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Cable provider Adelphia was one of the major accounting scandals of the early 2000s that led to the creation of the Sarbanes-Oxley Act. A key provision of the Act was to create a stronger ethical climate in the auditing profession, a consequence of the apparent role that auditors played in some of the scandals. SOX mandated that auditors cannot audit the same companies for which they provide consulting services, as this link was perceived to result in audit teams being pressured to perform lax audits in order to secure more consulting business from the clients. There were other provisions in SOX that increased the regulatory burden on the auditing profession in response to lax auditing practices in scandals like Adelphia (McConnell & Banks, 2003). This paper will address the Adelphia scandal as it relates to the auditors, and the deontological ethics of the situation.
Adelphia was once a privately-held firm of the Rigas family, but they took the firm public. When the firm went public, it became subject to a range of accounting regulations as it entered the jurisdiction of the Securities Exchange Commission. Adelphia was bound to adhere to generally accepted accounting principles (GAAP) in the preparation of its financial statements. As the scandal broke, it related primarily to the use of company funds for personal spending by the Rigas family. While such a practice might have been acceptable if the firm was family-run, it is not acceptable in a public corporation. The Rigas family and directors of the firm took steps to cover up this spending, including holding significant amounts of debt off of Adelphia's balance sheet. When one of its subsidiaries filed for Chapter 11 bankruptcy, Adelphia guaranteed the debt of that subsidiary, causing outrage among Adelphia shareholders who were unaware that this debt existed or that Adelphia was going to guarantee it (Barlaup, Dronen and Stuart, 2009).
As the investigation into the matter by regulators continued, more improprieties were revealed. There was a culture of lying about the financial condition of the company. Former executives revealed that figures were routinely invented in order that the company was able to meet the restrictive covenants on its debt, for example, allowing the Rigas family to continue to take out debt for the corporation and use that money to finance their own personal lifestyles. Complicit in this were the company's auditors, Deloitte.
Deloitte auditors were found lacking in their duties. As Barlaup (2009) notes, Deloitte ignored several red flags about Adelphia. In their audits, they should have encountered the suspiciously-luxurious lifestyle of the Rigas family, for example. Deloitte also ignored the fact that that company was often late with its financial statements, and failed to report key debt and other issues at all. When pressed to reveal certain information, Adelphia often refused. Deloitte failed to respond adequately to these events. It should have been more rigorous in its investigations of Adelphia, but it was not. As Barlaup (2009) notes, auditors have an obligation to treat with suspicion or at least skepticism all financial statement items, and to always remember that the possibility of fraud exists. Trained auditors, therefore, would have known that something was wrong with the statements of Adelphia, but approved of the statements anyway.
Deontological ethics rely on a standard of duty to determine the morally-correct outcome. The consequences of the actions are not relevant -- only whether the action was morally correct. This ethical theory rests on the idea that some actions are always unethical and therefore should never be conducted. This is the ideal ethical philosophy for the accounting profession, since auditors are obliged by law and by the governing bodies of the profession to uphold certain specific principles no matter the cost. These principles form the categorical imperative of the accounting profession. As Barlaup (2009) correctly notes, one such principle is that the auditors' duty is to the capital markets in general, not to the client. If there are problems with the financial statements, then the auditor must report them and deal with them, regardless of how it impacts the client.
One of the reasons why Sarbanes-Oxley sought to remove the link between auditing companies and consulting work is that the same company in the pre-SOX days would perform both tasks for the same client. The auditing work was by far the lesser of the two in terms of revenue, despite the importance of auditing to the integrity of the financial markets. The relationship between the auditing task and consulting revenue was that a poor audit score would reduce the amount of consulting work that the auditor would be hired to do. While Barlaup (2009) does not outline the consulting relationship that Deloitte had with Adelphia, it is clear that the possibility of consulting revenue was affecting the independence of the auditors.
Reduced auditor independence is at odds with the categorical imperatives surrounding the auditing profession. Auditors must address concerns that they have with the financial statements, but in this case they did not, even though the warning signs were quite obvious. Further, when Deloitte's auditors pushed for further information or clarification from Adelphia, they were often rebuffed. This would cause the auditors to sign off on the financial statements anyway, but express their reservations. The problem is that signing off on the statements was the one major discipline mechanism that the auditors had -- if they refused to sign off on the statements the company would run into problems with the SEC, but if they did sign off the likelihood of SEC investigation was greatly reduced.
Thus, the imperative exists within the auditing profession to stand tough with companies like Adelphia. Barlaup correctly recognizes this as a major problem in the Adelphia case -- Deloitte had concerns and reservations at times, but always approved of Adelphia's financial statements and never undertook the sophisticated, aggressive investigation that was required to uncover the depth of Adelphia's accounting fraud. As a result, the fraud continued for several years, until the subsidiary bankruptcy finally brought it to light. As a measure of ethical performance, Deloitte failed miserably to uphold the standards by which auditors must perform their duties.
The acts of the Adelphia executives were in clear violation of the shareholders' trust and that of the general investing public. The closeness of the executive group and the Board to the Rigas family was cited as one of the red flags Deloitte failed to address. The executives are bound by a duty to the shareholders of the company to pursue those strategies and tactics to maximize shareholder wealth, as per basic agency theory and explained by Milton Friedman in 1970. While such strategies can take any number of forms, outright fraud is not one of them. When fraud is discovered, the company typically faces such strong sanctions from the SEC and negative reaction from the market that shareholder wealth is eroded. In the short-run, fraud preserves shareholder value but never in the long run. Thus, any executive engaging in fraud is necessarily violating the categorical imperative to take actions that increase shareholder value.
The directors and executives allowed the Rigas family to use the company as its piggybank. They also allowed for the routine falsification of company documents. This practice became so widespread that it was part of the corporate culture at Adelphia. It was entirely predictable that undertaking such illegal actions would bring about the downfall of the company -- this occurred in 2002 -- so the directors and executives who participated in this fraud or were aware of it are culpable for violating the categorical imperative that dictates they have a duty to maximize shareholder wealth. Where Barlaup (2009) seeks to draw a conclusion that better knowledge of ethical theories might have led to a different outcome, I find that conclusion…[continue]
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