Source: https://www.sec.gov/litigation/admin/34-44444.htm
Timestamp: 2019-04-23 11:56:56+00:00

Document:
In anticipation of the institution of these administrative proceedings, Respondent has submitted an Offer of Settlement ("Offer"), which the Commission has determined to accept. Solely for the purpose of these proceedings, and any other proceeding brought by or on behalf of the Commission or in which the Commission is a party, and prior to a hearing and without admitting or denying the Commission's findings contained herein, except for the jurisdiction of the Commission over it and over the subject matter of these proceedings, which Respondent admits, Respondent consents to the entry of the findings and the imposition of the remedial sanctions set forth in this Order Instituting Public Administrative Proceedings, Making Findings, and Imposing Remedial Sanctions Pursuant to Rule 102(e) of the Commission's Rules of Practice ("Order").
This action arises out of Andersen's issuance of materially false and misleading audit reports on Waste Management, Inc.'s ("Waste Management" or "Company") financial statements for the period 1993 through 1996. During this period, the Company engaged Andersen to audit its financial statements included in its Annual Reports on Form 10-K filed with the Commission pursuant to the Securities Exchange Act of 1934 ("Exchange Act"). For each year 1993 through 1996, Andersen issued an audit report on Waste Management's financial statements in which it stated that the Company's financial statements were presented fairly, in all material respects, in conformity with generally accepted accounting principles ("GAAP") and that Andersen had conducted its audit of those financial statements in accordance with generally accepted auditing standards ("GAAS"). Andersen's representations were materially false and misleading.
The Andersen engagement teams that performed audits of the Company's 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 for 1993 through 1996, the engagement team had identified and documented numerous accounting issues underlying misstatements that the Restatement ultimately addressed, and had brought certain of those issues to the attention of the Consulted Partners. Because Andersen failed to ensure that all known misstatements were quantified and all likely misstatements were estimated, Andersen knew or was reckless in not knowing that the audits of the financial statements on which the Firm issued unqualified audit reports during those years were not conducted in accordance with GAAS.
As a result of the conduct of its partners, as described herein, Andersen 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. Andersen, thereby engaged in improper professional conduct within the meaning of Rule 102(e).
Arthur Andersen LLP is a national public accounting firm and, during the relevant period, maintained a principal office in Chicago, Illinois.
Waste Management, Inc. was a Delaware corporation with its principal place of business in Oak Brook, Illinois. Through its subsidiaries, Waste Management provided comprehensive solid and hazardous waste services, energy recovery services, and environmental technologies, engineering and consulting services.10 On July 16, 1998, Waste Management merged with USA Waste Services, Inc. The newly formed company retained the Waste Management name.11 At all times pertinent to the period covered by this Order, the common stock of Waste Management was registered with the Commission pursuant to Section 12(b) of the Exchange Act and traded on the New York Stock Exchange.
As early as 1988, members of Andersen's audit engagement team recognized that Waste Management employed "aggressive" accounting practices to enhance its earnings. In fact, certain of these practices violated GAAP. They included, among other things, Waste Management's repeated fourth quarter adjustments to reduce depreciation expense on its vehicles, equipment and containers cumulatively from the beginning of the year. Over time, the Waste Management engagement team identified other non-GAAP accounting practices. These practices included, among other things, the Company's adoption of a non-GAAP method of capitalizing interest on landfill development costs, its failure properly to 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 reserves (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, the Company deferred recognition of current operating expenses to future periods in order to inflate its current period income. Andersen's audit engagement teams identified and documented each of these practices at various times between 1989 and 1992.
In 1991, Andersen assigned Allgyer to become the audit engagement partner for the Waste Management engagement. Cercavschi, who had been on the Waste Management engagement team since at least as early as 1988, remained as the senior manager and continued on the engagement after he became a partner in 1994. In 1993, Maier became the concurring partner on the engagement.
Allgyer became a partner at Andersen in 1976, and thereafter served as the engagement partner on the audits of several large public companies. Between 1988 and the time he became the engagement partner on the Waste Management engagement in 1991, Allgyer had no public company engagement partner responsibilities, though he continued to serve as the advisory partner on several large public engagements during this period and thereafter. Andersen regarded Allgyer as one of its top "client service" partners. Andersen selected Allgyer to become the engagement partner because, among other things, Allgyer had "extensive experience in Europe" and demonstrated a "devotion to client service" and had a "personal style that . . . fit well with the Waste Management officers." During this time (and continuing throughout his tenure as engagement partner for Waste Management), Allgyer held the title of "Partner in Charge of Client Service" for Andersen's Chicago office and served as "marketing director." In this position, Allgyer coordinated the marketing efforts of Andersen's entire Chicago office including, among other things, cross-selling non-attest services to audit clients.
Earnings growth became more difficult for Waste Management in the late 1980s and early 1990s. In quarterly reviews, the engagement team observed that the Company had made adjustments to certain reserves (liabilities) by "borrowing" amounts from future quarters or by making unsupported and undisclosed changes in estimates to reduce operating expenses. In 1993, the Audit Division Head determined that Waste Management was a "high risk client." An unsigned report generated by Andersen's WinSMART system, a computerized risk management classification program using data input by the engagement team, classified Waste Management as a "high risk client" and indicated, among other things, that Waste Management "actively managed reported results," had a "history of making significant fourth quarter adjustments" to its financial statements, and was in an industry that required "highly judgmental accounting estimates or measurements." Andersen's Chicago office placed the Company on its "monitored client list" - a list that it used to monitor clients that posed a significant audit risk to the Firm.
