June 7, 2002

Arthur Andersen's Fall From Grace Is a Sad Tale of Greed and Miscues

By KEN BROWN and IANTHE JEANNE DUGAN
Staff Reporters of THE WALL STREET JOURNAL

At "Andersen U.," the lush, 150-acre campus where Arthur Andersen LLP has trained tens of thousands of new recruits, there's a shrine to ethical accounting.

A display in the Andersen Heritage Center is devoted to yellowing press clippings of a long-ago campaign to clean up the accounting industry by Leonard Spacek, who led the firm from 1947 to 1963. In one, he accused Bethlehem Steel of overstating its profits in 1964 by more than 60%. In another, he bashed the Securities and Exchange Commission for failing to crack down on companies that cooked their books, saying that at best the regulatory agency has been "a brake on the rate of retrogression in the quality of accounting."

Now, it's the quality of Andersen's accounting that has set off an ethical crisis. Since 1993, the firm has been embroiled in a series of major accounting scandals -- from Sunbeam Corp. to Waste Management Inc. to Enron Corp. Facing an obstruction-of-justice charge in a Houston federal court, Andersen itself is disintegrating and will likely be gone in a matter of months regardless of the verdict -- a humiliating end to a company that once stood as the world's largest professional-services firm and whose 85,000 employees last year generated $9.3 billion in revenue.

Andersen's descent from conscience of the accounting industry to accused felon didn't happen overnight. Rather, it stemmed from a series of management miscues and compromises over the decades. As the firm grew from a close-knit partnership to a globe-spanning behemoth, pressure to boost profits became intense. Andersen leaders responded by pushing partners to become salesmen -- upsetting the delicate balancing act any auditor must perform between pleasing a client and looking out for the public investor.

This shift saw the rise of a new breed of accountant -- such as the senior executive who punctuated his speeches with violin music and exhorted his troops to "empathize" with the companies whose books they checked.

Andersen spokesman Patrick Dorton acknowledges that the firm has made some mistakes in the past, but says it was undertaking reforms. He adds: "The issues and concerns raised affect the entire profession and not only Andersen."

Arthur Andersen himself originally built his business by putting reputation over profit. In 1914, months after the 28-year-old Northwestern University accounting professor founded his tiny company, the president of a local railroad demanded that he approve a peculiar transaction that would have lowered the company's expenses and boosted earnings. Mr. Andersen, who at the time was worried about meeting his next payroll, told the president that there was "not enough money in the city of Chicago" to make him do it, according to a book published by the firm in 1988. The client promptly fired the accountant, but Mr. Andersen was vindicated months later when the company filed for bankruptcy.

Mr. Andersen lived in a bygone era. Back then, competition among accounting firms was muted. The closest auditors came to selling was gentle networking on the boards of local charities. What the business lacked in excitement, it made up in reliability: Under federal laws enacted in the 1930s, public companies had to submit their financial statements to independent auditing every year. Partners at the firms earned enough to drive a Cadillac and join the local country club, but no one got rich being an auditor. In the late 1960s, a mid-level Andersen partner made about $30,000, or $160,000 in today's dollars.

Daniel Malachuk joined Arthur Andersen in 1970, fresh out of the Navy with a master's degree in finance. Flying to Chicago for his orientation, he remembers being met by a driver holding a cryptic "Arthur An" sign -- a nod to federal rules at the time that barred advertising. He was driven to the campus of the newly opened Andersen U., officially known as the Center for Professional Education, located on the Fox River about 40 miles from the firm's Chicago headquarters. The former college campus had a one-hole golf course, running trails and gourmet food prepared by the same company that cooked for the Chicago Bears.

Tradition was everywhere. The heavy wooden doors that marked the entrance to the campus's main building matched those that once stood outside Arthur Andersen's own office and dozens of flags, which represented every country that had students training at the center, hung in the lobby. New hires, known as "green beans," recited the founder's motto, "Think straight, talk straight." And they learned Andersen's "four cornerstones" -- provide good service to the client; produce quality audits; manage staff well; and produce profits for the firm.

