Jamaica water properties



This case focuses on David Sokol, an executive who has made a “name” for himself in recent years within the energy industries. After becoming recognized as a successful “turnaround” agent for troubled companies, Sokol was hired in 1992 to serve as the chief operating officer of JWP, Inc., a large, New York-based conglomerate. At the time, JWP had an impressive history of sustained profits and revenue growth that was being threatened by the company’s far-flung operations and unwieldy organizational structure. Unknown to Sokol, JWP’s impressive operating results over the prior few years had been embellished by the company’s CFO and several of his top subordinates. Because of Sokol’s reputation for being a “hands-on” executive who insisted on personally obtaining a thorough understanding of his employer’s financial affairs, the CFO attempted to conceal misrepresentations in JWP’s accounting records from Sokol. Despite the efforts of the CFO, Sokol quickly uncovered suspicious items in JWP’s accounting records after he assumed responsibility for the company’s day-to-day operations.

The diligent and persistent Sokol eventually met with JWP’s CEO and informed him of the problems he had uncovered. Sokol insisted that an accounting firm other than JWP’s audit firm be retained to perform a forensic investigation. Sokol questioned whether JWP’s audit firm could objectively perform that investigation since there were close relationships between key members of the audit engagement team and JWP’s top accountants, including its CFO. In fact, the CFO and three of his key subordinates had formerly worked for JWP’s audit firm. Before the second accounting firm could complete its investigation, Sokol discovered additional distortions in JWP’s accounting records. Sokol rejected a $1 million “stay” bonus offered to him by JWP’s CEO and resigned as the company’s COO after turning over the evidence he had collected to the board of directors. The SEC issued a series of accounting and auditing enforcement releases focusing on the JWP accounting fraud. JWP’s CFO and the three subordinates who had helped him carry out the fraud were sanctioned by the SEC. JWP’s audit firm, Ernst & Young, reportedly paid $23 million to settle lawsuits filed by JWP’s stockholders. Ernst & Young was eventually successful in defeating a large lawsuit filed by JWP’s former lenders. However, in the latter lawsuit the federal judge who presided over the case severely chastised Ernst & Young for its “willingness to accommodate” JWP’s former CFO and for its “spinelessness” in performing JWP’s annual audits.

Jamaica Water Properties–Key Facts

1.In 1992, David Sokol accepted an offer to become the COO of JWP, Inc., a large, New York-based conglomerate whose impressive earnings and revenue trends were being threatened.

2.Unknown to Sokol, JWP’s operating results had been embellished by an accounting fraud directed by the company’s CFO, Ernest Grendi, and three of his subordinates.

3.Grendi relied on the far-reaching authority granted to him by Andrew Dwyer, JWP’s CEO, and on his “intransigent and intimidating” personality to gain complete control over JWP’s accounting function.

4.Because Sokol had a reputation as an effective and hands-on executive, Grendi attempted to conceal misrepresentations in JWP’s accounting records from Sokol.

5.Sokol discovered suspicious items in JWP’s accounting records shortly after joining the company, which prompted him to insist that an accounting firm be brought in to perform a forensic investigation of those records.

6.Sokol wanted a firm other than JWP’s audit firm, Ernst & Young, to perform the investigation because of close, personal relationships that existed
between members of the Ernst & Young audit team and JWP’s key accounting officials, including Ernest Grendi.

7.After discovering additional problems in JWP’s accounting records, Sokol gave the evidence that he had collected to the company’s board and resigned.

8.Before he resigned, Sokol was offered a $1 million “stay” bonus by JWP’s CEO, an offer he declined.

9.JWP eventually filed for bankruptcy and was reorganized as Emcor Group Inc.

10.Ernest Grendi and the three subordinates who helped him direct the fraud were sanctioned by the SEC.

11.Ernst & Young ultimately paid $23 million to settle lawsuits filed against the firm by JWP’s former stockholders.

12.In another lawsuit filed against Ernst & Young by JWP’s former lenders, a federal judge criticized the accounting firm for accommodating Ernest Grendi and for exhibiting “spinelessness” during its annual JWP audits.

Instructional Objectives

1.To provide students with a vivid example of a corporate executive who insisted on “doing the right thing” regardless of the personal consequences he faced.

2.To demonstrate how close personal relationships between auditors and client personnel can jeopardize independent audits.

3.To demonstrate the audit risks posed by a client executive who dominates his or her firm’s accounting and financial reporting function.

Suggestions for Use

This case provides a welcome relief from the “typical” series of events profiled in the majority of cases presented in this text. Because “bad news” scenarios—Enron, WorldCom, Adelphia, and so on and so forth—are much more likely to surface in the public domain, the majority of my cases involve unethical corporate executives. Not so in this case. Well, at least, the main “actor” in this case, David Sokol, is scrupulously honest. During my courses, I frequently remind students that most corporate executives, accountants, and auditors are honest and ethical. This case provides a stark and powerful example of one such individual. When I discuss a case such as this in my courses, I try to provide other examples of positive role models among corporate executives. Granted, most of these examples do not involve accounting or auditing matters, but, nevertheless, they help to blunt the impression that students may receive from studying my cases that most corporate executives are “crooks.”

An implicit theme of this case that I want students to recognize is the contrast between the persistent and vigorous efforts of David Sokol to “get to the bottom” of the suspicious items he uncovered in JWP’s accounting records versus what Judge William Conner referred to as the “spinelessness” of JWP’s auditors. The JWP audits were similar to most problem audits in that the auditors encountered numerous red flags and questionable entries in the client’s accounting records but, for whatever reason, apparently failed to thoroughly investigate those items. On the other hand, Sokol refused to be deterred in his investigation of the troubling accounting issues that he discovered. The relationships that existed between members of JWP’s accounting staff and the Ernst & Young audit team apparently influenced the outcome of the JWP audits. Of course, the Sarbanes-Oxley Act of 2002 attempts to curb the impact of such relationships on independent audits—for example, by requiring periodic rotation of audit engagement partners.

