KPMG
The fox in the henhouse...
or, who audits the auditors?
Sightings from The Catbird Seat
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August 4, 2009
GE Settles Accounting
Fraud Charges
In a blow to its reputation as a finance paragon, GE settles SEC fraud claims related to hedge accounting and revenue recognition.
Marie Leone and Tim Reason, CFO.com | US
Some members of the General Electric accounting staff worked hard to figure out ways to hide the negative accounting impacts of transactions booked in 2002 and 2003, according to court documents released by the Securities and Exchange Commission.
In fact, the SEC complaint relates several instances of round-robin email discussions among GE accountants, internal auditors, executives, and the company's external auditor, KPMG, debating whether aggressive accounting would past muster with regulators.
Ultimately, it didn't.
Today, after a four-year investigation, GE settled accounting fraud charges with the SEC for allegedly misleading investors with improper hedge accounting and revenue recognition schemes. Specifically, GE was charged with violating accounting rules when it changed its original hedge documentation to avoid recording fluctuations in the fair value of interest rates swaps, which would have dragged down the company's reported earnings-per-share estimates.
In addition, the SEC charged GE with concocting schemes to accelerate the recognition of revenue from its locomotive and aircraft spare parts business, to make the company's financial results appear healthier than they actually were.
Without admitting or denying guilt, GE paid a fine of $50 million, and agreed to remedial action related to internal control enhancements. "GE bent the accounting rules beyond the breaking point," noted Robert Khuzami, director of the SEC's Division of Enforcement, in a statement....
The SEC uncovered the violations after conducting "risk-based" investigations at GE, in which the government staffers identify a potential risk in an industry or at a particular company and develop a plan to test whether the problem actually exists. In the case of GE, the SEC identified potential misuse of hedge accounting as a possible risk area.
The SEC filed its complaint in the U.S. District Court for the District of Connecticut pointing out that GE met or exceeded analysts' consensus earnings-per-share expectations every quarter from 1995 through filing of its 2004 annual report. However, the SEC charged that during 2002 and 2003, "high-level GE accounting executives or other finance personnel approved accounting that did not comply with generally accepted accounting principles" in order to hit the EPS estimates....
According to GE, the company produced 2.9 million documents, and spent $200 million over four years in legal and accounting fees, to cooperate with the SEC's probe and conduct its own "comprehensive review" of the problems. In the second quarter of 2007, the company noted in a regulatory filing that it took disciplinary action against employees involved in the locomotive transactions, which included firing workers who "engaged in intentional misconduct."
Despite its sterling reputation for financial management, GE also has long been the subject of charges from critics that its reliable earnings derived not from the natural smoothing effect of its diversified holdings, but its ability to use that complex structure — including financing arm GE Capital Corp — to manage earnings. "We have not used the words 'earnings management,' but we have said GE misapplied accounting rules so it could cast its financial results in a better light," Bergers told CFO....
According to court documents, days before GE's quarterly results were to be released in 2003, the company developed an entirely new approach that, "when applied retroactively to transactions that occurred months before, allowed GE to obtain the desired accounting results." The new approach violated GAAP, asserted the SEC. As a result, GE overstated earnings in the fourth quarter of 2002 by more than 5%, and thereby met its revised consensus EPS estimates, added the SEC in its complaint.
The fact that GE had not missed consensus estimates for the previous eight years "is signficant," Berger told CFO. "The motivation [for the accounting change] was to increase earnings."
In addition to reworking its accounting approach, the SEC charged that GE also improperly used the so-called shortcut accounting treatment for its swaps, which it was ineligible to use....
http://www.cfo.com/article.cfm/14162632
December 17, 2008
The Madoff Fraud: How Culpable Were the Auditors?
By Stephen Gandel
Add the nation's largest accounting firms to the list of watchdogs and regulators that didn't catch the multibillion-dollar Madoff investment scam.
KPMG, PricewaterhouseCoopers, BDO Seidman and McGladrey & Pullen all gave clean bills of health to the numerous funds that invested with Bernard Madoff and his asset-management firm. Clients say the large accounting firms signed off on statements that said the Madoff investment vehicles had billions of dollars in assets as well as an unlikely track record showing years of always-positive returns. The billions have vanished, and the impressive returns now look to have been made up.
See the top 10 financial collapses of 2008.
"It's surprising that the auditors for these various funds didn't identify that the underlying assets were not there," says Christopher Wells, a partner at the law firm Proskauer Rose who specializes in hedge funds. "You would think that is something they test."
On Tuesday, New York Law School sued BDO Seidman along with the fund it audited, Ascot Partners. Investors in Ascot, which was managed by GMAC chairman J. Ezra Merkin and invested all its money with Madoff, lost a reported $1.8 billion. New York Law School said its endowment fund had $3 million in Ascot. It's the first suit to name an accounting firm in connection with the Madoff case.
Lawyers predict lawsuits against the other accounting firms will soon follow. "The fact that they didn't catch the fraud leads me to believe that they blew it," says Scott Berman, a lawyer at Friedman Kaplan Seiler & Adelman who has reached settlements with auditors in similar cases in the past. "I am going to look hard at whether there is liability there."
The difference between this case and other hedge fund frauds in which auditors have been held liable is that Madoff was not actually a client of any of the large auditing firms. Madoff's firm used the small New City, N.Y., accounting firm Friehling & Horowitz — which reportedly had offices in a strip mall and had only three employees, including a secretary, an accountant and a partner in his seventies who lived in Florida. Industry experts now say that the size of Madoff's accounting firm should have been a giant red flag.
Of course, many of the people who invested money with Madoff didn't know they were relying on a rinky-dink accounting firm to watch over their investments. That's because more than half of the $25 billion-plus in losses investors have so far claimed came to Madoff through so-called feeder funds. These funds were set up by outside firms, which would then funnel the money they received from investors to Madoff.
Unlike Madoff's, all the firms running feeder funds had well-known accounting firms listed as their auditors. So, for instance, when investors put money in the Rye Select Broad Market fund, one of the largest Madoff feeders, its statement said that their investments had been audited by KPMG....
