When to the sessions of sweet silent thought
Independence is one of the most important standards for an auditor of a public company. Before the technical debates, before the decisions about classification of transactions, before the methodologies, checklists, and workpapers, before any mechanical pencils are pumped with lead, you must decide whether to accept the client, and every subsequent engagement for that client, based on the codified standards for independence and objectivity.
The Big 4 audit firms have struggled with independence expectations before. EY lost the right to take on new audit clients for six months over its relationship with PeopleSoft. PwC and EY professionals have been convicted of insider trading recently and now Deloitte is suing one of their own Vice Chairman over insider trading. The firms have had issues with alliances and PwC got caught taking kickbacks from alliance partners for government work. They do strange and mysterious work that muddies the waters over whose side they are really on. They have cozy relationships with their travel services providers. They join their audit clients pre-retirement in senior positions. They are asked by the government to work with assets from failed financial institutions they audited.
Heck, you know why PwC has a such huge compliance and independence monitoring operation in Jersey City?
- Widespread violations of independence rules going back to at least 2000,
- Exacerbated by significant violations identified when Price Waterhouse merged with Coopers and Lybrand resulting in a consent decree and government monitoring of required improvements in their compliance culture, and
- Continued issues with independence violations and cultural resistance to compliance at least until the PCAOB started inspecting the firms, as evidenced in their inspection report of audits from 2003.
The firms may call these situations all anomalies, and “all in the past,” but they add up to real pathology – a case of incorrigible ingratitude for a government-sponsored, highly lucrative franchise to provide audit opinions for public companies.
The independence standards are not new. They did not appear suddenly post- Sarbanes-Oxley, although additional restrictions were the direct result of Arthur Andersen and its no-holds-barred approach of accepting any and all work with Enron. Some of the strongest “critics” of the accounting profession, such as Arthur Levitt, have been vocal about conflicts of interest and the need to strengthen both actual and perceived independence of auditors for a long, long time. Levitt has, unfortunately, mellowed with age and his own self interested pursuits.
Recall the debates in early 2000, prior to Enron, as the Big 6 accounting firms sought to overcome the commoditization of the audit product and, at the same time, capitalize on trends and opportunities in technology by competing with traditional consulting firms.
In April 2000, you proposed reforming the accounting industry. What happened? What was the industry’s reaction?
The number of cases of financial fraud that we were seeing at the commission had absolutely exploded. Managed earnings became the regular way of going rather than the exception. So I went to the leaders of the Big Five accounting firms. And I said that we have got to change the rules, and that means the conflicts that exist have got to be eliminated.
Two of the firms, Ernst & Young and Price Waterhouse, said that they would try to work with us on trying to change those rules. Three of the firms, KPMG, Deloitte, and Arthur Andersen, at a private meeting that we had, said, “We’re going to war with you. This will kill our business. We’re going to fight you tooth and nail. And we’ll fight you in the Congress and we’ll fight you in the courts.” …
What kind of clout does the accounting industry have on Capitol Hill?I guess I learned over coming months that they had enormous clout; that their contributions to members of Congress who never thought about an accounting issue or an accountant and suddenly picked up the cudgels for the profession…”
As a direct result of Enron, and what was seen by many as triple dealing by Arthur Andersen to the detriment of the integrity of their actual audit – AA was external auditor, internal audit outsourcer and significant technology consultant to Enron – the rules did change. They are quite lengthy, and have been refined since, but basically…
“it shall be unlawful for a registered public accounting firm…that performs for any issuer any audit required …to provide to that issuer, contemporaneously with the audit, any non-audit service…
Federal securities laws also require that financial statements filed with the SEC be certified (audited) by independent public accountants. Rule 2-01 of Regulation S-X is their standard for accountant independence. The general standard in Rule 2-01(b) provides that:
The Commission will not recognize an accountant as independent, with respect to an audit client, if the accountant is not, or a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the accountant is not, capable of exercising objective and impartial judgment on all issues encompassed within the accountant’s engagement.
Rule 2-01(b) further provides that:
In determining whether an accountant is independent, the Commission will consider all relevant circumstances, including all relationships between the accountant and the audit client, and not just those relating to reports filed with the Commission…
Revision of the Commission’s Auditor Independence Requirements, 65 Fed. Reg. 76008, 76059 (Dec. 5, 2000). As part of this guidance, the Commission also cited numerous prior no-action letters …the Staff has examined whether the firms are associated entities by considering such factors as whether (1) the accounting firm has any ownership interest in the consulting firm; (2) there are restrictions on the use of the accounting firm’s name by the consulting firm; (3) the firms’ corporate governance structures are separate; (4) there is any revenue sharing between the firms; (5) there are any joint marketing agreements between the firms; and (6) there will be any on-going shared services between the firms.
