Lack of Accountability

Corporate Research E-Letter No. 21, February 2002 

LACK OF ACCOUNTABILITY: THE ENRON/ARTHUR ANDERSEN SCANDAL AND THE FUTURE OF THE ACCOUNTING BUSINESS

by Philip Mattera
 

In 1913 a diligent CPA named Arthur Andersen went into business with a colleague and built what would become one of the largest accounting firms in the world. In its early years the firm developed a reputation for integrity. For example, when auditing the books of a steamship company, it insisted on reporting the financial impact of the sinking of a freighter, even though it occurred after the reporting period had ended.

Fast forward nearly 90 years. In January 2002 the firm admitted that its accountants had destroyed a “significant” number of documents related to its work for Enron Corp., the audacious energy-trading company that had crumbled over the previous few months, costing its shareholders tens of billions of dollars in lost equity.

The Enron debacle has turned into the most far-reaching business scandal in many years. It has raised fundamental questions about the integrity of American big business, the influence of corporate money on the political system and the oversight mechanisms that are supposed to keep publicly traded companies honest.

At the center of this firestorm has been Arthur Andersen, which failed to notice -- or chose to ignore -- the huge volume of transactions that Enron, now in Chapter 11 bankruptcy, was improperly excluding from its financial statements, thus giving investors a wildly exaggerated impression of its growth and profitability.

Andersen’s dismal performance as a financial watchdog has led to a wave of proposals to reform the accounting business, including a truly independent system of oversight. The big firms have finally acknowledged that it is not a good idea for auditors to serve as management consultants for the same clients (as Andersen did for Enron) or even to serve as both internal and external auditors for the same company.

It remains to be seen whether these relatively limited reforms are sufficient to resolve the crisis of legitimacy brought about by Enron. In the meantime, Andersen itself is fighting for survival. Clients are taking their business elsewhere and employees are bolting. The firm is the target of lawsuits by Enron shareholders and creditors. State accountancy boards are considering whether to yank its license. The creation of an oversight panel headed by former Federal Reserve Chairman Paul Volcker has done little to quiet the uproar. This week there have been reports that Andersen is trying to negotiate a $750 million settlement of all the civil litigation facing it, though there is still the possibility of criminal charges. Additional troubles may lie ahead as more information comes to light about the circumstances leading up to the bankruptcy of Global Crossing Ltd., another high-flying Andersen client that has fallen to earth.

FROM PENN CENTRAL TO WASTE MANAGEMENT

For long-time observers of the business scene, the Andersen fiasco does not come as a surprise. For the past quarter-century, Andersen and the other big accounting firms -- long known as the Big Eight and now consolidated into the Big Five (see below for lists) -- have been embroiled in a series of scandals involving their failure to detect and disclose financial irregularities at companies they audited.

During the 1970s the firms were taken to task for failing to alert shareholders to the problems that led to the collapse of the Penn Central Railroad and for saying nothing about the widespread payment of bribes by U.S.-based multinationals to secure foreign business.

In the 1980s Peat Marwick gave Penn Square Bank a clean bill of health just before it collapsed under the weight of bad energy loans. It later came out that the firm had audited only 15 percent of the bank’s loan portfolio. Various accounting firms found themselves being sued by the federal government for their role in auditing the books of crooked savings and loan associations. This led to a series of settlements, the largest of which was the agreement by Ernst & Young in 1992 to pay a record $400 million in connection with about a dozen failed S&Ls. Industry observers argued that the amount was a bargain for Ernst, given that the federal government had been seeking about $1 billion in damages. The following year Arthur Andersen agreed to pay the feds $82 million to settle charges in connection with the collapse of Charles Keating’s Lincoln Savings and Loan Association.

The Big Eight also had to contend with lawsuits brought by disgruntled shareholders of companies whose problems were not revealed by auditors. As private partnerships, the accounting firms did not have to reveal the size of the settlements they paid in these cases, but occasionally the veil was lifted. During 1985 Congressional hearings on the shortcomings of the accounting business, the firms disclosed how much they had paid out over the previous five years. By far the largest sum came from Arthur Andersen, which had forked over $137 million to plaintiffs.

More recently, KPMG paid $75 million in 1998 to settle a group of lawsuits charging that its audits of Orange County, California had failed to warn about the dangers of risky investments that led to a financial meltdown. Ernst & Young has been embroiled in litigation over financial fraud at Cendant Corp. Last year Arthur Andersen (whose parent company is now known simply as Andersen) paid $110 million to settle shareholder suits in connection with financial chicanery at Sunbeam Corp. Andersen also had to pay a $7 million penalty to resolve civil charges brought by the SEC, which found the firm’s audits of trash hauler Waste Management Inc. -- which failed to detect more than $1 billion in overstated earnings --  to be “false and misleading.”

