In order “to offer high-quality accounting services”, Arthur Andersen (AA), a Northwestern accounting professor started a business to offer services to clients promoting “integrity and sound audit opinions over higher short-run profits”. The company’s “four cornerstones” was good service, quality audits, well-managed staff, and profits for the firm. Their strategy was to focus on quality and high standards of audits rather than profits, a very successful strategy that led to consistent growth over the years.
Environmental, strategic, and organizational changes
In designing the optimal architecture for a given firm, market conditions, technology, and government regulation should be taken into consideration as these are important factors and determinants of strategy. At the top is firm’s external business environment which comprises of technology, markets, and regulations all of which feeds down strategy, organizational architecture, incentives and actions, and firm value.
In order to focus on generating new business and cut costs AA adopted a new strategy which involved evaluating its partners on how much new business they brought to the firm. This newly adopted strategy made it more about the numbers and making money. In order to reduce the costs they required partners to retire at the age of 56 years. With this strategy it led to the increased emphasis on revenue growth as well as expense reduction.
There were new partners that rose to the top, Steve Samek, a prominent example of a partner that was able to turn a $50,000 audit fee into a $3 million audit engagement. Although some rose to the top, such a policy it led to fewer experienced auditors and fewer partners overseeing audits and signing off on inaccurate financial statements for companies that overstated revenues due to improper write off of assets.
Another prominent change within the firm was when an Andersen engineer, Joseph Glickauf, demonstrated that computers were able to automate bookkeeping records. This was noted to be a “monumental change in the partnership” and allowed the company to enter the consulting business in 1954. They were able to help their clients automate their accounting records and they were able to develop the largest technology practice of any accounting firm.
The firm’s external environment was also changing in 1930s as the federal government adopted new laws that required public companies to submit their financial statements to an independent auditor every year. Added regulations led increased revenues during this period and helped with the firm’s reputation and growth.
In 1998 when Samek became the managing partner he formulated a new strategy the “2X” performance evaluation system which included advice on how partners should “empathize” with clients. Along with making organizational architecture changes he also changed the culture by making the dress code a relaxed and adopted a new logo that incorporated a rising sun.
Enron’s Audit due to a few “bad partners”
Arthur Andersen began auditing Enron’s books in 1986. Early 2001 Enron was considered the “premier energy company” with a market value of equity of approximately $75 billion and such a high market value meant that it was important to pay close attention to the books of Enron since there is heavy reliance on the auditor’s opinion. Enron’s engagement fees accounted for just a small portion of AA’s revenues but most of the revenues came from a Huston office that was set up in Enron’s Huston headquarters with the partner David Duncan.
In evaluating Andersen’s claim that their problems on the Enron audit were due to a few “bad partners” I would disagree because of the close relationship that the two companies shared along with a poorly developed organizational architecture. The Huston headquarters had over 150 Andersen professionals on site that seemingly knew or were aware of the accounting scandal but chose to ignore it. Professional judgment and independence also was not practiced as noted “there were so many people in the Huston office with their fingers in the Enron pie if there was an auditor who did not want sign off on an audit they would be fired.
This was not the only crisis that AA was involved in which made outsiders questioned their practices and overlook their claim. There were lawsuits against Arthur Andersen. Prior to the Enron scandal AA had settled a dispute with the Securities and Exchange Commission paying more than $7 million for accounting and auditing work of Waste Management Corporation. Additionally, the SEC sued an Andersen lead partner on the Sunbeam Corporation audit.
These crises along with their claim that their problem with the Enron audit was due to a few “bad partners” was merely the result of an unsound organizational structure along with policies and practices that the firm implemented. The unsound organizational structure of Arthur Andersen changed the motivation of employees within the firm and changes within the firm over the years one of which was the compensation of partners did not allow for integrity when work was being done for these public companies.
What could have been done differently?
The organizational architecture of Arthur Andersen seemed to have gone a different route from what it was intended for and much of the success that Arthur Andersen was short term and partner based. Policies that were implemented led partners to engage in mischievous acts to gain more business. Slowly their policies and practices became more about money rather than quality audits using the right protocols.
Other than management who were involved in mischievous acts I would recreate or polish existing polices to realign it to their initial strategy which was to provide “quality accounting services to clients and promote integrity and sound audit opinions over higher short-run profits”. It is noted that an ill designed organizational architecture can result in poor performance and company failure and AA made material changes that changes their business environment and strategy which led to their collapse. Their flawed organizational architecture made it hard for new talent (other than partners who were all about numbers) to be discovered. It became more about making your numbers so I would also design a system that allowed for inefficient management to be replaced by new talent who are not only about creating value for the firm but also to fill in gaps that may be in architecture.
Andersen and multitask principle agent theory
Incentive conflicts existed at Arthur Andersen. At AA there was management and partners that acted in their own self interest through maximizing their own utility at the expense of the other partners that was vested in the company. This also seemed to be a recurring problem that affected the company because on multiple occasions a partner was accused acting in their own self interest. Conflict of interest with alters the principal agent relationship also played a big part at the rise of the Enron scandal because a widespread concern among investors, regulators, and the public rose which may have motivated many AA professional on the Enron engagement to sign off on questionable accounting practices. Risky practices to reap short term benefits paved also paved the way for dishonesty and fraud.