Against this background, in 1993 and early 1994, Andersen audited Waste Management's 1993 financial statements. By February 1, 1994, the engagement team quantified current and prior period misstatements totaling $128 million, which, if recorded, would have reduced net income before special items by 12%. The engagement team prepared Proposed Adjusting Journal Entries18 ("PAJEs") in that amount for the Company to record in 1993.19 The engagement team also identified accounting practices that gave rise to other known and likely misstatements involving understatements of operating expenses for which it did not prepare PAJEs.20 The engagement team informed Maier of the PAJEs and accounting practices giving rise to the other known and likely misstatements. 21 The Company refused to record the PAJEs or to correct the accounting practices giving rise to the PAJEs and other misstatements and likely misstatements.
On February 3, 1994, Allgyer conferred with the Managing Partner of the Firm who, as noted above, also served as the advisory partner assigned to the Waste Management engagement.27 They reviewed the PAJEs and the "continuing audit issues," and the Managing Partner concurred in the decision to issue an unqualified audit report on the Company's 1993 financial statements. The Managing Partner further concurred in the decision that Allgyer should discuss with the Company changing its accounting practices and reducing the cumulative amount of the PAJEs in the future.
Following his consultations, Allgyer approached Waste Management and proposed a plan - in the form of a "Summary of Action Steps ("Action Steps") - to reduce, going forward, the cumulative amount of the PAJEs and to change, among other things, the accounting practices that gave rise to the PAJEs and to the other known and likely misstatements. For each accounting issue, the Action Steps identified the minimum steps Waste Management "must do" to correct the problem while also proposing two additional approaches - "reasonable" and "conservative" - to which the Company should aspire. The "must do" column specified the steps that the Company must do to write off the cumulative amount of the PAJEs over time - typically between five and seven years - and to change certain, but not all, of the accounting practices underlying the PAJEs and the other known and likely misstatements.
The accounting issues for which the Action Steps provided "must do" corrective steps were as follows: Self-insurance reserve; Closure/Post-closure reserve; Deferred Project Costs; Unamortized Land (NRV); Deferred Systems Costs; Income Tax Reserve; Environmental Reserve; Depreciation/Salvage Value; Landfill Capitalized Interest; and Discount Rates.28 This list included items that gave rise to PAJEs and other known and likely misstatements (although none of these items were specifically identified as such).
Prior to the Company's public announcement of its 1993 earnings, the Company's CEO agreed to the terms of the Action Steps. Allgyer then reviewed the Action Steps with Waste Management's CFO and CAO, both of whom (together with Allgyer) signed the Action Steps and initialed certain changes they had negotiated, including an extension of time to write off one misstatement that had been quantified as a PAJE. Allgyer then met with the Company's President and separately with its General Counsel to discuss Andersen's PAJEs and the Company's agreement to the Action Steps.
At Allgyer's direction, Cercavschi prepared a more detailed memorandum on February 11, 1994 (the "February 11th Memorandum"), memorializing their discussions with senior Company officials. The February 11th Memorandum discussed the PAJEs, certain of the other known and likely misstatements (though not identified as such), and various changes in estimate that contributed $100 million ($50 million of which resulted from reductions to the Company's depreciation expense and unsupported increases to salvage values) to earnings in 1993. The February 11th Memorandum also specifically discussed the Action Steps and described them as the "minimum changes we have concluded are necessary for WMX to implement immediately" and concluded that the Company's compliance with the "must do" items "brings the Company to a minimum acceptable level of accounting . . . ." Many of these "must do" items did not require immediate or complete correction of the misstatement or change of the accounting practice at issue but allowed Waste Management several years to correct the misstatement or to change the practice. The February l1th Memorandum noted that Allgyer would discuss the Action Steps and the other issues he had raised in the memorandum with the Company's audit committee.
Andersen's audit report on the Company's 1993 financial statements is dated February 16, 1994. The engagement team prepared a February 16, 1994 Final Engagement Memorandum, which described the Action Steps as an "action plan" that was "designed to improve the client's accounting methods" that "should result in more conservative accounting practices and lessen the amount of audit adjustments required in future audits." The memorandum further noted that the Company "has agreed to implement the `must do' action steps in 1994."
On February 21, 1994, Allgyer distributed the February 11th Memorandum and its attachments, including the signed Action Steps, to Maier and others. On March 14, 1994, Allgyer met with the Waste Management audit committee to review the results of the 1993 audit. The Office Managing Partner for Andersen's Chicago Office accompanied Allgyer to the meeting. Allgyer reported to the committee the amount of the passed adjustments and that discussions among senior management and Andersen had resulted in a "plan" to reduce the shortfalls over the next several years in a manner satisfactory to Andersen. Allgyer did not provide a copy of the Action Steps to the audit committee. On March 30, 1994, the Company filed with the Commission its 1993 Form 10-K enclosing Andersen's unqualified audit report.
In 1994 and early 1995, Andersen audited Waste Management's 1994 financial statements. During the audit, the engagement team quantified current and prior period misstatements for which it prepared PAJEs of $163 million,29 calculated on a "pre-tax equivalent basis," which it represented was equal to 11.7% of pre-tax income before special gains and accounting changes.30 In 1994, the Company continued to engage in the accounting practices that gave rise to the PAJEs and the other known and likely misstatements. The engagement team informed Maier of the PAJEs and the accounting practices underlying the other known and likely misstatements (for which the engagement team did not prepare PAJEs). The Firm's AOP Manual required Allgyer to consult with other partners. On January 19, 1995, Allgyer, Maier, and Cercavschi and two managers met with the Practice Director and the Audit Division Head to discuss the 1994 audit. They discussed their disappointment with the progress the Company had made to reduce the overall level of the PAJEs and questioned whether Waste Management had "taken the pill" yet.
