Case - Androids Under Attack

7/22/2019 Case - Androids Under Attack

http://slidepdf.com/reader/full/case-androids-under-attack 1/7

Androids Under Attack

Ali Shah Hashim

rd

ffii*(;/l

David Lawrence, 43 years of age, joined the auditing firm ofAndroids 20 years ago and earned

a salary of USD 700,000 per annum. He was the Androids' partner in charge of auditing En-

ronaa's accounts since 1987 his job was to check Effonaa's accounts and to make sure that

they fairly represent the state of the business. Androids had been Enronaa's auditor for the

past l6 years.

On the moming of October 23,David,and his auditing team listened in on a call between stock

analysts and Enronaa executives, who were trying to explain the company's financial free fall.

There were too many unanswered questions. After lunch, David called the entire Enronaa team

together in Conference Room 37C1. His heart beat faster as he thought about the net that was

closing in onAndroids. As his eyes wandered around the room, on one of the conference room

walls was an imposing picture of Arthur Androids. David was particularly proud of the long

and distinguished history of the firm. His mind wandered as if to witness how in 1913, Arthurand Clarence, both from the audit firm of Price, bought out a small audit firm in Illinois to formArthur, Clarence & Co which becameAndroids & Co. in 1918. Androids, who headed the firmuntil his death in 1945, was a zealous supporter of high standards in the accounting industry.

A stickler for honesty, he argued that accountants' responsibility was to investors, not their

clients' management. During the early years, it was reputed that Androids was approached byan executive from a local rail utility to sign off on accounts containing flawed accounting, orelse face the loss of a major client. Androids refused in no uncertain terms, replying that he

would not sign thsaccounts "for all the money inAmerica." Leonardo Sparky, who succeeded

Androids at the founder's death, continued this emphasis on honesty. For many years, the An-droids'motto was, "Think straight, talk straight."

Whilst waiting for his team members, David sat to have coffee with Ken Bailey, a junior part-ner in Androids. "I thought you would like to know," David said, "that late last night, I had an

emergency conference call with partners from the Chicago Head Office", Ken Bailey listened

attentively as David continued. "The partners said in no uncertain terms that Androids' futureis in my hands. Period." David couched towards Ken Bailey and showed the audit

workpapers

on Enronaa, and continued, "There were evidences that could suggest we assisted Enronaa tosort of 'puff up' the reported returns of off balance sheet activities by units called 'raptors . . . "David said, as he began to painfully explain the technical intricacies of Enronaa's accounting

to Ken Bailey. Fie explained how he learned from Tom Fitzgerald,a co-partner of the Enronaajob, that some of the many off-the-books partnerships, like Chewco and Chewbacca,had not

11aia1 -tian lG11s;; t;Accoultanrs

been properly acco

m 1997. Nonethele

conclusions, there

had to be reflected

mounting. In a serie

my team had been

i,enored. In fact, a

calls were stunned

David's explanatio

and conference cal

called LJM2, Tom

similar troubles, a

people listening in

ally knew for certa

Enronaa, he was th

really were legitima

earlier during the f

ton partners briefe

partners described

explain his point o

Enronaa to hide its

and David started

junior auditor. Ke

pers would be take

said, "Yes, I am ve

The general expect

deception. At best

deliberately overlo

consulting and oth

"I don't know wha

"Androids is unde

target was the fact

with the Securities

the SEC a civil pen

of Solid Waste. "M

an injunction that

both sat down and



-:5--*-*

b+en properly accounted for and were not independent entities, as Enronaa had told Androids :;- 1997. Nonetheless, in the end, Tom agreed that if they were to continue revisiting prior

:;:;*-,nclusions, there would be no end to the process. The upshot: its millions in debt and losses ,E

-d to be reffected in Enronaa's books. David continued, "I must admit, questions have been5

=truntinB. In a series of September conference calls between our Chicago and Houston offices,:rt team had been struggling as to how to properly restate and account for losses that had been

:mored. In fact, a number of our parlners in Chicago who sat in on one of the conference

calls were stunned by the amount of losses that needed to be restated." Ken Bailey interjected

