Scott London Subverted Sarbanes-Oxley: Big Four Mock Audit Partner Rotation

By Francine • Apr 22nd, 2013 • Category: Audit Quality, Latest, Pure Content, The Case Against The Auditors

The earth rotates revolves around the sun. Galaxy Doppler shifts are almost always redshifts. The further away the galaxy the faster it is receding.

I’m learning a lot in my first class, Cosmology, in the University of Chicago Masters in Liberal Arts Program. The universe has order. There’s synchronicity and “smoothness” to where it is and how it came to be that scientists have a hard time explaining.

Such laws rarely seem to apply very well to human nature. Where did earthbound humans part ways with the natural world?

I wrote today in Forbes about a small little thing I noticed in one of the first stories about Scott London. As I tried to research and write about it, I waited for someone else to pick up on it. (No one else did.) I’ve been busy the last couple of weeks since the KPMG press release about Scott London’s breach of client confidentiality hit the wires on April 8 but I researched the issue and called KPMG and Skechers and waited.

There’s one small detail that came out early, mentioned in The Financial Times by Kara Scannell and Dan McCrum when they interviewed Skecher’s CFO David Weinberg, that matters a lot to the current debate in the U.S. and U.K regarding audit firm rotation and the compromise rules for lead partner rotation on audit engagements.

Mr London had worked on Skechers’ audits in seven or eight of the last 13 years, said Mr Weinberg, returning after a five-year rotation away two or three years ago. He said that he had worked with him regularly, and never had questions about his work or integrity: “not even the slightest”, he said.

The rest of the column goes on to explain that London seems to have subverted the intent of Sarbanes-Oxley Section 203 that requires lead engagement partner rotation off engagements to promote objectivity, independence and professional skepticism. But he’s not alone. The more I looked into this the more I realized it’s probably pretty common in the firms. After ten plus years of Sarbanes-Oxley, we’ve probably got quite a few of these roll off, roll back on partners out there. An early draft of a paper by four academics, including former PCAOB academic fellow Brian Daughtery, says almost everyone does it.

Assignments for the lead engagement partner, concurring partner, and other senior members of the audit team are planned well in advance of required rotation so members are not rotated simultaneously. Some firms have policies that specify the qualifications of the partner assigned to client engagements. Depending on the engagement, regional or national office approval may be required on partner assignments. One OMP indicated firm policy does not allow a partner to be a concurring partner before being a lead partner. Another indicated his international firm now has a policy that does not allow partners to ever return to a former public client unless the national office agrees to make an exception based on extenuating circumstances.

An important element of mitigating the negative aspects of rotation is ensuring partners are properly trained. One OMP noted the path to partnership is now approximately 13-15 years, primarily driven by the complexity of GAAP. Another noted many senior managers rotate to larger practice offices or the national office for training before standing for partnership.

But…

By the time the Daugherty/Dickins/Hatfield/Higgs paper was published in 2012, Brian Daugherty told me that none of the Big Four audit firms prohibited a partner from returning to a former public client as lead engagement partner. None, that he became aware of during the research, prohibit the audit partner from acting as an advisory/consulting partner before, after, or during the cooling off period as lead audit engagement partner or as concurring/quality partner. One firm that did forbid partners to return to a lead audit engagement partner role after a rotation off, except on an exception basis, dropped the prohibition before the paper was published.

Despite being very open and chatty with the press about the London incident – looks like KPMG fed a positive story to the WSJ about all they are doing to review internal policies - KPMG did not want to give me exact dates of London’s assignments on Skechers and what he did during his roll-off. Neither did Skecher’s CFO.

Did London act as concurring or quality review partner during those five years? Even worse, did London act as Advisory partner, responsible for increasing non-audit tax and consulting fees at Skechers like Deloitte’s Tom Flanagan did at the Fortune 500 clients he traded illegally on?

Skechers spent $351,000 for “All Other” services with KPMG between 2003 and 2008. Given the Sarbanes-Oxley prohibitions against an auditor providing services other than tax and “audit related” this seems odd. The explanation?  ”These are fees for other permissible work performed by KPMG LLP that does not meet the other category descriptions.” Translated, that means, “We don’t think we have to explain it you.”

