Accounting Ethics (and fraud)

The Bernard Madoff Quiz - What would you have done?

2009-03-19T07:07:00.000-07:00

Although I retired from my accounting practice, I still author courses on ethics and fraud and occasionally present live programs on those topics. In my latest course on accounting fraud, I included a discussion of the Bernard Madoff scandal as personally experienced by me. Several of my clients had investments with Madoff and lost a substantial amount of money. The brief discussion is followed by a quiz asking what you would have done at the time and now with hindsight how would you have reacted. Take a couple of minutes (or weeks or years) and answer the questions below. Feel free to post you comments and answers.

Case Study – Bernie Madoff (Part I)

As part of your accounting services you provide limited financial planning services to your clients. One of your new clients (a middle aged married couple) asks you to review their portfolio and make recommendations for investing an additional $100,000 they currently have in cash. In reviewing their portfolio you note that the client is adequately diversified for their age between fixed income and equities.

The equity portion of their portfolio is heavily weighted (approximately 35%) in an investment with a private money manager named Bernard Madoff. Those securities have outperformed all the other investments by 3-4% per year. When you ask the client about the investment, they tell you that they feel lucky that they have been able to get Mr. Madoff to accept their account. His minimums are usually over $1 million, but because several of their friends also invested with him at the same time, he waived the minimum and took their investment of $250,000. They further told you that Mr. Madoff was formally president of the NASDQ and has a track record of over 25 years of beating the S&P 500. You do your due diligence and confirm your client’s statements about Mr. Madoff. He does indeed have a long term track record and was one of the founders of the NASDQ. On Wall Street, he is considered something of a guru, not unlike Warren Buffet, but with a different emphasis.

Questions (assuming no prior knowledge of the Madoff scandal):

What recommendations would you make to your client about the existing 35% investment with Bernie Madoff?

What recommendation would you make regarding the $100,000 they currently have in cash? How would your recommendation be affected if your client tells you that they would like to give the additional $100,000 to Madoff to invest?

With the information you have at this point in the case, is there anything else that you should do?

Case Study – Bernie Madoff (Part II)

It is now tax season and your new client has asked you to prepare their tax returns. You provide them with a tax organizer, which they fill-in reasonably well. You also ask them to include their W-2s, 1099s.

While reviewing their information you note that their investment in Madoff Investments does not have a 1099B for sales or a 1099 DIV or 1099 INT. Instead you receive a multi-page printout listing hundreds of transactions that were made during the year. You ask your client when they will be receiving the 1099s from Madoff and they show you the cover letter that says to call a specified number if you or your tax professional has any difficulty in using the information provided to prepare the client’s tax return.

So you call the number provided and speak with a representative from Madoff (later you learn it is his accounting firm). The Madoff representative explains how to use the summary sheet to record the total sales for the year, where to pick up the dividends and interest, and how to back into cost basis using the totals on the summary for gains and losses. In addition there is another printout that must be used for options trading, which is how you were told, Madoff makes the extra percentage gains on his investments. You also learn that the gains and losses for the options must be recorded on the tax return according to “the 60/40 rule” where 60% are recorded as long term and 40% as short term no matter how long they are actually held. In addition, all open options from regulated contracts are marked-to-market at year end.

In recording the information on the tax return, you notice that the total sales for the year are over $5 million.

Questions (assuming no prior knowledge of the Madoff scandal):

Should you mention to your client that the $5 million in sales may draw the attention of the IRS, because of the relative size of that number compared to the rest of the return?

Should you discuss with your client the possibility that their account is being “churned”[1]?

Based on the information you have thus far in the case, what further information do you believe you need in order to prepare the tax return with regard to the Madoff investment?

Case Study – Bernie Madoff (with hindsight)

We now know the Madoff investments for some period of time have been fraudulent.

Were there indicators that might have caused you to react differently with regard to your client’s investment?

With the advantage of hindsight, what additional due diligence could you have performed?

With regard to the financial planning
With regard to the tax preparation

Do you currently have any clients that you might need to consider whether or not there may be some inappropriate actions taking place?

