms merged, giving them various efficiencies; however, these combinations also led to a high level of concentration, which the government might interpret as “too few to have one fail.”  Firm leaders were sellers of services rather than accounting experts.  Firm objectives, as seen in the objectives of the AICPA, overemphasized consulting at the peril of neglecting audit responsibilities.  Ironically, this period also witnessed an attack on independence, previously thought to be the bedrock of the profession.  The decade also brought about litigation reform that decreased the risks and the amounts of litigation against accounting firms, but the firms responded by increasing the risks of audit failures.  The consequence was more efficient but less effective audits.

 Arthur Andersen was an active participant in these events and so it is not surprising that it encountered several audit failures, some of which were spectacular.  Audit failures occurred, for example, at Boston Chicken, Arizona Baptist Foundation, Sunbeam, Waste Management, Global Crossing, Enron, and WorldCom.  Can one firm have so many failures and lack responsibility for their audits?  Let’s explore in more detail some of these audits and then answer the question.

 Boston Chicken

 We discussed of the accounting shenanigans at Boston Chicken in “The Context for [Enron’s] Accounting Crimes.”  Basically the firm manipulated its investment accounting for subsidiaries by obtaining a call option on them.  When the income statement revealed profits, Boston Chicken would exercise the call and start using the equity method.  But, Boston Chicken should have used the equity method from the beginning as the call gave it significant influence over the franchisees.

 As usually happens when the stock price plummets, investors sue the auditor.  Andersen paid $10.3 million to settle one suit by investors; see “Andersen, Underwriters, Agree to Pay $19.4 in Boston Chicken Debacle”

 Arizona Baptist Foundation

 Arthur Andersen also was the auditor of Arizona Baptist Foundation.  In this case, those who ran the foundation actually were operating a complex Ponzi scheme.  Unfortunately, Andersen auditors did not discover the scheme and the investors lost virtually everything.

 Here too it is not surprising that investors sued Andersen.  Among other things, the plaintiff complained that Andersen partners ignored a whistle blower who alleged the existence of hug real estate losses.  Andersen agreed to pay $217 million (“Andersen Reaches Settlement in Baptist Foundation Lawsuit” ).

 Sunbeam

 We cataloged some of the crimes by Al Dunlop, then CEO of Sunbeam, in “The Context for [Enron’s] Accounting Crimes.”   Essentially, the firm engaged in aggressive revenue recognition via its bill and hold program.  It also falsely raised its reserves, thereby decreasing the associated expenses.

 In this case, the SEC finally gets involved and points its finger at the auditing firm.  In Administrative Proceeding 3-11020, the SEC complained about the auditing and imposed remedial sanctions against Philip Harlow, the Andersen engagement partner.  The SEC said that he “failed to exercise professional skepticism when performing” the audit.  The SEC further stated that he did not exercise due care and dismissed certain risks that he should have known were material—some involved excessive restructuring reserves and some the aggressive revenue recognition by Sunbeam.  Finally, the SEC alleged that “Harlow failed to obtain sufficient competent evidential matter” for which to issue an opinion.  In short, Mr. Harlow “engaged in ‘improper professional conduct.’”

 The SEC would not allow Harlow to appear before them as an accountant, though he could request reinstatement after three years.  One wonders whether the sanctions were significant; certainly, they failed to deter other Andersen partners from underauditing their clients.

 Waste Management

 Managers at Waste Management understated depreciation charges, refused to write down losses at landfills, and used business combination accounting inappropriately.  Details can be found at “The Context for [Enron’s] Accounting Crimes.”

 Arthur Andersen stumbled upon the accounting fraud, but did not reveal it to the board of directors or anybody else; instead, Arthur Andersen helped managers to cover it up.  See “Arthur Andersen LLP and Three Partners Settle Civil Injunctive Action.”  Also see the related Administrative Proceeding No. 3-10513.

 Specifically, Arthur Andersen and partners Robert E. Allgyer, Edward G. Maier, Walter Cercavschi, and Robert G. Kutsenda made a deal with Waste Management.  Arthur Andersen would not publicize the fraud if mangers at Waste Management agreed to amortize its ill-gained profits over a ten-year period.  Waste Management agreed to the deal, but reneged.