The Commission’s interpretations of Rule 2-01 also are collected in Section 600 of the Codification of Financial Reporting Policies (the “Codification”), entitled “Matters Relating to Independent Accountants.” Section 602.02.e of the Codification addresses business relationships—such as joint ventures, limited partnership agreements, and investments—that may impair an auditor’s independence. That section provides, in part, that:
Direct and material indirect business relationships . . . with a client . . . will adversely affect the accountant’s independence with respect to that client. Such a mutuality or identity of interests with the client would cause the accountant to lose the appearance of objectivity and impartiality in the performance of his audit because the advancement of his interest would, to some extent, be dependent upon the client.
All this text to set up the current scenario: By 2005, PwC wanted back into the consulting business as soon as their non-compete with IBM expired. PwC, KPMG and EY had become skittish after the new Sarbanes-Oxley rules came out in 2002. To avoid the most difficult independence issues, they decided to sell out and focus on audit and to a lesser extent tax and then internal audit.
Deloitte did not.
Deloitte has had some success at staying out of trouble, other than the kind you can get into for project failure, while hanging on to a lucrative consulting practice that includes heavy systems implementation and integration services. The other three firms later reexamined their precipitous decisions and PwC, in particular, began devising a strategy to get back in. Only one problem. They had a five year non-compete with IBM that prohibited their involvement with anything anywhere near approaching systems integration work until the summer of 2007.
PwC skirted the issue of the non-compete for a while by developing Advisory (consulting) engagements focused on managing risk and internal controls. Their Advisory practice during the greatest period of SOx demand, 2002-2005, existed largely to service Sarbanes-Oxley engagements. Small moves to align with former in-house technology vendors such as Versa and alliances with SAP, Oracle, and Microsoft gave PwC a taste again of the bigger fees. Unfortunately, almost anyone who knew anything about selling or managing a consulting project longer than a year or with fees over a million, especially if it touched on anything technology related, had left for IBM or other true consulting firms.
When the decision to go back big was made, primarily because of the pressure on Sarbanes-Oxley fees after Auditing Standard 5 was enacted, PwC had to find a way around their own weakness in technology leadership, lack of experienced resources, and the constraints of the IBM non-compete agreement.
In July of 2008, Gartner recorded PwC’s triumphant comeback to the world of full project life cycle technology consulting as:
At the PricewaterhouseCoopers’ Analyst Day, senior practice leaders emphasized that PwC delivers services across the full project life cycle, including implementation.
The non-compete with IBM expired in 2007, five years after their sale of the previous consulting practice to IBM. PwC was now ready to showcase proof that they were back in the game. Only one hitch: They continued to play coy about their true strategy with their own partners as late as March 2009 when they explained in an email their desire to purchase BearingPoint’s consulting business. Sources have told me that Dennis Nally (US Chairman) and Juan Pujadas (Global Advisory Leader) told partners then:
“This transaction, if it closes successfully, represents one more step among many that collectively advance our strategic agenda – namely our commitment to help clients create and sustain lasting change. In short, we expect to expand our strength in areas such as strategy, planning, operations and technology – particularly with regard to SAP and Oracle expertise. While we are not getting back into the large scale IT implementation business, those IT credentials are essential, in some cases, for PwC to advise our clients in their successful undertaking of a large scale business transformation project…”
The statement is couched in enough semantics to make it unclear who will draw the line, and how and where it will be defined, when proposing and executing systems implementation or integration engagements, especially ones that require technical architecture and coding activities. How did they get here – a place which seems to me to be a little bit of a backtrack from their summer of 2008 statements to analysts and, yet, still a bold statement for an audit firm?
The two case studies used to win over analysts in July of 2008 are exemplary of not only the practice pieces PwC played during the period up to the expiration of their non-compete with IBM but of the arrogant, egregious, and in-your-face disregard for independence standards, if not in fact then certainly in appearance.
Again from Gartner’s report:
In 2002, PwC sold a large part of its consulting practice to IBM for $3.5 billion. For five years thereafter, PwC was prohibited from engaging in most IT system integration projects. Since 1 October 2007, when the non-compete agreement expired, there has been speculation as to whether PwC would get back into the IT implementation business. At the PwC’s Analyst Day, U.S. Advisory Strategy Leader Joe Duffy ended the speculation, stating, “We are full scale in the implementation and integration business.”
PwC clarified that its implementation stops short of coding for large-scale customization of business applications. The firm offered an example wherein its India-based operations performed the coding for a client’s financial data warehouse, but a system integration partner coded the business application customization.
To demonstrate the range of its capabilities, PwC offered two case studies with clients and engagement teams:
• Idearc, a $3 billion Verizon spinoff, which had to break free of the parent’s shared services and stand up its own systems within a year
• Microsoft, for which PwC helped manage the transition of acquired companies’ systems to Microsoft ones
With Idearc, PwC was engaged through the full project life cycle leading to the one-day flash cut- over to Idearc’s new systems. Much of this engagement occurred while PwC was still under the IBM noncompete agreement, and Satyam Computer Services did much of the system integration work. PwC also helped Idearc shift to an IT strategy heavily dependent on outsourcing, which saved the new company millions of dollars.The Microsoft engagement demonstrated how PwC can partner in an ongoing program. Implicit but unspoken was that PwC is well-positioned to play a part in the Yahoo acquisition if that should happen.