If you run across a similar situation in the future, do you feel any more comfortable about how to handle it? Would you report such a situation to the SEC, IRS, or other regulatory body?
[1] Churning – the excessive purchase and sale of investments to generate higher commissions.

This is One of those Moments

2006-08-21T01:30:00.000-07:00

After 28 years in accounting, I will be taking down my shingle in just a little over a week.

I have been eagerly talking about the official date - September 1, 2006 - with a great deal of anticipation. But as I was driving to San Luis Obispo from my home in South Orange County to present my last three seminars, there was also a bit of sadness as the realization that a lifetime of work was coming to an end.

It was on the Pacific Coast Highway with the sun glistening off the water that I began to get a lump in my throat. Earlier in the day I had found it amusing that it took me nearly ten minutes to select which suit I was going to wear for that "final seminar". Now I was thinking about the multitude of clients that I had tried to help straighten out their books or get a loan or improve their personal financial condition so they could have that retirement or vacation or even that sports car they wanted.

But most of all I was thinking about the past half dozen or so years that I have spent working with my colleagues to help restore the nobility and sensibility of a profession that for far too many seems to have lost its direction.

Perhaps it was nothing more than being in the right place at the right time. But these last few years of challenging the direction we had taken, asking the tough questions, and sometimes even lecturing about professionalism and ethics seemed pretty important at that moment.

I was listening to a CD from the movie, Yentl, when these words from Alan & Marilyn Bergman seemed to capture everything I was feeling.

There are moments you remember all your life. There are moments you wait for and dream of all your life.
This is one of those moments.

Some Fun with Accounting Definitions

2006-06-15T08:02:00.000-07:00

I noticed that consulting giant Deloitte Consulting released a software program – Bullfighter - that identified and helped eliminate business jargon. Author’s Note: On Deloitte’s website it states that they are no longer associated with any product that tries to make financial information clearer to the investor (or something to that effect.)

I thought it might be helpful to investors if I defined a few important accounting terms in light of recent corporate events.

Balance sheet – a place to hide the other side of a fictitious transaction.

Income statement – a description of the money that companies don’t really make, but show to investors.

Cash flow statement – a description of how companies take money from their investors and give it to their top executives.

Accountant – someone hired to explain how companies really made more money than they actually did.

Accounting standards – a group of words that allow companies to do anything they want to do.

Big bath – How companies take a $2 per share loss and make it into a $4 per share loss so next year’s loss won’t look nearly so bad.

Bottom line – the tip of the iceberg.

Derivative – a financial instrument that is derived with the idea of stealing your money.

Financial instrument – similar to a medical instrument used for small, dark places.

Off-balance-sheet financing – a technique used when you can’t find a reasonable place to put the other side of the entry.

Principles vs. rules – a choice of ways that accountants and companies can use accounting standards to confuse investors.

Smoothing – a technique of reversing reserves that shouldn’t have been recorded in the first place.

Stock options – a financial instrument where the company has the option of screwing the IRS or the investors.

One of my favorite ways to use business jargon is through circular definitions – where one term is defined by another unintelligible term. However, sometimes this method can be very informative.

Enron – see Global Crossing
Global Crossing – see Adelphia
Adelphia – see Xerox
Xerox – see Tyco
Tyco – see Health South
Health South – see WorldCom
WorldCom – see Enron

Of course, every one knows that I am just kidding and having a little fun. Obviously a statement of cash flow is really a place where companies hide money they give to influential politicians so real solutions to serious problems will never take place.

A Story of Moral Courage

2006-05-28T08:23:00.000-07:00

In a sad, but uplifting story, I am writing this entry to tell you about the passing away of one of my hometown football legends who was much more than a great athlete. His name was Joe Brodsky. Joe passed away this past Thursday, May 25, after a long battle with prostate cancer. He was 71. Joe played for the FIRST local Miami football team ever to beat Miami High School. Miami High was a national power that in the earlier days of the 20th century often played junior college teams or out-of-state powerhouses, because there was no one locally who could compete with them.