Relation between “hard” and “soft” elements of the firm’s corporate culture
Hard and soft elements better known as the 7S Model is a model of organizational effectiveness was developed at McKinsey & Co. Consulting firm in the 1980’s. It proposes that there are seven factors within a firm that needs to be aligned and reinforced in order to be successful. Hard elements include structure, strategy and systems and the soft elements include shared values, skills, style and staff.
Hard elements are influenced and identified by management. It is the formal architecture and primary determinant of a firm’s value. Soft elements on the other hand are those intangible elements that are influenced by corporate culture. AA for example organizational architecture, Samek tried to change the softer elements of AA’s corporate culture. For example, the dress code was relaxed, the wooden doors at AA’s office entrances were removed, and the firm adopted a new corporate logo, the rising sun. This gives the company a sense of direction and motivation and serves as a means for communicating and reinforcing firm goals.
According to this model it is required that there is a balance between the hard and soft elements. As it relates to AA there was no good balance between both elements. At the pinnacle of this model are shared values a soft element which was a broken element that made the model hard to achieve at AA. There was no proper defined corporate culture at AA so there was nothing to link how people will behave in the firm or to hold the architecture of the firm up. The concept of shared values should starts at highest level (i.e. partners of AA) and they should instill these values to their senior management who must then continue the process till it reaches first year hires. However, if unethical behavior starts at the highest level the companies culture will be damaged before it reaches first year hires and the will adopt the unethical behavior
In addition to changing Andersen’s organizational architecture, Samek tried to change the softer elements of AA’s corporate culture. For example, the dress code was relaxed, the wooden doors at AA’s office entrances were removed, and the firm adopted a new corporate logo, the rising sun.
Were actions at Arthur Andersen unique?
There may have been certain environmental factors (i.e. intense competition), opportunities, or lack of regulations and monitoring that may motivate other companies to partake in the same unethical decisions as AA. There may also be no telling whether or not other accounting companies practiced unethical decisions because they may be able to better conceal these unethical practices so it goes unnoticed. This situation was not unique to Arthur Andersen. The severity of the scandal made it hard for AA to bounce back whilst other companies may have been able to resolve issues dealing with unethical behavior to lessen the severity and make it seem miniscule to the public.
There is beyond no doubt that after the fall of AA and Enron that top accounting companies started to ensure that their practices and organizational structure was sound to prevent the same crises such as that of AA from happening to their company. As a top partner of another accounting firm during Andersen’s demise I would closely review practices of the firm, and closely follow articles and regulations released by the SEC, GAAP, and other regulatory agencies regarding auditing procedures. Lastly, I would also ensure that the proper protocols are followed regarding existing, new, or prior engagements (i.e. practicing independence, professional judgment or skepticism).
SEC proposed regulations in 2000 to limit consulting work by accounting firms
Legislators were acting in the public’s interest as they may have noticed that the proposed regulation was flawed and may have stirred up controversy in the securities market. The proposal was under scrutiny as it was noted to be “fatally flawed” and existing regulations passed were challenged as it was noted that a more active role needed to be taken in making changes in the measurement and reporting system in support of better information to foster better decisions making by corporations, investors and the government.
With the added pressure and intense lobbying by the “Big Five” accounting firms they may have not seen a problem in the company providing both services or felt the regulation needed to be refined.
Enforcing ethical standards because of Andersen scandal
Whilst it may not have been the main reason for the AICPA to release a set of standards for the conduct of CPAs, the Arthur Andersen scandal certainly gave rise to the development of the Code of Professional Conduct. When scandals pertaining to audit of financial statements occur the first person to blame is the firm of the CPA on the audit engagement. The AA scandal has definitely heightened the public’s awareness of the need for increased attention to all ethical business practices by professionals especially CPA who investors heavily rely on for their opinion.
The AICPA is only to be blamed for not setting higher ethical standards for their members and making it a priority. They do not have control over unethical conduct of members but they can enforce and clearly state the ramifications. It is important to note that the firm that hires the CPA to perform services should also instill their own code of conduct.
Appointment of a new oversight board
Rather than continuing to be self regulated after the scandal, the appointment of an oversight board was necessary as they provide independent oversight of public accounting firms providing audit services. They register auditors, define, inspect, and enforce specific processes and procedures for compliance of audits as well as for quality control.
Auditors of public accounting companies are inspected by the PCAOB not less than once every 3 years and except any deficiencies, the inspection report becomes public information after completion of an appeal period. The PCAOB further has authority to investigate and discipline violations of the Sarbanes Oxley Act, board rules, securities laws and professional standards.
This oversight board will provides insight on all public accounting firms so investors are confident in relying on their opinions about a particular firm’s financial statement. The Sarbanes Oxley Act allowed more eyes from the outside to look in on the practices of these accounting firms.