Don’t Blame Joe Berardino For Arthur Andersen

Bela Barner

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Answering To a Higher Authority

Core Values are not convenient slogans that can be invoked to rally employee morale or impress clients. Firms that have core values live by them, and often pay a significant price for doing so. Within a year of opening his accounting firm, Arthur Andersen himself refused to certify the skewed accounts of a large railroad client. Despite the insistence and eventual threats of the railroad president, Mr. Andersen simply replied that no amount of money could make him approve bad bookkeeping. Arthur Andersen lost the client, but laid a piece of foundation that would serve the firm for decades to come.

This is the first evidence of Arthur Andersen’s core value of independence. The firm endowed itself with the courage to say “no” to clients, even at the risk of losing their business, because Arthur Andersen felt that its true customers were shareholders. Typical of core values, Mr. Andersen’s insistence on rigorously applying the standards of public accounting embedded itself in the fabric of his firm. Its lore sent an unmistakable message to college graduates hired into the firm. Mr. Andersen urged his staff to “think straight, talk straight”, suggesting that the firm’s business left little room for interpreting the books beyond what was specified by the rules of the profession.

It is not unusual that Arthur Andersen inherited its founder’s steadfast belief in rendering audit opinions irrespective of clients’ sometimes-pointed interests. Many start-up firms adopt the personal values of their founders. What transforms a founder’s belief into a core value is, among other things, its ability to transcend generations of leadership. Arthur Andersen probably had an even more dogmatic believer in independence in its second leader, Leonard Spacek.

Spacek was even more outspoken against the audit industry’s chummy client relationships than his predecessor. He was purportedly even more blunt with clients, at one point informing a client that Price Waterhouse would be a better choice than his own firm for a specific piece of accounting expertise. In a famous speech to railroad industry controllers in 1957, Spacek railed against the industry’s self-serving accounting standards so daringly that some of his peers outside the firm tried to revoke his accounting license for defaming the profession. They failed.

For Arthur Andersen, living its core value of independence went well beyond the act of its top leaders carrying its brazen message to clients and industry counterparts. The firm’s Professional Standards Group was endowed with the final say on any and all of the complex accounting issues facing its army of auditors. It was no coincidence that this group was comprised of the firm’s most technically astute partners—and not its rainmakers.

This group’s sense of purpose enabled Arthur Andersen to continue to lead the industry in establishing conservative standards on controversial issues, often to the chagrin of its competitors. In the late 1970’s, the firm virtually single-handedly ordered that the immensely successful IBM 360 computer be amortized over five years, instead of the then-accepted ten years. Arthur Andersen also pushed for a revised bank loan accounting standard that many predicted would anger the firm’s clients. The rule was eventually adopted, and the clients stuck around.

Arthur Andersen found that rigorous auditing paid off. The firm grew rapidly. By 1970, the firm had offices in 27 countries employing more than 10,000 people and generating enough revenue to make it the second largest audit firm behind Peat Marwick. Rapid growth posed new problems, and the firm worked vigorously to establish and maintain standards for audit quality and consistency across its expanding empire. During this period, the firm developed the slogan “One Firm, One Mind” to signify its dedication to professionalism and adherence to its standards. Like many visionary firms that expend considerable energy and resources to preserve their core, Arthur Andersen recruited young, trained heavily, and fostered a culture that bred a sense of upholding a higher responsibility to the investing public.

Cracks in the Foundation

It was also during the 1970’s that the firm introduced its double wooden doors as a symbol of confidentiality—and separation—from its clients and industry peers. Perhaps the thick double doors were also an indication of the difficult challenges to come. Recession brought on stiff price competition and stalling audit revenues. Lawsuits by disgruntled shareholders over the business failures of some high-risk clients instigated a legal battle with the SEC that some claim created an adversarial relationship that lasted for decades.

These events were the first visible tremors of forces that would continually shake the firm over the next thirty years. The opposing forces of a stagnating audit business and a rapidly growing consulting business created a “stress” fracture along these practice lines. This was not the case of an upstart group of partners splintering off in a new direction in an opportunistic bid to recharge revenue growth. Rather, it was the inexorable and accelerating build-up of two forces moving in opposite directions. Arthur Andersen’s consulting roots extended back to 1942, when it launched its Administrative Accounting division. In 1954, the firm installed arguably the first-ever computerized accounting system in a project for General Electric. By 1968, consulting fees totaled 23% of firm revenues. By 1979, that figure had reached 42%.

Still, Arthur Andersen continued to be guided by its belief in independence above all else. In 1979, the SEC, increasingly concerned about potential conflicts of interest posed by audit firms performing non-audit services, suggested that clients disclose the amount and percentage of non-audit fees paid to its auditors. Not to be outdone, Arthur Andersen’s leadership proposed an even more radical step: completely separate audit and non-audit practices. Harvey Kapnick, the firm’s third leader, was well aware of the ethical stresses within the partnership created by the consulting practice. He proposed a spin-off of the consulting business into a sister firm.

Kapnick was confident that his proposal would be accepted by the partnership at the firm’s annual meeting. Instead, it caused uproar. The audit partners loudly refused to let go of the golden consulting goose. Kapnick resigned in disgust. The fault line was now plainly visible.

It would be dangerous to cite this event as the point in Arthur Andersen’s history when its trajectory changed from being a champion of shareholders’ rights to veering toward an ethical wilderness. It was, however, an opportunity for the firm to look into the mirror and perhaps recognize the forces that were challenging its fundamental beliefs. As it was, the unresolved question about mixing audit and consulting services with clients was allowed to fester.

And fester it did. In 1984, Arthur Andersen’s consulting business generated more profit than its auditing business for the first time in the firm’s history. In 1989, Arthur Andersen formally separated its audit and consulting practices by creating two firms under an umbrella firm. By this time, it was clear that the firm was no longer of “one firm, one mind.” The firm had lost its center of gravity, and was now unbound and free to fall in any direction.

By the 1990’s, the direction was clear. Partners in both the audit and consulting practices witnessed the strained marriage erupt into a bitter power struggle at the top. It then began to spiral toward divorce. Both sides began devoting increasing time and energy to preparing for life after the final break-up. To say that these events were a distraction would probably be an understatement.

In the meantime, the Professional Standards Group, once the map and compass for pinpointing the firm’s direction on sensitive accounting issues, saw its authority vanish. In 1992, the firm’s top managers instructed the Accounting Principles Group to rethink its conservative position on expensing stock options. Ten years before, the mere act of challenging this group would have been unthinkable. Now, its opinions barely seemed to matter. Perhaps the final insult to the group was the removal of Professional Standards Group partner Carl Bass from the Enron account at the client’s request, after Bass had raised serious concerns about some of Enron’s policies.