At the meeting, the participants also discussed the Company's method of capitalizing interest on landfill development costs.31 Andersen had previously concluded that the Company's existing methodology violated GAAP32 and urged the Company to adopt a new one that conformed with GAAP, which the Company agreed to do in the Action Steps. In 1994, the engagement team reviewed the Company's proposed capitalized interest methodology that the Company planned to implement in 1995, and determined that the new method conformed with GAAP. Andersen concurred with the Company's characterization of the adoption of the new methodology as a prospective change in accounting estimate and the Company's determination to phase-in its adoption of the new methodology over a three-year period beginning in 1995. Andersen also concurred with the Company's plan to change from a non-GAAP method to a GAAP method without any disclosure of the change in the Company's financial statements because Andersen incorrectly concluded that this involved a change in estimate that was immaterial. The engagement team consulted with Maier, the Practice Director, and the waste industry expert in Andersen's Accounting Principles Group. All three partners concurred in the Company's treatment of the change in methodology as a change in accounting estimate and in the Company's non-disclosure of the change in its financial statements.33 The Practice Director further recognized that the phase-in did not conform with GAAP, but accepted it provided the amounts were not material.
In this meeting, the partners applied the roll-forward method to the 1994 PAJEs and concluded that the current period misstatements for which PAJEs had been prepared were not material. As a result, the partners determined that Andersen would issue an unqualified audit report on the Company's 1994 financial statements. In reaching this determination, the Engagement Partners did not seek quantification and estimation of the other known and likely misstatements (for which no PAJEs were prepared) that resulted from accounting practices previously noted in the Action Steps. Following the meeting, Allgyer consulted with the Managing Partner who concurred in the decision to issue an unqualified audit report. On March 13, 1995, Allgyer, Cercavschi and the Managing Partner attended the audit committee meeting to review the results of the 1994 audit. Again, no one from Andersen provided a copy of the Action Steps to the audit committee, but during the Firm's private session with the committee, Allgyer and the Managing Partner reported the amount of the passed adjustments and complained to the committee members that management had not performed the "plan" to reduce the shortfalls and change its accounting practices as it had agreed to do in the previous year. On March 30, 1995, the Company filed with the Commission its 1994 Form 10-K enclosing Andersen's unqualified audit report.
During 1995, the engagement team closely monitored the Company's implementation of the Action Steps by generating quarterly scorecards reflecting the Company's progress or, as was often the case, lack of progress in changing its accounting practices. In many instances, the Company continued to utilize accounting practices that did not conform with GAAP and did not implement the Action Steps.
On December 31, 1995, Waste Management exchanged its interest in a privately held subsidiary of ServiceMaster Master Limited Partnership ("ServiceMaster") known as Consumer Services for an interest in ServiceMaster itself, a publicly traded entity. This transaction resulted in a $160 million gain to Waste Management. In its 1995 financial statements, the Company used the gain to offset $160 million in unrelated operating expenses and misstatements that, in most instances, had been the subject of PAJEs in 1994 and earlier.34 The Company offset the misstatements and expenses against the gain in Sundry Income, Net. The amount netted represented 10% of 1995 pre-tax income before special charges. The Company made no disclosure of the netting in the notes to its financial statements or in management's discussion and analysis ("MD&A").
Waste Management consulted Allgyer and Cercavschi with respect to the accounting treatment for the ServiceMaster transaction, and informed them of its intent to net the expenses against the gain without disclosure in the financial statements. Allgyer and Cercavschi recognized that the Company's proposed treatment did not conform with GAAP and that "theoretically, the gain and the provisions [i.e. the current and prior period misstatements] should be reported separately in the consolidated income statement with discussion in the MD&A and footnotes." Nevertheless, they reached a preliminary determination that the matter was not material but recognized the need to consult with Kutsenda. Allgyer and Cercavschi consulted Kutsenda about the netting and whether Andersen would be required to qualify or withhold its audit report if the Company netted the ServiceMaster gain against the misstatements and did not disclose it. Kutsenda concluded that, although the netting did not conform with GAAP and the netted items would not be disclosed, Andersen did not need to qualify or withhold its audit report. He reasoned that the netting and the non-disclosure of the misstatements and the unrelated gain did not prevent the issuance of the unqualified audit report because he concluded, for various reasons, that they were not material to the Company's 1995 financial statements taken as a whole. In fact, these items were material. For example, the misstatements represented 10% of pre-tax income. Kutsenda did insist that, with respect to the gain and the charges, the Company "book [them] broad" on its general ledger, that is, record the gain and expenses to their respective categories for internal record keeping purposes, and that offsetting should only occur in the reported financial statements. Kutsenda agreed that Andersen could issue an unqualified audit report on Waste Management's 1995 financial statements.
By netting $160 million of current and prior period misstatements against the ServiceMaster gain, the Company reduced its 1995 misstatements. As a result, the engagement team proposed PAJEs at $67 million (on a pre-tax equivalent basis).35 Because the aggregate PAJEs were less than 8% of net income from continuing operations, Allgyer did not consult with the Practice Director and the Audit Division Head as he had in 1993 and 1994. Allgyer did consult, however, with Maier and the Managing Partner, both of whom, based on Kutsenda's determination with respect to the netting, concurred in the decision to issue an unqualified audit report on the Company's 1995 financial statements. On March 11, 1996, the Managing Partner accompanied Allgyer and Cercavschi to the audit committee meeting, at which Allgyer reviewed the results of the 1995 audit, including netting, with the audit committee. Included within the written agenda that Andersen furnished to the committee was a schedule of the misstatements which were netted against the ServiceMaster gain. The agenda also contained a scorecard identified under the heading "1993 Agreed-Upon Action Items Still in Process of Completion" which reflected the Company's failure to implement certain of the changes called for by the Action Steps. On March 29, 1996, the Company filed with the Commission its 1995 Form 10-K enclosing Andersen's unqualified audit report.
