Ethics Case
A Sad Tale: The Demise of Arthur Andersen
In January 2002, there were five major public accounting firms: Arthur Andersen, Deloitte Touche, KPMG, Pricewaterhouse-Coopers, and Ernst & Young. By late fall of that year, the number had been reduced to four. Arthur Andersen became the first major public accounting firm to be found guilty of a felony (a conviction later overturned), and as a result it virtually ceased to exist.
That such a fate could befall Andersen is especially sad given its early history. When Andersen and Company was established in 1918, it was led by Arthur Andersen, an acknowledged man of principle, and the company had a credo that became firmly embedded in the culture: “Think Straight and Talk Straight.” Andersen became an industry leader partly on the basis of high ethical principles and integrity.
How did a one-time industry leader find itself in a position where it received a corporate death penalty over ethical issues? First, the market changed. During the 1980s, a boom in mergers and acquisitions and the emergence of information technology fueled the growth of an extremely profitable consulting practice at Andersen. The profits from consulting contracts soon exceeded the profits from auditing, Andersens core business. Many of the consulting clients were also audit clients, and the firm found that the audit relationship was an ideal bridge for selling consulting services. Soon the audit fees became “loss leaders” to win audits, which allowed the consultants to sell more lucrative consulting contracts.
Tension between Audit and Consulting
At Andersen, tension between audit and consulting partners broke into open and sometimes public warfare. At the heart of the problem was how to divide the earnings from the consulting practice between the two groups. The resulting conflict ended in divorce, with the consultants leaving to form their own firm. The firm, Accenture, continues to thrive today.
Once the firm split in two, Andersen began to rebuild a consulting practice as part of the accounting practice. Consulting continued to be a highly profitable business, and audit partners were now asked to sell consulting services to other clients, a role that many auditors found uncomfortable.
Although the accountants were firmly in charge, the role of partners as salespersons compounded an already existing ethical issue—that of conflict of interest. It is legally well established that the fiduciary responsibility of a certified public accounting (CPA) firm is to the investors and creditors of the firm being audited. CPA firms are supposed to render an opinion as to whether a firms financial statements are reasonably accurate and whether the firm has applied generally accepted accounting principles in a consistent manner over time so as not to distort the financial statements. To meet their fiduciary responsibilities, auditors must maintain independence from the firms they audit.
What might interfere with the objective judgment of the public accounting firms? One problem arises because it is the audited companies themselves that pay the auditors fees. Auditors might not be completely objective when auditing a firm because they fear losing consulting business. This is an issue that regulators and auditors have not yet solved. But another problem arises in situations where accounting firms provide consulting services to the companies they audit. Although all of the major accounting firms were involved in this practice to some extent, Andersen had developed an aggressive culture for engaging partners to sell consulting services to audit clients.
Andersen & Problems Mount
The unraveling of Andersen began in the 1990s with a series of accounting scandals at Sunbeam, Waste Management, and Colonial Realty—all firms that Andersen had audited. But scandals involving the energy giant Enron proved to be the firms undoing. The account was huge. In 2000 alone, Andersen received $52 million in fees from Enron, approximately 50 percent for auditing and 50 percent for other consulting services, especially tax services. The partner in charge of the account and his entire 100-person team worked out of Enrons Houston office. Approximately 300 of Enrons senior and middle managers had been Andersen employees.
Enron went bankrupt in December 2001 after large-scale accounting irregularities came to light, prompting an investigation by the Securities and Exchange Commission (SEC). It soon became clear that Enrons financial statements for some time had been largely the products of accounting fraud, showing the company to be in far better financial condition than was actually the case. The inevitable question was asked: Why hadnt the auditors called attention to Enrons questionable accounting practices? The answer was a simple one. Andersen had major conflicts of interest. Indeed, when one member of Andersens Professional Standards Group objected to some of Enrons accounting practices, Andersen removed him from auditing responsibilities at Enron—in response to a request from Enron management.
Playing Hardball and Losing
The SEC was determined to make an example of Andersen. The U.S. Justice Department began a criminal investigation, but investigators were willing to explore some “settlement options” in return for Andersens cooperation. However, Andersens senior management appeared arrogant and failed to grasp the political mood in Congress and in the country after a series of business scandals that had brought more than one large company to bankruptcy.
After several months of sparring with the Andersen senior management team, the Justice Department charged Andersen with a felony offense—obstruction of justice. Andersen was found guilty in 2002 of illegally instructing its employees to destroy documents relating to Enron, even as the government was conducting inquiries into Enrons finances. During the trial, government lawyers argued that by instructing its staff to “undertake an unprecedented campaign of document destruction,” Andersen had obstructed the governments investigation.
