The Private Securities Litigation Reform Act of 1995 (Public Law 104- 67) added Section 10A to the Securities Exchange Act of 1934 (15 U. S. C. 78j- 1). Section 10A reporting requirements first became effective for fiscal years beginning on or after January 1, 1996.

The GAO[1] prepared a report in February 2000[2] and again in September 2003 at the request of Congress, regarding the audit industry’s compliance with Section 10A. The GAO also reported the statistics for SEC enforcement actions under Section 10A.

The February 2000 report stated that six Section 10A reports had been submitted by audit firms through December 14, 1999. Records from the SEC’s Office of the Chief Accountant show that during the period December 15, 1999 through May 15, 2003 – four years of turmoil in the markets and in the accounting industry – an additional 23 Section 10A reports were submitted.

From the inception of the 10A reporting requirement in 1996 through May 15, 2003, a total of 29 Section 10A reports were submitted to the SEC. The reports cover a variety of potential illegal acts, including improper revenue recognition, unusual capital transactions relating to stock warrants, inadequate financial statement disclosures, and failure to disclose expenses relating to stock options.

In the 2003 report, the AICPA attributed the low level of 10A reporting to the reasons they cited as stated in the 2000 GAO report: In most cases, management or the board of directors, often with the participation of internal or external counsel, took timely and appropriate action to address a situation involving an illegal act when it was brought to their attention by auditors.

According to SEC officials in 2003, all Section 10A reports from 1996 to 2003 were investigated. Of the 29 SEC registrants named in the reports as of 2003, 10 were the subject of active SEC enforcement investigations, 8 had actions brought against them by the SEC, and 11 reports were closed without formal action being taken by the SEC.

Injunctive actions and administrative proceedings were filed in 8 cases alleging violations such as (1) failure to disclose transactions in public statements to shareholders and the SEC, (2) inclusion of fraudulently- valued assets on financial statements filed with the SEC, (3) underreporting the value of inventory resulting in an understatement of expenses and liabilities and an overstatement of income, and (4) improper revenue recognition and understatement of expenses.

A violation reported under Section 10A may be closed without formal action being taken by the SEC because the registrant is no longer publicly traded, has a very small dollar amount of assets, or is no longer doing business. In certain instances, after discussions with the SEC, the registrants took remedial action, which the SEC found satisfactory, such as obtaining a review of the registrant’s quarterly financial statements filed with the SEC.

In 2002, the American Institute of Certified Public Accountants (AICPA) issued a new audit standard for detecting fraud, Statement on Auditing Standards (SAS) 99: Consideration of Fraud in a Financial Statement Audit. The AICPA believed SAS 99 would substantially change auditor performance, thereby improving the likelihood that auditors will detect material misstatements in financial statements due to fraud by placing an increased focus on exercising professional skepticism throughout the audit. The new standard required auditors to identify and consider risks of material misstatement due to fraud when planning and performing the audit through brainstorming among audit team members, inquiring of management, performing analytical procedures, considering inappropriate reporting of revenue and management override of internal controls, evaluating internal controls that address the identified risks of fraud, and assessing throughout the audit and at the completion of the audit the risk of fraud based on the results of auditing procedures.

The new standard also required auditors to communicate about fraud to management, the audit committee, and others, and to document the auditors’ consideration of fraud. SAS 99 was adopted and effective for audits of financial statements for periods beginning on or after December 15, 2002. The PCAOB, the regulator for the auditing industry established by the Sarbanes-Oxley Act in 2002, updated the standard the first time with Auditing Standard No. 5, adopted in 2007. The PCAOB revised the standard further in December 2010 as AU Section 316: Consideration of Fraud in a Financial Statement Audit.[3]

The Sarbanes-Oxley Act of 2002 also contains a number of provisions aimed at improving the quality of audits of public companies including more audit committee involvement with the auditor, a requirement for auditors to attest to management’s assessment of internal controls over financial reporting, a requirement for audit partner rotation, prohibition of certain non-audit services to audit clients, prohibition of providing audit services to a company that employs as a top official a previous member of the audit engagement team, and greater penalties for failure to report fraud.

Rule 240 10A-1 states that auditor reports under Section 10A must be submitted to the SEC’s Office of the Chief Accountant. The report must be in writing and identify the registrant and the auditor and the date that the registrant received the Section 10A report from the auditor. In addition, the report must include either a copy of the auditor’s report or a summary of the report including a description of the act that the auditor has identified as a likely illegal act and the possible effect of that act on the financial statements. The rule is based on the premise that the reports under Section 10A are supposed to assist the SEC in performing its enforcement responsibilities and therefore, the auditors’  reports are nonpublic.

After receiving and logging the Section 10A reports, the Office of the Chief Accountant forwards the reports to the Division of Enforcement, which conducts investigations into possible violations of federal securities laws and prosecutes the SEC’s cases. The reports are also forwarded to other divisions within the SEC, including the Division of Corporation Finance, which reviews the financial statements and other financial reports filed by SEC registrant companies. The Office of the Chief Accountant and the Division of Enforcement monitor the progress on any investigation initiated or facilitated by a Section 10A report.

Auditors are still getting used to an external regulatory regime under the PCAOB since 2002 versus the self-regulatory regime they operated under with the AICPA, their trade organization, as the rulemaker and enforcer. Frauds did not end after the Sarbanes-Oxley Law was enacted. It’s now apparent that fraud drove many of the financial crisis failures. The subprime crisis turned into a credit crisis then a full blown financial crisis. Major industrial and financial services companies in the United States and abroad were bailed out, forcibly acquired, and effectively nationalized in order to survive.

During that time, no warning bells for shareholders and society as a whole, in the form of “going concern” opinions, were sounded. As financial crisis litigation has increased, we are now seeing, almost four years later, the extent to which accounting fraud, disclosure fraud, and accounting manipulation played a role in these failures. We have also seen a record number of enforcement actions for illegal acts by corporations and individuals under the Foreign Corrupt Practices Act.

Section 10A is not mentioned very often in enforcement actions against auditors. Frankly, there are few enforcement actions against auditors at all compared to the number of enforcement actions against client company executives. But 10A has been mentioned recently on two specific occasions.

“The reliability of global capital markets depends on auditors fulfilling their obligation to investors to perform robust audits, resulting in well-founded audit reports. Two of the PW India firms, PW Bangalore and Lovelock, repeatedly violated PCAOB rules and standards in conducting the Satyam audits. These confirmation deficiencies contributed directly to the auditors’ failure to uncover the Satyam fraud.”

James R. Doty, PCAOB Chairman

On April 5, 2011, the Securities and Exchange Commission (SEC) and the Public Company Accounting Oversight Board (PCAOB) announced settled disciplinary orders against five firms, members of the PricewaterhouseCoopers LLP (PwC) global network, for violations of PCAOB rules and standards and for violations of federal securities laws as well as improper professional conduct by PW India while PW Bangalore served as auditor of record for Satyam.

In addition, the SEC also sanctioned the PW India firms for, “violation of Section 10A(a) of the Exchange Act by failing to conduct procedures designed to provide reasonable assurance of detecting illegal acts that would have a direct and material effect on the determination of financial statement amounts.”

Technically, this was not an enforcement action for, “failing to report likely illegal acts that have a material impact on a company’s financial statements,” but instead for failing to perform the audit in such a way that those illegal acts have a high likelihood to be detected. The SEC, and the PCAOB which filed a simultaneous enforcement action, chose to believe that PW India was ignorant of the illegal acts. The jury is still out, literally, in India, on whether the Price Waterhouse India auditors were aware of the illegal act, complicit in the fraud with executives, and did not report them or were simply incompetent as the SEC would lead us to believe.

On October 3, 2011, the PCAOB issued Staff Audit Practice Alert No. 8, Audit Risks In Certain Emerging Markets.

In the Alert, the PCAOB warned that although authorities in many emerging market countries were taking steps to improve investor protection, the PCAOB, “has observed from its oversight activities some conditions in audits of certain companies in emerging markets that indicate heightened fraud risk. Other situations have come to light in recent corporate filings with the Securities and Exchange Commission (“SEC”) and in SEC orders suspending trading in securities of certain companies in emerging markets.”

In just two months in 2011, more than 24 companies with their principal place of business in the People’s Republic of China (“PRC”) filed Forms 8-K with the SEC reporting auditor resignations, accounting irregularities, or both.[4] “In some instances, the auditor’s letter of resignation stated that the auditor resigned because of circumstances that could constitute illegal acts for purposes of Section 10A of the Securities Exchange Act of 1934 (“Exchange Act”).” [5]

The SEC took action, including instituting stop order proceedings against two PRC-based companies.[6] Additional auditor resignations, recorded on Form 8-K, have occurred.[7]

• How many of the auditors associated with the 24 companies with their principal place of business in the People’s Republic of China that filed 8-Ks also filed 10A reports? Did the auditors who mentioned, “circumstances that could constitute illegal acts for purposes of Section 10A of the Securities Exchange Act of 1934,” file 10A reports with the SEC?
• Did the auditors of the two PRC-based companies where the SEC issued stop order proceedings perform their duties under Section 10A or did they fail to conduct procedures designed to provide reasonable assurance of detecting illegal acts that would have a direct and material effect on the determination of financial statement amounts?
• Will we see any SEC enforcement actions against these auditors for failing to detect these illegal or fraudulent acts via proper audits and failure to report the illegal acts to the SEC?
• Did the auditors do their job in China?

Investors count on the auditors as the last defender of shareholder interests before regulators and the lawyers get involved. I wanted to see if the auditors had at least warned the SEC of potential frauds and illegal acts, in particular during the period leading up to the 2008 financial crisis bailouts.

I checked with the GAO in June of 2011 to see if anyone in Congress had asked for an update since 2003 on Section 10A reporting by auditors. Chuck Young, Managing Director of Public Affairs said, “No, we have not done any review since the one in 2003.”

So I prepared a Freedom of Information Act (FOIA) request in June and then again in October for the same information Congress and the GAO had previously requested from the SEC. The first request I made covered the entire period since the last report to Congress, 2003, until the present. It also referred to a tracking system that the 2003 report said would be implemented to help track these submissions by auditors and the SEC’s actions on them.

5) It was reported to the GAO in May 2003 that the Division of Enforcement was developing a computer tracking system for referrals of Section 10A reports, as well as complaints concerning possible financial reporting violations. Please attach any status reports that document the development progress and eventual implementation of this “computer tracking system”.

Unfortunately, the helpful response from the SEC to my initial request was that a request for data for the period May 16, 2003 through May 31, 2011 was too extensive, especially because the above referenced “computer tracking system” had not yet been implemented.

So I revised my request to cover just the years since January 1, 2007 as a start. The idea was to replicate the statistics the GAO had prepared, at least. If I could also see the underlying reports and data, all the better.

In December the SEC responded to my request, but refused to provide information about three of the four inquiries. They cited confidential treatment of investigatory materials or they told me to do my own investigating. I will appeal. I can also appeal to the House Financial Services Committee’s Subcommittee on Oversight and Investigations. Maybe the Congressmen will make a new request to the GAO to update this important oversight report since it’s not been done during the post-Sarbanes-Oxley era and now post-financial crisis period.

It’s quite surprising that the one substantive response from the SEC I did get was to my FOIA inquiry regarding the number and case numbers of SEC actions filed, by year, between January 1, 2007 and September 30, 2011 against auditors for alleged violations of Section 10A for failing to report likely illegal acts materially impacting on a company’s financial statements.