"All they really had to substantiate the gains of these funds was Madoff's own statements," says Harry Susman, a lawyer at Houston-based Susman Godfrey.
"They were supposed to be the watchdogs. Why did they sign off on these funds' books?"
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Three Partners Agree to Permanent Injunctions, Record Penalties and SEC Suspensions
On February 22, 2006, the Securities and Exchange Commission announced that all four remaining defendants in an action brought against them and KPMG LLP ("KPMG") by the agency in connection with a $1.2 billion fraudulent earnings manipulation scheme by the Xerox Corporation from 1997 through 2000 have agreed to settle the charges against them.
Three partners agreed to permanent injunctions, payment of record civil penalties and suspensions from practice before the Commission with rights to reapply in from one to three years. The fourth partner agreed to be censured by the Commission.
The settlements relate to Xerox's fraudulent scheme that involved various manipulations of accounting for leases of Xerox office equipment. The Commission alleged that the manipulations were necessary for Xerox to meet promises it made to Wall Street that its earnings would continue to grow. The manipulations helped Xerox to "close the gap" between its actual performance and what it promised analysts.
KPMG was Xerox's independent auditor each of those years. KPMG issued unqualified audit reports asserting that Xerox's financial statements were consistent with Generally Accepted Accounting Principles ("GAAP") and that KPMG had conducted an audit each year in accordance with Generally Accepted Auditing Standards ("GAAS").
The SEC alleged in its complaint against KPMG and five KPMG partners filed in 2003 that these statements were materially false and misleading and aided and abetted Xerox's filing of false financial reports with the Commission.
When Xerox retained new auditors in 2002, it restated $6.1 billion in equipment revenues and $1.9 billion in pre-tax earnings for 1997-2000. The complaint alleged that KPMG and its partners knew or should have known about the improper topside adjustments that resulted in $3 billion of the restated revenues and $1.2 billion of the restated earnings.
The defendants whose settlements were announced are Ronald Safran, the KPMG engagement partner on the Xerox audit for 1998 and 1999; Michael Conway, the senior engagement partner on the Xerox audit for 2000; Anthony Dolanski, the engagement partner on the Xerox audit for 1997; and Thomas Yoho, the SEC concurring review partner for KPMG on the Xerox engagement from 1997-2000.
Safran, Conway and Dolanski each consented to the entry of final judgments against them by the U.S. District Court for the Southern District of New York. Yoho agreed to the entry of a Commission order imposing a censure pursuant to Rule 102(e) of the SEC's Rules of Practice. Each defendant entered into his settlement without admitting or denying the SEC's allegations or findings.
The final judgments, which are subject to approval by the Honorable Denise L. Cote, order the engagement partners to pay civil penalties that are the largest penalties ever imposed by the Commission against an individual auditor: Safran and Conway to each pay a civil penalty in the amount of $150,000, and Dolanski to pay a penalty in the amount of $100,000.
The final judgments also order that Safran, Conway and Dolanski be permanently enjoined from violating certain provisions of the federal securities laws (Sections 17(a)(2) and (3) of the Securities Act of 1933) and from aiding and abetting violations of other securities laws (Section 13(a) of the Securities Exchange Act of 1934 and Rules 12b-20, 13a-1 and 13a-13 thereunder).
Safran, Conway and Dolanski each also consented to the issuance of an SEC Order based on the entry of the injunctions which will suspend them from appearing or practicing before the SEC as accountants. Safran will be suspended with a right to reapply in three years, Conway in two, and Dolanski in one...
AUDITORS EXPOSED!
Cozy Deals Alleged!
How ‘independent’ are those book checkers?
By Marianne Lavelle, U.S. News & World Report
The numbers arriving in investors’ mailboxes may banish forever their image of accountants as green-eye-shaded drones.
Accounting firms seem neither dreary nor detached now that it is clear, thanks to new federal disclosure rules, how much money they’ve been making from their cozy relations with the very companies they audit.
Only 27 cents of every dollar companies paid their independent auditors last year had to do with the all-important sign-off on corporate financial statements. The rest went for services that the so-called Big Five accounting firms have branched into, from information technology to management consulting. The accounting firms point out there’s nothing illegal about doing other work for auditing clients, and last year the Securities and Exchange Commission lost a bitter battle to prohibit such activity.
Former SEC Chairman Arthur Levitt, as part of his drive against “accounting hocus-pocus,” said regulations were needed to assure investors that auditors had no reason to hide corporate financial woes. But accounting-industry friends in Congress threatened to block the new rules, so the SEC compromised by requiring firms for the first time to disclose what they paid their outside accountants for audit and other services.
Back seat.
“Eye-popping” is how Patrick McGurn of Institutional Shareholder Services in Rockville, Md., a proxy advisory service, describes the numbers released so far.
An SEC analysis of 563 proxy statements filed by big companies this year shows Big Five firms made $5.8 million in nonaudit fees from the average client, while pulling in only $2.2 million for audit work.
“The numbers demonstrate he problems may be larger than were originally thought,” acting SEC Chairwoman Laura Unger says.
The auditor independence issue may take a back seat once President Bush’s choice for SEC chairman, Washington lawyer Harvey Pitt, takes the helm. Pitt, whose name was sent to the Senate last week for approval, has represented the Big Five and questioned the need to rein in consulting work.
For the moment, however, the SEC is active on the issue. Last month, it levied the largest penalty ever against a Big Five firm.
Arthur Anderson LLP agreed to pay $7 million to settle charges relating to its mid-1990s work for Waste Management, Inc. The SEC said Andersen helped the huge trash hauler overstate income by more than $1 billion. Noting the $11.8 million in nonaudit fees Andersen got from WMI, Unger calls the case the “smoking gun” proving consulting gigs can compromise independence.
Whether or not the SEC continues its tough policing, aggrieved investors have seized upon the conflict issue.
PricewaterhouseCoopers (PwC), itself the target of three ongoing SEC investigations, agreed in May to pay $55 million to settle a class-action lawsuit by shareholders of MicroStrategy Inc.