Over the ensuing 30 years, Mr. Malachuk saw the firm change to the point that making profits eventually dwarfed all else. He and other partners joked that the four cornerstones were really "three pebbles and a boulder."

Seeds for Demise

Although nobody knew it at the time, the seeds for Arthur Andersen's eventual demise were sown in 1950, when the firm introduced the "Glickiac" to the world. Named after its inventor, an Andersen engineer named Joseph Glickauf, the clunky device created a sensation by demonstrating that computers weren't just for scientists: Companies could use them to automate their bookkeeping. This ushered in an entirely new business. Rather than just audit the books, Andersen would set up the computers clients needed to keep the books. It wasn't long before Andersen boasted by far the largest technology practice of any accounting firm, raking in huge profits.

The flood of money introduced a new element of tension into the partnership. Under rules set by the auditors who ran the firm, all of the profits from all the practice areas had to go into one big pot to be divided among partners. But since the average consultant brought in more money than the average auditor, the consulting side complained the arrangement was unfair.

The week after New Year's Day in 1989, at a world-wide meeting of the firm in Dallas, the consultants finally made their break. They won an agreement to separate into two units -- Arthur Andersen and Andersen Consulting -- under a Geneva-based parent company known as Andersen Worldwide SC. But most importantly, the accounting side agreed to make the profit-sharing more equitable. Under a complex formula, the less profitable of the two firms would get a check for a small portion of the profits of the more profitable one.

The implications for the auditors were grim: Growth in the traditional accounting business was slowing because of competition, and audit fees were in a tailspin. Despite grueling hours, accountants' salaries were lagging behind those of other professionals such as lawyers and investment bankers. And they bridled at the thought of being eclipsed by the swashbuckling consultants. Under the accounting side's top partner, Richard Measelle, Arthur Andersen fought back. "It was a matter of pride," Mr. Measelle says.

To make sure auditors weren't just auditing, they began to be judged on how much new business they brought in. A superb auditor "who could not get a lick of business" was secure in the 1970s, says Mr. Measelle, who held the top post until 1997. But now, "their job security was a lot less."

Mr. Measelle believed he could boost sales while maintaining high auditing standards. But, he isn't sure both parts of his message got through. "I have to admit that there was this feeling that the No. 1 thing was to make your numbers and to make money," Mr. Measelle said, but "that wasn't what we were trying to do."

To cap costs, Andersen began requiring partners to retire at 56 years of age, enforcing a policy that was long overlooked. This made way for less-expensive -- and less-experienced -- partners. It created more revenue per partner -- in recent years, average partners made around $600,000 -- but left fewer partners overseeing audits.

"Though most auditors at Arthur Andersen are competent and honest," a longtime audit partner says, "a whole new breed was not steeped in new training and was far more focused on selling."

The auditors and the consultants competed fiercely, turning the annual race for profits into a devilish sport. In 1993, Arthur Andersen's cost-cutting efforts and some sales success combined with a weak market for the consultants to make the race even closer than usual. With just a few months left in the firm's fiscal year, the warring sides were neck and neck. So each swept around the office for expenses they could cut, revenue they could post. The auditors won -- and to commemorate drew up a poster that showed Mr. Measelle driving a car that was leaving Andersen Consulting in its dust.

In this competitive environment, Steve Samek emerged as a force within Andersen. A product of the gritty Chicago suburb of Cicero, Mr. Samek graduated from Southern Illinois University with an accounting degree and made partner at 32. Like most Andersen partners, he was clean-cut with a haircut looking as if it hadn't changed since he was six years old. But unlike many, Mr. Samek had a flair for the dramatic and loved the public stage. By the end of the decade, he would be running Andersen's entire U.S. operation and giving as many as 100 speeches a year.

