Arthur Andersen Case

Case Study on “Arthur

Andersen”

Course : Auditing Course Code : ACT 341.1

Prepared For Rakibul Hasan (Rkb) Course Instructor North South University

Prepared By Name

ID

Kazi Nazrul Islam

101 0275 030

Zulker Nayem

101 0274 030

Sharmin Sultana S. M. Musa

092 0125 030

Date of Submission: 10 June, 2012

ACT 341

[CASE STUDY ON ARTHUR ANDERSEN]

Table of Contents

Index Questions

Page no.

1. Describe Arthur Andersen‟s organizational culture and

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explain how the firm‟s culture may have contributed to its downfall. 2. Explain why the provision of non-auditing services to an

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audit client may compromise the auditor‟s independence. In your answer, list two threats that jeopardize compliance with the principle of independence and explain why they are threats. 3. List the safeguards that Arthur Andersen might have

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employed to reduce the threat to an acceptable level. 4. Explain why it is important for accounting firms like

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Arthur Andersen to maintain their independence in fact and in appearance. 5. Explain how Arthur Andersen may have violated the

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public interest principle.

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[CASE STUDY ON ARTHUR ANDERSEN]

Question # 1 : Describe Arthur Andersen’s organizational culture and explain how the firm’s culture may have contributed to its downfall.

Arthur Andersen LLP was founded in Chicago in 1913 by Arthur Andersen and partner Clarence De Lany. Over a span of nearly 90 years, the Chicago accounting firm would become known as one of the “Big Five” largest accounting firms in the United States. They did their business with success in many years. They made huge profit. But for some unethical position, huge risk and internal inefficiency contributed to its downfall.

In the beginning, Andersen was a watchdog. Founder Arthur Andersen made the firm's name stand for something nearly a century ago, when he refused a client's demand to approve a ledger that falsely inflated profits. For decades thereafter, an auditing opinion from Andersen was the gold standard for corporate books and records. If Andersen said the numbers were solid, then investors, bankers, regulators and the public at large could count on it.

Over time, greed corrupted Andersen. Its leaders became more devoted to collecting hefty fees than keeping books straight. Clients paid a fortune for Andersen's consulting services, making its basic function of auditing into little more than an afterthought. The firm's most experienced accounting technicians, the sticklers who maintained its principles, saw their status plunge in the partnership's hierarchy. As Enron ran wild, Andersen's Professional Standards Group proved too weak to intervene. Money had trumped honest services.

The decentralization of the firm was a big challenge for auditors because it was hard to oppose some clients who desired to see the limits of accounting principles. For example, the energy trading firm Enron was a client of Arthur Anderson who paid a huge amount of money for consulting services which was a small fraction of Andersen‟s revenue but that was big chunk amount for the local office. So in local office, the managers with individual goal of revenue, wanted Enron as their client though Enron wanted them to cheat on their investors by hiding their financial weakness.

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ACT 341

[CASE STUDY ON ARTHUR ANDERSEN]

Enron's executives were able to lie about their business performance and prospects because Andersen went along. When the lies caught up with its client, instead of admitting its failure to safeguard the public trust, Andersen engaged in a cover-up. Its employees shredded not just a few Enron-related documents, but box after box, day after day, for a period of weeks.

Andersen did exactly what Enron wanted them to do. As a result Andersen was charged of not full disclosure financial position to their investors. Then Enron was delisted by New York Stock Exchange and messed up the investment of many investors including 4000 employees. Finally Enron was bankrupted. As a result, Andersen was convicted for destroying audit related documents of Enron and it was at the end of the day lost its right of practice.

Question # 2 : Explain why the provision of non-auditing services to an audit client may compromise the auditor’s independence. In your answer, list two threats that jeopardize compliance with the principle of independence and explain why they are threats.

During 1980s a significant growth occurred in consulting business as the accounting firms were offered consulting services along with traditional services. The realization that non auditing business was more profitable motivated the auditors more towards non-auditing services. But they faced strong critic argument. Argument was about the incompatibility of these two works. For example, if Andersen at the beginning of consulting services creates an audit report for Enron, how could it check its own work as an auditor? So it was difficult for the auditors to be honest while making the report and also be independent while checking the report made by them. Because they were getting more money from consulting services than auditing. As a result of that auditors had to compromise their independence for consultancy.

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[CASE STUDY ON ARTHUR ANDERSEN]

So two threats that jeopardize the compliance with the principle of independence, if we consider the case of Andersen, are 1. Consultancy business in parallel to auditing. 2. Implementing the 2X strategy. It is discussed above how a parallel consultancy service jeopardizes the principle of independence of an auditor. Now the following paragraph discusses about how an extra revenue earning strategy of an auditing firm can jeopardize the principle of independence, for Andersen it is 2X strategy.

In 1998, Steve Samek became the top partner of Andersen. Samek had a strategy named „2X‟ strategy. Under this strategy, partners had to bring in two times of their revenues in work outside their area of practice. This strategy made the partners act as salespeople. This strategy also created tension between satisfying the clients and serving the public interest. To keep the client interest up the auditors had to jeopardize the compliance with the principle of independence. Because partners were desperate to bring two times of their revenue in work and tend to please clients in consulting works. So they started to hide information from investors that were important for them to invest in that particular country and were supposed to be disclosed. They tried to manipulate numbers in financial statements to hide the financial weakness or losses of the company. At the end of the day, auditors had to sacrifice their independence for consultancy.

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ACT 341

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Question # 3 : List the safeguards that Arthur Andersen might have employed to reduce the threat to an acceptable level.