Skechers paid KPMG an awful lot, too, for tax services compared to its audit fee, $4, 512,000 over the ten year period 2002-2011, or 34% of total audit fees for the same period of $13,129,000. In 2004, Skechers paid KPMG approximately $680,000 for acquisition due diligence services, categorized as “audit related” when due diligence services are prohibited consulting services by an auditor unless they’re tax-related.

There’s more at Forbes, KPMG’s Inside Trader: What The Auditor, and Skechers, Don’t Want To Talk About. You might be asking, though, how can we as investors know if the Big Four are complying with the audit partner rotation law? Who checks to see that they are following any of these laws Congress makes that are supposed to make us believe that auditors are back on the job, looking out for shareholders after Enron?

We can’t.

If an audit firm violates the rule, we’ll probably find out about it only if something worse happens that causes that information to be disclosed. The audit firms know which partners are assigned to clients, audit and non-audit. They have to know to manage their business as well as insure compliance in case that audit is selected for inspection. Public companies and their Audit Committees know who is assigned to their engagements. Rarely do the firms and their clients volunteer information about tenure on engagement unless there’s a lawsuit, or if feelings are hurt such as in the Skecher’s case. The Skecher CFO’s disclosures to the FT about Scott London’s tenure on the engagement are unusual since there’s been no lawsuit.

Yet.

If a company and its Audit Committee don’t like a member of the audit engagement, especially the lead partner or another key member, that partner will most likely never get the nod in the first place or be off the engagement quickly. See the Nortel case or the Navistar case – both Deloitte – to see what happens when the audit firm is slow or stubborn to react to client complaints about a partner they “can’t work with”. If the client management and Audit Committee like an engagement partner and that partner wants to stay on that client, that’s a different story. Rest assured the firm will do everything to keep him or her involved, even denying other partners in the firm the opportunity for the experience and “prestige” – that is, the partner compensation that comes with a fee rich client – from such a client assignment.

The PCAOB certainly knows the engagement team for every audit it selects for inspection. The recent disclosure of the PwC Part II report and the regulator’s criticism of some partners’ account assignment overload and lack of time spent on supervision shows they have the information and aren’t afraid to use it to make a point.

The inspection team observed that the engagement partners for three of the six audits discussed in Part I.A had a significant number of issuer audit clients with year ends at or around December 31. For one of these three engagements, the hours reported by the engagement partner on the audit represented approximately 2.1 percent of the lead office audit hours. This was approximately 45 percent less than the average percentage of lead office engagement hours reported by the engagement partners on the other 49 issuer audits selected for inspection. The engagement partner for another audit24/ described in Part I.A was responsible for four issuer audit clients with a calendar year end, an average market capitalization of approximately $2.7 billion, and average audit fees of approximately $1.1 million. These facts and the significance of the deficiencies in these engagements suggest that the Firm may not sufficiently monitor partners’ workloads to ensure that they do not negatively affect partners’ ability to effectively participate in the planning and execution of their audits and to appropriately supervise and review their audits.

Does the PCAOB collect data during their information request to the firms on an annual inspection cycle – nine of them only – about all engagements and their full teams?

Does the PCAOB track partner assignments over time, in general, or on specific high risk engagements to catch rotation violations or patterns of behavior that may point to other issues?

Maybe. We won’t know unless the data collected is the basis for a disciplinary action that takes forever to surface and is probably not on the top of the regulators priority list. In the ten years since the PCAOB has been up and running and issuing inspection reports I have never seen a sanction or disciplinary action by the PCAOB or SEC for a partner and a firm that violated the partner rotation rules.

Main page photo courtesy of the University of Chicago Kavli Institute for Cosmological Physics.

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11 Responses »

  1. As much as KPMG would like to just label Scott London a “bad apple” and a “rogue partner”, I sense there is a lot more to this story that has not yet come to light. Thanks for continuing to pursue this investigation. It seems like a lot of other financial reporters have already moved on.

  2. [...] Ms. McKenna expands her discussion in her blog post at re: The Auditors – Scott London Subverted Sarbanes-Oxley: Big Four Mock Audit Partner Rotation. [...]