The SEC replied that, “ a search was conducted of the Commission’s various systems of records, but did not locate or identify any information responsive to your request.”

There are still many unanswered questions about how and why the financial crisis frauds occurred. New frauds, such as the Chinese reverse merger frauds, took advantage of a public listing loophole that the SEC and auditors missed. All these investor losses occurred under the supposedly watchful eyes of auditors, who are paid dearly to protect shareholders but in many cases are either complicit, incompetent, or both.

Dear SEC, Please send me the following records:

SEC Response:

As was mentioned in our letter of October 25, 2011, the FOIA was not intended to compel agencies to become ad hoc investigators for requestors whose requests are not compatible with their own information retrieval systems.[8] Nor does the FOIA require agencies to conduct legal research and answer questions disguised as FOIA requests.[9] Consequently, we have processed the portions of your request where responsive records exist; however, we did not process the portions wherein questions are posed.

(1)  Please provide the number of Section 10A submissions, by year, from January 1, 2007 through September 30, 2011 and a copy of each report filed that identifies the registrant and the auditor and the date that the registrant received the Section 10A report from the auditor. The filing should include either a copy of the auditor’s report or a summary of the report including a description of the act that the auditor has identified as a likely illegal act and the possible effect of that act on the financial statements.

(2)  Please provide the status of the SEC actions on those 10A reports that were filed, by year, between January 1, 2007 and September 30, 2011.

SEC Response: After consulting with Commission staff, we have determined the following: With respect to items 1 and 2 of your request, responsive records are withheld in their entirety under FOIA Exemptions: 5 U.S.C. § 552 (b) (3) and 7(A), 17 CFR § 200.80 (b) (3) and (7) (i).

The internal records which consist of material pertaining to Rule 240 10A-1 are protected form disclosure under FOIA Exemption 3. Exemption 3 permits the withholding of documents specifically exempted from disclosure by another Federal statute. Section 240.10A-1 states in part, that records submitted under this section, “shall be deemed to be an investigative record and shall be non-public and exempt for disclosure pursuant to the Freedom of Information Act to the same extent an for the same periods of time that the Commission’s investigative records are non-public and exempt for disclosure under among other applicable provisions, 5 U.S.C. 552 (b) (7) and 17 CFR 200.80 (b) (7).” See, 17 CFR § 240.10A-1.

In addition, with respect to on-going enforcement activities pertaining to any f the 10A submissions, the records are protected form release under Exemption 7(A), which protects form disclosure records compiled for law enforcement purposes, the release of which could reasonably be expected to interfere with enforcement activities.

(3)  Please provide the number and case numbers of SEC actions filed, by year, between January 1, 2007 and September 30, 2011 against auditors for alleged violations of Section 10A for failing to report likely illegal acts materially impacting on a company’s financial statements.

SEC Response: With respect to Item 3 of your request, based on the information you provided in your letter, a search was conducted of the Commission’s various systems of records, but did not locate or identify any information responsive to your request.

(4)  Please provide the number of 8-Ks filed for auditor changes each year 2007-2010 and the number of requests for additional information from the registrants as needed to clarify matters reported on 8-Ks for auditor changes.

During this period, did the Division of Corporation Finance identify any significant potential violations of SEC laws and regulations as a result of auditor changes, or forward any matters to the Division of Enforcement for further investigation? How many were identified or forwarded, by year January 1, 2007 to September 30, 2011?  Please include status reports of these investigations, if any.

SEC Response: Finally, with respect to Item 4 of your request, a significant portion of the information sought is publicly available on our website at www.sec.gov under the section “Filings and Forms.” Specifically, anyone can search the EDGAR database for Form 8-Ks filed during any year, and for staff comment letters and response letters for any filings filed during 2007-2010. The Commission does not maintain a retrieval system designed for culling data based on the information cited in your request.

[2] U.S. General Accounting Office, Securities Exchange Act: Review of Reporting Under Section 10A, GAO/AIMD-00-54R (Washington, D.C.: Feb. 4, 2000).

[3] The PCAOB was established pursuant to the Sarbanes-Oxley Act of 2002 (Act) to oversee the audits of public companies that are subject to the U.S. Federal securities laws. As provided for by the Act, the PCAOB will set professional standards (including auditing, attestation, quality control, ethics, and independence standards) to be used by public accounting firms registered with the PCAOB in the preparation and issuance of audit reports of public companies.

[4] See letter from SEC Chairman Mary Schapiro, dated April 27, 2011, to the Chairman of the House Subcommittee on TARP, Financial Services, and Bailouts of Public and Private Programs, Congressman Patrick McHenry, at http://s.wsj.net/public/resources/documents/BARRONS-SEC-050411.pdf.

[5] See the discussion in the section in the PCAOB Alert on illegal acts.

[6] See SEC Press Release, Stop Order Proceedings Instituted Against China Intelligent Lightning and Electronics, Inc., and China Century Dragon Media, Inc. (June 13, 2011) at: http://www.sec.gov/news/press/2011/2011-127.htm

[7] See, e.g., Longtop Financial Technologies Limited, Form 6-K (May 23, 2011), Exhibit 2 at: http://www.sec.gov/Archives/edgar/data/1412494/000095012311052882/d82501 exv99w2.htm.

[8] Blakey v. DOJ, 549 F. Supp. 362, 366-367 (D.D.C. 1982).

[9] Satterlee v. IRS, No. 05-3181, 2006 WL 3160963, at *3 (W.D. Mo. Oct. 30, 2006).

Main page photo source: Adventures of a Ghanian

You may remember earlier this year when The New York Times broke a little story about General Electric’s tax savvyways and the best tax law firm the universe had ever seen (aka the GE tax department).

The report caused more than a few people to get bent out of shape because the Times said GE was enjoying $14.2 billion in profit while “claim[ing] a tax benefit of $3.2 billion.” What that “benefit” really entailed was a mystery but many people jumped to the conclusion that it was a “refund” andProPublica (possibly a little peeved that they got scooped) tried to set the record straight on the Times story.

Despite all the back and forth, everyone was pissed at GE. The company lost aTwitter joust with Henry Blodget and then a bogus press release went out claiming the company was returning the “refund” of $3.2 billion and the Associated Press ran it. Slightly awkward.

Francine McKenna also did a write-up on KPMG’s role in this little soap opera, as the firm has been the auditor for GE since Bill Taft was maxing out the White House bathtub.

The latest twist comes from a tip we received earlier about a “Preservation Notice” sent to all KPMG employees yesterday from the firm’s Office of General Counsel (“OGC”).

URGENT TARGETED PRESERVATION NOTICE: GENERAL ELECTRIC’S LOAN STAFF ARRANGEMENTS

Please be advised that until further notice from KPMG LLP’s (KPMG or firm) Office of General Counsel (OGC), you are hereby directed to take all steps necessary to preserve and protect any and all documents created or received from January 1, 2008 through the date of this Notice relating or referring to the loaning, assignment or secondment of tax or other professionals to General Electric Company and its direct and indirect subsidiaries, affiliates and divisions (collectively “General Electric’s Loan Staff Arrangements”).

Last March, I wrote the story that highlighted this arrangement. The preservation notice refers to tax and “other loaned staff arrangements” so there may be more like this at GE.

Uh oh.

Based on my reading of the rules, loaning, assigning, or seconding tax or any “bookkeeping” staff is not allowed for the auditor. What’s worse is that KPMG had been sanctioned recently for a similar issue in Australia. I guess they thought the SEC/PCAOB would never go after them in the U.S. and never for trying to “please” such a high-profile client.

The Sarbanes-Oxley Act of 2002 started out tough on tax. The rules regarding prohibited activities by the auditor, intended to preserve their independence, scared the living daylights out of the largest firms. It appeared initially that the SEC would prohibit the tax side of the firms from providing highly lucrative tax advice to their audit clients. Many of those professionals started planning an exit from their firms so they could continue working with long time clients.

A compromise was reached. The result is one of the loosest and most generous exceptions to auditor independence rules on the books.

The Commission reiterates its long-standing position that an accounting firm can provide tax services to its audit clients without impairing the firm’s independence. Accordingly, accountants may continue to provide tax services such as tax compliance, tax planning, and tax advice to audit clients, subject to the normal audit committee pre-approval requirements under 2-01(c)(7).

The Sarbanes-Oxley Act of 2002 also prohibits an auditor from providing “bookkeeping” services to its audit clients.

The rules utilize the previous definition of bookkeeping or other services, which focuses on the provision of services involving: (1) maintaining or preparing the audit client’s accounting records, (2) preparing financial statements that are filed with the Commission or the information that forms the basis of financial statements filed with the Commission, or (3) preparing or originating source data underlying the audit client’s financial statements. Our experience with this definition demonstrates that the concept of bookkeeping and other services is well understood in practice.

In defiance of these provisions, KPMG – GE’s auditor – provides “loaned staff” or staff augmentation to GE’s tax department each year. These “temps” perform tasks that would be otherwise the responsibility of GE staff. Sources tell me KPMG employees working in GE tax have GE email addresses, are supervised by GE managers – there is no KPMG manager or partner on premises – and have access to GE employee facilities. They use GE computers because the software required for their tasks is GE proprietary software.

This type of “secondment” to an audit client is never allowed. KPMG should know better. KPMG was recently sanctioned by the SEC for a similar transgression involving their Australian office.

KPMG Australia and at least one other KPMG member firm outside Australia seconded non-tax professional staff to work at each client’s premises, under the supervision and direction of each client, doing the same types of work that each client’s own employees or managers ordinarily would perform, in violation of the prohibition under Rule 201(c)(4)(vi) against “[a]cting, temporarily or permanently, as a director, officer, or employee of an audit client, or performing any decision-making, supervisory, or ongoing monitoring function for the audit client.”

KPMG earns approximately 10% of their total fee from GE for tax services not connected to the audit directly or indirectly. GE’s policies state that these engagements, if for more than $1 million dollars, must be pre-approved by the GE Audit Committee. However, these services should never have been provided at all per SEC independence rules -rules that pre-date Sarbanes-Oxley.

KPMG is well known for supporting, as an auditor, aggressive tax strategies.  Recent controversy over long-time audit client Citigroup’s use of deferred tax assets to pump up its profits is one example.  KPMG also once flew too close to the flame as a tax shelter provider. Its advice to private clients on how to pay less to the IRS almost got the firm taken out of the game completely.

So why, for a measly $8-10 million a year, is KPMG playing with fire in providing these low value, low margin, low status services to GE?  It may be that KPMG wants to hold on to the relationship at any cost.

Read the rest of my original story at Forbes.

Read the rest of the Going Concern story here.

The first column, “Deloitte Blurs The Lines To Court Mutual Funds,” discusses the appointment of SEC and Investment Company Institute alumni Elizabeth Krentzman as that firm’s new head of the U.S. mutual funds practice. Her responsibilities include business development and delivery of audit services as well as tax, financial advisory, and consulting.

Elizabeth Krentzman is a lawyer, not a CPA. She’s worked 11 out of the last 14 years at Deloitte, always on the consulting side of the house. But now auditors are reporting to her.

That’s because this month she got a new job leading Deloitte’s U.S. mutual fund industry practice. She oversees the auditors as well as the tax, financial advisory and consulting staff who serve that industry…

Read the rest here.

I can’t be there tomorrow in person so I thought I would answer a few of the questions for you and for them.

I’ve provided comments to some of the questions below in Bold. I’ve written on these topics many, many times. Instead of repeating those remarks, I’m directing you to some of the most relevant posts.  If you’d like to add your comments please add the appropriate question number for the PCAOB Board.

