Tuesday, October 27, 2020

The SEC Proposes to "modernize" Auditor Independence Rules

Editor's Note: The Public Interest Section of the American Accounting Association is pleased to publish the following blog post by Francine McKenna, independent journalist at The Dig, a newsletter, an educator and a researcher. Please contact lawrence.chui@stthomas.edu with questions, comments, or suggestions about our blog, or to express interest in our organization. Disclaimer: When you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.

Thursday, October 22, 2020

Project Big Picture, Covid-19 and the frailty of English Football Finance

Editor's Note: The Public Interest Section of the American Accounting Association is pleased to publish the following blog post by Dr Rob Wilson & Dr Daniel Plumley from Sheffield Business School, Sheffield Hallam University, Sheffield, UK. Please contact lawrence.chui@stthomas.edu with questions, comments, or suggestions about our blog, or to express interest in our organization. Disclaimer: When you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.

 

Covid-19 has unmasked the frailty of the English football financial model. A host of professional clubs in the football pyramid on the brink of financial collapse. The UK government has persisted with its ban on allowing fans to attend live events, which cuts off the lifeblood of the ticket revenue that ensures clubs can meet their financial obligations. Yet, English club finances were bleak well before Covid.

Since the formation of the English Premier League (EPL) in 1992 and the lucrative broadcasting revenues that have followed, the financial gap between the ‘bigger’ clubs and the rest has continued to grow. In this regard, the recent discussion regarding Project Big Picture (a motion tabled by the US owners of Liverpool and Manchester United to revisit the governance structure of the EPL broadcast revenue distribution), labelled a sugar coated cyanide pill, has raised further eyebrows surrounding its financial implications for a number of clubs. Ironically, it is the power and dominance of clubs such as Liverpool and Manchester United that is in part the issue.

Revenue distribution (from the EPL TV deal) in the English football pyramid is a major problem and leads to significant financial inequality between the EPL and the English Football League (EFL). It has also contributed to a decline in competitive balance in the pyramid. On the face of it, there are some positives to Project Big Picture that can address these issues. A £250m bailout to the EFL would not only be welcome but necessary for some lower league clubs to survive. Similarly, the proposed distribution formula of 25% of future EPL broadcasting revenue to the EFL is a positive step. Reducing the EPL to 18 teams could, theoretically lead to stronger competitive balance; good news for future revenue generation if we accept that competitive balance, and uncertainty of outcome, drives revenue. Perhaps most importantly, Project Big Picture proposes to scrap parachute payments which are destructive to competition (especially in the Championship) and help fuel inequality.

However, clubs outside the wealthy elite should be troubled by changes to the voting rights proposal. This is another land grab by the clubs that feed at the top table and destabilises the foundations of the football pyramid. The ‘big 6’ clubs have already taken more share of the international television money and reducing the number of teams needed to pass a collective vote will only be to the detriment of the smaller clubs in the league system.

The devil, as always, is in the detail and all may not be what it seems linked to these proposals. Further detail regarding the 25% of future broadcast revenues for the EFL revealed cause for concern. It stated that clubs promoted from the EFL will have £25m deducted from their TV money for the first 2 seasons in the EPL and this is then returned when/if they are relegated. This system effectively retains a parachute payment and, importantly, reduces the ability of promoted clubs to compete in the EPL. Additionally, the total number of games sold to broadcasters in the future will be smaller as the proposals will also allow clubs to sell up to eight of their own games through their own broadcasting channels. The 25% of the total pot to share between the other 72 clubs continues to shrink as the finer details emerge.

Project Big Picture appears to be over before it has started, and talk has quickly moved to a European Football League (an idea that has been on/off the table for the last two decades). This time, it appears to have FIFA’s backing and is reportedly being supported by Wall Street banking giant JP Morgan to the tune of $6bn. It would see a move to a US style sports model for European football and, unsurprisingly, the American owners at Liverpool and Manchester United have been mentioned as the driving force behind the proposals. UEFA, European footballs governing body will reject the proposals, seeing it as a direct threat to their flagship Champions League competition.

