I watched the AICPA's excellent FBI Webcast today (Nov. 6). One segment that I really enjoyed was a video of Walter Pavlo, a former MCI executive who served prison time for fraud. This was a person with all intentions of being highly professional on a fast track to being in charge of collecting reseller bad debts for MCI. In that position, he just stumbled upon too much temptation for what is tantamount to a kiting scheme.

You can read details about Walter Pavlo's fraud at http://www.forbes.com/forbes/2002/0610/064.html  
This Forbes site was temporarily opened up for the AICPA Webcast viewers and will not be available very long. If you are interested in it, you should download now!

Meet an Ex Con Named Walter Pavlo Who Did Time in Club Fed

What you find below is a message (actually three messages and a phone call) I received  from a man involved in MCI's accounting fraud who went to prison and is now trying to apologize (sometimes for a rather high fee) to the world. 

You can read details about Walter Pavlo's fraud at http://www.forbes.com/forbes/2002/0610/064.html

I wrote the following last year at  http://faculty.trinity.edu/rjensen/fraud.htm

I watched the AICPA's excellent FBI Webcast ( Nov. 6, 2003 ). One segment that I really enjoyed was a video of Walter Pavlo, a former MCI executive who served prison time for fraud. This was a person with all intentions of being highly professional on a fast track to being in charge of collecting reseller bad debts for MCI. In that position, he just stumbled upon too much temptation for what is tantamount to a kiting scheme.

Message from Walter Pavlo on February 24, 2004

Bob,

I routinely do a search on my name over the Internet to see if there are comments on my speeches that I conduct around the country. I saw that you had a comment on a video in which I appeared but was unable to find the complete comment on your extensive web-site. Whether positive or negative I could not ascertain but am still interested in your thoughts and would appreciate them.

I did read some of your comments regarding the stashing of cash off-shore by executives who commit crimes and the easy life they have at "club fed". Here I would agree that there are a few who have such an outcome, but this is not the norm. However, I would disagree that there is a "club fed" and on that you are misinformed.

I had off-shore accounts and received a great deal of money. However, the results of story are more tragic. All of the money is gone or turned over to authorities (no complaints here, this is justice), I lost my wife of 15 years and custody of my children, I lost all of my assets (retirement, etc.) and at 41 I am starting life over with little to show of my past accomplishments (which were many). Stories like mine are more common among rank and file middle managers who find themselves on the other side of the law. There are few top executives in prison but that appears to be changing. Time will tell if they fare as well.

Prison, while deserving for a crime of the magnitude that I and others committed, is a difficult experience and one that is difficult from which to recover. In the media and in comments such as the ones your offer, it appears that this part of the story is not revealed and that it is better to appeal to the fears and anger of the general population. I would encourage you to consider other view points for reasons of understanding the full story. I feel that this is important for people to know.

Thank you for your time and would appreciate receiving your feedback.

Walt Pavlo
125 Second Avenue, #24 New York, NY 10003
Phone: (201) 362-1208

Message 2 from Walter Palvlo (after he phoned me)

Bob,

Attached is an article that appeared in Forbes magazine in the June 10, 2002 issue. I was interviewed for this article while still in prison and some six months prior to WorldCom's revelations of the multi-billion dollar fraud that we know of today.

It was a pleasure to speak with you and I hope to correspond with you more in the future.

Walt Pavlo

125 Second Avenue, #24 New York, NY 10003

Phone: (201) 362-1208

This is part of a resume that he sent to me (I think he wants me to promote him as a speaker)

Walter "Walt" Pavlo holds an engineering degree from West Virginia University and an MBA from the Stetson School of Business at Mercer University. He has worked for Goodyear Tire in its Aerospace division as a Financial Analyst, GEC Ltd. of England as a Contract Manager and as a Senior Manager in MCI Telecommunication's Division where he was responsible for billing and collections in its reseller division.

As a senior manager at MCI, and with a meritorious employment history, Mr. Pavlo was responsible for the billing and collection of nearly $1 billion in monthly revenue for MCI's carrier finance division. Beginning in March of 1996, Mr. Pavlo, one member of his staff and a business associate outside of MCI began to perpetrate a fraud involving a few of MCI's own customers. When the scheme was completed, there had been seven customers of MCI defrauded over a six-month period resulting in $6 million in payments to the Cayman Islands.

In January 2001, in cooperation with the Federal Government, Mr. Pavlo pled guilty to wire fraud and money laundering and entered federal prison shortly thereafter. His story highlights the corrupt dealings involving the manipulation of financial records within a large corporation. His case appeared as a cover story in the June 10, 2002 issue of Forbes Magazine, just weeks before WorldCom divulged that it had over $7 billion in accounting irregularities.

Currently, Mr. Pavlo is the Director of Business Development at the Young Entrepreneurs Alliance (YEA), a non-profit organization in Maynard, Massachusetts. YEA's mission is to provide at-risk and adjudicated teens with the opportunity to attain long-term economic independence by teaching them about business ownership. Mr. Pavlo's primary responsibility is to develop the business programs, raising funds through speaking engagements and charitable donations to YEA.

Mr. Pavlo has been invited to speak on his experiences by the Federal Bureau of Investigation, US Attorney's Office, major university MBA programs, corporations and various professional societies. The purpose of these speeches is to convey to audiences an understanding of the inner-workings and motivations associated with complex white-collar crimes, with an emphasis on ethical decision-making.

Walter Pavlo sent me the following information regarding my question whether he makes pro-bono presentations.  He replied as follows:

Bob,

On the note of pro-bono work, most of what I have done to date has been pro-bono.  Whenever I am in an area with a paying gig, I try to reach out to universities in the area to offer my services at no charge.  I could have done this for Trinity when I was in San Antonio last year for the Institute of Internal Auditors .  I'll be sure to look you up if I'm going to be in the area.

Walt

Ken Lay's secret recipes for legally looting $184,494.426 from the corporation you manage --- 
The Enron, Andersen, and Worldcom Scandal Modules Moved to --- http://faculty.trinity.edu/rjensen/Fraud.htm  

The Saga of Auditor Professionalism and Independence
http://faculty.trinity.edu/rjensen/Fraud001c.htm

E&Y Suspended for Lack of Auditor Independence

"Big Auditing Firm Gets 6-Month Ban on New Business," by Floyd Morris, The New York Times, April 17, 2004 ---  http://www.nytimes.com/2004/04/17/business/17ERNS.html 

Ernst & Young, the big accounting firm, was barred yesterday from accepting any new audit clients in the United States for six months after a judge found that the firm acted improperly by auditing a company with which it had a highly profitable business relationship.

The unusual order, which included a $1.7 million fine, brought to an end a bitter fight in which the Securities and Exchange Commission had contended that Ernst violated rules on auditor independence by jointly marketing consulting and tax services with an audit client, PeopleSoft Inc.

The overwhelming evidence," wrote Brenda P. Murray, the chief administrative law judge at the S.E.C., is that Ernst's "day-to-day operations were profit-driven and ignored considerations of auditor independence." She said the firm "committed repeated violations of the auditor independence standards by conduct that was reckless, highly unreasonable and negligent."

The rebuke to Ernst, which said it would not appeal the decision, is the latest embarrassment for one of the Big Four accounting firms, which have come under heavy criticism and increased regulation as a result of accounting scandals in recent years. Those scandals led to the demise of Arthur Andersen, which had formerly been among the Big Five.

The judge was harshly critical of the Ernst partner who was in charge of independence issues, saying he kept no written records and had failed to learn enough facts before saying the relationships between Ernst and PeopleSoft were proper. That partner, Edmund Coulson, was chief accountant of the S.E.C. before he joined Ernst in 1991.

Ernst's consulting and tax practices used PeopleSoft software in their business, and the two companies participated in some joint promotion activities. Ernst contended that it should be viewed as a customer of PeopleSoft in the relationship, but the judge said it went far beyond that.

She noted that Ernst had billed itself in marketing materials as an "implementation partner" of PeopleSoft and had earned $500 million over five years from installing PeopleSoft programs at other companies, which use the software to manage payroll, human resources and accounting operations.

She issued a cease-and-desist order against the firm, saying it had refused to admit it had done anything wrong and that there was no reason to believe it would not violate the rules again. She also fined it $1,686,500, the total amount of audit fees the company received from PeopleSoft in the years that were involved, plus interest of $729,302, and ordered that an outside monitor be brought in to assure the firm complied with the rules in the future.

S.E.C. officials said the decision would send a message to other firms. "Auditor independence is one of the centerpieces of ensuring the integrity of the audit process," said Paul Berger, an associate director of the commission's enforcement division, adding that the judge's decision "vindicates our view that Ernst & Young engaged in a business relationship that clearly violated" the rules.

Ernst, based in New York, had previously denounced the commission for seeking a ban on new business, saying any such punishment was completely unwarranted. But last night the firm said it would accept the ruling and would not appeal. It had the right to appeal to the full S.E.C. and then to federal courts if the commission ruled against it.

"Independence is the cornerstone of our practice and our obligation to the public," said Charlie Perkins, a spokesman for Ernst & Young. "We are fully committed to working closely with an outside consultant in the review of our independence policies and procedures."

Mr. Perkins said the firm had decided not to appeal because it wanted to put the matter behind it, and emphasized that it would be able to continue serving its existing clients.

The six-month suspension appears to match the longest suspension on signing new business ever imposed on a leading accounting firm.

In 1975, Peat Marwick, a predecessor of KPMG, agreed to accept a similar six-month suspension as part of a settlement of charges it had failed to properly audit five companies, including Penn Central, the railroad that went bankrupt.

