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This paper analyses impact of Management Advisory Services on Arthur Anderson & Co. for Financial Auditor Independence

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Auditor Independence

The financial statements of organization are the measure of its performance. The financial health of an organization can be judged from its financial statements. That is the reason why the statements should represent a true and fair view of its position. Often people at key positions are encouraged to falsify accounts to meet short term needs such higher earnings per share or profit after tax. Sometimes people engage in such activities to conceal the actual position of the organization and make it look profitable in the eyes of investors. It is not just big organizations but the small ones are also tempted to employ such techniques, like understating revenue, underreporting liabilities, overstating revenue, misuse of reserves and other techniques.  It is not just the organization which can be sued but also the people involved in the development of such scam. That also includes the auditor of the organization. If it can be proved that the auditor could have found out the fraud in the normal course of events which he failed to do so he can be charged with professional misconduct and can be tried against.According to Lord Denning, an auditor “must come to (his task) with an inquiring mind – not suspicious of dishonesty, I agree – but suspecting that someone may have made a mistake somewhere and that a check must be made to ensure that there has been none…” (Formento v. Seldson Fountain Pen Co., [1958] 1 WLR 45). (Morgan 2000) 

An organization involves in such scams when it fails to account a chunk of its income.In the light of such scams it becomes the duty of the auditor to be independent in the performance of attest function. It has been held, in observations relied on by the Supreme Court of India, “The auditor must exercise such reasonable care as would satisfy a man that the accounts are genuine, assuming that there is nothing to arouse his suspicion and if he does that he fulfils his duty; if his suspicion is aroused, his duty is to 'probe the thing to the bottom'…” ( ICAI v. P.K. Mukherji, AIR 1968 SC 1104).(Indian Kanoon 1952) 

Threats to Independence

Some of the major factors which impair the perception of independence of an auditor are as follows:

1.      Management Advisory Services.

2.      Size of the audit firm.

3.      Tough competition in the auditing services market.

4.      Tenure of the audit service.

5.      Audit fees.

 

Management Advisory Services

This is a well known fact that audit firms apart from auditing services provide a wide range of advisory services as well. This can be related to self interest.The compatibility of auditing and advisory services has been a matter of debate. The interest of the client and the auditor seem to be identical under the consulting relationship. In some countries a practicing auditor can not engage in the provision of advisory services, as an auditor who provides advisory services to an organization cannot be independent while discharging his attest functions. However this has not been able to curb such practice as auditors in a lot of countries have both audit as well as consulting firms.

Size of the audit firm

The size of an audit firm to a certain extent can affect its independence. The small size of the firm can encourage it to provide personalized services to its clients. That is the reason why big firms are likely to behave independently. It is because of their size that such firms are able to conduct audits more professionally. Audit reports of big firms are like E&Y, KPMG and PWC are considered to be more reliable than the audit report of smaller firms. Although there have been cases where the audit reports of big firms have proved to be not as reliable as was the case in Satyam Scam. Satyam’s statutory auditor was PWC. This scam has also been termed as the “India’s Enron” scandal.

Tough competition in the auditing services market

There has been tough competition amongst accounting firm which has created enormous amount of pressure on them and has proven bad for the profession. In an intensely competitive environment the firms find it difficult to be independent while discharging attest function as the client can easily find another auditing firm for the same. The independence of an audit firm is tested when the client engages in “opinion shopping”. The client asks another audit firm for its opinion which might affirm that of the client’s. This put tremendous pressure on the audit firm forcing it to change its point of view, hence comprising its independence.

Tenure of the audit service

The independence of an audit form might be compromised when it has been in a long association with a client. The interest of the client and the auditor seem to be identical under long associations. This quiet often results in the following of audit procedures which are not rigorous as long term associations can lead to development of faith on the client which can make the audit firm complacent in its approach. Hence, unknowingly its independence is compromised.

Audit fees

A large audit fee can test the resolute of an audit firm. The sheer size of the fee can compromise its integrity and independence. PWC charged Satyam millions of dollars in audit fees. This is probably what led to turning a blind eye. Studies have showed that large audit fees impair the judgment and view of the auditor. In fact according to a study it is believed to be the leading factor responsible for compromising the independence and integrity of an auditor. (Samad & Shahrir 2006)

