UNITED STATES OF AMERICA
Before The
SECURITIES AND EXCHANGE COMMISSION

SECURITIES EXCHANGE ACT OF 1934
Release No. 44444 / June 19, 2001

ACCOUNTING AND AUDITING ENFORCEMENT
Release No. 1405 / June 19, 2001

ADMINISTRATIVE PROCEEDING
File No. 3-10513

In the Matter of ARTHUR ANDERSEN LLP Respondent.

: : : : : : : :

ORDER INSTITUTING PUBLIC ADMINISTRATIVE PROCEEDINGS, MAKING FINDINGS AND IMPOSING REMEDIAL SANCTIONS PURSUANT TO RULE 102(e) OF THE COMMISSION'S RULES OF PRACTICE

I.

The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest that public administrative proceedings be, and hereby are, instituted against Arthur Andersen LLP ("Andersen," the "Firm" or "Respondent") pursuant to paragraphs (1) and (3) of Rule 102(e) of the Commission's Rules of Practice [17 C.F.R. § 201.102(e)(1) and (3)] ("Rule 102(e)").¹

II.

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").

III.

The Commission makes the following findings:²

A. SUMMARY

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.

Waste Management's financial statements were not presented fairly, in all material respects, in conformity with GAAP for 1993 through 1996. The Company used improper accounting to inflate its operating income and other measures of success, primarily by deferring the recognition of current period operating expenses into the future and by netting one-time gains against current and prior period misstatements and current period operating expenses. For each year 1993 through 1996, Andersen, as a result of the conduct of certain of its partners as described herein, knew or was reckless in not knowing that the Company's financial statements were not presented fairly, in all material respects, in conformity with GAAP but nonetheless approved the issuance of an unqualified audit report on the financial statements each year. Six Andersen partners were involved, at various times during the relevant period, in the issuance of unqualified audit reports on Waste Management's annual financial statements. Those partners were: Robert E. Allgyer ("Allgyer"), the engagement partner; Edward G. Maier ("Maier"), the concurring partner and the risk management partner for the Firm's Chicago office; Walter Cercavschi ("Cercavschi"), originally a manager and, as of September 1, 1994, an audit partner on the engagement, (Allgyer, Maier, and Cercavschi are hereinafter collectively referred to as the "Engagement Partners"); Robert G. Kutsenda ("Kutsenda"), the Practice Director for Andersen's Central Region³ ("Practice Director");⁴ the Managing Partner of the Firm ("Managing Partner") and the advisory partner to the engagement team; and the Audit Division Head for the Chicago office ("Audit Division Head") (Kutsenda, the Managing Partner, and the Audit Division Head are hereinafter collectively referred to as the "Consulted Partners").⁵

In February 1998, Waste Management announced that it was restating its financial statements for the five-year period 1992 through 1996 and the first three quarters of 1997 (the "Restatement"). To date, the Restatement is the largest in the Commission's history. In the Restatement, the Company admitted that through 1996 it had materially overstated

its reported pre-tax earnings⁶ by $1.43 billion and that it had understated certain elements of its tax expense by $178 million as follows:⁷

Vehicle, equipment and container depreciation expense	$ 509
Capitalized interest	192
Environmental and closure/post-closure liabilities	173
Purchase accounting related to remediation reserves	128
Asset impairment losses	214
Software impairment reversal	(85)
Other	301
Pre-tax total	$ 1,432
Income tax expense restatement8	$ 178

Andersen audited and issued an unqualified audit report on each of Waste Management's original financial statements and on the financial statements in the Restatement. By issuing an unqualified audit report on the financial statements in the Restatement, Andersen acknowledged that the Company's original financial statements for the periods 1992 through 1996 were materially misstated and that its prior unqualified audit reports on those financial statements should not be relied upon.⁹ In the Restatement, the Company admitted that it had overstated its net after tax income as follows:

Year Ending	Originally Reported (in thousands)	As Restated (in thousands)	% Overstated
12/31/92	$850,036	$739,686	14.9%
12/31/93	$452,776	$288,707	56.8%
12/31/94	$784,381	$627,508	25.0%
12/31/95	$603,899	$340,097	77.6%
12/31/96	$192,085	$(39,307)	100+%

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).

B. RESPONDENT

Arthur Andersen LLP is a national public accounting firm and, during the relevant period, maintained a principal office in Chicago, Illinois.

C. ISSUER

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.

D. FACTS

1. Background

Andersen audited Waste Management's annual financial statements since before Waste Management became a public company in 1971. Andersen regarded Waste Management as a "crown jewel" client. Until 1997, every chief financial officer ("CFO") and chief accounting officer ("CAO") in Waste Management's history as a public company had previously worked as an auditor at Andersen.¹² During the 1990s, approximately 14 former Andersen employees worked for Waste Management, most often in key financial and accounting positions.¹³

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.