Several months after the completion of the 1995 audit and the Company's filing of its 1995 Form 10-K with the Commission, Andersen prepared a memorandum articulating its disagreement with the Company's use of netting gains and the lack of disclosure. The memorandum discussed the ServiceMaster transaction of 1995 and gains from other transactions in 1996 that were netted without disclosure. According to the memorandum, Andersen recognized that "[t]he Company has been sensitive to not use special charges [to eliminate balance sheet errors and misstatements that had accumulated in prior years] and instead has used `other gains' to bury charges for balance sheet clean ups." [Emphasis in original] Andersen memorialized its "position" by stating "[w]e disagree with management's netting of the gains and charges and the lack of disclosures. We have communicated strongly to WMX management that this is an area of SEC exposure. We will continue to monitor this trend, and assess in all cases the impact of non-disclosure in terms of materiality to the overall financial statement presentation and effect on current year earnings." Despite its concerns about the Company's use of netting, Andersen did not withdraw or modify its 1995 audit report or take steps to prevent the Company from continuing to use netting in 1996 to eliminate current period expenses and prior period misstatements from its balance sheet.
In 1996 and early 1997, Andersen conducted its audit of Waste Management's 1996 financial statements. Allgyer again served as the engagement partner for the 1996 Waste Management audit, and Cercavschi became the engagement partner for the Waste Management Groups. During the audit, Andersen quantified current and prior period misstatements of $105 million on a pre-tax equivalent basis, which equaled 7.2% of pre-tax income from continuing operations before special charges, and prepared PAJEs in that amount.38 Because the PAJEs fell below Andersen's 8% consultation threshold, Allgyer and Cercavschi did not consult with their senior partners.
Although Andersen disagreed with the Company's use of netting and the lack of disclosures, Waste Management continued to use netting. In 1996, the Company offset current period expenses and prior period misstatements against a portion of the gains realized 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 $85.1 million on the sales of the two subsidiaries. The engagement team prepared a Proposed Reclassification Journal Entry ("PRJE")39 in this amount, which, if recorded, would have further reduced pre-tax income from continuing operations before special charges by 5.9%.40 The Company refused to record the PRJE.
In addition to its PAJEs and PRJE, the engagement team once again identified accounting practices that gave rise to additional known and likely misstatements for which it prepared no PAJEs. In 1996, Waste Management 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. As a result of both not recording the PRJE and these known and likely misstatements, the Company reported operating income that was $114 million (after tax) more than its actual operating income - resulting in what the engagement team termed a "one-off" accounting problem.41 Allgyer and Cercavschi determined that Andersen would issue an unqualified audit report on the Company's 1996 financial statements. After conducting his concurring partner review, Maier concurred in their decision. On March 10, 1997, Allgyer presented the results of Andersen's 1996 audit to Waste Management's audit committee. Allgyer identified the "one-off, non-recurring income" problem and distributed an agenda in which he told the audit committee that "gains from sales of discontinued operations were improperly recorded through continuing operations" and that "the 1996 difference between reported ($857 million) and actual ($776 million) income from continuing operations of $81 million [or 16 cents a share] will have to be "replaced" through other sources in 1997." On March 29, 1997, the Company filed with the Commission its 1996 Form 10-K enclosing Andersen's unqualified audit report.
In late 1997, after top management had departed the Company, new management instituted a review of the Company's prior period financial statements. Based on this review, the Company determined to restate the Company's financial statements for the period 1992 through 1996 and the first three quarters of 1997. The Company retained Andersen to audit the restated financial statements. On February 24, 1998, Andersen issued an unqualified audit report on the restated financial statements.
An auditor's "ultimate allegiance" is to the corporation's shareholders and to the investing public, not to the Company's management or to its employment relationship with the client. United States v. Arthur Young, 465 U.S. 805, 817-818 (1984).42 When an auditor fails to stand up to management in the face of improper accounting practices but instead issues unqualified audit reports on financial statements that it knows or is reckless in not knowing are materially misstated, the auditor betrays its allegiance to the shareholders. This conduct elevates management's interests over those of the shareholders and, when publicly revealed, injures not only the shareholders but also the investing public's confidence in the integrity of an auditor's report and the audit process. Ultimately, it is self-defeating for an auditor to accommodate management's immediate interest in issuing materially misstated financial statements. Materially misstated financial statements certified by the auditor create false public perceptions of management's current performance and can create misplaced expectations of future results as well. Such misplaced expectations increase the pressure on management to continue to engage in improper accounting practices. Unless the auditor stands up to management as soon as it knows that management is unwilling to correct material misstatements, the auditor ultimately will find itself in an untenable position: it either must continue issuing unqualified audit reports on materially misstated financial statements and hope that its conduct will not be discovered or it must force a restatement or qualify its report and thereby subject itself to the liability that likely will result from the exposure of its role in the prior issuance of the materially misstated financial statements.
In this case, Andersen failed to stand up to management to prevent the issuance of materially misstated financial statements. Instead, Andersen allowed the Company to establish - and then continue for many years - a series of improper accounting practices. As a result, Andersen found itself in 1998 in the position of auditing the Restatement and issuing an unqualified audit report in which it acknowledged that the prior financial statements on which it had issued unqualified audit reports were materially misstated. Under the circumstances set forth in this Order, the Firm must be held responsible for the acts of its partners in the years preceding the Restatement and, accordingly, must be sanctioned.
During the 1993-96 time period, Andersen expressed its opinion that the Company's financial statements were fairly presented in conformity with GAAP and that the Firm's audits had been conducted in accordance with GAAS. Both representations were materially false and misleading.
As set forth above, prior to the year-end 1997 Restatement, the Company engaged in a broad range of non-GAAP accounting practices that materially understated expenses, did not disclose misstatements by, among other things, improper netting, and overstated income and other measures of financial success. The Company's financial statements for the period 1993 through 1996 contained numerous material misstatements that resulted from non-GAAP accounting practices that had been identified, if not quantified, during the Firm's audits, as evidenced by the Action Steps. By issuing an unqualified audit report on the Company's Restatement, Andersen acknowledged that the Company's original financial statements had been materially false and misleading when issued.
