In January 2002, there were five major public accounting firms: Arthur

Andersen, Deloitte Touche, KPMG, Pricewaterhouse-Coopers, and Ernst

& Young. By late fall of that year, the number had been reduced to

four. Arthur Andersen became the first major public accounting firm to

be found guilty of a felony (a conviction later overturned), and as a

result it virtually ceased to exist.

That such a fate could befall Andersen is especially sad given its early

history. When Andersen and Company was established in 1918, it was led

by Arthur Andersen, an acknowledged man of principle, and the company

had a credo that became firmly embedded in the culture: “Think Straight

and Talk Straight.” Andersen became an industry leader partly on the

basis of high ethical principles and integrity.

How did a one-time industry leader find itself in a position where it received a
corporate death penalty over ethical issues? First, the market changed.
During the 1980s, a boom in mergers and acquisitions and the emergence
of information technology fueled the growth of an extremely profitable
consulting practice at Andersen. The profits from consulting contracts
soon exceeded the profits from auditing, Andersen’s core business. Many
of the consulting clients were also audit clients, and the firm found
that the audit relationship was an ideal bridge for selling consulting
services. Soon the audit fees became “loss leaders” to win audits, which
allowed the consultants to sell more lucrative consulting contracts.

At Andersen, tension between audit and consulting partners broke into open

and sometimes public warfare. At the heart of the problem was how to

divide up the earnings from the consulting practice among the two

groups. The resulting conflict ended in divorce, with the consultants

leaving to form their own firm. The firm, Accenture, continues to thrive

today.

Once the firm split in two, Andersen
began to rebuild a consulting practice as part of the accounting
practice. Consulting continued to be a highly profitable business, and
audit partners were now asked to sell consulting services to other
clients, a role that many auditors found uncomfortable.

Although the accountants were firmly in charge, the role of partners as
salespersons compounded an already existing ethical issue—that of
conflict of interest. It is legally well established that the fiduciary
responsibility of a certified public accounting (CPA) firm is to the
investors and creditors of the firm being audited. CPA firms are
supposed to render an opinion as to whether a firm’s financial
statements are reasonably accurate and whether the firm has applied
generally accepted accounting principles in a consistent manner over
time so as not to distort the financial statements. To meet their
fiduciary responsibilities, auditors must maintain independence from the
firms they audit.

What might interfere with the objective
judgment of the public accounting firms? One problem arises because it
is the audited companies themselves that pay the auditors’ fees.
Auditors might not be completely objective when auditing a firm because
they fear losing consulting business. This is an issue that regulators
and auditors have not yet solved. But another problem arises in
situations where accounting firms provide consulting services to the
companies they audit. Although all of the major accounting firms were
involved in this practice to some extent, Andersen had developed an
aggressive culture for engaging partners to sell consulting services to
audit clients.

The unraveling of Andersen began in the 1990s with a series of accounting

scandals at Sunbeam, Waste Management, and Colonial Realty—all firms

that Andersen had audited. But scandals involving the energy giant Enron

proved to be the firm’s undoing. The account was huge. In 2000 alone,

Andersen received $52 million in fees from Enron, approximately 50

percent for auditing and 50 percent for other consulting services,

especially tax services. The partner in charge of the account and his

entire 100-person team worked out of Enron’s Houston office.

Approximately 300 of Enron’s senior and middle managers had been

Andersen employees.

Enron went bankrupt in December 2001 after
large-scale accounting irregularities came to light, prompting an
investigation by the Securities and Exchange Commission (SEC). It soon
became clear that Enron’s financial statements for some time had been
largely the products of accounting fraud, showing the company to be in
far better financial condition than was actually the case. The
inevitable question was asked: Why hadn’t the auditors called attention
to Enron’s questionable accounting practices? The answer was a simple
one. Andersen had major conflicts of interest. Indeed, when one member
of Andersen’s Professional Standards Group objected to some of Enron’s
accounting practices, Andersen removed him from auditing
responsibilities at Enron—in response to a request from Enron
management.

The SEC was determined to make an example of Andersen. The Justice

Department began a criminal investigation, but investigators were

willing to explore some “settlement options” in return for Andersen’s

cooperation. However, Andersen’s senior management appeared arrogant and

failed to grasp the political mood in Congress and in the country after

a series of business scandals that had brought more than one large

company to bankruptcy.

After several months
of sparring with the Andersen senior management team, the Justice
Department charged Andersen with a felony offense—obstruction of
justice. Andersen was found guilty in 2002 of illegally instructing its
employees to destroy documents relating to Enron, even as the government
was conducting inquiries into Enron’s finances. During the trial,
government lawyers argued that by instructing its staff to “undertake an
unprecedented campaign of document destruction,” Andersen had
obstructed the government’s investigation.

Since a firm convicted of a felony cannot audit a publicly held company, the
conviction spelled the end for Andersen. But even before the guilty
verdict, there had been a massive defection of Andersen clients to other
accounting firms. The evidence presented at trial showed a breakdown in
Andersen’s internal controls, a lack of leadership, and an environment
in Andersen’s Houston office that fostered recklessness and unethical
behavior by some partners. In 2005, the United States Supreme Court
unanimously overturned the Andersen conviction on the grounds that the
jury was given overly broad instructions by the federal judge who
presided over the case. But by then it was too late. Most of the
Andersen partners had either retired or gone to work for former
competitors, and the company had all but ceased to exist.