David's explanation, "Yes, I heard along the grapevine that issues were raised in the memos'

and conference calls being held about Enronaa. Given the problems with a Fastow partnership

called LJM2, Tom was concerned that Enronaa probably had an LJM1 lurking out there with

similar troubles, and he asked about it in a conference call with at least a dozen Androids's

people listening in." David did not want to confirm Ken Bailey's obseruation, but he person-

ally knew for certain that such a meeting did take place. In fact, as the partner in charge of

Enronaa, he was the one who assured everyone in that meeting that the investments in LJMIreally were legitimate. In reality, he was not so sure. In fact, the question had already come up

earlier during the firm's annual review of the Enronaa account in February 2001, when Hous-

ton parlners briefed their Chicago headquarters in a conference call. At that time, Androids'

partners described Enronaa's accounting for trades as 'intelligent gambling'. David tried to

explain his point of view to Ken Bailey, "Yes, we had used accounting practices that allowed

Enronaa to hide its debts, but really these are all within the context of fair value accounting..."

and David stafted to explain the grey areas of fair value accounting as if Ken Bailey was a

junior auditor. Ken Bailey sat patiently to allow David to finish and then said, "Our work pa-

pers would be taken out of context, blown out of proportion." David nodded in agreement and #said, "Yes, I am very concetned about that, especially with all other litigations still unresolved.

FThe general expectation was that the auditor would have been able to spot large scale fraud or

deception. At best, Androids' critics would say, the auditors were incompetent; at worse, they

deliberately overlooked irregularities at Enronaa in order not to lose the lucrative stream ofconsulting and other work it provided.

"I don't know what to do," David confessed. Ken Bailey looked at him thoughtfully and said,

"Androids is under attack " It was already in the news, and what made Androids a tastier

target was the fact that Enronaa was not the first time. Androids had had prior entanglements

with the Securities and Exchange Commission (SEC). Only recently, Androids agreed to pay

the SEC a civil penalty of USD 7 million to settle charges related to the flrm's work as auditors

of Solid Waste. "More importantly, Ken, as part of the settlement with the SEC, we agreed to

an injunction that forbade Androids from future'wrongdoing," David said, wonyingly. They

both sat down and talked about the Solid Waste case (see below):

N4llalrirrr Inililrtc ol Aco.rrrnirts



SOLID WASTE CASE

POINTS OF DISCUSSION BETWEEN DAVID AND KEN

Androids, together with its client, Solid Waste, agreedto

payUSD 22g million to settlea class-action suit about questionable accounting practices. Androids would have to pay

Solid Waste USD 20 million as part of a malpractice settlement. The US Security Ex-change Commission (SEC) found Androids guilty of issuing materially false and mis-leading audit reports on Solid Waste financial statements for the period 1993 through1996' For each year from 1993 through 1996, Androids issued an audit report on SolidWaste's financial statements in which it stated that the company's financial statements

were presented fairly, in all material respects, in conformity with generally accepted

accounting principles ("GAAP") and that Androids had conducted its audit of those fi-nancial statements in accordance with generally accepted auditing standards ("GAAS,,).SEC found that Androids' representations were materially

false and misleading. SolidWaste's financial statements were not presented fairly, in all material respects, in con-formity with GAAP from 1993 through 1996. Androids had allowed the managementof Solid Waste to use improper accounting to inflate its operating income and othermeasures of success, primarily by defening the recognition of current period operatingexpenses into the future and by netting one-time gains against cuffent and prior periodmisstatements and current period operating expenses. For each year from 1993 through1996, Androids, as a result of the conduct of ceftain of its partners, knew or was recklessin not knowing that the Company's flnancial statements were not presented fairly, in allmaterial respects, in conformity with GAAP but nonetheless, approved the issuance ofan unqualified audit report on the financial statements each year.

Six Androids parbrerswere involved, at various times during the relevant period, in the issuance of unqualifledaudit reports on Waste Management's annual financial statements. In February 199g,Waste Management announced that it was restating its financial statements for the five-year period 1992 tbrough 1996 and the first three quarters of 1997 . It was the largestrestatement of results in the history of the SEC. The company admitted that through1996, it had materially overstated its reported pre-tax earnings by $ 1.43 billion and thatit had understated certain elements of its tax expenses by $17g million.

