Published: February 14, 2002 in Knowledge@Emory
In 1915, young Arthur Andersen found himself under pressure from a midwestern railroad company to approve what he considered a questionable account. Even with the life of his young firm on the line, the 30-year-old accountant told his client that there “was not enough money in the city of Chicago” to induce him to change his report.
Placed in a similar situation by Enron in the past few years, Arthur Andersen’s successors evidently found that the city of Houston had sufficient funds. Where did the firm – now known as just Andersen – go wrong? Observers of the accounting world at Emory University say that the pressure of the business climate over the past 20 years may have contributed to the questionable role Andersen played in the boom – and eventual bust – of Enron. Some also predict that the firm’s entanglement with the Enron scandal will lead to big changes in U.S. accounting in the coming years, but they are unsure about what those changes will or should be.
None of the Emory faculty interviewed had a theory of why Andersen has been embroiled in some of the highest profile cases of cooked books over the past few years, including Waste Management and Sunbeam. Al Hartgraves, professor of accounting at Emory University’s Goizueta Business School, says he was not sure either, but he did note the irony of a 1992 Accounting Today popularity poll in which public companies’ financial departments voted Arthur Andersen their favorite accounting firm, giving them high marks for such qualities as “creativity” and “flexibility.”
Even now, accounting professors say, the facts of the Enron case are far from clear. “It’s somewhat mysterious because I’ve never seen such a convoluted set of transactions in all my life,” observes Hartgraves, who has studied Enron’s latest filings. “It is almost like they were attempting to make [the books] so complex that no one but they would know what they were doing.”
For Frank J. Vandall, professor of law at Emory University’s School of Law, the situation seems analogous to cases in which criminal defense attorneys get too close to their clients, observe that crime actually does pay, and decide to make a career change.
But Sander Abernathy, a 2001 Goizueta EMBA, audit partner at Bridges & Dunn-Rankin, LLP, an Atlanta-based accounting firm, notes that problems usually begin a bit at a time, first by approving something that under some circumstances might be a little questionable. “What happens is that [auditors] start out and they approve one transaction, of a particular type, and the client says, Ha– I can do that! If I can do one, he has to let me do two, and if I can do two, he has to let me do 30. Before long, you have financials that are completely distorted. What I learned early on was, never give clearance on a single transaction if 50 of them aren’t going to be acceptable. Because what inevitably happens is that the client finds 50 of them,” Abernathy says.
When that happens, the pressure can grow to accept the situation, according to Abernathy. “Auditors are supposed to say no. In fact, if you hang around with us very long, you’ll find we’re pretty good at it, we do it a lot. We’ll only say yes under duress, but you know, where there’s $50 million in fees [Enron paid Arthur Andersen $52 million in 2000], there’s probably enough duress to make it happen,” he notes.
Whether shredding documents is wrong is also situational, according to Emory accounting professors. All firms shred older work documents on a routine basis. But not when there’s a risk of lawsuit. “The shredding of documents, the work paper documents, is a common practice,” says Goizueta accounting lecturer Robert Minnear. “There’s nothing unusual about that. However, it’s also common practice that if you think you’re going to be sued or your client is going to be investigated, you don’t keep destroying work papers.”
If there’s a systemic problem, Minnear suggests, it should be uncovered first before leaping to a solution. “Rather than saying ‘the whole profession is a bunch of high-priced prostitutes, let’s substitute that with government auditors – or some crazy thing like that, let’s find out what happened,” he says and cautions, “you’re not going to find out what happened overnight.”
People should keep in mind that there are many safeguards in the system already, Minnear explains. Public accounting firms always have a second partner who signs off on every audit, research teams trained to provide guidance on difficult issues, internal reviews and peer reviews to spot-check past engagements.
Hartgraves and Abernathy both believe that the real culprit is not so much auditing but Wall Street’s insistence that companies meet expected earnings at all costs, a pressure which, they say, often leads to bad decisions. Abernathy says a friend who formerly worked in Enron’s London office told him that he would often work for 12 weeks on a deal, only to be told the last two weeks in the quarter that the quality of the deal didn’t matter; he should just get it done so the company could make its numbers.