1) PwC is denying to its own partners the kind of work it’s getting ready to do for clients and the additional risk the firm will be exposed to. PwC leadership is soliciting their obeisance, in the end, for the glory and enrichment of a few partners for only a little while.
2) Potential “Advisory” clients are being told by analysts and via other public relations efforts that PwC is a viable choice for systems integration/implementation projects. PwC is now actively recruiting SAP, Oracle, and other technical specialists as well as planning on acquiring them from BearingPoint. This is despite the fact that PwC still isn’t being honest with itself about whether it’s in the systems integration business or not, to what extent, and for how long.
This is the second time around. Will another regulatory push or a big litigation loss push them to reverse course again and sell the consulting practice as soon as they’ve fattened the calf? And what of the potential exposure to a client who chooses a Big 4 systems integrator given the quite uncertain economic landscape in many industries? Your Big 4 audit firm systems integration partner today may unexpectedly become your auditor by acquisition or default tomorrow.
3) Satyam was, until the scandal broke in December of 2008, Price Waterhouse India’s audit client. The analyst report implies that Satyam was a strategic partner to PwC, globally enabling them to bypass both the constraints of their non-compete with IBM and to provide a viable solution for their lack of technical expertise and technical bench strength. If true, this is abhorrent, especially given subsequent events that occurred at Satyam
PwC appears to have had at least a strategic relationship, if not an ostensible prime/sub relationship with Satyam, for Idearc and perhaps other projects while at the same time enabling via negligence or worse the humongous fraud that is Satyam. The two Price Waterhouse India partners responsible for Satyam’s audit are still in jail.
Satyam was a global engagement for PwC by virtue of Satyam’s presence in the US via US-based operations and clients and issuance of their ADRs on the NYSE. Satyam’s management, promoted by PwC as a strategic partner for systems integration engagements and a recommended choice for IT outsourcing, is now being called thieves and liars by PwC’s Chairman.
On the Satyam scam, DiPiazza said: “What we understand is that this was a massive fraud conducted by the (then) management, and we are as much a victim as anyone. Our partners were clearly misled.”
Did the strategic importance of Satyam as a systems integration partner and technical resource cause global PwC leadership to overlook, look the other way, or not take action on reports of poor quality or lack of independence by Price Waterhouse India partners and others? Did PwC leadership – US, global, and Indian- enable and perhaps promote complicity in the fraud called “India’s Enron” for the sake of their consulting business strategy? Did Satyam pay PwC for the privilege of being included in these deals by agreeing to exorbitant, higher than market audit fees as has been reported?
The IT outsourcer chosen by Idearc, after the project was completed by PwC-Satyam was – Satyam! Were there other incentives, financial and/or strategic, for PwC to encourage this choice with their client?
Remember also, The PCAOB inspected several Indian firms and their clients in the Spring of 2008. Per reports by the FT, PwC and Satyam were included in this list. PwC’s leadership would have known well in advance of this inspection that their audit client was going to be part of the inspection. They would have known before this meeting in July of 2008 if there were issues with Satyam that would embarrass them later if they used Satyam’s name in an Advisory sales piece. Their Advisory leadership did it anyway.
4) Idearc is now in Chapter 11. One of PwC’s major activities during the project was to advise on the complete design of Idearc’s financial and accounting function, both to enable independence from the Verizon infrastructure and to meet the requirements for a new public company. Obviously, a Chapter 11 within a few years, casts a shadow over PwC’s recommendations to Idearc for financial reporting technology, finance/accounting policies and procedures, and the necessary qualifications and number of staff supporting these activities.
5) Yahoo is a PwC audit client. Gartner reports that PwC implied it would be well positioned to support their Advisory client, Microsoft, in the potential acquisition of Yahoo, their audit client. If true, this is sheer arrogance. It’s another example of the disregard for auditor independence that permeates public statements and private ones by PwC’s about its plans to re-enter the systems integration business.
Given all of this, why are the PCAOB and SEC allowing a firm like PwC to buy BearingPoint and position themselves even deeper back into the systems consulting realm? Well, one reason is that, according to the PCAOB’s spokesperson, the Sarbanes-Oxley law, as a general matter, did not give them the authority to stop acquisitions that are clearly not in the public interest. They have no authority to stop any acquisition by the audit firms.
PwC chose to boast back in July 2008 about two consulting engagements, of all possible engagements, that provide the best example of their supremely arrogant DNA. They don’t expect to be called to account when intentionally ignoring the most basic expectation investors have of an auditor – independence and objectivity, in fact and appearance.
This attitude dares you, and the regulators, to say, “Enough is enough.”
“In discussing the operation and character of the grid within the general field of modern art I have had recourse to words like repression or schizophrenia…we speak of the etiology of a psychological condition, not the history of it. History, as we normally use it, implies the connection of events through time, a sense of inevitable change as we move from one event to the next, and the cumulative effect of change which is itself qualitative, so that we tend to view history as developmental. Etiology is not developmental. It is rather an investigation into the conditions for one specific change–the acquisition of disease–to take place…”