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Chapter 21End of the MillenniumOne last word on auditor independence. During our rulemaking, many argued the problem was only in our minds, as we couldn’t cite examples of audit failures where the auditors had also provided significant consulting or other nonaudit services. We put this notion to rest last week when we sued Arthur Andersen for having issued false and misleading audit reports in the Waste Management debacle.(SEC Commissioner Laura S. Unger)Arthur Andersen’s home office in Chicago was less than 10 miles from Waste Management’s Oak Brook, Illinois headquarters. And the two firms shared more than a telephone area code. Fourteen former Andersen auditors worked at Waste Management during the 1990s, often in key financial and accounting positions. Every Waste Management chief financial officer and chief accounting officer from 1971 to 1997 was an Andersen alumnus. Andersen partner Robert E. Allgyer took over the Waste Management audit in 1991. Shortly after Allgyer’s appointment, Waste Management froze Andersen’s audit fees at their 1990 level while allowing Andersen to earn additional revenues for “special work.” During the next six years, Andersen collected $7.5 million in audit fees and $11.8 million for other services. Allgyer, who also served as the marketing director of Andersen’s Chicago office, was compensated, in part, based on his firm’s total billings to Waste Management.Andersen auditors identified hundreds of millions of dollars of misstatements in Waste Management’s 1993 through 1996 financial statements without insisting that the misstatements be corrected. SEC commissioner Laura Unger inferred that Andersen’s willingness to condone Waste Management’s flawed accounting might have been related to Waste Management’s payment of high nonaudit fees and employment of Andersen alumni. She cited Andersen’s flawed audits of Waste Management as justification for stricter auditor independence requirements. 8,064 ViolationsThe Sunbeam and Waste Management audits demonstrated to the SEC how tolerant auditors had become of their clients’ aggressive accounting. But it was an even more blatant scandal that triggered the most extensive revision of SEC independence requirements in 70 years.In the winter of 1997, an anonymous letter to the SEC prompted an investigation that uncovered 8,064 independence violations by PricewaterhouseCoopers partners and employees. More than half of the firm’s 2,700 U.S. partners—including 6 of the 11 partners responsible for the firm’s independence policies—owned investments in the firm’s audit clients. Even chairman James Schiro, a member of the Independence Standards Board, was guilty of a minor violation involving $1,600 of an audit client’s stock.PwC spokesmen protested that many of the 8,000 violations were technical in nature, such as one partner who was cited because each of his children owned a single share of Walt Disney Co. stock framed and hanging in their bedrooms. But nearly 40 percent of the violations were direct employee investments in clients. Investigators identified 140 instances of partners and managers owning stock issued by companies they helped audit. The PwC scandal created a dilemma for the AICPA. What should the Institute’s Professional Ethics Executive Committee, which was responsible for disciplining AICPA members, do with more than 1,500 PwC auditors accused of violating professional standards? AICPA president Barry Melancon opted to absolve the guilty parties by attacking the rules. The day after PwC disclosed its violations, Melancon issued a press release urging the SEC to soften its independence requirements. When Business Week (February 7, 2000) published an editorial citing PwC’s noncompliance as evidence that auditors had abandoned their commitment to the public trust, Melancon responded with a letter to the editor saying that the proper conclusion to draw from PwC’s 8,064 violations was that the existing rules were unreasonable:CPAs play a critical role in protecting the public interest and in promoting the smooth functioning of our capital markets. Objectivity and independence are professional obligations we take seriously. However, the profession has the right to expect the rules to remain current and relevant. Many of the independence rules for auditors were created decades ago, before working spouses and ubiquitous 401(k) plans, for example. No one disagrees that auditors must remain independent from the companies they audit, but forcing partners’ spouses to divest themselves of their pension plan because it includes investments in an audit client supervised by a partner they don’t know 3,000 miles away defies common sense. It’s time to write independence rules that make sense in today’s