Joe was an All American high school player at Miami Jackson High school and then became an All American college player at the University of Florida. If you go on the University of Florida website, you will find that some of his records still stand today! For over 40 years, his record for interception return yardage stood as an NCAA record.

But his greatest accomplishments were as a coach and family man.

As coach, he led two different high schools to state championships - Miami Jackson and Hialeah Miami Lakes - and then was a coach of an NCAA (University of Miami) and a Super Bowl championship team (Dallas Cowboys). He is the only coach to have ever done that! (That's a good trivia question).

Joe helped develop numerous running backs who went on to successful pro careers. While at the Dallas Cowboys, he coached Herschel Walker and helped develop Emmitt Smith and Daryl Johnston, both of whom won Pro Bowl accolades. He also had a tremendous sense of humor and provided an honest and forthright assessment of what took place during a game or at the team’s practice. Reporters often sought him out for quotes for the next morning's news.

Joe also had two children who became star athletes after playing for him in high school. He had the added pleasure of coaching the Hialeah Miami Lakes football team to a state championship with his son Joe, Jr. playing quarterback and his other son, Larry, playing receiver. In an interesting twist of fate, Larry played with Herschel Walker when they both were with the New Jersey Generals of the USFL and played on the first USFL game ever televised.

For a coach to be monetarily successful, he has to be willing to constantly move from job to job and city to city. What impressed me most about Joe was that he turned down numerous offers so that he would not have his family traipsing around the country, even though he saw some of his closest friends become nationally recognized sports figures. One of them, Lee Corso, played high school football with Joe. Lee is one of the most prominent broadcasters in college football today and previously had successful stints at several colleges across the country. Lee could often be found over Joe’s house. I remember seeing them both at Thanksgiving dinner on more than one occasion. But Joe was satisfied being a great teacher and a wonderful husband and father.

How do I know all of this? You see Joe Brodsky was also my cousin and someone I am proud to say I knew. Joe was truly a man of moral courage.

Some Additional Thoughts on ENRON

2006-04-21T10:01:00.000-07:00

I don't know how many of you have been following the trial of Jeffrey Skilling and Kenneth Lay of Enron infamy. But I have been reading the daily reports from the Wall Street Journal and Houston Chronicle - as well as a lawyer's blog, Enron Trial Legal Commentary. They give an interesting day to day perspective of what has gone on in the trial.

However, the New York Times just published an opinion column with a perspective on the eight days of testimony of Jeffrey Skilling. What I found particularly interesting was a quote from Mark C Zauderer, an attorney who deals in white collar criminal law, "At the end of the day a trial like this is a morality play. It is not just what happened, and who said what to whom, but who is an honest person."

If Mr. Zauderer is correct, I have considerable doubt whether the jury will be able to reach a guilty verdict in this trial. All that Mr. Skilling and Mr. Lay need is one juror who recognizes his own human frailties in the two defendants. The way things have been going in this world, the percentage of people in our society who are capable of greed or arrogance is a whole lot higher than one out of twelve. They might also identify with someone who could justify lying for a particular cause (or as Mr. Skilling put it, "Perhaps I loved Enron too much").

You might notice that the words guilt and innocence never enter into the equation; nor does the actual question of whether the actions were indeed moral or ethical. No, it is possible that Mr. Skilling and Mr. Lay may receive a pass from a society who seems to have no problem with cheering for their local sports hero who abuses women or enjoys watching strangers make secret deals to vote someone off an island.

After all, it is only a game...and what Enron and other similar companies did in the latest round of corporate scandals was also just a game, unless you happened to be one of the thousands who lost their jobs or savings or had their lights turned off just because someone could.

Open Letter to the California Board of Accountancy

2006-03-22T10:09:00.000-08:00

Now that the issue of practice privilege has been temporarily dealt with, I would like to see the California Board of Accountancy (CBA) get back to its primary mission – to protect the public.