Ernst & Young Lehman Litigation: It’s No Victory If You’re Going To Trial (Judge Kaplan was damning in his criticism of vague and subjective auditing standards and found it impossible to hold Ernst & Young liable for not complying with them.)

New At Forbes: My Comments On The Latest Sanctions Against Ernst & Young

Going In Circles: A Few Remarks On Audit Reform (On auditor rotation and auditor signing of audit reports.)

The State of Sarbanes-Oxley Compliance: The Protiviti Survey Results

Say Anything: The Big 4 Defense of Overtime Exemptions

McKenna At The Georgia Southern Fraud And Forensic Accounting Conference (With a link to my presentation, “The Skeptical Professional: Requirements and Case Studies”)

Being Expedient: PwC Settles US Class Action

McKenna Speaks At The American Accounting Association Public Interest Section

Not Over Until It’s Over: Price Waterhouse India Settles Satyam (The Satyam case is a classic one regarding auditor independence and auditor skepticism.  Price Waterhouse India demonstrated not much of either.  The PwC US and International firms lack the authority to force them to.  The regulators are not doing anything about this and the courts are impotent, in many cases, to correct this fault.)

Price Waterhouse India Settles With Regulators But Satyam Saga Not Over

Will Auditors Be Held Accountable? The PCAOB Has A Plan

Auditors Abandon Investors On Liability Limits

Auditors Under Pressure In The UK. Or Are They?

Dear PCAOB Board: Your Job Is To Serve And Protect Investors

Top Ten Things Lawyers Should Know About Auditors

Asking The Difficult Questions: An Article About Audit Committees For IIA’s Internal Auditor Magazine

Questions in PCAOB Concept Release on the Auditor’s Report

Content of the Auditor’s Report

Questions

1. Many have suggested that the auditor’s report, and in some cases, the auditor’s role, should be expanded so that it is more relevant and useful to investors and other users of financial statements.

a. Should the Board undertake a standard-setting initiative to consider improvements to the auditor’s reporting model? Yes

Why or why not? Investors pay billions worldwide for an audit report that is universally panned. Investors have been vocal In the UK and in the US regarding the uselessness of the ‘pass/fail” approach to the auditor’s opinion. The current report provides little information about the judgments and decision processes taking place behind the scenes.  Auditors failed during the financial crisis to warn investors of trouble, let alone provide the realistic guaranty of safety for even a limited period of time that shareholders expect.  If this is an “expectations gap” we must close it, either by removing the requirement for an audit opinion from exchange rules – and admitting its futility like the US SEC did with ratings agencies – or improving it so it has a useful purpose for investors. They deserve to get their money’s worth from the effort.

b. In what ways, if any, could the standard auditor’s report or other auditor reporting be improved to provide more relevant and useful information to investors and other users of financial statements? Two places where the current report could be improved are:

1. Development of a clearing house of auditor names attached to public company audit engagements worldwide with their biographies and information about sanctions, suspensions and litigation against them.  I’m not so concerned about seeing a name on a printed report as knowing who is responsible for that audit over time and their qualifications and professional history.

2. The addition of an auditor’s “Disclosure and Analysis” would be priceless. It should be addressed directly to shareholders, not the Audit Committee, and be written in the style of Warren Buffet’s letter to shareholders.  It should state where the auditors and management disagreed and which one prevailed.  It should focus on judgments, estimates, and the range of practices especially regarding interpretation of key accounting standards amongst that issuer’s peer group.

c. Should the Board consider expanding the auditor’s role to provide assurance on matters in addition to the financial statements? If so, in what other areas of financial reporting should auditors provide assurance? Auditors should provide explicit assurance on MD&A. They are already required by standards to communicate with the Audit Committee regarding the adequacy of required disclosures. Interim Auditing Standard AU 380 requires auditors to determine whether all audit-related matters are communicated to the committee:

The auditor’s responsibility under Generally Accepted Auditing Standards (GAAS)

• Significant accounting policies
• Management judgments and accounting estimates
• Audit adjustments
• The auditor’s judgments about the quality of the entity’s accounting principles
• The quality of the management discussion and analysis (MD&A)
• Disagreements with management
• Consultation with other accountants
• Major issues discussed with management before retention
• Difficulties encountered in performing the audit

An Auditor’s Discussion and Analysis should repeat the substance of these communications and highlight where the Audit Committee and/or management disagree with auditors.

2. The standard auditor’s report on the financial statements contains an opinion about whether the financial statements present fairly, in all material respects, the financial condition, results of operations, and cash flows in conformity with the applicable financial reporting framework. This type of approach to the opinion is sometimes referred to as a “pass/fail model.”

a.    Should the auditor’s report retain the pass/fail model? No If so, why?

b.    If not, why not, and what changes are needed? The auditor’s report requires more detailed grading with an explanation of the grades.  Perhaps the grades can be assigned based on whether the failings are individually material or material in aggregate and whether they relate to adherence to standards, aggressive use of estimates and models, lack of disclosure, or poor internal controls.  I am in favor of the separate opinion on internal controls and question a company that could have an adverse opinion on internal controls (material weaknesses) and yet receive a clean opinion on their financial statements.

c.     If the pass/fail model were retained, are there changes to the report or supplemental reporting that would be beneficial? If so, describe such changes or supplemental reporting.

3. Some preparers and audit committee members have indicated that additional information about the company’s financial statements should be provided by them, not the auditor. Who is most appropriate (e.g., management, the audit committee, or the auditor) to provide additional information regarding the company’s financial statements to financial statement users? I am skeptical that most Audit Committees are sufficiently detached and independent of management that communications from them would be any more useful to shareholders.  That is a problem in and of itself.  If auditors were required to provide their own discussion or analysis, they may be reminded of their own need for independence from management.  However, the problem we have, and which is not solved by revisions to the audit report itself, is the problem of auditor independence as long as the auditors are paid by and contract for their services with an Audit Committee controlled by and in service to management.

At the PCAOB’s public meeting in March I heard some object to the auditor providing information to shareholders directly because that might harm the “relationship” between auditors and management.  Yes.  And that is exactly why auditors should be forced to face shareholders directly. Even the SEC’s Chief Accountant and the PCAOB Chairman have admitted auditors are too cozy with management, a non-independent Audit Committee encourages and enables that, and many auditors have forgotten who their true clients are – shareholders.  Auditors should respond directly to shareholders, not to the management-controlled proxy – a potentially non – independent Audit Committee.

4. Some changes to the standard auditor’s report could result in the need for amendments to the report on internal control over financial reporting, as required by Auditing Standard No. 5. If amendments were made to the auditor’s report on internal control over financial reporting, what should they be, and why are they necessary?

We should go back to a separate auditors report on internal controls over financial reporting. If an issuer receives an adverse opinion on internal controls it should be rare or impossible for that issuer to receive any “passing” grade on the financial statements.

Potential Alternatives for Changes to the Auditor’s Report

A. Auditor’s Discussion and Analysis

Questions

5. Should the Board consider an AD&A as an alternative for providing additional information in the auditor’s report? Yes

a. If you support an AD&A as an alternative, provide an explanation as to why. See above 1.b.

b. Do you think an AD&A should comment on the audit, the company’s financial statements or both? Both. Provide an explanation as to why. Should the AD&A comment about any other information? The quality of management’s D&A and any disagreements in that regard over sufficiency or quality of disclosures.

c. Which types of information in an AD&A would be most relevant and useful in making investment decisions? I think information about how the issuer compares in key metrics, disclosures, aggressive interpretation of standards, and use of models and estimates to their peers would be very useful.  In some industries, one auditor has an audit relationship with several major companies, addresses similar issues, evaluates similar approaches and either sees consistent or inconsistent results. This type of discussion and comparison would be very useful to identify outliers and anomalies as well as instances of collusion amongst companies with significant business alliances or who act as counterparties to each other.

d. If you do not support an AD&A as an alternative, explain why.

e. Are there alternatives other than an AD&A where the auditor could comment on the audit, the company’s financial statements, or both? What are they?

6. What types of information should an AD&A include about the audit? What is the appropriate content and level of detail regarding these matters presented in an AD&A (i.e., audit risk, audit procedures and results, and auditor independence)?

7. What types of information should an AD&A include about the auditor’s views on the company’s financial statements based on the audit? What is the appropriate content and level of detail regarding these matters presented in an AD&A (i.e., management’s judgments and estimates, accounting policies and practices, and difficult or contentious issues, including “close calls”)?

8. Should a standard format be required for an AD&A? Why or why not?

9. Some investors suggested that, in addition to audit risk, an AD&A should include a discussion of other risks, such as business risks, strategic risks, or operational risks. Discussion of risks other than audit risk would require an expansion of the auditor’s current responsibilities. What are the potential benefits and shortcomings of including such risks in an AD&A? The auditor is required to be aware of and knowledgeable about these areas per the standards. The auditor must take them into consideration in planning the scope of the audit. I see no additional work to disclose them and to give investors information about how this issuer compares to peer group.

10. How can boilerplate language be avoided in an AD&A while providing consistency among such reports? Regulators should forbid it and enforce accordingly.  All shareholders will, hopefully, start demanding meaningful information.

11. What are the potential benefits and shortcomings of implementing an AD&A?

12. What are your views regarding the potential for an AD&A to present inconsistent or competing information between the auditor and management? I’m not troubled by this.  In fact, I look forward to it. What effect will this have on management’s financial statement presentation? Management will be required to defend it. They should be prepared to do so or to back down.

B. Required and Expanded Use of Emphasis Paragraphs

Questions

13. Would the types of matters described in the illustrative emphasis paragraphs be relevant and useful in making investment decisions? If so, how would they be used?

14. Should the Board consider a requirement to include areas of emphasis in each audit report, together with related key audit procedures?

a. If you support required and expanded emphasis paragraphs as an alternative, provide an explanation as to why.

b. If you do not support required and expanded emphasis paragraphs as an alternative, provide an explanation as to why.

15. What specific information should required and expanded emphasis paragraphs include regarding the audit or the company’s financial statements? What other matters should be required to be included in emphasis paragraphs?

16. What is the appropriate content and level of detail regarding the matters presented in required emphasis paragraphs?

17. How can boilerplate language be avoided in required emphasis paragraphs while providing consistency among such audit reports? 18. What are the potential benefits and shortcomings of implementing required and expanded emphasis paragraphs?

C. Auditor Assurance on Other Information Outside the Financial Statements

Questions

19. Should the Board consider auditor assurance on other information outside the financial statements as an alternative for enhancing the auditor’s reporting model?

a. If you support auditor assurance on other information outside the financial statements as an alternative, provide an explanation as to why.

b. On what information should the auditor provide assurance (e.g., MD&A, earnings releases, non-GAAP information, or other matters)? MD&A, 10Qs.  Auditors should distance themselves from non-GAAP disclosures. Earnings releases should not be inconsistent with 10Qs.

c. What level of assurance would be most appropriate for the auditor to provide on information outside the financial statements?

d. If the auditor were to provide assurance on a portion or portions of the MD&A, what portion or portions would be most appropriate and why?

e. Would auditor reporting on a portion or portions of the MD&A affect the nature of MD&A disclosures? If so, how?

f. Are the requirements in the Board’s attestation standard, AT sec. 701, sufficient to provide the appropriate level of auditor assurance on other information outside the financial statements? If not, what other requirements should be considered?

g. If you do not support auditor assurance on other information outside the financial statements, provide an explanation as to why.