As an auditor, he sometimes approved aggressive accounting tactics. In the early 1990s, Mr. Samek picked up a potentially lucrative client, a fast-growing restaurant chain called Boston Chicken. In auditing its books, he allowed the chain to keep details of losses at its struggling franchisees off its own financial statements as it groomed for a public offering. The IPO was a resounding success, soaring 143% in its first day of trading, and, for a time, Boston Chicken was a marquee client. Mr. Samek was rewarded for his work, getting praised in an internal performance review for turning "a $50,000 audit fee into a $3 million full-service engagement."

The system eventually collapsed and the company, by then called Boston Market Corp., filed for bankruptcy protection in 1998. Andersen had helped create a "facade of corporate solvency," according to a pending lawsuit filed last year in Phoenix federal district court by the company's bankruptcy trustee.

Mr. Samek, who left the account before the 1993 IPO, points out that the SEC approved of the accounting before the company went public. Mr. Dorton, the Andersen spokesman, says the lawsuit has no merit and that Boston Chicken's risky business plan was widely discussed in part because the company's financial statements had the appropriate disclosures.

Counting The Days

The history of Arthur Andersen

 

[Arthur Andersen]
1913 Arthur Andersen (left), a 28-year-old accounting professor, co-founds Andersen, DeLany & Co.

 

1914 Mr. Andersen tells a client "there isn't enough money in the city of Chicago" to make him sign off on a dubious transaction.

 

1918 The firm, now called Arthur Andersen & Co., starts a "management- information consulting" practice.

 

1947 Mr. Andersen dies. Leonard Spacek steps in as managing partner, preventing the firm from dissolving.

 

1954 Andersen consultants help General Electric automate its payroll using the Glickiac computer (right), the first commercial use of the computer in the U.S.

 

1959 For the first time, the firm admits partners from outside the U.S.

 

1979 Andersen becomes the world's largest professional-services firm.

 

1989 The accounting and consulting practices break into separate companies under a Swiss parent.

 

1998 Andersen agrees to pay $75 million to settle shareholder suits arising from an accounting scandal at Waste Management. (See article10.)

 

2000 An arbitrator rules that Andersen Consulting can break free entirely by paying just $1 billion and changing its name. The new moniker: Accenture. (See article11.)

 

May 2001 Andersen pays $110 million to settle shareholders' claims related to accounting scandal at Sunbeam. (See article12.)

 

February 2002 Andersen agrees to pay $10.3 million to settle shareholders' lawsuits related to Boston Market bankruptcy. (See article13.)

 

[photo]
March Andersen agrees to pay $217 million to settle a lawsuit stemming from the collapse of the Baptist Foundation of Arizona, later withdraws offer, but then, in a turnabout a week into trial, agrees to pay a $217 million settlement again. (See article14.)

 

May 6 Andersen trial for obstruction of justice begins (left). (See article15.) (Complete coverage16.)

 

Source: WSJ research

 

Mr. Samek, now 49, rose quickly. In 1989, five years after he made partner, he was named to run a large portion of the firm's Chicago auditing practice overseeing about 350 people. In 1996, he became the firm's world-wide head of auditing, with indirect responsibility for 40,000 people. In the spring of 1998, he was put in charge of all of Andersen's U.S. operations, which account for about half of the firm's revenue.

Mr. Samek gave rousing speeches designed to inspire the auditors to sell everything from tax services to consulting work to their clients. In one speech, Mr. Samek was accompanied by a violinist who played as he told auditors to think of themselves as maestros. In another he stood in awe at the pace of change in technology. Using a pen as a prop, Mr. Samek said that if jets had evolved as rapidly as computers, "a 747 would be size of this pen, could fly around world in two seconds and use three cents of fuel."

Some senior partners regarded the sermons as gibberish but others saw him as a kindred soul.

"He was auditor extraordinaire," says Tom Nelson, a former partner who says he, too, aspired beyond the "boring" confines of accounting.

