ACC 4291

Integrated Case Study

Sem 2, 2014/15

Androids Under Attack

By Ali Shah Hashim
David Lawrence, 43 years of age, joined the auditing firm of Androids 20 years ago and earned a
salary of USD 700,000 per annum. He was the Androids partner in charge of auditing Enronaas
accounts since 1987 his job was to check Enronaas accounts and to make sure that they fairly
represent the state of the business. Androids had been Enronaas auditor for the past 16 years.
On the morning of October 23, David and his auditing team listened in on a call between stock
analysts and Enronaas executives, who were trying to explain the companys financial free fall. There
were too many unanswered questions. After lunch, David called the entire Enronaa team together in
Conference Room 37C1. His heart beat faster as he thought about the net that was closing in on
Androids. As his eyes wandered around the room, on one of the conference room walls was an
imposing picture of Arthur Androids. David was particularly proud of the long and distinguished
history of the firm. His mind wandered as if to witness how in 1913, Arthur and Clarence, both from
the audit firm of Price, bought out a small audit firm in Illinois to form Arthur, Clarence & Co., which
became Androids & Co. in 1918. Androids, who headed the firm until his death in 1945, was a
zealous supporter of high standards in the accounting industry. A stickler for honesty, he argued that
accountants responsibility was to investors, not their clients management. During the early years, it
was reputed that Androids was approached by an executive from a local rail utility to sign off on
accounts containing flawed accounting, or else face the loss of a major client. Androids refused in no
uncertain terms, replying that he would not sign the accounts for all the money in America.
Leonardo Sparky, who succeeded Androids at the founders death, continued this emphasis on
honesty. For many years, the Androids motto was, Think straight, talk straight.
Whilst waiting for his team members, David sat to have coffee with Ken Bailey, a junior partner in
Androids. I thought you would like to know, David said, that late last night, I had an emergency
conference call with partners from the Chicago Head Office, Ken bailey listened attentively as David
continued. The partners said in no uncertain terms that Androids future is in my hands. Period.
David couched towards ken Bailey and showed the audit work papers on Enronaa, and continued,
There were evidences that could suggest we assisted Enronaa to sort of puff up the reported returns
of off balance sheet activities by units called raptors David said, as he bagan to painfully explain
the technical intricacies of Enronaas accounting to ken Bailey. He explained how he learned from
Tom Fitzgerald, a co-partner of the Enronaa job, that some of the many off-the-books partnerships,
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like Chewco and Chewbacca, had not been properly accounted for and were not independent entities,
as Enronaa had told Androids in 1997. Nonetheless, in the end, Tom agreed that if they were to
continue revisiting prior conclusions there would be no end to the process. The upshot: its millions in
debt abd losses had to be reflected in Enronaas books. David continued, I must admit, questions hve
been mounting. In a series of September conference calls between our Chicago and Houston offices,
my team had been struggling as to how to properly restate and account for losses that had been
ignored. In fact, a number of our partners in Chicago who sat in on one of the conference calls were
stunned by the amount of losses that needed to be restated. Ken Bailey interjected Davids
explanation, yes, I heard along the grapevine that issues were raised in the memos and conference
calls being held about Enronaa. Given the problems with a Fastow partnership called LJM2, Tom was
concerned that Enronaa probably had an LJM1 lurking out there with similar troubles, and he asked
about it in a conference call with at least a dozen Androids people listening in. David did not want to
confirm Ken baileys observation, but he personally knew for certain that such a meeting did take
place. In fact, as the partner in charge of Enronaa, he was the one who assured everyone in the
meeting that the investments in LJM1 really were legitimate. In reality, he was not so sure. In fact, the
question had already come up earlier during the firms annual review of the Enronaa account in
February 2001, when Houston partners briefed their Chicago headquarters in a conference call. At that
time, Androids partners described Enronaas accounting as intelligent gambling. David tried to
explain his point of view to Ken Bailey, Yes, we had used accounting practices that allowed Enronaa
to hide its debts, but really these were all within the context of fair value accounting and David
started to explain the grey areas of fair value accounting as if Ken Bailey was a junior auditor. Ken
bailey sat patiently to allow David to finish and then said, Our work papers would be taken out of
context, blown out of proportion. David nodded in agreement and said, Yes, I am very concerned
about that, especially with all other litigations still unresolved. The general expectation was that the
auditor would have been able to spot large scale fraud or deception. At best, Androids critics would
say, the auditors were incompetent; at worst, they deliberately overlooked irregularities at Enronaa in
order not to lose the lucrative stream of consulting and other work it provided.
I dont know what to do, David confessed. Ken Bailey looked at him thoughtfully and said,
Androids is under attack! It was already in the news, and what made Androids a tastier target was
the fact that Enronaa was not the first time. Androids had had prior entanglements with the Securities
and Exchange Commission (SEC). Only recently, Androids agreed to pay the SEC a civil penalty of
USD 7 million to settle charges related to the firms work as auditors of Solid Waste. More
importantly, Ken, as part of the settlement with the SEC, we agreed to an injunction that forbade
Androids from future wrongdoing, David said, worryingly. They both sat down and talked about the
Solid Waste case (see below):

