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Arthur Andersen Case Study
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“Nothing…is duller than accounting––until someone is defrauded. And after every modern financial disaster… investors have tended to ask the same question: where were the auditors?”1
Joseph Berardino, CEO of Arthur Andersen, slept peacefully in a hotel room in Tokyo on November 28th, 2001 when he was suddenly awakened by a phone call from one of his colleagues in New York City. “The Justice Department is thinking of indicting Andersen, Joe,” said one of his partners. Berardino was instantly awake.
Berardino had remained upbeat about the future of Andersen since he became that company’s CEO six months earlier. He had written an essay for the company newsletter a year earlier describing the business world as entering “. . . terrific times. Exciting times for our clients and our people.2” But an indictment from the SEC could ruin his accounting firm and end the “terrific times” that he’d predicted for Andersena only a few months before.
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At the end of 2001, Andersen faced criticism for its botched audits of Enron Corporation, a failed energy-trading firm, and for destroying documents related to the audits. Already Enron’s woes had made front-page headlines for weeks. “This is going to be a whole new ballgame,” thought Berardino3. If the SEC announced that it would subpoena Andersen’s files, the story would appear in the nation’s major newspapers the next day. Clearly, Andersen would have to make some sort of announcement about the investigation. He picked up the phone to call David Tabolt, chief spokesman for Andersen, to discuss communication options, especially with the media. “David, it’s Joe, how should we respond to questions about this problem?”4.
1Mayer, Jane. “The Accountants’ War”. The New Yorker, April 22, 2002. Pg. 64.
2Schwartz, John and Jonathan Glater. “At Andersen’s Helm, A Winner of Battles Who Faces a War”. The New York Times. Jan 14, 2002.
3Brown, Ken and John R. Wilke. “Berardino’s Hopes of Saving Andersen Were Dashed Following Indictment”. The Wall Street Journal. March 28, 2002.
4This case study is a fictionalized account based on actual events that occurred at Arthur Andersen, LLP.
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This case was written by Professor Paul A. Argenti and Kimberley Tait D’01, with additional research by Abigail Nova D’01, based on an earlier case entitled “The Case of Missing Time”, developed by Northwestern University in 1971. All names and organizational designations have been disguised.
© 2001 Trustees of Dartmouth College. All rights reserved. For permission to reprint, contact the Tuck School of Business at 603-646-3176.
Arthur Andersen (A)
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Founding of Arthur Andersen
Arthur Andersen and Clarence DeLany co-founded the accounting firm Andersen, DeLany, & Company in 1913. Soonafterwards, in 1918,DeLany left the company and the name changed to Arthur Andersen & Co. After DeLany’s departure, Arthur Andersen built his company as its sole leader over the next four decades.
Arthur Andersen Case Study
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Andersen grew steadily throughout the Roaring Twenties, Great Depression, and both World Wars. The firm benefited from new government regulations that required more company filings and led to an increasingly complicated tax code for corporations. Andersen continually sought out chances to increase its reach. In 1928, it began the financial investigations that would eventually become its consulting practice. In 1932, it became the bankruptcy trustee for Samuel Insull’s failed utility empire. Andersen’s branches spread to new locations throughout the United States, and after 1963 it would venture into foreign countries as well.
When Arthur Andersen died in 1947, he left behind a modestly successful, well-established firm. He was replaced, after a brief bout of family infighting, by Leonard Spacek. Spacek quickly ended the arguments over Andersen’s successor that had put senior employees at odds with eachother, and pulled the managers together to focus on a new era for Andersen, positioning the company to become one of the world’s leading accounting firms5. By the year 2001, the trademark Andersen would include a worldwide network of operations with annual revenues exceeding $9.3 billion (See Exhibit 1-1).
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Expanding Services at Arthur Andersen: 1950-2000
In the nineteenth century, accounting included primarily bookkeeping responsibilities; over the course of the twentieth century, however, the accounting industry moved far beyond this original function. Work at Arthur Andersen eventually included services such as both internal and independent audits, tax process oversight, legal services, and human resource work.
One of the most significant non-auditing functions that Andersen offered its clients was consulting. This piece of the firm’s business began early in the company’s history and by 1954, Andersen had developed a separate unit for its consulting business. Andersen experienced internal conflicts between accounting and consulting from the time that these two branches split until the year 2000. Eventually, Andersen established Andersen World, a global corporation that provided an umbrella organization for both consulting and accounting, in the hope that a reorganized company structure could defuse some of the tension. But quarrels only intensified, especially as Andersen Accounting developed its own consulting division to serve those companies not covered under the Andersen Consulting unit.