As an auditing firm Arthur Andersen should have employed some safeguards to reduce its threat to an acceptable level. A list of some of these safeguards are given below:

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They needed to emphasis on their auditing business than their consulting business.

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They might not follow decentralization in their root level of business.

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They might follow the ethical rules of the auditors.

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The Company needed to audit the Enron very efficiently so that they could find out the real picture of the company.

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Arthur Andersen might not spoil the document, when they did this. It came to mind that they were guilty for the cause.

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They might not overstate Financial Statements so highly; they might take this into a certain level.

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Arthur Andersen should show the real profit of the company. When they showed this, it occurred a huge problem for the company. And it becomes a one of the most terrible cause for their Elimination.

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They needed to follow Safeguards created by the profession, legislation, regulation.

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Arthur Andersen might provide high education, training and experience requirements for entry into the profession.

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They needed to continue professional development requirements.

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Arthur Andersen should have followed corporate governance regulations.

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The Company must have followed professional standards of their Company and their auditing activities.

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Arthur Andersen should have started effective well publicised complaints systems which enable colleagues, employers and members of the public to draw attention to unprofessional or unethical behaviour.

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Explicitly stated duty to report breaches of ethical requirements.

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ACT 341

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[CASE STUDY ON ARTHUR ANDERSEN]

They must have followed the external review by a legally empowered 3rd party of the reports, returns, communications or information produced by a professional accountant.

If the Company would employ the above listed safeguards they might not get collapsed.

Question # 4 : Explain why it is important for accounting firms like Arthur Andersen to maintain their independence in fact and in appearance.

Auditor independence is often referred to as the basis of the auditing profession because it is the foundation for the public‟s trust in the attest function.

Independence in appearance is what third parties would perceive as being independence. Auditors are perceived by others to be independent. If a person audit a company and his/her relative is the CEO or the Chairman, then the person would be perceived to not be independent.

Independence in fact is based on auditor‟s actions in a situation or real independence. It is like he/she is able or not, to make independent decisions if he/she is pushed into a corner under pressure. It is the same as in mental. It is how he/she acts and thinks him/herself, how he/she would make decisions.

It is very much important for accounting firms like Arthur Andersen to maintain their independence in face and in appearance. Because-

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Auditor independence helps to ensure quality audits and contributes to financial statement users‟ reliance on the financial reporting process.

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Auditor independence has long been understood in terms of independence “in fact” and independence “in appearance.” An auditor who is independent in fact has the ability to 7

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make independent audit decisions even if there is a perceived lack of independence or if the auditor is placed in a potentially compromising position. Nonetheless, even when the auditor is in fact independent, one or more factors may lead the public to believe the auditor does not appear independent. This may cause users of financial statements to believe they cannot rely on financial information. 

Since auditor independence in fact is a mental state, investors and other users of financial statements cannot accurately assess actual auditor objectivity; they can only evaluate an auditor‟s appearance of objectivity.

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When an auditor acts independently in fact and issues an unbiased audit opinion, investor confidence is eroded if investors and other users of the financial statement information do not perceive that the auditor was independent in appearance.

Arthur Andersen, Enron‟s former auditor, was perceived as lacking independence. Because the accounting firm earned more revenue from non-audit services than from audit services. While independence in fact and in appearance are both required in order to achieve the goal of independence, the Enron debacle and the negative publicity that the auditing profession received, may have altered the public‟s expectations.

So, we can say that in order to gain public trust it is very much important for accounting firms like Arthur Andersen to maintain their independence in face and in appearance.

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Question # 5 : Explain how Arthur Andersen may have violated the public interest principle.

Among all the ethical principles that guide the work of auditors who conduct audits, public interest principle is the most important one. The public interest is defined as the collective well-being of the community of people and entities the auditors serve. Observing integrity, objectivity, and independence in discharging their professional responsibilities assists auditors in meeting the principle of serving the public interest and honoring the public trust. These principles are fundamental to the responsibilities of auditors.

Economic activity could not take place without financial reporting. Economic activity requires assessing and pricing risks accurately, which in turn requires accurate accounts. Not only accuracy, but also comparability of financial accounts is a basic requirement of any efficient economic system. Accuracy and comparability are necessary to ensure that the public can assess the relevant risk and take their decisions. Markets, specially financial markets, conduct transactions on the basis of information. Further, good auditing increases and value of information and thus increases confidence, a necessary condition of financial stability and maintaining the public interest.

Arthur Andersen violated the public interest principle by breaching the public trust entrusted on them. Arthur Andersen was the auditor of many big firms such as Enron, Waste Management, Sunbeam etc. Thousands of investors relied on the audit report audited by the firm to take their financial decisions. As the accounting firm issued misleading audit reports, it caused many investors to walk on the wrong path. By misstating the earnings Arthur Andersen lured the general public to invest more on the firm which would eventually go bankrupt very soon. This many investors broke.

As a well reputed accounting firm the scandal of Arthur Andersen also endangered the reputations of all other audit firms and raised the questions on ethics and integrity of the audit

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ACT 341

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firms. As a consequence people lost their confidence on financial markets which ultimately affected the whole economic system.

Moreover, by helping many big firms to manipulate their financial conditions Arthur Andersen helped the firms to walk to the berg of destruction. As a result thousands of employees lost their job which caused severe problems for thousands of families.

In conclusion, Arthur Andersen violated every public interest whenever it placed a misleading audit report as the main duty of an auditor is to serve the public interest.

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