Meanwhile, the lack of balance in English footballs financial equation remains. Clubs continue to make poor financial decisions, becoming emotionally involved in spending more than they earn. A trait more commonly found in regular business sectors. Were clubs run as a genuine going concern, there would be no need for a bailout in the first place. But, perhaps this is a question better addressed to the auditors of the clubs in distress? Some have argued that Project Big Picture provides financial sustainability when, in fact, the opposite is probably true. It would simply enable a continuation of the status quo, potentially fuelling a new wave of reckless spending.

If Project Big Picture has underlined one thing it is that English football is crying out for a reboot. It needs more effective financial regulation, fairer distribution of revenue and salary caps to force owners into making better choices. Clubs need to work collectively to preserve their product, casting aside self-interest in the winner takes all scenario. It’s an alien concept for business leaders that chase profit maximisation and market domination and needs external intervention from finance professionals. Without competition in football, there is no product for fans to buy.

Friday, October 9, 2020

Saving the Independent Audit

Editor's Note: The Public Interest Section of the American Accounting Association is pleased to publish the following blog post by Steve Mintz, Professor Emeritus, Cal Poly, San Luis Obispo. Please contact lawrence.chui@stthomas.edu with questions, comments, or suggestions about our blog, or to express interest in our organization. Disclaimer: When you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.


[This blog is taken from an article to be published in the October 2020 issue of The CPA Review.] 

The standards for an independent audit seem to be loosening. One area of concern is when nonaudit services are performed for an entity that becomes an affiliate of the audit client. Problems arise when otherwise permissible nonaudit services are provided to a non-audit client that becomes an affiliate of an audit client. The independence rules then apply to both clients as if they were one entity.

Some firms are now using a materiality criterion to determine whether these nonaudit services provided to an affiliate entity, that would be prohibited if the parent had provided them, violate the independence requirement in audit engagements. Applying such a materiality standard can have the effect of dismissing otherwise improper relationships. In some cases, audit firms are misrepresenting nonaudit services as part of the audit services to get around the rules that prohibit certain nonaudit services for audit clients. Purposely doing so misleads the users of financial statements about the independence of the client.

Clearly there is a problem that left untreated may fester and lead to independence violations that get worse or more intense. Too many auditors are violating ethical requirements. The possibility exists that auditors may be subconsciously regarding the independence ethical requirements as not applying to them or not worth considering because they know they are objective and have integrity. It may be that a strictly audit firm may be able to do a better job of ensuring adherence to the independence rules than a firm that has a mixed rather than an exclusively audit culture. One possible solution is to operationally split off audit services from nonaudit services to protect the independent audit.

Materiality Exceptions

KPMG was involved in a client acceptance process for an entity when it learned that the firm had been providing nonaudit services to affiliates of the entity that the firm would be prohibited from providing if it became the independent auditor of the entity. These services included bookkeeping and payroll services provided to affiliates in 11 different countries. According to Accounting and Auditing Enforcement Release No. 3530, “the KPMG audit engagement team – in consultation with the firm’s Independence Group – concluded that, based on the perceived immateriality of the locations and services provided,” KPMG’s overall independence would not be impaired if it became the auditor of the entity but also continued providing the nonaudit services to the affiliates during the transition period of February 22, 2008 and July 1, 2008. KPMG became the auditor and confirmed to the client that it was independent with respect to [the client] and its related entities under applicable SEC and PCAOB independence requirements.”[1]

Using a materiality criterion to determine whether certain nonaudit services should be allowed opens a can of worms. Logical questions are: (1) Is independence a standard left to the individual judgment of the auditors or is it based on SEC regulations and PCAOB standards? and (2) Where do you draw the line in making materiality determinations?

Mischaracterizing Nonaudit Services

In 2014, PwC performed nonaudit services for an audit client concerning Governance Risk and Compliance (GRC) software that was used to coordinate and monitor controls over financial reporting, including employee access to critical financial functions.” At the time the GRC system was being implemented, it was intended to be subject to the internal control over financial reporting audit procedures.

Communications between PwC and its audit client show that the client’s head of internal audit was concerned whether the firm could provide an implementation proposal and inquired about auditor independence. The supervising partner responded that “we are absolutely permitted to implement so there will be no issues…,” even though he was aware that the firm’s independence policies did not allow it or him to implement the GRC system.[2]

Communications with the client show the disconnect between the client’s expectations and how PwC was describing its information systems services ostensibly to skirt the requirement not to perform certain nonaudit services for audit clients. An email from the then head of internal audit of the client, who objected to the description of services contained in the draft engagement letter, informed PwC that the proposed work was an implementation project that’s been outsourced to the firm.