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5 Hoover’s Online, “Andersen Overview”, 2001; Wartzman, Rick “After WW II, Founder’s Death Shook Arthur Andersen Firm”, The Wall Street Journal, May 1, 2002.
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Power struggles continued between the different departments at Andersen into the 1990’s. In the 1990’s the problems of how to combine consulting and auditing work grew in scope as observers outside of Andersen raised questions about potential conflicts of interest at the “Big Five” accounting firms, all of which derived significant revenues from consulting services. A 2002 report in The Accounting Review, for example, calculated that throughout the 1990s profits from consulting at the Big Five auditors were three times those produced by auditing work6. The ratios of an individual executive’s annual income were often weighted even more heavily towards consulting. The resulting incentive structure produced rewards for those workers who brought in a high volume of consulting work, not those who performed their duties well as auditors. In the bestcase this system advanced the careers of mediocre accountants. In the worst case, Andersen partners approved on poor auditing jobs when executives received high commissions from the consulting business generated by a company’s fraudulent financial transactions.
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Consulting was not the only relationship between auditors and their clients that came under scrutiny in the 1990s. Individual branches of Andersen each focused on a single large client. Critics accused these offices of losing their neutrality through close associations with the companies they would audit. At Enron, for example, Andersen served not only as an external auditor, but the company’s internal auditor as well. This close connection led to a situation in which Andersen accountants, acting in their capacity as independent auditors, signed off on their own internal accounting work. Andersen accountants were also often checking the work of past, or potential, employers. The “cross pollination” of employee pools between Andersen’s Houston office and Enron headquarters was an established practice. The President, Vice President, and Chief Account Officer positions were all held by former Andersen employees7.
Although the SEC would later accuse Andersen partners of actively promoting their own interest over their accounting duties in the new business climate, a large part of the changes seen in the accounting industry were simply responses to changes in business. During a period of incredible economic growth in the 1990s, new forms of assets and liabilities emerged, firms entered into joint-ventureagreements, and engaged in a variety of business transactions across different markets. The public could now invest in “innovative” companies that had expanded beyond a focus on one or two fields to trade in multiple fields, many of which had little connection to each other. Enron, once a gas pipeline company, was considered a visionary leader in this new environment. The corporation placed a premium on novel ideas, investing in everything from broadband to pulp, and leveraging a large amount of debt to fund these projects. With the high volume of money changing hands in the bull markets, opportunities arose for some executives to divert funds for their personal use. These new strategies were unprecedented in the accounting world, and so auditors, like Andersen, had to discover new ways to monitor business effectively. Sometimes they did not succeed.
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6Mayer, Jane. “The Accountants’ War”. The New Yorker, April 22, 2002.
7Ibid
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Setbacks at Andersen 1996-2000
Not all transactions went smoothly as both the business community and auditing firms generated new functions that did not fit easily into the regulatory framework devised by the government in the 1930s. The SEC had begun to adapt, but only slowly, and during the process of changing federal oversight, the Big Five accounting firms entered into more and more political battles. Andersen found itself at odds with government regulators and eventually it came under investigation for several improper auditing jobs.
Two major scandals broke at Andersen during the 1996-2001 period: Waste Management Systems and Sunbeam. Of these, Waste Management proved the most damaging. In 1998, Waste Management, an Andersen client for several decades, restated its earnings to show an overestimate of $1.4 billion over a four-year period. This was the largest restatement in American history (Enron would later reveal a $600 million error—less than half of Waste Management’s inflation). The SEC investigation into this incident turned up several incriminating documents at Andersen offices. After this investigation, Andersen instituted its document retention policy that would lead to the shredding of Enron documents three years later.
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Sunbeam also misstated its earnings for years when that company was an Andersen client, though not to the same degree as Waste Management. In both cases, Andersen paid fines that reached hundreds of millions of dollars, but managed to escape without any official recognition of wrongdoing8.