The day Arthur Andersen loses the public's trust is the day we are out of business.  
Steve Samek, Country Managing Partner, United States, on Andersen's Independence and Ethical Standards CD-Rom, 1999.

In his eulogy for Arthur Andersen, delivered on January 13, 1947 the Rev. Dr. Duncan E. Littlefair closed with the following words:

Mr. Andersen had great courage.  Few are the men who have as much faith in the right as he, and fewer still are those with the courage to live up to their faith as he did...For those of you who worked with him and carry on his company, the meaning is clear.  Those principles upon which his business was built and with which it is synonymous must be preserved.  His name must never be associated with any program or action that is not the highest and the best.  I am sure he would rather the doors be closed than that it should continue to exist on principles other than those he established.  To you he has left a great name.  Your opportunity is tremendous; your responsibility is great.

It is not too much to expect that principles have a place in business today.  They do.  It's too late for this once-great Firm, but there's still time for the rest of us.
As quoted from pp. 253-254 in Final Accounting, by Barbara Ley Toffler (Broadway Books, 2003).  I might  note that the main message at the start of Barbara Ley Toffler’s book is that Andersen adopted a policy of overcharging for services or in her words “padding the bill.”  This perhaps was the beginning of the end!
You can read about Arthur Andersen at http://fisher.osu.edu/acctmis/hall/members-chrono.htm 

"Our study demonstrates that audit firms may lie to keep a profitable audit client if the expected benefits of keeping the client happy outweigh the expected costs of an audit failure if the firm gets caught," said Debra Jeter, co-author of the study and an associate professor of accounting at the Owen Graduate School of Management at Vanderbilt.

Surprise!  Surprise!
I have long contended criticisms of auditing firm ethics due to consulting practices were are overblown relative to the much larger problem of local firm dependence on the proportion of revenue generated from their largest audit clients. --- http://faculty.trinity.edu/rjensen/FraudConclusion.htm#IncompetentAudits 

This is also implied in the by Jonathon Weil's 2001 article about Andersen's dependence upon the $1 million dollar per week fees from Enron.

TITLE: Basic Principle of Accounting Tripped Enron 
REPORTER: Jonathan Weil 
DATE: Nov 12, 2001 
PAGE: C1 in The Wall Street Journal
LINK: http://interactive.wsj.com/archive/retrieve.cgi?id=SB100551383153378600.djm 
TOPICS: Accounting, Auditing, Auditing Services, Auditor Independence

2003 Update
You might watch for a forthcoming paper in the November/December issue of the Journal of Accounting and Public Policy --- http://www.elsevier.com/inca/publications/store/5/0/5/7/2/1/505721.pub.htt 

From the AccountingWeb on October 28, 2003

A study by Vanderbilt University researchers has found that audit firms are still likely to produce inaccurate audit opinions to benefit a big client — as long as company officials think they can get away with it.

"Our study demonstrates that audit firms may lie to keep a profitable audit client if the expected benefits of keeping the client happy outweigh the expected costs of an audit failure if the firm gets caught," said Debra Jeter, co-author of the study and an associate professor of accounting at the Owen Graduate School of Management at Vanderbilt.

However, the report also suggests that increased scrutiny over the auditing industry, brought about by the accounting scandals of the past two years, may help improve reporting as the possibility grows that wrongdoing will be discovered. Pressure brought by Securities and Exchange Commission enforcement and new rules set by the Public Company Accounting Oversight Board (PCOAB) could influence auditors’ decisions.

"If the likelihood that the firms will get caught if using questionable accounting increases," Jeter added, "their auditors, in evaluating the costs of an audit failure, will think twice and realize that their best interest lies in insisting on fair reporting."

Audit firms should rotate partners in charge of large audits, the study says, and audits should remain independent of consulting work by the same firm.

For companies being audited, Jeter advised that companies must constantly improve the internal audit function. "Top management should require managers at various levels within the firm to certify the numbers they are responsible for. Companies should make sure that most — if not all — audit committee members are financially literate and that they meet more than once a year. This is vital."

The study will be published in the November/December 2003 issue of the Journal of Accounting and Public Policy. "The Impact on the Market for Audit Services of Aggressive Competition by Auditors" is co-authored by Jeter; Paul Chaney, associate professor of accounting at the Owen School at Vanderbilt; and Pam Shaw of Tulane University.

"Staggering Lawsuits Hit CPA Firms," AccountingWEB, December 27, 2002 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=96875 

04/12/02 Xerox to Pay Record Financial Fraud Penalty, Investigation Turns to KPMG

04/26/02 Three Big Five Firms Get Sued over 'McScandal'

05/07/02 Andersen Reaches Settlement in Baptist Foundation Lawsuit

06/11/02 PwC Finds Accounting Lawsuits Broke Records in 2001

06/24/02 BDO Seidman Nears End of Case Involving Criminal Charges

07/18/02 PwC Settles Rash of Auditor-Independence Violations

07/29/02 KPMG Gets Probation For Bungling Orange County Audit

08/28/02 Andersen Worldwide To Pay $60 Million in First Enron Settlement

08/29/02 Andersen Worldwide Faces $350 Million RICO Action

09/24/02 Peregrine Files For Bankruptcy, Sues Andersen For $1 Billion

10/22/02 PwC Named in $100 Million Lawsuit

10/29/02 PwC Pays $21.5M to Settle Case With Anicom

11/08/02 H&R Block Slapped With $75 Million Kickback Ruling

12/24/02 E&Y Slapped With $1 Billion Lawsuit

August 3, 2003 excerpt from a speech by Art Wyatt (See the link below that Tracey provides)

The firms need to consider a number of initiatives.  The tone at the top of the firms needs to change.  As a starting point, leadership of the major firms might require that their managing partners meet the standards established by Sarbanes-Oxley for the individual on SEC-registrant audit committees that is designated as a qualified financial expert.  Recent managing partners have too often been chief cheerleaders promoting revenue growth or individuals with more administrative expertise than accounting and auditing expertise.  The policies established at the top of the firms must be approved by and articulated by individuals who have the professional respect of the managers and staff.  The challenge to restore the primacy of professional behavior in the conduct of services rendered will not be easily met.  Such restoration likely will not be met at all if the chief messenger is known throughout the firm as being primarily an advocate of revenue growth even when that growth may be at the expense of the firm's reputation for outstanding professionalism in the delivery of its services.

The top leadership in the firms also needs to consider whether the four largest firms are really effectively unmanageable.  In smaller accounting firms (or when the current four large firms were smaller), a key partner is able to monitor partner performance and be able to assess the strengths and weaknesses of the individual partners.  As the large firms have grown to their current size, the challenge to have such effective monitoring is substantial.  Maybe some consideration should be given to whether a split-up of a big firm would enhance the firm's quality control and permit more effective delivery of quality service.  While such a thought will no doubt be draconian to some, one only has to consider what might be the end result if one of the current four large firms meets the same fate as Andersen.  Firm break-ups might then be at the mercy of legislative or regulatory intervention--an even more draconian thought.  The bottom line, however, is, are the large firms able to manage their practices effectively to assure top quality service to their clients and the public?

The firms need to place greater internal emphasis on quality control in audit performance.  More effort should be devoted to assuring that clients have met the intent of the applicable accounting standards, and less effort should be devoted to assisting clients to structure transactions to avoid the intent (and sometimes the letter) of the standards.  In working with the FASB the focus of the firms should be on pressuring the FASB to develop standards that are conceptually sound and that avoid compromises that are designed to keep one segment of society happy at the expense of sound financial reporting.  Too often the accounting firms have acted at the direction of their clients in lobbying the FASB on specific technical issues and have not met the standards of professionalism that the public can rightfully expect from the leading accounting firms.  Too many of the FASB standards contain conceptual impurities that encourage gaming the system, and too many firms are active participants in the gaming activity.  Lobbying the FASB on behalf of particular client interests is not professional on its face and casts as much of a cloud on the firm's independence as does providing a range of consulting services to audit clients.

As a side note, I have seen comments by leaders of several of the Big 4 firms recently suggesting that the real cause of recent financial statement shortcomings is the failure of existing accounting standards to reflect the underlying economics of reporting companies.  These statements seem to be self-serving attempts to deflect criticism from accounting firm performance to the adequacy of the current set of generally accepted accounting principles.  To test the sincerity of these comments, I suggest one analyze the recent firm submission to the FASB on proposed standards that have emphasized economic reality over "backward-looking historical cost."  I suspect such analysis would suggest the several firms have missed numerous opportunities to encourage the FASB in its efforts to adopt standards that reflect better economic reality and, in fact, have often taken strongly contrary positions, at least in part at the urging of their clients.

While on the subject of the FASB, we need to recognize that the Board fared well in the Sarbanes-Oxley legislation.  Going forward, the Board needs to do a better job in educating congressmen and senators on their proposed standards and why the lobbying efforts of constituents are often far more self-serving than desirable from the perspective of fair financial reporting.  The Board needs to attack a significant number of its existing standards that are conceptually unsound and that embody a series of arbitrary boundaries that attempt to prevent users from misapplying the standard.  We should have learned by now that standards that contain arbitrary rules in the attempt to circumvent aberrant behavior really act to encourage that very behavior.  Firm leaders should recognize that their audit personnel will be far better off in dealing with aggressive client behavior if the standards that are operational are soundly based and consistent with the Board's conceptual framework.  Isn't it more important to provide your staff with the best possible tools to meet their challenges than it is to gain some short-term warm feelings by bowing to a client's wishes?  The big firms need to decide that the FASB is their ally, not their opponent, and become more statesmanlike in pursuing sound accounting standards.  This will require leaders who understand the nuances of technical accounting requirements and who are able to grasp that acceptable levels of profitability will flow from delivering top quality professional service to clients.

