Case #2.

2 - Waste Management Due Professional Care

Case #2.2 Waste Management Due Professional Care

I. Technical Audit Guidance
To maximize the knowledge acquired by students, this book has been designed to be read in
conjunction with the post-Sarbanes-Oxley technical audit guidance. All of the post-SarbanesOxley technical guidance is available for free at http://www.pcaobus.org/Standards/index.aspx.
In addition, a summary of the Sarbanes-Oxley Act of 2002 is also available for free at
http://thecaq.aicpa.org/Resources/Sarbanes+Oxley/Sarbanes-Oxley++The+Basics.htm.
II. Recommended Technical Knowledge
The Sarbanes-Oxley Act of 2002
Section 203
Section 206
Generally Accepted Auditing Standards
The Second General Standard (Independence)
III. Teaching Hints
This case provides students with the opportunity to understand what is meant by an audit
firm exercising due professional care in completing the audit and the consequences associated
with a failure to do so. In addition, the case provides a mechanism to illustrate auditor
independence and why it is important to the audit profession. More specifically, the case
provides students with an opportunity to understand how a lack of independence may impact the
objectivity of auditors and potentially lead to biased professional judgments. Finally, the case
provides a context to discuss what is meant by an adjusting journal entry proposed by an auditor.
To meet these objectives, this case illuminates a number of relevant issues about the business
relationship that existed between Arthur Andersen and Waste Management, the quality control
review process at Arthur Andersen and Waste Managements refusal to record adjusting journal
entries proposed by Arthur Andersen.

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We believe it is essential for students to carefully read over the recommended technical
knowledge, along with this case reading. The educational psychology literature suggests that the
acquisition of technical/factual type knowledge increases dramatically when such knowledge can
be applied in a realistic context. Thus, we urge instructors to use this case as a mechanism to
impart the relevant technical audit knowledge, as outlined above.
This case assignment will work best if is scheduled to coincide with the auditors'
professional responsibilities topic or the independence topic in the auditing course. The case can
also be used in conjunction with a discussion of the importance of quality control at an audit
firm. Alternatively, the case could be used when discussing the completion of the audit topic to
illustrate the issues involved in forcing the clients to record adjusting journal entries.
Overall, we believe that it is helpful for students if instructors introduce the notion of an
auditor's responsibility to financial statement users before discussing how a lack of independence
can potentially bias an auditor's professional judgments. Specifically, we suggest that instructors
do everything possible to illustrate the tension that auditor's face when attempting to maintain an
attitude of independence during the financial statement audit. Students need to realize that the
nature of the auditing process sometimes makes it difficult to remember that your primary
responsibility when completing an audit is to financial statement users, not to client personnel.

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We recommend that instructors spend time in class discussing the nature of the quality
assurance at an audit firm. This discussion can be accomplished quite effectively while going
over the response to question number two in the case. In addition, depending on the point of the
semester that this case is used, instructors should also consider spending class time explaining
the nature of the adjusting journal entries proposed by auditors. Again, this can be accomplished
quite effectively while going over the response to question three in the case. Finally, the subject
of materiality can be raised in class when discussing whether Andersen should have forced Waste
Management to record the adjusting journal entries.
Each of these points can also be used to help discuss the difficulties associated with
professional judgments made by auditors and just how important it is to be unbiased in making
all decisions. Indeed, what makes this tension more pronounced is the subjectivity that is
inherent in many professional judgments made be auditors. The overriding objective of this
discussion is to get students to think about the types of professional judgments that auditors
make (e.g., requiring the client to record adjusting journal entries) and then to demonstrate how a
lack of independence can impact the final professional judgment. To facilitate class discussion in
this regard, it is useful to talk about the subjectivity that is inherent in an auditor's application of
Generally Accepted Auditing Standards. In addition, it may also be useful to talk about the
subjectivity inherent in the application of Generally Accepted Accounting Principles. Both
aspects of subjectivity characterize the environment that auditors make decisions within and it
absolutely essential that auditors are independent in all areas.

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4.

Please refer to Section 203 and Section 206 of SARBOX. How would these sections of the law have impacted
the Waste Management audit? Do you believe that these sections were needed? Why or why not?

IV. Assignment Questions & Suggested Answers

1. Refer to the second general standard of Generally Accepted Auditing Standards
(GAAS). What is auditor independence and what is its significance to the audit
profession? In what ways was Arthur Andersens independence potentially
impacted on the Waste Management audit, if any?
According to the second general standard of Generally Accepted Auditing Standards, In all
matters relating to the assignment, an independence in mental attitude is to be maintained by the
auditor or auditors. Unfortunately, the facts of the case reveal numerous issues that suggest that
Andersen's independence may have been compromised on the Waste Management audit.
For example, at Andersen, the compensation of partners depended on their ability to crosssell other services to its audit clients. More than half of the fees for Waste Management were
charged for non-audit services. The size of the nonaudit fees would likely have made it hard for
the Andersen partners to challenge Waste Management's team on the difficult accounting issues.
In addition, more than fourteen former Arthur Andersen accountants were working at
Waste Management. Several were in senior executive positions, including Thomas Hau, the
chief accounting officer. Another concern is how Robert Allgyer was chosen for the engagement.
He was chosen based on his personal style that fit well with the Waste Management officers.