Mr. Samek says the partners who criticized him were those who refused to change their ways. Accountants "tend to be a bit more dry," he says. "I tend to be a little different, a little more visual, right brain versus left brain, a little bit more creative."

Even as Mr. Samek tried to inspire the troops, problems with Andersen's audits began to mount. Andersen paid investors $110 million for its botched audits of Sunbeam, the home appliance maker that was caught artificially boosting revenues by offering retailers incentives to accept more product than they could sell. And in 1997, client Waste Management Inc. had the largest earnings restatement to date, wiping out $1.7 billion in profits that it pulled in through the 1990s.

'Rainmaker'

The lead auditor on Waste Management was Robert Allgyer, who was known inside the firm as "the Rainmaker" for his success in cross-selling extra services to auditing clients. He was clearly successful at selling to Waste Management, which paid $17.8 million in fees unrelated to the audit between 1991 and 1997, against audit fees of $7.5 million. But he was also signing off on drastically inaccurate books. Among other things, the fast-growing trash hauler wasn't properly writing off the value of assets such as garbage trucks as they aged, a ruse that pumped up reported profits.

The SEC's acting commissioner, Laura Unger, concluded that the agency had the "smoking gun" it was looking for to prove that the lure of consulting fees compromised auditor independence. The SEC filed suit in March 2002, accusing six former Waste Management executives of fraud. It alleges that Mr. Allgyer's judgment was skewed by consulting fees, in particular a $3.7 million "strategic overview" of Waste Management operations. The project lasted for 11 months, but the client didn't adopt the recommendations. One former Waste Management board member later described the project as a "boondoggle."

Mr. Allgyer, who is retired, declines to comment. The waste hauler says its accounting problems are a thing of the past. The former executives said the charges were false. Andersen said at the time "there was no independence violation and the SEC had no case to make one."

Soon enough, Andersen executives had another crisis to take their minds off Waste Management. Efforts to expand the accounting side of the business were petering out. By 1997, auditing and tax work brought in $1.8 billion, up just 12.5% from 1993, according to Bowman's Accounting Report, an industry newsletter.

Andersen Consulting, meanwhile, had rebounded strongly, more than doubling revenue to $3.1 billion during the period as companies around the world went on a spending spree to upgrade their computer systems. The consultants were now bringing in 58% of the overall firm's revenues, and subsidizing the accountants to the tune of about $150 million a year -- and complaining bitterly about it.

After a showdown in San Francisco in December 1997, Andersen Consulting partners voted unanimously to split off entirely. They filed an arbitration claim with the International Chamber of Commerce. The old Andersen had been building its own consulting practice, but it couldn't make up for the revenue it was about to lose.

Mr. Samek turned up the heat. After being named the top partner in 1998, he shocked many auditors with something he called his "2X" strategy. Partners should bring in two times their revenues in work outside their area of practice. That meant that if an auditor brought the firm $2 million a year policing a company's books, he should bring in an additional $4 million in nonaudit services, such as tax advice and technology consulting. Auditors were judged against "2X" on newly revamped performance reviews.

The strategy was a centerpiece of Mr. Samek's hard-covered internal manual called "U.S. Strategy," an 80-plus-page tome that included advice on how to "empathize" with clients. Former partners say Mr. Samek left long voicemail messages advising them to read the book repeatedly to make sure the concepts were drilled into their heads.

One longtime audit partner says the stress was intense. "I've never had a problem selling audit work. Tax work sold itself. But getting into new things and consulting and selling was very challenging," he says.

Andersen by now was implementing a strategy to sell more audit work by handling far more than the traditional, once-a-year external audit of the public books. Now, it was pitching clients to outsource their internal bookkeeping operations.

Critics such as Arthur Levitt, at the time the chairman of the SEC, worried that the practice would hurt the quality of the audit, because it removed a separate function that served as a second opinion. In effect, accounting firms would be checking their own work. Still, Arthur Andersen persevered -- and ultimately took the concept a step further, pioneering the "integrated audit," which would mingle not only internal and external audits but a whole package of services ranging from tax strategy to advice on corporate-finance issues.