The final engagement letter described the work on the GRC project “as performing assessments and high-level recommendations” even though an internal PwC communication had characterized the engagement as a design and implementation project.

The firm agreed to pay over $7.9 million to settle charges with the SEC that it performed prohibited nonaudit services during an audit engagement including exercising decision-making authority in the design and implementation of software relating to an audit client’s financial reporting and engaging in management functions.

SEC Proposal to Amend Auditor Independence Rules  

On December 31, 2019, the SEC proposed amendments to Rule 2-01 of Regulation S-X that would loosen independence rules with respect to the auditing of affiliates. The proposal would limit the range of audit client affiliates from which an auditor must maintain its independence by amending the definition of “affiliate of the audit client” to carve out affiliates under common control (i.e., sister entities) that are not material to the controlling entity.

The proposed rule would give auditors more discretion in assessing conflicts of interest in affiliate relationships with audit clients of the firm. The motivation for the change seems to be an analysis by the SEC that the audit firm can maintain its objectivity and impartiality (hence its independence) in these control relationships based on a materiality exception. According to SEC Chair Jay Clayton, the rules changes would “permit audit committees and [SEC] commission staff to better focus on relationships that could impair an auditor’s objectivity and impartiality,”…and avoid “spending time on potentially time-consuming audit committee review of non-substantive matters.[3]

By introducing a significance test to determine whether an affiliate is material to the controlled entity, the SEC is opting to rely on the judgment of the auditor and audit firm to determine when independence is impaired rather than strictly applying the ethics rules as written. While a materiality test applied to financial reporting issues is commonplace (i.e., to determine whether restatements to the financial statements are warranted), it has no place in ethics determinations. Any rule violation, regardless of size tests, is unethical. There should not be a material test to determine right versus wrong. Moreover, once the door is opened to making materiality judgments on independence issues, the firms may seek to use it in interpreting other rules. For example, should a firm be able to provide “non-material” contingent fee and commission-based-services to a non-audit-affiliate once it is combined with the controlling entity for which audit services are provided? The problem with establishing a materiality criterion in one rule is it becomes an ethical slippery slope for other rule interpretations.

The U.K. Experience

There has been a great deal of controversy in the UK about how best to restrict nonaudit services for audit clients. The U.K. Competition and Markets Authority (CMA), a government department in the U.K., issued a report on April 18, 2019, that recommends an operational split of audit and nonaudit services. The large firms would be split into separate operating entities with respect to auditing and consultancy functions to reduce the influence of consulting practices upon auditing divisions. The split would help to prevent potential conflicts of interest from impairing audit independence and increasing the public trust in the quality of financial statements. However, the watchdog stopped short of recommending a full break-up based on firm services.[4]

A study group report prepared on behalf of the U.K. Parliamentary Labour Party calls for a legal split between audit and nonaudit services. The group was not convinced that an operational split would go far enough, calling instead for two legally separate organizations. In essence, it calls for a structural break-up of large firms saying that it would be more effective than other options in “tackling conflicts of interest” and providing “professional skepticism needed to deliver high-quality audits.”[5]

On July 6, 2020, the Financial Reporting Council told the Big 4 accounting firms to draw up plans for an operational split by separating their audit businesses by October 23, 2020 and for the work to be completed by mid-2024. The changes do not apply to smaller firms. The regulator stopped short of ordering a full, structural breakup that would have required audit entities to be spun off into separate legal entities.

The UK experience should be looked at by the SEC to assess whether a split-off of nonaudit services and audit services operationally could work in the U.S. The profession has talked about it for many years. It may be premature to study a legal split into two entities. Given the expanding scope of prohibited nonaudit services and how they may be mischaracterized to skirt the independence rules it seems that the time is right for such a split in the U.S. to protect the interests of the public that rely on the independent audit to make investment decisions.

 


[1] (SEC, Accounting and Auditing Enforcement Release No. 3530, January 24, 2014, In the Matter of KPMG LLP, Respondent, (https://www.sec.gov/litigation/admin/2014/34-71389.pdf). The firm’s actions violated SECs Rule 201 (c)(5) and Rule 10A-2 .

