Title :       10. Audit Liability - Part 3 - Enron, Worldcom, Andersen and the Sarbanes-Oxley Act - Lessons Two and Three
   Author : Mark L. Cheffers*  

Lesson 2. Form-over-substance financial reporting can have disastrous results

In a Wall Street Journal opinion piece, Joseph Berardino, the former CEO of Andersen, acknowledged that the firm may have focused on form over substance in reviewing certain Enron transactions. Berardino also opined that astute investors could have picked up on the troubles at Enron earlier if they had read the documents carefully. He cited this as evidence of a systemic financial reporting problem. Was the problem form over substance with respect to certain Enron transactions or form over substance with respect to the presentation of the overall financial position of Enron? Why not just record the transactions plainly and properly so that they could be understood?

Recently, the bankruptcy court expert retained to review the accounting and financial representations made by Enron released a 2,000-page report. That report essentially concluded that the financial statement manipulations were endemic within Enron. The company's use of mark-to-market accounting and off-balance sheet schemes was so significant and widespread that it was difficult to find any part of Enron's balance sheet that was unaffected. Assuming this is a fair representation, one has to wonder what Berardino meant by "may have focused on form over substance." How misleading does it have to get before something would have been done?

According to Berardino, the problem lay with "the rules" or the profession's need to "update financial reporting requirements," and not with Andersen's treatment of the transactions. This statement raises several questions.

1. Would updated financial reporting requirements have ensured that entities established by and substantially controlled by Enron's management be consolidated into their results?

2. Would updated financial reporting requirements have ensured that the auditors looked at transactions conducted by two apparently separate companies, but negotiated between the CFO and CEO of the same company, with a jaundiced eye?

3. Would new reporting requirements have ensured that the auditors examined the entirety of the relationship of a group of entities with respect to disclosing the real debt to equity ratios that encumber a parent company?

The simple answer to these questions is No. All of these requirements already existed, at the most fundamental level of financial reporting. The only reason Andersen did not ensure proper financial reporting was because they did not desire to, not because the financial reporting requirements were out of date.

Lesson 3. Independence Matters

Over the past five years, the profession has seen a great focus on auditor independence. Why all the concern and consternation? Fundamentally, the issue was about independence versus advocacy. Coupled with a dramatic growth in non-audit services and a move by the profession to become "global business advisors" or something similar, both regulators and stakeholders began to pressure the profession. Obviously, the revelations of Andersen's conduct came at a time when the issue was in full debate. As a result, the Enron and Andersen relationship burst onto the scene like a match to gasoline. Several of the key factors and issues concerning Andersen's independence are discussed below.

A. Andersen truly believed they were independent, but how?

Andersen surely believed that it was providing Enron with cutting edge financial reporting advice. They were paid to be experts at finding the most advantageous ways for their clients to report financial results. They were working with a "next generation" company that was run by brilliant and dynamic individuals. Enron's CEO was a former McKinsey head. Andrew Fastow, its CFO, was so impressive that he received the Andersen-funded CFO Magazine's "CFO of the year award" in 1999. Andersen contended that its audits were done with the requisite independence of mind and that careful consideration was given to the acceptance of each new engagement. The trouble is that hardly anybody in the world believed that. Why could they not see the obvious manipulations they had facilitated? The answer now seems clear. They were simply too deeply involved in advancing what they perceived were their clients' interests.

Any client that can produce $50 million annually in fees (excluding fees related to the SPEs that were supposedly independent of Enron) is a value producer of magnificent proportions. A Big Five partner would have done just about anything to land a client like Enron. Think about it this way: a conservative valuation of a cash flow of $50 million per year would be $500 million. Enron was potentially worth more than $500 million to Andersen. Is anyone supposed to believe that this did not influence how Andersen looked at gray area accounting and financial reporting issues?

B. Auditors should not offer both the diagnosis and the cure

At the core of this crisis was the ongoing question of whether auditors should provide both diagnostic and curative services. Sarbanes-Oxley seeks to separate these two functions. In the medical profession, it is sometimes better for the doctor who diagnoses a problem to fix it than to wait for a second practitioner to provide the cure. It is generally more efficient and less risky to the patient for the first doctor to complete the entire process. Even so, many significant procedures require a second opinion or even third-party payer approval. Third-party payers has become a part of the process because there are, unfortunately, some physicians who order more tests and procedures than necessary in order to make more money for themselves. Thus, for some physicians, independence is compromised by self-interest. The accounting profession faces a similar challenge. Much emphasis has been placed on generating more fees from existing clients. This creates the temptation for an auditor to identify real or cosmetic problems as part of an audit in order to benefit from "curing" the problem with lucrative non-audit services. One need look no further than the Andersen memo that predicated the decision to keep Enron as a client, in part, on the belief that the company would soon become a $100 million a year client.

C. "Stop me before I shoot myself"

The question of Andersen's independence from Enron is much like the problems baseball owners face. Every few years, a majority of baseball owners band together to try to impose new rules that would effectively restrict the salaries being paid to ballplayers. The effort can be summed up by the expression, "Stop me before I shoot myself." In the end, the owners never actually impose any new rules and the reason is that they do not really want to be stopped from getting the players they need to compete and win, whatever the cost. As a result, they give up on the changes that might ensure the overall prosperity of the league and focus on their own self-interest.

This analogy reflects the challenges Big Four firms face in providing non-independence services to their audit clients. Non-independence services became so important to the profitability of many of these firms that the equivalent of financial civil wars have been fought over how to keep audit and non-independence services together (i.e., Andersen/Accenture). Little debate was given to the fact that Andersen charged $27 million for the non-audit services it provided to Enron, despite the fact that they had separated from their consulting business prior to that time period. If they had split from their consulting work, why were they performing so many services? The answer again appears to be clear. The split between the two entities was not a principled separation, but a political one. Andersen had every intention of rebuilding its consulting services to previous levels, except this time under much tighter controls. Ultimately, the issue was about profitability.

D. A well-planned audit requires an auditor who truly "understands the business"

Understanding a business has become the most important aspect of auditing a complex client. Andersen had to have known what Enron was doing. The better one can understand the business risks, competitive pressures and environmental trends affecting a client, the better one can develop an audit plan. Many non-audit services are perfectly suited to advancing these goals. Some are not. Ideally, auditors should provide only those non-audit services that involve no "independence" issues.

Two points about the failed Andersen audit seem worthy of analysis. First, Andersen did so much work for Enron that they must have understood the true nature of the business. Second, that understanding should have led to better audits. Yet, in this case, an understanding of the business actually seemed to lead to worse audits. Why was this? The answer seems simple again. By becoming Enron's financial adviser about all kinds of financial manipulations, Andersen prohibited itself from being objective in its assessments of the underlying accounting issues.


*Mark L. Cheffers, CPA, ABV, is a former PWC manager, Harvard MBA and highly experienced litigation consultant.


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