In February 1998, Steve Miller, the interim CEO of Waste Management, released his in-depth review of the company's audit practices. His findings stunned Wall Street: Waste Management, he announced, had "overstated" its pretax earnings by $1.43 billion from 1992 to 1996. Furthermore, the company would make a $1.7 billion restatement of its earnings—the largest in U.S. corporate history at that time. At this news, the stock price imploded, costing shareholders more than $6 billion virtually overnight. This ensured that the Securities and Exchange Commission (SEC) would investigate not only Waste Management but also its longtime accounting firm, Arthur Andersen, which had "signed off" on all of the revenue statements under revision.

Miller, a well-known turnaround artist, had been under pressure from institutional shareholders to explain the company's declining stock price and then set things right. While Waste Management had been one of the great success stories of Wall Street for more than twenty years, in the 1990s its momentum slowed. Apparently it had begun to employ "aggressive accounting" (i.e., manipulating income statements to satisfy investors and boost stock prices) as early as 1988 to maintain the appearance of growth. Since Waste Management's beginnings, Arthur Andersen had served as the firm's external audit company.

From 1991 to 1997, Andersen had earned approximately $7.5 million in audit fees from Waste Management and nearly $12 million from consulting. That made Waste Management a "crown jewel client" for Andersen. For years, the SEC had criticized the practices of the major accounting firms, in particular their double role as auditors and consultants. Now the SEC was contemplating a complaint against Andersen for conflict of interest, fraud, and perhaps more.

Background

Arthur Andersen had long set the industry standard for professionalism in external accounting. In its own eyes, the firm stood for public service and independent integrity; it was committed to protecting shareholder interests and even saw itself as a guardian of public trust. Andersen employees often spent their entire careers at the firm, where the corporate culture was strong and uniform and was supported by a rigorous system of education and acculturation into the firm's values. In the early years, the partners knew each other governing "face to face" and they largely agreed on the standards the firm needed to maintain. However, as the company experienced explosive growth and its mode of governance evolved, the culture and standards began to weaken.

The Founding Father

 

Born in 1885 to a family of Norwegian immigrants, Arthur E. Andersen made his way in the world through "strong values and hard work." In 1913, while he was working as a professor at Northwestern University, he and a partner took over the company that came to bear his name. In an era when accounting standards were in flux, the firm distinguished itself for its willingness to tell the unvarnished truth. Rather than bend to a client's demands, Arthur E. Andersen was prepared to lose an account in order to avoid compromising his firm's standards. In one famous incident that became a staple in company lore, the president of a large client company barged into Andersen headquarters and demanded an audit certification on his own terms—flatly contradicting the findings of an accountant there. Without hesitation, Arthur E. Andersen answered, "There is not enough money in the city of Chicago to induce me to change the report." While he lost the client, the reputation of his company for unyielding integrity was confirmed. ⁸ In 1939 Andersen established the "Blueback" policy, a value-added service that had partners submit a project wrap-up memo (in a blue cover) that detailed any financial, management, or strategy issues that might help their clients. These memos distinguished the company from other accounting firms, which concentrated almost exclusively on the certification of their clients' numbers.

As the firm grew, its partners formed a select elite; they all knew and respected each other as professionals. Under the strong leadership of Arthur E. Andersen, who owned the majority of shares in the partnership, an intimate and highly uniform culture developed in which Andersen's personal voice spoke for everyone on matters of policy. He wanted the firm to remain small and directed the officers to seek outstanding talent just out of college—individuals who could be molded in an apprenticeship under a senior certified public accountant (CPA). He preferred young graduates from a modest background who possessed a "Midwestern work ethic" and ideally came from a family farm. In 1940 the apprenticeship system was expanded into a formal training program that all new employees were required to attend.

The "Andersen way" was based on (1) honesty and integrity; (2) a one-firm, one-voice partnership model; and (3) training in methodology that was uniformly applied and obeyed. Andersen employees were supposed to appear homogeneous and act predictably, and were "trusted to do as they were taught." And while they should not expect to get rich, they knew that they represented a venerable profession with pride.

Spacek's Rule

In 1947 Arthur E. Andersen died without naming a successor. After a leadership crisis, the twenty-five remaining partners eventually elected Leonard Spacek to serve as managing partner (the de facto leader of the firm). Spacek resembled Arthur E. Andersen both in his Midwestern background and his staunch support of the Andersen way. While he could not control the partnership as the majority shareholder, Spacek quickly proved himself a domineering and forceful leader. He had a vision for the accounting profession, and eventually he became well known (and highly unpopular) as a severe critic of accounting standards and practices.