[2] SEC, AAER Release No. 4085, In the Matter of Brandon Sprankle, CPA, Respondent, September 23, 2019.

[3] (“SEC Planning to Loosen Auditor Independence Rules, January 2, 2020, https://www.cfo.com/auditing/2020/01/sec-planning-to-loosen-auditor-independence-rules/).

[4]  (Competition and Markets Authority, “Statutory audit services market study,” Final Report, April 18, 2019, https://assets.publishing.service.gov.uk/media/5d03667d40f0b609ad3158c3/audit_final_report_02.pdf).

Auditor Independence

Editor's Note: The Public Interest Section of the American Accounting Association is pleased to publish the following blog post by Francine McKenna, independent journalist at The Dig, a newsletter, an educator and a researcher. Please contact lawrence.chui@stthomas.edu with questions, comments, or suggestions about our blog, or to express interest in our organization. Disclaimer: When you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.


Auditor independence issues have been in the news in recent years in the US and in the UK. Investors wonder why they should trust auditors’ opinions when the auditors consistently miss corporate fraud, conflicts of interest and other malfeasance while also being accused or suspected of their own conflicts of interest. Which side are the Big 4 audit firms, in particular, on these days — the shareholder and capital markets or their paying clients? Public Interest and Audit Section member Francine McKenna, C.P.A. is an adjunct professor at American University's Kogod School of Business where she teaches “The Manager in the International Economy" in AU’s online MBA Program. In June 2020, she presented the paper, “SEC Proposals to ‘Modernize’ Auditor Independence Rules: Doublespeak for Capitulating to the Big 4's Dominance?” at the inaugural AAA SPARK conference for the Public Interest Section. You can find her presentation page here. The SPARK paper was based on a four-part series, published in January 2020, in her newsletter, The Dig. We’ll republish the original four-part series on the blog starting this month. 

The series updates our knowledge of new and old auditor independence violations, in particular by the Big 4 global audit firms since the adoption of updated auditor independence rules in 2001 and after additional restrictions were placed on audit firms by the Sarbanes-Oxley Act of 2002. She highlights the violations that were prosecuted by the SEC and many that weren’t. The paper also explained why the Big audit firms, in particular, have been lobbying to relax auditor independence rules, why the SEC is agreeing with those requests and the PCAOB is following the SEC’s lead.  Finally, the paper discusses the implications of this “modernization” effort for the capital markets and the auditor’s public duty.

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Back To The Classroom: A Professor’s Experience

Editor's Note: The Public Interest Section of the American Accounting Association is pleased to publish the following blog post by Michael Kraten, Professor of Accounting at Houston Baptist University. Please contact lawrence.chui@stthomas.edu with questions, comments, or suggestions about our blog, or to express interest in our organization. Disclaimer: When you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.


As a professor at a private regional university in one of America’s largest cities, last week’s “back to the classroom” experience was a surreal one. Speaking for 75 consecutive minutes through a face mask. Fidgeting while anchored to the podium, unable to move around the room, to remain within a camera range. Watching with trepidation while students move within six feet of friends, tug down their masks to speak, and generally struggle to respect the restrictions of social distancing standards.

How can one teach under such circumstances? How can one meet the semester’s learning objectives when students are permitted to “elect the remote learning option,” thereby eliminating the classroom entirely and opting to “attend” sessions by watching the video recordings of the live lectures?

Thus far, I only have one week of teaching under my belt. Nevertheless, I am already adapting to new realities by emphasizing certain principles:

1. EMPATHY. In unprecedented circumstances, I find that I cannot anticipate the needs of students without making a conscious effort to “stand in their shoes” and “see through their eyes” to identify their obstacles to learning. By making such an effort, I can recognize difficulties and develop solutions that may not have occurred to me otherwise.

For instance, consider an ostensibly inconsequential student presentation assignment. For students who are learning remotely, the physical classroom must be replaced by some type of electronic communication platform.

At first blush, a video platform such as Zoom or Skype may appear to offer an effective solution. But what if I view this assignment through the eyes of a disadvantaged student? Does that student possess a broadband internet connection at home? In more extreme circumstances, does the student live in a home at all? And in a “presentable” one at that?