SOLID WASTE CASE

POINTS OF DISCUSSION BETWEEN DAVID AND KEN
Androids, together with its client, Solid Waste, agreed to pay USD 229 million to settle a class-action
suit about questionable accounting practices. Androids would have to pay Solid Waste USD 20
million as part of a malpractice settlement. The US Securities and Exchange Commission (SEC)
found Androids guilty of issuing materially false and misleading audit reports on Solid Wastes
financial statements for the period 1993 through 1996. For each year from 1993 through 1996,
Androids issued an audit report on Solid Wastes financial statements in which it stated that the
companys financial statements were presented fairly, in all material respects, in conformity with
generally accepted accounting principles (GAAP) and that Androids had conducted its audit of those
financial statements in accordance with generally accepted auditing standards (GAAS). SEC found
that Androids representations were materially false and misleading. Solid Wastes financial
statements were not presented fairly, in all material respects, in conformity with GAAP from 1993
through 1996. Androids had allowed the management of Solid Waste to use improper accounting to
inflate its operating income and other measures of success, primarily by deferring the recognition of
current period operating expenses into the future and by netting one-time gains against current and
prior period misstatements and current period operating expenses. For each year from 1993 through
1996, Androids, as a result of the conduct of certain of its partners, knew or was reckless in not
knowing that the Companys financial statements were not expressed fairly, in all material respects, in
conformity with GAAP but nonetheless, approved the issuance of an unqualified audit report on the
financial statements each year. Six Androids partners were involved, at various times during the
relevant period, in the issuance of an unqualified audit report on Solid Wastes annual financial
statements. In February 1998, Solid Waste announced that it was restating its financial statements for
the five-year period 1992 through 1996 and the first three quarters of 1997. It was the largest
restatement of results in the history of the SEC. The company admitted that through 1996, it had
materially overstated its reported pre-tax earnings by USD 1.43 billion and that it had understated
certain elements of its tax expenses by USD 178 million.
SECs investigation into the audit working papers of Androids revealed that the Androids engagement
teams that performed audits of Solid Wastes financial statements in the late 1980s, first discovered
several of the accounting practices resulting in certain of these misstatements. In the course of its
original audits from 1993 through 1996, the engagement team had identified and documented
numerous accounting issues underlying misstatements that the restatement ultimately addressed, and
had brought certain issues to the attention of Androids partners. Based on the evidence of Androids