To back up his beliefs, Spacek increased Andersen's investment in its training programs, which consumed 15 to 20 percent of the net revenue of the firm. His goal was to create an educational system that would produce "Androids"—professionals of similar background, training, and demeanor—who would maintain the highest and most consistent professional accounting standards. Andersen employees also studied a series of methodologies that taught them technical audit procedures as well as the "proper" persona to display, from the company dress code to required daily appearances in the "correct" business-lunch restaurants. In the accounting profession, Andersen employees became famed as members of a culture that demanded the strictest conformity in appearance and behavior. This culture implied that employees were interchangeable and equally reliable as professionals of the highest caliber.

Under Spacek's leadership, Andersen grew rapidly, though cautiously, by entering international markets and offering new services. Rather than seek growth via acquisitions of similar accounting firms, Spacek chose to develop new offices and employees from within through the recruiting and training system. Maintaining a strict hierarchy based on expertise, Andersen sent experienced partners to open and run the new offices, many of which were overseas. As in the United States, the partner in charge of each new office built links with local universities to find high-quality candidates that would fit the Andersen style.

Furthermore, the company's consulting business really began to expand in earnest in the early 1950s when it designed and implemented the first business applications for a computer at General Electric. Having beaten the other big auditing companies to the punch in computer technologies, Andersen went on to establish itself as the preeminent provider of consulting services in the burgeoning field. The company began hiring computer consultants, but the new hires introduced a different type of employee to the firm—the consultants were not part of the accounting culture, although in the beginning they received the same training as accountants. Later, the power of the consultants would grow commensurate with consulting revenues.

To a degree, the Android culture remained cohesive, held together by the centralized training system and the authority and expertise of the partners. But by the 1970s tensions were brewing. During Spacek's tenure, there was a great increase in the partnership ranks, which had expanded from 25 to 826 members. In addition, Spacek had also presided over a proliferation of international offices. The many partners, spread across several continents, were chafing under Spacek's heavy-handed rule. When Spacek retired in 1973 they voted to ensure that no single partner would ever wield the kind of influence that Spacek and Arthur E. Andersen had; it became the era of "one partner, one vote." Tensions also increased because the larger number of partners meant that they could no longer govern in person ("face to face") as they had done in earlier times. Moreover, the rise of Andersen consultants introduced a new mentality into the company—salesmanship in search of discretionary funds from clients—that differed fundamentally from the legally required services that external auditors provided year by year. As a result, cooperation and cultural cohesion began to weaken, as did the ability of the firm's managing partner to lead.

Growth and Reorganization:

After Spacek's departure, the firm continued its rapid growth. To govern it more effectively, the new managing partner, Harvey Kapnick, broke the firm into service divisions of consulting, tax, and audit in the mid-1970s. While adopted to create manageable units, this move effectively split the firm into competing fiefdoms, with consulting experiencing the most rapid growth. According to some observers, at this moment the "common good" ceased to be the basis of company loyalty, and division and geographic location became the ties that bound people together. Consultants fought for, and won, the right to bypass the training regimen of the accountants, which further undermined the uniformity of Andersen's culture.

External factors also began to impact the firm. First, while audit revenues were dependable as a legal requirement for public companies, their profitability had hit a plateau. The U.S. government was pursuing efforts to inject more competition into the auditing industry. Prior to a 1973 legal challenge for violation of antitrust laws, industry associations had prohibited competitive bidding between accounting firms; four years later, similar industry bans on advertising were lifted. In addition, a wave of consolidation added to the competition between firms. Increasingly, clients were offered packages of audit services that resembled commodities, accompanied by advertising campaigns. As a result, consulting revenues became an increasingly important source of profit within the firm.

Second, in the wake of the merger-and-acquisition trend that began in the 1960s, disappointed investors began to seek legal compensation for failed deals—often from accounting firms. To respond to the explosion of audit-related litigation, Andersen adopted a damage-control policy on the advice of its lawyers. In addition, the firm joined the other big accounting companies to pool resources in an insurance fund to pay shareholder settlements.