SEC's investigation into the audit working papers of Androids revealed that theAn-droids' engagement teams that performed audits of Solid Waste's

financial statementsin the late 1980s, first discovered several of the accounting practices resulting in ceftainof these misstatements. In the course of its original audits from 1993 through 1996, theengagement team had identified and documented numerous accounting issues underly-ing misstatements that the restatement ultimately addressed, and had brought certain

issues to the at

working papers

were quantifled

droids knew oron which Andr

conducted in ac

knew or was rec

were materially

and the financia

improper profes

Background o

Androids audite

became a public

client. Until 199

("CAO") in Sol

auditor at Andro

worked for Solid

As early as 1988

Waste employed

were practicallyrepeated flnal yea

equipment cumu

fied other non-G

GAAP method o

to accrue for its t

ing to increase its

of operating exp

refusal to write-o

These accounting

understating opercurrent operating

Androids'audit e

various times thro

audit fees at the p

Ilalaysiet lnstiluie oi Accountants





tax, attest work unrelated to financial statement audits or reviews, regulatory issues, and

consulting services.

Evidences in the Audit Working Paper of Solid Waste

By February I, 1994, the engagement team quantified current and prior period mis-

statements totaling $l2B million, which, if recorded, would have reduced net income

before special items by l2oh.The engagement team also identified accounting practices

that gave rise to other known and likely misstatements involving understatements ofoperating expenses. The engagement team proposed adjusting entries in that amount

for the Company to record. Solid Waste's management refused to record the journal

entries or to correct the accounting practices giving rise to the adjustments and other

misstatements and likely misstatements. Androids'partners relented and instructedtheengagement team to identifi, these as "continuing audit issues." They determined that

Androids would nonetheless issue an unqualified audit report on Solid Waste's 1993

financial statements.

Audit working papers of 1996 and the 1991 audit showed that although the Androids

audit team disagreed with the company's use of netting and the lack of disclosures, Sol-

id Waste continued to use netting. In 1996,the company offset current period expenses

and prior period misstatements against a portion of the gains realised from the sale oftwo discontinued operations, the effect of which was to boost income from continuing

operations. The company netted and misclassified gains and profits of approximately

USD 85.1 million on the sales of the two subsidiaries. The engagement team prepared

a proposed journal adjustment, which, if recorded, would have further reduced pre-tax

income from continuing operations before special charges by 5.9%. The company re-

fused to record the adjustments. In addition, the company inflated income by making

unsupported changes to its salvage values, improperly accounting for insurance recov-eries and incorrectly applying purchase acquisition accounting principles to its envi-ronmental remediation reserves (liabilities) in order to reduce current period operating

expenses. SEC found evidence in the audit working papers that showed the partners ofAndroids had allowed an issue of an unqualified audit report on the company's financial

statements.

rntl

;;F-

The Solid Waste case followed Androids' decision to pay USD 110 million to settle a lawsuiton audits at Sunbeamic, another US client found to have less than reliable accounts. KenBailey was his junior and yet understood what David had long been observed since he first

N4alaysian lnstilute ol Acc.)untnuts

joined Androids inas accountancy fithe desire to grow

firm rapidly expan

derived from such

portunities for con

David and Ken kne

David said "Andro

likes of Enronaa w

accounts. I'll do a

staff in 390 offices

David saw a windo

"By the way, didof Androids on th

meaning of the doc

Bailey explained t

was supposed to de

atkacting outside s

ing final versions othat Ken Bailey wo

continued, "David,

replied, "Yes, I hav

to discuss the matte

ments to shred." D

We cannot be keep

ley asked, 'oHave y

don't see what's wr

Androids'official p

spite ofhis reservat

"How did we get int

not already have the

where Enronaa's fin

auditors sign off on

a former Androids'p

and say they needed

with them." Ken Ba



joined Androids in the 1980s - a period when standards throughout the industry began to fall

as accountancy firms struggled to balance their commitment to audit independence against

the desire to grow their burgeoning consultancy practices. Androids was no exception. The

flrm rapidly expanded its consultancy practice to the point where the bulk of its revenues were

derived from such engagements, while audit partners were continually encouraged to seek op-portunities for consulting fees from existing audit clients.

David and Ken knew that the firm would be in "deep trouble" for its role in Enronaa's collapse.

