Synopsis
David Sokol, an executive renowned in the energy industries, was at the center of this case. In 1992, Sokol joined JWP, Inc., a New York-based conglomerate, as its chief operating officer. Despite JWP’s impressive history of profitability and revenue growth, their operations and organizational structure were becoming unmanageable and jeopardizing their success. Unbeknownst to Sokol, however, the company’s CFO and several top subordinates had been inflating JWP’s financial performance over the past years. As a hands-on executive who prioritized understanding his employer’s financial matters thoroughly, Sokol became determined to uncover any inaccuracies concealed by the CFO regarding JWP’s accounting records once he assumed control of day-to-day operations.
The diligent Sokol met with JWP’s CEO to report the problems he had discovered. Sokol insisted on hiring a different accounting firm for a forensic investigation, questioning the objectivity of JWP’s audit firm due to close relationships between members of the audit team and JWP’s top accountants. Before the second accounting firm finished its investigation, Sokol found more distortions in JWP’s accounting records. Despite being offered a $1 million bonus, Sokol rejected it and resigned as COO after providing evidence to the board of directors. The SEC released a series of accounting and auditing enforcement releases focusing on the JWP accounting fraud. The SEC sanctioned JWP’s CFO and three subordinates involved in the fraud. Ernst & Young, JWP’s audit firm, paid $23 million to settle lawsuits from JWP’s stockholders. Ernst & Young successfully defended against a large lawsuit from JWP’s former lenders, although the federal judge scolded them severely in that case.Young is known for its willingness to accommodate JWP’s former CFO and its spinelessness in conducting JWP’s annual audits.
Jamaica Water Properties – Important Information
In 1992, David Sokol agreed to become the Chief Operating Officer (COO) of JWP, Inc., a New York-based conglomerate. The company’s impressive earnings and revenue trends were at risk.
2. Sokol was unaware that JWP’s operating results had been inflated due to an accounting fraud committed by the company’s CFO, Ernest Grendi, and three of his subordinates.
3. By relying on the extensive authority given to him by Andrew Dwyer, JWP’s CEO, and his “intransigent and intimidating” nature, Grendi was able to establish full control over JWP’s accounting department.
4. In an effort to hide misrepresentations in JWP’s accounting records from Sokol, Grendi tried to cover up because Sokol was known as a capable and involved executive.
5. Shortly after joining the company, Sokol found suspicious items in JWP’s accounting records. As a result, he demanded that an accounting firm be hired to conduct a forensic investigation of those records.
6. Sokol sought a different auditing firm to conduct the investigation due to the close personal relationships between members of JWP’s audit firm, Ernst & Young, and key accounting officials at JWP, notably Ernest Grendi.
7. Sokol resigned after presenting the evidence of additional problems in JWP’s accounting records to the company’s board.
8. Prior to his resignation, Sokol was presented with a $1 million “stay” bonus by JWP’s CEO, which he turned down.
9. JWP filed for bankruptcy and was later reorganized as Emcor Group Inc.
Ernest Grendi and his three subordinates who assisted him in directing the fraud were given sanctions by the SEC.
11. In the end, Ernst & Young reached a settlement of $23 million to resolve the lawsuits brought against them by JWP’s previous shareholders.
12. Ernst & Young was sued again by JWP’s previous lenders, and a federal judge accused the accounting firm of showing spinelessness and accommodating Ernest Grendi during the annual audits of JWP.
Instructional Objectives
1. The purpose is to show students a prominent example of a corporate executive who made it a priority to “do the right thing” regardless of personal consequences.
2. The purpose is to illustrate how intimate relationships between auditors and client staff can compromise independent audits.
3. The purpose is to show the audit risks that arise when a client executive has control over the accounting and financial reporting function of their firm.
Here are some recommendations on how to utilize this:
This case stands out from the usual scenarios of unethical corporate executives that are often featured in this text, such as Enron, WorldCom, and Adelphia. However, in this case, the main individual involved, David Sokol, is known for his honesty. In my courses, I frequently emphasize that the majority of corporate executives, accountants, and auditors are ethical and maintain high standards. This particular case serves as a powerful example of an individual who upholds these principles. When discussing this case with my students, I always make sure to provide other positive role models among corporate executives, even if they are not directly related to accounting or auditing matters. This is important in order to counter any negative impression that students may develop from studying cases that primarily involve unethical behavior.
An implicit theme of this case is the contrast between David Sokol’s persistent and vigorous efforts to investigate suspicious items in JWP’s accounting records, and the perceived “spinelessness” of JWP’s auditors as described by Judge William Conner. The audits conducted on JWP were similar to other problematic audits, as the auditors came across several red flags and questionable entries in the client’s accounting records. However, for some reason, they seemed to have failed to thoroughly investigate these flagged items. Conversely, Sokol remained undeterred in his investigation of the troubling accounting issues he uncovered. The relationships between members of JWP’s accounting staff and the Ernst & Young audit team seemingly influenced the outcome of the JWP audits. The Sarbanes-Oxley Act of 2002 aims to address the impact of such relationships on independent audits, including the requirement for periodic rotation of audit engagement partners.