Suggested Solutions to Case Questions

1.I discourage students from providing casual “I would have done the same thing that he did” type answers to this question. Before they answer this question, encourage your students to obtain a clear “picture” of the situation in which Sokol found himself. He had just given up a terrific position with a company that he had earned widespread acclaim for “turning around.” Plus, he had uprooted his family and moved away from his beloved Nebraska to the unfamiliar and fast-paced atmosphere of New York City. Like anyone who has made such an abrupt change, Sokol likely experienced a certain amount of cognitive dissonance or doubt regarding the wisdom of his decision. No doubt, that dissonance was compounded when he began uncovering the problem items in JWP’s accounting records. A normal reaction in such circumstances would have been for Sokol to “pooh-pooh” the suspicious accounting issues and to focus his energy and efforts on JWP’s challenging operating problems. In fact, Sokol did just that, to some extent. Notice that the case points out that Sokol tried to “convince himself” that the suspicious accounting matters were aberrations. Nevertheless, he never dismissed those items completely and continued to investigate them, which he certainly had an obligation to do.

2.One such measure was taken in the summer of 2002 when the SEC began requiring corporate executives to sign a pledge that the financial statements being filed by their company with the federal agency are materially accurate, a requirement that was formalized in Section 302 of the Sarbanes-Oxley Act. Logically, corporate executives should be more likely to “blow the whistle” on an accounting fraud that they discover given this new requirement. By strengthening the audit committee function, the Sarbanes-Oxley Act provides another incentive for corporate personnel to “come clean” when they discover problematic accounting issues or items. More rigorous audit committees should be more likely to eventually uncover problematic items, so corporate executives and employees should be more inclined to “go ahead” and reveal such items as soon as they discover them.

In addition to punitive approaches to encouraging corporate executives and employees to report fraudulent accounting schemes, Corporate America could adopt “kinder and gentler” strategies to persuade those individuals to be scrupulously honest and forthright. For example, explicit awards for commendable conduct, such as that exhibited by David Sokol, could be used to recognize ethical corporate executives. Likewise, boards of directors could choose to incorporate economic incentives for ethical conduct in the compensation packages of corporate executives.

3.The answer to Question #2 suggests that one approach to encouraging ethical conduct by corporate executives would be to reward them monetarily for such behavior. That suggestion was made in response to a “how to” question, while this question raises the “should” or normative issue regarding such a strategy. You may have a different attitude, but my general inclination in responding to this question is “No.” Shouldn’t ethical behavior or conduct be an implicit and assumed feature of every job role in Corporate America—from janitorial positions to the office of the CEO? In other words, should employees and executives be rewarded for doing what they have been hired to do? On the other hand, I agree that recognizing ethical conduct, such as that of David Sokol, with plaques, public proclamations, and other token gestures is appropriate and likely helps to encourage other individuals to resolve ethical dilemmas by “doing the right thing.”

4.Auditor-client relationships can adversely impact audit quality by undercutting or undermining the independence of auditors. Auditors who lose their objectivity because of close ties to client personnel may be less than rigorous in assessing a client’s internal controls, may be overly reliant on client representations (as audit evidence), and, ultimately, may issue an inappropriate report on a given client’s financial statements.

Listed next are examples of specific measures that an audit firm could take to limit or mitigate the risk that auditor-client relationships will impair the quality of their audits:

Include an explicit policy statement in the firm’s audit procedures manual alerting auditors to the potential problems posed by friendships with client personnel. During the staffing phase of each audit, require a senior member of the audit engagement team to question other team members regarding any potential conflict of interests stemming from relationships with client personnel. Require the review or concurring partner for each audit to assess the independence of the audit engagement partner vis-à-vis client executives and other key client employees. Encourage audit team members to report, even if anonymously, potentially problematic relationships between their colleagues and client personnel. Rotate assignments of audit team members periodically so that they do not work with the same client personnel each audit.

5.I have never heard of such agreements prior to this case—maybe you have. Clearly, such agreements can prove to be problematic, as Judge Conner suggested, since they may place audit firms in a situation where the budgeted resources for a given engagement are insufficient. Over a three-year time frame, the financial condition, operating results, and a variety of other factors relevant to a client can change dramatically, resulting in significant changes in the resources needed to complete an audit. If the audit fee is capped, an audit firm may be more prone to “cut corners” on a given engagement, resulting in a decline in audit quality. So, generally, I would suggest that these types of agreements are not appropriate, although they are not expressly prohibited by professional standards.

6.Stockholders are generally in a stronger position than creditors and other parties to sue a company’s former auditors. In civil cases filed under the common law, stockholders qualify as primary beneficiaries of an audit in all jurisdictions. On the other hand, lenders and other creditors may only qualify as “foreseen” or “foreseeable” beneficiaries of a given audit. This distinction is important because in many jurisdictions only primary beneficiaries can use auditors for negligence. Other parties in the latter jurisdictions must prove that auditors were guilty of something more than negligence during a given engagement. [Note: For a more elaborate discussion of auditors’ liability under the common law, see the solution to Case 7.7, “Fred Stern & Company, Inc.”] Because of the stronger position that stockholders often have under the common law, audit firms are more inclined to settle stockholder lawsuits out of court.

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