The software maker was forced last year to admit it had been losing millions while telling investors it was profitable. PwC profited from consulting for MicroStrategy and also acted as reseller for some of its software. Like Andersen, PwC denies that its independence has been impaired, but this will not be the firm’s last such legal tussle.
A pending lawsuit by Raytheon Co. shareholders, who lost millions when the defense contractor restated its earnings, may also raise the conflict issue. Nearly 95 percent of the $51 million Raytheon paid PwC last year was for nonaudit services, though Raytheon says much of that was for work it considered audit-related, like tax services.
Such lawsuits are likely to multiply. If an accounting firm was making money from its audit client, “it shows motive,” say an investors’ lawyer. And since firms under shareholder fire are often financially troubled, wealthy accounting giants are attractive prey....
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TWO SETS OF BOOKS
Audits can amount to a tiny share of fees
paid to accounting firms.
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Marriott Intl. - Total Fees: $31,331,300 - Paid to: Arthur Andersen - Nonaudit fees: 96.65%
Sprint - Total Fees: $66,300,000 - Paid to: Ernst & Young - Nonaudit fees: 96.23%
Raytheon - Total Fees: $51,000,000 - Paid to: PricewaterhouseCoopers - Nonaudit fees: 94.12%
Motorola - Total Fees: $66,200,000 - Paid to: KPMG - Nonaudit fees: 94.11%
Gap - Total Fees: $8,245,000 - Paid to: Deloitte & Touche - Nonaudit fees: 93.10%
$ $ $ $ $
SEC's Top Cop Says Enron
'Not Going To Distract Us'
SAN DIEGO -(Dow Jones)- Investigation into the collapse of Enron Corp. won't stop regulators from pursuing other cases, the top cop at the Securities and Exchange Commission said Friday.
"Enron's not going to distract us," SEC enforcement division director Stephen Cutler said at a Northwestern University legal conference here. He gave the usual disclaimer that his remarks reflect his own views, not those of the SEC.
The SEC began investigating Enron last October, after the Houston energy company announced it had overstated four-and-a-half years of earnings. The SEC later expanded the probe to include document destruction by Enron's outside auditor, Arthur Andersen. A criminal investigation by the Justice Department also is under way, along with investigation by numerous congressional committees.
"People may have a sense that all we care about is Enron," said Cutler.
While he acknowledged the case is getting a lot of attention, he said it won't stop other SEC investigations in their tracks, and promised that in coming months, "you'll be seeing lots of good cases from us."
Connections between SEC commissioners and accounting firms won't stop the agency from cracking down on accounting fraud, Cutler indicated.
Some critics have questioned whether the SEC may adopt a softer touch on accountants given that Chairman Harvey Pitt represented accounting firms in his past law practice, and the newly named commissioner Cynthia Glassman worked for a Big Five accounting firm.
"I think there's a misperception out there about this new commission and its willingness to be tough" in fighting financial fraud, Cutler said.
Accounting cases account for the bulk of the SEC's enforcement actions now. Last year, the agency brought more than 100 cases alleging financial fraud and in case, obtained a record $7 million settlement from Andersen for its role in auditing Waste Management Inc., another big accounting blowup.
Cutler said the fine, the largest ever paid by a Big Five accounting firm, shows that in financial fraud cases, audit firms "will be held accountable" along with audit partners.
Independence is another area getting close scrutiny from SEC attorneys, Cutler indicated. The SEC recently settled a case against KPMG that alleged it violated independence rules by investing in a mutual fund that was an audit client.
"There will be other independence cases to come," Cutler added. He said the agency is concerned when a "web of relationships" or business deals might cloud an auditor's judgment or undermine independence.
– By Judith Burns, Dow Jones Newswires, Copyright (c) 2002 Dow Jones & Company, Inc.
ACCOUNTING FIRMS TARGETED IN
INSURANCE COMPANY FAILURES
By Joe Frey, www.insure.com
If accounting firms are the financial police for insurance companies, who will police the police? State departments of insurance, that’s who.
Two major accounting firms are taking heat from the New York and Ohio insurance departments for recent insurance company failures. The New York superintendent of insurance, Neil Levin, has filed a lawsuit against PricewaterhouseCoopers LLP, alleging the firm was negligent in its audit of three failed insurance companies that allegedly cost New York residents $100 million.
The Ohio Department of Insurance (DOI) settled a lawsuit for $9.99 million with accounting firm KPMG Peat Marwick for its involvement in the PIE Mutual Insurance Co. insolvency.
The Ohio DOI had alleged that KPMG Peat Marwick “failed to detect that PIE had fraudulently recorded a $58 million asset on its financial statements” in 1996. As part of the settlement, KPMG Peat Marwick admits no wrongdoing.
PIE sold medical malpractice coverage in Indiana, Kansas, Kentucky, Maryland, Mississippi, Missouri, Ohio, Pennsylvania, and West Virginia.
The New York Suit
Coopers & Lybrand, which merged with Pricewaterhouse in 1998, served as financial auditor for Home State Holdings Inc. and two of its subsidiaries, Home Mutual Insurance Co. and New York Merchant Bakers Insurance Co., from 1989 to 1997. The lawsuit alleges that PricewaterhouseCoopers failed to catch “numerous red flags” about the insurers’ financial stability that could have prevented insolvency. They filed for bankruptcy in 1998.
The major transgression the lawsuit alleges is that PricewaterhouseCoopers failed to notify the insurance department that Home State failed to maintain enough cash reserves to pay claims. Home State and its subsidiaries sold auto and homeowners insurance in New Jersey, New York, and Pennsylvania.
The lawsuit also claims that six officers of Home State committed fraud, were negligent, and breached their fiduciary duties.
New Yorkers pick up the tab
Levin is seeking $100 million in punitive damages from PricewaterhouseCoopers to offset the estimated price tag that New York state insurance guaranty funds – which are financed by all policyholders in the state through insurance premiums – had to pay to rescue Home State’s insolvent subsidiaries.
“Had Coopers ... detected and reported the true facts, Merchant Bakers and Home Mutual would have corrected the problems and avoided the insolvency damages alleged,” the lawsuit says.