THE ACCOUNTING OLIGOPOLY

These scandals, along with Enron, are quite a record for an industry that, at least until recently, managed to retain an image as staid and dependable. A good part of the problem is that, for much of the past century, the large accounting firms have operated what amounts to an oligopoly. As early as the 1950s, the Big Eight audited the books of more than 70 percent of the companies traded on the New York Stock Exchange. By the 1980s that amount was close to 100 percent.

That kind of concentration fostered a cozy atmosphere in the profession. Until the 1970s, accounting firms were not allowed to advertise and client-poaching was rare. Things began to change in the 1980s, especially as a merger wave began to reduce the number of big accounts. The Big Eight became increasingly aggressive in luring new business, but their attempts to foster closer ties with clients were limited by rules requiring their strict independence from the companies they were auditing.

Two solutions emerged. If they couldn’t expand market share by attracting new clients, firms would join forces with their competitors. In 1989 three mega-mergers involving members of the Big Eight were announced. Two of these were successful: Ernst & Whinney joined with Arthur Young to form Ernst & Young, while Deloitte Haskins & Sells merged with Touche Ross to create Deloitte & Touche (the parent company’s name was later changed to Deloitte Touche Tohmatsu). The marriage of Arthur Andersen and Price Waterhouse was called off because of compatibility problems.

The reign of the Big Six lasted until 1997, when two more combinations were attempted. Price Waterhouse and Coopers & Lybrand tied the knot and formed what became known as PricewaterhouseCoopers. Plans for a union of Ernst & Young and KPMG Peat Marwick were dropped in the face of resistance from antitrust regulators. (Peat Marwick had merged with KMG, itself the combination of several European and smaller U.S. firms, in 1987.) The industry is now dominated by the Big Five, though that would drop to four if Andersen doesn’t survive.

The other way in which the accounting industry managed to expand was to branch out from the mundane business of auditing into a variety of other business services with greater growth potential. Foremost among these was management consulting, which for many of the firms became a multi-billion-dollar business. The problem was that consulting put the firms in the role of quasi-insiders and flew in the face of the accounting profession’s independence rules. For decades the SEC and Congress periodically raised concerns about the dangers of the industry’s increasing involvement in consulting. The most serious reform effort was mounted in 2000 by SEC Chairman Arthur Leavitt, but the industry used its lobbying muscle to defeat Leavitt and later breathed a sigh of relief when Harvey Pitt, a corporate lawyer who had represented the industry, was named by President Bush to head the Commission.

By this time, however, several of the Big Five had already decided that spinning off their management consulting arms was unavoidable. In 2000 Ernst & Young sold its consultancy to France’s Cap Gemini Group for $11 billion. KPMG’s consulting business is now a separate company, which is publicly traded. After a protracted struggle, Andersen’s consulting operation split off to form Accenture Inc. (though Andersen continued to do work of this kind on its own). Last month, PricewaterhouseCoopers announced plans to split off its consulting unit through an initial public offering. A week later, Deloitte Touche Tohmatsu took steps to separate its consulting business, but in a less definitive way.

THE SITE LOCATION RACKET

Apart from general management consulting, the big accounting firms also moved into specialized areas of consulting. One of the most controversial of these is the business of advising companies on where to locate new facilities. Several of the Big Five have held onto this activity even after spinning off other consulting operations.

On the surface, site location seems to be simply a matter of scouting out property that best meets the physical requirements for a new factory or warehouse. Yet this business -- pioneered by Fantus, now a part of Deloitte Touche Tohmatsu --  long ago got into the less savory activity of helping companies find communities that are so desperate for investment that they are willing to offer extensive tax breaks and other subsidies. The site location consultants are in a position to pressure local officials to provide more and more generous incentives, in the name of “improving competitiveness.” Their efforts have helped to create a climate in which communities bid against one another and often end up offering subsidy packages far in excess of the economic benefits of the investment. Last year Andersen’s Business Location Services unit played a key role in helping Chicago win the competition launched when Boeing decided to move its headquarters from Seattle. Andersen accomplished this, in part, by producing a report to Illinois officials that made highly questionable projections about the economic impact of Boeing’s new head office.

Thanks to the Enron scandal, the ability of the Big Five to continue in this field may be in question. There have been recent reports that members of Congress are considering introducing legislation that would call on the SEC to review whether audit firms should be prohibited from doing tax-related work, which could be defined as including site relocation consulting. Perhaps this will be the step that begins to free state and local governments from the tyranny of the arbiters of “business climate.”

THE BIG FIVE
(parent company worldwide revenues for fiscal years
 ending in 2001)

Source: company press releases for all but Ernst & Young, which is an estimate from the Forbes 500 Privates list

The ranks of the Big Eight prior to the beginning of the consolidation wave in 1989 were:

• Arthur Andersen
• Arthur Young
• Coopers & Lybrand
• Deloitte Haskins & Sells
• Ernst & Whinney
• Peat, Marwick, Mitchell
• Price Waterhouse
• Touche Ross