September 10, 2003 message from Tracey Sutherland [tracey@aaahq.org] 

The 88th Annual Meeting of the American Accounting Association was held August 3-6, 2003, in Honolulu, Hawaii. Opening speaker Arthur R. Wyatt's presentation garnered a standing ovation. So that his comments can be shared beyond those able to attend the meeting the full text of his challenging speech, "Accounting Professionalism--They Just Don't Get It!" is available online at http://aaahq.org/AM2003/WyattSpeech.pdf 

This paper reviews, examines, and interprets the events and developments in the evolution of the U.S. accounting profession during the 20th century, so that one can judge "how we got where we are today."  While other historical works study the evolution of the U.S. accounting profession,¹ this paper examines two issues: (1) the challenges and crises that faced the accounting profession and the big accounting firms, especially beginning in the mid-1960s, and (2) how the value shifts inside the big firms combined with changes in the earnings pressures on their corporate clients to create a climate in which serious confrontations between auditors and clients were destined to occur.  From available evidence, auditors in recent years seem to be more susceptible to accommodation and compromise on questionable accounting practices, when compared with their more stolid posture on such matters in earlier years.
"How the U.S. Accounting Profession Got Where It Is Today: Part I," by Stephen A. Zeff, Accounting Horizons, September 2003, pp. 189-205.

Note from Bob Jensen
Steve's main points are consistent with Art Wyatt's remarks at the 2003 AAA Annual Meetings in Hawaii.  However, Steve fleshes in more of the historical detail.  I am really looking forward to Steve's forthcoming Part II continuation.

I might elaborate a bit on Steve's assertion that:  "From available evidence, auditors in recent years seem to be more susceptible to accommodation and compromise on questionable accounting practices, when compared with their more stolid posture on such matters in earlier years."  Out of context, this implies that auditors of old were more moral, ethical, and professional.  But such behavior in context is relative to the changing pressures, temptations, and opportunities of a changed auditing environment.

Just because all the "stolid" male (virtually all were male before the 1970s) auditors decades earlier never committed adultery with Elizabeth Taylor does not mean that they were above temptation.  Such temptation never came their way, because Elizabeth Taylor in her prime never had any inclination toward auditors (sigh).  Along a similar vein, these "stolid" auditors only appeared to be less "susceptible to accommodation and compromise on questionable accounting practices" because temptations, pressures, and opportunities in the 1960s and earlier were totally unlike the auditing climate of the 1980s and 1990s.  My point is that auditors are human beings who have changed much less than the temptation environments and contractual complexities within which the audits take place.  The same thing has happened in the profession of journalism in the age of technology, and I highly recommend the professionalism concerns voiced at http://www.journalism.org .  Journalists have not changed nearly so much as the journalism environment in the age of technology and civil strife around the world.

I also get riled when some analysts (not Steve) suggest that accounting principles today are too complex and that the simpler standards of the 1960s and earlier are all we need for current financial reporting purposes (e.g., see Scott McNealy's recommendations below ).  Those simpler standards never envisioned contractual complexities of the 1990s when newer types of derivative financial instruments (e.g., swaps), newer types of off balance sheet ploys (e.g., variable interest entities), and compound debt/equity instruments were invented.  Old standards are no more effective in modern accounting any more than battleships are effective in an age of nuclear submarines, laser-guided missiles, and satellite tracking systems.  My point here is that the FASB and IASB standards of the 1990s and later are complex because the contracts being accounted for became so complex.  There are no simple solutions to complex contracting except for simplistically naive fair value solutions that are out of touch with reality.  

November 6, 2003 reply from Gerald Trites [gtrites@STFX.CA] 

I recently read with great interest the Zeff paper in Horizons, the first part of a two part paper on the slow decline of the profession - or perhaps more accurately, its transition from profession to industry - during the 20th century.

Having lived through a good part of the period he covered in the first part, I can say it does a remarkable job of capturing the essence of the events during the period - a period characterized by by the inexorable forces on the profession by its publics, and the abandonment of professionalism for commercialism.

The papers should be required reading for every young person who wishes to obtain a professional accounting designation and the subject of discussion and debate in classrooms.

There was a recent cartoon in the New Yorker where an executive was sitting at a boardroom table with other executives and saying "The auditors are not team players any more." We can only hope. I hope this is the beginning of a return to professionalism. Maybe educators can help to make it so.

And congratulations to Professor Zeff.

Jerry Trites

November 6, 2003 reply from Amy Dunbar [Amy.Dunbar@BUSINESS.UCONN.EDU] 

Zeff's piece is great, and I look forward to the second part. The blinders came off my eyes with respect to our profession (I previously thought it was a few bad apples) when I listened to the tax shelter testimony live on Oct. 21 via Realplayer (ah, the wonder of technology). The testimony is available on http://www.senate.gov/~finance/sitepages/hearing102103.htm . In particular, the PCAOB testimony is interesting. I now think that public accounting firms should not be able to audit clients that have purchased a "no business purpose" tax shelter from the audit firm. Perhaps the solution is to say that if the corporation is a tax client, you can't audit the company. That solution is overkill, but I no longer trust the firms to judge "business purpose." I have asked my graduate tax students to write their last memo on what Congress should do to address the tax shelter issue. The memos should be interesting reading.

Sansing, ever the terse analytic, would agree with the former IRS Chief Counsel, B. John Williams, who said the following, "One of the foundation stones of the credibility of the Service with the American public is that the Service proceed analytically rather than emotively. 'Abusive' reflects the indignation that the Service feels about a transaction, but the Service's feelings about a transaction do not state a legal basis for disallowing the tax benefits from a transaction. 'Abusive' is not an analytical term, it is an emotive term, and the mission of the Service is to apply the law fairly and impartially, not to apply the law in a manner that is biased toward a result the government wants."

Dunbar, ever the emotional observer, would encourage a little righteous indignation. Good heavens! Read the testimony of Henry Camferdam (someone said he was on 60 Minutes). When did our profession lose its way? Read Zeff!

Amy Dunbar 
UConn

November 6, 2003  Reply from Paul Williams [williamsp@COMFS1.COM.NCSU.EDU] 

For those of you are members of the Public INterest Section of the AAA and have free access to the section journal, Accounting and the Public Interest, there is an excellent article by Tony Tinker that sheds considerable light on this notion of the "decline of the profession." It's a myth because it presumes there was a golden era of the profession when it performed in some ideal, Durkheimian sense. But the profession of accounting was never very high up in a place it could decline from. Tom Lee documents that the first chartered accountants (ever) in Scotland (the primordial swamp from which all CPAs emerged) garnered their "charter" in order to restrain trade for their services -- they were a rather unsavory bunch whose motivation for creating the "profession" was hardly to serve the public interest. The only way accounting could ever be a profession in the classical sense in which we seem to be speaking of it as a service to mankind is that its service be performed in the employee of mankind, not in the employee of sizable private interests that are not nearly as politically and socially benign as Adam Smith's baker.

November 6 reply from Bob Jensen

Hi Paul,

With due respect, I think there was a "Golden Age" period where professionalism was quite high. I would argue that it was in the early part of the 20th Century when the large firms were formed by high integrity professionals with names like Andersen, Ernst, Haskins, Sells, Ross, Lybrand, etc. These were extremely high integrity professionals who set tough tones at the top for their employees, especially the outstanding Norwegian (my hero) named Arthur Andersen.  Read part of the eulogy for Arthur Andersen, delivered on January 13, 1947 the Rev. Dr. Duncan E. Littlefair --- http://faculty.trinity.edu/rjensen/fraud.htm 

Interestingly, the early public accounting firms may have had the highest integrity between 1900 and 1933 when auditing was not required by the U.S. Government, and CPA's did not have an auditing monopoly. I think that the early firms really believed their futures depended upon integrity and quality of service since the decision to have an audit was discretionary in the sense of agency theory where having an audit generally added value to share prices vis-à-vis not having an audit. 

As I have indicated elsewhere, however, this does not mean that "stolid" (Zeff's term) auditors of the 1950s, 1960s, and 1070s who seemingly remained highly professional would have blown the whistle on Enron, Worldcom, Xerox, Sunbeam, etc. in recent years. My comments on this are given at http://faculty.trinity.edu/rjensen/fraud123103.htm 

We have also had some outstanding auditors who worked public servants in government. But in the U.S., the least professional and most greedy leaders are generally in the top tiers of government (Congress, Senate, Executive Cabinet, etc.) These powerful individuals, in turn, exert pressure on agencies like the FDA, FTC, FPC, FAS, SEC, etc. to serve the interest of the companies rather than the public.

Where are the biggest crooks in most nations? Generally in high levels of government. Hence, I would prefer not to look to government for people committed to "service (as) an employee of mankind."

Where does one find an "employee of mankind?" (a Tony Tinker term) In my opinion, an employee of mankind is a high integrity professional who is driven by inner morality forces no matter where she/he happens to be employed (public or private). Public accounting in theory is neat, because the integrity is more necessary to survival of the profession than in other professions that sell more than integrity.

The problem is really not one of organizational structure. It is one of slight moral decay in the midst of enormous increases in temptation. I suspect the rise in temptation and opportunity are the main culprits.

