Study: SOX Regulations Not Enough to Overcome ‘Alumni Effect’ in Audits

New research shows that auditors are more accommodating to clients who once worked at a Big 4 firm, threatening auditor independence and professional skepticism.

The so-called “alumni effect,” was outlined in a paper published in the March issue Accounting Horizons, a journal of the American Accounting Association.

In the wake of high-profile accounting scandals at Enron, Global Crossings and other companies in the early 2000s, lawmakers passed the Sarbanes-Oxley Act (SOX), which banned accounting firms from performing audits if a top financial or accounting executive of the client was employed by the auditor during the preceding year. After all, top executives of Enron and Global Crossings were alumni of their companies’ external auditors.

However, the new research suggests that SOX is not effective in eliminating the threat to independence.

In a controlled experiment with three different conditions, audit managers assessed the potential impairment of goodwill. The study says: “The results indicate that auditors are more likely to make a judgment that agrees with the client’s position when the CFO is a former engagement partner from their firm, and are more confident in the CFO’s position when the CFO is a former Big 4 partner, whether from their own firm or another firm, than when the CFO is not identified as having any affiliation with any audit firm.”

The study says 76% adopt the client’s position if the client’s CFO is a former colleague at their Big 4 audit firm, while only 44% do so if the CFO is not. The alumni effect occurs even if it has been two years since the CFO left the audit firm, double the minimum required in the U.S.

“Obviously, a one-year or two-year cooling-off period is not enough to avoid the alumni effect, particularly if it requires overcoming social bonds that colleagues often develop,” says Michael Favere-Marchesi of Simon Fraser University’s Beedie School of Business, who was quoted in Favere-Marchesi conducted the study with Beedie colleague Craig Emby. “It may be that five or 10 years would be enough. Alternatively, it may be that audits of companies where a CFO or other higher-up is a former engagement partner should be banned entirely, as some research on auditor independence has suggested.”

These conclusions are based on an online experiment involving 140 managers of Big 4 firms in Canada and the U.S. The managers all received the same background information about a corporate client and its industry as well as a draft of the current year’s financial statement. Three experimental conditions were set regarding the CFO’s background, and the key issue was the valuation of goodwill, an asset on corporate balance sheets that arises when a firm purchases a company for more than the fair value of its net assets.

“Being told the CFO had formerly been a Big 4 partner inclined participants to agreement on goodwill impairment but not nearly as much as the alumni effect did,” reported. “And least likely of all to be swayed were participants whose CFO had neither alumnus status nor Big 4 imprimatur.”

The study authors urge regulators for “a more robust cooling-off period covering a wider range of management positions,” noting that the possibility of a longer period has been raised by the SEC’s PCAOB.

Compliance Education Institute Sues Dixon Hughes Goodman for Copyright Infringement

Compliance Education Institute has filed suit against Charlotte, N.C.-based Dixon Hughes Goodman (FY17 net revenue of $404 million) for copyright infringement of its Certified Regulatory Vendor Program Manager (CRVPM®) course.

As noted in the filing entered into Federal court in New York, Michael Blevins, a manager in the DHG Risk Practice, enrolled in the CRVPM course and became a Certified Regulatory Vendor Program Manager in Jan. 2015. DHG then published a four-part vendor management series on its DHG Views public website on March 1, 2015 where it remained for two years.

Chris Ricchiuto, partner in the risk practice, is shown as the author and a consolidated version of the four-part series was also posted on the public website of the Institute of Internal Auditors (IIA) Charlotte chapter. Both Blevins and Ricchiuto are shown as co-authors. The IIA is named as a co-defendant in the suit.

“It’s David vs Goliath,” says Mick Kless, CEO of Compliance Education Institute. “After many months of trying to resolve this issue with this 2,000 employee, top 20 audit firm without satisfactory result, I felt that it was best to file a complaint in court and post the complaint and the exhibits to our website. Let the legal system and jury of public opinion draw their own conclusion. View the evidence and you be the judge.”

KPMG Audits of Carillion Probed by FRC

According to Bloomberg, The U.K. Financial Reporting Council (FRC) opened a probe into New York-based KPMG LLP’s (FY16 gross revenue of $8.6 billion) audits of Carillion Plc, after the builder collapsed under debt earlier this month.