 In the June 19, 2001 Administrative Proceeding, the SEC excoriated the auditors: “Andersen knowingly or recklessly issued false and misleading unqualified audit reports.”  The SEC fined the firm $7 million and permanently enjoined Andersen from violating Section 10(b) of the Securities Exchange Act.  The firm consented, of course without admitting anything.  Unfortunately, the firm’s audit of Enron became suspect during the fall of 2001, just a few months after agreeing to the permanent injunction due to the Waste Management fiasco.  This chain of events put the firm under the SEC’s spotlight for violation of the consent decree.

 Enron

 The engagement partner on the Enron audit was David B. Duncan.  The SEC found the audit deficient, as explained in Litigation Release No. 20441 and in the associated complaint SEC v. Duncan.  The SEC also brought action against three other partners of Arthur Andersen: Thomas H. Bauer as see in Administrative Proceeding 3-12939; Michael Lowther, Administrative Proceeding 3-12938; and Michael Odom Administrative Proceeding 3-12937.

 The SEC begins by noting that Duncan himself noted the high audit risks in Enron due to their aggressive accounting and a culture of meeting earnings forecasts in any way possible.  Yet the SEC concluded that the Andersen audit did not implement procedures consonant with Enron’s level of audit risk.

 Enron’s prepay transactions obscured the level of debt held by Enron and it misclassified financing cash flows as operating cash flows.  The SEC stated that Duncan did not properly audit these prepay transactions and that the firm did not obtain sufficient evidential matter to determine whether Enron followed GAAP.  Nor did the firm recognize the inadequacy of the disclosure surrounding these transactions.

 The SEC also focuses on Project Nahanni, a transaction it says had no economic substance.  Project Nahanni was designed to give Citigroup a majority interest and Enron a minority interest in a subsidiary called Margengo.  The economics of this transaction was Citigroup’s loaning money to Enron, but Enron treated this as an intercompany item and did not report this debt on the consolidated balance sheet.  The SEC concluded that the transaction was not properly audited; indeed, that Duncan and the Andersen team did not exercise professional skepticism when examining this transaction.

 The Raptors were SPEs employed by Enron in various hedging transactions; however, these hedges were protected only by Enron’s own stock, thus they were not true hedges.  The SEC says the unusual nature of these transactions should have been a red flag to Arthur Andersen and again accused Duncan of not exercising due professional care or having sufficient professional skepticism.

 Putting these concerns together, the SEC said the audit report was deficient.  Further, it claimed that Duncan was reckless by signing the audit report.

 Thomas Bauer was chastised because of the JEDI/Chewco transaction.  JEDI was a limited partner that should have been consolidated with the operations of Enron but was not.  Chewco was an SPE designed to buy out CalPERS’ interest in JEDI.  The transaction failed to provide three percent equity to justify its non-consolidation.  Bauer and Andersen should have known that GAAP required consolidation.

 Michael Lowther was the Andersen partner in charge of Enron’s energy audit division and served as the concurring review partner for the Enron audits.  As with Duncan, the SEC showed displeasure in Lowther’s audit involvement with respect to the prepay transactions, Project Nahanni, and the Raptor transactions.

 The SEC cited Michael Odom for the underauditing of the prepay transactions and the Raptor transactions.

 Duncan consented to a permanent suspension from practicing before the SEC as an accountant.  The others were also suspended from SEC practice, though allowed to appeal for reinstatement after two or three years.

 Summary

 Can one firm have so many failures and lack responsibility for their audits?  We think not.  Audit failures at Boston Chicken, Arizona Baptist Foundation, Sunbeam, Waste Management, and Enron prove that the leadership and the culture at Arthur Andersen were deficient during the 1990s and into the early part of the 21^st century.  Several audit partners did not perform adequate audits and were found lacking in professional skepticism.  In short, they sided with the management teams instead of fulfilling their trust with investors and creditors.

 We reiterate that Arthur Andersen was not alone.  These deficiencies occur at the other large audit firms as well.  Why Enron blew up instead of another firm with another auditor is a quirk of history.  Meanwhile, the collapse of Arthur Andersen serves as an example that poor audits can reverberate to the firm’s demise.  If anybody is listening.

 This essay reflects the opinion of the authors and not necessarily the opinions of The Pennsylvania State University, The American College, or Villanova University.