Another blow to Andersen Accounting came in August of2000, when a lengthy arbitration process ended in the formal separation of its consulting unit to become its own, unaffiliated company. The disputes between the consulting and auditing branches of Andersen reached back almost half a century. Directly following its legal split from Andersen, the consulting firm renamed itself Accenture and launched a massive campaign to reinvent its image, purging itself of any remaining ties with Andersen by emphasizing its historically separate nature (the Accenture website credits the company’s beginnings to a plan to install a computer in General Electric in 1953 without any mention of accountants). Now Accenture is a publicly owned company that specializes infast-paced development of innovative technology solutions for its global clients9.
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Even with its setbacks at the end of the 1990’s, Andersen did not lose its place as a major accounting firm. The company had 1,500 senior partners and retained 85,000 employees in 84 different countries at the start of 2000. At this time, hoping to prepare the company to handle any future crises, management brought in a new CEO: Joseph Berardino.
8Eichenwald, Kurt. “Andersen Misread Depths of the Government’s Anger”. The New York Times. March 18, 2002. A-1.
9Accenture company website: http://www.accenture.com (Accessed 7/30/2002).
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Berardino Heads Andersen
Joseph Berardino was billed as a crisis manager who could “take Andersen back to its roots”, helping the company recover from its recent accounting scandals, along with healing the rift created by the contentious divorce with Andersen Consulting. Berardino had a solid accounting background. He took pride in his skills as an auditor and had been a dedicated employee at Arthur Andersen since he graduated from Fairfield University in 1972. Senior executives greeted him as a “buck stops here” type of CEO who could clean up the dubious bookkeeping that had gotten the company in trouble before10.
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Unfortunately for Berardino, most of the errors that would lead to Andersen’s unraveling were in place long before he took his place as CEO in January of 2001. For example, although he did consolidate top management into a council of 5 (down from 17) to chart a decisive course for the company, the partners who dealt with the hundred top clients had already established a high level of autonomy in their branches. David Duncan had abused this authority when his Houston office approved fraudulent Enron accounts. The inflated earnings in Enron reports that would prompt the SEC investigation had been recorded during the five years prior to Berardino’s promotion. It was too late for him to undo these mistakes; he could only mitigate their repercussions.
Many of the problems Andersen faced were not unique to that company. In truth, for Berardino to truly return to accounting its “roots”, to the way it had been before the 1990s, he would have had to change an entire industry, not just one firm. Every auditor had to evaluate a new range of business activities engaged in by corporations who no longer conformed to traditional financial practices. The other Big Five accounting firms also all combined consulting and auditing work. The Big Five accountants shared so many concerns, in fact, that they had banded together into a single lobbying group to challenge Congress on unwanted regulatory changes and donate large sums to political campaigns sympathetic to their cause.
Berardino himself had earned his reputation in the accounting world for his confrontations with then- chairman of the SEC Arthur Levitt. Berardino challenged Levitt directly when the chairman moved to block Andersen’s attempts to rejuvenate its consulting activities following the 2000 Accenture split. Like many in the accounting industry, Berardino argued that consulting work enhanced auditing by giving employees a firsthand knowledge of the industry that they monitored. Berardino understood that auditors were no longer just auditors and he saw no need to challenge what had become standard practice.
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10 Schwartz, John and Jonathan Glater. “At Andersen’s Helm, A Winner of Battles Who Faces a War”. The New York Times. Jan 14, 2002.
Brown, Ken. “Berardino, Picked to Lead Audit Firm Back to its Roots, Faces Bigger Task.” The Wall Street Journal. January 14, 2002.
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By 2001, the accounting industry bore little resemblance to 1913’s art of bookkeeping. Auditors faced unprecedented pressure. They monitored businesses that did not fit into established categories. And as technology evolved and information became quickly accessible and transmittable, accountants had greater capacity to add new services to their work, including consulting duties. The potential existed for a reshuffling of auditing practice not only at Andersen, but across every firm in the industry. When sweeping change did occur, it occurred with Arthur Andersen in the media spotlight as a symbol of the failures of the accounting industry.
Arthur Andersen in the Public Eye
Prior to 2001, most Americans paid little attention to the role of the “Big Five” auditors in the business world. The new business environment of increasingly close auditor-client ties had led to concerns within the industry. Lobbyists for the major accounting firms had established a place for themselves on Capitol Hill, while executives within the firms themselves struggled with questions of proper oversight and possible conflicts of interest. The general public, however, remained mostly disengaged from this debate.
