DIES Androids Under Attack Ali Shah Hashin David Lawrence, 43 years of age, joined the auditing firm of Androids 20 years ago and earme, 4 salary of USD 700,000 per anhum, He was the Androids’ partner in charge of auditing Fp ronaa’s accounts since 1987 — his job was to check Enronaa’s accounts and to make sure that they fairly represent the state of the business. Androids had been Enronaa’s auditor for thy past 16 years, On the morning of October 23, David and his auditing team listened in on a call between stack 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 teain together in Conference Room 37C 1. His heart beat faster as he thought about the net that was closing in on Androids. 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, Arthur and Clarence, both from the audit firm of Price, bought out a small audit firm in llinois to Form Arthur, Clarence & Co which became Androids & Co. in 1918. Androids, who headed the firm until his death in 1945, was a zealous supporter of high standards in the accounting indus\y 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, of else face the loss of a major client. Androids refused in no uncertain terms, replying that he would not sign the accounts “for all the money in America.” 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 past ner in Androids, “I thought you would like to know,” David said, “that late last night, I had! an emergency conference calls 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 pape: 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. He explained how he learned from Tom Fitzgerald, a co-partner of the Enron) Job, that some of the many off-the-books partnerships, like Cheweo and Chewbacca, had i_ been properly accounted for and were not independent entities, as Enronaa had told Androids in 1997. Nonetheless, in the end, Tom agreed that if they were to continue revisiting prior conclusions, there would be no end to the process. The upshot: its millions in debt and losses had to be reflected in Enronaa’s books. David continued, “I must admit, questions have been ‘mounting. In a series of September conference calls between our Chicago and Houston offices, iny team had been struggling as to how to properly restate and account for losses that had been ignored. In fact, a number of our partners 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 cails being held about Enronaa, Given the problems with a Fastow partnership ~_ called LIM2, Tom was concerned that Enronaa probably had an LMI 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 observation, but he person - ally knew for certain that such a meeting did take place. In fact, as the partner in charge of __Enronsa, he was the one who assured everyone in that meeting that the investments in LIM1 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 Enrona account in February 2001, when Hous- ton partners 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 hida its debis, but really these are all within the context of fair value accounting...” and David started 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, 1am very concerned about that, especially with all other litigations still unresolved _ 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. “T don’t know what to do,” David confessed. Ken Bailey looked at him thoughtfully and said, “Androids is under attack!” Tt was already in the news, and what made Androids a tastier farget 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 firm'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, worryingly. They both sat down and talked about the Solid Waste case (see below):Tag s. = _ Be SOLID WASTE CASE POINTS OF DISCUSSION BETWEEN DAVID AND KEN Androids, together with its client, Solid Waste, agreed to pay USD 229 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 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 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 fi nancial statements in aceordance 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. 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 deferring the recognition of current period operating expenses into the future and by netting one-time gains against current and prior period misbtatements and current period operating expenses. For each year from 1993 through 1996, Androids, as a result of the conduct of certain of its partners, knew or was reckless in not knowing that the Company’s financial statements were not presented fairly, in all material respects, in conformity with GA*AP but nonetheless, approved the issuance of an unqualified audit report on the financial statements each year. Six Androids partners were involved, at various times during the relevant period, in the issuance of unqualified audit reports on Waste Management's annual financial statements, In February 1998, ‘Waste Management announced that it was restating its financial statements for the five- year period 1992 through 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 ithad understated certain clements of its tax expenses by $178 million. SEC’s investigation into the audit working of Androids revealed that the Androids" en- gagement teams that performed audits of Solid Waste’s financial statements in the late 1980s, fitst discovered several of the accounting practices resulting in certain of these misstatements, In the course of its original audits from 1993 through 1996, the engage- ‘ment team had identified and documented numerous accounting issues underlying mis- statements that the restatement ultimately addressed, and had brought certain issues to FIG sees ett tens© the attention of Androids’ partners. Based on the evidence of Androids’ audit working papers, SEC found Androids failed to ensure that all known misstatements were quanti- fied and all likely misstatements were estimated. SEC also found that Androids knew or was reckless in not knowing that the audits of the financial statements on which © Androids issued unqualified audit reports during those years that were not conducted in accordance with GAAS, As a result of the conduct of its partners, Androids knew or ‘was reckless in not knowing that the unqualified audit reports that it had issued, were | materially false and misleading because the audits did not conform with GAAS and _ the financial