Steve Silver, a spokesman for PricewaterhouseCoopers, says the lawsuit is totally without merit and his company plans to vigorously fight it.
The Ohio suit
PIE Mutual was Ohio’s largest medical malpractice insurer until 1998, when the DOI seized control of the company because its liabilities exceeded its assets by $275 million. The DOI is currently liquidating PIE Mutual, attempting to pay off the estimated $600 million to $800 million in outstanding claims. The Ohio DOI has recouped approximately $240 million from the sale of PIE Mutual’s assets and the settlement with KPMG.
John Charlton, a spokesperson for the Ohio DOI, says there’s a good chance that claimants will not receive 100 percent of what’s owed them, but he is not sure of the magnitude of the shortfall.
“The guaranty funds have stepped up and have been paying in the nine states in which PIE was licensed,” he says, meaning policyholders in Indiana, Kansas, Kentucky, Maryland, Mississippi, Missouri, Ohio, Pennsylvania, and West Virginia are paying for part of the tab....
Multidisciplinary Practice: Big Changes Brewing for the Accounting Profession
By Jack Baker, Randall K. Hanson, and James K. Smith
It Won't Be Long Before It Happens
The offering of legal services through multidisciplinary practices (MDP) appears to be moving toward acceptance in the United States. The MDP movement has gained momentum from the American Bar Association Commission on Multidisciplinary Practice's recommendation to allow attorneys to share fees and partner with non-attorneys.
The rule changes would allow accounting firms to employ attorneys that, subject to certain restrictions, could offer a full array of legal services to their clients. Although the ABA House of Delegates voiced strong opposition and deferred voting, the MDP commission was instructed to gather additional information and resubmit the recommendation.
The commission's latest recommendation may have encouraged a number of recent strategic alliances between professional service firms. In addition to approaching accounting firms, law firms have shown an interest in strategic alliances with other professional service firms, such as financial consultants. These alliances are sure to increase the pressure on the ABA to restructure its ethics rules. The ABA recognizes that if it does not write the regulatory rules on MDP, someone else will. . . .
The Unauthorized Practice of Law. The ABA's decision to explore rule changes in the MDP area may result partially from its failed debate in the late 1990s with the accounting profession about the unauthorized practice of law (UPL). (See "CPAs and the Unauthorized Practice of Law," The CPA Journal, August 1998, and "Attorneys and CPAs: Cooperation or Confrontation?" The CPA Journal, June 1999, for background on the difficulties faced by bar associations in prosecuting accounting firms under UPL statutes.)
Not only is the definition of the practice of law elusive in many areas of CPA practice, such as tax, but Federal statutes that may preempt state UPL statutes further cloud the issue. These difficulties may explain why two recent UPL cases against Big Five accounting firms were dropped.
Accounting firms have further complicated the UPL issue by hiring a record number of attorneys. The Big Five now employ approximately 5,000 attorneys, making them the largest employer of attorneys in the United States. Attorneys employed by accounting firms perform many of the legal tasks that accountants are unable or unqualified to do.
The state bar associations' primary weapon for combating this development is to charge accounting firm attorneys with violating Model Rules of Professional Conduct (MRPC) 5.4, which prohibits attorneys from sharing legal fees with nonattorneys, forming partnerships with nonattorneys to render legal services, or rendering legal services under the direction of nonattorney employers.
ABA's Proposed Changes to Model Rules of Professional Conduct
The ABA's MDP commission issued its recommendation in support of MDPs in June 1999, proposing that the ABA allow attorneys, subject to carefully defined safeguards, to share legal fees with nonattorneys and provide legal services to clients through MDPs. At the ABA's annual meeting in August 1999, the commission unanimously recommended ethical rule changes in favor of MDP to the ABA House of Delegates, which voted to defer action on the recommendation and instructed the commission to gather additional information and resubmit the recommendation.
The MDP commission defines an MDP as a "partnership, professional corporation, or other association or entity that includes lawyers and nonlawyers and has as one, but not all, of its purposes the delivery of legal services to a client(s) other than the MDP itself or that holds itself out to the public as providing nonlegal as well as legal services."
Under the recommendation, attorneys practicing in MDPs remain subject to the rules of professional conduct, such as independence of professional judgment, protection of confidential client information, and loyalty to clients through avoidance of conflicts of interest. . . .
Strategic Alliances
The problems associated with the MDP commission's recommendation have not slowed down the MDP movement. If anything, it has gained substantial momentum, as evidenced by the number of strategic alliances between law firms and other professional service firms. While the most notable alliances are with accounting firms, some law firms show a willingness to consider alliances with other professional service firms.
The most significant strategic alliance to date is between Ernst & Young and a new Washington, D.C., law firm. Ernst & Young has agreed to supply the law firm with a significant amount of start-up capital and to lease it adjacent office space in a building that Ernst & Young owns. In return, the law firm has agreed to be known as McKee, Nelson, Ernst & Young LLP (MNEY). MNEY will initially focus on tax-related legal work with plans to expand to a full-service law firm.
Philip A. Laskawy, chair and CEO of Ernst & Young, pointed out that while the firm already provides legal services directly or through similar alliances in 40 countries through Ernst & Young Law, this alliance will extend that capability to the United States.
Ernst & Young's alliance with MNEY certainly tests the limits of the current legal ethics rules that prohibit attorneys from sharing legal fees with nonattorneys. Ernst & Young may have selected Washington, D.C., because of its more liberal ethics rules: Washington, D.C., is the only jurisdiction that allows attorneys to share profits with non-attorneys, but it requires the attorneys to remain in control of the firm providing the services.
In addition to the choice of jurisdiction, Ernst & Young has been careful to address the literal requirements of the MRPC. For example, Ernst & Young's Washington, D.C., accounting firm and MNEY are set up as separate entities with separate billing. In addition, Ernst & Young is not involved in the firm's day-to-day management.
Ernst & Young has been assured by outside counsel, a former chair of the District of Columbia's UPL committee, that the arrangement is perfectly allowable under its rules of professional conduct. However, other ethics experts believe that Ernst & Young is trying to see how far it can push the regulators.
