“Too Few to Fail” or Something More?

This was originally posted on November 28, 2006.

During a recent dinner party, the subject of the deferred prosecution agreement for KPMG related to the firm’s issues with their Tax Practice came up. You may find this to be odd, but everyone likes to compare notes on each other. This group of others in the profession were very interested in my views of the competitive landscape, both in general and in our town. Since I was no longer associated with a Big 4 firm, we could talk openly.

I had been lamenting the fact that the firms, in general, had lost their momentum in building successful business development organizations, such as those that the software firms like SAP and Oracle employed. When three of the Big Four firms disgorged their consulting businesses and focused on external audit and limited advisory practices such as tax and internal audit after Sarbanes Oxley was passed, they had also lost the need to actively market their services at the professional level. They went back to the genteel ways of the locally-led and focused accounting firm approach and threw off the crude “sales” approaches of the consulting firms.

The firms had never really adapted well to a team sales approach, that is, a practice partner teamed with a professional business development executive. One manages the content while the other manages the process. Although they often restarted the efforts, none really ever warmed up to the approach for the long-haul the way the full-time consultants and system integrators had to in order to compete with the software and hardware firms like Cisco.

A few mentioned that they had heard that KPMG was now required by the deferred prosecution agreement with the US Justice Department to refrain from all active sales efforts in the Tax Practice. And given the atmosphere in the firm, with the Monitor hovering over everything and their desire to get to the end of 2006 with a clean bill of health from the US Justice Department (DOJ), KPMG was being very low-key on all active business development activities. In fact, they had heard that use of the words “sales” or “business development” are prohibited. All such efforts have to be referred to as “client relationship” or “relationship-building” activities. In general, it seemed KPMG was not actively soliciting new clients in any practice.

In a sense they do not have to actively solicit, nor can they, really. Given the independence requirements, it is well known to the audit firms which companies are potential and possible clients for non-audit services and which are not. Of those that are allowed per independence restrictions, some are already clients. With current resource constraints adding to their limitations, the Big 4 firms are not really actively soliciting work, but only responding to changes in clients’ needs. If a client wants to solicit a new vendor for a non-audit service, they have to be as careful as the firms in not asking anyone with a conflict to even consider the assignment. If a company wants to work with only the Big 4 and the firms only want to work with a certain size company with a certain risk profile, everyone already knows which dancers are on the dancefloor and which are not already committed to a partner. The firms are really just moving the deck chairs around on the Titanic when they resign from a client as an external audit client, only to pick it up again as a non-audit client and vice-versa.

But the idea – that KPMG could not use these words or actively solicit new business – was interesting. There had been no formal restrictions on soliciting new business, such as in the Ernst and Young case.

I reviewed the actual deferred prosecution agreement and found that it did, in fact, set limits on the sales marketing activities of the Tax practice as well as cause them to close certain tax-related practices. However, these restrictions did not extend to any other practice. It seems that the risk averse nature of the firm took over and that they have encouraged a slow down of all sales, business development, and marketing activities given their discomfort with and inability to manage and control these activities without causing independence violations.

But before I finished my review, I ran into another interesting paragraph in this document, #21 entitled, “No Department of Justice Debarment.”

What is “debarment?”

Debarment means an action taken by a Federal agency to prohibit a recipient from participating in Federal Government procurement contracts and covered nonprocurement transactions. A recipient so prohibited is debarred, in accordance with the Federal Acquisition Regulation for procurement contracts (48 CFR part 9, subpart 9.4) and the common rule, Government-wide Debarment and Suspension (Nonprocurement), that implements Executive Order 12549 and Executive Order 12689.

So KPMG is still a “responsible contractor” to the US Department of Justice, deemed to not be debarred for purposes of its contracts with the Department of Justice, even though the document that DOJ and KPMG signed states that they will consent to the filing of a one-count “Information” with the US District Court for the Southern District of New York charging KPMG with conspiracy to 1) defraud the US and the IRS and 2) to commit tax evasion, and even though KPMG would be under scrutiny until at least December 31, 2006 and beyond in terms of its obligation to cooperate with both the DOJ and IRS.