Within the inherent limitations of the audit process, the auditor must search for adequate evidence and diligently pursue any evidence suggesting the presence of irregularities and evaluate the evidence developed with an attitude of professional skepticism.
In this case, Andersen, as discussed above, failed to "diligently pursue . . . evidence suggesting the presence of irregularities" before concluding that the PAJEs were not material.
principles, the auditor should aggregate misstatements that the entity has not corrected in a way that enables him [or her] to consider whether, in relation to individual amounts, subtotals, or totals in the financial statements, they materially misstate the financial statements taken as a whole.
The aggregation of misstatements should include the auditor's best estimate of the total misstatements in the account balances or classes of transactions that he [or she] has examined (hereafter referred to as likely misstatement), not just the amount of misstatements he specifically identifies (hereafter referred to as known misstatement) . . . . If the analytical procedure indicates that misstatement might exist, but not its approximate amount, the auditor ordinarily would have to employ other procedures to enable him [or her] to estimate the likely misstatement in the balance or class.
If the auditor concludes that the aggregation of likely misstatements does not cause the financial statements to be materially misstated, he [or she] should recognize that they could still be materially misstated due to further misstatement remaining undetected. As aggregate likely misstatement increases, the risk that the financial statements may be materially misstated also increases... [The auditor] can . . . reduce this risk of material misstatement by modifying the nature, timing, and extent of planned audit procedures on a continuous basis in performing the audit.
GAAS, therefore, does not permit an auditor to avert his or her eyes from accounting practices which he or she knows or has reason to suspect may give rise to misstatements or likely misstatements. Before evaluating his or her audit findings for materiality, GAAS requires that the auditor estimate the "total misstatements" for the account balances and classes of transactions "that he [or she] has examined" to determine the extent of "likely misstatements." Even if the auditor determines that the aggregate misstatements are not material to the company's financial statements, he or she must recognize that as the aggregate misstatements increase, the risk of "further misstatement remaining undetected" also increases. Under these circumstances, the auditor must adopt appropriate audit procedures "on a continuous basis" to assure that the financial statements are free from material misstatement before issuing the audit report.
In this case, as discussed above, the PAJEs identified in connection with the Firm's 1993-96 audits did not capture the total misstatements and likely misstatements that resulted from non-GAAP accounting practices identified by the Engagement Partners prior to issuing the unqualified audit reports. In any event, assessments of materiality should never be purely mechanical. Quantifying, in percentage terms, the magnitude of a misstatement, regardless of size, is only the beginning of an analysis of materiality. It cannot appropriately be used as a substitute for a full analysis of all relevant, qualitative considerations, particularly where, as here, Waste Management had been assessed as a "high risk client" and there were numerous red flags and other indicia of irregularities in the Company's financial statements. Instead of ascribing sufficient weight to the other issues that were not listed as PAJEs and requiring additional audit procedures to determine whether there were additional misstatements in the account balances and classes of transactions that were audited, Andersen applied the "roll-forward" analysis to only those misstatements for which the engagement team listed PAJEs.
GAAS also makes clear that all auditors, not just those on the engagement team, must perform their work with due care: "Due care imposes responsibility upon each person within an independent auditor's organization to observe the standards of field work and reporting." AICPA, Codification on Statements of Auditing Standards, AU § 230.02. Although not part of the engagement team, when he was consulted by Allgyer and Cercavschi, Kutsenda was required under GAAS to exercise due professional care so that an unqualified audit report was not issued on financial statements that were materially misstated. Kutsenda knew, or should have known, that the netting of the ServiceMaster gain violated GAAP, that prior-period misstatements of which he was aware would not be disclosed to investors, that the impact of the netting on the Company's 1995 financial statements was material, and that an unqualified audit report on those financial statements was not warranted.
Through its partners, Andersen knew or was reckless in not knowing that the audit reports issued on the 1993-96 financial statements were materially false and misleading. Andersen knew or was reckless in not knowing that (a) the Company's financial statements were not presented in conformity with GAAP and (b) the Firm's audits of those financial statements were not conducted in accordance with GAAS. Yet, in each of those years, Andersen issued audit reports falsely representing that the financial statements and audits had satisfied the requirements of GAAP and GAAS, respectively.
Rule 102(e)(1)(ii) of the Commission's Rules of Practice, 17 C.F.R. § 201.102(e)(1)(ii), authorizes the Commission to sanction any person who is found by the Commission after notice and opportunity for hearing to have engaged in improper professional conduct.
Under principles of enterprise liability, the conduct of the partners who caused the Firm to issue the materially false and misleading audit reports is imputed to Andersen. The circumstances of this case, including the positions within the Firm of the partners who were consulted by the engagement team, the gravity and duration of the misconduct, and the nature and magnitude of the misstatements mandate that the Firm be held responsible for the acts of its partners in causing the Firm to issue false and misleading audit reports in the Firm's name. Accordingly, through its partners, Andersen engaged in improper professional conduct within the meaning of Rule 102(e).
On June 19, 2001, the Commission filed a complaint against Andersen and others in the United States District Court for the District of Columbia. SEC v. Arthur Andersen LLP, et al., No. 1:01CV01348 (JR) (D.D.C.). The Commission's complaint alleged, among other things, that (1) Andersen knowingly or recklessly issued materially false and misleading audit reports on Waste Management's financial statements for the period 1993 through 1996, and (2) as a result of this conduct, Andersen violated Section 10(b) of the Exchange Act, and Exchange Act Rule 10b-5. On June 19, 2001 the United States District Court for the District of Columbia entered a final judgment permanently enjoining Andersen from violating Section 10(b) of the Exchange Act, and Exchange Act Rule 10b-5. Andersen consented to the entry of the final judgment without admitting or denying the allegations of the Commission's complaint.