Other Big Five firms are also announcing strategic alliances with influential U.S. law firms. In addition to its strategic alliances with the Chicago law firm of Horwood Marcus & Berk and the San Francisco-based international law firm of Morrison & Foerster, KPMG has announced an alliance with members of SALTNET, a network of state and local tax attorneys. KPMG is also expected to announce the hiring of seven international tax attorneys from the firm Weil, Gotshal & Manges, a move that John Lanning of KPMG says "will allow KPMG to take a leap forward in the international tax arena."
PricewaterhouseCoopers has announced an alliance with the Washington, D.C., law firm of Miller & Chevalier, and, perhaps more significantly, the ABA's litigation section has selected the accounting firm as its litigation-consulting sponsor. . . .
Many other accounting firms pursuing arrangements with law firms or attorneys may be keeping a low profile to prevent UPL sanctions. For example, some smaller accounting firms have reportedly hired attorneys as part-time employees with the understanding that their associated legal work will be done outside the accounting firm and billed back....
Jack Baker, PhD, CPA, is an associate professor of accounting and
Randall K. Hanson, JD, LLM, is a professor of business law, both at the University of
North Carolina at Wilmington.
James K. Smith, PhD, JD, LLM, CPA, is an assistant professor of accounting at the
University of Nevada, Las Vegas.
CORPORATE AUDITORS UNDER SIEGE
by Daniel L. Berger and Blair Nicholas
In the depths of the greatest financial disaster to ever hit this country, sixty-six years ago Congress passed the federal securities laws in an effort to rebuild investor trust and confidence in the integrity of the financial market.
Trust and integrity are the cornerstones of an efficient financial marketplace, and nothing is suppose to safeguard the market's integrity like an independent accountant's audit of corporate financial statements. This is true because the independent auditor assumes a public responsibility transcending any employment with the corporate client.
The independent auditor's ultimate responsibility is to the corporation's creditors and stockholders, as well as to the investing public. Simply put, if investors cannot trust the auditors to police corporate management, they cannot trust the financial data on which billions of buy and sell decisions are based each day.
This "public watchdog" function demands that the auditor maintain total independence from the client at all times to ensure objective, truthful reporting and complete fidelity to the public trust.
The importance of this independence requirement was well summarized by the Supreme Court of the United States in United States v. Arthur Young & Co., sixteen years ago when it stated, "Public faith in the reliability of a corporation's financial statements depends upon the public perception of the outside auditor as an independent professional . . . . If investors were to view the auditor as an advocate for the corporate client, the value of the audit function itself might well be lost."
Accordingly, it is not enough that the audit quality is maintained and that the numbers are accurate, it is also critical that public investors ― the users of corporate financial reports ― know that the auditors are acting objectively and independently in their role as the public's financial cop.
The American Institute of Certified Public Accountants Code of Professional Conduct describes the principle of "objectivity and independence" by mandating that: "a member should maintain objectivity and be free of conflicts of interest."
The application of this common-sense idea could not be simpler: Independent auditors who are engaged to judge the fairness of management's financial statements should avoid all conflicts of interest that would impair their judgment or create the appearance of an impairment. Indeed, these independence requirements are particularly critical today as public pension funds, as well as individual investors, are fueling the bull market by investing a healthy portion of their portfolio in the securities market.
This huge increase in investment activity in securities, so crucial to our national prosperity, only intensifies the basis for the core values of the independent auditor ― objectivity and independence, honesty and integrity, commitment to quality and professional expertise ― in the preparation of corporate financial statements.
Independent Auditors Under Fire
At the same time auditor independence requirements are becoming increasingly crucial, the auditing profession has come under fire as a recent Securities and Exchange Commission ("SEC") report cited more than 8,000 violations by PricewaterhouseCoopers ("PWC"), the world's largest accounting firm, of one of the basic rules of ethics of audit firms: You don't hold investments in a company audited by your firm.
The SEC report estimated that eighty-six percent of PWC's 2,700 audit partners had at least one ethical violation. Among the more serious violations, PWC's accountants owned stock in companies audited by the firm, took out loans from clients audited by the firm, had spouses or other relatives who worked for a client, and managed family trusts that held investments in a client.
In a letter to his partners, PWC's Chairman, Nicholas G. Moore and Chief Executive James J. Schiro, called the SEC's investigation's findings "embarrassing to our firm and to all of us as partners." SEC Chief Accountant Lynn Turner called the SEC's report "a sobering reminder that accounting professionals need to renew their commitment to the fundamental principle of auditor independence."
At the SEC's request, the Public Oversight Board, an agency created by Congress to keep watch on auditors, will now examine the accounting practices of ten accounting firms, including major auditing firms such as Ernst & Young, KPMG Peat Marwick, Deloitte & Touche and Arthur Andersen. In recent times, however, corporate auditors have been guilty of more than just violating fundamental conflict-of-interest rules, they have been at the center of nearly every recent financial scandal.
Judge Friendly of the Second Circuit in United States v. Benjamin , noted three decades ago: "In our complex society the accountant's certificate . . . can be instruments for inflicting pecuniary loss more potent than the chisel of the crowbar."
Judge Friendly's words have been borne out, as independent auditors have been held responsible for the outright manipulation and inflation of public companies' earnings to boost stock prices, despite the auditing firms' claims that they departed too early, arrived too late, or for some other reasons were not knowledgeable about the huge financial frauds that have recently rocked our nation's securities market.
For example, in In re Waste Management Securities Litigation , Arthur Anderson paid $70 million; in Cendant , Ernst & Young paid $355 million; and in Informix Ernst & Young paid $32 million ― all to resolve securities fraud actions where there were egregious irregularities with the financial statements of these publicly traded companies and the auditors were at the epicenter of the financial fraud.
As United States District Court Judge Stanley Sporkein, former enforcement chief of the SEC, aptly questioned in presiding over the litigation concerning the Lincoln Savings financial collapse: "Where were these professionals . . . [referring to the auditors] when these clearly improper transactions were being consummated? Why didn't any of them speak up or disassociate themselves from the transaction?"
