Auditor Independence: Another Case of Misplaced LoyaltyBy Francine • Sep 2nd, 2014 • Category: Independence, PCAOB, Pure Content, Sarbanes-Oxley, SEC, The Case Against The Auditors
I wrote a couple of weeks ago about the PwC Director, now partner, who is mixed up in PwC’s fine and sanctions for its lack of independence and objectivity at consulting client Bank of Tokyo-Mitsubishi UFJ. PwC consulted with the bank about money laundering allegations, at the request of regulators who were looking for reassurances from PwC that the bank was now complying with the law.
The New York Times article about New York Department of Financial Services Superintendent Benjamin Lawsky’s enforcement action against PwC says that “when it was time for Bank of Tokyo-Mitsubishi to file the report with regulators two weeks later, PricewaterhouseCoopers bowed to pressure from bank lawyers and executives, deleting some of the harshest characterizations and diluting others.”
PwC was not performing an audit for the bank but a consulting engagement out of the firm’s Bank Regulatory Compliance practice. PwC, like Deloitte before it, was hired to step into the shoes of the regulator, tasked with cleaning up issues at a bank after an enforcement action by a regulator.
What PwC, and Richard Inserro the director/partner, did at Bank of Tokyo-Mitsubishi UFJ —roll over for the sake of a client relationship and compromise professional integrity and ethical standards—sounds quite similar to what one PwC former unlicensed senior associate, Ryan Adams, describes as what is expected of PwC audit associates, too. Adams describes similar “attention to clients” in a voluntary declaration filed in 2012 in support of PwC and in opposition to class certification in the class action overtime lawsuit Kress v. PricewaterhouseCoopers.
Adams was assisted in the matter by PwC’s lawyers at Gibson Dunn.
Ryan Adams now works as a financial reporting executive for a PwC audited Nasdaq-listed public company, Marin Software. Adams graduated from college with an accounting degree in 2003. He was a senior audit associate, according to his declaration, until August of 2007 when he was promoted to manager. According to the California State Board of Accountancy, Adams was licensed as a CPA in June 2007.
Adams’ participation in this class action lawsuit, in support of PwC’s defense against it, presents a serious auditor independence violation, for his company and for PwC.
An auditor must be independent of its client, per SEC rules, for at least three years prior to an IPO. Marin Software qualifies as an Emerging Growth Company, so the restriction is limited to the two years of financial statements included in its S-1. The S-1 signaling Marin Software’s intention to go public was filed in March 2013 and shortly afterward Marin Software raised $109.3 million from an IPO.
Since Adams joined Marin Software as Director of Financial Reporting in December 2011, the “cooling off” period may also apply. That’s true if Marin Software was one of the audits Adams worked on in the PwC San
Jose Francisco office.
The “cooling off” period states that the accounting firm is no longer independent when a member of the audit engagement team commences employment with the issuer in a financial reporting oversight role within the one-year period preceding the date of the commencement of audit procedures.
The SEC’s Final Rule for Auditor Independence, effective February 5, 2001, states:
Independence generally is understood to refer to a mental state of objectivity and lack of bias.14 The amendments retain this understanding of independence and provide a standard for ascertaining whether the auditor has the requisite state of mind. The first prong of the standard is direct evidence of the auditor’s mental state: independence “in fact.” The second prong recognizes that generally mental states can be assessed only through observation of external facts; it thus provides that an auditor is not independent if a reasonable investor, with knowledge of all relevant facts and circumstances, would conclude that the auditor is not capable of exercising objective and impartial judgment.
It would be hard to argue that PwC can be objective about Ryan Adams, and the accounting selected by his company, when Adams is testifying on behalf of PwC in a litigated court case. How can PwC be independent of Marin Software and Adams, a CPA and Financial Reporting Director at this newly public PwC-audited client company if he’s testifying on PwC’s behalf in litigation that could impact PwC’s business model in California and, perhaps, nationally?
(Marin Software’s CFO John Kaelle is a Cooper’s and Lybrand alum. Cooper’s is a predecessor firm of PwC.)
Another issue I had to address on PwC’s audit of the construction company client was the proper accounting treatment of ‘puttable’ common stock that the company had issued. … “[P]uttable common stock may be characterized as a liability rather than equity depending on its particular characteristics. [8:4-8 (Paragraph 15)]
I … determined in my judgment that the [puttable] stock was likely best characterized as ‘mezzanine equity,’ or equity that has enough characteristics of debt that it should be treated as a liability on the client’s financial statements.
However, in following up with the client’s Chief Financial Officer (‘CFO’) regarding this issue, it became clear to me that the client strongly preferred that the stock be treated as permanent equity in its financial statements. The client’s concern was that if the stock was treated as debt, the client’s debt-to-equity ratio would be impacted, which would in turn potentially impact various covenants that the client had with its lenders.
Adams is very proud of his lone wolf approach to handling this issue and others and pleasing the client and his superiors.
Following my discussion with the client’s CFO, I reviewed and analyzed the client’s bank covenants to assess the merits of the client’s concerns and reviewed more accounting guidance in this area. After further considering this issue, I ultimately concluded that treating the stock as equity was permissible and in line with GAAP. I then documented my work, which was reviewed and approved by the Manager and Partner on the engagement. [9:7-18 (Paragraph 16)]
PwC changed the treatment of puttable stock from a liability to an asset on the client’s financial statements when the client expressed concerns about the puttable stock being deemed a liability. Classification as a liability would weaken the financial ratios the client’s lenders looked at. How did Ryan Adams as a senior associate, less than four years out of school and not yet a licensed CPA, please PwC’s audit client? He “revisited” the issue when the CFO objected to his analysis and found a rationale that fit with what the client wanted.