Third, Andersen and the other major accounting firms began to consult each other regarding lobbying campaigns in order to oppose regulatory oversight from the SEC and other agencies, as well as to avoid political pressure from the U.S. Congress.

In the face of these new conditions and pressures, some inside the firm began to fear that audit standards were slipping. For them, Andersen's responses to the challenges it faced appeared largely defensive and reactive, paying little attention to the strategic direction of the company. The situation was, in their eyes, ripe for conflicts of interest to develop: in their search for big clients, many accountants had begun to act like salespeople for consulting contracts while doing their jobs as external auditors. Others argued that Andersen was still the best and that local partners could be trusted to do their jobs competently and with integrity.

In the late 1970s, for example, Andersen won the DeLorean sports car account, which was secured in large part by partner Dick Measelle. John DeLorean, a flamboyant character, promised significant revenues for the firm. When presented with evidence that DeLorean was charging personal luxury expenses to his company—his Mercedes-Benz, some household items, and even a personal assistant—Measelle accepted his client's explanations and offered Andersen's approval of the company's books. Rather than challenge DeLorean's bookkeeping, Measelle appeared eager to accommodate DeLorean. Upon DeLorean's company's bankruptcy, the oversights sanctioned by Measelle and his colleagues led Andersen to pay $62 million to settle lawsuits with disgruntled investors; in addition, the British government barred Andersen from auditing in the country from 1985 to 1997. However, rather than suffering a damaged career, Measelle was promoted for his ability to bring in clients like DeLorean, and he eventually served as CEO. Apparently, most in the company viewed the DeLorean debacle as a one-off incident rather than a pattern that might indicate future problems at the firm.

The Rise of the Consultants 

As the company entered the economic boom of the 1990s, its focus shifted to profitability, eclipsing Andersen's spirit of public service. Because the new leadership viewed consultants and investment bankers as examples they wished to emulate, tremendous pressure was created within the company to find new sources of revenue. However, many other forces began to impact the firm as well, including internal tensions and pressures from government reformers.

The Consultant/Auditor Balance Shifts

Back in 1979, the Andersen partners had chosen information systems consulting as the way to make up for the slow growth in audit revenues. While auditors continued to control the partnership, the consulting division operated autonomously and began to develop its own subculture. The group recruited veteran engineers, computer scientists, and consultants with little (if any) experience in accounting and sought business differently than Andersen had in the past. Consultants were salespeople; they were required to innovate, sell, and perform cutting-edge computer services, always with an eye to initiate a new consulting cycle for additional services. The major competitors, EDS and IBM, were cutting-edge technologists, which increased the pressure. Consulting hires also expected faster promotions, pay and bonuses that were directly tied to their immediate contributions, as well as a shorter wait to make partner. This "sales" mentality stood in stark contrast to the traditional mission of Andersen accountants: protection of the shareholders and the public interest in proper reporting standards.

During the 1980s, consulting began to overtake auditing as a percentage of total revenues at Andersen (see Exhibit 1). However, of 2,134 partners in 1989, only 586 were consultants. In addition, on a per-partner basis, consultants were bringing in $2.3 million, while accountants achieved only $1.4 million. Not surprisingly, the consultants began to agitate for greater power within the organization. This led to a series of lawsuits between partners that further undermined the unity of the Andersen culture. The consultants eventually became an independent business unit called Andersen Consulting in 1989, as opposed to simply a division. The split allowed both the accounting and the consulting units to track all accounts separately, including income and profits. Each unit began to operate on its own floor of the same office building as an entirely separate entity. Although Arthur Andersen was largely restricted from engaging in consulting, the accounting side was still permitted to pursue consulting with clients that had less than $175 million in annual revenue.

While the arrangement appeared to work, it only papered over deeper fissures within the organization. Resentment and professional jealousies continued to fester, with accusations of disloyalty as well as a sense that the "stodgy" accounting side was holding the consultants back. As the split became ever more apparent the two groups began to act as if they were independent companies the tension between the two cultures became increasingly bitter and divisive. 

The Rainmakers

While there was no decisive turning point in the evolution of the company, leadership of the accountants (within Arthur Andersen & Co.) slowly shifted to those who could bring in new business—the "rainmakers." Unlike their predecessors, whose expertise was in technical accounting and auditing skills, these young leaders were distinguished by their ability to attract profitable consulting engagements. In 1992 this transition culminated in a huge purge of low-performance partners. Ten percent of all partners were forced out; often, some of those who departed represented the traditional values of the firm and had functioned as mentors to younger accountants. As a result, oversight of younger partners was sharply curtailed, while the local independence of Andersen offices grew.