While owning stock in a client is an obvious example of why a corporate auditor would refuse to "speak up," it also provides an example of part of a larger problem: the fundamental principle of total independence has been severely jeopardized as accounting firms in recent years have become multi-dimensional professional service conglomerates.
The Metamorphous of The Auditing Profession: The Watchdogs Become the Puppies of Management
In the 1970s, accounting firms like Ernst & Young and PWC functioned largely as independent auditors. Business consulting was merely an offshoot of traditional accounting and auditing ― a way to derive more income from the same base of clients. But the consulting business took off beginning in the mid-1980s, when consultants from large auditing firms won over the trust of corporate chief financial officers and landed huge technology consulting projects.
Today, corporate accounting firms view auditing as a low-profit, low-growth service of diminishing importance, and have instead focused their resources on the more profitable and faster growing non-audit services, including business consulting, tax consulting, human resources consulting, and corporate finance consulting. As a result, non-audit consulting fees have increased as a percentage of the largest accounting firms' revenues from 15% in 1978 to 24% in 1990 and to 38% in 1996.
This explosion in growth and demand for non-audit services has resulted in auditing firms "lowballing" their quoted auditing fee (whereby firms offer big reductions in their audit fees), in order to more easily leverage themselves into the companies to cross-sell the firm's more profitable non-auditing services, usually on a no-bid basis. For example, in 1991, PWC won a contract to audit Prudential after offering a discount of almost 40% off its original quote.
By the time Prudential dropped PWC as its auditor last year, PWC's annual consulting fee was more than 300% greater than PWC's annual audit fee. What is the reasonable investor to think when an auditing firm certifies a company's financial statements as complete and accurate, yet the auditing firm is generating three times its auditing fee from providing business consulting to the same company?
Clearly, the independence of the auditor is contaminated, the auditor is more reticent than ever to disagree with corporate management on financial reporting issues, and the credibility of an industry which is suppose to be free of potential or actual conflicts of interest is diminished.
Auditing the Auditors
As business consulting services continue to grow at a rapid clip in this Internet age and auditing firms continue to direct more of its resources toward providing non-audit services to its clients, the issue of auditor independence will only intensify. In fact, Lynn Turner, chief accountant for the SEC, recently advocated that public companies should disclose all business links with outside auditors so shareholders can better evaluate possible conflicts of interest.
Ms. Turner stated that "given the explosion of these [non-audit] services, it's time for the public to know" and urged that mandatory disclosure of possible conflicts of interest should be required by the Independence Standards Board, a self-regulatory organization, or a new SEC rule. Clearly, someone needs to watch the watchdog.
The SEC's willingness to raise tough questions about conflicts of interest has been rewarded by the recent separation of auditors' consulting arms. PWC recently announced that it will split its business into two parts, with separate management teams and boards, one to run the audit business, the other to run the consulting business. Similarly, following the SEC's report exposing PWC's ethical violations, Ernst & Young sold its consulting arm to Cap Gemini, a French computer-services company.
The SEC should keep the heat on auditing firms to divest or at the very least, come up with some reorganization scheme that protects shareholders from actual or potential conflicts of interest.
Independence and integrity have always been the bedrock of the accounting profession and, in order to inspire investor confidence in the integrity of the American financial market, the auditor must remain independent.
– Daniel L. Berger can be reached at dlb@blbglaw.com and Blair Nicholas can be reached at blair@blbglaw.com.
http://www.inthesetimes.com/issue/26/20/feature3.shtml
KPMG EXPECTS SEC ACTION ON XEROX AUDITS
Associated Press
NEW YORK - The accounting company KPMG LLP, anticipating a possible SEC fraud complaint, yesterday issued a five-paage defense of its 1997 audits of Xerox Corp.’s financial statements.
KPMG’s chief executive, Eugene D. O’Kelly, said the complaint, which the company expected to be filed as early as next week in federal court in New York, would be “a great injustice.”
“At the very worst, this is a disagreement over complex professional judgments,” O’Kelly said in a statement....
KPMG issued a statement late yesterday in response to “a complaint KPMG learned may be filed by the SEC in federal district court against the firm, three current partners and one former KPMG partner in connection with its audits of the 1997-2000 financial statements of its former client, Xerox Corp.”
The company said it stood “firmly behind” those likely to be named in the complaint.
KPMG was dismissed in 2001 as Xerox’s longtime auditor.
In June, Xerox said it had booked billions of dollars in revenue before it should have over a five-year period and restated its financial results for 1997 through 2001 in compliance with the terms of a settlement of an accounting investigation by the SEC.
The restatement was required under the agreement. The SEC said the accounting improprieties increased the copier company’s reported pretax profits by $1.5 billion from 1997 through 2000.
Xerox posted too much revenue from equipment contracts up front instead of over the life of leases for servicing and financing equipment. That had the effect of pumping up a given year’s revenue figure.
Without admitting or denying wrongdoing, Xerox paid a $10 million civil penalty, the largest levied against a company for financial-reporting violations....
Outgoing SEC Chairman Harvey Pitt was criticized last spring for meeting privately with the head of KPMG – which Pitt had represented as a securities lawyer – as its audits of Xerox were being investigated.
Marcos' Missing Millions
By Lucy Komisar
Corporate corruption scandals roil the United States, dragging down with them the reputations of the major accounting firms that signed off on--or even designed--fraudulent financial practices. These global auditors were supposed to keep corporations honest. But a closer look at Switzerland, the birthplace of financial legerdemain, shows that accounting deceit is nothing new. Western financial managers cut their teeth designing systems for Third World dictators to loot their countries.
Perhaps the most notorious example is Ferdinand Marcos, who is suspected of stealing at least $10 billion from the Philippines before being overthrown in February 1986. The Philippine government has spent more than 15 years trying to track and recover the money, some of which was secreted away by Swiss bankers and stashed in offshore havens.
Now, a former attorney with accounting firm KPMG in Zurich has come forward claiming she has evidence that on March 23, 1986 ——just a day before a freeze would be placed on Marcos’ accounts — KPMG secretly transferred $400 million from Credit Suisse Zurich to a Liechtenstein trust on the ex-dictator’s behalf.