A. Respondent is hereby censured.
(1) The Commission may censure a person or deny, temporarily or permanently, the privilege of appearing or practicing before it in any way to any person who is found by the Commission after notice and opportunity for hearing in the matter: . . .
(A) Permanently enjoined by any court of competent jurisdiction by reason of his or her misconduct in an action brought by the Commission, from violating or aiding and abetting the violation of any provision of the Federal securities laws (15 U.S.C. §§ 77a-80b-20) or of the rules and regulations thereunder; . . .
(3)(iv) . . . A person who has consented to the entry of a permanent injunction . . . without admitting the facts set forth in the complaint shall be presumed for all purposes under this paragraph (3) to have been enjoined by reason of the misconduct alleged in the complaint.
2 The findings herein are made pursuant to the Offer that Andersen submitted and are not binding on any other person or entity in this or any other proceeding by the Commission.
3 Andersen's Central Region included its Chicago, Omaha, Kansas City and Indianapolis offices.
4 Other conduct by Andersen and certain of its partners relating to the audits of Waste Management's financial statements for the years 1992 through 1996 is described in the Commission's Complaint in SEC v. Arthur Andersen LLP, et al., No. 1:01CV01348 (JR) (D.D.C.) [Release No. LR-17039] (June 19, 2001) and the Commission's Order Instituting Public Administrative Proceedings, Making Findings, and Imposing Remedial Sanctions Pursuant to Rule 102(e) of the Commission's Rules of Practice in Robert G. Kutsenda, CPA, [Release No. 34-44448] (June 19, 2001).
5 The engagement team also consulted with and relied upon Andersen's waste industry expert in its Accounting Principles Group (a unit within Andersen available for consultation on significant accounting issues) concerning certain of the Company's accounting practices discussed herein. This partner's duties included responding "to inquiries [from the engagement team] concerning the appropriate interpretation of accounting principles and SEC rules and regulations."
6 Additionally, Waste Management restated its financial statements for the first three quarters of 1997 to correct a $250 million overstatement of pre-tax earnings. In the fourth quarter of 1997, Waste Management further recorded approximately $1.7 billion in impairment losses and other charges. All amounts in this Order are pre-tax unless otherwise noted.
7 Of these amounts, $1.17 billion of the pre-tax overstatement and $130 million of the tax expense understatement related to 1992 through 1996. In addition, approximately $260 million of the pre-tax overstatement and $48 million of the tax expense understatement related to 1991 and earlier periods.
8 This restatement related to the Company's understatement of its tax reserve and the overstatement of certain tax credits. As a result of restating prior period earnings, the Company also realized a tax benefit of approximately $517 million, which was offset against the restated tax expense in the Restatement.
9 Although the Restatement covered Waste Management's annual financial statements issued for 1992 through 1996, this Order concerns the Firm's audit reports for the periods 1993 through 1996. For the Commission's action relating to, among other things, Allgyer's conduct relating to Andersen's 1992 audit, see SEC v. Arthur Andersen LLP, et al., No. 1:01CV01348 (JR) (D.D.C.) [Release No. LR-17039] (June 19 2001).
10 On May 14, 1993, the Company changed its name from "Waste Management, Inc." to "WMX Technologies, Inc." On May 9, 1997, the Company changed its name back to "Waste Management, Inc."
11 On June 21, 2000, the Commission instituted and simultaneously settled administrative proceedings imposing a cease and desist order against the newly formed company. See In the Matter of Waste Management, Inc. [Release No. 34-42968] (June 21, 2000). The facts and circumstances giving rise to the order in that matter related to the new company's false and misleading earnings projections issued in 1999. The facts and circumstances giving rise to this Order relate solely to "old Waste Management," that is, to Waste Management as it existed prior to its merger with USA Waste Services, Inc.
12 In 1990, a former Andersen audit engagement partner for the Waste Management account became the CAO and Controller at the Company, a position that he held until mid-1997. At the time he left Andersen, he was the head of the division within Andersen responsible for conducting Waste Management's annual audit (but was not the engagement partner). After he left the Firm, responsibility for the audit shifted to a different division within Andersen. Similarly, a former Andersen manager who left the Firm in 1972 served as Waste Management's CFO until 1990, and also served as a member of the Company's Board of Directors between 1981 and 1997 and as a member of the audit committee between 1993 and 1997. Another former Andersen auditor who left the Firm in 1973 succeeded him as CFO in 1990 and served in that position until early 1997.
13 While at Andersen, most of these individuals worked in Andersen's "enterprise" group, the group responsible for auditing Waste Management's financial statements prior to 1991. All but a few of these individuals left Andersen more than ten years before the 1993 audit commenced.
14 As used herein, "audit fees" is defined as the aggregate fees billed by Andersen for the audit of Waste Management's annual financial statements and the reviews of Waste Management's quarterly financial statements (including certain audits and quarterly reviews of Waste Management's affiliate, Chemical Waste Management).
15 The $11.8 million in fees related to the following services: $4.5 million for "Audit work under ERISA," "Special purpose letters (EPA)," "Franchise audits and other reports," "Registration statements and comfort letters," "International Public Offering (including tax, consulting, domestic filing requirements and financial reporting)," "SFAS 106 and 109 adoption," "Accounting research/discussions," and "Other (Audit Committee meetings)"; $1.7 million for "Tax consultation (state, expatriate, other)"; $4.5 million for various consulting services, including $450,000 for "Information systems consulting"; and $1.1 million for miscellaneous other services.
16 Of $6 million in Andersen Consulting fees, $3.7 million related to a Strategic Review that analyzed the overall business structure of the Company and ultimately made recommendations on implementing a new operating model designed to "increase shareholder value." Allgyer was a member of the Steering Committee that oversaw the Strategic Review, and his time for these services was billed to the Company by Andersen Consulting.
