Coffee Break: Reforms should put fear of God into auditing industry

"How are the mighty fallen!"

2 Samuel 1 v. 25

When it comes to the indictment and vilification of Big Five accounting firm Arthur Andersen, the question is not why Andersen is in trouble, but how Ander-sen got away with its highly questionable activities as long as it did.

In other words, who was auditing the auditor?

The answer is, nobody.

With the Enron debacle, the public's faith in financial reporting was shaken. And rightly so. But the handwriting was appearing on the wall well before 2001.

It is obvious that it's time for an ac-counting from the accounting and auditing profession.

Betrayal of trust

As detailed in a March 26 release from the Securities and Exchange Commis-sion, Andersen's shenanigans didn't begin with Enron.

Witness the blind eye it turned to the blatantly fraudulent activities of Waste Management Inc. senior officers, who now are being sued for fraud by the SEC.

In the case against Waste Manage-ment's corporate officers, "Our complaint describes one of the most egregious accounting frauds we have seen," said Thomas Newkirk, associate director of SEC's Division of Enforcement. "For years, these defendants cooked the books, enriched themselves, preserved their jobs and duped unsuspecting shareholders."

The company's officers, according to the SEC complaint, inflated profits by $1.7 billion in order to meet earnings targets. As a result, defrauded investors lost more than $6 billion.

Arthur Andersen, as auditor, had an ethical and moral responsibility to the company's shareholders to raise red flags regarding the firm's accounting practices.

It didn't.

Andersen issued unqualified, or "clean," opinions on Waste Management financial statements from 1993 through 1996.

Yet, during that same period, Anderson accountants "identified and documented numerous accounting issues giving rise to misstatements and likely misstatements, and brought certain of the issues to the attention of Andersen's practice director, the firm's managing partner and the audit division head for the firm's Chicago office," the SEC stated.

In fact, the wrongdoing only came to light in mid-July 1997 when a new Waste Management chief executive ordered a review of the company's accounting practices. As a result, in 1998 the company restated its financial statements for 1992 through the third quarter of 1997, revealing that it had misstated pre-tax earnings by approximately $1.7 billion.

That restatement caused stock to plummet, resulting in the more than $6 billion loss to investors.

In May 2001, an Andersen partner was charged with fraud by the SEC for authorizing unqualified audit opinions on beleaguered Sunbeam Corporation for 1996 and 1997, even though he knew of accounting improprieties and disclosure failures on the part of the company.

Punishment

For its role in the Waste Management fraud, Arthur Andersen, the watchdog that rolled over and played dead, was fined and the Andersen partners involved slapped on the wrist in a June 19, 2001, settled enforcement action by the SEC.

True, the fine against Andersen in the Waste Management case was, at $7 million, the largest-ever civil penalty in en-forcement action against a Big Five ac-counting firm.

However, during the period when the fraud occurred, Andersen and its related businesses benefited by more than $25 million.

Andersen agreed to the antifraud injunction "without admitting or denying the allegations or findings," marking the first such injunction against a Big Five firm in 20 years.

Three of the Andersen partners cited also "without admitting or denying the allegations or findings" agreed to the payment of civil penalties ranging from $30,000 to $50,000 each and were barred from practicing before the SEC as ac-countants.

However, one had the right to request reinstatement after five years and two had the right to request reinstatement after three years. A fourth partner was not fined but agreed to a bar on practicing before the SEC as an accountant with the right to request reinstatement after one year.

Now, Enron.

Accountability

The accounting industry is working to make amends and restore public confidence by proposing reforms regarding audits and accountability. I applaud such efforts, provided they go far enough.

Oversight must be more direct and enforcement must have real teeth if the investing public is to have any faith in our financial reporting system.

The fear of God needs to be instilled in those who would profit from the juggling of numbers, and those who would wink at it.

For example, stiff prison sentences in maximum security facilities not "white collar" country club prisons might go far in deterring the greedy.

Forfeiture of all profits realized on the part of the auditing firm and its related or affiliate businesses might encourage stricter internal controls on the part of auditing firms.

Moreover, it is time to scrutinize the sometimes incestuous staffing situations of major corporations: is there not an inherent conflict of interest in a company hiring as top financial executives people who were previously employees of its "independent" auditing firm?

Until 1997, every chief financial officer and chief accounting officer in Waste Management's history as a public company had previously worked as an auditor at Andersen.

I do believe the accounting industry and government regulators can deal with this situation, but I'm from Missouri: They're going to have to show me. I expect real change, real reform and real penalties.