Audits – Compliance Building

Auditor Independence Enforcement Actions

The Securities and Exchange Commission announced its first enforcement actions for auditor independence failures. I expect your auditors may have a bunch of new restrictions and questionnaires when it is time for the annual audit.

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The SEC announced two separate enforcement actions, both involving Ernst & Young.

In one case, Gregory S. Bednar got too cozy with a audit client’s CFO. Bednar and the CFO stayed overnight at each other’s homes, took family trips together and they exchanged hundreds of personal messages.

In the other case, Pamela Hartford violated the auditor independence rule by having a romantic relationship with an executive at an audit client.

According to the SEC’s orders, Ernst & Young required audit engagement teams to follow certain procedures to assess their independence. They asked employees if they had family, employment, or financial relationships with audit clients that could raise independence concerns. The SEC says that is not enough. Apparently the SEC is expecting a broader question about “non-familial close personal relationships” that could impair the audit firm’s independence.

Ernst & Young’s independence policies “recognized that a non-familial close personal relationship between an engagement team member and a client employee in an accounting or financial reporting oversight role could present an independence problem”. But the firm had no procedures to identify those relationships and whether a relationship could jeopardize independence.

I expect that audit firms are going to broaden their independence questionnaires. I expect some of the questions and responses could be quite awkward.

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The SEC Goes After the Gatekeepers: Grant Thornton Edition

“Audit firms must be held responsible when systemic failures such as inadequate engagement procedures, staffing, or supervision cause the firms’ work to fall significantly short of expected standards, particularly when multiple audits and engagements are involved.”

– Andrew J. Ceresney, Director of the SEC’s Division of Enforcement.

The SEC recently brought separate cases against senior housing provider Assisted Living Concepts and alternative energy company Broadwind Energy for disclosure violations.

Assisted Living Concepts and Broadwind Energy both had the same engagement partner. The SEC brought charges against the engagement partner, Melissa Koeppel, and Jeffrey Robinson who worked on the Assisted Living Concepts audits.

Assisted Living Concepts had faked occupancy levels by including employees and other non-residents as occupants to meet loan covenants. The SEC order claims that the auditor was aware of this red flag and should have done more. If the firm had done so, it would have spotted the fraud.

“Grant Thornton was aware of red flags suggesting audit quality issues in the audits conducted by one of its engagement partners and its audit quality more generally, but failed to remedy the situation,” said Andrew J. Ceresney, Director of the SEC’s Division of Enforcement

The SEC charges that the auditor should have spotted the issue with an impairment at Broadwind.

“They also failed to exercise due professional care and skepticism or obtain adequate audit evidence related to a significant bill-and-hold transaction. The revenue from this transaction allowed Broadwind to meet its debt covenants.”

Without admitting or denying the SEC’s findings, Koeppel agreed to pay a $10,000 penalty and be suspended from practicing before the SEC as an accountant for at least five years, and Robinson agreed to pay a $2,500 penalty and be suspended from practicing before the SEC as an accountant for at least two years.

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The SEC Goes After the Gatekeepers

When a fraud is uncovered, the Securities and Exchange Commission not only wants to get the fraudsters, it also wants to get those who should have stopped the fraud: the gatekeepers. The SEC recently brought a case against an investment advisory firm and its CEO for fraudulently inflating the values of investments in the portfolio of a private fund they advised so they could attain unearned management fees. The SEC also brought a companion case against the fund’s external auditors

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Chris Yoo and his firm agreed to settle fraud charges related to his failure to inform clients that they received significant fees when referring clients to invest in the fund. In addition to failing to disclose the conflict, beginning in 2011, Yoo directed the firm to withdraw purported fees that were based on fraudulently inflated investment values or were otherwise disproportionate from the fund’s actual profits. Yoo falsely claimed that the fund owned an asset that had appreciated to approximately $2 million in value. In reality, the fund owned an entirely different asset that was worth less than $200,000. As a result of Yoo’s false claim, the fund’s financial statements materially overstated the fund’s investment values. As a result of the inflated values, they withdrew nearly $900,000 in purported fees to which they were not entitled.

The SEC thought the external auditors should have caught the fraud if the auditors had properly conducted a GAAP audit.

Raymon Holmdahl and Kanako Matsumoto worked for Peterson Sullivan LLP and served as the leads on the audit of Yoo’s fund.

“Holmdahl and Matsumoto did not uncover the fraudulent activity because they failed to properly verify the fund’s assets despite having reason to question Yoo’s valuations,” said Erin E. Schneider, Associate Director for Enforcement in the SEC’s San Francisco Regional Office.

Holmdahl and Matsumoto took over the audit work after the previous auditor resigned because it disagreed with the valuation of a particular security. The old auditor could not find enough evidence of the existence of the asset or its valuation. Holmdahl and Matsumoto failed to get third party verification.

Yoo’s fund claimed to own shares in “Prime Pacific Bank” that were illiquid. The fund used a model to claim a price of $3.22 a share, more than triple the $1 purchase price. In reality, the fund owned shares in “Prime Pacific Financial Services” that traded at price between $0.27 and $0.70 during the relevant period. A third party verification should have caught this name mistake.

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