Since a firm convicted of a felony cannot audit a publicly held company, the conviction spelled the end for Andersen. But even before the guilty verdict, there had been a massive defection of Andersen clients to other accounting firms. The evidence presented at trial showed a breakdown in Andersens internal controls, a lack of leadership, and an environment in Andersens Houston office that fostered recklessness and unethical behavior by some partners.
In 2005, the United States Supreme Court unanimously overturned the Andersen conviction on the grounds that the jury was given overly broad instructions by the federal judge who presided over the case. But by then it was too late. Most of the Andersen partners had either retired or gone to work for former competitors, and the company had all but ceased to exist.
Discussion Questions
The fall of Arthur Andersen, one of the largest accounting firms in the world, was a significant moment in the history of corporate America. Once renowned for its high ethical standards and integrity, the firm was embroiled in several accounting scandals, most notably involving Enron, that led to its ultimate demise. Arthur Andersen's downfall raises several key ethical and legal questions regarding the responsibilities of corporations, the conflict of interest between auditing and consulting services, and the extent to which market pressures can incentivize unethical behavior. The case serves as an important study of corporate ethics, regulation, and accountability in a highly competitive and profit-driven market environment. This essay will explore the extent to which market pressures encouraged unethical behavior at Arthur Andersen, assess the seriousness of the conflicts of interest involved, examine whether Sarbanes-Oxley effectively addressed these issues, and consider whether the government's actions against Arthur Andersen were justified.
Market pressures played a significant role in driving unethical behavior at Arthur Andersen. The case of Arthur Andersen illustrates how the competitive environment within the accounting industry incentivized the firm to prioritize profits over ethical standards. In the 1980s and 1990s, the accounting industry underwent significant changes as consulting services became increasingly profitable, surpassing traditional auditing services in terms of revenue generation. Arthur Andersen capitalized on this shift by promoting consulting services alongside its audit work. However, the aggressive push to sell consulting services to audit clients led to an inherent conflict of interest, as auditors were placed in the role of salespeople. The pressure to generate revenue from consulting contracts created a dynamic in which the firm’s auditors might be reluctant to challenge questionable accounting practices, particularly if doing so jeopardized the lucrative consulting relationships.
The tension between the consulting and auditing functions at Arthur Andersen was exacerbated by the fact that auditors were often placed in uncomfortable positions, forced to act as both independent reviewers of a company’s financial statements and salespeople for consulting services. As consulting contracts became a major source of income, audit services increasingly became a loss leader, meaning they were offered at a lower price to win clients for the more profitable consulting services. This dynamic led to a blurring of the lines between independent audit work and the consulting services provided to the same clients, resulting in conflicts of interest and compromising the firm’s ability to maintain objectivity and independence.
Moreover, the highly competitive market incentivized the firm to retain major clients like Enron, even when there were red flags regarding their accounting practices. The $52 million that Andersen earned in fees from Enron in 2000, with half of this income derived from consulting services, exemplifies the firm’s dependence on large clients. The desire to retain such clients, coupled with the financial benefits of the consulting work, likely contributed to Andersen’s willingness to overlook questionable accounting practices at Enron. As one member of Andersen’s Professional Standards Group objected to Enron’s accounting practices, his removal at the request of Enron management illustrates how deeply the firm’s commitment to ethical auditing had eroded under market pressures.
The conflicts of interest in the Arthur Andersen case were severe and systemic, particularly the conflict between the auditing and consulting services provided to the same clients. The role of a Certified Public Accountant (CPA) firm is to provide independent and objective assessments of a company’s financial statements to ensure that investors, creditors, and the public receive accurate and reliable financial information. However, when an accounting firm also provides consulting services to the same clients, the firm's independence can be compromised. Auditors may be less inclined to scrutinize the financial statements of a company aggressively if doing so could jeopardize a lucrative consulting relationship.
In the case of Andersen, the firm’s leadership actively encouraged partners to sell consulting services to audit clients, creating an environment in which conflicts of interest were unavoidable. The problem was compounded by the fact that audit fees had become loss leaders, meaning that Andersen was more reliant on consulting fees to maintain profitability. This created a perverse incentive structure where the firm's financial success was tied to maintaining favorable relationships with clients rather than providing rigorous and independent audits.