17 Notes from Andersen's firmwide compensation committee reflect comments that since Allgyer "took over [Waste Management] . . . [Andersen and Andersen Consulting] have done . . . millions of [dollars of] work." These notes also reflect that Allgyer received his greatest increase in partnership compensation units in 1996. That increase was driven in part by the fact that Allgyer had been "aggressively recruited" by a major Chicago corporation for a Chief Operating Officer position that offered "significant . . . financial rewards." The increase in Allgyer's compensation also was driven by Allgyer's success that year in obtaining new audit, tax and financial consulting work, expected to generate more than $1 million annually over several years, from a public agency in Chicago.
18 A proposed adjusting journal entry is an adjustment proposed by the auditor to the company during the audit which, if accepted by the company, would correct a misstatement in an account balance or class of transactions contained in the company's books and records.
19 During the audit, the PAJEs ranged between 12% and 14.11% of income after taxes but before special items. The engagement team quantified final cumulative 1993 PAJEs which, if recorded, would have reduced income after taxes but before special items by 13%.
20 These unquantified misstatements included, among other things, amounts for deferred costs of impaired projects that should have been written off, land carrying values in excess of net realizable value, the Company's improper purchase acquisition accruals in connection with the establishment of environmental remediation reserves (liabilities), reversals of the environmental remediation reserves (liabilities) to income, and unsupported changes to the salvage values of the Company's waste vehicles and containers. The engagement team also knew of the Company's capitalized interest methodology, which Andersen knew did not conform with GAAP but which it had determined was not materially inaccurate. See infra note 32.
21 Pursuant to the AOP Manual, Maier's responsibilities as concurring partner included, among other things, the duty to read the Company's financial statements; the duty to discuss with the engagement partner significant accounting, auditing or reporting issues including controversial or complex accounting matters; the duty to review certain working papers, including risk analyses, final engagement memoranda, summaries of proposed adjusting and reclassifying entries, and the audit review questionnaire and the duty to inquire concerning "uncompleted audit procedures" and "open matters, if any, that could have a material effect on the financial statements or [the Firm's] auditor's report." In addition to these procedures, the AOP Manual provided that the concurring partner may be directed to perform "extended concurring partner review procedures on a particular high-risk engagement, such as a detailed review of selected working papers covering a sensitive audit area . . . for the purpose of evaluating the adequacy of the work performed and the documentation thereof." As risk management partner for the Chicago office, Maier's responsibilities included, among other things, supervising the risk management processes for high-risk clients and ensuring that risk management procedures were followed, participating in client acceptance and retention decisions, ensuring that practice directors were consulted when significant accounting, auditing or reporting issues arose, consulting with engagement teams on significant accounting, auditing and reporting issues, including any outstanding issues relating to the audit and reaching agreement with the engagement team on issuance of the auditor's report.
22 Pursuant to the AOP Manual, the Practice Director was a member of the "firmwide organization" and had "firmwide responsibilities" for Andersen's Chicago, Omaha, Kansas City and Indianapolis offices. As set forth in the AOP Manual, these responsibilities included, among other things, oversight of "quality and risk management processes," and consulting on "significant auditing, accounting, financial statement presentation and reporting problems encountered during an audit." The AOP Manual instructed the engagement partner to include practice directors "among those consulted on significant problems," such as when "the aggregate effect of passed adjustments was greater than 8% of net income from continuing operations."
23 The Audit Division Head's responsibilities included, among other things, reviewing and approving client acceptance and retention decisions, overseeing the quality of audits, managing client risk to the Firm, approving risk assessments, implementing firm policies and procedures and responding to requests to consult on significant, accounting, auditing and reporting issues. As the senior risk manager in the Chicago office, the Audit Division Head was responsible for ensuring that risk management procedures were followed. The Audit Division Head delegated the risk management and consultation responsibilities to Maier but retained responsibility for ensuring that Maier complied with all procedures.
24 The agenda for the meeting listed the following items as "continuing audit issues": "Deferred costs (systems, site/cell development, project costs, deferred start-up/other)," "Environmental and closure/post-closure exposure," "Interest capitalization methodology," "Tax rate," "NRV of Land," and "Discounting rates." The agenda did not identify these items as PAJEs or other known and likely misstatements (except for deferred costs, which was a PAJE).
25 The "roll-forward" method -- sometimes referred to as the "roll over" method -- is distinguishable from another analytical procedure for evaluating the materiality of audit findings known as the "iron curtain" method. Using the "iron curtain" method, the auditor aggregates the total misstatements, consisting of unadjusted misstatements arising in prior periods together with misstatements arising in the current period, and compares the aggregate amount to the income statement to determine whether the income statement is materially misstated. Andersen's AOP Manual expresses a preference for the "iron curtain" method and states that "reducing the total cumulative effect of current year passed adjustments by the amount passed in the prior year is ordinarily not acceptable when evaluating the materiality of current year passed adjustments." The AOP Manual further notes that Statement of Financial Accounting Standards (SFAS) No. 16 requires "that adjustments for amounts relating to prior periods be charged or credited in their entirety to the current period . . . ." (Emphasis added). During the audit of the Company's 1993 financial statements, Allgyer and Maier conferred with two of the Consulted Partners because the aggregate PAJEs exceeded 8% of net income from continuing operations. These Consulted Partners were presented with aggregate PAJEs (both current and prior periods) of 12% and then applied the "roll-forward" method to assess the materiality of the PAJEs. The "roll forward" method compares only the current period misstatements to the income statement. The partners determined that the current period misstatements were not material to Waste Management's 1993 income statement. They then compared the aggregate PAJEs (the prior and current period misstatements) to the balance sheet and determined that they were not material to that part of the financial statements. Regardless of whether the auditor uses the "roll-forward" or "iron curtain" method, Statement on Auditing Standards 47 requires the auditor to quantify all known misstatements and to estimate likely misstatements in the account balances and classes of transactions that the auditor has examined before making a materiality decision. Here, the additional known and likely misstatements beyond the PAJEs were not quantified, estimated, or even considered by the Engagement Partners in making their materiality decision.