20. What are the potential benefits and shortcomings of implementing auditor assurance on other information outside the financial statements?

D. Clarification of the Standard Auditor’s Report

Questions

21. The concept release presents suggestions on how to clarify the auditor’s report in the following areas:

• Reasonable assurance
• Auditor’s responsibility for fraud
• Auditor’s responsibility for financial statement disclosures
• Management’s responsibility for the preparation of the financial statements
• Auditor’s responsibility for information outside the financial statements
• Auditor independence

a. Do you believe some or all of these clarifications are appropriate? If so, explain which of these clarifications is appropriate? How should the auditor’s report be clarified?

b. Would these potential clarifications serve to enhance the auditor’s report and help readers understand the auditor’s report and the auditor’s responsibilities? Provide an explanation as to why or why not.

c. What other clarifications or improvements to the auditor’s reporting model can be made to better communicate the nature of an audit and the auditor’s responsibilities?

d. What are the implications to the scope of the audit, or the auditor’s responsibilities, resulting from the foregoing clarifications?

22. What are the potential benefits and shortcomings of providing clarifications of the language in the standard auditor’s report?

Questions Related to all Alternatives

23. This concept release presents several alternatives intended to improve auditor communication to the users of financial statements through the auditor’s reporting model. Which alternative is most appropriate and why?

24. Would a combination of the alternatives, or certain elements of the alternatives, be more effective in improving auditor communication than any one of the alternatives alone? What are those combinations of alternatives or elements?

25. What alternatives not mentioned in this concept release should the Board consider?

26. Each of the alternatives presented might require the development of an auditor reporting framework and criteria. What recommendations should the Board consider in developing such auditor reporting framework and related criteria for each of the alternatives?

27. Would financial statement users perceive any of these alternatives as providing a qualified or piecemeal opinion? If so, what steps could the Board take to mitigate the risk of this perception?

28. Do any of the alternatives better convey to the users of the financial statements the auditor’s role in the performance of an audit? Why or why not? Are there other recommendations that could better convey this role?

29. What effect would the various alternatives have on audit quality? What is the basis for your view?

30. Should changes to the auditor’s reporting model considered by the Board apply equally to all audit reports filed with the SEC, including those filed in connection with the financial statements of public companies, investment companies, investment advisers, brokers and dealers, and others? What would be the effects of applying the alternatives discussed in the concept release to the audit reports for such entities? If audit reports related to certain entities should be excluded from one or more of the alternatives, please explain the basis for such an exclusion.

IV. Considerations Related to Changing the Auditor’s Report

A. Effects on Audit Effort

B. Effects on the Auditor’s Relationships

C. Effects on Audit Committee Governance

D. Liability Considerations

E. Confidentiality

Questions

31. This concept release describes certain considerations related to changing the auditor’s report, such as effects on audit effort, effects on the auditor’s relationships, effects on audit committee governance, liability considerations, and confidentiality.

a. Are any of these considerations more important than others? If so, which ones and why?

b. If changes to the auditor’s reporting model increased cost, do you believe the benefits of such changes justify the potential cost? Why or why not?

c. Are there any other considerations related to changing the auditor’s report that this concept release has not addressed? If so, what are these considerations?

d. What requirements and other measures could the PCAOB or others put into place to address the potential effects of these considerations?

32. The concept release discusses the potential effects that providing additional information in the auditor’s report could have on relationships among the auditor, management, and the audit committee. If the auditor were to include in the auditor’s report information regarding the company’s financial statements, what potential effects could that have on the interaction among the auditor, management, and the audit committee?

To his credit, Judge Kaplan does leave one important allegation for Ernst & Young to defend:

Ernst & Young had reason to know that Lehman’s 2Q 2008 financial statements could be materially misstated because of the extensive use of Repo 105 transactions.

John McDermott of FT Alphaville does a good job explaining why:

Kaplan dismisses the majority of the specific allegations against the auditors but writes that one particular incident means that the case against them cannot be thrown out [when] he stops to ask another question on Repo 105:

In other words, have plaintiffs sufficiently alleged that E&Y knew enough about Lehman’s use of Repo 105s to “window-dress” its period-end balance sheets to permit a finding that E&Y had no reasonable basis for believing that those balance sheets fairly presented the financial condition of Lehman?

The answer: yes, in one case.

Plaintiffs rely for this purpose on precisely the same alleged red flags discussed previously in connection with E&Y’s GAAS opinion – the “true sale” opinion, the netting grid, and the Lee interview. The first two are no stronger in this context than in that. The Lee interview, however, is a different matter.

The “Lee interview” pertains to warnings allegedly made by Matthew Lee, Lehman’s SVP for Global Balance Sheet and Legal Entity Accounting, that Ernst & Young were told of a $50bn repo 105 move in June 2008 but did not pass on the full information to Lehman’s board. Thus, it failed to fulfill GAAP requirements as part of its Q2 2008 auditing.

I’ve been saying for a while that there’s too much deflective focus on the accounting for Repo 105 and not enough on the disclosure.

Now they’ve got a public airing of some dirty laundry by the PCAOB.

From Compliance Week:

The Public Company Accounting Oversight Board has barred the now-former E&Y partner, Peter O’Toole, from associating with a PCAOB-registered firm for three years and fined him $50,000. The board barred the now former senior manager, Darrin G. Estella, from associating with a PCAOB-registered firm for two years. Both auditors can petition the board for reinstatement at the end of their penalty periods. In December, the PCOAB issued an earlier action against Jacqueline Higgins, an E&Y manager, in connection with the same incident.

The PCAOB says the three auditors created, backdated, and added documentation to an audit file when they learned it would soon be inspected by the board. The disciplinary orders say O’Toole was the engagement partner for an audit of an unnamed public company with a Sept. 30, 2009, year-end. The firm gave the company a clean audit opinion on Nov. 23, 2009, then learned the audit would be inspected in April 2010, with inspectors planning to study “securities valuation.”

Ernst & Young spokesman Charlie Perkins tells The Financial Times, “no harm, no foul,” as far as the firm is concerned.

“Our firm’s policy explicitly prohibits persons from supplementing or changing audit workpapers in circumstances like those present here,” said Charles Perkins, a spokesman for Ernst & Young, in a statement.

“When we determined that firm policy had been violated, we subsequently separated the partner and senior manager from the firm. We have co-operated fully with the PCAOB throughout its investigation of this matter. The conduct described in the order had no impact on our audit conclusions or on the client’s financial statements.”

Unless there are sanctions, we won’t know if more of this kind of thing is happening at U.S. firms. That’s becasue that part of the PCAOB inspection report is private.

We do know it’s happening at Ernst & Young in the U.K. Repeatedly.

From my post at Forbes.com, “By Any Means Possible: Auditors Try To Meet Standards By Faking It”:

The latest inspection report for Ernst & Young in the U.K., the same global firm that the PCAOB recently disciplined, cited specific deficiencies: (The AIU inspected thirteen engagements of a total of 295 eligible.)

Signing and dating of audit reports:

On two audits the auditor’s report was signed prior to the completion or evidencing of all necessary review procedures.

Completion of audit disclosure checklists:

…On two of the files that we reviewed it was unclear from the audit file whether the team had re‐performed the completion of the financial statements disclosure checklist.

Audit finalisation:

We found weaknesses in connection with audit finalisation procedures on seven of the audits we reviewed. The majority of these weaknesses related to undetected clerical drafting errors in the accounts including, in one case, an error in the disclosed audit fee.

I presented the luncheon keynote speech Friday, April 1st at the AAA mid-year meeting here in Chicago at the Hyatt Regency hotel.

My speech was entitled, “The Future of the Accounting Profession“. I also participated  in a panel discussion on Saturday afternoon, “Defining the Public Interest,” moderated by Professor Patrick Kelly of Providence College.

I’ve reprinted my speech below.

For the panel, I was asked to suggest research topics for accounting and audit academics who are interested in public policy and accounting and audit in the public interest. Get a grant and we can work together!

Here’s my Top X List. For more details get in touch or look around the site for more ideas and starting source material.

Going Concern warnings

• How soon after warning did a Chap 11 filing occur?
• How often do warnings occur outside of annual reporting period? What events precipitate them?
• How many companies survive a going concern warning one year, two years, five years?
• Re the banks – In UK and US, choose the top 20 banks that received bailouts, were nationalized for force acquired at brink of failure. None of them (except Bear Stearns, but it was a retro warning) received going concern warnings the annual reporting period prior to this event, i.e. 2007 and 2008 annual reporting periods. Review criteria for going concern and compare to balance sheets in four last quarterly reports. How many were insolvent or deserving of auditor going concern warnings based GAAS?

Audit firm litigation

• Settlements – examine trend of settlements twenty years (pre-post PSLRA) correlating to largest firms revenues reported, estimated margins. Are firms settling for more because claims are higher or because plaintiffs can squeeze more out of them as firms grew and prospered with lower settlements in lean year?
• Look at the few large cases that went to trial with a judgment against the Accounting firms (BDO-Bankest, PwC Ambassador Insurance). What are factors that cause a firm to go to trial rather than settle since it’s so rare?  Do they always lose at trial? Why?
• What is the magic number for a settlement that would be catastrophic to a Big 4 global firm?  Does it matter if it is in US or abroad – see EY’s legal troubles in Hong Kong  – Some have written it is $1 billion per firm or multiple smaller settlements for less than a billion that come too quickly.
• What is the litigation capacity of the largest four firms based on what we know about settlement patterns, revenues, margins and estimating source of funds and reserves. Look at trend in partner capital contributions, growth of partner numbers, aging population, other sources of capital…

Contingency disclosures and parallel assets – Review disclosures, valuations, reserves

• How often do two public companies in litigation have the same auditor?  Are litigation disclosures similar?  -  Using put-back or repurchase risk and reps and warranties issues as a starter – FHLB vs. BAC and JPM (PwC) , FRE vs JPM or BAC (PwC)
• Same assets on either side of an audit client – PwC and GS vs AIG re: super senior CDS, Repo 105 transaction between Lehman with UBS as counterparty (EY)

SEC sanctions against individual audit partners last ten years.

• Where are they now?  Do they stay at their firm? (DiFazio Delphi Deloitte) Move to another firm after sanction is lifted? (BDO partner) Do something else? Start a hedge fund?
• Are the sanctions issued so late after activity that some are already retired? (Bally’s EY)  What is deterrent effect? Track impact on audit quality of individual partner sanctions and look at a recidivism rate, if applicable.
• What would the impact of a “known and repeat offenders” list be on the profession? Would there be a deterrent effect?  Could easy access to the sanctioned and sued professionals and their location and status help investors?

And here’s the speech I gave on Friday April 1. There were some slides that were displayed at strategic spots.  They can be found here.

Good afternoon.

Thank you so much to Michael Kraten and the program committee for asking me to speak and allowing me the opportunity to participate in this conference. It’s enormously rewarding to me to be here amongst accounting educators with an interest in their public duty and the profession’s activities in the public interest.

My mother always thought I would be a teacher. That’s also a very noble profession. So it’s an honor to be here sharing my thoughts with a group of professional educators in my chosen field. Because as much as I am now a writer and speaker, I am still an accountant and I consider myself a professional.

I’ve worked a lot of different places over the years and I’m no different than you or your students in finding the world we live in a constant professional challenge.

I think your students will face more than one ethical dilemma during the first year of their career at a large public accounting firm or other work environment. In a public accounting firm, which is my focus, the landmines are everywhere.