The seriousness of these conflicts of interest is underscored by the accounting scandals that emerged at firms such as Sunbeam, Waste Management, and Colonial Realty—all audited by Andersen. These scandals were characterized by accounting irregularities and fraud that went undetected or unreported by Andersen’s auditors. In the case of Enron, the failure of Andersen to call attention to fraudulent accounting practices ultimately led to one of the largest corporate bankruptcies in U.S. history and contributed to the loss of billions of dollars for investors and employees.
The Sarbanes-Oxley Act (SOX), passed in 2002 in response to the Enron scandal and other corporate accounting scandals, was designed to address many of the systemic issues that had contributed to the failures of firms like Arthur Andersen. SOX imposed strict new regulations on corporate governance, financial reporting, and auditing practices in an effort to restore investor confidence and prevent future corporate fraud.
One of the key provisions of SOX was the separation of auditing and consulting services to mitigate conflicts of interest. Section 201 of the Act prohibits accounting firms from providing certain types of non-audit services, such as consulting, to clients for whom they are also providing auditing services. This provision was intended to restore the independence of auditors and prevent the type of conflicts that had arisen at Andersen, where the firm’s financial success was tied to both auditing and consulting services for the same clients.
SOX also established the Public Company Accounting Oversight Board (PCAOB) to oversee the auditing of public companies and enforce standards for audit practices. The creation of the PCAOB was a direct response to the breakdown in internal controls and ethical standards at firms like Arthur Andersen, and it was designed to provide an additional layer of oversight to ensure that auditing firms adhered to ethical and professional standards.
While SOX addressed many of the most serious conflicts of interest, it is debatable whether the Act has been entirely successful in eliminating unethical behavior within the accounting industry. Some critics argue that while SOX has increased regulatory oversight and improved transparency, it has also imposed significant costs on companies and accounting firms, leading to concerns about overregulation. Additionally, some of the issues related to market pressures and the desire to retain large clients may still persist, even if firms are no longer allowed to provide consulting services to their audit clients.
The U.S. government’s decision to prosecute Arthur Andersen for obstruction of justice and effectively destroy the company raises important questions about corporate accountability and the fairness of punishing an entire firm for the actions of a few individuals. On one hand, the government’s actions can be seen as justified given the seriousness of the ethical violations at Andersen, particularly in relation to the Enron scandal. The firm’s failure to maintain independence, its involvement in document destruction, and its role in enabling Enron’s fraudulent accounting practices all contributed to a massive loss of investor confidence and the collapse of a major corporation.
From this perspective, the government’s prosecution of Andersen can be viewed as a necessary step to send a strong message to the accounting industry and corporate America as a whole. By holding Andersen accountable for its role in the Enron scandal, the government signaled that companies would face severe consequences for unethical behavior and for failing to adhere to professional standards. The decision to pursue criminal charges against Andersen also underscored the importance of maintaining the integrity of the auditing profession, which is critical for the functioning of financial markets.
On the other hand, some critics argue that the government’s actions were too severe and that the punishment of Andersen was disproportionate to the actions of a few individuals within the firm. The fact that Andersen’s conviction was later overturned by the Supreme Court on the grounds that the jury had received overly broad instructions raises questions about whether the firm was treated fairly in the legal process. Furthermore, the demise of Andersen had significant consequences for thousands of employees who were not involved in the unethical behavior and who lost their jobs as a result of the firm’s collapse.
The demise of Arthur Andersen serves as a cautionary tale about the dangers of ethical complacency, conflicts of interest, and the pressures of a competitive market. While Andersen was once known for its high ethical standards, the firm ultimately succumbed to the temptations of profit maximization at the expense of professional integrity. The aggressive pursuit of consulting fees, combined with the conflicts of interest inherent in providing both auditing and consulting services to the same clients, led to a breakdown in ethical standards that contributed to the Enron scandal and the firm’s eventual downfall.
The Sarbanes-Oxley Act addressed many of the systemic issues that contributed to Andersen’s demise by imposing stricter regulations on auditing practices and corporate governance. However, the Act alone cannot fully eliminate the pressures and incentives that can lead to unethical behavior in the corporate world. Ultimately, the fall of Andersen highlights the need for continued vigilance, strong leadership, and a commitment to ethical principles in the face of market pressures.
In assessing the government’s role in the destruction of Andersen, it is clear that the firm’s actions warranted serious consequences. However, the decision to prosecute the entire firm for the actions of a few individuals raises important questions about fairness and the appropriate balance between corporate accountability and individual responsibility. The case of Arthur Andersen serves as a powerful reminder of the importance of maintaining ethical standards in business, particularly in industries where conflicts of interest are inherent and the stakes are high.
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