There are various solutions to deal with this problem, though (regrettably) none is ideal. Nevertheless, by applying a sense of empathy, I may be more likely to identify the challenges that students may confront during a simple presentation activity.

2. FLIPPING THE CLASSROOM. A traditionally structured course requires students to listen to lectures and discuss cases in live classroom environments, and then to go home and apply their knowledge by completing homework assignments. For many years, though, some teachers have “flipped the classroom” by instructing students to watch video lectures at home. Then students are expected to complete their application activities in the classroom, guided by teachers who serve as coaches and mentors instead of serving as lecturers.

To be sure, this is not a new pedagogical strategy. However, when many students must “attend” lectures through videos because personal circumstances prevent them from traveling to their classrooms, “flipping the classroom” may evolve from an optional strategy to a mandatory imperative. Under such circumstances, teachers can embrace the “flipping” model and communicate with these remote students electronically, in an empathetic manner, while serving as coaches and mentors.

3. PULL COMMUNICATION. Under normal circumstances, teachers communicate with students by making verbal announcements in classrooms and posting text messages on email messages, blogs, video chat rooms, and electronic announcement boards. Students then reply by verbal conversations and email transmissions.

Under pandemic conditions, teachers can continue to communicate by utilizing these traditional methods. But imagine the discomfort that students may experience while telling teachers “I have Covid” in open Zoom chat rooms, or while reporting on students who attend off-campus “no masks allowed” parties via email messages.

New communication methods may be needed to “pull” such information from students by removing the behavioral obstacles that impede such conversations. Anonymous message systems and private reporting mechanisms may conflict with recent trends towards open and transparent group communication methods, but they may enable more effective interactions during the pandemic era.

Technology clearly plays a key role in each of these three circumstances. However, the solution in each circumstance is not technology itself. Rather, the “Path Forward” may involve the establishment of a more durable and reliable human connection between the professors and the students whom they serve.

Tuesday, August 4, 2020

Integrated Reporting and Risk: A Helix and a Spring

Editor's Note: The Public Interest Section of the American Accounting Association is pleased to publish the following blog post by Michael Kraten, Professor of Accounting at Houston Baptist University. Please contact Michael.Kraten@SaveTheBlueFrog.com with questions, comments, or suggestions about our blog, or to express interest in our organization.

This post has also appeared on the blogs of the Sustainability Investment Leadership Council, and on Dr. Kraten's own blog Save The Blue Frog. I encourage you to use these links to peruse these outstanding online publications.

Three years ago, COSO updated its Integrated Framework for Enterprise Risk Management (ERM). It was a noteworthy event in the business community, given that the Committee of Sponsoring Organizations of the Treadway Commission (COSO) is the leading authority that promulgates guidance about internal control and enterprise risk management systems.

Prior to this update, organizations utilized a cubic ERM framework that COSO first promulgated in 2004, following a scandal plagued era that featured the collapses of Enron, Arthur Andersen, and WorldCom. The original cubic ERM model emphasized the practices of event identification, risk assessment, control practices, and response capabilities.

After years of widespread use, the 2004 COSO Cube became synonymous with the practice of ERM. In its 2017 update, though, COSO presented a new “Focused Framework” with five components: (a) Governance and Culture, (b) Strategy and Objective Setting, (c) Performance, (d) Review and Revision, and (e) Information, Communication, and Reporting. To emphasize the “interrelated” nature of these five components, COSO designed a visual framework that weaves the five together in the form of a multi-colored Helix.

The designers of the Integrated Reporting <IR> Framework may have taken this Helix into account when they defined their own framework development goals earlier this year. Since 2013, issuers of integrated reports have used the International Integrated Reporting Council’s (IIRC’s) colorful Six Capitals model to structure their presentations. Some even referred to the framework as the Octopus Model, given its vaguely mollusk-like shape.

Like COSO, the IIRC felt the need to update this original framework. Its design project remains in progress, but the organization recently issued a model entitled “From String to Spring” that features an extension of the Six Capitals model.

Each of the six capitals of the <IR> Framework, like each of the five components of the ERM framework, is represented by a colorful String. Whereas the five “interrelated” Strings of the ERM framework are woven into a colorful Helix, the six “integrated” Strings of the <IR> Framework are woven into a colorful Spring.