world.PwC’s pervasive noncompliance with SEC rules naturally sparked questions about whether similar problems existed at other accounting firms. SEC chief accountant Lynn Turner asked the AICPA’s Public Oversight Board (POB) to oversee investigations at the other Big Five accounting firms. In a move than enraged SEC chairman Arthur Levitt, the AICPA sent a letter to POB chairman Charles Bowsher stating that it would “not approve nor authorize payment for invoices submitted by the POB or its representatives that contain charges for the special reviews ….” The AICPA, which funded the POB, flatly refused to investigate whether auditors at other accounting firms were investing in their clients’ securities.Chairman Levitt had harbored doubts about auditors’ independence ever since his appointment by President Bill Clinton in 1993. Levitt frequently criticized accountants’ performance of management advisory services for audit clients. After more than six years in office and with the likely end of his term in sight, Levitt finally had the case he needed to build public support for substantive reform. PwC’s complaints that its employees had been confused by the SEC’s Byzantine independence rules earned more scorn than sympathy. And the AICPA’s blatant refusal to enforce its own Code of Conduct cost it the moral high ground. Levitt decided to devote his last months in office to reforming the SEC’s auditor independence requirements. With George W. Bush leading Al Gore in public opinion polls, it was now or never. The SEC’s Proposal to Modernize the Rules Governing Auditors’ IndependenceIn June 2000, Levitt proposed the first major overhaul of SEC auditor independence requirements since 1983. The new rules were based on four principles for evaluating an auditor’s independence. The SEC stated that an auditor is not independent when the auditor (1) has a mutual or conflicting interest with the audit client, (2) audits his or her own work, (3) functions as management or employee of the audit client, or (4) acts as an advocate for the audit client.The SEC conceded in its proposal that some of the rules that had tripped up PwC’s employees were unnecessarily restrictive. The old SEC rules prohibited all partners, and their family members, from investing in any entity audited by the firm. When Price Waterhouse merged with Coopers & Lybrand in 1998, thousands of employees had been forced to divest themselves of stock in the other firm’s audit clients. Few auditors worked directly on more than a handful of the combined firm’s 3,000 public clients, yet many employees had incurred large tax liabilities from selling significant portions of their investment portfolios. Proposed rule 2-01(c)(1) prohibited direct investments in the firm’s audit clients only by those participating in the client’s audit and their immediate family members.The proposal also loosened restrictions on accountants auditing organizations where their family members were employed. The old SEC rules, adopted before dual-career families were common, limited where auditors’ spouses and other family members could work. Several spouses of Price Waterhouse and Coopers & Lybrand partners had been forced to quit their jobs in 1998 even though the spouses’ jobs had nothing to do with accounting and the partners did not participate in the employers’ audits. Proposed rule 2-01(c)(2) stated that an auditor’s independence would be considered impaired only if a close relative was employed in an accounting or financial reporting oversight role.Other proposed rule changes were not received so warmly by the AICPA and the Big Five accounting firms. The proposal identified ten nonaudit services that, if provided to an audit client, would impair an auditor’s independence. Most of the identified services, such as bookkeeping and executive recruiting, were already precluded by SEC and AICPA rules. Many accountants objected strongly, however, to the proposed addition of internal audit outsourcing and information systems design and implementation to the list of prohibited services. These were two of the most profitable and fastest growing services in the public accounting profession.When Arthur Levitt met with the chairmen of Arthur Andersen, KPMG, and Deloitte & Touche to explain his proposal, they listened impassively, showing no willingness to negotiate. Levitt asked for a counterproposal, but they refused to even discuss limiting their consulting services to audit clients. Andersen chairman Bob Grafton warned Levitt at the end of the meeting, “Arthur, if you go ahead with this, it will be war.” The AICPA unleashed its 14 paid lobbyists on Capital Hill and mailed thousands of sample letters for AICPA members to copy onto their own letterhead and send to their Congressional representatives. Arthur