In 1990. David Sokol faced a problem that has stymied the careers of many business executives. At the time, Sokol served as president of Ogden Projects, Inc., an environ- mental services company: Sokol had his sights set on becoming the company's chief executive officer (CEO), but something, or rather someone, stood in his way, namely, the boss's son. Many company insiders believed that the chairman of Ogden Corporation, the parent company of Ogden Projects, had already decided to appoint his son as the next CEO of Ogden Projects. Rather than provoke an unpleasant "scene." Sokol graciously resigned and returned to his hometown of Omaha, Nebraska, to search for another position.

A few months later, in early 1991. Sokol landed a job with a large Omaha construc- tion and mining company. That firm owned a controlling interest in California Energy: a public company based in San Francisco that was struggling financially Sokol's new employer gave him the difficult task of "turning around" CalEnergy by appointing him the company's CEO. Sokol, who majored in civil engineering, not business, at the University of Nebraska, spent his first several weeks in his new posi- tion scrutinizing CalEnergy's accounting records. He quickly decided that the com- pany's financial problems stemmed from poor cost control and inefficiencies in its operations. Within a few months. Sokol had implemented an austerity program for CalEnergy. That program included eliminating executive perks such as private jets and limos, slashing the company's bloated payroll by 25 percent, and moving CalEnergy's corporate headquarters from the pricey San Francisco Bay area to the more modest and economical outskirts of Omaha.

The rapid and dramatic impact that Sokol's turnaround program had on CalEnergy's operations caught the attention of corporate boards across the nation. In early 1992. Sokol was offered the position of president and chief operating officer (COO) of JWP Inc., a large, New York-based conglomerate. JWP had an impressive history of sustained profitability and revenue growth that was being threatened by its sprawling operations and heavy administrative burden. In early 1992, the company had 117 offices and 23 sub- sidiaries scattered across the country, several overseas operating units, and a huge new division that was competing in a lucrative and rapidly developing market. JWP's CEO. Andrew Dwyer, knew that despite being soft-spoken and thoughtful, Sokol had a well- deserved reputation of being an effective corporate manager who could quickly "whip a company into shape. Sokol eventually succumbed to Dwyer's persistent recruiting efforts and agreed to assume responsibility for directing JWP's day-to-day operations.

From Queens to Computers 

The Jamaica Water Supply Company began operations in 1886 as a small business that delivered water to a few neighborhoods in the Queens borough of New York City. Gradually, the company expanded its geographic market and eventually became one of New York State’s largest water utilities. In the mid-1960s, Martin Dwyer took control of the company. Dwyer realized that the heavily regulated water utility industry limited his company’s profit potential, so he decided to branch out into other businesses.
Because of his familiarity with governmental agencies, Dwyer began offering various contracting and construction services to local municipalities. Soon, Dwyer's company was installing telephone lines, working on street lighting projects, and developing traffic control systems. Over the next several years, the company expanded into other lines of business by acquiring a varied assortment of small firms in the New York City metropolitan area.
Throughout its long existence, Jamaica Water Supply had been characterized by financial stability, slow but steady growth, and modest profits. That all changed under Dwyer’s leadership. During the 1960s and 1970s, the company grew rapidly, while its profits—and losses—vacillated sharply from year to year. To finance the company’s expansion program, Dwyer borrowed heavily from banks and other lenders. By the mid-1970s, high interest rates, a severe nationwide recession, and a series of poor decisions by Dwyer and his management team had driven the company to the verge of bankruptcy. To salvage the company, Martin Dwyer stepped down as its top executive in 1978 and placed his 30-year-old son, Andrew, in charge.
The younger Dwyer quickly disposed of the company’s weakest divisions, paid off much of its debt, and developed a new, more focused business plan. This business plan called for the company to become the “premier technical services” firm in the world.” By the mid-1980s, the company, renamed JWP (Jamaica Water Properties)
Inc. by that time, offered a wide range of services involving the design, development, and maintenance of complex mechanical, electrical,and computer systems. JWP targeted its services to high-tech industries, including the financial services industry.
The company developed sophisticated control systems that helped major Wall Street firms, such as Merrill Lynch and Goldman Sachs, more efficiently and cost-effectively manage their operations.
By the early 1990s, Andrew Dwyer’s new business model for JWP had converted the company into a multibillion-dollar firm with a workforce of more than 20,000 employees. The company’s stock was listed on the New York Stock Exchange and included in the Standard & Poor's 500. Probably most impressively, the company reported increased revenues each quarter over a 12-year period from 1979 through 1991. Although JWP still had a water utility division, that division accounted for only 2 percent of the firm’s annual revenues.
In early 1991, Dwyer made a key decision that he hoped would catapult JWP to among the largest and most prominent companies in the nation. Dwyer purchased the large computer retailer Businessland, Inc. Businessland’s operations were integrated into a new division of JWP that marketed computer hardware, business software applications, and information systems development services. Dwyer believed the new division would provide JWP with the means to compete with companies such as IBM and Microsoft that were profiting enormously from the computer revolution sweeping through the business world.
Despite Dwyer’s lofty plans for his new division, he realized that it only worsened a problem that JWP had been battling over the previous few years. The company’s rapid growth during the 1980s had resulted in a farflung and unwieldy organization that was difficult to manage and weighted down by disproportionately high administrative expenses. To remedy this problem, Andrew Dwyer went in search of an individual with a proven track record of managing companies facing difficult circumstances.
In a matter of weeks, Dwyer identified David Sokol as the top candidate for JWP’s COO position.