The Professional Standards Group (PSG), an oversight office within Andersen that was once a plum assignment for the future accounting elite, visibly diminished in importance. During the 1980s, for example, the PSG had ruled that stock options should be categorized as an expense that is, as a charge against profits, identical to other forms of compensation. However, at the start of the 1990s boom, when stock options were rapidly increasing in popularity and prestige, both the high-tech industry and the U.S. Congress pressured accounting industry leaders to consider a different interpretation. After a brief debate, Andersen's top leaders reversed the PSG ruling, allowing firms to avoid categorizing stock options as an expense. Many of Andersen's old guard saw this as a shocking precedent. While the PSG would continue to make rulings and pronouncements, local offices had gained a new independence to overrule voices that dissented from their judgment calls on-site. During this period the company continued to sell lucrative services to their audit clients in the 1990s, and this strategy enabled top partners to triple their earnings. In 1994 Arthur Andersen created a formal practice entitled Arthur Andersen Business Consulting (AABC).

Some partners voiced concerns that in their effort to use audits as a gateway to far more lucrative consulting arrangements, Andersen auditors were trying to please their clients rather than carrying out their traditional audit functions. For example, in 1996 then-partner Barbara Toffler attended a lavish party to celebrate the twenty-five-year anniversary of Waste Management's IPO as well as its longstanding professional relationship with Andersen. While there was no reason at that time to suspect anything about Waste Management's accounting practices, Toffler later wrote, "[Andersen and Waste Management] were acting like they were on the same team not as if one was supposed to be the other's gatekeeper." ³¹ It was during this period that Andersen's accountants began to conduct both internal and external audits on the same clients, in effect operating on both sides of the coin—aiding corporations to prepare their books while at the same time providing accounting oversight functions.

Enter the SEC

The issue of independence between the auditing and consulting functions began to concern SEC Commissioner Arthur Levitt. Early in his tenure, under pressure from the U.S. Congress, he had accepted (against the advice of the Financial Accounting Standards Board (FASB)) its contention that "expensing stock options" would be too costly to so-called "New Economy" startups. As he watched executive pay "spiral out of control in the mid-1990s," he regretted his earlier decision and chose to open a new battle on auditor independence. In June 2000, despite the opposition of the largest accounting firms, Levitt proposed tough new rules that would bar accounting firms from consulting for their clients.

A bitter political battle followed in which the big accounting firms lobbied Congress to pressure the SEC. Fortunately, a young peacemaker emerged from within the industry: Joseph Berardino, a partner from Andersen known for both his ability to attract clients and his integrity. Berardino negotiated compromises between all parties that structured a final deal, and he became known as "Levitt's secret weapon." While Levitt had to abandon the strict separation that he proposed, the big accounting firms agreed to two principles. First, they had to disclose what they earned from auditing and consulting fees; and second, the audit committees of company boards had to certify that their non-audit services were compatible with their independence as auditors. While Levitt was impressed by Berardino's shuttle diplomacy, he concluded the affair with misgivings about the accounting profession and the quality of its leadership. Accounting firms, in his view, were all facing the same challenges regarding their independence and potential conflicts of interest. 

The Divorce

In dollar terms, the emphasis on sales and profit at Andersen appeared to be a success. The firm's overall revenues grew from $3 billion in 1988 to $16 billion in 1999; during that time, employee rolls quadrupled. Nonetheless, the auditors were beginning to compete directly with the consultants for the same clients, and, fearing cannibalization from the accountants' unit, the Andersen Consulting partners voted unanimously in 1997 to secede from Arthur Andersen. To come to terms with the corporate divorce as specified in Andersen Worldwide's partnership agreement, George Shaheen, the head of Andersen Consulting, initiated an arbitration process at the International Chamber of Commerce in Paris; he argued that the competition between the two sides of the company violated the company's existing division of labor agreement. At that point, relations between the two business units had degenerated into open hostility.