The FRC will examine KPMG’s work from 2014 and whether the auditor breached any “ethical and technical standards.” The FRC will also look at how KPMG recognized revenue on significant contracts and its accounting for pensions.

Carillion, a U.K. construction company with government contracts in everything from hospitals to the HS2 high-speed rail project, collapsed in January after failing to shore-up finances and get a government bailout, leaving behind debts of $2.3 billion.

“Several areas of KPMG’s work will be examined including the audit of the company’s use and disclosure of the going concern basis of accounting,” the FRC says. We will “conduct the investigation as quickly and thoroughly as possible.”

“Transparency and accountability are vital in building public trust in audit,” KPMG said in statement to Bloomberg. “We believe it is important that regulators acting in the public interest review the audit work related to high profile cases such as Carillion.”

“It is vital that we are able to have confidence in audit and financial statements,” says Michael Izza, chief executive of the institute of chartered accountants in England and Wales. “If there are lessons that need to be learned, whether by auditors, the accountancy profession, or management, we must identify them and act.”

PwC Appeals Two-year Ban on Audits in India

According to Telegraph India, PwC (FY16 gross revenue of $14.3 billion) in India is appealing a two-year ban on auditing public companies by the Securities Exchange Board of India (SEBI).

SEBI claims PwC auditors failed to uncover irregularities in the account of Satyam, which was one of India’s leading software providers. PwC is appealing the ban and asking for the appeal to be heard on an expedited basis.

“We are happy that Securities and Appellate Tribunal (SAT) has expressed its intention to resolve our appeal against SEBI on an expedited basis, and has set an expectation of a tight timeline of six weeks to dispose the appeal. The clarification that current engagements can continue through the year, is welcome. Over the years, our stakeholders have witnessed the huge investment we made in tools, training and infrastructure and we remain committed to maintaining the highest standards of quality in our services,” says PwC in a statement.

The appeal is expected to be heard by the end of next month. “We applied for a stay, which was rejected, however, as the appeal has not yet been heard but will be heard by the end of February,” says spokesman Mike Davies.

Six CPAs Charged In Scheme to ‘Steal the Exam’ for KPMG

Six CPAs – three former employees from PCAOB and three from New York-based KPMG (FY16 gross revenue of $8.6 billion)– are facing charges related to a years-long scheme to leak insider information from PCAOB to help the Big 4 firm improve its audit results, multiple news sources reported.

The three ex-employees of PCAOB, who went on to work for KPMG or were seeking employment there, stole the information tied to future exams, the Justice Department and the Securities and Exchange Commission said Monday.

“These accountants engaged in shocking misconduct – literally stealing the exam – in an effort to interfere with the PCAOB’s ability to detect audit deficiencies,” said Steven Peikin, co-head of the SEC’s enforcement division, according to Bloomberg. In The Washington Post, SEC Chair Jay Clayton called the case “disturbing,” noting that “audited financial statements are at the heart of the SEC’s disclosure-based regulatory regime. . . . In matters of this type, I am also concerned about potential adverse collateral effects, including on our Main Street investors.” (Read Clayton’s full statement.)

The government alleges that KPMG was trying to improve on the poor grades it received from PCAOB in 2013 and 2014. In 2014, for example, it received about twice as many negative comments, on average, during its inspections as its competitors.

Soon after the conduct was discovered in early 2017, the six respondents were terminated, resigned or placed on leave before separating from KPMG and the PCAOB.

The ex-PCAOB employees are: Brian Sweet, of Fresno, Calif., Cynthia Holder, of Houston, and Jeffrey Wada, of Tustin, Calif. According to court papers, they made unauthorized disclosures of PCAOB plans for inspections of KPMG audits from 2015 until February 2017.

The ex-KPMG employees are: David Middendorf, of Marietta, Ga., then-national MP for audit quality, Thomas Whittle, of Gladstone, N.J., PIC for inspections, and David Britt, of New Canaan, Conn., banking and capital markets group co-leader.

Britt and Whittle pleaded not guilty during an appearance before U.S. Magistrate Judge Andrew J. Peck in Manhattan on Monday, Bloomberg reported. Middendorf made a court appearance in Atlanta and was released on bail. He denies the allegations.

Sweet left PCAOB and went to work for KPMG, U.S. District Court papers say. On his last day at PCAOB, Sweet copied confidential information, including a list of accounting firm audits the PCAOB would inspect in 2015, to a personal hard drive, according to the government. Sweet has pleaded guilty to conspiracy and is cooperating with prosecutors, his lawyer says.