Andersen's laboratory was Enron, an audit client since 1986. Andersen in the mid-1990s hired Enron's entire team of 40 internal auditors, added its own people and opened an office in Enron's Houston headquarters that was as big as some regional Arthur Andersen offices. With more than 150 people on-site, Andersen staff attended Enron meetings and helped shape new businesses, according to current and former Andersen and Enron employees.

The experiment came at a time when Andersen was becoming increasingly decentralized, with more and more power residing with local "office managing partners," each with their own revenue targets and balance sheets. At the same time, several members of the "Professional Standards Group" -- a panel of internal experts who handled tricky accounting questions -- had been moved from the Chicago headquarters to local offices to give clients quicker answers.

The thrust of both moves was to make it harder for auditors to fight back against clients who wanted to test the limits of accepted accounting standards. Enron, for example, represented just a small fraction of Andersen's revenues. But to David Duncan, who served as the lead auditor to the energy company, it was his livelihood.

Enron became so powerful that one Houston-based member of the Professional Standards Group complained that his advice against certain accounting practices was being ignored. The audit partner, Carl Bass, told Mr. Duncan that Enron should take a $30 million to $50 million accounting charge for a specific transaction. "The team apparently does not want to go back to the client on this," Mr. Bass said in a December 1999 e-mail to a colleague in Chicago that was obtained by congressional investigators. Four months later, Mr. Bass was removed from his Enron oversight role in response to complaints by Enron's chief accounting officer at the time, Richard A. Causey, about Mr. Bass's resistance to the company's financial-reporting practices. Mr. Causey's attorney didn't return calls seeking comment.

The Enron audit was part of a broader move by Andersen to reshape itself into a "New Economy" powerhouse offering a wide array of auditing services that their fast-growing clients needed.

The new philosophy was described in a book by Mr. Samek and two other partners: "Cracking the Value Code -- How Successful Businesses are Creating Wealth in the New Economy." Published by HarperCollins in 2000, the book argues that old-fashioned accounting failed to measure the value of intangible assets, such as employees and business relationships. The sky-high prices of technology stocks such as America Online, Williams Cos., and Charles Schwab Corp., proved accountants needed to creatively approach hard-to-value assets. Mr. Samek discussed the philosophy at a gathering of top business and political leaders in Davos, Switzerland, while passing out a white paper that touted Enron as a model company of the new economy.

Andersen cited the book's premise for opposing a proposal by the SEC in 2000 to limit the amount of consulting work that accounting firms could perform for their audit clients. In testimony before the Senate Banking Committee in July 2000, Mr. Samek called the SEC proposal "fatally flawed." He said it arrived "just as we need to take an even more active role in making needed changes in the measurement and reporting system in support of better information for decision-making by corporations, investors and the government." The Big Five accounting firms defeated the SEC proposal. That same year Andersen unveiled a zippy new logo, a big orange ball, with only the word Andersen beneath it. The big Andersen wooden doors were taken down all over the world.

A month after Mr. Samek's testimony, Arthur Andersen was crushed when an arbitrator ruled that the firm wouldn't receive a $14 billion payment it had been hoping for from the departing partners at Andersen Consulting, now known as Accenture Ltd. Arthur Andersen's CEO, Jim Wadia, resigned immediately.

Several top partners, including Mr. Samek, ran for the top job in a race that became a referendum on the firm's direction. The winner was Joseph Berardino, an understated accountant who had run the firm's U.S. auditing operation. Mr. Samek took a marketing position in Chicago. Mr. Berardino resigned after Andersen was indicted, and both men, like many senior partners at Andersen, are carrying out their first job searches since college.

-- Alexei Barrionuevo, Jonathan Weil and Bill Richards contributed to this article.

Write to Ken Brown at ken.brown@wsj.com17 and Ianthe Jeanne Dugan at ianthe.dugan@wsj.com18

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