In the next edition of New Bookmarks, I will have more to say about how this problem will be corrected. Look for the heading "1984+50: Screwed and Tattooed" in the forthcoming edition of New Bookmarks (probably around October 20).

I just finished watching the AICPA's excellent FBI Webcast today (Nov. 6). One segment that I really enjoyed was a video of Walter Pavlo, a former MCI executive who served prison time for fraud. This was a person with all intentions of being highly professional on a fast track to being in charge of collecting reseller bad debts for MCI. In that position, he just stumbled upon too much temptation for what is tantamount to a kiting scheme.

You can read details about Walter Pavlo's fraud at http://www.forbes.com/forbes/2002/0610/064.html  This Forbes site was temporarily opened up for the AICPA Webcast viewers and will not be available very long. If you are interested in it, you should download now!

The FBI agents in the Webcast made a careful distinction between career con artists (who jump from con to con before and after prison because they seem to be inherently addicted to the game) versus others who commit fraud as a result of opportunity and temptation that exceeds their will power. These agents suggested an analogy of a bag of money being found where there appears to be no possibility of being detected. People who would never steal might succumb to "finders keepers" temptations, especially if they thought the money was lost by drug dealers who had no legitimate claim to the money in the first place and needed to somehow be punished.

Morality has not declined in the professions nearly as much as temptations and opportunities have created new environments that test morality. An analogy here is pornography. Playboy Magazine thrived in the 1960s when there was little else boys could easily get their hands on to hide under the mattress (yeah I did that). These boys were more curious than addicted. In the 21st Century with millions of free pictures of the hardest core imaginable only a few mouse clicks away, temptations and opportunities have created an entirely new addiction environment for both young people and pedophiles that prey on the young.

The obvious solutions are to do our best to convince others (e.g., auditors) not to succumb to opportunity, but it is difficult to raise the morality bar. Another solution is to reduce the temptations by increasing the probability of getting caught (e.g., better controls). At this precarious juncture in the life of our profession, we need to concentrate on both alternatives. 

But it will be a sad day when we go too far, and I will have more to say about that in the next edition of New Bookmarks.

Bob Jensen

November 8, 2003 Reply from Paul Williams [williamsp@COMFS1.COM.NCSU.EDU] 

Bob, I appreciate your thoughtful response. My response to that is that we would tragically remiss if we simply dismiss what we have observed as the "decline of the profession" as simply a matter of a few bad apples. It is a structural/ organizational problem. As the philospher Colin McGinn noted, "The sure mark of an ideology, in science and philosophy as in politics, is the denying of obvious facts." When you attribute the highest period of auditor integrity to the period 1900 to 1933 how is it that we experienced the market bubble that led to the passage of the securities acts? Didn't the profession fail then? You always demonize government -- it's always the government's fault. The most corrupt are always at the top of the government (yet it is the "tops" of multinational corporations who are being carted off to jail). That is simply naive and untrue. How many of us participating on this network have the good life we have today as the result of the construction and support of universities operated by the state that gave many of us of humble background access to education, and experiment unique in the history of the world (an experement we are, by the way dismantling). Of course we all deserve what we have by virtue of only our individual virtue and hard work. I certainly resent being taxed to afford the same opportunity given to me to someone elses' grandchildren. 

For citizens of a democracy to despise their government is hardly a healthy sign; after all, who elected these corrupt people? What we need is a healthy dose of self-reflection; we need to stop blaming "them." If the profession has declined and we are members of the profession as its teachers, then we are certainly part of the problem. Your hero, Arthur Andersen was perhaps the leading proponent of expanding services to clients to include consulting; he, more than anyone else, transformed the profession into one of full service for clients (i.e. management consulting). Andersen also pioneered the organizational structure of mass produced services, which certainly contributed to the severing from the "profession" of the notion (that is being so romantically bandied about in this discussion) of the dedicated small practitioner diligently serving his or her small business client. The AIA is preparing a white paper on accounting education that is nearly ready for public consumption. A central theme of that paper is de-mythologizing accounting instruction. Perhaps it isn't a coincidence that the ascendance during the 1960s in the academy of the "Chicago School" corresponds to the beginning of the decline of the profession according to many contributors to this conversation. 

If, as you say, accounting is about integrity (accounting education is first of all a moral one?) what might be the consequences of supplanting the "golden era of accounting" discourse (that of Andersen, Ernst, Haskins, etc) with one glorifying the imaginary world of efficient markets, opportunistic "agents", the sanctity of disembodied property, and the complete irrelevance of such "naive notions as fairness." (this is a direct quote from one of the intellectual leaders of our modern academy). The accounting you are nostalgic for is an accounting we haven't taught for at least 25 years. Accounting textbooks today are little more than dumbed down finance and microeconomics books. 

The rationales we provide for why we do what we do are exclusively rationalized on neo-classical grounds. The FASB justifies its existence as producing information that leads to more efficient allocations of capital, yet we have absolutely no idea whether anything the FASB does actually produces such a result. We just believe the myth. We serve "investors," which is really a euphemism for "a disembodied structure of technology called capitalism" (I thank Ed Arrington for this eloquent phrase). And even if this is hat we are about, recent events should certainly cause us to doubt that the way we are going about it is working. Wall Street is rigged. It always has been. The regulations that emerged out of the market crash were not simply some malicious attempt on the part of corrupt politicians to frustrate the magical working of the invisible hand (careful readers of Adam Smith will know that he never imagined this simple metaphor would become a priniciple for organizing every aspect of human life, a prospect he would have found appalling). There were reasons for those regulations, a lesson we are now relearning. The free market is, after all, the most carefully constructed and heavily regulated institution in human history (Andrew Abbott, Chaos of disciplines). For us academics in accounting, the current plight of the profession is an excellent opportunity for us to bring some intellectual coherence to the activity of accounting. Paton and Littleton certainly understood the significance for accounting of the corporate form of business and that significance lay in its power (made all the more significant by the Supreme Court bestowing "personhood" on them). As they noted the humble role of accounting is to implement social controls. That probably means that the role of accounting is not to leverage those controls for the benefit of only a small percentage of the people on the planet.

November 8, 2003 reply from Bob Jensen

Hi Paul,

As usual you provide an extremely thoughtful and academic counterargument. It is too involved to respond to quickly without more time.

However, I still must ask the question as to why white crime is such good business in every nation? I contend that it's because business firms and the lawyers who benefit from business dealings in so many ways literally control the power centers in government. Certainly this is the case in Washington DC and all our state legislatures. Serious reforms are either blocked or watered down with loopholes. The new SOX legislation is costly for business firms, but nearly half the respondents in an AICPA poll during yesterday's FBI Webcast did not have much faith that SOX will deter white collar crime.

I'm always looking for an example in a large nation where the government really can be trusted any more than the executives of industry and labor leaders within that nation. This just does not seem to evolve in the governance of nations. Even when an honest white knight like Jimmy Carter is placed in power, the other power centers will merely checkmate him/her in some way.

Focusing too much upon structural changes, such as government takeover of industry, overlooks real issue which is how to improve morality within any structure. Anecdotally, the upheaval of the KGB in the Soviet Union did not do much to improve morality as long as members of the old KGB merely took on new titles when running a seemingly "more democratic" government. My simplistic solution is either to replace the people who cannot change their stripes with better people or to make it more difficult for old crooks still in power to get away with what they used to get away with in the older structure.

Certainly there are no easy answers, but I am still looking for a government that seriously makes white collar crime such a serious offense that such crime is seriously deterred in the private and public sectors.

Free speech probably does more to deter white collar crime than any government or corporate ethics charter in history. Put the KGB and Kozlowski types in any power structure and the system will be corrupted.

What we need is more referendum power. For example, I would call for a referendum that never opens the door of a prison any person who intends to live in a luxurious lifestyle before making all reparations to victims of his/her crime. This should then be backed by enforcement since laws are meaningless unless they are enforced.

November 8, 2003 reply from David Fordham

Much of the discussion (including that in Zeff's article) seems to be perpetuating, rather than clarifying and eliminating, a basic misunderstanding.

That misunderstanding is the confusion between the field of "Accounting" and the field of "Auditing". Take a close look at the posts so far on this topic, and most of what is said applies to auditing, but only peripherally (if at all) to many other facets of the profession of "accounting".

Having been "raised" in the area of industry accounting (cost accountant, cost analyst, etc. eventually ending up as Corporate Controller for Paperboard Industries), I see accounting as being much more than mere auditing. In fact, I see auditing as a specialty within the field of accounting, where the term accounting also encompasses cost, tax, systems design, forecasting, interpretation, and yes, even advising.

It is the field of auditing which the public (and regulators) tend to focus on, so that is what the public seems to equate with accounting. I see very little of the current controversy applying to most of what I consider "accounting".

Perhaps the term CPA should be renamed "Certified public auditor"?

We as accountants have done an absolutely pitiful job of informing the public of the true nature of our profession, and these misunderstandings are what is, in my opinion, causing some of the problems for us. If we begin differentiating ourselves and explaining the differences between bookkeeping, accounting, auditing, tax advising, etc. and begin clarifying the many myriad and diverse services we provide as a profession, the public (and even our own prognosticators and pundits) can better debate our efficacy and the need for additional (or decremented) oversight of our profession, or even the posited decline of the profession.

E.g., let's use the term "accounting profession" to really mean the "accounting" profession, and not just the "auditing" profession.

Comment?