Given the obvious similarities between the Helix and the Spring, it is hard to believe that the two design teams were oblivious to each other’s efforts to update their original Frameworks. Indeed, by presenting such similar models, COSO and the IIRC remind us of the significant “interrelationships” and “integrations” that link the functions of enterprise risk management and integrated reporting.

Thursday, July 2, 2020

The Case For Delisting Chinese Companies From U.S. Stock Exchanges

Editorial Note: We are delighted to present this essay by contributing columnist Steve Mintz, Professor Emeritus, Cal Poly, San Luis Obispo. When you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.

We welcome contributions by all members of the academic and business communities who maintain an interest in Accounting and the Public Interest. Please direct your queries to Michael Kraten at mkraten@hbu.edu.

The Trump administration is considering whether to step into the controversy over whether foreign companies listing their stock on U.S. exchanges should be subject to the same accounting and audit regulations as U.S. companies. The problem is some foreign companies are reluctant to provide access to the Public Company Accounting Oversight Board to enable it to conduct audit inspections of registered public accounting firms. Absent equal access, there is a disconnect between regulatory oversight of U.S. companies and foreign firms.

According to the SEC, 224 U.S.-listed companies representing more than $1.8 trillion in combined market capitalization are located in countries where there are obstacles to PCAOB inspections of the kind. About 95 percent of firms whose financial statements cannot be reviewed use Chinese auditors.

The Public Interest

The public interest demands that foreign governments provide such access to level the playing field and protect investors. U.S. investors need to know that foreign companies are following the same rules that U.S. companies follow. Effective audits and regulatory oversight provide the foundation of trust in foreign companies listed on U.S. exchanges.

The world’s capital markets are global, as are the world’s largest companies. It is important that capital investment continue to flow internationally and U.S. stock markets are a major player in that process. In return for free access to foreign companies listed on U.S. exchanges, foreign companies must abide by market rules. One such requirement is for the PCAOB to have access to audits conducted by registered firms in order to inspect audits and make sure the financial information is of high quality and reliable.

U.S. Regulations

In order for the securities to be traded in U.S. capital markets, public companies, whether located in the U.S. or abroad, must comply with certain U.S. legal requirements, including the requirement to periodically file financial statements with the U.S. Securities and Exchange Commission. Sarbanes-Oxley requires that the auditor of these statements—whether a U.S. auditor or a non-U.S. auditor— must be registered with and be subject to the jurisdiction of the PCAOB. This includes undergoing regular PCAOB inspections to assess the auditor’s compliance with U.S. law and professional standards in connection with its audits of public companies.

According to the SEC, the PCAOB has conducted inspections of registered audit firms in 50 different non-U.S. jurisdictions (https://www.bloomberg.com/news/articles/2020-05-20/senate-passes-bill-to-delist-chinese-companies-from-exchanges). For the most part, regulators from foreign jurisdictions have cooperated with the PCAOB and allowed U.S. auditors to have access to the audit information of foreign companies. Still, this level of interconnectedness creates challenges, including regulatory oversight with respect to U.S.-listed companies with international operations.

Chinese Companies

Chinese companies that list their shares in the U.S. have long fought with the PCAOB over audit inspections. In some cases, the government either prohibits it or is not interested in cooperating with U.S. regulators. The Chinese typically explain it by saying the financial information may contain state secrets. More likely, it is a cultural issue in that by examining the audits already conducted by Chinese audit firms, a message is sent that those firms and, indeed, the Chinese system cannot be trusted  

President Trump and U.S. lawmakers have decided to get involved. Back in May, the President said that regulators are looking to see whether Chinese companies should be forced to comply with American accounting rules. Senators Chris Van Hollen (D-Md.) and John Kennedy (R-La.) have sponsored bipartisan legislation (Holding Foreign Companies Accountable Act) that would kick Chinese companies off U.S. stock exchanges if they continue to deny the PCAOB to access their audits (https://www.congress.gov/bill/116th-congress/senate-bill/945).

The U.S. Senate overwhelmingly approved the Act (S.945) on May 20, 2020, that would bar Chinese companies such as Alibaba Group Holding Ltd. and Baidu Inc. if they do not certify that they are not owned or controlled by a foreign government. Moreover, if the board is unable to inspect the issuer’s public accounting firm for three years, the issuer’s securities are banned from trade on a U.S. exchange or through other methods.