statements did not conform with GAAP. Androids thereby, engaged in im- proper professional conduct Background of the Auditing of Solid Waste Androids audited Solid Waste’s annual financial statements since before Solid Waste became a public company in 1971. Androids regarded Solid Waste as its “crown jewel” client. Until 1997, every chief financial officer (“CFO”) and chief accounting officer (‘CAO”) in Solid Waste’s history as a public company had previously worked as an auditor at Androids. During the 1990s, approximately 14 former Androids’s employees worked for Solid Waste, most often in key financial and accounting positions. | As early as 1988, members of Androids’ audit engagement team recognised that Solid _ Waste employed “aggressive” accounting practices to enhance its earnings, and some were practically violating GAAP. They included, among other things, Soli] Waste’s repeated final year adjustments to reduce depreciation expense on its property plant and ‘equipment cumulatively from the beginning of the year. Androids’ audit team identi- fied other non-GAAP accounting practices, including, Solid Waste’s adoption of a non- GAAP method of capitalising interest on landfill development costs, its failure properly to accrue for its tax and self-insurance expenses, its improper use of purchase account- ing to increase its environmental remediation reserves (liabilities), its improper charges of operating expenses to the environmental remediation reserves (liabilities), and its refusal to write-off permitting and/or project costs on impaired or abandoned landfills. _ These accounting practices together increased reported operating income primarily by _understating operating expenses, In most instances, Solid Waste deferred recognition of current operating expenses to future periods in order to inflate its current period income. Androids’ audit engagement teams identified and documented each of these practices at various times throughout the audit engagement, Solid Waste capped Androids" corporate audit fees at the prior year’s level but allowed the Androids to earn additional fees for vst coms Fh IES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 1, 1994, the engagement team quantified current and prior period mis- statements totaling $128 million, which, if recorded, would have reduced net income before special items by 12%. 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 identify 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 1997 audit showed that although the Androids aulit team 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 discon- tinued 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, ifrecorded, 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 incor: rectly applying purchase acquisition accounting principles to its environmental reme- diation reserves (liabilities) in order to reduce current period operating expenses, SEC found evidence in the audit working papers showed that the partners of Androids had allowed an issue of an unqualified audit report on the company’s financial statements ‘The Solid Waste case followed Androids’ decision to pay USD 110 million to settle a laws on audits at Sunbeamic, another US client found to have less than reliable accounts. K. Bailey was his junior and yet understood what David had long been observed since he fi ui en rst joined Androids in the 1980s - a period when standards throughout the industry began to fail Mata rte oAcsnatnsthe desire to grow their burgeoning consultancy practices. Androids was no exception. The “far rapidly expanded its consultaney practice to the point where the bulk of ts revenues were - derived from such engagements, while audit partners were continually encouraged to seek op- cunities for consulting fees from existing audit clients avid and Ken knew that the firm would be in “deep trouble” for its role in Enronaa’s collapse. avid said “Androids was already under probation with the SEC and another scandal in the kes of Baronaa would mean the end of our business. | am the partner in charge of Bnronaa’s ‘ounts. I'll do all within my powers to protect the interests of Androids, We have 85,000 ‘aff in 390 offices in 84 countries. That’s the bigger picture.” : |i ome ctices “| Jayid 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 caning of the document retention policy had been debated repeatedly within Androids. Ken jailey explained that he didn’t understand the e-mail. “You know, I asked Nancy whether 1 _ {vas 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 ~‘teplied, “Yes, I have read the e-mail and that is why,I have called a meeting of the team today discuss the matter. If we were to follow Nancy’s advice we've got tons, literally, of docu- ‘iments to shred,” David took a deep breath, “Nancy’s e-mail is the key to my devision today. fe 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, I jon’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 ppite 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 that Androids’ - auditors sign off on some transactions. Ken Bailey himself remembered how Warren White, | #fomer Androids’ pariner, 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 if Androids’ accountants objected, Enronaa’s finance staff ‘ould call Androids’ Chicago headquarters, seeking the advice of senior partners, The con- vesattettsoneeesference calls would stretch for hours, with the Androids’ staffers flipping through financiat | 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 firm was unwilling to step away. All of us are sucked into this mess,” and added, “Ken, do yoit 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 of Enronaa and Androids’ col. leagues on an annual golf outing to elite courses around the country. 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 confergnce room 37C1 was filled with every member of Androids’ Enronaa team. David stood up and addressed his team and told his team that Androids would have to aid in an SEC inves ligation 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 year and a half earlier to avoid having plaintiff lawyers use Androids’ paperwork as ammunition against the firm in court “We must learn from our experience in handling our audit working paper in the audit of our client Solid Waste”. 1B sr seenseat seven