Dark Secrets

David Sokol accepted Andrew Dwyer’s offer to become JWP’s COO in January 1992 because he enjoyed tackling challenging assignments. But Sokol was unaware of the biggest challenge he would face at JWP Over the previous several years, the company’s financial data had been embellished by a pervasive accounting fraud.
The abusive accounting practices included misapplying the purchase method of accounting for acquisitions, recording fictitious assets, improper accounting for net operating loss (NOL) carryforwards, failing to record appropriate allowances for uncollectible receivables, and misapplying the percentage-ofcompletion method of accounting for long-term contracts. Collectively, these accounting abuses had a significant impact on JWP’s reported profits. For example, in 1991, JWP reported a net income of \($60.1\) million. A subsequent investigation by the Securities and Exchange Commission (SEC) revealed that the company’s actual profit for that year was \($28.9\) million.
The principal architect of JWP’s accounting fraud was Ernest Grendi, JWP’s chief financial officer (CFO). Three of the company’s senior accountants helped him carry out and conceal the fraud. Each of the four individuals was a CPA and a former employee of JWP’s audit firm, Ernst & Young. Similar to most accounting frauds, simple greed was the factor that apparently motivated Grendi and his three lieutenants. Over the course of the JWP fraud, the four individuals received sizable bonuses linked to the company’s overstated earnings and cashed in large gains in the stock market by selling JWP securities at prices inflated by the fraudulent earnings figures. Although they benefited financially from Grendi’s scam, Andrew Dwyer and the company’s other top executives were never implicated in the fraud.
Grendi’s subordinates often joked that rather than applying generally accepted accounting principles, or GAAP their company applied EGAAP—Ernest Grendi’s Accepted Accounting Principles. These subordinates used another distinctive phrase in referring to the unusual revenue pattern apparent in JWP’s internal financial reports.
Near the end of a quarterly accounting period, JWP’s accounting staff often “frontloaded”
the revenue recognized on long-term construction contracts to ensure that the company sustained its unbroken chain of quarterly revenue increases. The resulting accounting entries produced sharp spikes in JWP’s revenue charts near the end of quarterly accounting periods. These recurring spikes became known as the “High Sierras” by Grendi’s co-conspirators.
Prior to David Sokol’s arrival at JWP Grendi relied on the farreaching authority granted to him by Andrew Dwyer and on his “intransigent and intimidating”’ personality to establish complete control over JWP’s accounting function. He also used his menacing personality to neutralize JWP’s various control functions, particularly the company’s internal audit staff. A JWP internal auditor subsequently reported that fear of being fired had deterred him from challenging the company’s improper accounting treatments. Another JWP internal auditor expressed a similar sentiment when he reported that he had feared being “crushed like a flea” if he questioned the company’s improper accounting decisions......

Questions 

1. Place yourself in David Sokol’s position. After discovering the suspicious items in JWP’s accounting records, would you have taken a different course of action than he did? Why or why not?
2. What measures can and should be taken to make it easier for corporate employees to “blow the whistle” on a fraudulent scheme they uncover within their firm?
3. Should businesses, accounting firms, and other organizations explicitly reward ethical behavior by their employees and executives? Defend your answer.
4. List several measures accounting firms can take to reduce the risk that personal relationships between client personnel and members of an audit engagement team will adversely affect the quality of an audit.
5. Do you believe the 1988 “retention agreement” that Ernst & Young made with JWP was appropriate? Defend your answer.
6. Why do you believe that Ernst & Young agreed to pay a large settlement to JWP’s stockholders but chose to contest the lawsuit filed against it by the insurance companies?