“To be frank, that’s what American business has become in a lot of places, and then we say, well, the auditor should have caught all that,” Abernathy says, when it’s not really the auditor’s fault. “If you beat your horse with a club every three months, you can’t blame the groom if it falls over at some point in time.”
Indeed the outcry over the Enron situation has many feverishly seeking ways to ensure this doesn’t happen again. One remedy being batted around would require accounting firms to divest themselves of their profitable consulting arms. Abernathy is skeptical about the usefulness of the move, since audit partners in the Big Five firms are only concerned about the revenue their own group creates, and normally couldn’t care less about consulting. “The real conflict of interest, and I don’t know how to fix this, is that the clients pay for their own audits,” he says. “It’s kind of like asking football players to pay for their own referee … Whether consulting occurs or not, you still have the problem.”
One remedy that would help, Abernathy says, is to increase the penalties for signing inaccurate audits, making it easier to take away licenses of CPAs who prepare bad financial results. But even without any changes, Abernathy says he hopes that this will strengthen auditors’ resolve. “My hope is that out of all of this, auditors will develop more backbone, will be more willing to say, ‘you know, maybe all the i’s are dotted and the t’s are crossed, but at the end of the day, it just doesn’t look right and we’re not going to sign off on this.’”
Emory scholars say the Financial Accounting Standards Board, accounting’s rule-making body, can’t afford to back down from this controversy. Hartgraves says the FASB has often taken a strong stand on an accounting problem only to have the SEC and Congress force them to water it down – experiences that may have slowed the board’s reflexes.
One example: In 1995, FASB recommended that stock options be accounted for as an expense, on the grounds that it would make the actual expenditures for employee compensation much clearer. After extended corporate outcry that included 1000 letters of comment, a House of Representatives hearing, and a Senate resolution condemning the decision, the board backed off and settled for some watered-down provisions. It was an experience that left the board “bruised and reeling,” according to Accounting Today.
In Hartgraves’s view, the only way to change this private organization would be to change campaign finance laws, a move that would presumably decrease corporate pressure on Congress to maintain the status quo.
Minnear agrees the FASB needs to respond to the situation soon. “If they don’t, they’re going to have it taken away from them and given to somebody else,” he says.
That somebody else just might be the International Accounting Standards Board, speculates Hartgraves. The IASB sets the accounting standards used in the European Union and in a number of other countries around the world.
Strategically, some Emory professors say that the Andersen debacle is likely to lead to some big changes not only in the rules of the game, but the players. Jagdish N. Sheth, professor of marketing at Goizueta, says that he believes this event may prove “a fatal blow” for Andersen. He says he suspects that in the short run, partners and clients will leave the firm, the firm will file for bankruptcy protection, and that the reorganized firm will try to find a merger partner.
Within a few years, Sheth expects that there will be a Big Three in accounting, instead of a Big Five, in line with the theory he expounds in his recently published book, The Rule of Three: Surviving and Thriving in Competitive Markets, which he co-wrote with Rajenda S. Sisodia. Sheth’s theory postulates that in most industries, competition eventually reduces the field to three major players, and he sees the same dynamic at work here.
As for the auditing divisions, Sheth expects they will either be spun off as separate enterprises or will become separate, regulated divisions within the larger accounting firms, in much the same way as the Baby Bells divided their local business from their other enterprises, or energy firms separated their local regulated activities from their other businesses.
But until that happens, how should individual investors protect themselves? If an accounting professor has trouble with the financials of a company like Enron, how can individual investors hope to avoid buying tickets on the next corporate Titanic? They can’t, replies Hartgraves, particularly if the troubles aren’t even on the balance sheet, as was the case with Enron. All you can do is invest in companies that make money in a way that’s easy to understand.
Abernathy urged caution before buying shares in a company that looks too good to be true, particularly if it doesn’t have a long track record. “If you kind of look back over history, companies like Enron have a period of extraordinary returns, phenomenal growth, phenomenal profits and all this stuff. If you see that, there’s probably something underneath it that stinks.”