David R. Fordham 
PBGH Faculty Fellow 
James Madison University

November 8, 2003 reply from Amy Dunbar [Amy.Dunbar@BUSINESS.UCONN.EDU] 

Tax accountants are out there are selling "no-business-purpose" shelters. And I certainly don't think our corporate accountants are blameless. I think this is about power, and whether the person is an auditor, consultant or industry accountant, once the person develops an appetite for power and the money that goes with power, ethics frequently becomes a dispensable good.

Amy Dunbar 
UConn

A presentation Stanford University accounting professor Maureen McNichols on the subject of
"What Led to Enron, WorldCom and the Like?"
Top Stories, Graduate School of Business, October 2003 --- http://www.gsb.stanford.edu/news/headlines/2003alumniwkend_mcnichols.shtml

The ending of the presentation went as follows:

Discretion as the Better Part of Accounting

Arising out of the governance mayhem of the past decade are key lessons for regulators, auditors, investors, analysts, managers, and directors, McNichols said. Due to the large and complex nature of the checks and balances of an evolving system, it is imperative that each member of the governance system understands how the role he play fits into the big picture.

For regulators, there is the sobering fact that redundancy in governance systems do not preclude failures and that the oversight processes and self-regulation of auditors, analysts, and boards of directors are "only as strong as the weakest links." The focus of the Sarbanes-Oxley Act of 2002 on financial statements and auditors and strengthening the role of the audit committee is a move in the right direction, she said.

The key lesson for auditing firms is to provide auditors with incentives to convey all relevant information to the board of directors or audit committee. Regulators will respond to audit failures and obstruction of justice with very significant penalties.

She argued that for analysts to generate truly independent research, they must be rewarded for the quality of the research they provide, and they must examine the quality of corporate earnings and financial statements diligently.

Corporate managers, for their part, must understand that distorting financial statements imposes huge costs on the rest of the economy. Furthermore, she said, financial statements that provide a misleadingly-glowing view of future growth may provide incentives for the company itself to act inappropriately by making excessive capital investments, as the telecom bubble illustrates.

Managers, instead, need to understand that they are best serving investors by presenting credible financial statements—and that firms with better reporting will be valued more highly by investors. Not insignificantly, managers must also take to heart that "misleading investors can lead to civil and criminal prosecution," said McNichols.

She argued it is neither possible nor desirable to turn preparation of financial statements into a mechanical process. Indeed, the level of discretion and judgment required to prepare financial statements that represent the economic state of the organization fairly and transparently will increase, not decrease, in coming years.

Finally, McNichols outlined a number of critical lessons for directors. First, the oversight role of directors has increased substantially, though the advisory role is no less important. Secondly, the legal standard for a director is to demonstrate good faith judgment, and this requires that decisions are arrived at through a sound process. A critical aspect of a good process is ensuring that directors receive all relevant information.

McNichols recommended the "TV test" described by faculty colleague Bill Miller, who attributes it to the Business School's Dean Emeritus Arjay Miller. His test for good decision-making was whether he would feel comfortable explaining the board's decision on the evening news. "If you're not comfortable with that, you probably need to go back and examine your process for arriving at judgments," said McNichols.

From SmartPros --- http://www.smartpros.com/x35996.xml 

SEC: Ernst & Young Violated Rules

Nov. 15, 2002 (Associated Press) — Federal regulators, after an initial failure, alleged for a second time Wednesday that Ernst & Young violated rules designed to keep accountants independent from the companies they audit when it engaged in business with a software company client.

---

The Securities and Exchange Commission took the action again against the big accounting firm now that there are enough SEC commissioners without a conflict of interest in the case. An administrative law judge at the SEC dismissed it several months ago because only one commissioner had voted to authorize the action.

New York-based Ernst & Young disputed the SEC's allegations, as it did when they were first raised in May. "Our position has remained the same throughout: Our conduct was entirely appropriate and permissible under the profession's rules," firm spokesman Les Zuke said in a statement.

"It did not affect our client, its shareholders or the investing public, nor has the SEC claimed any error in our audits or our client's financial statements as a result of them. The commission's proceedings are focused on consulting, which, because we sold our consulting business in May 2000, is now a moot point," the statement said.

The issue of auditor independence was among those at the heart of the Enron affair, which raised questions about Enron's longtime accountant, Arthur Andersen, having done both auditing and consulting work for the energy-trading company.

Andersen was convicted in June of obstruction of justice for destroying Enron audit documents.

In its administrative proceeding, the SEC said that Ernst & Young was auditing the books of business software maker PeopleSoft Inc. at the same time it was developing and marketing a software product in tandem with the company. Ernst & Young engaged in the dual activities from 1993 through 2000, according to the SEC.

The SEC said the product, named EY/GEMS, incorporated some components of PeopleSoft's proprietary source code into software previously developed and marketed by Ernst & Young's tax department. The SEC alleged that Ernst & Young tried to gain a competitive advantage by putting the source code into its product and agreed to pay PeopleSoft royalties of 15 percent to 30 percent from each sale of the product.

When the case arose in May, there were only three commissioners on the five-member SEC: Chairman Harvey Pitt, Cynthia Glassman and Isaac Hunt. Pitt and Glassman removed themselves from voting on whether to take the action against Ernst & Young because Pitt had represented the firm as a private securities lawyer and Glassman had been an Ernst & Young executive.

That left only Hunt to authorize the SEC attorneys to proceed, prompting the administrative law judge's dismissal.

A new hearing will be scheduled before a law judge to determine whether any sanctions should be imposed on Ernst & Young, the SEC said.

It was the second time the SEC had brought an auditor independence action against Ernst & Young. The firm settled a 1995 action by agreeing to comply with independence guidelines.

Robert Herdman, who resigned as the SEC's chief accountant last Friday in the controversy over the selection of former FBI director William Webster to head a special accounting oversight board, also had been an executive of Ernst & Young before coming to the SEC.

In a similar case, the SEC in January censured another Big Five accounting firm, KPMG, for allegedly violating the auditor independence rules. The agency said KPMG invested $25 million in a mutual fund at the same time it was auditing the fund's books.

KPMG, which was not fined, agreed to the SEC's censure without admitting or denying the allegations and agreed to take measures to prevent future violations.

The SEC adopted the independence rules in November 2000 after a bitter fight between the accounting industry and Arthur Levitt, then the SEC chairman. He and others worried that accountants in some cases had become too cozy with the companies they audited, threatening the integrity of financial reports and undermining investor confidence.

The rules identified several services as inconsistent with auditor independence, including bookkeeping, financial systems design and implementation, human resources and legal services.

Packers Versus the Giants: A Great Ethics Video Clip

A very short video clip mentioned below concerns an incident instigated by Green Bay Packer quarterback Brett Favre in the Green Bay's last regular season game this season. What is neat is that students will probably never forget the video clip if you show it in class.

The video clip plays a scene from the last game between the Packers and the New York Giants. The commentator, George Wills, then points out that all a star defensive player for the Giants, Michael Strahan, only needed one sack of the quarterback to set an NFL record. Near the end of the game, the Packers were certain to win, and both teams were going through the agonizing necessity of playing the game out.

On a snap of the ball, all-pro Brett Favre runs straight at Strahan and allows himself to be easily tackled. This gives Strahan the record, and Brett Favre is roundly patted on the back as a "Great Guy" by players from both teams while Strahan appears to be bowed in a prayer of gratitude. The questionable "sack" was allowed to stand on the record books --- http://sports.espn.go.com/nfl/clubhouse?team=nyg 

In the videotaped commentary, George Wills raises a serious question of whether what Favre did was ethical. Was it fair to the current record holder who, possibly, earned every sack the hard way? Did it make a mockery out of the NFL, and make it more like the phony game of professional wrestling where virtually everything is staged?

The video clip then very briefly questions other great records. For example, opposing teams bent over backwards one year to give Joe DiMaggio his hitting record.

I find this video clip fascinating. It is at the end of an ABC video on the Enron scandal. Enron takes up most of the half-hour video, and the George Wills NFL commentary is about five minutes at the end of the tape. What I am saying is that the George Wills piece is very short, but it is very powerful about the importance integrity and independence. Geroge Wills is most certainly opposed to what Brett Favre did by openly giving Strahan an easy sack. One might say that it sacked the integrity of the NFL.

As a faculty member, I wonder if professors sometimes do the same thing when bumping "good guy" grades upward. It may be applauded by most other students, but does it compromise the integrity of the grading system?  I have overlooked some matters of student integrity recently, and it is now bothering my conscience.

In accountancy, I wonder if auditors sometimes do the same thing when "overlooking" certain discrepancies, because it is applauded by clients and current shareholders even though it compromises the integrity of the auditing system.

Video Ordering Details
Sam Donaldson's Sunday Morning (January 13) ABC show called "This Week." You can purchase it for $30 at <http://www.abcnewsstore.com/product-details.cgi?_item_code=B020113+01>
The show and video are entitled "The Collapse of Enron." The unrelated NFL ethics issue takes up about five minutes near the end of the tape.

Contextual Integrity and Contextual Ethics

The major problem with integrity is that there is nearly always a time when integrity either is or should be compromised in certain situations, usually situations where there is no harm done by a "white lie" or a "silence" about something that otherwise would cause harm or embarrassment.  What is confusing is that second order effects are not always taken into account!  For example, the direct effects of what Brett Favre did for Michael Strahan (see the above module) on surface seemed like a good thing to do at the time.  But think of those second order effects:

1. The record set will always be demeaning to Strahan, because it was not earned fair and square in good sportsmanship.  His record becomes known as a sham throughout history.
   
