On September 19 and 20, 2013, the American Law Institute presented its annual course, Accountants’ Liability: Managing Risks in a Changing Environment. One highlight of the conference was a Public Company Accounting Oversight Board (PCAOB) panel presentation featuring Claudius B. Modesti, Director, Division of Enforcement and Investigations, and Jarett B. Decker, Deputy Director and Chief Trial Counsel Division of Enforcement and Investigations. The panel offered insight into how accounting firms and individuals can maximize the effectiveness of statements of position prepared under PCAOB Rule 5109 in response to charging letters from the staff.
Under Rule 5109(d):
Registered public accounting firms, and persons associated with firms, who become involved in an informal inquiry or a formal investigation may, on their own initiatives, submit a written statement to the Board setting forth their interests and positions in regard to the subject matter of the investigation. Upon request, the Board’s staff, in its discretion, may advise such persons of the general nature of the investigation, including the indicated violations as they pertain to those persons and the amount of time that may be available for preparing and submitting a statement prior to the presentation of a staff recommendation to the Board for the commencement of a disciplinary proceeding. In the event a recommendation for the commencement of a disciplinary proceeding is presented by the staff, any submissions by interested persons will be forwarded to the Board in conjunction with the staff recommendation.
Decker noted that the Division of Enforcement’s practice under this rule has evolved and that the staff has tended to provide a “more fulsome” notice of the issues that are of concern, in an effort to receive more detailed responses from the accounting firms and individuals under investigation regarding the context, defenses, and mitigating factors relating to those issues. Decker explained that the audience for these statements of position is “highly sophisticated and experienced”; that the staff “gets into the weeds” when deciding whether to bring charges; and that the statement of position process has led the staff to decide not to recommend charges to the Board. In other words, he concluded, “This is not a perfunctory process.” He went on to offer suggestions on how to make statements of position more helpful and persuasive to the staff.
Four Commonly Seen Defense Themes
Decker identified four common defense themes in Rule 5109 statements of position: (1) management fraud; (2) materiality; (3) “we did enough”; and (4) role defenses. As discussed below, the Division of Enforcement’s view is that each of these themes should be adjusted to take into account the fact that the audience is the PCAOB, rather than a judge or jury in a civil case where issues of causation and relative fault might hold more sway.
The “Management Fraud” Theme
Decker characterized the first common defense theme that he and his staff see in Rule 5109 statements of position as “management fraud”: the accounting firm provides in its statement of position a “lurid description” of management’s conduct, citing to internal communications that were not shared with the auditors, and referring to the professional literature providing that a well-orchestrated fraud may not be detected by a well-conducted audit. While acknowledging the validity of this general principle, Decker described this formulation as “at best, incomplete and at worst, irrelevant” in light of the auditor’s responsibility, found in AU § 110.02, “to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.”
A more helpful presentation, Decker continued, would provide facts or perspective on how management’s conduct actually derailed the audit and led the auditors to believe that they had reasonable assurance. As an example, Decker offered a hypothetical situation in which auditors sent a confirmation to a third party to confirm an accounts receivable balance, the third party colluded with management to falsify the confirmation response, and there was no reason for the auditors to detect that the confirmation was falsified. Management fraud would not be a relevant response if the PCAOB’s concern related to a perceived acceptance of a management representation without testing; in that circumstance, it would be more helpful to discuss why testing, or more rigorous testing, of that representation was not deemed necessary.
The “Materiality” Theme
Decker next focused on what he termed the “materiality” defense, whereby accounting firms compare the accounting item at issue to the company’s total revenue. While that may be a good technique for private litigation, Decker said, such comparisons will not get accounting firms very far with the PCAOB.
Rather, the PCAOB is interested in knowing what risks the auditor perceived during the audit, how risky the auditor perceived this particular issue to be at the time, and why this particular issue did not appear as important during the audit as it later turned out to be. Decker pointed out that the PCAOB’s inquiries and investigations often focus on accounting items that were identified by the audit team as high-risk items, and therefore the PCAOB wants to know if the audit team responded to that high-risk item appropriately. Statements of position frequently warn against judging the quality of the audit with the benefit of 20/20 hindsight – a caution that Decker stated the staff already takes into account.
The “We Did Enough” Theme
Decker described the third common defense theme as the “we did enough” defense: an audit is meant to provide “reasonable assurance,” rather than an absolute guarantee. Less effective statements of position, according to Decker, articulate that principle, provide a broad recitation of all testwork that touched in any way on the issue, blend it all into a “reasonable assurance smoothie,” and then assert in conclusory fashion that the audit team “did enough.”
This defense fails to be persuasive, Decker explained, because the PCAOB’s frame of reference tends to be that the audit documentation raised certain specific questions that a reasonable auditor would want to answer with substantial evidence, but the PCAOB does not see that the question was asked or, if asked, that the evidence was obtained. Instead of serving the PCAOB a “reasonable assurance smoothie,” accounting firms should explain how, in the full context of the information obtained, the issue identified by the PCAOB would not have been raised, or should point out how the audit evidence obtained did answer that question.
In response to a question about a hypothetical situation in which the fraud was so pervasive that the audit would have been derailed regardless of the testwork performed, Decker and Modesti contrasted the PCAOB’s mission with the arguments that are relevant to civil litigation (for example, that loss causation is lacking). The PCAOB can bring an action for audit failures even if no misstatement resulted; for example, if the auditor did no work at all before signing the audit report, but the financial statements happened to be fine, the lack of a material misstatement would mean that there is no cause of action under Section 10(b), but that auditor, they said, “clearly should not be trusted to audit financial statements.” The PCAOB’s focus is on whether the auditor performed the audit in accordance with GAAS, not on whether a loss flowed from an auditor’s failure to do so.
The “Role Defense” Theme
The final common defense theme identified by Decker was the “role defense”: the individual auditor, in his or her role, would not have received the information necessary to provide notice of the issue that is of concern to the PCAOB. While this theme might be effective, for example, with regard to a concurring review partner or perhaps a low-level staff auditor, Decker noted that it would be problematic for an audit engagement partner to contend that he or she did not have the same level of information as lower-level members on the audit team.
Miscellaneous Practice Pointers
The PCAOB suggested that accounting firms or associated persons should seek a sit-down meeting with the PCAOB after submitting their Rule 5109 statements of position and after the PCAOB has had a chance to review the response. Modesti also advised that if the statement of position cites to the record, accounting firms or associated persons should make life easier on the PCAOB staff by attaching an appendix with record cites. Modesti also noted a trend in statements of position including expert submissions; according to Modesti, expert submissions are most helpful to the PCAOB when the opinions are specific and targeted to the issues of concern to the staff and when the expert’s technical industry experience bears on the underlying accounting issue.