They may have to decide whether to check a box for a test or review that wasn’t done. They may be asked to create or backdate a workpaper to complete a file before a quality review or PCAOB inspection. They may be pressured to falsify their timesheet to stay under budget for their part of the engagement.

Some will make the right decision and some will go along to get along. This is self-interest and career survival. These are the pressures that chip away, day after day, at their self-esteem as professionals and their ethical resolve.

I graduated in 1984 with a degree in Accounting from Purdue University.

1. My first nine post-graduate years were spent, first, as an internal auditor and financial analyst at the first “too big to fail” bank, Continental Illinois National Bank and Trust of Chicago. Then I worked as a financial reporting manager, G/L manager and Controller in two different B2B industrial distribution companies.

Some of my best “truth is stranger than fiction” stories are from those years and it was during this period that I passed the CPA exam.

2.  The next eight years I spent with KPMG Consulting, JP Morgan, and then returned to BearingPoint as a consultant. The last half of this period was spent 100% in Latin America.

3.  The post 9/11 years, until recently, were spent at two firms, Jefferson Wells, part of Manpower, as a Regional VP for the Midwest including Toronto, and at PwC, auditing the firm itself.

4.  I’ve been on my own now since October 2006, writing re: The Auditors, writing the column at Forbes and writing for others such as Accountancy Age in the UK.

I’ve now embraced another profession – journalism – that has its own list of ethical standards for writers that want to be taken seriously. But journalism is a profession with a voluntary set of standards and code of ethics, not the legally required ones we have to adhere to.

So, what are the standards accounting professionals must acknowledge and adhere to?

First, let’s differentiate between an “accounting professional” and the accounting or audit industry where many professionals practice.

Those of you who are CPAs and teach rather than work in industry can attest that I’m talking about two different things. Accounting professionals work in industry, government, politics, journalism, academia, and other vocations other than a public accounting firm.

What does it mean to be an “accounting professional”?

[Slide1]

That’s it.  If you work in client service, if you are a CPA, your first obligation as a professional is to your client – not your firm, your partners, or even your family. If your client is doing something illegal, then your obligation shifts to society and to law enforcement. That may seem harsh, but it’s the code that’s supposed to insure that lawyers and accountants, for example don’t cut corners out of their own self-interest and to the detriment of their client’s interests.

Many of you, as accounting educators, send a large number of your graduates, especially your best and brightest to work for public accounting firms.

In the United States, certified public accountants are the only authorized non-governmental type of external auditors who may perform audits of financial statements and provide reports of those audits for public review, submission to the SEC, and to comply with exchange listing standards. In the United States, the firms and their state-certified, licensed professionals are also required to be independent of the entities being audited.

Public accounting is an industry that employs many accounting professionals, as well as lawyers and other professionals. Each group has its own set of standards and a code of ethics. As a regulated industry, all employees of public accounting firms have an obligation to behave within laws and standards governing that industry that are intended to protect investors and serve the public’s interest.

Look at the four largest global public accounting firms. They officially operate as a loose confederation of separate private partnerships for legal reasons and to insure secrecy, but their size and complexity makes them look more like corporations to the outsider. They manage by consensus, but in reality a limited number of partners lead the firm and make decisions on behalf of thousands of “partners” who are more like highly paid executives.

The top four firms generate more than $100 billion in total revenues globally and employ more than 600 thousand people. As auditors and advisors, they work inside the banks, brokerage firms, auto manufacturers, mortgage brokers, and homebuilders. They’re “in the know” about every public company and most large private companies, earning millions of dollars in fees, for audit opinions that, in my opinion, have ultimately proved worthless when it comes to the big financial institutions. Auditors were right there standing by in the boardrooms when the US government took over Fannie Mae, Freddie Mac, Citigroup, and AIG.

They are still at standing executives’ right hands, and also earning more fees helping the US federal government under TARP to organize and control the taxpayers’ new investments in subprime loans, non-liquid assets, and exotic financial instruments. The public accounting firms make money whether companies thrive or whether they fail. The Big 4 firms are now charging billions to advise each other’s clients as those companies file for bankruptcy protection.

Once your students go to work for the firms, they’ll be forced by the reality of auditor litigation, risk, independence, and quality policies, and seeing their firm’s name in the paper more often to think about some serious industry issues:

• Should auditors be immune from liability or accountability for their malpractice and when they’re guilty of aiding and abetting fraud?
• Does the “too few to fail” argument have merit?
• Is it realistic for us to expect auditors to acknowledge a public duty?
• Do audit firms have a right to look after their partners and their profits before the public?
• Do accountants working in for-profit private audit firms feel like professionals?
• Can large audit firms maintain ethical standards, as a firm and as a group of individuals?
• Whose ethical standards should the firm and the individual uphold?
• Does an individual who would otherwise be ethical or at least true to his own values, become compromised once he works for a larger firm?

I believe that a very good discussion of this challenge (larger firms becoming immoral or amoral) is taught in the seminar, “Leading Professional Services Firms, ” in Harvard Business School’s Executive Education program.

[Slide 2]

You can agree or disagree whether these ideals work when serving multi-billion dollar multinationals to produce the current audit report product. When a professional services firm strays from these principles, it runs the risk of sacrificing values, culture, a code of ethics and the requirement to put the client’s interests above theirs that is inherent in being a firm made up of  “professionals”.

A corporate structure, for example, means a professional services firm has to focus on financial results and meeting shareholder expectations rather than meeting partner expectations within the constraints of the values, expertise and professional code of ethics that the firm agreed on when it came together.

Some interesting examples of corporate model professional services firms with varying levels of success are:

• BearingPoint, a spin-off of KPMG,
• Accenture, Huron Consulting, and Protiviti all have an Arthur Andersen pedigree, and
• Resources Global, a spinoff of Deloitte.

Growing too large or acquiring firms that have very different values or culture, even within the partnership model, can also stretch the limits of aligned behavior.

One case that will have a significant effect on how employees of the audit firms view themselves and how the firms view their contribution is the class action in California, Campbell v Pricewaterhouse, a lawsuit about overtime.

Several overtime lawsuits are pending against some of the major accounting firms doing business in California. These suits were filed by non-CPAs, non-licensed associates (entry level college graduates), who believe they were misclassified under California law as exempt professionals and are due overtime and other benefits due to non-exempt employees.

I have mixed feelings about these lawsuits. In twenty-five years of working as an accountant, consultant and internal auditor, I have never been paid time and a half. When you choose to work in a profession, you don’t expect it. My father belongs to three unions and has pensions and generous health benefits in retirement as a result. When I was growing up, as the oldest of six on the South Side of Chicago, his overtime pay as a fireman and bricklayer was what made extras like vacations and college possible. But it was the dream of an easier life for their kids – higher pay for less labor because they had worked long and hard to educate all of us – that drove my parents to give us the chance for a “professional” career.

Many college graduates, these days, don’t see the point in working eighty hours a week during the busy tax or audit season for a fixed salary. When they calculate their hourly rate, even given the fairly generous salaries, signing bonuses, and benefits the best and brightest get as new Audit Associates, many question the total cost of the sacrifices they’re making.

All they see are strained relationships with family and friends, excessive stressful travel, late nights spent performing mind-numbing “monkey work” on laptops, non-stop scanning and photocopying, fewer partners and opportunities for promotion, and very little use of the ambition and brains they thought they were hired for.

It’s no wonder that with the increase in layoffs and cutbacks at the audit firms during the general economic slowdown, when Sarbanes-Oxley work slowed and the financial crisis hit, accountants starting careers in the new millennium have to squint to see the light at the end of the tunnel.

A few states like California, Wisconsin, and Massachusetts – and Canada where similar suits were settled with very little notice here – have wage and hour laws that are perceived as more employee-friendly. Some believe the audit firms are breaking the law in many states by treating non-licensed, non-supervisory, staff as “exempt” from overtime.

The suits are all in various stages but Campbell v. PricewaterhouseCoopers is the fastest moving. On March 11, 2009 a lower court in California court granted plaintiffs’ motion for summary adjudication on the issue of exemption. The judge agreed that the audit associates at PwC in California are not exempt from overtime pay under the 2001 wage order.

But the court noted that the determination regarding exemption is one involving a controlling question of law, that there is substantial ground for difference of opinion, and that an immediate appeal from the order will materially advance the ultimate termination of the litigation. Therefore, Judge Karlton certified the matter for interlocutory appeal pursuant to 28 U.S.C. § 1292.

What all this legalese means is that the plaintiffs and their law firm are winning so far. The Ninth Circuit Court of Appeals accepted the appeal and Campbell will finally be argued today before the 9th Circuit Court of Appeals. The oral arguments will produce a ruling either affirming or reversing the lower court decision. That means either the audit associates will finally win or the issue will go to trial.

The judge, when concluding that “unlicensed accounting assistants do not fall under the learned professional exemption”, made this observation:

The court would be less than frank not to recognize the difficulties this interpretation tenders for some of the employees identified in PwC’s brief. They are not before this court and thus no opinion concerning them need be reached. I note in passing, without intending to suggest resolution of other issues, that at least arguably the work engaged in by the class members is more like the work of paralegals than law clerks.

Does the requirement of a Masters in Accountancy in order to reach the 150-hour CPA licensing requirement in some states negate my assumption of a graduate degree as a sufficient, if not a necessary, condition to be considered a “professional” without a license?

Will universities that provide their states’ CPA hour requirements without the necessity of a graduate degree doom their graduates to status as “para-accountants” until licensing?

There’s an economic argument at play here: In this environment more work produced for less pay is both tolerated by labor and a business model that rewards firms with higher profitability. But there’s also a practical regulatory issue at stake: Can the regulators allow audit firms – who play a role as critical regulatory cogs in the financial system wheel – to delegate more judgment and decision making over financial reporting and disclosure to the lowest level of staff because they are the per-hour cheapest?

If you’ve watched any medical-themed TV show, you know what lack of sleep, overwork, crappy food, and low pay means for emergency room health care delivery. You may also be able to afford the sweatshop approach to media. But can your 401k afford “slave labor” when the product of using the lowest cost labor input is fraud and failure?

Individual assimilation and success in a Big 4 public accounting firm starts with selection based on university credentials, referrals from professors, family background, and business ties, as well as having political beliefs and economic philosophies that are aligned with firm values. This process now starts in some universities in freshman year, with some students having two or three internships before they graduate.  For some students it starts even earlier.  One or both parents work for the audit firms and the career is one that has always been considered a safe choice. That’s especially true if the apple doesn’t fall far from the tree in talents and personality.

Auditors often marry other auditors or accountants because in school or in their early career they have no time to date anyone else! How many of you married an accountant?

Internal operations of the public accounting firms, especially the largest ones, are conducted in a secretive manner. Financial results and common business metrics are minimally disclosed to the outside and on a “need to know” basis even internally. Once initiated into firm culture, survival requires adoption of an informal oath of allegiance that makes it shameful to betray even one’s deadliest enemy, your competitors, to legal and regulatory authorities. It’s a Big 4 type of omertà, the extreme form of loyalty and solidarity in the face of authority usually attributed to the Mafia.

Examples of an extreme sense of loyalty to even those who’ve disgraced the profession can be found when partners that have been sanctioned by the SEC, forbidden to audit public companies, are later reinstated. Deloitte, for example, kept the partners responsible for Delphi and Navistar on their payroll during their SEC suspension and they survived the sanction to audit more public companies.

Only in cases of potential criminal indictment, such as insider trading or the tax shelter scandals are individuals thrown under the bus by their firms. That’s because the financial and reputational risk to the firms of not cooperating with a Department of Justice criminal indictment is more significant than the cost of defending and typically settling private securities litigation.