audit working papers, SEC found Androids failed to ensure that all known misstatements were
quantified and all likely misstatements were estimated. SEC also found that Androids knew or was
reckless in not knowing that the audits of the financial statements on which Androids issued
unqualified audit reports during those years that were not conducted in accordance with GAAS. As a
result of the conduct of its partners, Androids knew or was reckless in not knowing that the
unqualified audit reports that it had issued, were materially false and misleading because the audits
did not conform with GAAS and the financial statements did not conform with GAAP. Androids
thereby, engaged in improper professional conduct.
Background of the Auditing of Solid Waste
Androids audited Solid Wastes annual financial statements since before Solid Waste became a public
company in 1971. Androids regarded Solid waste as its crown jewel client. Until 1997, every Chief
Financial Officer (CFO) and chief accounting officer (CAO) in Solid Wastes history as a public
company had previously worked as an auditor at Androids. During the 1990s, approximately 14
former Androids employees worked for Solid waste, most often in key financial and accounting
positions.
As early as 1988, members of Androids audit engagement team recognised that Solid Waste
employed aggressive accounting practices o enhance its earnings, and some were practically
violating GAAP. They included among other things, Solid Wastes repeated final year adjustments to
reduce depreciation expense on its property, plant and equipment cumulatively from the beginning of
the year. Androids audit team identified other non-GAAP method of capitalising interest on landfill
development costs, its failure to properly accrue for its tax and self-insurance expenses, its improper
use of purchase accounting to increase its environmental remediation reserves (liabilities), its
improper charges of operating expenses to the environmental remediation reserve (liabilities), and its
refusal to write off permitting and/or project costs on impaired or abandoned landfills. These
accounting practices, together increased reported operating income primarily by understating
operating expenses. In most instances, Solid Waste deferred recognition of current operating expenses
to future periods in order to inflate its current period income. Androids audit engagement teams
identified and documented each of these practices at various times throughout the audit engagement.
Solid waste capped Androids corporate audit fees at the prior years level but allowed Androids to
earn additional fees for tax, attest work unrelated to financial statement audits or reviews, regulatory
issues, and consulting services.

Evidences in the Audit Working Paper of Solid Waste

By February 1, 1994, the engagement team quantified current and prior period misstatements totalling
USD 128 million, which if recorded, would have reduced net income before special items by 12%.
The engagement team also identified accounting practices that gave rise to other known and likely
misstatements involving understatements of operating expenses. The engagement team proposed
adjusting entries in that amount for the Company to record. Solid Wastes management refused to
record the journal entries or to correct the accounting practices giving rise to the adjustments and
other misstatements and likely misstatements. Androids partners relented and instructed the
engagement team to identify these as continuing audit issues. They determined that Androids would
nonetheless issue an unqualified audit report on Solid Wastes 1993 financial statements.
Audit working appers of 1996 and the 1997 audit showed that although the Androids audit team
disagreed with the companys use of netting and the lack of disclosures, Solid waste continued to use
netting. In 1996, the company offset current period expenses and prior period misstatements against a
portion of the gains realised from the sale of two discontinued operations, the effect of which was to
boost income from continuing operations. The company netted and misclassified gains and profits of
approximately USD 85.1 million on the sale of the two subsidiaries. The engagement team prepared a
proposed journal adjustment, which if recorded, would have further reduced pre-tax income from
continuing operations before special charges by 5.9%. The company refused to record the
adjustments. In addition, the company inflated income by making unsupported changes to its salvage
values, improperly accounting for insurance recoveries and incorrectly applying purchase acquisition
accounting principles to its environmental remediation reserves (liabilities) in order to reduce current
period operating expenses. SEC found evidence in the audit working papers that showed the partners
of Androids had allowed an issue of an unqualified audit report on the companys financial
statements.