I understand that this may seem overly critical, but I believe the CBA has lost its focus over the past few years since the large accounting scandals hit the press. Too much time and energy has been spent in areas that should be addressed by the SEC, the PCAOB, the NYSE, NASDAQ, and other national regulatory agencies. The limited budgets, staff, and state-oriented focus do not make state boards of accountancy the most effective place to deal with large multi-state issues.

For example, I don’t believe that standard setting (such as California’s documentation standards) is the proper role for a state board of accountancy - not that the focus put on the issue did not have positive affects on getting the other organizations to act.

Let me share an example of what I believe are the more critical areas for state boards of accountancy and especially for CBA.

Last week I received a call from a practitioner who wanted me to help him with the preparation of a reviewed financial statement of a not-for profit organization. After asking him a few questions, I learned that he had not prepared a financial statement of any kind (compiled, reviewed, or audited) in many years and was not familiar with the special characterisitcs of a not-for-profit organization. I soon learned that he did not feel he had the time and was not interested in taking appropriate courses or obtaining the appropriate resources such as Practitioners Publishing Company’s Compilation and Review or Not-for-Profit guides. Finally I suggested that he compare the situation to me being asked to prepare an estate tax return for the first time. I suggested that he joint venture the engagement with an experienced practitioner from his local area.

I could hear from his tone that this was not what he wanted to hear. He just wanted a quick fix.

I tell you this story because it is not uncommon for me to get these kinds of calls or questions at one of my seminars. It is way more common than many in our profession would want you and the public to believe. While certainly not a majority, I believe that the number of practitioners who do not see themselves as professionals, is large enough that significant harm is being done to the public and businesses in California.

What Can the California Board of Accountancy Do?

1. The CBA should immediately reinstate the Section 89.1 program of financial statement reviews.

2. Peer review should be made mandatory NOW, not years from now.

The focus of these programs should be on practitioners and firms that opt-out of the AICPA program. While we can all debate the relative merits of the AICPA program and the PCAOB program for public companies, these programs do exist. The most immediate problem is practitioners who skip through the system and have no inkling of what they are doing or that what they may be doing is wrong. They are not helping their clients who rely on their financial information or outside users, who lend, borrow, bond, or invest based on insufficient or erroneous information.

There is one other area, I believe should be of the highest priority for the CBA - that is improving the services to their constituencies. This means more staff and more funds.

I find it hard to believe that the Board chose to reduce their budget and reduce the fees charged to practitioners at a time when so much more needs to be done. Practitioners constantly complain to me that they cannot get anyone at the CBA to return their calls. The “Quarterly” Update from the CBA should be quarterly once more. The public also needs far better information of what they should expect from licensed practitioners and why it is important for them not to get slipshod work.

I hope this letter is not disregarded because of my strong positions, but is used as a first step in reexamining the CBA’s methods of meeting its mission for protecting the public.

ENRON: The Smartest Guys in the Room

2006-01-22T03:02:00.000-08:00

I just finished watching Bethany McLean and Peter Elkind's's movie, ENRON: The Smartest Guys in the Room. The authors and the movie deserve all the credit they are receiving. Apparently it has a good chance to win the Oscar for best documentary of the year.

The Culture of Enron

The movie focuses on the culture and influence inside Enron and how such a culture can subvert many normally ethical people. It also clearly delineates the key arguments against the "holy" triumvirate of Kenneth Lay, Jeffery Skilling, and Andy Fastow.

Bethany McLean, from Fortune Magazine, was one of the very first news reporters who questioned the accepted mantra on Wall Street that Enron's business plan was above reproach.

What makes this movie (and/or) book a must for accountants and others with review or regulatory responsibility is that it so clearly shows how easily this kind of abuse can take place...and what needs to be done to prevent it from happening again. I also liked the way the director presented the subject in a very entertaining way - describing the macho trips taken by key Enron executives and comparing them to the high risks taken inside the company. I watched the movie with a friend who initially had no interest in a movie on accounting, but she loved it. That's because Smartest Guys in the Room is really a human interest story told in a business setting.