David said "Androids was already under probation with the SEC and another scandal in the

likes of Enronaa would mean the end of our business. I am the partner in charge of Enronaa's

accounts. I'll do all within my powers to protect the interests of Androids. We have 85,000

staff in 390 offlces in 84 countries. That's the bigger picture."

David saw a window of opportunity to destroy certain self incriminating audit working papers.

"By the way, did you read Nancy's e-mail on October 19,2001, reminding all employees

of Androids on the policy of routine document shredding?" Ken Bailey asked David. The

meaning of the document retention policy had been debated repeatedly within Androids. Ken

Bailey explained that he didn't understand the e-mail. "You know, I asked Nancy whether I

was supposed to delete the e-mails about Enronaa in my possession, even though the case was

attracting outside scrutiny. I met Nancy and she advised me that the policy called for keep-

ing final versions of the memos while discarding drafts." Ken Bailey explained. David sensed

that Ken Bailey would not be comfortable with an order to shred the documents. Ken Bailey

continued, "David, I am really bothered about doing all these shredding thing." To that David

replied, "Yes, I have read the e-mail and that is why I have called a meeting of the team today

to discuss the matter. If we were to follow Nancy's advice we've got tons, literally, of docu-

ments to shred." David took a deep breath, "Nancy's e-mail is the key to my decision today.

We cannot be keeping self incriminating work papers that might be used against us." Ken Bai-

ley asked, "Have you really put careful thoughts on the matter?" David simply said, "Ken, Idon't see what's wrong with shredding the documents. Anyway, we're merely complying with

Androids'official policy which our lawyers must have put a lot of legal thoughts into it." In

spite of his reservation, Ken Bailey kept quiet.

"How did we get into this mess?" Ken Bailey wondered aloud. It was not as if he or David did

not already have the answer. David knew that there was a pressured atmosphere in Houston,

where Enronaa's finance staff was on the phone nearly every day, demanding thatAndroids'

auditors sign off on some transactions. Ken Bailey himself remembered how Warren White,

a former Androids' paftner, used to complain to him, "They would call you on a Friday night

and say they needed an answer by Saturday and we would be having midnight conferences

with them." Ken Bailey knew that ifAndroids'accountants objected, Enronaa's finance staff

lUrla:,siali Ilislilutr aJl-^"lcotrlJi$tt

:J

,.'}

.T

.J

e

{flH

H{



would call Androids' Chicago headquarters, seeking the advice of senior partners. The con-ference calls would stretch for hours, with the Androids' staffers flipping through financialdocuments and policy statements, finding ways to appease Enronaa. The marathon sessions

would pressure Androids' auditors to view accounting issues Enronaa's way. Androids knew

what Enronaa wanted and usually sought to give it to them. David explained, "We all knewthey were the largest single client in the Houston office. The Enronaa account had become so

lucrative for Androids that the fitm was unwilling to step away. All of us are sucked into thismess," and added, "Ken, do you know, I received an e-mail from Michael Jones informing me

that the partners had discussed whether outsiders would question Androids given that fees on

the Enronaa account could soar to as much as USD 100 million per annum. Androids' leaders

had decided to retain Enronaa as a client and determined the size of fees was not an issue." The

admission from David did not surprise Ken Bailey. Androids'leaders had handpicked Davidbecause they knew that from Enronaa's perspective, David was a good fit. Its chief accounting

officer, Casey, an Androids' alumnus, was friends with David. Casey had been a manager on

the Enronaa account, part of the team of auditorsworking with the client, before he took a jobat Enronaa. The pair often vacationed together, leading a group ofEnronaa and Androids' col-

leagues on an annual golf outing to elite corrses around the counky.

David and his team faced a crisis on several fronts. Their Chicago bosses were headed theirway. So were federal investigators. David ended his conversation with Ken Bailey as soon as

conference room 37C1 was filled with every member ofAndroids'Enronaa team. David stoodup and addressed his team and told his team thatAndroids would have to aid in an SEC inves-tigation of Enronaa. Then, he quickly added, they should comply with the document retentionpolicy. He told his team that Androids had created the policy a yeff and a half earlier to avoidhaving plaintiff lawyers use Androids' paperwork as ammunition against the firm in court."'We must leam from our experience in handling our audit working papers in the audit of ourclient Solid Waste".

Malal,sim Insliture of Accounanis

Documents

Case - Androids Under Attack