    
2. If the former record holder earned the record the hard way, the loss of that record to Strahan is an injustice.
   
    
3. The NFL's system of designating records is put into question and no longer trusted.
   
    
4. Brett Favre will always be mistrusted as if he is hoping for the return of a favor.  If he is approaching an NFL passing record, will NY Giants defensive backs ease off of receivers in future games to repay Brett for the favor he did for Strahan?  Respect for his motives and accomplishments may in fact be demeaned because of what he did for Strahan.

What students must learn is that situational integrity/ethics compromise the system, degrade the legitimate achievements of their peers, and become inherently unfair.  Questions regarding those situations include the following:

• Is what you are doing something you would proudly admit to your parents, your minister, and your best friend?
  
   
• Does your breach of integrity directly or indirectly harm any person now or in the future?
  
   
• Does your breach of integrity potentially harm trust and faith in the system and its reputation?
  
   
• Does your breach of integrity, however small, pave the way to similar actions in the future by you or by others who follow your precedent?  For example, if only one person ever shoplifted the loss to society is virtually zero.  If one person gets away with shoplifting and, thereby, inspires others to do so, the loss to society becomes enormous.
  
   
• Why should it be up to you whether more good than bad comes from your breach of integrity?  For example, a leading executive at Trinity University justifies what Brett Favre did as follows:  "The new record holder, Michael Strahan, is a nearly perfect role model whereas the former record holder was a drug-dealing junkie even while he was playing defensive end for the New York Jets."  In other words, good guys deserve to be helped when attempting to beat the records of bad guys.  If this how Brett Favre also reasoned when helping Strahan break the record, I would contend that Brett Favre has no right to make such a judgment and in doing so may do more harm than good.
  "
   
• If other persons are getting away with a breach of integrity, say by copying homework, does this justifying your joining in on their misdeeds?

Message from Steven Bachrach (Department of Chemistry at Trinity University)

The Sunday New York Times this past weekend (1/13/02) has a very interesting article on the "integrity" of sports records that clearly indicates that the Favre-Strahan controversy is not unprecedented.

A few examples:

Nykesha Sales, opened up the last game of her college career hobbling onto the floor due to a ruptured Achilles tendon and was allowed to unopposedly sink a basket to set a career scoring mark.

Gordie Howe skates for 47 seconds in a minor league hockey game to set the "record" for being the first athlete to compete in 6 decades.

Denny McLain grooves 3 pitches to Mickey Mantle so that Mantle can hit a home run, passing Jimmie Foxx into 3rd place all time.

Our own David Robinson scores 71 points (thanks to exclusive feeding of the ball) in the last game of the 1993-1994 season to pass Shaq as the scoring leader. A similar situation lead to Wilt Chamberlin's famous 100 point game.

One begins to wonder whether there is any point to a discussion of ethics when it comes to sports records, especially those involved in team sports.

Steve

Thank you for the update Barbara.

It is interesting to juxtapose the Tribune's article on E&Y (my former employer) against "How Accounting Can Get Back Its Good Name," by Jim Turley, Chairman, Ernst & Young which you can read near the very bottom of http://faculty.trinity.edu/rjensen/fraud.htm 

We expect professions to fail, but why is our profession failing so badly and so often?

A message from Barbara Leonard on February 8, 2002

Hi Bob,

This story (from the Chicago Tribune) may be of possible interest in the discussion on "independence".

-------------------- Superior's auditor also consulted --------------------

Ernst & Young's dual role at bank called a conflict

By Melissa Allison Tribune staff reporter

February 8, 2002

WASHINGTON -- Ernst & Young LLP, the auditing firm accused of inadequately overseeing the books of now-failed Superior Bank FSB, also received consulting fees from the bank that totaled at least twice as much as the fees it received for its accounting services, a federal regulator said.

"It was a direct conflict," said Gaston Gianni, inspector general for the Federal Deposit Insurance Corp., in testimony to the Senate Banking Committee Thursday.

At the hearing, the FDIC, the Treasury Department and the General Accounting Office placed the blame for Superior's failure on poor management, lax oversight by regulators and inadequate oversight by Ernst & Young.

The only committee member present was its chairman, Sen. Paul Sarbanes (D-Md.), who likened Superior's downfall to another corporate failure attracting close congressional scrutiny.

"It's a little bit like Enron, isn't it?" Sarbanes quipped after hearing about the shortcomings of Superior's management, auditors and regulators. He later suggested that Congress might need to more closely oversee the activities of bank regulators to prevent future failures.

The July 2001 failure of Oakbrook Terrace-based Superior, which was owned equally by the Pritzker family of Chicago and the Dworman family in New York, could cost the Savings Association Insurance Fund $300 million to $350 million, making it the most expensive thrift failure since 1992.

In its consulting capacity, Ernst & Young approved of the method Superior used to value certain complex assets. As the bank's auditor, the accounting firm for years affirmed that those same assets had been properly valued, Gianni said. The FDIC did not disclose the amount of fees paid by Superior to Ernst & Young.

In fact, those so-called "residual" assets--generated by portions of loans the bank kept for itself after selling the rest of the loans to investors--were so overvalued on Superior's books that, when they were adjusted in 2001 to meet regulators' requirements, the bank became significantly undercapitalized and eventually failed.

Ernst & Young spokesman Les Zuke said, "We're surprised by the description of our fees." He would not confirm or deny that the firm did consulting work for Superior, but said the firm continues to work with regulators investigating Superior's failure.

In a statement, the accounting firm blamed Superior's failure on three factors: a substantial high-risk loan portfolio, multiple and rapid declines in interest rates beginning early in 2001, and a quickly deteriorating economy that had a disproportionate impact on borrowers to whom Superior catered.

Red flags missed

Gianni and others blamed the Office of Thrift Supervision, Superior's primary regulator and an agency of the Treasury Department, for not acting sooner to remedy the bank's problems, which they said were evident beginning in the mid-1990s.

"Superior exhibited many of the same red flags and indicators reminiscent of problem thrifts of the 1980s and early 1990s," said Jeffrey Rush Jr., inspector general of the Treasury Department.

Rush later said his office is working with regulators and the Department of Justice to determine whether there were violations of federal law in connection with Superior's failure. OTS examiners were aware of unusual methods the bank used to value its so-called residual assets, but continued to believe that Superior officials and Ernst & Young knew what they were doing.

Rush attributed the lack of regulatory skepticism to an OTS belief that "the owners would never allow the bank to fail, Superior management was qualified ... and external auditors could be relied on to attest to Superior's residual asset valuations. All of these assumptions proved to be false."

No one at the OTS has been fired because of Superior's failure, OTS spokesman Sam Eskenazi said, but there have been personnel moves among people involved with the case. He would not elaborate on those changes.

Panelists praised the FDIC for reaching an agreement recently with other bank regulators that allows the agency to take part more frequently in financial institution examinations. The OTS had denied an FDIC request to participate in a 1999 exam of Superior.

Whatever the shortcomings of Superior's auditors and regulators, the people most to blame were its management, directors and owners, according to the panelists Thursday.

Subprime lending a culprit

They pointed particularly to Superior's 1993 move into subprime lending, a riskier form of lending that targets customers with poor credit histories, and its overvaluation of assets connected to loans that were sold to investors.

The failure "was directly attributable to the bank's board of directors and executives ignoring sound risk management principles," Gianni said. "Numerous recommendations contained in various OTS examination reports beginning in 1993 were not addressed by the board of directors or executive management."

A Pritzker family spokesman had no comment about that accusation, and a Dworman spokesman did not return telephone calls.

In November, the FDIC approved the sale of $1.1 billion in deposits and about $45 million in assets from the defunct Superior to Cleveland-based Charter One. It is expected to sell the rest of Superior's old business, the subprime lender Alliance Funding, soon.

"The History and Rhetoric of Auditor Independence Concepts," by Sara Ann Reiter and Paul F. Williams --- http://les.man.ac.uk/IPA/papers/44.pdf 

This paper presents an historical and rhetorical analysis of auditor independence concepts. This analysis is relevant as the newly formed Independence Standards Board in the U.S. is beginning work on a conceptual framework of audit independence to use as a basis for regulation. Debate about independence concepts has a long history and some elements of the accounting profession are suggesting that a radical turn away from historical and philosophical conceptions of independence is currently needed. Independence concepts are both defined and limited by the metaphors used to convey them. These metaphors in turn reflect culturally significant narratives of legitimation. Both the metaphors and legitimating narratives surrounding auditor independence are historically rooted in the moral philosophy framework of the ethics of rights. Current independence proposals represent a shift from the profession=s traditional moral philosophy grounding to a basis in economic concepts and theory. The character of the independent auditor is changing from "judicial man” to "economic man.” A number of consequences to the standing of the profession in the public's eyes, as well as to its internal character, may arise from the changing narrative of auditor independence

Messages from Paul Williams and Elliot Kamlot on January 11, 2002

-----Original Message----- 
From: Paul Williams [mailto:williamsp@COMFS1.COM.NCSU.EDU]  
Sent: Friday, January 11, 2002 7:40 AM 
To: AECM@LISTSERV.LOYOLA.EDU 
Subject: Re: Professionals 
Has the time finally arrived when serious discussion needs to occur about the absurdity of "independence" and having profit motivated individuals perform an activity that they apparently have no spirit for? The classic functionalist notion of professional connoted someone who performed an activity for its own sake and performing it excellently was the objective (MacIntyre's notion of the excellence of a practice). Doing it only for the money, though it is the model of human nature that dominates our discourse, is not conducive to one becoming a "classic" professional. And if classic professionalism is indeed an impossiblity in a world jaded by "wealth creation," then, since the audit function is essentially a regulatory activity, let regulators do it. On 10 Jan 02, at 17:04,
Paul

Elliot Kamlet wrote: 
> If Andersen doesn't quit it, we accountants will go from professionals to 
> clowns. I'm ready to sue them for their impact on the profession of which
 > I am a member! >

Reply from Bob Jensen on January 11, 2002

Try to sue the government for a bad audit or a bad investigation. At least when the Big Five lets investors down, investors can unleash tort vultures that hover over the Big Five offices daily waiting for a chance to swoop down. Investors like the University of California are suing Andersen big time at the moment, but try suing the SEC if it should happen to conduct a bad investigation of Andersen and Enron.

