Coming on the heels of accusations that the SEC is trending toward less vigorous enforcement against financial reporting violations, the SEC published here and here its settlements with the two Arthur Andersen partners that planned and supervised the 2001 audit of WorldCom. Six years later, the settlements amount to little more than slaps on the wrist: both auditors were suspended from practicing before the SEC for at least three years, no monetary penalties were assessed, and no admissions of guilt were obtained. (By the way, one of the auditors has let his CPA license lapse, and the other is still licensed as a CPA in Mississippi.)
I have three questions for the SEC. First, why were these individuals allowed to settle without admitting or denying guilt in what appears to have been an open-and-shut case? Second, why were no monetary penalties assessed? Third, why did it take six years, with only this so-called "settlement" to show for all this time and, presumably, effort?
I’ll leave any kind of thorough treatment of the last two questions for future ruminations (feel free to do it without me!), and will focus henceforth on my dissatisfaction with a settlement that does not require auditors to admit to the public that they made inexcusable mistakes — in what was apparently a slam-dunk case.
Most readers will recall that the WorldCom accounting fraud was astonishing for both the magnitude of the errors in the financial statements, and the simplicity of the accounting. We’re not talkin’ ’bout complex financial arrangements, arcane consolidation, pension, stock option or revenue recognition rules; we’re talkin’ the third week of Accounting 101. We’re talkin’ about capitalizing telephone line access fees ("line costs") that should have been expensed. Over a number of quarters, $3 billion in payments that should have been reported as expenses on the income statement were parked in property and equipment (P&E) accounts on the balance sheet. The "top-side" accounting entries to effectuate the fraudulent misstatements circumvented internal controls and were made by accountants with the highest authority in the company.
The $3 billion capitalization of line costs was the first of the WorldCom accounting frauds to come to light, but it paled in comparison to the additional $8 billion of accounting misstatements that were subsequently discovered. As Cynthia Cooper, the whistle blower on the first $3 billion wrote in her recent book (I reviewed it here):
"…[top management at WorldCom] had a process called ‘close the gap,’ whereby they would compare quarterly revenue to Wall Street expectations, analyze potential items they could record to make up the difference, and book revenue items that had not been booked in the past."
Given the magnitude of the misstatements, it doesn’t seem possible that they could have occurred in the absence of a broken audit. The two Andersen partners on the WorldCom account were charged with violating the SEC’s own rules of professional conduct as they apply to accountants* who practice before the Commission: Rule 102(e). That also should have kept things relatively simple, as the case would be made before an administrative law judge; no interaction with the courts or other government agencies would have been required. I’m not a lawyer, but I think that the threshold standard of proof in such a case would have been the same as civil litigation, "preponderance of evidence."
Also, the SEC reached only for the low-hanging fruit when bringing their charges against the two audit partners, both of whom had been involved with WorldCom for a number of years. Basically, in addition to intentional, knowing or reckless conduct, the most difficult to prove, there are two other ways that an accountant can violate Rule 102(e):
- A single instance of highly unreasonable conduct that results in a violation of professional standards in circumstances in which the accountant should know that heightened scrutiny is warranted, or;
- Repeated instances of (merely) unreasonable conduct, each resulting in a violation of professional standards that indicate a lack of competence.
The SEC wisely chose the second of these two. All they wanted, and needed, to address was conduct in violation of the equivalent of the third week of Accounting 101, plus the third or fourth week of Auditing 101. At the risk of being tedious, but to educate my readers who are taking Auditing 101 and to make the point that the SEC must have had a slam-dunk case, here is but a sample of the SEC’s allegations:
- Andersen discovered fraud of a similar nature a year earlier, and affecting the same PP&E accounts. There were other strong indicators that fraud might occur, like the financial straits of the CEO, a history of aggressive accounting, and industry factors. Consequently, the engagement team classified overall audit risk as "maximum." However, substantive tests of PP&E , one of the most significant balance sheet categories, were not expanded.
- The auditor’s did not design or implement procedures to review top-side entries, evidently relying on management’s representation that there were no significant top-side entries–even though fraud via top-side entries took place just one year earlier.
- Additions to the PP&E accounts were only examined through the third quarter of 2001, and not as of the end of the fiscal year. $841 million of the fraudulent charges to PP&E occurred in the fourth quarter.
- A reconciliation of beginning and ending PP&E balances was not done. If the auditors had done so, they would have discovered that the $3 billion in fraudulent charges to PP&E were made in circumvention of normal approval processes.
- The expense accounts that were reduced by the top side entries were not reconciled to the financial statements and general ledger. "Had they done so, the auditors would have discovered that the line cost expenses they were testing were significantly larger than the line cost expenses reflected in WorldCom’s financial statements and general ledger."
Back to the Question
Let’s be generous, and presume that those who pull the levers at the SEC subjugate their personal interests for the public interest. Indeed, one could argue that there have been many cases where the SEC obtained the same monetary fines and sanctions — or maybe even more — in a settled action than it could have gotten in court. One of the reasons this may be the case is that many defendants have an economic disincentive to admit guilt in an SEC action. That’s because (once again, I’m not a lawyer) one who admits guilt to the government may not deny it in a private action — where the money penalties could be much bigger.
So, in many instances, it may actually serve the public interest to give defendants the option of settlement with the SEC without an admission of guilt; but, my point is that it is certainly not always the case. Now, ceasing to presume motives as pure as the driven snow, the SEC counts scalps, and a settlement containing an agreement to be sanctioned, however meaningless, counts as a scalp to be hung up before Congress and the world. Fewer settlements mean more trials, and more trials mean fewer scalps. Even considering the predisposition for scalps of any color, this case took six years just to get settled! And, how many defendants are coerced into settling without admitting or denying guilt just so the SEC can have their scalp, even though the accused parties truly feel they did nothing wrong, but need to get the matter put behind them?
Focusing specifically on the case of the WorldCom auditors, I can’t possibly see how the public interest was served by settling without a fine, and without an admission of guilt. If there was ever a case where the SEC could have sent an unequivocal message by making its case in court, this one was it. Can anyone say that more was gained by settling? Given the magnitude of the numbers, timing and other circumstances, can anyone say that the public does not rightfully want to know whether and how WorldCom’s auditors violated the basic standards of their profession?
And, not only is there a message opportunity, the public deserves more justice and closure. Will private litigation against these auditors take place? I doubt it, because their pockets probably aren’t deep enough to fund the private attorneys. Therefore, the argument of a defendant loathe to settle because of exposure to private litigation goes poof. Will the AICPA or state accountancy boards discipline these auditors? It’s been six years, and so far not a peep from them either — just one more reason we need the PCAOB.
For the SEC, it shouldn’t be about the money they collect in fines, or the number of years of sanctions they obtain from settlement, or even (and this is, I admit, controversial) about the sheer number of cases they bring. It should be about deterrence: the message sent by a case that will contribute to greater trust in the capital markets by reducing the risk of fraud. The reality, though, is that it is very convenient and self-serving to measure and report monetary fines,** volume of cases and years barred from practicing before the Commission. The flip side of this reality is that one cannot possibly measure how many frauds did not occur because of the threat of vigorous and consequential law enforcement. Ergo, the focus of bureaucrats on scalps; in the case of the 2001 WorldCom audit that misplaced focus results in giving unduly short shrift to deterrence.
*Note to students: the SEC rules of professional conduct apply to all accountants at public companies — not just their auditors.
**Well, maybe you can’t always measure the effectiveness of the SEC by the fines they mete out. See Jonathan Weil’s commentary in bloomberg.com on how he believes SEC Chair Cox inflated the numbers he reported in recent congressional testimony.