After all that detailed research and analysis and the manager and partner’s concurrence, this junior staff member was talked down by the CFO of this public company when he presented his recommended approach to the transaction. The engagement team kowtowed to the CFO and treated the transaction the way the client wanted it treated because to do otherwise would negatively impact the financial ratios and the client’s relationship with its lenders.
Apparently Adams and the team never consulted with PwC GAAP and SEC reporting experts to resolve the difference of opinion or to gain support for their supposedly well-thought out argument. Instead, Adams got guff from the CFO and went back to the drawing board to find a way to rationalize what the client wanted.
That sounds a lot like the EY and Bally’s case and the EY and Medicis Pharmaceuticals case. Both cases resulted in significant sanctions against professionals and the firms because of partners who ignored or compromised accounting standards, with the acquiescence and complicity of national practice partners. The objective was to please the clients rather than maintain the integrity of the financial statements.
Except in this case, it seems that Adams and his colleagues didn’t even ask the experts. That’s not supposed to happen.
Adams was a good PwC foot soldier and is now a loyal alumni. However, Adam’s supposed unrelenting individualism on the job is contrary to the team ethic that is paid lip service by the firms and the professional standards that say, over and over again, that partners, not newbie unlicensed college graduates, must be the ones to make sure staff are competent to do the work they are assigned, evaluate technical issues, and resolve conflicts with clients.
PwC has a motto: Don’t make a decision alone. If there’s a question, consult. Nowhere in Adam’ declaration does it say that he or his managers and partners consulted with the PwC national office on technical issues. Instead, it’s non-stop litany of “I looked it up. I figured it out on my own. I used my university accounting knowledge and there were no PwC guides or manuals to show me.”
One of the PCAOB’s quality control review inspection items — the deficiencies that are private unless the audit firm doesn’t fix them on a timely basis— is the use of consultations by engagement teams. Deloitte was dinged in the 2011 publication of Part 2 of its 2006 PCAOB inspection report for insufficient policies to promote consultation by engagement teams with internal industry experts and its SEC reporting and GAAP/IFRS experts.
The inspection team identified complex fact patterns in significant accounting and auditing areas, which were associated with deficiencies noted in seven engagements, including five engagements discussed in Part I.A, where the engagement teams did not consult with the Firm’s National Accounting Research or Quality Assurance departments. In addition, * * * * engagement teams consulted in three instances at below “Level A,” and neither the engagement team nor the National Accounting Research personnel raised the issue to a higher level as allowed by the policies.
Adams describes an environment at PwC where associates and senior associates, unlicensed audit staff with less than four years of experience, are left alone at client sites for large expanses of time, often until all the fieldwork is completed. Adams says they checked on him by phone or by an occasional site visit of the manager.
Moreover, my audit testing work was not reviewed until after I had finished it; I performed the work in the manner that I thought was most in compliance with professional auditing standards, and only after I completed my work did anyone review it. Similarly, while I often reported to my Manager regarding the status of the audits I helped manage, the day-to-day decision-making regarding issues such as staffing, work distribution, coaching, and client-relationship issues was largely left to me to perform in my best judgment. Of course, as with all of my work, my Manager checked in on the progress of the audit whether by phone or by visiting the client site-to review my decisions and let me know if there was anything that he or she disagreed with or that I should change.
Adams also gives the impression that on his engagements the managers and partners did drive-by planning and supervision. Such a self-sufficient chap…
At the outset of the audit planning process, I met with the Manager and Partner on the engagement for about an hour. They described the background of the client, what they knew about the client from the proposal process, why the client switched to PwC, and, in general terms, the audit issues that they thought I should look out for when investigating the client. After this meeting, I spent about a week researching the client and getting familiar with its business.
Among other things, I reviewed the client’s financial statements and compared them to the year-end audit papers that I had previously reviewed, I examined the client’s accounts in more detail, I researched the industry in which the client worked and the client’s position within the industry, and then I assessed what accounts needed auditing, what accounts presented heightened fraud risks, and how the PwC team could most efficiently and effectively test the client‘s accounts.
I again did not rely on any specific guide or manual during this process. I was instead required to use my professional judgment and my accounting background to determine what was relevant and what was not in many different audit areas, as well as assess the ways in which the client’s industry-driven characteristics would impact the approach that PwC would take with regard to each audit area.
As an unlicensed audit staff Adams apparently did it all!
As a lead senior, I was responsible for overseeing the day-to-day functioning of every aspect of the audit. This included planning and staffing the audit, developing the budget for the engagement, monitoring the audit work to ensure that the audit team remained within the budget, monitoring the progress of the audit, and making sure that the audit team’s progress was consistent with the timelines we set. It also included managing client relationships, coordinating communications with the client, raising issues to the client, keeping the client informed of the team’s progress, performing audit testing and related analyses, coaching more junior staff, and reviewing the work performed by audit team members.
In March of 2009 the PCAOB publicly criticized PwC for poor supervision of staff and made portions of its 2008 quality control inspection public. That’s done when a firm, like Deloitte did twice, fails to make sufficient progress towards correcting deficiencies in the quality control programs within twelve months. The PCAOB’s Inspection Report said “deficiencies … suggest that audit personnel were not adequately supervised” and “senior members of some engagement teams … may not be exercising an appropriate level of supervision over the audit.”
PwC is scheduled to go to trial in another overtime class action, Campbell vs. PwC, in March of 2015. This wage and hour lawsuit was originally filed on October 27, 2006 and was certified as a class action on March 24, 2008. It will be interesting to see how PwC handles the seeming contradiction between what they argue in these cases to justify exercise of judgment and discretion by journeymen versus what the auditing standards demand of partners.