The attorney, Marie-Gabrielle Koller — named in this article for the first time — first testified about the events behind closed doors before a French parliamentary commission in May 2000. Its report referred to her only as “Madame Z.” Last year, the Quebec native sent her information to U.S. authorities, but elicited no interest from Washington. Now Koller, 46, has privately offered to provide evidence to the Philippine government in exchange for a cut of the amount recovered. With interest, the hidden $400 million would be worth twice as much today.
Koller didn’t join KPMG until 1996, when she was assigned to the Credit Suisse account — a decade after the Marcos government fell. She learned of the midnight Marcos money-laundering operation from a colleague that year, after a Zurich court ordered the transfer to the Philippines of another account — originally worth $356 million — frozen in Switzerland since 1986.
That money had been held on the basis of documents found in the Presidential Palace days after Marcos fled to Honolulu in February 1986 . But there were no documents about the $400 million. Bank officials had been warned that the Swiss Banking Commission, bowing to international pressure, was about to freeze all suspected Marcos accounts.
So, in the dead of night on March 23, 1986, lawyers for KPMG (then known as Fides, a subsidiary of Credit Suisse) moved the $400 million in Marcos funds to a Liechtenstein trust, Limag Management und Verwaltungs AG — which dispersed the money via new secret “foundations” (in German, anstalts). Limag AG was headed by Peter Sprenger, also the director of Liechtenstein’s Credit Suisse Trust AG and parliamentary leader of the Vaterlandische (Fatherland) Union, one of Liechtenstein’s conservative main parties.
Europeans joke that Liechtenstein is where Swiss bankers go to hide their money. The tiny country, just 72 miles east of Zurich, is the place where the Swiss send their dirtiest customers. Liechtenstein has gotten rich by laundering the money of drug traffickers, Mafiosi, tax cheats and other criminals.
A 1999 report from the German secret service described Liechtenstein as a criminal state in the middle of Europe. The German finance minister denounced the country as “a worm in the European fruit.”
Indeed, when clients wanted to transact “sensitive” business, KPMG referred them to associates in Liechtenstein — with the assurance of added secrecy and protection from foreign law enforcement inquiries. Koller says even Liechtenstein was initially “unhappy” with Marcos’ money being transferred there, but Limag resolved the problems by giving a well-paid board chairmanship to Prince Constantin, the elderly uncle of constitutional monarch Prince Hans-Adam II.
“The bank bought the Prince’s uncle,” Koller explained to the French parliamentary commission that was investigating money-laundering in Switzerland. “Everybody is bought in Liechtenstein.”
In 1997, Koller was fired by the manager of KPMG Zurich (which had been made independent of Credit Suisse — at least officially — so that it could continue as its auditor under new accounting regulations). She was sacked after testifying against a Credit Suisse Trust AG client who was involved in a conspiracy to sell tainted blood forcibly taken from prisoners by the Stasi the East German secret police.
In addition, Koller believes she was fired because Credit Suisse realized that she — like other KPMG and bank employees — knew what happened to the Marcos money. She told the French inquiry: “My superior told me ... that I would never work again as a lawyer and that my career was finished in Switzerland and in Liechtenstein because I had spoken to the authorities. “
Last year Koller approached the Justice Department via Virginia lawyer David Smith, a former associate director of the Asset Forfeiture Office. There was no response from the Justice Department’s anti-money laundering division or from the FBI. Both offices declined to comment for this story.
So in February, Koller anonymously approached the Philippine government through her attorney, Ian M. Comisky of high-powered Philadelphia law firm Blank, Rome, Comisky & McCauley, which has close ties to the Bush administration.
In his letter, Comisky wrote, “KPMG-Fides and Limag AG employees made admissions regarding the transfer of the Marcos monies to Liechtenstein, and our client has contemporaneous memoranda prepared at the time of the admissions.” ...
Lucy Komisar, a New York journalist, is writing a book about how bank and corporate secrecy support international crime and corruption. She reported from the Philippines at the time of the Marcos overthrow.
January 15, 2002
SEC Censures KPMG for Having Investment in Client
By Albert B. Crenshaw, Washington Post Staff Writer
The Securities and Exchange Commission yesterday censured the giant accounting firm KPMG LLP for auditing a client's financial statements at the same time it had what the SEC called "substantial financial investments in the client."
The SEC called KPMG's behavior "an extreme departure from the standards of ordinary care." Stephen M. Cutler, the agency's director of enforcement, said the censure "reflects the seriousness with which the SEC treats violations of auditor independence rules, even in the absence of demonstrated investor harm of deliberate misconduct."
No monetary penalty was imposed. In addition to the censure, KPMG agreed to tighten its procedures and training to ensure that it remains fully independent of the clients it audits.
KPMG neither admitted nor denied the SEC's allegations. And spokesman Bob Zeitlinger said the firm made the investment inadvertently "in what we thought was a mutual fund sponsored by . . . a non-audit client."
SEC officials have been concerned about auditor independence for several years. The issue has been receiving renewed attention since the collapse of Enron Corp., including questioning the performance of its auditor, Arthur Andersen.
Two years ago, an SEC investigation of another big accounting firm, PricewaterhouseCoopers, found thousands of cases in which the firm's partners and senior employees had financial interests in companies the firm was auditing.
PricewaterhouseCoopers agreed to take various steps to prevent a recurrence.
Shortly afterward the SEC began a "look back" program that required accounting firms, including the five largest, to review their investments and weed out potential conflicts of interest.
In the KPMG case, the accounting firm served since 1976 as auditor of a family of mutual funds managed by AIM Management Group Inc. of Houston. In 2000, KPMG, at the recommendation of one of its lenders, SunTrust Bank, placed $25 million in AIM's Short-Term Investments Trust, a money-market fund, the SEC said.
After 11 subsequent investments through September 2000, KPMG's investment in the AIM fund reached 35 percent of the firm's total invested surplus cash and roughly 15 percent of the fund's net assets. Because the investment had come through SunTrust, KPMG personnel apparently did not grasp the situation, even though the accounting firm received statements clearly labeled AIM, the SEC said.
