Wednesday, January 24, 2018

Moral Hypocrisy: The KPMG / PCAOB Scandal

Auditors aren't that great at detecting fraud and sometimes claim their audits aren't designed to detect it. It looks like they may not be that great at committing it, either (though not for lack of effort).

The good news: the conspiracy was uncovered by someone within the firm who suspected that something wasn't right and spoke up, leading to quick and decisive action from the firm.

The bad news: several high-ranking officials within one of the largest accounting firms were allegedly involved in a conspiracy to defraud the federal government. These individuals are supposed to be examples of integrity to their firm and to the profession as a whole. If the allegations are true, this looks pretty bad for the firm and the profession.

The story: five KPMG employees have been charged with conspiracy and wire fraud; another employee pled guilty to conspiracy last week. These individuals were fired last year when the firm discovered that they were obtaining information about which of the firm's audit clients were going to be inspected by the PCAOB. Three of them were high-ranking KPMG partners, including David Middendorf, Thomas Whittle, and David Britt. The others were former PCAOB employees, two of whom had been hired by KPMG.

According to the sealed indictment of the case, there is evidence in emails and other written or sworn testimony that the top audit partners hired these individuals to help them get this information. It appears that they did this for three years until they were a little too helpful and raised the suspicions of another KPMG partner. That partner called the firm's in-house legal counsel and the resulting investigation uncovered the scheme. That's when the firm made the right choice in firing all involved employees and reporting the situation to the government.

Now, the government has brought charges and appears to have some pretty compelling evidence. One notable omission from the revealed charges is Scott Marcello, KPMG's former lead audit partner, who was also fired last year in relation to this scandal.

So why is this a big deal for KPMG? First, KPMG is in the business of performing independent audits of financial statements and to give an opinion that the statements are not materially misstated. When a KPMG audit client intentionally misstates their financial statements and violates accounting principles, they are committing fraud and investors usually lose a lot of money. This is how Enron and WorldCom and other major frauds take place.

So how does a smart fraudster conceal a fraud from their auditor? They often take one of two approaches: 1) they learn what the auditor is planning to test by either guessing based on prior years (auditors are often very predictable); or, 2) they hire former auditors and ask them what the audit plan is.

In this case, these KPMG partners appeared to be taking a page out of a fraudster's playbook and hiring former PCAOB employees to discover the PCAOB's audit plan. When top partners from an audit firm are acting like fraudsters, we know there are problems...

How does this all translate into the market for KPMG's audit services? Time will tell but if board members who hire auditors were to view this attitude as systemic at KPMG then those who want to send a signal to the market that their books are clean may be hesitant to hire KPMG.

To their credit, the firm appears to have done the right thing once it was brought to the attention of in-house counsel. The tough questions are how these partners got to the positions they were in and whether KPMG has done anything to ensure others like them have found the exit door. For example, were there other audit partners who were told to clean up their audits because the PCAOB had selected them for inspection but they didn't raise the issue?

Overall, I don't believe it's enough to just talk more about ethics in a situation like this. The firm needs to exonerate the partner who was uneasy and called legal counsel. That partner is, in my opinion, a hero! Also, the firm needs to clean house on any partners who have shown any sign of similar behavior. This also includes partners who were going along with the news to clean up their audits because the PCAOB would be looking without raising an eyebrow.

The value of auditing is largely contingent on public perception of auditor integrity. These partners' actions damaged a service and firm that is critical to the efficient operation of our capital markets. For that reason, they betrayed us all. As a professor of auditing, I am particularly disappointed that members of the audit profession stooped this low. I hope the firm takes action necessary to recover from this. Time will tell.

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