California Electric Crisis

Special attention is given to the California electric crisis as the author and director have been able to obtain copies of the actual audiotapes used by Enron traders. It is both frightening and disheartening that these traders were able to disconnect the results of their actions - that millions of people would be without power - from their sole focus - making millions of dollars for Enron and themselves. So what if they had to create artificial shortages to do it. That was all part of the deregulation game.

There are some super bonus materials in the DVD including interviews with the director and authors.

Another Story that Must be Retold

The Enron story is an important one that needs to be told over and over and over again - from different perspectives and to different audiences. This is the one version that bridges the gap between the technical insider information version and the broad ethical perspective version of what and why it happened.

We should never forget, Power tends to corrupt and absolute power corrupts absolutely. Great men are almost always bad men, even when they exercise influence and authority; still more when you superadd the tendency or the certainty of corruption by authority.
- Lord Acton (1887)

Accounting Ethics vs. Life's Ethics: Is There Much Difference?

2006-01-03T06:47:00.000-08:00

During the past few years, the accounting and business communities have been faced with huge ethical conflicts that shook the related professions to their core. What are the responsibilities of management, boards of directors, the internal accounting departments, the external auditors, the underwriters, the legal departments both internal and external, and who are they responsible to?

Enron, WorldCom, Tyco, Xerox, Adelphia, Global Crossing contained numerous ethical decisions for each of these groups and most of the public would agree that the system failed. Arthur Andersen, historically one of the most stalwart and conservative of the international CPA firms, was deemed to have failed in fulfilling their responsbility to protect the public in multiple cases of fraud and mismanagement. Two of the four largest remaining international CPA firms - KPMG and Ernst & Young have been fighting charges of developing and promoting tax shelters that have put into question the role of accounting firms in today's society.

So I ask, "Are the ethical failures highlighted by these cases much different from the critical ethical dilemmas now facing our society in general?

The Institute of Global Ethics, a Maine-based think tank, organized to promote ethical behavior in individuals, institutions, and nations through research, public discourse, and practical action recently published their Top 10 Ethics Stories of 2005"

These stories include issues that range from government corruption to the right-to-die to massive financial fraud to decisions that result in people physically suffering or dying. In other words, they did not draw a distinction between business ethics and the ethics we face in everyday life. The issues and decision making strategies we make in our personal life and in our business life are similar. That is why I often integrate life issues with business issues when I teach ethics in my accounting ethics classes and courses.

I found it of particular interest that they selected the issue of torture as the number one ethics story for 2005. For the past year I have led off my accounting ethics class with the following case study.

What is Ethical?
The year is 1983. You are a high ranking US intelligence officer. There has been substantial “chatter” that a terrorist attack will take place in the next 24 hours. You hear this from your electronic listening methods as well as your human intelligence sources. You have captured suspected terrorists in your prisons, some of which have been captured during the past 72 hours. Officially, the US abides by the rules of the Geneva Convention. In view of the imminent danger to innocent lives, what methods of interrogation would you use?

About 12 hours later, a key ally's intelligence raids a hotel just inside Lebanon and provides you with a captured suspected terrorist. The papers captured with the terrorist provide strong indications that the original chatter was correct and that the terrorist act will take place against a US facility in the next 12 hours.

You conduct your interrogations of the prisoners and the captured suspected terrorist in accordance with the Geneva Convention and US policy, which do not include torture or humiliation (including the kinds we saw at the Abu Ghraib prison); nor do you ask any of your allies to conduct the interrogations for you, since many don’t have the same restrictions you do. Twelve hours later, bombs go off in a US army barracks in Lebanon killing 241 soldiers.

Questions for Discussion
As you read through each of these paragraphs, did your views change as to what decision you would make?

How did you reconcile your decision with public policy?

How did you justify your decision with your own ethical beliefs?

Do you believe that the violation of one person's rights destroys the rights of everyone?

Ultimately, have you made the most ethical decision?

Finally, if you were faced with an ethical decision that conflicts with your personal belief of what is right and wrong, but could protect the life (or the financial well being) of one person, what would you do? Would your decision change if the number of persons saved were in the hundreds or thousands?

I have added a comment feature for this posting. Feel free to post your comments as to how you would deal with this difficult ethical issue.

