The Lost Art of an Independent Audit
The time has come to revisit the issue whether all nonaudit services should be prohibited for audit clients. The accounting profession continues to struggle with independence issues when both services are provided. The threats and safeguards approach in the AICPA Code does not seem to have reduced the instances of independence violations. Deficiencies in CPA firm quality controls and the failure to communicate independence issues with audit committees have exacerbated the problem. Recent examples, just in 2019, illustrate a decline in basic ethics and the failure to protect the public interest.
- On September 23, 2019, PwC agreed to pay $7.9 million to settle charges that the firm violated the SEC’s auditor independence rules by performing prohibited nonaudit services during an audit engagement, including exercising decision-making authority in the design and implementation of software relating to an audit client’s financial reporting, and engaging in management functions thereby creating a self-review threat to independence.
- On September 10, 2019, Marcum LLP, one of the largest independent public accounting and advisory services firms in the nation, settled disciplinary proceedings with the PCAOB over advocating numerous issuer auditor clients in connection with the firm’s annual MicroCap Conference. As the host, Marcum praised the presenting companies, which included many of the firm’s auditing clients, as high-quality companies that were selected via a vetting process thereby creating an advocacy threat to independence.
- On August 27, 2019, the SEC charged RSM US LLP (formerly known as McGladrey LLP), which is the fifth largest accounting firm in the U.S., with violating SEC independence rules in connection with more than 100 audit reports involving at least 15 audit clients for which they provided prohibited nonaudit services including corporate secretarial services, payment facilitation, payroll outsourcing, loaned staff, financial information system design or implementation, bookkeeping, internal audit outsourcing, and investment adviser services. A partner also had a prohibited employment relationship in serving as a non-discretionary member of the board of an affiliate of an RSM US issuer audit client, a management participation threat to independence.
- On February 13, 2019, the SEC announced an agreement with Deloitte Touche Tohmatsu LLC (Deloitte Japan) to pay $2 million to settle charges that the firm issued audit reports for an audit client at a time when dozens of its employees maintained bank accounts with the client’s subsidiary thereby creating a self-interest threat to independence. An investigation by the firm revealed that 88 other Deloitte Japan employees had financial relationships with the audit client that compromised their independence.
This is just the tip of the iceberg. During the past few years we’ve witnessed the KPMG-PCAOB cheating scandal whereby the firm received inside information about audits to be inspected by the PCAOB from staffers who went to work for the firm. A partner at Ernst & Young tipped off a friend about non-public actions to be taken by an audit client that had the potential of moving the stock price.
What's Happening in the U.K?
It seems the United Kingdom is taking the matter of a conflict of interests seriously. The Financial Reporting Council (FRC), the United Kingdom’s accounting watchdog, has been examining the question of whether the performance of all nonaudit services should be prohibited for audit clients in the aftermath of the liquidation of two large companies, Carillion and BHS. The impetus for the review is FRC’s claims that auditors from KPMG in both instances did not do enough to challenge management and did not maintain their professional skepticism. KPMG, for its part, indicated it would not continue to provide nonaudit services to audit clients but had some qualifiers, such as continuing to provide nonaudit services, such as consultancy, to smaller UK-listed clients, as well as private firms of all sizes. It also failed to give an end date for the changes.
Other firms, including PwC and EY, also said they would stop offering non-essential consulting services to its largest British public audit clients by 2020. The firms stated their goal is to eliminate any perception of conflict between selling audit and consulting work to the same client. The key here is what is a “non-essential consulting service?” Perhaps the firms purposefully left it vague.
Enter the UK Competition and Markets Authority, a government department in the UK, that issued a report on April 18, 2019 recommending an operational split of audit and nonaudit services. The large firms would be split into separate operating entities with respect to auditing and consultancy functions to reduce the influence of consulting practices upon auditing divisions. The split would help to prevent potential conflicts of interest from impairing audit independence and increasing the public trust in the quality of financial statements. However, the watchdog stopped short of recommending a full break-up based on firm services.
A study group chaired by Prem Sikka, a professor of Accounting and Finance at the University of Sheffield, prepared a report on behalf of the UK Parliamentary Labour Party, that concluded an operational split would not go far enough, calling instead for two legally separate organizations. In essence, it calls for a structural break-up of large firms saying that it would be more effective than other options in dealing with conflicts of interest and providing professional skepticism needed to deliver high-quality audits.
Role of the SEC and PCAOB
The SEC and PCAOB should closely monitor the events in the UK as regulators deal with the issue of how best to eliminate threats to independence that might occur when nonaudit services are provided for audit clients. Regardless of the method chosen, the time has come to split off nonaudit services as a separate unit, at a minimum, and study the issue of legal separation much as is being done in the UK. Nothing short of these remedies is necessary to protect the public interest.
Posted by Steven Mintz, aka Ethics Sage, on December 30, 2019. Dr. Mintz is the author of a college accounting textbook, Ethical Obligations and Decision Making in Accounting: Text and Cases. You can sign up for his newsletter and learn more about his activities on his website: https://www.stevenmintzethics.com/. Follow him on Facebook at: https://www.facebook.com/StevenMintzEthics.