KPMG’s contracts with the Department of Justice are to audit Department of Justice financial statements.

While the Department of Justice was investigating and prosecuting KPMG for its transgressions regarding its Tax practice, KPMG was the auditor of its financial statements, issuing a disclaimer of opinion in fiscal year 2004 due to the number of weaknesses and the lack of cooperation of the Department of Justice in providing enough information to resolve their concerns before the deadline for the audit report. In fiscal year 2005, KPMG again was the auditor of the Department of Justice financial statements, this time issuing an unqualified opinion, even though the material weaknesses from the prior year were still outstanding in the Office of Justice Programs division.

So picture this scene…

KPMG is negotiating with the Department of Justice about its troubles while Department of Justice is negotiating with KPMG, their auditors, regarding their audits of DOJ financial statements. Given the major issues in found at DOJ during fiscal year 2004, DOJ must negotiate a way to get KPMG to show that there is some improvement and that they are not in violation of federal regulations and other such bothersome requirements.

Who had the leverage here? I would venture to guess that in addition to the “too few to fail” doctrine at work here, there was also an attitude on the part of KPMG of, “Hey DOJ losers, who are you to call us a mismanaged, uncontrolled mess?”

Office of Justice Programs Annual Financial Statement Fiscal Year 2005
Audit Report 06-17 March 2006 Office of the Inspector General
Commentary and Summary

This audit report contains the Annual Financial Statement of the Office of Justice Programs (OJP) for the fiscal years ended September 30, 2005, and September 30, 2004 (as restated). Under the direction of the Office of the Inspector General (OIG), the audit was performed by KPMG LLP (KPMG) and resulted in an unqualified opinion for FY 2005. An unqualified opinion means that the financial statements present fairly, in all material respects, the financial position and the results of operations. OJP also received an unqualified opinion on its restated FY 2004 financial statements (OIG Report No. 05-38).

In its FY 2005 Report on Internal Control over Financial Reporting, KPMG identified four reportable conditions, three of which were considered to be material weaknesses. All four reportable conditions are repeated from the restated FY 2004 report. …In its Report on Compliance and Other Matters, KPMG reported that OJP’s financial management systems were not in compliance with the Federal Financial Management Improvement Act of 1996 with regard to federal financial management systems requirements and applicable federal accounting standards. KPMG also reported non-compliance with the Inspector General Act of 1978, Prompt Management Decisions and Implementation of Audit Recommendations, on timeliness of follow-up actions.

U. S. DEPARTMENT OF JUSTICE ANNUAL FINANCIAL STATEMENTFISCAL YEAR 2004
OFFICE OF THE INSPECTOR GENERAL COMMENTARY AND SUMMARY
This audit report contains the Annual Financial Statement of the U.S. Department of Justice (Department) for the fiscal year ended September 30, 2004. Under the direction of the Office of the Inspector General (OIG), KPMG LLP performed the consolidated Department audit and six of the ten component audits. Two other independent public accounting firms performed the remaining four component audits, upon which KPMG LLP relied when issuing the report on the consolidated financial statements. For FY 2003, PricewaterhouseCoopers LLP performed the consolidated Department audit and five of the eleven component audits, with two other firms performing the remaining six component audits. For the Office of Justice Programs (OJP), KPMG LLP performed the FY 2003 audit and PricewaterhouseCoopers LLP performed the FY 2004 audit.

The Department received a disclaimer of opinion on its FY 2004 financial statements. The consolidated disclaimer was caused by a disclaimer on the financial statements of the OJP. Another component, the Bureau of Alcohol, Tobacco, Firearms and Explosives (ATF) received a qualified opinion on its FY 2004 financial statements, but this had no affect on the consolidated disclaimer. The other eight components received unqualified opinions on their FY 2004 financial statements.

It is important to note that despite the disclaimer of opinion at the consolidated level, many parts of the Department made significant progress regarding its financial statements. Three components corrected material weaknesses reported last year. Eight components produced financial information much more quickly this year and obtained unqualified opinions. The Department also made good progress in improving the quality of interim period financial statements. Processes were changed as needed and more were identified for improvement next year.