Here are the suggested solutions to the case questions.
1. Before answering, I discourage students from casually responding to this question by saying “I would have done the same thing.” Instead, I urge them to understand the situation Sokol was in when he recently left a successful job and relocated his family to New York City. This sudden change likely caused him to doubt his decision. Furthermore, discovering irregularities in JWP’s accounting records only added to that doubt. In such circumstances, it would have been normal for Sokol to overlook the suspicious accounting issues and concentrate on JWP’s operational problems instead. Nevertheless, Sokol did not completely dismiss those issues but rather continued investigating them, which was the appropriate course of action.
2. The SEC implemented a measure in the summer of 2002 that mandated corporate executives to sign a pledge confirming the accuracy of their company’s financial statements filed with the federal agency. This requirement was formalized as Section 302 of the Sarbanes-Oxley Act. Consequently, corporate executives now have a higher likelihood of reporting any accounting fraud they discover. Furthermore, the Sarbanes-Oxley Act strengthens the audit committee function, providing more incentive for corporate personnel to disclose problematic accounting issues or items. With enhanced audit committees, problematic items are more likely to be uncovered, prompting corporate executives and employees to promptly come forward and disclose such items when found.
In order to promote honesty and integrity within Corporate America, there are various approaches that can be taken, including both punitive and more positive strategies. One option is to provide explicit awards for commendable behavior, such as what David Sokol demonstrated. Additionally, boards of directors have the opportunity to include financial incentives for ethical conduct in the compensation packages of executives.
The response to Question #2 suggests that one way to encourage ethical conduct by corporate executives is to provide them with monetary rewards for such behavior. This suggestion was offered in response to a practical question, while this question raises a normative issue about whether or not this strategy should be employed. Despite having a different perspective, my initial inclination in addressing this question is to say “No.” Shouldn’t ethical behavior be an implicit and expected aspect of every job in Corporate America, from janitors to CEOs? In other words, should employees and executives receive compensation for fulfilling their basic responsibilities? However, I do agree that recognizing ethical behavior, like that of David Sokol, through awards, public acknowledgments, and other symbolic gestures is appropriate and likely encourages others to make ethical choices by “doing the right thing.”
The quality of audits can be negatively impacted by close relationships between auditors and clients as it compromises the independence of auditors. When auditors have strong connections with client personnel, they may become biased and fail to evaluate a client’s internal controls thoroughly. Instead, they overly rely on client statements as evidence during the audit process. As a result, they might issue an inappropriate report regarding the financial statements of a particular client.
The following are examples of specific measures that an audit firm can implement in order to reduce or mitigate the risk of auditor-client relationships compromising the quality of their audits:
Include a clear policy statement in the audit procedures manual of the firm, alerting auditors about the potential issues that can arise from friendships with client personnel. During the staffing phase of every audit, it is necessary for a senior member of the audit engagement team to inquire about any conflicts of interest that may stem from relationships with client personnel. The review or concurring partner for each audit must assess the independence of the audit engagement partner concerning client executives and other important client employees. Auditing team members are encouraged to report potentially problematic relationships between their colleagues and client personnel, even if anonymously. Periodic rotation of audit team members’ assignments should be implemented to prevent them from working with the same client personnel in each audit.
5. Prior to this case, I was unfamiliar with such agreements, but perhaps you are already aware of them. These agreements can be problematic, as Judge Conner pointed out, because they may place audit firms in a situation where they lack the necessary resources for a specific engagement. Over a span of three years, significant changes can occur in a client’s financial condition, operating results, and other crucial factors that impact them; consequently, the resources required to complete an audit may also undergo substantial changes. In cases where the audit fee is restricted, there is an increased likelihood that an audit firm might take shortcuts on a particular engagement leading to diminished quality of the audit itself. Thus, although these types of agreements are not explicitly prohibited by professional standards, I believe they are generally unsuitable.
6. Stockholders have a stronger position compared to creditors and other parties when it comes to suing a company’s former auditors. In all jurisdictions, stockholders are considered primary beneficiaries of an audit in civil cases under common law. On the other hand, lenders and other creditors may only be deemed as “foreseen” or “foreseeable” beneficiaries of a specific audit. This distinction is crucial because in many jurisdictions, only primary beneficiaries can hold auditors accountable for negligence. However, for other parties in these jurisdictions, they must prove that auditors were not just negligent but also guilty of something more during the engagement. Please see Case 7.7 “Fred Stern & Company, Inc.” for a more comprehensive discussion on auditors’ liability under common law. Due to stockholders’ stronger position, audit firms are more likely to settle lawsuits filed by stockholders outside of court.