Arthur Andersen Case Study
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Arthur Andersen always had an indirect responsibility to the public. In its capacity as an independent auditor, Andersen oversaw business transactions and bookkeeping, and verified the profits that each company posted so that potential investors could base their investment decisions on credible information. At the same time, however, it was the large corporate clients that generated profits for Andersen and so it was these clients with whom top executives cultivated good relations, to the exclusion of relationships with other key constituencies.
When Enron officials pointed their fingers at the fraudulent bookkeeping behind their company’s bankruptcy in 2001, the public began to ask how the $600 million error could have occurred. As the investigation into Enron’s business practices progressed, the media and the public both became increasingly critical of Arthur Andersen, which had consistently turned a blind eye to questionable financial transactions. Andersen had faced accounting scandals before but none of these had Enron’s potency. The auditing firm could not escape public censure in the aftermath of the energy giant’s demise.
The American public, fueled by images of loyal Enron workers left with no work, no pension, and worthless stock options, immediately condemned Enron executives as criminals. Furthermore, they saw Arthur Andersen as directly implicated in these executives’ criminal activities. To many, Andersen would become synonymous with Enron’s failure. Whether or not Andersen was unique in its relations with its clients, its Enron association became the symbol of a corporate world in which unscrupulous top executives could use sophisticated financial manipulations for personal profit at the expense of their companies.
In the wake of Enron, the auditing firm that had devoted so much of its time and attention to courting its top corporate clients would have to answer to a new constituency– the American public. Many of Andersen’s new critics had no prior knowledge of the accounting business;
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they had never previously questioned who audited the books of the companies on which they relied for services, employment, or returns on their investments. Instead, the average citizen relied on a regulatory structure in place at the SEC to protect against fraudulent bookkeeping practices. This infrastructure had failed them. Worse, many Americans believed that the private auditors charged with enforcing accounting standards had joined forces with the very companies who were abusing these standards. To these critics, Andersen executives had committed a double betrayal, both collecting illegal profits and neglecting their duties as watchdogs.
Andersen was not alone in questionable auditor/ client relations; the accounting industry as a whole had undergone substantial changes through the 1990’s. Andersen was alone, however, in its link to the Enron debacle and in bearing the brunt of Americans’ outrage over what had happened. The investors to whom Andersen’s corporate clients responded would soon demand stricter inspection of accounting procedures. Some would ask for a separation from Andersen. For the first time, a major auditing firm’s reputation with the American public would have a direct impact on the future of the company. And Andersen, by November of 2001 was ill-prepared to handle this new constituency.
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The Enron Collapse
Through the 1990s, Enron enjoyed a very close relationship with the Andersen partners that it hired as accountants. This relationship included the “cross pollination” of employee pools, both internal and external audits performed by Andersen, and a large volume of consulting work done by Andersen accountants as well. David Duncan was head of Andersen’s Houston office. He directly oversaw the auditing of Enron’s accounts and exercised significant power in determining the relationship between Andersen and Enron. Duncan had personal ties to both Houston, as a graduate and active alumnus of Texas A & M, and Enron, where he regularly joined in company sponsored events and even shared office space at Enron headquarters11.
Duncan’s personal autonomy in handling the Enron portfolio extended beyond the Houston office to an ability to overrule those governance committees that Andersen headquarters had established to ensure proper accounting procedure. Duncan could even remove committee members from ruling on Houston office work. He acted on this power when, in December of 1999, Carl Bass voiced concerns over bookkeeping at Enron. Bass was a member of Andersen’s Professional Standards Group (PSG), a committee of expert auditors charged with reviewing particularly complicated accounts. Duncan had dismissed PSG objections on four separate occasions prior to 1999. In that December, Bass detected improper records for a sale of options by a special purpose enterprise owned by an officer at Enron. Although the sale eventually went through as originally recorded, Bass would not drop his complaint over
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11 Herrick, Thaddeus. “Were Enron, Andersen Too Close?”. The Wall Street Journal. January 21, 2002.
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the transaction. Over a period of several years Duncan, on Enron’s behalf, petitioned to have Bass removed from the case. Bass was eventually removed from the PSG12.
After the complaint about Bass, in February of 2001, executives at Andersen once again expressed serious reservations about Enron as a client. And once again the Houston office persuaded top officials not to terminate the contract. By this time the errors that would lead to Enron’s bankruptcy later that year had already accumulated. Congressional investigators would later find that Enron had used outside partnerships owned by Enron executives, like those uncovered in Bass’ review, to hide millions of dollars of debt.
