Androids Under Attack

Ali Shah Hashim

been properly accou

m 1997. Nonetheles

conclusions, there w mounting. In a series

had to be reflected ir

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 Enronaa's accounts since past

my team had been st

i,enored. In fact, a David's explanation

1987

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

calls were stunned b

and conference calls

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

l6

years.

called LJM2, Tom v 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

similar troubles, ant

people listening in."

ally knew for certai

Enronaa, he was the

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

really were legitimar

earlier during the

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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, Arthur and Clarence, both from the audit firm of Price, bought out a small audit firm in Illinois to form Arthur, Clarence & Co which becameAndroids & Co. in 1918. Androids, who headed the firm until 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 by an executive from a local rail utility to sign off on accounts containing flawed accounting, or else 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 Androids'motto was, "Think straight, talk straight."
Whilst waiting for his team members, David sat to have coffee with Ken Bailey, a junior part"I thought you would like to know," David said, "that late last night, I had an

fir

ton partners briefed

partners described

explain his point

I of

Enronaa to hide its

and David started tr junior auditor. Ken pers would be taken said, "Yes, I am veIl The general expecta

deception. At best,l

deliberately overloc consulting and other

ner in Androids.

"I don't know what

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' future
is in my hands. Period." David couched towards Ken Bailey and showed the audit work papers on Enronaa, and continued, "There were evidences that could suggest we assisted Enronaa to

sort 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 Enronaa job, that some of the many off-the-books partnerships, like Chewco and Chewbacca,had not
11aia1 -tian

"Androids is under target was the fact tl with the Securities a the SEC a civil pena of Solid Waste. "Mc an injunction that fc both sat down and t:

lG11s;; t;Accoultanrs

-: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 been 5 In a series of September conference calls between our Chicago and Houston offices, =truntinB. :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 personally 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 LJMI really 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 Houston 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 papers 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. F The 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 of consulting and other work it provided.

d
e

"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,

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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, agreed to pay USD 22g million to settle a 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 Exchange Commission (SEC) found Androids guilty of issuing materially false and misleading audit reports on Solid Waste financial statements for the period 1993 through
1996' For each year from 1993 through 1996, Androids issued an audit report on Solid Waste'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 financial statements in accordance with generally accepted auditing standards ("GAAS,,). SEC found that Androids' representations were materially false and misleading. Solid Waste's financial statements were not presented fairly, in all material respects, in con-

issues to the atte

working papers. were quantifled r droids knew or v on which Androi conducted in accr knew or was reck were materially I and the financial improper professi

Background

oft

formity with GAAP from 1993 through 1996. Androids had allowed the management of Solid Waste to use improper accounting to inflate its operating income and other measures of success, primarily by defening the recognition of current period operating expenses into the future and by netting one-time gains against cuffent and prior period misstatements and current period operating expenses. For each year from 1993 through 1996, Androids, as a result of the conduct of ceftain of its partners, knew or was reckless in not knowing that the Company's flnancial statements were not presented fairly, in all material respects, in conformity with GAAP but nonetheless, approved the issuance of an unqualified audit report on the financial statements each year. Six Androids parbrers were involved, at various times during the relevant period, in the issuance of unqualifled audit reports on Waste Management's annual financial statements. In February 199g,

Androids audited became a public c client. Until 199? ("CAO") in Solid auditor at Androic worked for Solid'

it was restating its financial statements for the fiveyear period 1992 tbrough 1996 and the first three quarters of 1997 . It was the largest restatement of results in the history of the SEC. The company admitted that through
1996, it had materially overstated its reported pre-tax earnings by 1.43 billion $ and that it had understated certain elements of its tax expenses by $17g million.

Waste Management announced that

SEC's investigation into the audit working papers of Androids revealed that theAndroids' engagement teams that performed audits of Solid Waste's financial statements in the late 1980s, first discovered several of the accounting practices resulting in ceftain of these misstatements. In the course of its original audits from 1993 through 1996, the engagement team had identified and documented numerous accounting issues underlying misstatements that the restatement ultimately addressed, and had brought certain

As early as 1988. Waste employed' were practically r repeated flnal year equipment cumule fied other non-GA GAAP method of r to accrue for its ta: ing to increase its t of operating exper refusal to write-off
These accounting

understating operal current operating e.

Androids'audit

en1

various times throu audit fees at the pr

Ilalaysiet lnstiluie oi Accountants

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

joined Androids in
as accountancy

consulting services.

firr

the desire to grow firm rapidly expand Evidences in the Audit Working Paper of Solid Waste

derived from such e portunities for cons

By February I, 1994, the engagement team quantified current and prior period misstatements 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 of operating 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 instructed the engagement 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.

David and Ken kner

David said "Androi likes of Enronaa wo accounts. I'll do all staff in 390 offices i
David saw
a

windou

"By the way, did y,

rn

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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, Solid 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 of two 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

of Androids on the meaning of the docu Bailey explained thi was supposed to del{ atkacting outside sc ing final versions of that Ken Bailey wou continued, "David, I replied, "Yes, I have
to discuss the matter ments to shred." Dar

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journal adjustment, which, if recorded, would have further reduced pre-tax income from continuing operations before special charges by 5.9%. The company refused to record the adjustments. In addition, the company inflated income by making unsupported changes to its salvage values, improperly accounting for insurance recoveries and incorrectly applying purchase acquisition accounting principles to its environmental remediation reserves (liabilities) in order to reduce current period operating expenses. SEC found evidence in the audit working papers that showed the partners of Androids had allowed an issue of an unqualified audit report on the company's financial
a proposed

We cannot be keepin ley asked, 'oHave yot don't see what's wrot

Androids'official po spite ofhis reservatic

"How did we get into not already have the

statements.

The Solid Waste case followed Androids' decision to pay USD 110 million to settle a lawsuit on audits at Sunbeamic, another US client found to have less than reliable accounts. Ken Bailey was his junior and yet understood what David had long been observed since he first
N4alaysian lnstilute ol Acc.)untnuts

where Enronaa's fina auditors sign off on s a former Androids'pz and say they needed

with them." Ken Bai

:J

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 opportunities for consulting fees from existing audit clients.

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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 keeping 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 documents 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 Bailey asked, "Have you really put careful thoughts on the matter?" David simply said, "Ken, I don'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
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would call Androids' Chicago headquarters, seeking the advice of senior partners. The conference calls would stretch for hours, with the Androids' staffers flipping through financial documents 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 knew they 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 this mess," 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 David because 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 auditors working with the client, before he took a job at Enronaa. The pair often vacationed together, leading a group ofEnronaa and Androids' colleagues 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 their way. 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 stood up and addressed his team and told his team thatAndroids would have to aid in an SEC investigation of Enronaa. Then, he quickly added, they should comply with the document retention policy. He told his team that Androids had created the policy a yeff and a half earlier to avoid having 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 our client Solid Waste".

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Malal,sim Insliture of Accounanis