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Article IV of the AICPA Code of Conduct (Objectivity and Independence) states: A

member in public practice should be independent in fact and appearance when providing
auditing and other attestation services. Close relationships might affect independence in
appearance, even if independence in fact is maintained. Clearly there was cause for concern at
Waste Management.
2. Considering the example in the Waste Management case, please explain why a
review by the Practice Director and Audit Division Head is important in the
operations of a CPA firm. In your opinion, was this review effective in the present
context? Why or why not?
A review by the Practice Director and Audit Division Head serves as a quality control
mechanism for the audit as the work of the engagement partner and concurring partner are
reviewed. Since the practice director and audit division head are not directly involved with the
engagement, each professional is in a position to provide an unbiased opinion on all work
completed.
This type of review is important because of the specialized knowledge possessed by each
professional. Thus, this review, if conducted effectively, can reduce the exposure of the firm to
financial loss resulting from litigation, customer complaints and loss of reputation due to
intentional or unintentional errors in an individual engagement. Indeed, an effective control of
this type helps to ensure that individual partners conform with a firms best practices and that
GAAP was properly and consistently applied on the engagement.
In this case, the review does not appear to have been effective as Andersen issued an
unqualified opinion on Waste Management when misstatements of $128 million or 12% of net
income were not deemed material by Andersen.

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3. Please explain what is meant by an auditors proposed adjusting journal entries

(PAJEs). Do you believe that Andersens final decision regarding the PAJEs was
appropriate, under the circumstances? Would your opinion change if you knew that
all of the adjustments were based on subjective differences (e.g., a difference in the
estimate of the allowance for doubtful accounts), as compared to objective
differences (e.g., a difference in the account receivable balance of their biggest
customer)?
PAJEs or Proposed Adjusting Journal Entries refer to the adjustments recommended by
the auditors for the clients financial statements to comply with GAAP. These entries are used as
a mechanism to correct an account balance that is not recorded in accordance with GAAP. The
decision made by Andersen regarding the PAJEs was inappropriate under the circumstances
because the differences would likely have mattered to financial statement users. Andersen
partners had a high level of professional training and experience in adhering to professional
standards. As a result, it is surprising that they did not require the adjustments to be recorded.

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Because of the magnitude of the adjustments, taken together, it probably would not have
mattered if the adjustments were based on subjective as compared to objective differences
discovered by Andersen. It is important to point out that the PAJEs resulted in an overstatement
of net income by 12 percent. So, regardless of subjective differences or objective differences,
the proposed adjustments were material in nature and would have resulted in a change in
earnings per share. It is however important to point out that the subjective differences often lead
to negotiation between the auditors and the client, where the objective difference typically do
not. And, it is during these negotiations where an auditors independence is truly put to the test.
This is a terrific opportunity to bring up this tension in class and illustrate the difficulties of
maintaining an independent and objective mind as an auditor.
4. Please refer to Section 203 and Section 206 of SOX. How would these sections of the
law have impacted the Waste Management audit? Do you believe that these sections
were needed? Why or why not?
Section 203 of the Sarbanes-Oxley Act requires audit partners to rotate off an audit
engagement after five years. Section 206 says that the CEO, Controller, CFO, Chief Accounting
Officer or person in an equivalent position cannot have been employed by the companys audit
firm during the 1-year period (the cooling off period) proceeding the audit.

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Many believe that this law goes far enough, and that the audit firm itself should not have to
rotate off an audit engagement every five years. Arguments against the rotation of the audit firm
argue that forcing audit firm rotation every five years would be too chaotic and the costs for both
audit firms and clients would be significant. Audit firms incur substantial costs in the first
couple years of an audit engagement as they are acquiring information about the firm, its
industry and its internal control system for the first time. Requiring audit firms to switch every
five years would inflate audit costs as firms would constantly be in the process of performing due
diligence and researching their clients. The inflated costs of performing the audit would
undoubtedly be passed onto clients. Another argument against audit firm rotation is that
requiring firms to switch may be counterproductive in that fraud may actually be harder to find
as the new audit firm is not as familiar with the clients business processes, risks, and attitude of
management.
Waste Management had several employees who were formed employees of Arthur Andersen.
In addition, every chief financial officer and chief accounting officer at Waste Management until
1997 was a former auditor of Andersen. Section 206 of SOX would have affected Waste
Managements chief officers since the former Andersen employees would have had to wait at
least one year before stepping into the position.

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Arguments supporting section 203 and 206 believe these sections are needed in order to keep
a respectable distance between the client and audit firm. Rotating partners every 5 years will
make it harder for employees of the audit firm to create close relationships with employees at the
client company. This distance helps create an image of independence. Section 206 also supports
the argument of independence. By requiring former audit employees to wait one year before
stepping into a C position it creates an image of independence. The former employee can take
time off the engagement and employees still on the engagement have time to make changes to
procedures and such; this way the former employee does not know every procedure being done
and is at a far enough distance to be out of the loop. If the former employee stepped into the
position right away he would know all of the audit procedures being used and could inform other
members of management of how to hide fraud and other scandals from the auditors.
The key arguments against section 203 and 206 support the overarching belief that rotating
partners is too costly. A student may argue that if partners are rotated every 5 years there will
always be a learning curve which will slow down the audit, creating higher costs for clients and
audit firms. A student may also argue that making a former employee wait at least one year
before stepping into an influential position at the former client is costly to the client. In addition,
a student may argue that it is better for the former audit employee to be in the position right away
this way no current knowledge of the company is lost.

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