The Solid Waste case followed Androids decision to pay USD 110 million to settle a lawsuit on
audits at Sunbeamic, another US client found to have less than reliable accounts. Ken Bailey was his
junior and yet understood what David had long observed since he first joined Androids in the 1980s
a period when standards throughout the industry began to fall as accountancy firms struggled to
balance their commitment to audit independence against the desire to grow their burgeoning
consultancy practices. Androids was no exception. The firm rapidly expanded its consultancy practice
to the point where the bulk of its revenues were derived from such engagements, while audit partners
were continually encouraged to seek opportunities for consulting fees from existing audit clients.
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David and Ken knew that the firm would be in deep trouble for its role in Enronaas collapse.
Davod said, Androids was already under probation with the SEC and another scandal in the likes of
Enronaa would mean the end of our business. I am the partner in charge of Enronaas accounts. Ill do
all within my powers to protect the interests of Androids. We have 85,000 staff in the 390 offices in 84
countries. Thats the bigger picture.
David saw a window of opportunity to destroy self -incriminating audit working papers. By the way,
did you read Nancys email on October 19, 2001, reminding all employees of Androids on the policy
of routine document shredding? Ken Bailey asked David. The meaning of the document retention
policy had been debated repeatedly within Androids. Ken Bailey explained that he didnt understand
the e-mail. You know, I asked Nancy whether I was supposed to delete the e-mails about Enronaa in
my possession, even though the case was attracting outside scrutiny. I met Nancy and she advised me
that the policy called for keeping final versions of the memos while discarding drafts. Ken Bailey
explained. David sensed that Ken bailey would not be comfortable with an order to shred the
documents. Ken bailey continued, David, I am really bothered about doing all these shredding
thing. To that David replied, Yes, I have read the e-mail and that is why I have called for a meeting
of the team today to discuss the matter. If we were to follow Nancys advice, weve got tons, literally,
of documents to shred. David took a deep breath, Nancys e-mail is the key to my decision today.
We cannot be keeping self-incriminating work papers that might be used against us. Ken Bailey
asked, Have you really put careful thoughts on the matter? David simply said, Ken, I dont see
whats wrong with shredding the documents. Anyway, were merely complying with Androids
official policy which our lawyers must have put a lot of legal thoughts into it. In spite of his
reservation, Ken bailey kept quiet.
How did we get into this mess? Ken Bailey wondered aloud. It was not as if he or David did not
already have the answer. David knew that there was a pressured atmosphere in Houston, where
Enronaas finance staff was on the phone nearly every day, demanding that Androids auditors sign off
on some transactions. Ken Bailey himself remembered how Warren White, a former Androids
partner, used to complain to him, They would call you on a Friday night and say that they needed an
answer by Saturday and we would be having midnight conferences with them. Ken bailey knew that
if Androids accountants objected, Enronaas finance staff

would call Androids Chicago

headquarters, seeking the advice of senior partners. The conference calls would stretch for hours, with
the Androids staffers flipping through financial documents and policy statements, finding ways to
appease Enronaa. The marathon sessions would pressure Androids auditors to view accounting issues
Enronaas way. Androids knew what Enronaa wanted and usually sought to give it to them. David
explained, We all knew that they were the largest single client in the Houston office. The Enronaa
account had become so lucrative for Androids that the firm was unwilling to step away. All of us are
sucked into this mess, and added, Ken, do you know, I received an e-mail from Michael Jones
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informing me that the partners had discussed whether outsiders would question Androids given that
fees on the Enronaa account could soar to as much as USD 100 million per annum. Androids leaders
had decided to retain Enronaa as a client and determined the size of fees was not an issue. The
admission from David did not surprise Ken Bailey. Androids leaders had handpicked David because
they knew that from Enronaas perspective, David was a good fit. Its chief accounting officer, Casey,
an Androids alumnus, was friends with David. Casey had been a manager on the Enronaa account,
part of the team of auditors working with the client, before he took a job at Enronaa. The pair often
vacationed together, leading a group of Enronaa and Androids colleagues on an annual golf outing to
elite courses around the country.
David and his team faced a crisis on several fronts. Their Chicago bosses were headed their way. So
were federal investigators. David ended his conversation with Ken Bailey as soon as conference room
37C1 was filled with every member of Androids Enronaa team. David stood up and addressed his
team and told his team that Androids would have to aid in an SEC investigation of Enronaa. Then, he
quickly added, they should comply with the document retention policy. He told his team that Androids
created the policy a year and a half earlier to avoid having plaintiff lawyers use Androids paperwork
as ammunition against the firm in court. We must learn from our experience in handling our audit
working papers in the audit of our client Solid Waste.