On his first day at KPMG, Sweet had lunch with his new boss, Whittle, and other colleagues, where he disclosed that a particular client audit would be examined by the PCAOB, according to the filing. Several days later, Sweet emailed the list of KPMG audit clients that what would be reviewed to Whittle, who then forwarded on to his boss Middendorf, writing: “The complete list. Obviously, very sensitive. We will not be broadcasting this.”

On Sweet’s recommendation, Holder joined KPMG a few months later. Like Sweet, she copied confidential PCAOB data before leaving, the court documents claim. Wada also sought work there.

Before Wada could land a job, KPMG’s office of general counsel began an investigation. Sweet and Holder allegedly tried to avoid detection by deleting texts with Wada and confidential PCAOB documents from company computers, but were eventually fired, the Post reported.

KPMG promptly notified authorities, and has been fully cooperating with the government, spokesman Manuel Gonclaves said in a statement.

“KPMG took swift and decisive action, including the engagement of outside legal counsel to conduct a detailed investigation and the separation of involved individuals from the firm,” Gonclaves said. “Since then, KPMG has taken remedial actions to assure that such conduct cannot happen again.”

The PCAOB, for its part, is also cooperating. “The new PCAOB Board will conduct an ongoing review of the organization’s information technology and security controls, as well as its compliance and ethics protocols, to assess their effectiveness,” PCAOB Chairman William Duhnke said in a statement.

The PCAOB was created by Congress under the 2002 Sarbanes-Oxley Act, corporate reform legislation that was designed restore public confidence in the audit industry after accounting scandals at Enron Corp. and WorldCom Inc.

Calif. Accountancy Board Recommends License Suspension

Irvine, Calif.-based Hagen Streiff Newton & Oshiro (HSNO) is facing a critical report by the California Board of Accountancy for its audits of spending and contracts at Great Park in Irvine, the Voice of OC reported.

Former Mayor Larry Agran, whose political career was damaged by the Great Park audits, said, “For heaven’s sakes, if you can’t trust auditors to be honest and straightforward, then who can the public trust?” The Voice of OC is a nonprofit news organization that covers Orange County’s local governments.

The firm said in a statement that it “strongly disagrees with the State Board’s Accusation, as they appropriately completed the engagements with the city of Irvine in accordance with professional standards.”

Mayor Pro Tem Christina Shea defended the audits and said one of the contractors on the project filed the complaint with the Board of Accountancy.

“It’s just another political operation to justify what they did at the Great Park,” Shea told Voice of OC. “I think they’re just doing everything they can to exonerate themselves … we stand behind our audit, the city does and I do.”

The city spent over $1.4 million on the audits that examined why more than $250 million was spent to develop 88 of the Great Park’s 1,300 acres. The firm reviewed spending and Great Park development contracts awarded between July 2005 and the end of 2012.

The state auditor, Elaine Howle, also criticized spending on the park. She cited poor governance from the city, saying a city subcommittee failed to enforce auditing standards and that city officials failed to enforce the industry standards to ensure an impartial analysis.

The accountancy board report says HSNO violated numerous public accounting standards and recommended HSNO reimburse the state for the cost of the investigation and pay an administrative penalty. It’s also recommended HSNO and its lead accountant in the audits have their accounting licenses revoked, suspended or restricted.

PwC Hit with Two-Year Audit Ban

The Securities and Exchange Board of India (SEBI) has banned PwC (FY16 gross revenue of $14.3 billion) from auditing listed companies in the country for two years, after it failed to spot a $1.7 billion fraud at the now defunct Satyam Computer Services, according to CNN.

SEBI claims PwC auditors failed to uncover irregularities in the account of Satyam, which was one of India’s leading software providers.

These irregularities were revealed in 2009 by Ramalinga Raju, the company’s chairman. He admitted to inflating Satyam’s profits with “fictitious” assets, non-existent cash and misreporting of debts the company was owed. He was sentenced to seven years in jail along with nine co-conspirators in 2015.

SEBI believes that PwC overlooked “several red flags…. which were all too obvious for any reasonable professional auditor to miss.”

SEBI also ordered the accounting firm to relinquish “wrongful gains” of around 130 million rupees ($2 million), plus 12% interest per year for the past eight years.