  3. @Big4Veteran

    Well, this is my beat. But thanks. I agree there is more to the story. FT has a great update on the regulatory impact.

    Regulator urges end to auditor anonymity

  4. Worth remembering that rotation wouldn’t have prevented the Scott London problem. It wasn’t his closeness to the client that was the issue, more his closeness to his golf buddy. SOX rotation requirements in this case would just mean London would’ve rolled on to other large clients (given his status in the firm) which would have afforded equal opportunities to pass inside information to his friend.

    It seems to me to be stretching the imagination to interpret any perceived failure to comply with the spirit of SOX rotation requirements as evidence of a wider conspiracy from which there is ‘more to come’ too – surely nobody thinks London was put back on the Skectchers audit so that he could obtain this privileged information.

  5. @James

    “…surely nobody thinks London was put back on the Skectchers audit so that he could obtain this privileged information.”

    Are you sure? London himself was responsible for those assignment. Why did he put himself back on? Surely he had lots of important activities as leader of the practice by that time. (In addition, his consistent involvement in this client certainly influenced the amount of non-audit services that were performed, some of which, I believe, may have violated independence rules.)

    Access to information and the kind of detachment and rationalization that London seems to have exhibited comes from losing your objectivity, independence. He seems to have used inside info as currency to enhance his personal standing with his golf buddy and maybe others. There were reports he also talked about his clients in front of others. Yes, rotation would have made made it only slightly more difficult and slightly more obvious that he was keeping tabs on Skechers since he had access to all clients and al info in the region. His desire to please his friend would have forced him to use some other client’s information. But in a case where an audit partner is less powerful and not in control of all the information at all the clients in a region, shaking things up periodically has been seen, in the research, to help improve independence, objectivity and professional skepticism as well as audit quality.

  6. A couple of obvious points that you touch on that need emphasis. Sarbanes compliance/enforcement is nonexistence at least in any meaningful sense. Moreover the auditors and enterprise software suppliers (could be the same in some cases) exploits issue. The second issue the 34% tax fees are really the same issue. Through K Street, and outright manipulation of the code they move, arrange, operate, or control by the code or by mechanical means (main stream media bipartisan political bribes) , in a skillful manner taxing and profits accounting. It is expensive to set up companies, trust and corporate and government Kleptocracy. Keeping corporate tax rates high keeps the Tax audit, accounting, lobbyist and lawyers in the 1%, Just some of these schemes are here. http://assets.opencrs.com/rpts/R40623_20100903.pdf
    How about 127 billion TARP funds.
    http://www.gfintegrity.org/storage/gfip/images/gfi%20-%20us%20assets%20in%20tax%20havens.jpg

    It should not be surprising. It is just the what people elect and tolerate. Now if we could do a little lobbying on restoring insider trading congressional laws, conflicts of interest in CISPA , responsibility for 50B spent on domestic spying, student loan ………… ah instead of rattling on look at the picture and think before you swallow that left, right, statist, libertarian nonsense. The biggest problem is current statist do not have control of the dialog (propaganda) just the money. Unfortunately the money is for ??

    well to Quote Roger Walters

    “Money, get away
    Get a good job with more pay
    And your O.K.

    Money, it’s a gas
    Grab that cash with both hands
    And make a stash

    New car, caviar, four star daydream
    Think I’ll buy me a football team

    Money get back
    I’m all right Jack
    Keep your hands off my stack

    Money, it’s a hit
    Don’t give me that
    Do goody good bullshit “

  7. [...] Scott London Subverted Sarbanes-Oxley: Big Four Mock Audit Partner Rotation in re: The Auditors [...]

  8. [...] firm like BDO’s member firm to be the primary auditor. (BDO inherited Skechers recently after the KPMG inside trader scandal caused that firm to resign and likes doing gaming audits. )The U.S. BDO firm would audit the [...]

  9. [...] and Scott London’s – the partner who recently plead guilty for that inside trading debacle – compliance with the spirit and letter of the law for audit partner rotation, the compromise to audit firm rotation that was agreed to when Sarbanes-Oxley was enacted. They [...]

  10. The Earth revolves around the Sun. It rotates on its axis. You should correct your article. Don’t delete my comment again.

  11. @Daniel

    Fixed. Thanks. fm

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