Andersen, KPMG, and Deloitte & Touche employed their own lobbyists and conducted their own letter-writing campaigns. Total lobbying expenditures by the AICPA and the Big Five exceeded $12 million during 2000. But this was a small price to pay to protect their $10 billion consulting practices.The lobbying efforts produced results. Forty-six members of Congress wrote to Levitt urging him to withdraw, amend, or delay the independence proposal. And Levitt learned that Senator Richard Shelby (R, Alabama) was preparing an “appropriations rider” that would bar the SEC from spending any of its funds to implement or enforce the proposed rules. Levitt implored Senate majority leader Trent Lott (R, Mississippi) not to let Congress cut the SEC’s funding. He informed Lott that numerous publications, including the New York Times, Washington Post, Los Angeles Times, and Business Week, had endorsed the proposal. “Well, Arthur,” Lott replied, “I’m not familiar with what you’re proposing to do, but if those liberal publications are in favor of it, then I’m against it.” Levitt was not without allies. Four former SEC chairmen endorsed the revised independence requirements. Several expert witnesses, including influential money manager John H. Biggs, Comptroller of the Currency John D. Hawke, Jr., and former Federal Reserve chairman Paul A. Volcker testified in favor of the proposal at the SEC’s public hearings. And there was dissension among the normally unified leaders of the Big Five. Although KPMG partner Robert Elliott vowed not to let the SEC “bomb the profession back into the Stone Age,” Ernst & Young chairman Philip Laskawy endorsed the proposed ban on information systems design work and internal audit outsourcing. Ernst & Young was in the process of selling its consulting division to Cap Gemini and had little to lose from the new restrictions. PricewaterhouseCoopers did not endorse Levitt’s proposal, but with 8,064 recent independence violations on its record, the firm was in no position to publicly oppose regulatory reform.The five SEC commissioners were scheduled to vote on the independence proposal at their November 15, 2000 meeting. The AICPA and several influential Congressional committee chairmen urged delay, complaining that the SEC had not allowed sufficient time for public comment. In reality, Levitt’s foes wanted the vote delayed until after the new President took office and appointed a new SEC chairman.During the final 48 hours preceding the SEC’s scheduled vote, Levitt reached a compromise with AICPA president Barry Melancon and the leaders of the major accounting firms. Levitt, wanting to avoid litigation and fearing retaliatory budget cuts, offered to allow accounting firms to continue performing information systems design work for their audit clients on the condition that companies disclose in their annual proxy statements the amounts paid to their accountants for consulting services, with information systems fees broken out separately. Levitt also proposed allowing accounting firms to perform up to 40 percent of their clients’ internal auditing work.Melancon and the Big Five chairmen were drawn to the negotiating table by the GOP’s disappointing performance on November 7. Fearing that their Congressional allies would not be able to block Levitt’s original proposal and not knowing who would eventually win the presidency, the accounting industry leaders dropped their opposition to the diluted proposal. The SEC commissioners adopted the new auditor independence requirements on Nov. 15.Impact of the SEC’s New RulesWhen the first proxy statements containing the mandated fee disclosures appeared in 2001, even the SEC was shocked by the amounts some companies were paying their accountants for tax and consulting work. In 2000, the companies comprising the S&P 500 paid a total of $1.2 billion for audit work and $3.7 billion for nonaudit services. KPMG, for example, earned only $4 million performing Motorola Inc.’s audit but collected $62 million for computer consulting and other services. General Motors paid Deloitte & Touche $17 million to perform its audit and $79 million for other services. Sprint Corp. paid Ernst & Young $2.5 million for auditing and another $64 million for consulting and other services. The size of some of the consulting contracts led Arthur Levitt to comment:I’m not suggesting that each of these audit firms has compromised its independence. But I have to wonder if any individual auditor, working on a $2.5 million audit contract, would have the guts to stand up to a CFO and question a dubious number in the books, thus possibly jeopardizing $64 million in business for the firm’s consultants. The chances of that happening seem even smaller when you consider that many auditors are compensated partly