Accounting fraud may have hogged the enforcement headlines for the past few years, thanks to high-profile scandals at Enron, Adelphia and Tyco International. But over the past few weeks, a number of accounting firms have learned that the Securities and Exchange Commission and other federal officials are still determined to crack down on auditor independence abuses.
In fact, in April a judge told Ernst & Young it cannot accept new audit clients in the United States for six months precisely because it violated SEC rules on auditor independence.
According to the Commission, the accounting firm marketed consulting and tax services to audit client PeopleSoft Inc. "Considerable evidence shows that EY partners acted recklessly and negligently in committing willful and deliberate violations of well-established rules that govern auditor independence standards in connection with business relationships with an audit client," wrote Brenda P. Murray, the chief administrative law judge at the SEC (see box at right).
"EY's misconduct was blatant and occurred after the Commission and a court accepted EY's representations that it would observe the very same auditor independence rules that it now claims are too vague to be followed," she added.
The judge was especially critical of Edmund Coulson, the Ernst partner who was in charge of independence issues, saying he kept no written records and had failed to learn enough facts before saying the relationships between Ernst and PeopleSoft were proper, according to a published report at the time. Coulson was chief accountant of the SEC before he joined Ernst in 1991.
Adverse Effect
"Maintaining independence in fact and appearance is of critical importance to ensure the integrity of the audit process and maintain confidence in our capital markets," asserted SEC Chief Accountant Donald T. Nicolaisen, in a statement. "I recognize that the order may have a significant adverse effect on E&Y. It is my hope that E&Y does take these sanctions seriously and is committed to reforming its independence policies and procedures to ensure its independence and protect the investing public."
The dispute centered on PeopleSoft software that Ernst & Young used for its consulting and tax practices, and on joint promotion activities of the two companies.
The Big Four accounting firm had argued that it was merely a PeopleSoft customer, but, the judge reportedly noted that the firm had billed itself in marketing materials as an "implementation partner" of PeopleSoft, and that it had earned $500 million over five years from installing PeopleSoft programs at other companies.
Ernst & Young might have fared far worse had this case been decided under the auditor independence rules established by the Sarbanes-Oxley Act of 2002—but Ernst & Young's audits took place between 1994 and 1999.
Turning A Blind Eye
Meanwhile, earlier this month, PricewaterhouseCoopers agreed to pay $50 million to settle claims relating to its role as outside auditor of Raytheon in a securities fraud class action brought by New York State Comptroller Alan G. Hevesi, sole Trustee of the New York State Common Retirement Fund and court-appointed lead plaintiff in the action.
PwC, Raytheon's long time outside auditor, is alleged in the class action complaint to have "turned a blind eye to the company's improper accounting practices, and to have issued a clean audit opinion on the company's 1998 financial statements despite numerous red flags that should have alerted the auditors to underlying difficulties."
The suit asserted that the auditor's independence was compromised by a lucrative contract for non-audit consulting work that it was seeking from Raytheon shortly before the issuance of the clean audit opinion, "a practice that subsequently has been criticized by Congress and limited by the Sarbanes-Oxley Act."
Violations In Canada?
Also earlier this month, the Royal Bank of Canada said the Securities and Exchange Commission is investigating PricewaterhouseCoopers for a possible violation of auditor independence rules.
In a press release, the Royal Bank said it has received a subpoena from the U.S. securities regulator regarding PwC, which resigned as one of the bank's auditors last September.
According to the bank, the inquiry concerns PwC's resignation, its compliance with auditor-independence rules, and the non-audit services provided by its auditors.
Royal Bank of Canada must comply with U.S. securities rules because it is listed on the New York Stock Exchange.
Bad Timing
And last month the SEC's top accountant issued an auditor independence rules clarification that conflicts with the way accounting firms use the rules to justify charging audit clients contingent fees for tax advice. The clarification came via a letter in which Nicolaisen rejected the firms' interpretation (available from box above, right).
The timing is bad for the accounting firms, whose tax-shelter practices are being investigated by the Internal Revenue Service and the U.S. Attorney's Office.
If these cases aren't enough of a warning to auditors to watch their independence practices, back in early May, the Public Company Accounting Oversight Board, the new regulator created to oversee the nation's accounting profession, said it plans to make the independence of auditors and their sale of tax shelters two key issues for its 2004 agenda.
A No-Brainer
Board member Kayla Gillan told Reuters that the PCAOB is likely to decide whether corporate auditors may continue to sell tax-planning services to their audit clients. "It's something that I've been wanting to do since day one," Gillan told the wire service.
In an interview with Compliance Week, George Diacont, director of registration and inspections for the PCAOB, confirmed that auditor independence is a big priority for the new Board. "That's a no-brainer," he says by way of emphasis. "It's one of our priorities among a fairly large number of priorities."
More specifically, the PCAOB will focus on whether auditor independence is part of an accounting firm's policies, procedures, guidance materials, practice aids, and controls, and whether the firm is complying with all independence requirements.
"We are interested in independence issues relating to accounting firms' provisions of non-audit services to issuer clients," Diacont adds. Now, keep in mind that while the sale of some non-auditing services are explicitly prohibited by Sarbanes-Oxley, other non-audit services while not explicitly prohibited must be pre-approved by the audit committee of the auditor's client.
Last year, the PCAOB made a point of calling the chairman of company audit committees to determine whether communications between the audit firm and the audit chairman complied with existing requirements and whether those communications were candid and conducted in a manner that encouraged the free flow of information.
This year's questions to the chairmen will include independence issues, such as the sale of non-audit services, pre-approval of non-audit service and contingent and value added fee arrangements, Diacont adds.
He says the PCAOB will also be identifying those business relationships between the accounting firms and their clients that impair independence by creating a mutuality of interest between the firm and its client as well as the processes at the accounting firm designed to monitor compliance with independence policies.
More specifically, he will be looking at the firm's internal inspection program that, in effect, requires partners to monitor other partners. "We want to determine how the internal inspection programs works," he explains. "We want to see if that process is identifying auditing and accounting deficiencies including those related to compliance with independence requirements."
Another broad area of major concern is the relationship between a U.S.-based auditor and its foreign affiliates. Frequently, the foreign subsidiaries of U.S.-based companies are audited by those affiliate-accounting firms. Diacont concedes that independence could break down during this part of the process.
"We want to determine what procedures U.S. firms have to assure that these foreign affiliates understand U.S. independence requirements and are not engaging in activities that would impair independence," he explains. "They [the U.S. operation] could be non-compliant and not even know it."
He adds, "This is important to us and will continue to be."
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