Private parties have significant difficulty getting suits against audit firms past the complaint stage to discovery and a trial given the higher requirements for pleading particularity based on the Private Securities Litigation Reform Act of 1995. Particularity means that investors basically have to present, at the pleading stage, hard evidence such as whistleblowers or leaked documents proving complicity in a fraud or deliberate fraudulent behavior on the part of auditors, not just implied auditor fraudulent behavior. Third-party aiding and abetting allegations are not allowed to be made by anyone but the SEC.

In addition, the federal authorities are fiercely reluctant to be the instrument of destruction of another firm a la Arthur Anderson via a criminal indictment or a significant SEC civil complaint. That means the auditors have as much moral hazard now under the “too few to fail” doctrine as the banks have under “too big to fail”.

However, that doesn’t mean the audit firms aren’t faced with an enormous amount of litigation they spend significant time and money fighting.

[Slide 3]

And we haven’t even gotten started with holding them accountable for their role in the financial crisis.

[Slide 4]

[Slide 5]

It’s not easy for an individual external auditor to step up and do the right thing. The model of providing audits, a critical public service meant to protect shareholders via a profit making private partnership, often encourages “behavior that must be regulated”.

The Sarbanes-Oxley Act of 2002 established the PCAOB to replace industry self-regulation after Enron because the public perceived that peer review and self-regulation for auditors of public companies had failed.

Many accounting professionals who work for the audit firms write me in earnest for advice.  One of the more common sources of confusion is about their “true client.” They do not know who their real client is. They have either never been taught this concept or had it beaten out of them by the reality of which behavior is rewarded at their firms.

The client for audited financial statements is the shareholder, not the company management. The Audit Committee of the Board of Directors, who hires and is supposed to manage the external auditor, represents that shareholder client but has a legal duty to the corporation not the shareholder. Other stakeholders include bondholders, lenders, employees, vendors/customers who depend on the continued viability of the company, and regulators (whose role is to protect investors and overall capitalist system.)

When professionals forget or suppress acknowledgement of their true client, an auditor loses the ability to properly structure decisions with moral and ethical implications, let alone those with serious legal and regulatory ones.  In the face of potential legal implications of a decision, they seek advice from their own counsel in order to avoid liability.  In the face of a moral or ethical dilemma, they look at costs/benefits of looking out for the shareholder versus looking out for their own financial self-interest, at an individual and at a firm level.

This is not just my polyanna-ish opinion.

New PCAOB board member Lew Ferguson spoke at an open meeting of the PCAOB last week and explained the disconnect:

[Slide 6]

What’s also remained the same over forty years is the auditor’s attitude towards investors. Except for a brief period of mutual antagonism after the passage of the Sarbanes-Oxley Act in 2002, auditors behave more than ever as if company management – typically the CFO – is the client with the Audit Committee, rather than investors, now a priority in their “relationship management” activities.

Major investors told the PCAOB that they feel they’ve been left out.

It’s clear to me that auditors demonstrated a profound lack of professional skepticism and professionalism during the crisis. They ignored the possible motives and motivations of their audit subjects.

Rather that assuming management, and possibly the Board of Directors, is self-centered and human, they accorded them the highest form of deference. In the interest of maintaining financial and social relationships, the auditors did not sufficiently challenge and expose survival instincts and financial incentives on behalf of shareholders and the public.

[Slide 7]

Human beings, however noble, virtuous, and full of integrity in words often fall short in action. We only have to look at the cases of whistleblowers I’ve written about to see how hard it is to step up.

Whistleblowers and those that push unpopular ideas or try to report on wrongdoing often lose their jobs, are vilified by the former employers and sometimes their former colleagues, are often disbelieved and laughed at, attributed with bad attributes and intentions such as revenge, anger, payback, whining, mercenary goals, bitterness, spite, Don Quixote-like tilting at windmills, unreasonable idealism, and impractical expectations.

Whistleblowers are often very right, but often end up being right all alone.

How many times has an external or internal auditor been told when raising concerns or questions about lack of segregation of duties, improper expense reports, lack of proper authorizations for stock options or shady compensation decisions:

“He’s a man of integrity.  He lives this company. He is a pillar of the community.  He donates to charity. He is an elder statesman of the industry. He has unquestionable, unassailable ethics and cares about this company.”

And maybe they are also told, “How dare you suggest that he would ever do anything to harm his employees, shareholders, business partners…”

Faced with the challenge of questioning someone who everyone else thinks is an icon and may not be, most people back down, question themselves, wonder if they’ve read, seen, or heard what they thought they had. Pressured by the cost of moving forward with potentially imperfect evidence, or with an accusation that shakes the foundations of belief and trust, most “professionals” trust their boss, the lawyers, the advisors, and drop it.

And then there’s the money. Raising difficult issues potentially threatens lucrative business relationships, big deals, or an important promotion. Speaking up can be a career- limiting move, threatening your own livelihood in addition to the success of your office, your practice, and your firm.

But auditors, who are inevitably almost always CPAs, have a higher responsibility. Making the type-two error of being right in your suspicions of illegal activity and potentially enormous harm or loss and not acting on them is completely unacceptable.

Don’t let anyone ever tell you again, after Madoff and the rest of the cases of hubris we have seen during this ignominious year, that any man or woman is above suspicion.

When you’re told, “He’s an icon,” as a professional you should look even harder, be professionally skeptical, trust your own instincts and judgment as long as they have been educated and are competent and objective.

Please teach your students the principle of professional skepticism.

[Slide 8]

[Slide 9]

PCAOB Chairman Jim Doty explained this principle at that same open board meeting last Wednesday:

[Slide 10]

When public accounting firms behave unprofessionally – break laws and compromise standards – the audit industry damages the accounting profession.

The future of the accounting profession is, for better or worse, in the hands of the audit industry.

Mark O’Connor, CEO of Monadnock Research, put together a research note for his subscribers that gives us the details of the accusations. He also provides new insight into why a guy like Gupta may have committed these alleged crimes.

Gupta is alleged to have tipped Galleon’s Rajaratnam, a friend and business associate, providing him with confidential information learned during board calls and in other aspects of his duties on the Goldman and P&G boards. Gupta reportedly made calls to Rajaratnam “within seconds” of leaving board sessions where market-moving information was discussed.

The complaint alleges that Rajaratnam then either used the inside information on Goldman and P&G to execute trades on behalf of some of Galleon’s hedge funds, or shared it with others at Galleon, who then traded on it ahead of public disclosure. The SEC claims the insider trading scheme generated more than $18 million in a combination of illicit profits and loss avoidance.

The SEC also says that Gupta was, at the time of the alleged disclosures of confidential non-public information, a direct or indirect investor in at least some of Galleon’s hedge funds, and had other business interests with Rajaratnam.

Gupta, as a McKinsey veteran, embodied the “trusted advisor” consulting ethos and personified the McKinsey “advisor to CEOs” business strategy and brand. The firm’s value to its clients and its effectiveness as an advisor requires knowing their secrets and holding them close to the vest.

Gupta was McKinsey & Company’s worldwide Managing Director for 9 years from 1994 through 2003…Gupta, now 62, stepped down as a McKinsey partner in 2007, and has since served as Managing Director Emeritus, according to his profile at the Indian School of Business (ISB). Gupta was instrumental in co-founding ISB in 2001, and continues to serve as its current Governing Board Chairman and Executive Board Chairman. He is also a current or former board member (or trustee) of AMR Corp., the parent of American Airlines; the Rockefeller Foundation; the University of Chicago; Harman International Industries; Genpact India; the World Economic Forum; the International Chamber of Commerce, World Business Organization; New Silk Route and New Silk Route Private Equity; and the Emergency Management and Research Institute. Galleon’s Rajaratnam was also associated with the New Silk Route ventures, where Gupta continues as Chairman. Rajaratnam is no longer associated with those entities.

Several media commentators have openly wondered whether the accusations against Gupta, and earlier accusations in the same scandal against McKinsey senior partner and Gupta protégé Anil Kumar, strike a deadly blow to McKinsey.

Will Rajat Gupta Destroy McKinsey? John Carney, NetNet, March 2, 2011

McKinsey’s clients are attracted by its reputation for excellence and discretion—and its stellar network of alumni. Its consultants often refuse to even disclose who their clients are.

If the charges against Gupta prove true, it could be a mortal threat to the firm. Even if there’s no evidence that confidentiality was breached while Gupta was at the firm, being led by a man who would later leak insider information would be devastating. If Gupta is shown to have engaged in similar actions while he was at McKinsey, that could be the end for the Firm.

“At that point, I think we go the way of Arthur Andersen,” another former McKinsey consultant said, referring to the once-prestigious accounting company brought down by its connections to Enron.

Loose Lips, Reuters BreakingViews, Robert Cyran and Rob Cox, March 3, 2011

McKinsey’s reputation rests on its ability to keep secrets. Consultancies, unlike investment banks, don’t provide access to financial markets.  All they offer is counsel, which relies partly on confidences revealed by their clients. According to McKinsey, “Our clients should never doubt that we will treat any information they give us with absolute discretion.” The allegations against Gupta make it hard for clients not to wonder.

It’s understandable that, in the heat of this moment, some might naïvely compare the consequences of the criminal indictment of an audit firm with civil charges against an individual, albeit one who trades on – pun intended – his association with a prestigious professional services firm.

It’s not the same thing.

Extrapolating Gupta’s behavior to McKinsey as a whole is a stretch. I’m no McKinsey apologist but one man, even a former Global Managing Director, does not make this firm.

On the contrary. The firm made him and he’s the one whose currency is now worth less.

Let’s look at a few similar examples from the world of the Big 4 audit firms. The accounting firms are actually regulated and they’re still around in spite of inside traders inside of them, trading on their client confidences more than once.

A Deloitte active-duty Vice Chairman, Thomas Flanagan, was accused and settled with the SEC this past summer over insider trading charges related to several Fortune 500 companies. Auditors have a public duty to shareholders and a legal obligation under federal securities laws to maintain engagement confidentiality, in addition to their contractual obligation to do so.  Directors have a duty only to the corporation. And yet, the Flanagan story captured only momentary media attention and no one claimed Deloitte was going down as a result. In fact, the SEC never even charged Deloitte. It was somehow acceptable to the regulator when the firm said they had been duped by their own senior leader.

Closer to the kind of work McKinsey’s Gupta did for clients, we have another senior Deloitte partner accused of insider trading, Arnold McClellan. He advised private equity firms about the tax implications of proposed acquisitions. The level of trust  – and consequences of a betrayal of that trust  – in M&A advisory is akin to the level of trust expected of a company director. Interestingly, the two cases have a company in common – Kronos.

The McClellan case is pending but, in spite of being the second one for Deloitte in such a short time and with allegations of tipping others for profit that covered the same time period as the Flanagan case, Deloitte is still kicking consulting ass and taking names, including for the federal government.

And finally, but certainly not meant to complete an all inclusive list of auditors accused of betraying client confidences in service to insider trading, we have the poor Ernst and Young Tax partner James Gansman. He was lured by the bad, bad internets into a debauched life of inside trading and an illicit love triangle.

In the fall of 2004, a forty-something investment banker named Donna Murdoch logged into Ashley Madison, the discreet dating website married people visit “when divorce is not an option,” and introduced herself to James Gansman, a partner at Ernst & Young in New York. The two struck up a relationship, meeting occasionally in hotels in Philly, New York, and California, and talking on the phone about their lives: James told Donna about how he was kicking ass at work, Donna told James about how she was struggling with her subprime mortgage.

