The Commission, as part of its retooled enforcement program, is, in part, focusing on gatekeepers such as attorneys and accounts in an effort to achieve omnipresence. This has resulted in a number of proceedings against primarily small audit firms and/or individual auditors for what were essentially audit failures – situations where little or no real audit work was done. The Enforcement staff refers to this as Operation Broken Gate.
Now the Commission brought a settled administrative proceeding against audit giant KPMG, charging independence violations. In the Matter of KPMG LLP, Adm. Proc. File No. 3-15687 (Jan. 24, 2014). In connection with that proceeding the SEC also issued an Exchange Act Section 21(a) Report of Investigation to clarify a key question regarding auditor independence centered on loaned staff. SEA Release No. 71390, Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: KPMG, LLP (Jan. 24, 2014).
The proceeding naming KPMG as a Respondent centers on questions of independence. Specifically, uner Rule 2-01 of Regulation SX auditors must be independent of their SEC audit clients in fact and appearance. The Rule contains a non-exhaustive list of non-audit service which an auditor cannot provide to its audit clients. It also specifies that an auditor is prohibited from acting temporarily or permanently “as a director, officer, or employee of an audit client, or performing any decision-making, supervisory, or ongoing monitoring function of the audit client.”
Here the proceeding centers on the relationship of the audit firm with three unidentified audit clients. First, with respect to Company A, and SEC audit client, beginning in late 2008 and continuing through the end of 2009, KPMG hired an employee who recently retired from a senior position with a company affiliate and loaned that person back to the same affiliate.
In April 2007 the affiliate of Company A offered early retirement packages to certain employees. A package was accepted by an employee who worked as Senior Tax Counsel in the affiliate’s Office of Tax Affairs’ Trade & Customs Group. Subsequently, KPMG retained the employee after discussions with the affiliate about its staffing needs. The person was retained to do essentially the same work that had been performed for the affiliate. The audit firm then loaned the employee to the affiliate where essentially the same work was done.
This arrangement violated the independence rules. The violation arose because “the affiliate’s former employee acted as both a manager and an employee of Company A’s affiliate and provided advocacy services for the affiliate.” In addition, because the employee was permitted to hold stock in Company A while service in this capacity it further violated the independence rules.
Second, the Order alleges that with respect to Company B the audit firm provided prohibited non-audit services to an affiliate. KPMG was the outside auditor to Company B from 2005 through December 2011. In September 2006 Company B became an affiliate of a large financial services firm when one of that firm’s subsidiaries acquired all the shares of a controlling affiliate of Company B. At the same time the financial services firm became the owner of Company B’s General Partner which owned and controlled Company B.
The financial services firm was a non-audit client of KPMG from 2006 through the end of 2011. The firm provided a variety of services. Those included management functions, restructuring services and the loaning of staff services for bookkeeping and expert services.
Beginning in September 2006 Company B disclosed its relationship to the financial services firm in every annual report filed with the Commission. Nevertheless, the KPMG audit engagement team for Company B did not recognize the financial services firm as a controlling affiliate for independence purposes until late 2011. At that time the firm identified the issue and reported it to the audit committee. In December the audit firm was terminated by the audit committee.
In addition, six partners in the KPMG chain of command, and two partners in the firm’s office that conducted the audits of Company B, owned stock in the financial services firm. Both incidents were violations of the independence rules.
Finally, with respect to Company C, KPMG also provided prohibited non-audit services to an audit client such as bookkeeping and payroll services. In late 2007 KPMG submitted a proposal to provide audit services to Company C. During the client acceptance process the audit engagement team learned that their firm was providing certain non-audit services to an affiliate of Company C.
Subsequently, a plan was created under which it was determined that KPMG could continue to provide the non-audit services. Specifically, KPMG concluded that its overall independence would not be impaired by providing bookkeeping and payroll services to the affiliate in 11 different countries based on the nature of the matters, the countries in which they were provided and the fact that the services would shortly terminate.
In fact those non-audit services “constituted prohibited services in violation of the auditor independence rules (which do not provide for limited duration transition periods or include any exceptions based on the nature of the services provided),” according to the Order.
The Order alleges violations of Rule 2-02(b) of Regulation S-X which requires that the audit report state that the audit was made in accord with GAAS, which includes an independence requirement. A violation occurred each time KPMG issued an audit report for the three audit clients. As a result of the conduct detailed above, the firm also violated Rule 10A-2 of the Exchange Act each time it provided non-audit services that are prohibited to the three audit clients. The conduct with respect to the three clients also resulted in violations of Exchange Act Section 13(a) and the related rules which require that financial statements filed with the Commission be audited by independent auditors. Finally, the firm engaged in improper professional conduct within the meaning of Rule 102(e)(1)(ii) of the Commission’s Rules of Practice.
To resolve the matter the audit firm agreed to implement certain undertakings it proposed which include enhancing its ability to educate and monitor compliance by its personnel with respect to independence requirements and the retention of an independent consultant which whom the firm will fully cooperate. KPMG also consented to the entry of a cease and desist order based on the Sections and Rules cited in the Order and a censure. In addition, the firm will pay disgorgement of $5,266,347, prejudgment interest and a civil money penalty of $1,775,000.
The related Report focuses on the question of loaned staff by audit firms. Specifically, the investigation found that from 2007 through 2011 KPMG entered into loaned staff engagements with multiple SEC audit clients. Those arrangements involved loaned staff of non-management level KPMG professionals who performed junior level tasks related to tax compliance.
Auditor independence can be impaired in a number of ways, according to the Report. In the context here an auditor who provides services to an audit client in a way which is the functional equivalent of accepting an appointment as an employee of that client cannot expect to be independent.
With respect to the issues raised by the actions of KPMG, the Report makes three points: First, an auditor “may not provide otherwise permissible non-audit services . . . to an audit client in a manner that is inconsistent with other provisions of the independence rules . . .” Second, an auditor is not independent when a current “professional employee of the accounting firm is employed by the audit client.” Third, the provisions of Rule 2-01 regarding “acting as an employee” require careful consideration of “whether the relationship or service in question would cause the accounting firm’s professionals to resemble, in appearance and function . . . the employees of the audit client.”
Finally, each case must be viewed based on the specific facts and circumstances, according to the Report. The question of independence is not just a legal issue but also an ethical duty. Thus in certain situations, even if the legal requirement is not implicated, in view of the ethical requirements the “best course may be for the accountant to recuse himself or herself from an audit engagement” or, alternatively decline the non-audit engagement.