You Could Have a Big Surprise Next Tax Season

2005-08-26T08:15:00.000-07:00

Moved to www.cpaoutofstatelicensing.blogspot.com

Have State Boards of Accountancy or NASBA Outlived Their Usefulness?

2005-08-11T14:59:00.000-07:00

Purpose of State Boards of Accountancy and NASBA

State Boards of Accountancy were designed to protect the public from unscrupulous actions through licensing of CPAs and regulatory controls. The National Association of State Boards of Accountancy (NASBA) works to foster cooperation among the state boards. One of their chief showpieces has been the Uniform Accountancy Act (UAA). Much of the direction and purpose of the UAA is to minimize the differences between state laws and regulations permitting accountants to practice across state borders in the best interest of their clients.

Are the two compatible?

NASBA recently released a draft of proposed changes to the UAA. According to the release, these changes were the work of three committees of the AICPA and NASBA and have been ongoing since October 2004.

Licensing and Temporary Practice

The proposed changes to the UAA call for removing several of the restrictions that some states now impose to practice accounting in their state. The revisions would recognize CPA firms and individual CPAs who are licensed in a “substantially equivalent” state and provide for one master notice with the NASBA.

Meanwhile what has been taking place at the individual state level? State after state has been imposing new restrictions.

On July 1, 2005, Colorado passed emergency rules increasing the restrictions in their state. On August 1, 2005, the very same day that NASBA’s proposed changes were released, Illinois enacted onerous new restrictions that require out-of-state CPAs to have a temporary (or full) license if they do any accounting work for an Illinois company or prepare any Illinois tax return. This includes nonresident individual tax returns or partnership returns with multi-state requirements.

In fact, during the past two years, dozens of states have expanded their rules on temporary practice in their state, most in the name of protecting the public.

Peer Review

The proposed changes to the UAA call for mandatory peer review every three years. While the manner of peer review is to be determined by State Boards of Accountancy, the condition of peer review will be required for license renewal. In addition, State Boards of Accountancy will gain access to the peer review information in order to adequately discipline errant licensees.

The reality.

State rules regarding peer review are a hodgepodge of voluntary and mandated state and AICPA programs, many that maintain total confidentiality. Within the last month, my home state of California postponed mandatory peer review for the third time. The AICPA refused to sign on to the transparency of the peer review program because it was originally established with the promise of confidentiality.

More Conflicts between NASBA and State Boards of Accountancy

Education

NASBA also proposed rules to change the educational requirements for accountants wishing to sit for the CPA exam. These rules consisted of specific course requirements that would be necessary to meet minimum educational requirements. Numerous states and educational institutions have expressed serious reservations about limiting the flexibility of educational institutions in their course selection and dictating specific course requirements for CPA licensure.

Uniform CPA Examination

NASBA was one of the driving forces in changing the Uniform CPA exam and contracting with a third-party to write, market, and monitor the exam. There have been numerous problems with the new exam and several states have threatened to withdraw their participation from the program.

Where Do We Go From Here?

CPAs, their clients, and the public are caught in a cross current of misdirection, misunderstanding, and power politics. No one is being served. Perhaps it is time for the whole system to be revised.

In today’s world of multi-state and international companies, do the haphazard rules of 54 jurisdictions provide the best protection for the public? Has the time arrived for national licensing of CPAs with a Federal regulatory agency along the lines of the PCAOB for nonpublic entities? Or should we just admit that state’s rights should prevail and that NASBA and the Uniform Accountancy Act is just a practical impossibility. Perhaps CPAs in your state are superior to CPAs in mine.

Can We Really Have Independent Auditors?

2005-06-29T09:09:00.000-07:00

The issue and problems surrounding auditor independence and objectivity will continue as long as auditors are paid by their clients. Whether the audit fee is $25 million as it was with Enron or $25,000 for a private company audit, the independence of the auditing firm could be impacted by the importance of the fee (either real or imagined) to the engagement partner, the firm's managing partner, or the firm itself.

As of yet, no one with any clout has been willing to take up the debate... and yet there are viable alternatives that deserve to be discussed.

