PCAOB Enforcement of Auditor Independence Cases in 2017: What We Can Learn From Them?

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Cathy Allen

By Cathy Allen

Cathy Allen, CPA helps CPAs and others understand and apply auditor independence and professional ethics rules though consultation, training, litigation support and expert services. Ms. Allen was a Managing Director in PwC LLP and served as senior staff to the AICPA Professional Ethics Executive Committee (PEEC), where she was instrumental in developing standards and tools for the profession such as the AICPA Plain English Guide to Independenceand the Conceptual Framework for Independence. She authors several AICPA courses and other publications, including the Institute’s Ethics and Professional Conduct: Updates and Professional Ethics: The AICPA’s Comprehensive Course, and has written on professional ethics for various publications. Ms. Allen is a CPA in New York, New Jersey and Maryland and serves on the New York State Board for Public Accountancy and the National Association of State Boards of Accountancy (NASBA) Board of Directors as Northeast Regional Director. She also chairs the NASBA’s Ethics Committee and contributes to AICPA PEEC task forces.

The Public Company Accounting Oversight Board (PCAOB) was busy in 2017 enforcing its auditor independence rules, which the staff describes as a “high priority” area. A quick snapshot of the numbers shows:

Settled Disciplinary Orders: 12 cases included independence violations, involving 11 firms and ten associated persons (Total Settled Cases in 2017: 54).

Adjudicated Final Board Actions Imposing Sanctions in Disciplinary Proceedings: zero cases included independence violations (Total Adjudicated Cases in 2017: two).

Clearly, most of the PCAOB’s enforcement cases were resolved through settlement this past year. At approximately 22 percent, a significant portion of the total cases the Board settled involved one or more independence violations. In some cases, independence was the only charge, while in others the PCAOB also charged the firm and/or its members with violating auditing and quality control standards. Some cases cited violations relating to multiple clients and/or audit periods, including repeat violations. In one case, PCAOB inspectors called out a firm’s violation of independence due to prohibited bookkeeping services, which the firm nonetheless repeated the following year.

Independence issues related to:

  •  bookkeeping and financial statement preparation;
  •  performing an ongoing monitoring (management) function;
  •  business and employment relationships;
  •  family relationship;
  •  unpaid professional fees; and
  •  communications with the audit committee
What can we learn from these matters? This article explores the 12 settlement orders from 2017 that involved independence violations via a series of questions and answers.

What Did Firms Do to Violate the Securities and Exchange Commission (SEC) Prohibition on Bookkeeping and Financial Statement Preparation Services?

In seven matters, the firms provided prohibited bookkeeping and financial statement preparation services to their broker-dealer audit clients. According to the Orders, firms engaged in various activities, including that they:

  •  entered client information into a template that created the financial statements filed with the SEC;
  •  used client information to draft the notes to the financial statements filed with the SEC;
  •  used the client’s trial balance to prepare the computation of net capital and financial statements;
  •  prepared as part of the net capital computation a reconciliation between the firm’s and the client’s computations;
  •  made multiple changes to client-prepared financial statements and footnotes, which were sent back to the client for approval (in one case, the client noted that their financials “needs fixing”);
  •  prepared the FOCUS net capital computation filed with the Financial Industry Regulatory Authority (FINRA);
  •  prepared monthly calculations in a net capital worksheet to monitor whether the client was complying with net capital regulatory requirements; and
  •  prepared supplemental schedules filed with FINRA.
All the above activities are considered to violate the SEC’s prohibitions on auditing one’s own work and/or performing management functions on the client’s behalf. Under the SEC’s general standard, performing management functions (e.g., keeping the client’s books or monitoring monthly net capital) creates an unacceptable mutuality of interests that diminishes the auditor’s objectivity.

Why Did These Firms Violate the SEC’s Rule on Bookkeeping Services—Was It A Lack of Knowledge About the Rules, Disregard, or Some Other Reason?

Interesting question and difficult to answer based on the information in most of the orders. In one Order, the PCAOB revoked the firm’s registration due to what the Board referred to as “intentional or knowing misconduct, including reckless conduct, or repeated instances of negligent conduct.” Some auditors were aware—and told their clients—that they weren’t permitted to prepare their clients’ financial statements, but ultimately did so anyway. Typically, the client made a first attempt, which the firm would revise significantly and then send to the client’s management for approval. While this approach might pass muster under American Institute of CPAs rules (assuming the auditor met the AICPA Code’s General Requirements for performing nonattest services and the revisions were not extensive), clearly this is unacceptable from the SEC’s point of view.

Can Noncompliance Be Attributed to Confusion Regarding Changes to the Audit Requirements for Broker-Dealers Adopted as a Result of the Dodd-Frank Act?

Certainly possible, but if so, that confusion is not new. The Orders note that while some practitioners thought the rules changed in 2014 when nonpublic broker-dealer audits became subject to PCAOB auditing standards, as registrants, broker-dealer audits have been subject to SEC independence rules (Rule 2-01 of Regulation S-X) for many years, even though they performed audits under GAAS. (See the SEC’s Release, Broker Dealer Reports, pp. 94-97, which among other things discusses changes to Rule 17a-5.)

What Other Situations Caused Independence Violations?

Three cases involved prohibited business, employment or family relationships with clients. One involved a quality review partner whose son was employed in an accounting role at the audit client. The other two cases, which were related, involved an audit firm whose owners and directors were concurrently serving as directors and executives of the audit client. In one of those cases, the quality review partner who approved the audit was also found to have violated Auditing Standard 7, Engagement Quality Review, for failing to provide any evidence that the firm satisfied the independence requirements (a significant engagement deficiency). That reviewer also failed to observe the two-year cooling off period required by AS 7, having just served as the engagement partner.

Another case involved material, unpaid fees for previously performed services where the client made no payment commitment or other agreement to pay past due fees timely. The PCAOB also cited the firm for failing to provide written communication to the audit committee describing the past due fees as a possible independence concern. The violation occurred over two consecutive audits.

Finally, the PCAOB found one firm violated quality control and auditing standards and failed to provide a written communication about independence to the client’s audit committee.

What Sanctions Were Imposed in Connection With These Settlement Agreements?

The range of sanctions included:

  •  censures (firms and associated persons);
  •  civil money penalties (firms and associated persons);
  •  directives to establish (or enhance) policies and procedures to address deficiencies and provide additional training within a certain time frame;
  •  revocation of the firm’s registration with the PCAOB;
  •  bars on individuals to be an associated person in a PCAOB registered firm; and
  •  prohibition on accepting any new SEC Registered broker-dealer clients within one year from the date of the order.
For further information, see https://pcaobus.org/enforcement/Pages/default.aspx.

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