“The SEBI order relates to a fraud that took place nearly a decade ago in which we played no part and had no knowledge of,” says PwC.

Former MP of Hawaii Firm Receives 20-Year Prison Sentence

According to Honolulu Star Advertiser, Patrick Oki, previous MP of Spire Hawaii (formerly PKF Hawaii), was sentenced to 20 years in prison for stealing more than $400,000 from the company.

Circuit Judge Rom Trader gave a mandatory prison term of 20 years after Oki was found guilty on all counts, including money laundering, theft, forgery and using a computer to commit crimes during a two-week nonjury trial in February.

Oki admitted to claiming false reimbursements and lying to his partners. However, he said he took only what PKF owed him.

The judge decided to delay Oki’s restitution payment of $440,178 until the rightful recipients of the money can be determined. The state has asked the judge to order Oki to pay the money to his former partners at PKF.

PKF Pacific Hawaii changed its name to Spire Hawaii following Oki’s indictment and arrest in October 2015.

Law Firms Urge Clients to Prepare for New Federal Rules on Partnerships and LLCs

New federal rules relating to partnerships and limited liability companies have prompted law firms to warn their clients to prepare for a possible IRS audit by reviewing and amending governing documents and designating a partnership representative, the Daily Business Review reported.

The Daily Business Review, which covers legal and business news in South Florida, says that McDonald Hopkins, a law firm with six offices in the eastern U.S., has created an entire program to address the changes partnerships and LLCs may need to make.

These businesses must elect a “partnership representative” who will have sole decision-making power for the company and all shareholders in discussions with the IRS, which will designate one if the businesses don’t. The partnership representative decides whether the partnership or a particular partner will pay any underpayment in taxes the audit finds, Business Review reported.

“This person who serves as partnership representative has unfettered authority to act on behalf of the partnership,” says Jordan August, an associate at Carlton Fields Jorden Burt of Tampa, Fla. “It has become such an issue with partnerships because the new act gives all this authority to the partnership representative. It is imperative that the contractual terms of your partnership or LLC cover and address the manner in which the partnership representative will act on behalf of the partners in the event of an audit, including whether a push out election will be made. In the event that an additional tax is assessed, who will ultimately bear the burden of paying those additional taxes?”

The new rules also potentially shift the tax liability for LLCs and partnerships. Eligible partners need to decide annually whether to opt out of the new rule that provides that if the business is audited it will pay any underpaid taxes at the partnership level, or instead choose to be taxed at the traditional individual partner level, Business Review reported.

The changes are effective Jan. 1, are designed to raise tax revenue and make it easier for the IRS to audit partnerships and LLCs. Traditionally, the IRS audited and assessed tax on the partners or members rather than the entity itself. The new regulations centralize the assessment and collection of unpaid tax directly at the entity level from the partnership or LLC.

“It will be easier for the IRS to do an audit of just one entity, and less expensive for them as well, because they won’t need as many people out in the field,” says Raquel Rodriguez, Miami OMP at McDonald Hopkins. “If the audit is done at the partner level, the IRS currently has to seek out each member and do an assessment.”

The text of the new rules can be found here.

Former MP at Spire Hawaii Found Guilty on 13 Felony Counts

Patrick Oki, previous MP of Spire Hawaii (formerly PKF Hawaii) has been found guilty on 13 felony counts of money laundering, theft and forgery.

Oki, originally charged in April 2015, received the guilty verdicts in court and faces a minimum of 20 years behind bars for stealing $500,000 from his former firm.

“This verdict today should remove any doubt about Patrick Oki being a con man, a thief and a liar and now a convicted felon,” says deputy prosecutor Chris Van Marter.

Oki’s attorney Howard Luke says that Oki will likely appeal; that under the terms of the partnership agreement at PKF, Oki was entitled to the money he was accused of stealing.

“Actually he was underpaid – or under-compensated I should say – for the amount of money he should have been earning under the partnership agreement,” says Luke.

Over three years, prosecutors alleged, Oki forged signatures, made up fictitious companies and people, and even made up fake dealings with the Central Intelligence Agency, all as part of four separate schemes to steal from the firm and his four partners.

“When you look at the evidence we recovered, with him creating fake websites, fake emails and fake Paypal accounts, the fact that we found all of that is a reflection of the arrogance he had that he could get away with it,” says Van Marter.