Eventually the two settled into a comfortable day-to-day routine in their respective offices in New York and Philadelphia, staring at the same Yahoo Finance screen.

{…}

Eventually, their conversations about business grew more specific.

Mr. Gansman led Ms. Murdoch in a guessing game about which deals he was working on, she said. “The game was that I wouldn’t be looking and he would give me hints: The market cap of two billion or market cap of 400 billion, and here’s what they do, and he’d read it to me, and ultimately make sure I guessed,” Ms. Murdoch testified. Before long, the guessing game fell away. Mr. Gansman told her more directly about upcoming deals of Ernst clients, she said.

She made $400, 000 off the deal, and the SEC noticed. He made nothing, and now he’s going to jail. The end.

Ernst & Young survived the embarrassment of one of their partners being an inside trader. Even worse, the firm was mentioned in the same news stories as swinger cheater site AshleyMadison.com. Ernst & Young is still working for the federal government and several Fortune 500 clients as an auditor in spite of also being accused of complicity in the failure of Lehman Brothers.

You may wonder why Gupta, a rich and successful businessman, would risk everything to pass inside information to friends. He didn’t need the money. We have not seen any evidence he profited personally from the trades, unless Galleon’s Rajaratnam sent profits to him indirectly through other business interests in India, for example. Monadnock Research’s O’Connor gives us a clue into the gargantuan ego and pure pathology which might help someone like Gupta rationalize the behavior of which he is accused.

Just after starting his third term as McKinsey’s Managing Director in May 2001, Gupta did an interview with Wharton Professor Jitendra Singh for the Academy of Management Executive. [i] The interview was wide-ranging and retrospective on the subject of Gupta’s contributions to McKinsey since his appointment as its leader in 1994, with a special emphasis on his contributions toward policies, processes and systems to support enterprise knowledge innovation at McKinsey.

Monadnock Research co-founder, Mark O’Connor, interviewed Brook Manville, McKinsey’s Chief Knowledge Officer, four years into Gupta’s terms and featured many of the firm’s innovative efforts in his Yankee Group report, Knowledge Management: People and the Process.

Gupta closed the 2001 interview with the following quote, when addressing the question of what advice he would give to young men and women just starting their business and public service careers.

Gupta: “Oftentimes many of us get tied up in what is good for our careers, how to get ahead, what’s the best career to pick. More important is, I think, to develop as a professional, to have a learning mindset, to always learn from every experience and to become a richer human being. If you concentrate on that, then career success automatically follows. If you make career success an over-arching objective, you’ll not become a full human being, a rich human being, a great professional, or a great leader.

The second piece of advice I’d give is that I think it is vitally important to make other people successful. If you have a mindset of always trying to make other people successful, they will in turn make you more successful that you ever dreamed-of. So, I really believe that it’s not about getting ahead at the expense of others, it is getting ahead because lots and lots of people are helping you achieve it.

Singh: “Perhaps together with others.”

Gupta: “Yes. The last thing I’d say is that you have to have a set of values and principles that you really believe in that is your moral compass. Avoid the temptations of doing the politically right things, because the person you have to live with the most in your life is yourself. You have to always be true to your own set of values and principles, even though there may be temporary costs to that.”

McKinsey had that interview posted on its Web site at the time of this writing. Certainly there are many interpretations of Gupta’s words in this passage. The irony of it in support of the SEC’s allegations will almost certainly not be lost on government prosecutors.

What hangs in the balance, beyond the obvious allegations, is what Gupta truly meant philosophically with his advice to our next generation of business and government leaders. The best and worst examples of ethics are evident in his words. Clearly no reader of this interview would have had any question of its meaning in 2001. But there is a clear foundation for questioning it today.

Statement of Gary Naftalis, Counsel for Rajat Gupta

These allegations first made by the SEC are totally baseless. Mr. Gupta’s 40-year record of ethical conduct, integrity, and commitment to guarding his clients’ confidences is beyond reproach. Mr. Gupta has done nothing wrong and is confident that these unfounded allegations will be rejected by any fair and impartial fact finder.  There is no allegation that Mr. Gupta traded in any of these securities or shared in any profits as part of any quid pro quo. In fact, Mr. Gupta had lost his entire $10 million investment in the GB Voyager Fund managed by Rajaratnam at the time of these events, negating any motive to deviate from a lifetime of honesty and integrity.

Main page art is from Damien Hirst’s Sotheby’s sale, “Beautiful Inside My Mind Forever” described here.

The Supreme Court decision on Free Enterprise Fund v. PCAOB will be handed down on June 28th. Whether the PCAOB is or isn’t declared unconstitutional, there are some key gaps in the original Sarbanes-Oxley legislation that should be addressed.  Now is the time to give the PCAOB the tools it needs to be as effective as possible.

For those of you less familiar with the issues involved, the Journal of Accountancy does a great job of laying it out:

The case hinges on two intertwined legal issues that are unrelated to the effectiveness of the PCAOB, according to Metzger. The first issue is whether the PCAOB violates the appointments clause of the Constitution.

Even though the PCAOB is organized as a private-sector organization, because it was created by Congress with regulatory authority, the plaintiffs argue, it is legally an agency of the federal government for constitutional purposes. As such, PCAOB board members are appointed officers of the government.

The plaintiffs contend that the SEC’s oversight of the PCAOB, which includes approval of its budget, rules and disciplinary actions, falls short of comprehensive supervision because the SEC has no power over the PCAOB’s investigations or standard-setting agenda. This means, the plaintiffs say, that the five members of the PCAOB are principal officers of the government who must be appointed by the president.

The second issue raised by the plaintiffs is the separation of powers doctrine, which requires the president to execute laws made by Congress—to be in charge of the government. The power to appoint officers of the government is one indicator of presidential authority. The power to remove officers of the government is another. Under SOX, only the SEC can remove members of the PCAOB and then only under limited circumstances.

How will the case be decided? Legal blogger Josh Blackman has an opinion:

…this case will probably be settled along the lines of judicial non-involvement, whereas the liberal justices would join in a broader decision uphold the constitutionality of the Board. Charting a middle course between those two issues probably goes a long way toward explaining the delay in opinion.

How did this case ever get this far? Goes to show you the power of the overall anti-Sarbanes-Oxley sentiment and the sympathy for the small businessman, even if in this case he’s a CPA that won’t accept the fact his firm wasn’t ready for the post-SOx prime time.

Jonathan Weil in Bloomberg: Two years ago, a tiny Las Vegas accounting firm called Beckstead & Watts LLP filed a lawsuit challenging the constitutionality of the Public Company Accounting Oversight Board, after receiving an unflattering report card from the auditing profession’s fledgling regulator. The suit once seemed like a quixotic attempt at revenge, especially after a federal judge ruled against Beckstead last year. Not anymore, though…

Lousy Audits

At Beckstead, the board’s inspectors in 2004 found a firm with just one partner and two professional staff people, auditing the books of 61 companies. Many of its audits were lousy, the inspectors concluded. Beckstead responded by teaming with a nonprofit outfit called the Free Enterprise Fund and suing the board. Big-name lawyers agreed to take their case, including former Whitewater prosecutor Kenneth Starr, who signed their appellate brief.

Matt Kelly, Managing Editor of Compliance Week, calls the case a “time bomb”.

The PCAOB time bomb.

Sometime this month, the U.S. Supreme Court will rule on the question of whether the Public Company Accounting Oversight Board’s oversight structure is unconstitutional. It is entirely possible that the conservative majority on the court will side with the conservative activists who brought suit against the PCAOB, and invalidate its existence.

Nobody in Washington is talking about what to do after that.

I asked SEC Commissioner Luis Aguilar how the SEC might want to resolve the issue. He said the commissioners know the problem is out there and they have “Plans A, B and C” to respond, but declined to say what any of those plans might be. I asked Frank as well, and he essentially said his committee would work with the Senate Banking Committee to craft some legislative response, depending on exactly what the Supreme Court’s ruling says.

Matt’s prediction: The Supreme Court will rule the PCAOB an unconstitutional body, and ultimately the solution will be to peel away the appointed board and re-organize the rest of it as a Division of Public Accounting operating within the SEC.

The PCAOB has been challenged since its inception in 2002. In the past they tended to see the audit firms through rose-colored glasses. A post of mine all the way back in early 2008 was pretty critical:

It seems many feel we can rest easy, now that the profession in the US is not self regulating but regulated by the PCAOB, under the direction of the SEC. There’s an impression they’re looking at both the audits and the firms themselves.

Although they may be starting to lose their baby teeth, in reality, they’re just a warm puppy.

Not only are investors and the public prohibited from seeing the results of the private portion of the PCAOB’s reports, but the PCAOB under Mark Olson is, in truth, reluctant to judge the management of the firms themselves. And they’re not willing to entertain any contrary views.

I asked Mr. Olson the question directly at the Compliance Week Conference last June. He clearly stated that they were sticking primarily to re viewing the quality of audits themselves.

“…the PCAOB sees itself as regulators of the audit firms with regard to audit quality, and so any additional disclosure will come only as it relates to audit quality.”

The PCAOB is full of former Big 4 partners. They are loathe to criticize their colleagues, notwithstanding any symbolic fines. And when they do try to put a little meat into their critique, they are swatted back like so many houseflies.

Does the PCAOB, in its current form, really have the cojones to dig into the firms’ relationships to the major commercial and investment banks, private equity firms and related money men? I think not. Can we be sure these relationships are not fraught with both independence and integrity problems?

When I met with Senator Ted Kaufman in Washington DC two weeks ago, I made some recommendations for new legislation in the event the PCAOB is declared unconstitutional.

Speedy Congressional action will be necessary to reestablish the PCAOB or a comparable regulatory authority within the SEC, if we want to continue independent regulation of the audit firms. But let’s take the time to plug not only any gaps that may be cited by a potential Supreme Court decision regarding Presidential authority but also to fix some other critical holes in the original legislation.

Although I am a strong supporter of Sarbanes-Oxley, the law and the PCAOB have been vulnerable to criticism because of the hasty way the legislation, patterned after regulation of broker/dealers, was enacted. Given the chance, let’s give the PCAOB the teeth it needs to do its job for investors.

Some recommendations for a new PCAOB law:

1. Eliminate the revolving door
2. Eliminate obstacles to inspections of international firms
3. Make Part 2 of the inspection reports public in all instances
4. Enforce stronger sanctions on a more timely basis and more clearly delineate responsibility for sanctions between the PCAOB and SEC
5. Give the PCAOB the power, under law, to review or stop mergers and acquisitions by the firms that may not be in the public’s interest or may cause independence violations
6. Put bigger teeth into the inspections process

Eliminate the revolving door

Thomas Ray, the Chief Auditor and Director of Professional Standards for the PCAOB since its inception, returned to his old firm, KPMG, in March of 2009.

I wrote at the time:

Why wasn’t there a “no revolving-door” rule included when the PCAOB was established? Is there anything to prevent the Big 4 partners who staffed the accounting firm regulator from immediately returning to a firm they regulated, before their seat at PCAOB is even cold?

Even the SEC has stricter rules.

• Mr. Ray was at the PCAOB when KPMG escaped the guillotine in the tax shelter case.

• Mr. Ray presided over investigations of partner misconduct at Deloitte.

• Mr. Ray has an ongoing super-embarrassing issue with Mr. Flanagan, the accused former Deloitte Vice Chairman who allegedly traded on inside information about twelve of his audit clients.