In spite of Duncan’s insistence on keeping the Enron account, Andersen headquarters still believed that something had gone wrong in the Houston bookkeeping. On October 12th, 2001, ten days before the SEC announced its investigation of Enron, Nancy Temple sent out an e-mail that reminded employees of the company’s document retention policy. This policy had begun several years earlier after the Waste Management investigation, in which the SEC had uncovered wrongdoing at Andersen using evidence pulled from its Waste Management files. These incriminating files had resulted in a nearly $300 million fine for Andersen. Following Temple’s e-mail, in accordance with company policy, employees began to shred documents, including documents relating to the Enron case.
Arthur Andersen Case Study
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On October 22nd, 2001, the SEC publicly announced its probe into Enron’s financial transactions. The internal debates at Andersen over these transactions, debates which began in 1999 and continued up to the SEC announcement, indicate that the accounting firm knew that its own role in the energy company’s financial trouble might be called into question. If any doubt remained over whether Enron’s scandal would reach the auditors, Enron executives settled the matter on October 31st by convening a special committee to investigate Andersen’s accounting failures.
In spite of Andersen headquarters’ early realization that their Houston office could come under attack for its treatment of the Enron accounts, almost everyone else at the company remained in the dark about the problem. Branches outside of Houston received little or no preparation for October’s crisis. In fact, employees at Arthur Andersen described their preparation as virtually non-existent. Doug DeRito, the Atlanta partner at Andersen, went so far as to request Berardino’s resignation. He was angered by the lack of any internal information flow and declared “My ability to survive financially [through Enron] is at stake, and I have zero details”13.
On November 8th, 2001, Enron restated its finances back to 1997, revealing a $586 million loss. The company’s stock plummeted, and thefinger pointing began in earnest. Enron disavowed its books and blamed Andersen’s poor accounting standards for allowing millions of dollars worth of improper transactions to pass without anyone sounding an alarm. Enron
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12McNamee, Mike. “Out of Control at Andersen”. Newsweek. April 8, 2002.
13Brown, Ken, Ianthe Jeanne Dugan, Cassell Bryan-Low. “Berardino’s Resignation Leaves Andersen’s Drama Unresolved”.
The Wall Street Journal. March 27, 2002.
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had made many unwise business deals. Company officials insisted, though, that the error hadn’t been theirs alone, but their accountants’ as well.
Arthur Andersen had worked hard over the last century to develop a positive reputation among corporate clients like Enron (See Exhibit 1-2). The firm served these clients not only through external auditingservices, but consulting and internal auditing work as well and oversaw transactions of billions of dollars in the fast-paced financial world of the 1990’s. When companies that had hired Andersen as an accountant started to fail, however, the close auditor/ client relationships that first attracted clients to Andersen began to appear too close. Federal investigators would soon attempt to separate out acceptable company practices from compromising ones in the much-changed accounting world of 2001. And Arthur Andersen would be at the center of this debate.
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Problems Facing Andersen
With the SEC about to announce that it would subpoena Andersen’s files regarding the Enron case the next day, Berardino knew that his firm was in danger and needed immediate help. Andersen was already on SEC “probation” for earlier accounting errors with Waste Management and Sunbeam. Partners at the firm had reason to believe that the SEC would investigate its operations even further when it examined Andersen’s role as an auditor at Enron. Not only would Andersen be under federal scrutiny, but the heavy media coverage of Enron had placed the accountants under public scrutiny as well. Berardino had never represented Andersen to such a broad audience before, and he had almost no foundation from which to build a new campaign now. It would be difficult to put together a corporate communication strategy given the firm’s limited effort in this area, but Berardino knew he had to do something now, or the firm might never recover.
Case Questions
1.How does the changing environment for business affect Arthur Andersen’s ability to communicate in this situation?
2.Where is the firm most vulnerable, from a communications standpoint?
3.Who needs to be involved in discussions about how to communicate in the face of the SEC investigation of Andersen?
4.What role will Joe Berardino need to play in this situation?
5.What advice would you give Mr. Berardino if you had received his call from Tokyo instead of David Talbot?
Tuck School of Business at Dartmouth
Arthur Andersen Case Study
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