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Harvard Case - Consulting by Auditors (A): Levitt's Campaign

"Consulting by Auditors (A): Levitt's Campaign" Harvard business case study is written by Ashish Nanda, Kimberly A. Haddad. It deals with the challenges in the field of Negotiation. The case study is 18 page(s) long and it was first published on : Dec 6, 2000

At Fern Fort University, we recommend that Arthur Levitt, the Chairman of the Securities and Exchange Commission (SEC), proceed with his campaign to reform the accounting profession. This campaign should focus on enhancing auditor independence, promoting transparency and accountability, and strengthening corporate governance. While the campaign will face resistance from the accounting industry, the potential benefits for investors, the economy, and the public trust outweigh the challenges.

2. Background

This case study focuses on Arthur Levitt's campaign to reform the accounting profession in the late 1990s. The campaign was driven by concerns about the growing number of accounting scandals, fueled by a lack of auditor independence and a desire to manipulate financial statements for personal gain. The case highlights the conflict between the SEC, representing the interests of investors and the public, and the accounting industry, which sought to protect its own interests.

The main protagonists are Arthur Levitt, the SEC Chairman, and the accounting industry, represented by the American Institute of Certified Public Accountants (AICPA) and individual accounting firms.

3. Analysis of the Case Study

This case can be analyzed through the lens of Corporate Governance, Business and Government Relations, and Game Theory.

Corporate Governance: The case highlights the critical role of corporate governance in ensuring ethical and transparent business practices. The lack of independent audits and the prevalence of accounting manipulations demonstrate the breakdown of corporate governance mechanisms.

Business and Government Relations: The case showcases the complex relationship between the government, represented by the SEC, and the business sector, represented by the accounting industry. The SEC's role in regulating the accounting profession is crucial for maintaining investor confidence and protecting the public interest.

Game Theory: The case can be viewed as a game of strategy between the SEC and the accounting industry. Both parties have their own objectives and strategies, and the outcome depends on their actions and reactions. The SEC seeks to promote transparency and accountability, while the accounting industry seeks to protect its interests and maintain its reputation.

Key Issues:

• Auditor Independence: The case highlights the lack of auditor independence, as accounting firms were often beholden to their clients, leading to conflicts of interest.
• Accounting Manipulation: The case exposes the prevalence of accounting manipulation, where companies used creative accounting practices to inflate their profits and mislead investors.
• Corporate Governance Failures: The case reveals the failures of corporate governance mechanisms, including weak internal controls and a lack of oversight.
• Public Trust: The case underscores the importance of public trust in the financial system and the damage caused by accounting scandals.

4. Recommendations

1. Strengthen Auditor Independence: The SEC should implement stricter regulations to enhance auditor independence. This could include:

   • Rotation of Audit Partners: Requiring regular rotation of audit partners to prevent close relationships with clients.
   • Prohibition of Non-Audit Services: Banning accounting firms from providing non-audit services like consulting to their audit clients, to avoid conflicts of interest.
   • Increased Oversight: Establishing a more robust oversight mechanism for accounting firms, including increased scrutiny and audits by the Public Company Accounting Oversight Board (PCAOB).

2. Promote Transparency and Accountability: The SEC should focus on promoting transparency and accountability in financial reporting. This could involve:

   • Enhanced Disclosure Requirements: Requiring companies to disclose more detailed and transparent financial information, including off-balance sheet items and risk factors.
   • Increased Penalties for Fraud: Imposing stricter penalties for accounting fraud and other financial misconducts to deter such behavior.
   • Improved Corporate Governance Practices: Encouraging companies to adopt stronger corporate governance practices, including independent board oversight, internal controls, and whistleblower protections.

3. Strengthen Corporate Governance: The SEC should work with the business community to strengthen corporate governance practices. This could include:

   • Mandatory Corporate Governance Standards: Implementing mandatory corporate governance standards for all publicly traded companies, including requirements for independent board directors, audit committees, and internal controls.
   • Shareholder Activism: Encouraging shareholder activism to hold corporate management accountable for their actions.
   • Executive Compensation Reform: Reforming executive compensation structures to align executive incentives with long-term shareholder value creation.

5. Basis of Recommendations

These recommendations are based on the following considerations:

1. Core Competencies and Consistency with Mission: The SEC's core competency lies in regulating the financial markets and protecting investors. The recommendations align with its mission to ensure fair and transparent markets.
2. External Customers and Internal Clients: The recommendations directly benefit external customers, investors, and the public, by restoring trust in the financial system. They also benefit internal clients, the SEC staff, by providing them with stronger tools to enforce regulations.
3. Competitors: The recommendations do not directly target competitors, but they aim to create a level playing field for all companies by ensuring fair and transparent accounting practices.
4. Attractiveness ' Quantitative Measures: While it is difficult to quantify the benefits of these recommendations, they are expected to lead to increased investor confidence, reduced fraud, and a stronger economy.

6. Conclusion

Arthur Levitt's campaign to reform the accounting profession was a necessary and timely response to the growing problem of accounting scandals. The recommendations outlined above provide a framework for the SEC to achieve its objectives of enhancing auditor independence, promoting transparency and accountability, and strengthening corporate governance. By implementing these reforms, the SEC can help restore investor confidence, protect the public interest, and create a more stable and sustainable financial system.

7. Discussion

Alternatives:

• Self-Regulation: The accounting industry could have been allowed to self-regulate, but this approach has proven ineffective in the past.
• Minimal Intervention: The SEC could have taken a more hands-off approach, but this would have risked further erosion of public trust in the financial system.

Risks:

• Resistance from the Accounting Industry: The accounting industry is likely to resist these reforms, as they may impact their profitability and autonomy.
• Unintended Consequences: The reforms could have unintended consequences, such as increased compliance costs for companies or a shortage of qualified auditors.

Key Assumptions:

• The SEC has the political will and resources to implement these reforms.
• The accounting industry will eventually cooperate with the SEC in implementing these reforms.
• The reforms will be effective in preventing future accounting scandals.

8. Next Steps

1. Develop Detailed Regulations: The SEC should develop detailed regulations to implement the recommended reforms.
2. Engage with Stakeholders: The SEC should engage with stakeholders, including the accounting industry, investors, and other government agencies, to gather input and build consensus.
3. Monitor Implementation: The SEC should closely monitor the implementation of the reforms and make adjustments as necessary.
4. Public Education: The SEC should undertake a public education campaign to raise awareness about the importance of accounting reforms and the role of investors in holding companies accountable.

By taking these steps, the SEC can ensure that its reforms are implemented effectively and achieve their intended objectives.

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Case Description

This case highlights the debate between the Securities and Exchange Commission (SEC) and several of the large accounting firms over whether the same firms should offer consulting services to clients they audit.

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