• Mr. Ray is in the middle of the controversy regarding auditors and their judgment and application with regard to fair value accounting. (Although no one from PCAOB or the audit firms has been called before Congress to answer for their lack of judgment or lack of competence regarding complex financial instruments.)

Imagine the “wisdom and knowledge” about KPMG and all the other firms that Thomas Ray brings back to KPMG’s Professional Standards Office ? Am I the only one who thinks this is another slap in the face to the taxpayers, the shareholders, the professionals?

Next up, Mark Olson’s “retirement.” Am I to expect no one will notice, be surprised, be outraged, or prohibit him from returning to EY or, even worse, to a bank?

Update: March 20, 2009

Per a conversation with the PCAOB’s Inspector General, I was pointed to the PCAOB Ethics Code, approved by the PCAOB in June 2003 and effective pursuant to SEC Release No. 34-48755, File No. PCAOB-2003-04. (November 7, 2003)

This is all there is related to post-employment restrictions. How does this compare to general SEC post-employment restrictions, given that the SEC is the PCAOB’s governing agency?

Even if Mr. Ray had very good personal reasons for wanting to return to the private sector, it appeared his move back to KPMG gave him an opportunity, with few restrictions, to take advantage of his experience at the PCAOB for the benefit of his old firm.

Where did Mark Olson, former PCAOB Chairman, go after he left?

“We understand the issues of our clients from every perspective. The federal, regulatory, and financial services industry backgrounds of our professionals allow us to provide our clients with both the solution and the advantage. We help our clients think through problems, resolve issues, and identify opportunities.”

Mark W. Olson, Co-Chairman, Corporate Risk Advisors LLC.

Let’s put an end to the revolving door at the PCAOB.

Eliminate obstacles to inspections of international firms

“The Public Company Accounting Oversight Board (PCAOB) published a list of more than 400 non-U.S. companies whose securities trade in U.S. markets, but whose PCAOB-registered auditors the Board currently cannot inspect because of asserted non-U.S. legal obstacles…The auditors of the issuers appearing on the list are located in China, Hong Kong, Switzerland and 18 European Union countries.

The PCAOB continues to work to eliminate obstacles to inspections in these jurisdictions.”

Current law prohibits sharing of PCAOB inspection reports with foreign regulators. Because of this, many foreign regulators will not share their own reports or their countries have restricted PCAOB access, even though these issuers are listed on US exchanges. Obstacles must be eliminated that prohibit sharing of information across boundaries and reciprocity and cooperation between the US regulators and the regulators in home countries of more than 400 non-U.S. companies whose securities trade in U.S. markets.

And where the PCAOB does have the right to inspect, they need to speed up the issuance of their reports. We are still waiting for an inspection report of Indian firms from the spring of 2008, pre-Satyam fraud. The report is very late. If the PCAOB caught the issues, its tardiness makes the PCAOB findings ineffectual and of no use to the public. If the PCAOB inspectors didn’t catch the issues either the inspectors were incompetent and/or PwC was also extremely inept at auditing or extremely adept at aiding and abetting the fraud. Until the report is issued, we have no idea if the process was effective at all or if PwC covered-up the issues that precipitated the exposure of the Satyam fraud less than a year later.

Inspections and other documents produced via investigations and enforcement are not discoverable in civil actions per the Sarbanes-Oxley Act of 2002.

(5) USE OF DOCUMENTS.

(A) CONFIDENTIALITY.—Except as provided in subparagraph (B), all documents and information prepared or received by or specifically for the Board, and deliberations of the Board and its employees and agents, in connection with an inspection under section 104 or with an investigation under this section, shall be confidential and privileged as an evidentiary matter (and shall not be subject to civil

discovery or other legal process) in any proceeding in any Federal or State court or administrative agency, and shall be exempt from disclosure, in the hands of an agency or establishment of the Federal Government, under the Freedom of Information Act (5 U.S.C. 552a), or otherwise, unless and until presented in connection with a public proceeding or released in accordance with subsection (c).

This insulates the firms from accountability for repeated lapses in audit quality and compliance with standards. This prohibition on discovery for civil proceedings should be eliminated. In addition, the names of issuers who were the subject of audit discrepancies noted in inspection reports should be public and those issuers forced to disclose the resolution of the discrepancy noted.

Make Part 2 of the inspections reports public in all instances

The PCAOB prepares written report on each inspection and provides it, in appropriate detail, to the SEC and to certain state regulatory authorities. The Board also makes portions of the reports available to the public; however, certain information is restricted from public disclosure, or its disclosure is delayed, as required by the Act.

“Many reports contain nonpublic content, which may include, among other things, discussion of potential defects in a firm’s system of quality control. Any such quality control criticisms remain nonpublic if the firm addresses them to the Board’s satisfaction within 12 months after the report date. If a firm fails to satisfactorily address any of the quality control criticisms within 12 months, the portion of the report discussing the particular criticism(s) is made publicly available.”

Firms are openly flouting the prohibitions regarding audit partner compensation tied to business development and are still struggle mightily with enforcement of legal and regulatory compliance activities such as independence and rules against insider trading. The rule in the firms seems to be, “Ask for forgiveness not permission.”

Enforce stronger sanctions on a more timely basis and more clearly delineate responsibility for sanctions between the PCAOB and SEC

The PCAOB can issue an, “order of formal investigation when it appears that an act or practice, or omission to act, by a registered public accounting firm or any person associated with a registered public accounting firm may violate any provision of the Act, the Rules of the Board, the provisions of the securities laws relating to the preparation and issuance of audit reports and the obligations and liabilities of accountants with respect thereto, including the rules of the Commission issued under the Act, or professional standards.”

The SEC can also charge both the audit firms and individual professionals in the firms with violations of the securities laws and violations of rules specific to auditors such as independence.

From the Bally’s case: By issuing these false and misleading audit opinions, E&Y was a cause of and aided and abetted Bally’s violations of Sections 17(a)(2) and (3) of the Securities Act and

Sections 13(a) and (b)(2)(A) of the Exchange Act and Exchange Act Rules 12b-20, 13a-1, 13a- 11, and 13a-13. E&Y also violated Section 10A of the Exchange Act by not bringing to the attention of Bally’s Audit Committee Bally’s false and misleading disclosures of the $55 million special charge.

The SEC did not finalize the sanctions the Bally’s case against EY and the partners involved until six years later. The PCAOB has not sanctioned any Big 4 firm except Deloitte (twice). There may be ongoing investigations in cases such as the Flanagan-Deloitte inside trader case, but we will never know if they’re even considering sanctions against Flanagan or Deloitte unless or until sanctions are final.

There should be stronger sanctions against the firms – bigger fines and more timely charges. There must be better cooperation between the SEC and PCAOB in the case of auditor malpractice and aiding and abetting of securities fraud and more transparency regarding pending investigations or those where the audit firm or individuals are disputing it. Timely charges are critical because when sanctions aren’t finalized until after an audit partner retires they lose their impact and deterrent power.

Finally, there should be a centralized list of auditors who are currently or were in the past sanctioned so investors and the media can monitor their ongoing employment by the firms and/or continued responsibility for client work, placement in internal firm administrative roles or ongoing involvement in professional associations.

Give the PCAOB the power, under law, to review or stop mergers and acquisitions by the firms that may not be in the public’s interest or may cause independence violations

The PCAOB has no power to insure firms handle such acquisitions well from an independence perspective except for citing them after the fact when violations occur.

When BearingPoint Inc declared bankruptcy, there were a number of firms interested in parts of the whole. The company, the legacy consulting firm of public accounting firm KPMG spun off in 2000, was eventually bought in early 2009 by Deloitte who took most of the government services practice and PwC who took major parts of the commercial services practice to boost their reemergence as a systems integrator.

There were many, many instances of conflicts between Deloitte’s and PwC’s audit clients and existing BearingPoint consulting engagements. PwC, shortly after the acquisition, cut more than three hundred of its own consulting staff to make room for the BearingPoint professionals. Were these acquisitions in the best interest of the public given the firms’ primary responsibility as public accounting firms?

PwC has failed to make a dent in the systems integration market and Deloitte’s ongoing failures to perform are marked by repeated lawsuits. I question the wisdom of the regulator in allowing this expansion in the consulting businesses at that time.

The accounting regulator, the PCAOB, needs the power to review and stop such acquisitions if they jeopardize the firms’ primary public duty – auditing public companies.

Put bigger teeth into the inspections process

When I look back at earlier PCAOB inspections, I can see some cases where the inspectors identified and warned of issues that resulted in failures. It isn’t easy to figure this out, since the issuers are not identified. But with the benefit of hindsight, it’s apparent to me that the PCAOB inspectors certainly identified the issues over and over that would eventually cause many future failures if not the specific instances where those failures did eventually occur.

There are at least two cases I’ve identified where adequate identification and warning of poor audit processes was made: American Home and Huron Consulting. Slow issuance of the inspection reports, the lack of transparency caused by the secrecy provisions of the act and the overall obstinacy of the firms meant that, in these two cases, there was no warning of American Home’s failure or prevention of Huron’s restatement.

It’s been apparent to me that the audit firms don’t take the inspection results seriously, and don’t significantly change their processes as a result. In some cases they publicly embarrassed the PCAOB by openly disagreeing with them.

This is not the way to treat a regulator. Although the inspection process is intense, time consuming and very expensive for the audit firms to comply with, they are clearly paying it only lip service. They view it as a necessary evil rather than a constructive or a deterrent force. This must change if the PCAOB is ever going to be an effective tool for protecting the investor public.

Additional Note:

Some readers have encouraged me to included the names of the legislators who will be most likely responsible for any new PCAOB legislation.  An emergency bill will probably come out of the Senate Banking Committee Subcommittee on Securities, Insurance, and Investment. Interestingly there are no women on this committee.  Hmmmm…

They are responsible for:

- Securities, annuities, and other financial investments

- SEC: SIPC: CFTC (single stock futures and other financial instruments within CFTC jurisdiction)

- Government securities

- Financial exchanges and markets

- Financial derivatives

- Accounting standards

- Insurance

Democratic Subcommittee Members

Jack Reed (Chairman)

Tim Johnson

Charles E. Schumer

Evan Bayh

Daniel K. Akaka

Sherrod Brown

Mark R. Warner

Michael F. Bennet

Christopher J. Dodd

Republican Subcommittee Members

Jim Bunning (Ranking Member)

Judd Gregg

Robert F. Bennett

Mike Crapo

Bob Corker

David Vitter

Mike Johanns

Section 404 was adopted with little controversy in 2002, and for good reason. It simply mandated that public companies report on the effectiveness of their internal financial controls, and that auditors render an opinion on them.

Since the law already required companies to maintain effective controls — and had done so since 1977 — it seemed unlikely that would increase costs much for any company that was already in compliance. And it was crystal clear that controls either did not exist, or were evaded, at WorldCom and Enron.

“The PCAOB approved Auditing Standard No. 7, Engagement Quality Review on July 28, 2009. They also issued a Concept Release on requiring the engagement partner to sign the audit report.  The comment period closed September 11^th and boy oh boy were there a lot of comments. The firms came out en masse to denounce the proposal.  I described their strategy to a friend:

“Representatives from each firm got together at CAQ HQ over dinner.  (Well, maybe a conference call since everyone is tightening belt these days…) They listed all the possible objections, split them up, one each, and agreed to write the comment letters.” 

Jim Hamilton’s World of Securities Regulation has a great summary of their arguments followed by a little input from yours truly…”