What we have to keep in mind is how easy it is for large industries (whether or not they are oligopolies) to manipulate government watchdogs in virtually all types of government in any part of the world. I am not at all in favor of turning audits over to bureaucrats directly under the thumbs of government leaders --- bureaucrats  immune from lawsuits because they work for the government. How many of our present watchdog agencies such as the FPC, the FDA, etc. are more like chearleaders than regulators for the industries they are supposed to be watching over?

Consider the Enron scandal. It is still unclear, at the start of the investigation, just how "independent" Andersen was in its internal and external auditing performance. It is clear, however, that many top government officials in both the Executive and Legislative branches of U.S. government were directly involved as employees of Enron, its industry friends, or its auditor.

The Vice-President of the U.S. is a very close friend of Enron's CEO Ken Lay, and President Bush admits to a rather long friendship dating back to his days as Governor of Texas. Our Attorney General Ashcroft has had to bow out of the Justice Department's new criminal investigation of Enron because of large donations to Ashcroft by Enron and his close ties with Enron executives. It turns out that many of our top government bureaucrats are former Enron employees who probably got their appointments because of Enron's ties with top government leaders. Even the new Chairman of the SEC, Harvey Pitt, was a Lawyer for Enron's internal and external auditors (Andersen).

My point is that investors should not sleep easier if the SEC or some other government agency becomes the auditor of business firms. If fact, I think it will become an even bigger nightmare of influence peddling, because elected officials sell out so easily and cheaply. The present system has huge flaws, but I think it works better than the Agriculture Department works in preventing frauds in farm subsidy programs.

Try to sue the government for a bad audit or a bad investigation. At least when the Big Five lets investors down, investors can unleash tort vultures that hover over the Big Five offices daily waiting for a chance to swoop down. Investors like the University of California are suing Andersen big time at the moment, but try suing the SEC if it should happen to conduct a bad investigation of Andersen and Enron.

Perhaps independence is the wrong goal. Possibly public accounting auditors should someday "insure" their audits and cut out the tort lawyers.

Bob (Robert E.) Jensen Jesse H. Jones Distinguished Professor of Business Trinity University, San Antonio, TX 78212 Voice: (210) 999-7347 Fax: (210) 999-8134 Email: rjensen@trinity.edu  http://faculty.trinity.edu/rjensen 

Note from Bob Jensen:  You may want to find related materials on auditor independence at the following two links:

Bob Jensen's Threads on Accounting, Business, Economic, and Related History 
http://faculty.trinity.edu/rjensen/history.htm 

A message from Paul Williams on January 21, 2001

For a more thoughtful and analytical discussion of "moral breakdown" (the current one about which the rant below laments began in the 19th century) see Chapter 7 of Andrew Abbott's, Chaos of disciplines (University of Chicago Press, 2001).

In all, "about 18,000 to 20,000 employees lost money because their retirement accounts were invested in Enron stock," says Karl Barth, an attorney for Hagens and Berman, a Seattle law firm that's suing the energy trader on behalf of the employees. Chances for quick recovery appear nonexistent; the lawsuits won't be completed for years, corporate bankruptcy filings typically send shareholders to the back of the creditors line and, on Jan. 15, the New York Stock Exchange delisted Enron's stock. --- http://www.salon.com/tech/feature/2002/01/17/401k/index.html 

Note especially the following link at  --- http://www.accountingmalpractice.com.

Lessons from the Enron Collapse Part I - Old line partners wanted ... http://www.accountingmalpractice.com/res/articles/enron-1.pdf
 

Part II - Why Andersen is so exposed ... http://www.accountingmalpractice.com/res/articles/enron-2.pdf
 

Part III - An independence dilemma http://www.accountingmalpractice.com/res/articles/enron-3.pdf
 

This message contains two messages from Steve Zeff (Rice University) and one from me. I will begin with my message. Dr. Zeff, former President of the American Accounting Association, is one of our most dedicated accounting historians. In November 2001, Stephen A. Zeff received the Hourglass Award from the Academy of Accounting Historians. His homepage is at http://www.ruf.rice.edu/~sazeff/ 

Steve's first message below deals with the "state of professional decline" in public accountancy.

His second message (at the bottom) was prompted by my appeal to him to bring more of his vast knowledge of history to bear upon our exchanges on the AECM.

I think both of his messages tell us a lot about the state of affairs that led up to the Enron scandal (which sadly centers in his own home town.)

The only thing that I take exception with is his statement that I am one of the few who really cares about the state of professional decline. There are, in fact, many who have been far more courageous than me to document the decline in professionalism in accounting practice, scholarship, and research, headed by such critical scholars as Steve Zeff, Abraham Briloff, Eli Mason, Tony Tinker, Paul Williams, and others willing to speak out over the past three decades. See http://faculty.trinity.edu/rjensen/book01q3.htm#082401 

Joel Demski's pessimistic remarks are resounding louder after the fall of Enron --- http://www.cs.trinity.edu/~rjensen/001aaa/atlanta01.htm  I tried to consistently take a more optimistic stance, but the melt down of Enron has taken its toll on my view of my profession.

I hope you will carefully read the two messages from Dr. Zeff that follow my message below.

Bob Jensen

-----Original Message----- 
From: Jensen, Robert 
Sent: Sunday, December 30, 2001 2:13 PM 
To: 'Stephen A. Zeff' 
Subject: RE: threads on accounting fraud

Hi Steve,

What a nice message to encounter in my message box. Thank you for the kind words.

I think your remarks should be shared with accounting educators. Would you mind if I place your remarks in my next (probably January 5) edition of New Bookmarks? The archives are at http://faculty.trinity.edu/rjensen/bookurl.htm 

I hear from you so rarely that it is really a pleasure when I get a message from you. I have more respect for your dedication to our craft than you can ever imagine. I wish that you, like Denny Beresford, would share your vast storehouse of accounting knowledge and history with accounting educators on the AECM --- http://pacioli.loyola.edu/aecm/ 

Our younger accounting educators communicating on the AECM are very bright and skilled in technology, but they are usually a mile wide and an inch deep when it comes to accounting history.

I don't recall if I ever told you this, but your efforts to find Marie in the Rice alumni database led to the subsequent marriage between her and my friend Billy Bender. Both were well into their eighties on the wedding day. They were engaged while both attended Rice University in the 1940s, but the war called Billy away to be a Navy pilot. They had no subsequent contact for over 50 years until you helped Billy find Marie.

Thanks,

Bob Jensen

---

-----Original Message----- 
From: Stephen A. Zeff [mailto:sazeff@rice.edu]  
Sent: Sunday, December 30, 2001 1:36 PM 
To: rjensen@trinity.edu 
Subject: threads on accounting fraud

Dear Bob:

Yesterday I happened across your Threads on Accounting Fraud, etc. (the Enron case) at http://faculty.trinity.edu/rjensen/fraud.htm  , and I found it to be fascinating reading. I had already seen quite a few of the items, but I knew I could count on you to pull everything--and I mean everything--together. You do wonders on the Internet.

I don't know if you recall seeing my short article, "Does the CPA Belong to a Profession?" (Accounting Horizons, June 1987). The previous year, I was invited by the chairman of the Texas State Board of Public Accountancy to give a 15-minute address to newly admitted CPAs at the Erwin Center in Austin in November. Even though I am not a CPA, I accepted. I asked if they would mind if I were to say something controversial. They said no. Some 2,500 candidates, relatives and friends, and elders of the profession were in attendance, the largest audience to which I have ever spoken. Typically at such gatherings, the speaker enthuses about the greatness of the profession the candidates are about to enter. Instead, I opted to discuss whether the CPA actually belongs to a profession, and my view came down heavily on the skeptical side. Some of the questions I raised are being raised today about the supposedly independent posture of auditors and about the teaching of accounting. Fifteen years have passed, and things don't seem to have changed.

My address raised the question of whether the CPA certification constitutes a union card, a license to practice a trade, or admission to a profession. I reviewed a number of recent trends, including the growing commercialization of the practice of accounting, the increasing number of points of possible conflict between the widening scope of services and the attest function, the decline in the vitality of the professional literature, and the even greater emphasis on the rule-bound approach to teaching accounting in the universities. My conclusion was that accounting was in a state of professional decline that should concern all of its leaders.

Following the address, I expected to be taken to task for using such a solemn occasion, at which speakers are normally heard to celebrate the profession, to deliver a pessimistic message. I was, however, astonished that not one of the professional leaders in attendance uttered a word of criticism. When I pointedly asked several of the senior practitioners for their reaction to my remarks, the general response was a shrug of their shoulders. Yes, professionalism is not what it once was, but there seemed to be little that one could, or should, do to attempt to reverse the trend. This wholly unexpected reaction led me to conclude that I had underestimated the depth and pervasiveness of the malaise in the profession.