on the basis of how much nonaudit business they sell. Several investor groups reacted to the fee disclosures by sponsoring shareholder resolutions demanding that corporations stop purchasing management advisory services from accountants. One such resolution at Walt Disney Co. in 2002 received support from 42 percent of the company’s shareholders. Although the Disney resolution failed to win a majority of votes cast, the shareholders’ “higher-than-expected” support for the proposal prompted Disney’s board to stop purchasing management advisory services from auditor PricewaterhouseCoopers. Ann Yerger, director of research at the Council of Institutional Investors, warned corporate executives that, “Shareholders are sending a powerful and strong message that they believe the [auditing and nonauditing] functions should be separated.” As shareholders and corporate governance watchdogs became increasingly outspoken about potential conflicts of interest between auditing and consulting, corporate directors began discouraging companies from hiring accountants to perform management advisory services. Board members were frequently named as defendants in lawsuits alleging accounting fraud. Many directors feared that lucrative consulting engagements awarded to accountants would be cited as evidence of lax oversight if the company’s financial statements were ever called into question. The safest strategy, from the directors’ standpoint, was to look elsewhere for consulting advice. Apple Computer, Sara Lee, Johnson & Johnson and several other prominent companies decided in 2002 to stop purchasing internal audit and information technology consulting services from their auditors. The two-year period surrounding the SEC’s revision of its independence requirements saw the breakup of most of the Big Five accounting firms. Ernst & Young sold its information technology division to French consulting firm Cap Gemini in May 2000 for $11.1 billion. KPMG’s consulting division spun off into an independent, publicly traded company named Bearing Point. PricewaterhouseCoopers negotiated with Hewlett-Packard and considered an initial public offering before finally selling its technology services unit to IBM. Only Deloitte & Touche kept its consulting division and that wasn’t entirely by choice. D&T planned to sell its consulting practice through an initial public offering in early 2002, but cancelled its plans due to insufficient interest in the stock offering.Thus, Arthur Levitt succeeded in significantly reducing the consulting services performed by accounting firms for their audit clients. Many corporate boards adopted policies restricting the services purchased from accountants, and three of the four largest public accounting firms disposed of large portions of their consulting branches.Materiality GuidanceAuditing standards require auditors to provide reasonable assurance that their clients’ financial statements contain no material misstatements. The FASB, in Financial Accounting Concepts Statement No. 2, Qualitative Characteristics of Accounting Information, defined materiality as “… the magnitude of an omission or misstatement of accounting information that, in light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.”The primary problem with the FASB’s definition of materiality was that it was difficult to apply in practice. Who could predict how a “reasonable person” might react to a particular accounting error? So auditors developed various rules-of-thumb to help them evaluate whether misstatements were material enough to require adjustment. Some auditors deemed an error material if it exceeded 10 percent of earnings before taxes. Other auditors used 1 percent of the client’s total revenue or total assets as their yardstick for determining materiality. Some clients abused the concept of materiality by refusing to correct misstatements that fell short of the auditors’ materiality threshold. Negotiating audit adjustments became a routine part of the audit process. After the auditors presented their list of findings, the CEO and CFO bargained with the audit partner to determine the minimum adjustment needed before the partner would issue a clean opinion.Auditors frequently approved financial statements containing millions of dollars of known, but “immaterial,” errors. Andersen partner Phillip Harlow ignored $18 million of known misstatements in Sunbeam’s 1996 financial statements. Robert Allgyer overlooked $128 million of errors in Waste Management’s 1993 financial statements in return for Dean Buntrock’s promise to correct the errors in the future. And Arthur Andersen was not the only accounting firm allowing its clients to issue “immaterially” false financial statements. W.R. Grace & Co. manipulated its 1991 through 1994 earnings by