26 At or shortly after this meeting, despite having learned of cumulative PAJEs of 12% of net income before special charges and other "continuing audit issues," the Audit Division Head signed, and thereby approved, a WinSMART risk assessment form setting Waste Management's risk classification at "moderate risk," in contrast to his prior view that it was a high risk client.
27 Andersen's AOP Manual advises the engagement partner that the "first source of counsel should be the local office," which "means the advisory partner (if any), the Accounting and Audit Division Head, the office managing partners and others" when significant accounting issues arise during an audit. Pursuant to the AOP Manual, the advisory partner's responsibilities included, among other things, the duty to provide counsel and advice to the engagement partner on problems that arose during the audit, the duty to remain aware of the client's business and accounting problems and, when considered necessary or otherwise desirable, to join the engagement partner in important meetings with the board of directors, the audit committee and top management, particularly meetings that included discussion of the client's financial statements or significant accounting problems or policies and the scope of the audit and the duty to keep the partners having firmwide responsibility informed when significant problems arise in any area of the Firm's practice. The Managing Partner of the Firm was responsible for all of the operations of Andersen. With respect to audits, the Managing Partner was the "final arbiter of any controversy among the partners" and had the ultimate and absolute authority to prevent the Firm from issuing any audit report in the Firm's name.
28 The Action Steps also instructed the Company to defer "special gains." In fact, the Company subsequently used one-time gains to offset, or "net," current and prior period misstatements and current period operating expenses as set forth below. Both the deferral and the netting violate GAAP.
29 The engagement team proposed a PAJE to correct the misstatement resulting from the Company's under-accrual of its tax liability. The engagement team grossed up the PAJE for the tax misstatement to a pre-tax equivalent and included the grossed up amount in calculating the $163 million total.
30 The engagement team calculated that the final cumulative 1994 PAJEs (both current and prior period) equaled 13.3% of pre-tax income on a pre-tax equivalent basis.
31 FAS 34 prohibits a company from continuing to capitalize interest on development costs once the asset becomes substantially ready for its intended use. Since 1989, the Company had been using a method of capitalizing interest pursuant to which it continued to capitalize interest on certain development costs over the life of the landfill.
32 Andersen accepted the Company's use of a non-GAAP method because it concluded that the net impact of the method on the Company's income statement was not materially different from what the impact would have been if the Company had been using a method that Andersen believed conformed with GAAP. Andersen accepted the Company's accounting treatment after comparing two methods of capitalizing interest - the Company's method and the method that Andersen believed conformed with GAAP - on a few unrepresentative landfills and then accepted the results as representative of the results that would have been obtained had the Company run the comparison on all 100 or more of its landfills.
33 In connection with its work on the Restatement, Andersen determined, pursuant to FAS 34 and APB 20, that the Company should have accounted for the change in methodology as a change in accounting principle and that it should have recorded a cumulative adjustment in the amount of $132 million as of January 1, 1995. Although they had reached materially different conclusions in 1995, both the Practice Director and Andersen's waste industry expert concurred with Andersen's conclusions in the Restatement.
34 GAAP did not and does not allow current period operating expenses or current or prior period misstatements to be offset against unrelated one-time gains. GAAP required the Company to record its current period expenses in their proper operating expense categories and not net them against an unrelated gain in "other income and expense." With respect to the correction of prior period misstatements, GAAP required that these misstatements, if material to the current period, be corrected in their proper expense category in the appropriate period with disclosure.
35 As it had done in the 1994 audit, the engagement team grossed up the PAJE for the tax misstatement. During the 1995 audit, the engagement team prepared an analysis reflecting that, in the absence of the netting of certain prior and current period misstatements against the ServiceMaster gain, the Company's cumulative misstatements (on a pre-tax equivalent basis) would have been equal to 13.9% of pre-tax income before special charges. As noted above, the netting by the Company reduced the misstatements resulting in the PAJEs to below 8% of net income from continuing operations.
36 A July 12, 1996 memorandum in Andersen's working papers notes that "[the Company] indicated that the quality of the second quarters earnings . . . was good - no adjustments had been made to create them . . . . However, [the Company] indicated that [it] was currently in the process of looking at its balance sheet for more income. [The Company] indicated that any such adjustments would be recorded . . . in consolidation."
37 The Company recorded the reduction at the corporate level but the books in the field were never adjusted to reflect the decrease in the reserves.
38 As it had done in prior audits, the engagement team grossed up the PAJE for the tax misstatement.
39 A proposed reclassification journal entry is a correction to an amount misclassified between line items in the financial statements. Although a PRJE does not affect net income or total shareholders' equity, it may affect certain components of the financial statements depending on where the misclassification occurs - the statement of income, statement of cash flows, or the balance sheet.
40 In addition to misclassifying gains on the sale of discontinued operations, the Company misclassified certain items to inflate its cash flow from operations. Andersen's working papers document $142.2 million in misclassifications of the Company's operating cash flow. The effect of these misclassifications was to overstate cash flow from operating activities by 7%, understate cash flow from investing activity by 14% and understate cash flow from financing activities by 2%. The engagement team incorrectly determined that these amounts were not material to the statement of cash flows.
41 The engagement team and senior management at the Company used the term "one-off" accounting generally to describe the Company's practice of making one-time adjustments benefiting reported operating income in the current period that the Company would have to "replace" in the following year in order to maintain the same level of reported earnings.
By certifying the public reports that collectively depict a corporation's financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation's creditors and stockholders, as well as to [the] investing public.
This `public watchdog' function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust.
465 U.S. at 817-818, 104 S.Ct. at 1503 (emphasis in original).
43 Citations to SAS 47 are to those provisions that were in effect during the period that the audits herein were conducted.

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