Shortly after Allgyer's appointment as engagement partner, Waste Management capped Andersen's corporate audit fees at the prior year's level but allowed the Firm to earn additional fees for "special work." As reported to the audit committee, between 1991 and 1997, Andersen billed Waste Management corporate headquarters approximately $7.5 million in audit fees.¹⁴ Over this seven-year period, while Andersen's corporate audit fees remained capped, Andersen also billed Waste Management corporate headquarters $11.8 million in other fees, much of which related to tax, attest work unrelated to financial statement audits or reviews, regulatory issues, and consulting services.¹⁵ A separate but related entity, Andersen Consulting, also billed Waste Management corporate headquarters approximately $6 million in additional non-audit fees.¹⁶ In setting Allgyer's compensation, Andersen took into account, among other things, the Firm's billings to the Company for audit and non-audit services.¹⁷

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.

2. The 1993 Audit

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.

Andersen's Audit Objectives and Procedures Manual (the "AOP Manual") required that Allgyer consult with partners having firmwide responsibilities when cumulative PAJEs exceeded 8% of net income from continuing operations. As a result, on February 1, 1994, Allgyer and Maier consulted with the Practice Director²² and the Audit Division Head.²³ These partners reviewed and discussed the unrecorded PAJEs and what the engagement team identified as "continuing audit issues."²⁴ They determined that Andersen would nonetheless issue an unqualified audit report on Waste Management's 1993 financial statements. Applying an analytical procedure for evaluating the materiality of audit findings referred to as the "roll-forward" method, these partners determined that, because the majority of PAJEs concerned prior period misstatements, the impact of the PAJEs relating to current period misstatements on the Company's 1993 income statement was not material.²⁵ They instructed Allgyer to inform the Company that Andersen would issue an unqualified audit report. In addition, they instructed Allgyer to emphasize that Andersen expected the Company to change its accounting practices and to reduce the cumulative amount of the PAJEs in the future.²⁶

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.

3. The 1994 Audit

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.

4. The 1995 Audit

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.

5. The 1996 Audit

In 1996, the engagement team ceased monitoring the Company's implementation of the Action Steps. The Company continued to employ many of the non-GAAP accounting practices that it had previously used to manipulate its earnings and meet analysts' expectations. For instance, in its second quarter 1996 review, Andersen documented what became known as the "Second Quarter Sweep." After the field offices had closed their books, senior Company management canvassed the field controllers and requested that they identify any excess reserves (liabilities and asset valuations) that the Company could (and ultimately did) reverse into income.³⁶ As a result of the "sweep," on July 16, 1996, one day before it released its second quarter earnings, the Company improperly recorded a $29 million reduction of various reserve accounts (liabilities and asset valuations), which improved reported earnings of $.45 per share by approximately four cents per share.³⁷

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.

6. Subsequent Events

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.

E. LEGAL CONCLUSIONS

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.

1. Andersen's 1993-96 Audit Reports Were Materially False and

Misleading

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.

a. The Company's 1993-96 Financial Statements Were Not Fairly Presented in Conformity with GAAP

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.

b. Andersen's 1993-96 Audits Were Not Performed in Accordance with GAAS

It has long been settled that an auditor undertaking an examination of financial statements in accordance with GAAS has an affirmative obligation to plan and perform the audit so as to obtain sufficient competent evidential matter to afford a reasonable basis for the opinion on those financial statements. Statement on Auditing Standards No. 1, AU § 150.02; see also KMG Main Hurdman, 49 S.E.C. 668 (March 25, 1987) [Release No. 34-24257]. In Main Hurdman, the Commission observed that:

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.

As the Commission found in Main Hurdman, the existence of possible irregularities, even if determined not to be material, "reduce[s] the margin for error and should . . . cause[] the engagement team to view [the suspect transactions] in a more skeptical light." Id. Where, as here, the auditor has quantified misstatements and has prepared proposed adjusting journal entries, the auditor must include in his or her analysis an "estimate of the total misstatements in the account balances or classes of transactions that he has examined." Statement on Auditing Standards No. 47 ("SAS 47"), AU §§ 312.27 and 312.28.⁴³ SAS 47 provided, in pertinent part, as follows:

In evaluating whether the financial statements are presented fairly, in all material respects, in conformity with generally accepted accounting

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.

SAS 47, AU § 312.32 further provides, in pertinent part, that:

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.

2. Andersen's Responsibility

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.

3. Through Its Partners, Andersen Engaged in Improper Professional Conduct Within the Meaning of Rule 102(e)

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).

4. Settled Injunctive Action

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.

IV.

ORDER IMPOSING SANCTIONS

Based on the foregoing, the Commission deems it appropriate and in the public interest to accept the Offer of Settlement and accordingly,

IT IS HEREBY ORDERED, effective immediately, that:

A. Respondent is hereby censured.

By the Commission.

Jonathan G. Katz
Secretary

Footnotes