recording arbitrary liabilities in good years and reversing the accruals in lean years. Price Waterhouse auditors documented the manipulations in their audit workpapers, but issued clean audit reports after concluding that the effects on Grace’s annual earnings were not material. Arthur Levitt addressed the issue of materiality in a September 1998 speech at New York University’s Center of Law and Business.But some companies misuse the concept of materiality. They intentionally record errors within a defined percentage ceiling. Then they try to excuse the fib by arguing that the effect on the bottom line is too small to matter. If that’s the case, why do they work so hard to create the errors? Maybe because the effect can matter, especially if it picks up that last penny of the consensus estimate. Eleven months later, the SEC issued Staff Accounting Bulletin (SAB) No. 99, Materiality. SAB No. 99 rejected a bright-line materiality cutoff based on some arbitrary percentage of a financial statement component. Instead, the SAB required auditors to consider both quantitative and qualitative characteristics of known misstatements. Quantitatively small misstatements might be considered material if they changed a loss into income, concealed an unlawful transaction, affected a company’s compliance with loan covenants, converted an earnings decrease into an earnings increase, or enabled a company to just meet analysts’ expectations. SAB No. 99 also forbid companies from knowingly recording misstatements of any size for the purpose of managing or smoothing reported earnings. ConclusionSurprisingly, the Sunbeam and Waste Management earnings restatements, announced within eight months of each other in 1998, had little effect on Arthur Andersen’s reputation. The two scandals were almost lost among revelations of similar accounting failures at Phar-Mor (Coopers & Lybrand), Cendant (Ernst & Young), Rite-Aid (KPMG), W.R. Grace (Price Waterhouse), and Livent (Deloitte & Touche).Nor did the two bungled audits lead to significant improvements in Andersen’s auditing procedures. To the extent that Andersen leaders even acknowledged that errors had occurred during the Sunbeam and Waste Management audits, they dismissed the mistakes as aberrations, not indicative of pervasive flaws in the firm’s culture or audit methodology. But the failed Waste Management audit ultimately played a significant role in Andersen’s downfall. Andersen promised in its consent decree to permanently refrain from future securities law violations. In effect, the SEC placed Andersen on probation with a warning that future audit failures would result in severe punishment. A year later, the Justice Department cited Andersen’s fear of violating its probation as the firm’s motive for shredding hundreds of pounds of Enron-related documents. SourcesByrnes, Nanette. and Mike McNamee. “The SEC vs. CPAs: Suddenly, It’s Hardball.” Business Week, May 22, 2000.Lavelle, Louis. “Cozying Up to the Ref: Ernst’s Role in Tough New SEC Rules Riles Rivals.” Business Week, July 31, 2000.Levitt, Arthur. “The Numbers Game.” Speech at the New York University Center for Law and Business, New York, NY, September 28, 1998. Available at , Arthur. Take on the Street. Chicago: Pantheon Books, 2002.McNamee, Mike. “How Levitt Won the Accounting Wars.” Business Week, November 27, 2000.Melancon, Barry. “Accountants Need Clear, Modern Rules to Guide Them.” Business Week, February 28, 2000.Moore, Pamela L. “This Scandal Changes Everything.” Business Week, February 28, 2000.Norris, Floyd. “Accounting Firm Is Said to Violate Rules Routinely.” New York Times, January 7, 2000.Norris, Floyd. “Rules That Only an Accountant Could Fail to Understand?” New York Times, January 8, 2000.Plitch, Phyllis. “Investors Send ‘Strong’ Message in Disney’s Auditor Vote.” Dow Jones News Service, February 19, 2002.Securities and Exchange Commission. Proposed rule: Revision of the Commission’s Auditor Independence Requirements, June 27, 2000. Available at and Exchange Commission. Final Rule: Revision of the Commission’s Auditor Independence Requirements, February 5, 2001. Available at , Paul. “Accounting for the Big Five Breakups.” Financial Executive, October 2002.Unger, Laura S. “This Year’s Proxy Season: Sunlight Shines on Auditor Independence and Executive Compensation.” Speech at the Center for Professional Education, Washington D.C., June 25, 2001. Available at , Jonathan. “SEC Chief Calls Andersen Case ‘Smoking Gun.’” Wall Street Journal, June 26, 2001.Weirich, Thomas R., and Robert W. Rouse. “The New SEC Materiality Guidelines: When Are the Numbers Important Enough to Matter?” Journal of Corporate Accounting & Finance 11 (January/February 2000): 35-40. ................
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