However, the auditors for OR in FY 2004 could not perform the necessary testing to obtain an opinion in the required time frame because they were unable to rely upon OJP’s financial and information technology controls. The auditors found significant issues with OJP’s information technology controls that caused them to conclude they could not be relied upon in FY 2004. As a result, the only way to successfully complete the audit would have been to perform substantive testing of account balances, since system-produced data could not be relied upon, but there was not time to do this type of testing at year end. In addition, the auditors found significant issues with OJP’s overall control environment, grant accounting and monitoring, documentation and support for adjusting entries, and the financial reporting process to ensure compliance with generally accepted accounting principles. Many of these issues – including the overall control environment, grant accounting and monitoring issues, and documentation issues – remain unresolved as of November 15, 2004. Overall, the auditors for OR reported six reportable conditions, five of which were also considered to be material weaknesses…

…The Department previously received an unqualified opinion on its FY 2003 financial statements. However, during the FY 2004 audit of the OJP, sufficient uncertainty was raised as to the FY 2003 audit opinion of the OR to cause KPMG LLP, the auditors of OR for FY 2003, to subsequently withdraw their opinion regarding OJP and reissue it as a disclaimer. KPMG LLP concluded that additional procedures needed to be performed for FY 2003 to resolve these uncertainties but noted they were restricted from performing such procedures. The restriction to which this refers, and the only restriction on KPMG performing these additional procedures, was that there was insufficient time to perform these additional procedures before November 15, 2004, the due date mandated by the OMB for all federal agencies’ Performance and Accountability Reports. … The uncertainties regarding OJP also caused PricewaterhouseCoopers LLP, the consolidated auditors for FY 2003, to withdraw their FY 2003 opinion on the Department’s financial statements and reissue it as a disclaimer of opinion.

… The financial material weakness continues to include many serious issues at the component level, including the OJP issues, the accounts payable accrual at ATF, separation of duties issues at the US Marshals Service (USMS), and financial reporting and property issues at the Federal Bureau of Investigation (FBI)…

…However, the Department still lacks sufficient automated systems to readily support ongoing accounting operations and financial statement preparation. Many tasks still must be performed manually at interim periods and year-end, requiring extensive efforts on the part of financial and audit personnel. …

…In the FY 2004 consolidated report on compliance and other matters, the auditors identified four Department components that were not compliant with the Federal Financial Management Improvement Act of 1996 (FFMIA), which requires compliance with Federal financial management systems requirements, applicable Federal accounting standards, and the United States standard general ledger at the transaction level. The four non-compliant components were the ATF; the FBI; OJP, and the USMS. In addition, the FBI, the INS, the Offices, Boards and Divisions, the Working Capital Fund and the USMS were not compliant with FFMIA in FY 2003. In FY 2004, the USMS and OR were also cited for noncompliance with the Prompt Payment Act and OR was cited for noncompliance with the Improper Payments Information Act.
Footnotes:
1 A material weakness is a reportable condition (see below) in which the design or operation of the internal control does not reduce to a relatively low level the risk that error, fraud, or noncompliance in amounts that would be material in relation to the principal statements or to performance measures may occur and not be detected within a timely period by employees in the normal course of their assigned duties.
2 A reportable condition includes matters coming to the auditor’s attention that, in the auditor’s judgment, should be communicated because they represent significant deficiencies in the design or operation of internal controls that could adversely affect the entity’s ability to properly report financial data.
3 Disclaimer of Opinion – An auditor’s report that states that the auditor does not express an opinion on the financial statements.
4 Unqualified opinion – An auditor’s report that states the financial statements present fairly, in all material respects, the financial position and results of operations of the reporting entity, in conformity with generally accepted accounting principles.
5 Pursuant to the Homeland Security Act of 2002, Public Law 107-296, the Immigration and Naturalization Service transferred to the Department of Homeland Security on March 1, 2003. Additionally, the Bureau of Alcohol, Tobacco, Firearms and Explosives transferred from the Department of the Treasury into the Department of Justice on January 24, 2003.
6 Qualified opinion – An auditor’s report that states, “except for” matters identified in the report, the financial statements present fairly, in all material respects, the financial position and results of operations of the reporting entity, in conformity with generally accepted accounting principles.