The subject of who pays for accounting services was the leadoff section in chapter 4 of my book, Enron: A Professional's Guide to the Events, Ethical Issues, and Proposed Reforms. In it, I summarized three of the most feasible alternatives for paying for auditor services. I called for a national debate on the subject.

That was three years ago. Perhaps with the KPMG and E&Y lawsuits hanging over the accounting profession (Auditors: Too Few to Fail), now could be the time for such a public debate.

Each alternative has its pros and cons. Some of the highlights are summarized below. For a more complete analysis, you can email me at artbcpa@aol.com or read my book.

The "user pays" alternative looks to the user of financial statements for payment. For public companies, the theoretical difference between this alternative and what we have now should be small. Stockholders, represented by an independent audit committee and board of directors, hire the auditor and oversee the relationship. Unfortunately in practice management is often the one that actually makes that decision. The good news is that Sarbanes-Oxley is having a positive effect at many companies in the way auditors are chosen. For private companies this alternative would result in a major change in the way auditors are hired. Banks, bonding companies, and other users would directly hire the auditor.

The "pooled funds" alternative would require a group of companies to pool their funds. The auditor would be selected by an independent entity and the fee would be negotiated. Only the independent entity could hire or fire the auditors. This should result in a more independent selection process, but critics contend that a whole new set of bureaucracy and problems would develop.

The "government auditor" alternative would totally change the auditing function to a regulatory one. There are strong advocates and opponents of this alternative who are often influenced by their perspective of the proper role of government. The relationship between company and auditor would change. Critics contend that an adversarial relationship would be the result and the quality of audits would actually decrease.

Clearly there is still much to discuss. But with the recent scandals and their effect on the capital markets, the need for a public debate on the topic of independence and the payment of auditor fees should be clearer now than ever before.

The Innocence of Arthur Andersen? Nothing Could be Further from the Truth

2005-06-28T08:54:00.000-07:00

There seems to be some rush from former Arthur Andersen members and some others in the accounting profession to declare the recent ruling by the U.S. Supreme Court in overturning the conviction of Arthur Andersen in the obstruction of justice conviction for Enron as a declaration of their innocence. NOTHING COULD BE FURTHER FROM THE TRUTH.

In fact, the more we have learned, the more that should have been prosecuted.

Remember, Arthur Andersen had begun as one of the most stalwart, conservative accounting firms in the country, by a man who at the age of 27, had chaired one of the most prestigious accounting departments in the academic world at Northwestern University. The firm grew at a rapid pace to become one of the Big Eight accounting firms because people believed that the firm, and the members who worked for the firm, POSSESSED THE HIGHEST INTEGRITY.

They were prosecuted and fell, not because of Enron, but because they had forgotten everything that Arthur Andersen stood for. I do not question whether the judge in the obstruction case exceeded his authority in the instructions he gave the jury. I leave that for legal debates in law school and for future text books. I do question any connection between overturning the conviction of Arthur Andersen, the firm, with any concept of innocence.

Because what the FIRM did at Enron was just the tip of what they did at WorldCom, Waste Management, Sunbeam, Global Crossing, and Baptist Foundation of Arizona. What the FIRM did at Enron was an assault on every honest accountant in the profession. It was not just a breakdown by a few individuals, but an entire firm that had encouraged aggressive behavior by their partners and employees in order to maximize profits.

No other firm gave their partners the right to override their national technical department when issues of integrity arose.

No other firm shredded documents in anticipation of a SEC order – not at one office, but at several.

No other firm tried to justify at their trial a training video where partners told new staff that it was O.K. to shred documents until the firm received a formal subpoena, although their own internal documents expressly forbid it.

No other firm ignored repeated warning from the SEC as to their lack of management control.

The NCAA issues the death penalty to athletic departments when they have determined that the university has lost institutional control. Arthur Andersen, the FIRM, had lost institutional control.