Findings of the Enron Case

Enron had employed a technique known as mark to market which was previously employed or used by brokerage and trading companies. The use of this technique allowed Enron to recognize projected long term earnings from its energy contracts as current earnings. This revenue might have not been collected several years down the line. The employ of this technique made it really difficult to see how the organization was making its money. The basic accounting principle of “Matching Concept” was not followed by the organization. SPV or Special Purpose Vehicle’s were used to remove the debt off the balance sheet of the organization. At that time it looked like a revolutionary method but that indeed led to its downfall. SPV’s are securitization instruments. The assets generating steady flow of cash are pooled together and marketable instruments are sold against such assets. This help to solve the liquidity issues of an organization. By the use of this technique Enron offloaded millions of dollars in debtors. The stocks of the organization kept on falling throughout the first part of 2001. After the retirement of Skilling the company’s CEO Enron declared a loss of $638 million. It had to write down the book value of its stock by $1.2 billion. Its senior officers and employees had received $750 million in salaries and profits. This was the same year when Enron filed for bankruptcy.  (Thomson One 2009)

An analysis of the 2000 balance sheet reveals interesting facts about the organization. The organization recorded an increase in sales of 151% with an equal increase in cost of sales. The company had an inventory turnover ratio of 103.7% which quite unbelievable. This practice should have been questioned. The company had a debt to equity ratio of 75% which quite high. The ideal ratio should be around 25%. The accounts receivable are exceptionally high. A very high accounts receivable means that the consumers are not paying their bills on time which was definitely not the case. Another alarming fact was that the accounts receivable was rising faster than sales (243% - 151%=92%). The cash flow was growing at a rate of 289% which was again 46% greater than sales. The cash position per share says it all. Its cash position ratio was -$9.54.A minute negative sumisn't considered toograve.  But if cash flow is declining & debt ismounting, the organization may be in frailfinancial health.(Refer Figure.1, Appendix)

Amazingly Enron had created over 3000 SPV’s which offloaded the debtors from the organizations balance sheets. What most people didn’t understand was that these SPV’s were guaranteed by Enron. These entities were used to maintain the cash flow of the organization. It was the accounting policy of not consolidating the SPV’s that allowed the organization to hide its actual position from the investor and other users of the financial statements. Figure.2 in the appendix section shows how complex the structure was. They as auditors approved these faulty techniques which they could have qualified in the first place.

 

 

 

Arthur & Anderson and Enron

Arthur & Anderson was the statutory auditor of Enron. In the year 2001 as per the financial statement of Enron the firm was paid a fee of $25 million for auditing services and another $27 million for Management Advisory Services. It was the organization’s sole auditor for 16 years. It was responsible for its internal audits and for rendering Management Advisory Services. As discussed earlier all the factors which compromise the independence of an auditor can be found in this case. The fees paid were exceptionally high. Both the organizations had been associated for a long time. Last but not the least, many of the employees of Arthur & Anderson later became employees at Enron. “Ben Gilsan, Jr. was treasurer of Enron until he was fired in October 2001, for benefiting personally from one of Enron’s complex SPE investments. He was a former accountant with Andersen and played a key role in accounting-related deceptions. He pleaded guilty to one count of conspiracy related to financial reporting deception.” (Cunningham & Harris 2006, p.32)

Was Arthur Anderson & Co Aware of Wrong Doings at Enron?

The answer to this question would be yes. On 5th of Feb 2001 the partners of the firm met to decide on the things going on at Enron. They were particularly concerned about the CFO’s involvement in the SPE’s (Figure.3, Appendix). They also decided the same should be brought to the notice of the board, but the minutes of the meeting with the board of directors at Enron suggests that no such discussion ever took place.

 

Did Arthur Anderson & Co Assist Enron?

The answer to this question would again be yes. They were paid $5.7 million in from 1997 to 2001 to look after the transactions regarding LJM and Chewco. These were the main SPE’s connected with the Enron scandal.

 These are the reasons which resulted in the firm compromising its independence and integrity. When Arthur & Anderson learnt about the financial distress of Enron it started destructing the documents. (PBS 2008)

Though it had a clear cut policy of document retention the senior partner connected with the audit of Enron destroyed them so that no evidence could be produced against the firm (Refer Figure.4, Appendix)

It was later convicted of obstruction of justice for destroying the relevant papers. In addition to this the firm was found guilty of “improper professional conduct” and was fined $7 million. It had clearly assisted Enron in inflating the revenue of the organization.

Conclusion

The high fees for auditing and non-auditing services and its long association with Enron ultimately led to the demise of Arthur Anderson & Co. The firm later surrendered its license in 2002 to practice as CPA in USA which was overturned by the court. Though the firm still exists it has been unable to make a comeback because of the damage to its reputation. From almost 85000 employees the firm has come down to 200 who mainly look after the suits pending against the firm.

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