This contentious corporate divorce initiated years of upheaval for Andersen leaders, who were uncertain what the final structure of the company would be. It diverted the attention of top management from other, perhaps more pressing, questions, such as the overall direction the firm should take and whether, as a highly decentralized partnership, the company could be governed effectively. In August 2000 the International Chamber of Commerce came down on the side of the consultants, agreeing with Shaheen's contention that the accounting side had violated the agreed-upon division of labor between the groups. To become a separate corporate entity, Andersen Consulting was required to relinquish the Andersen name and pay $1 billion, far below the $14.6 billion that many Arthur Andersen partners had demanded and expected.

In January 2001 Andersen Consulting changed its name to Accenture. This constituted not only a successful re-branding campaign, but the new company assumed no legal liability for the many charges that Arthur Andersen was facing.

Leaders in the accounting unit were extremely bitter about the unexpectedly low settlement from the divorce, and they felt renewed pressure to find additional sources of revenue in a stagnant market for traditional accounting services. The push for profit, in the view of some partners, overtook all other concerns. Internal competition to claim the principal responsibility for certain clients, and thereby earn points toward the year-end bonus, became particularly fierce. According to Toffler, the firm felt "rudderless."

Waste Management

Because of its long and intimate professional relationship with the firm, many of Waste Management's internal accountants had been hired from Arthur Andersen, including virtually every chief financial officer and every chief accounting officer. Robert Allgyer served as the lead Andersen partner for the Waste Management account. According to Dick Measelle, the Andersen partner who had been promoted after the DeLorean incident, "Allgyer had a reputation as a businessman who was able to sell." Another Andersen partner involved with Waste Management was Robert Kutsenda, who, as audit practice director from the Chicago office, was charged with final oversight on technical issues. Like Measelle, Kutsenda had been promoted for his sales ability in the wake of another major embarrassment for Andersen, the Supercuts account, in which he had signed off on some aggressive accounting.

The SEC investigation of Andersen accounting proceeded, relying heavily on subpoenaed emails and memos written by Andersen employees. During the investigation, it appeared that Andersen auditors had uncovered a number of questionable practices at Waste Management as early as 1988. For example, Waste Management was attempting to increase its value by overestimating the salvage value of its older garbage trucks, in effect claiming that they were worth $30,000 when the actual figure was closer to $12,000. There were a number of similar instances of aggressive accounting, such as failing to properly depreciate the trucks, which many inside Andersen defended as judgment calls on local issues that accounting norms had not yet addressed clearly. While Andersen auditors had brought many of these issues to the attention of Waste Management executives (as well as to Andersen CEO Measelle), they did not press them to correct the company books, as documents subpoenaed by the SEC attested. Indeed, the Andersen auditors could have resigned in protest, but instead they chose to manage the risk of a valuable client. During the investigation, Andersen lawyers argued to the SEC that the auditors and the responsible partners had followed "accepted standards." In Toffler's view, however, "the auditors simply caved when the company refused to implement the changes they wanted.... So [the lead partners on the account] simply certified the audit and decided to hope that the company would see things their way the next year."

At the conclusion of the investigation in February 2001, the SEC determined that Arthur Andersen's audit reports on Waste Management were "materially false and misleading." Allgyer, who had already resigned, was suspended from practicing for five years, allegedly because he "recklessly caused the issuance" of the misleading reports. For his part, Kutsenda was suspended for one year, for conduct "in violation of applicable professional standards." Andersen agreed to pay a $7 million fine—the largest ever levied against an accounting firm—with no admission or denial of guilt regarding the violation of professional standards. As part of the deal, however, Andersen also agreed to an injunction that it would adhere to generally accepted accounting practices/standards (GAAP/GAAS) in the future—in effect, a legal commitment to never again violate securities laws. It was akin to being placed on probation.

 

QUESTION:

Suppose you were retained as an outside advisor to Arthur Andersen during the Waste Management crisis. What would be your advice to Andersen's leadership, considering the following questions and topics?   answer the questions following APA guidelines: 

1) What is the value of reputation to a firm like Arthur Andersen?

2) What were Andersen's corporate values?

3) How did Andersen build its strong culture?

4) In your view, what were the reasons for Arthur Andersen's problems?

5) What internal factors contributed to changes in Andersen's culture?

6) Were there external factors that contributed to changes in Andersen's culture?

7) What would be your advice to Andersen's leadership?

8) What concrete next steps should the company take?

Answer rating: 100% (QA)

The value of reputation to a firm like Arthur Andersen is immeasurable Reputation is a cornerstone of trust in the accounting and auditing industry A strong reputation not only attracts clients but al... View the full answer