What Arthur Andersen did to the accounting profession will take years to overcome. But perhaps what Enron and Arthur Andersen did for (or to) the investing public with the passage of Sarbanes-Oxley may take even longer to reestablish the balance in what the public wants and needs and accountants are able to deliver in a reasonably economical fashion.

Public Interest Meets Turf Wars and Self-Interest

2005-06-01T06:12:00.000-07:00

The high profile of the corporate scandals might lead some people to believe that opposing corporate reforms would be bad for their health. But when self-interest and personal power are at stake, even such clear issues as promoting transparency and corporate ethics have trouble bearing the weight.

The Public Company Accounting Oversight Board (PCAOB) was established by Congress to provide independent oversight over the preparers of financial information and the professions that help ensure their integrity. So when the PCAOB issues new standards to protect the public from overly aggressive corporate executives, one would think that everyone except the crooks would be rallying ‘round the flagpole.

Well, not quite!

You see, Congress specifically gave the PCAOB authority only over financial statements issued by publicly-held companies.

Are there others? Sure.

Banks want to make sure the companies they lend money to are being truthful. So do bonding companies who ensure the integrity of most contractors… and partners who might not be involved in the day-to-day activities of the company.

You get the idea. There are plenty of others who would like to be sure that the financial information they receive is truthful and clearly presents all of the information they need to know (what has become known as transparency).

So what is the problem?

Well, that’s where the turf war comes in.

The American Institute of CPAs, a professional organization of the CPA profession, was not overly thrilled about seeing a good chunk of their authority whisked away in the name of integrity. In fact, they looked downright incompetent during the Congressional hearings, since most of the scandals had taken place during their watch. Not that they were responsible for the corporate executives who secretly paid themselves hundreds of times the compensation that they had been receiving just a few years earlier or for the auditing firms like Arthur Andersen that decided that bottom line profits were more important than the integrity they had sworn to uphold. But somehow Congress and the public got this idea that people who had a personal self-interest in the outcome of the controls might not be the best people to be in charge of the regulatory process.

In May 2004, the non-independent AICPA issued a “white paper” to remind CPA firms that they were the boss when it came to nonpublic financial statements. In June, the PCAOB issued a series of questions and answers under heavy pressure from …well you decide.

Here are some examples:

If a CPA firm adopts the stricter standards of the PCAOB and refers to those standards in an audit report of a non-issuer , does the auditor represent that he or she has complied with the Commission’s auditor independence requirements? NO

Does a reference to the “auditing standards of the PCAOB” or to “the standards of the PCAOB” in an auditor’s report on the financial statements of a non-issuer imply that the non-issuer is subject to, or otherwise complied with, some or all of the provisions of the Act and other securities laws or the Commission’s rules and regulations? NO.

Does inclusion of a reference to the Board’s standards in an auditor’s report on the financial statements of a non-issuer cause the audit to become eligible for review as part of the Board’s inspection? NO.

If a non-issuer elects to have its financial statements audited pursuant to the Board’s standards, must it also have its internal control over financial reporting audited pursuant to the Board’s Auditing Standard No. 2, “An Audit of Internal Control Over Financial Reporting Conducted in Conjunction with an Audit of Financial Statement”? NO.

So much for turf wars, what about the self-interest?

Congress was very careful during the Congressional hearings on the scandals to remain neutral in the area of accounting standards. They recognized that an independent body, the Financial Accounting Standards Board (FASB) had been established several years earlier to ensure that experts in the field who had “no axe to grind” would be in charge of issuing the rules covering accounting standards. They recognized that many of the problems included in the Income Tax Code were the direct result of partisan pressures and political self-interest. Now the reasons for the independent body are becoming clear again.

Although experts from across this country and around the globe have clearly stated that financial statements that do not include stock options as a cost of doing business are a distortion of the concept of transparency and the integrity of financial statements, some members of Congress have put their political self-interest ahead of the principles they espouse. Interestingly, some of the supporters of the measure to restrict what the independent FASB is permitted to do, include pro-consumer advocates like Senator Barbara Boxer, who is up for re-election in a state that has influential high-tech companies that use stock options and oppose the new FASB rules.

Reprinted from July 2004 press release