I wish you and Erika a Happy New Year.

Steve. --

*************************************************************** 
Subsequent Message received from Steve Zeff

Bob:

It's always a delight to hear from you. Yes, of course you have my permission to place my remarks in your Bookmarks.

In fact, a lot of what I know about accounting history was packed into my recent book, Henry Rand Hatfield: Humanist, Scholar, and Accounting Educator (JAI Press/Elsevier, 2000).

For some years in the early 1990s, I wrote to successive directors of the AAA's doctoral consortium to persuade them that a session should be provided on the history of accounting thought. When the directors replied (which was less than half the time), they said that their planned programs were already full with the standard people and the standard subjects. They typically do bring a standard setter in (usually Jim Leisenring), but the last time someone held a session on accounting history at the consortium was in 1987 (I was the presenter, and the students told me that the subject I treated was entirely new to them.).Virtually no top doctoral programs in the country treat accounting history or even accounting theory. They deal only with how to conduct analytical or empirical research, and the references given to the students are, with a few exceptions (Ball and Brown, and Watts and Zimmerman), from the last six or eight years. Small wonder that tyro assistant professors struggle to learn what accounting is all about once they start teaching the subject. Our emerging doctoral students, for years, have had no knowledge of the evolution of the accounting literature, even the theory that is now finding its way in the work of Stephen Penman and Jim Ohlson.

I think that one of the aims of the consortium should be to "round out" the intellectual preparation of the doctoral students. Instead, the consortium goes deeper in the areas already studied.

Keep up the good work. You are one of the very few people in our field who really cares. And you have done a great deal--more than anyone else I know--to broaden the vision and knowledge base of our colleagues.

Steve. --

Stephen A. Zeff 
Herbert S. Autrey Professor of Accounting 
Jesse H. Jones Graduate School of Management 
Rice University 6100 Main Street Houston, TX 77005 

One of the most prominent CPAs in the world sent me the following message and sent the WSJ link:

Bob, More on Enron. 
It's interesting that this matter of performing internal audits didn't come up in the testimony Joe Beradino of Andersen presented to the House Committee a couple of days ago

"Arthur Andersen's 'Double Duty' Work Raises Questions About Its Independence," by Jonathan Weil, The Wall Street Journal, December 14, 2001 --- http://interactive.wsj.com/fr/emailthis/retrieve.cgi?id=SB1008289729306300000.djm 

In addition to acting as Enron Corp.'s outside auditor, Arthur Andersen LLP also performed internal-auditing services for Enron, raising further questions about the Big Five accounting firm's independence and the degree to which it may have been auditing its own work.

That Andersen performed "double duty" work for the Houston-based energy concern likely will trigger greater regulatory scrutiny of Andersen's role as Enron's independent auditor than would ordinarily be the case after an audit failure, accounting and securities-law specialists say.

It also potentially could expose Andersen to greater liability for damages in shareholder lawsuits, depending on whether the internal auditors employed by Andersen missed key warning signs that they should have caught. Once valued at more than $77 billion, Enron is now in proceedings under Chapter 11 of the U.S. Bankruptcy Code.

Internal-audit departments, among other things, are used to ensure that a company's control systems are adequate and working, while outside independent auditors are hired to opine on the accuracy of a company's financial statements. Every sizable company relies on outside auditors to check whether its internal auditors are working effectively to prevent fraud, accounting irregularities and waste. But when a company hires its outside auditor to monitor internal auditors working for the same firm, critics say it creates an unavoidable conflict of interest for the firm.

Still, such arrangements have become more common over the past decade. In response, the Securities and Exchange Commission last year passed new rules, which take effect in August 2002, restricting the amount of internal-audit work that outside auditors can perform for their clients, though not banning it outright.

"It certainly runs totally contrary to my concept of independence," says Alan Bromberg, a securities-law professor at Southern Methodist University in Dallas. "I see it as a double duty, double responsibility and, therefore, double potential liability."

Andersen officials say their firm's independence wasn't impaired by the size or nature of the fees paid by Enron -- $52 million last year. An Enron spokesman said, "The company believed and continues to believe that Arthur Andersen's role as Enron's internal auditor would not compromise Andersen's role as independent auditor for Enron."

Andersen spokesman David Tabolt said Enron outsourced its internal-audit department to Andersen around 1994 or 1995. He said Enron began conducting some of its own internal-audit functions in recent years. Enron, Andersen's second-largest U.S. client, paid $25 million for audit fees in 2000, according to Enron's proxy last year. Mr. Tabolt said that figure includes both internal and external audit fees, a point not explained in the proxy, though he declined to specify how much Andersen was paid for each. Additionally, Enron paid Andersen a further $27 million for other services, including tax and consulting work.

Following audit failures, outside auditors frequently claim that their clients withheld crucial information from them. In testimony Wednesday before a joint hearing of two House Financial Services subcommittees, which are investigating Enron's collapse, Andersen's chief executive, Joseph Berardino, made the same claim about Enron. However, given that Andersen also was Enron's internal auditor, "it's going to be tough for Andersen to take that traditional tack that 'management pulled the wool over our eyes,' " says Douglas Carmichael, an accounting professor at Baruch College in New York.

Mr. Tabolt, the Andersen spokesman, said it is too early to make judgments about Andersen's work. "None of us knows yet exactly what happened here," he said. "When we know the facts we'll all be able to make informed judgments. But until then, much of this is speculation."

Though it hasn't received public attention recently, Andersen's double-duty work for Enron wasn't a secret. A March 1996 Wall Street Journal article, for instance, noted that a growing number of companies, including Enron, had outsourced their internal-audit departments to their outside auditors, a development that had prompted criticism from regulators and others. At other times, Mr. Tabolt said, Andersen and Enron officials had discussed their arrangement publicly.

Accounting firms say the double-duty arrangements let them become more familiar with clients' control procedures and that such arrangements are ethically permissible, as long as outside auditors don't make management decisions in handling the internal audits. Under the new SEC rules taking effect next year, an outside auditor impairs its independence if it performs more than 40% of a client's internal-audit work. The SEC said the restriction won't apply to clients with assets of $200 million or less. Previously, the SEC had imposed no such percentage limitation.

The Gottesdiener Law Firm, the Washington, D.C. 401(k) and pension class action law firm prosecuting the most comprehensive of the 401(k) cases pending against Enron Corporation and related defendants, added new allegations to its case today, charging Arthur Andersen of Chicago with knowingly participating in Enron's fraud on employees.
Lawsuit Seeks to Hold Andersen Accountable for Defrauding Enron Investors, Employees --- http://www.smartpros.com/x31970.xml 

Hi Bill,

Andersen and the other firms "shifted their focus from prestige to profits --- and thereby transformed the firm. "

The same thing happened in Morgan Stanley and other investment banking firms. Like it or not, the quote below from Frank Partnoy (a Wall Street insider) seems to fit accounting, banking, and other firms near the close of the 20th Century.

From Page 15 of the most depressing book that I have ever read about the new wave of rogue professionals. Frank Partnoy in FIASCO: The Inside Story of a Wall Street Trader (New York: Penguin Putnam, 1997, ISBN 0 14 02 7879 6)

************************************************

This was not the Morgan Stanley of yore. In the 1920s, the white-shoe (in auditing that would be black-shoe) investment bank developed a reputation for gentility and was renowned for fresh flowers and fine furniture (recall that Arthur Andersen offices featured those magnificent wooden doors), an elegant partners' dining room, and conservative business practices. The firm's credo was "First class business in a first class way."

However, during the banking heyday of the 1980s, the firm faced intense competition from other banks and slipped from its number one spot. In response, Morgan Stanley's partners shifted their focus from prestige to profits --- and thereby transformed the firm. (Emphasis added) Morgan Stanley had swapped its fine heritage for slick sales-and-trading operation --- and made a lot more money.

************************************************

Bob Jensen 

-----Original Message----- 
From: William Mister [mailto:bmister@LAMAR.COLOSTATE.EDU]  
Sent: Tuesday, February 19, 2002 11:05 PM 
To: AECM@LISTSERV.LOYOLA.EDU 
Subject: Re: Andersen again

I refer you back to the Fortune article some years ago (old timers may remember it) that referred to then AA&Co as the "Marine Corp of the accounting Profession." In those days there were no "rogue partners." I wonder what changed? 

William G. (Bill) Mister 
William.Mister@colostate.edu 

A survey of Canadian business executives shows immense support for auditing reforms. Find out what reforms scored highest on their list. http://www.accountingweb.com/item/70425 

A survey of Canadian business executives shows immense support for auditing reforms. The reforms that scored highest were:

 

• Making it illegal to have liabilities off the balance sheet.
   
• Barring accountants from providing both auditing and consulting to the same client.

This response seems somewhat surprising in view of two other findings:

 

• Few executives feel strongly that the accounting profession is responsible for high profile collapses, such as Enron and past meltdowns in Canada.
   
• Most say they have a high level of confidence in the ethics of the accounting or auditing firm employed by their own organizations. The executives ranked the ethics of their own auditors a very high 6.0 out of a possible 7.

Some press accounts attribute the seemingly contradictory results to differences between big accounting firms and smaller ones. They point out that many survey respondents typically come from small to mid-sized companies not audited by large accounting firms.

When asked how much confidence they have in the ethics of the (presumably larger) firms auditing large publicly traded companies, the executives were decidedly less kind, ranking these firms only a 4.7 out of a possible 7.