In fact, when the treasurer compiled a list of investments for the look-back program, it included one identified as "AIM Institutional Funds/Suntrust Bank," according to the SEC. An AIM employee spotted the potential conflict in December 2000 during a routine check. "No member of the KPMG audit team had any prior knowledge that KPMG had an investment in an AIM fund," the SEC acknowledged.
KPMG then resigned from all its AIM audit engagements.
© 2002 The Washington Post Company
KPMG Conflict Cited in Audit of Company
By Albert B. Crenshaw, Washington Post
The Securities and Exchange Commission said yesterday that its staff, after a lengthy investigation, has accused accounting giant KPMG Peat Marwick LLP of violating professional standards and securities rules by auditing a company with which KPMG had extensive business relationships.
The agency said it would conduct a public hearing to determine whether the allegations are true, and if so what punishment is warranted.
The SEC staff contends that KPMG's 1995 "Independent Auditors' Report" of a financially troubled Long Island company called Porta Systems Corp. was not truly independent because of ties between the accounting firm, a consulting firm it organized, and the president of Porta, who was a part owner of the consulting firm.
Among other things, the accounting firm had lent $100,000 to the president of Porta, its audit client, and was entitled to a percentage of the earnings and other assets of Porta, the SEC staff charged.
KPMG Peat Marwick managing partner J. Terry Strange called the charges "a stretch" and said the firm "sought and obtained SEC approval" for the formation of the consulting firm, known as KPMG BayMark, in 1994. Its audit of Porta "was not affected in any way by the BayMark alliance," and "resulted in an opinion that expressed doubts about Porta Systems' ability to continue as a going concern," he added.
Strange said the firm "is committed to protecting its independence and takes those responsibilities very seriously. He said KPMG Peat Marwick would "vigorously defend" itself and expects to be vindicated.
The case is significant because it involves a growing issue in accounting. CPA firms are increasingly expanding into consulting and other "value-added" services beyond auditing, and regulators are concerned that these new relationships could compromise the independence of their audit reports.
Audited financial statements are the data on which investors rely when evaluating companies and their securities. The SEC staff did not address the content of the audit but rather questioned whether KPMG should have conducted it given its relationship with BayMark and Porta.
Any suggestion that the audits are less than objective or that the auditors could benefit by shading the numbers they attest to could in the long run be very damaging to the nation's financial markets.
The growing perception of potential conflicts of interest also worries the accounting profession. Earlier this year, the profession agreed with the SEC to establish a new Independence Standards Board to try to develop a better framework for evaluating auditor independence in today's business world.
The KPMG case, as outlined yesterday by the SEC, illustrates the complex relationships that sometimes exist:
In 1995, KPMG Peat Marwick organized KPMG BayMark, owned by Edward R. Olson and three others, to engage in new lines of business, such as turnarounds of troubled companies. Later that year, KPMG was hired by Porta, a manufacturer and distributor of telecommunications equipment, to help with its problems. That relationship led to the installation of Olson as Porta's president. At the time, Porta was an audit client of KPMG Peat Marwick's Long Island office.
Olson, whom the SEC staff called the "principal decision-maker at Porta," received the $100,000 loan, which created "a direct financial interest in Porta" for KPMG Peat Marwick, the staff said.
Board Members Resign From Troubled Belgian
Software Maker
By: SmartPros Editorial Staff
IEPER, Belgium, (SmartPros) —— Amid investigations into accounting regularities and reports of a possible conflict of interest at its internal auditor KPMG, troubled Belgian speech recognition software maker Lernout & Hauspie said three members of its board of directors have resigned.
Former co-chair and managing director Pol Hauspie, former managing director Nico Willaert, and former chief executive and president Gaston Bastiaens resigned from the firm last week. L&H also announced the immediate suspension of Joo Chul (John) Seo as president and general manager of L&H Korea and his removal as a director of L&H Korea. Seo was immediately relieved of all responsibilities.
"The decisions we have made represent the commitment of L&H's new management and Board team to a comprehensive remedial course of action," said John Duerden, managing director, president and chief executive of L&H. "We are committed to working closely with our outside auditor, KPMG, to restore their trust."
On Nov. 9, the same day L&H announced it would restate its financial statements for 1998, 1999 and the first half of 2000 due to accounting irregularities uncovered during an internal investigation, Hauspie and co-founder Jo Lernout stepped down as co-chairs and managing directors of the firm. Hauspie had taken a leave of absence for medical reasons from his responsibilities as a board director. At that time, Willaert also stepped down as managing director.
Dong-Hee (Daan) Kim, formerly a vice-president with the enterprise and telephony solutions division, has been appointed acting president and general manager of L&H Korea.
Shortly after the firm's decision to restate its financial results, its independent auditor, KPMG Bedrijfsrevisoren, said that its auditor's reports relating to the company's financial statements for 1998 and 1999 could "no longer be relied upon."
L&H also said that in the course of its investigations, its internal audit committee identified "facts which may have been concealed from its auditor."
The Wall Street Journal earlier this month reported a potential conflict of interest at the Big Five firm, in light of a discovery that the KPMG partner who was in charge of auditing L&H for many years had joined an L&H affiliate last year, shortly after KPMG signed off on the Belgian software company's now-disputed 1998 accounts.
BayMark also was entitled to fees, including a "success fee" of 5 percent of Porta's earnings for three years plus a percentage of its inventory and restructured debt. BayMark in turn was required to pay 5 percent of its income to KPMG Peat Marwick, creating what the SEC staff called "a contingent interest" in Porta's earnings, inventory and debt.
Because of these and other relationships KPMG "lacked independence" when it signed off of Porta's financial statements, which rendered them "materially false and misleading," the staff charged.
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[Catbird: It seems that Kamehameha Schools has quietly picked KPMG to replace the controversial PricewaterhouseCoopers as their new auditor. H-m-m-m.]
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For more of the Big Five jive from the Enron fallout,
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Originally posted November 1, 2001
Last update November 1, 2009, by The Catbird.