Costs and Benefits of Delisting

The costs of delisting Chinese companies should not be ignored. Indeed, the Trump administration may back off if it means delisting Chinese companies that do not comply with U.S. regulations when that motivates Chinese firms to flee to a competing foreign stock exchange. There may not be the appetite to deprive Americans of the chance to invest in Chinese companies. The stock exchanges may be reluctant to lose the presence of an important emerging market.

The benefits of removal from the exchanges are many. It starts with being able to verify that the audits were conducted in accordance with U.S. standards, which may be part of the reason Chinese authorities are reluctant to open up the books of Chinese companies. In China, most of the enterprises are state-owned and the standards for auditing are set by the government. Most important, holding both U.S.-based and foreign-based audit firms to the same PCAOB oversight rules enhances trust, a key element of transparency.

Chinese companies benefit by having access to American markets but they do not play by the same rules. A lack of transparency into the ownership and finances of Chinese companies has been criticized by American businesses. In particular, China has classified some auditor reports on company finances as state secrets, thereby prohibiting cross-border transfers of audit documentation.

Conclusions

U.S. audit firms suffer when Chinese authorities place barriers to access audit reports including those of Chinese affiliates of the Big Four accounting firms. Recently, each paid $500,000 to the SEC to settle a dispute about their refusal to provide documentation on Chinese companies, which an American judge ruled was a violation of U.S. law.

Recent examples of delisting illustrate why it is so important for the PCAOB to be able to audit Chinese affiliates of U.S. Big 4 audit firms. Failing to open up the books so that the PCAOB can conduct an audit inspection can mask a financial fraud that would otherwise be detected. A good example is Chinese company Luckin Coffee Inc., which recently disclosed it had an accounting fraud.  Luckin’s shares were sold on the exchange for just one year. It was touted as a Chinese rival to Starbucks. But trading was halted in April 2020 after an internal investigation found about $310 million in fabricated transactions.

Chinese companies should be held to the same standards as other foreign companies that list their stock on U.S. exchanges. There is no sound basis to give preferential treatment to Chinese companies simply because they are reluctant to open their books and audits for inspection by U.S. regulators.

Steven Mintz, professor emeritus Cal Poly San Luis Obispo

Tuesday, June 23, 2020

The Historical (And Yet Contemporary) Importance of Behavioral Accounting

Editor's Note: The Public Interest Section of the American Accounting Association is pleased to publish the following blog post by Michael Kraten, Professor of Accounting at Houston Baptist University. Please contact Michael.Kraten@SaveTheBlueFrog.com with questions, comments, or suggestions about our blog, or to express interest in our organization.

This post has also appeared on the blogs of Econvue and the Sustainability Investment Leadership Council, and on Dr. Kraten's own blog Save The Blue Frog. I encourage you to use these links to peruse these outstanding online publications.

The field of behavioral finance studies the behavior of the investment markets. Similarly, the field of behavioral economics studies the behavior of the global economy and the numerous national, regional, and local economies.

But what of the field of behavioral accounting? How does it resemble the fields of behavioral finance and economics? And how does it differ?

Behavioral accountants, like their colleagues in the other financial professions, focus on elements of human characteristics that can be identified in aggregate data sets. They recognize that organizations, like markets and societies, are composed of individuals who make personal decisions in often-predictable ways. Thus, because behavioral researchers can understand and predict individual decisions in various situations, they are also able to understand and predict the impact of aggregate decisions.

Accountants, though, specialize in the development of organizational reports that describe the conditions of organizations. Internal and external users of their reports rely on them to make important decisions that impact the well-being of those organizations. Thus, at times, accountants feel inherent tensions between the goals of “measuring and reporting data accurately and objectively” versus “measuring and reporting data that persuades the user to make decisions that help the organization.”

Individuals study to become public accountants to learn how to implement measurement and assurance procedures in support of the first goal. Separately, they study to become behavioral accountants to learn how to support the second goal. These goals overlap, but they are not mutually exclusive. In certain situations, they are perfectly aligned. In other situations, though, they have little in common, and they may even conflict.

A Controversial Example of Behavioral Accounting

A prime example of controversial behavioral accounting is commonly known as “greenwashing” in sustainability circles. Organizations cherry-pick data that appear to portray them as responsible guardians of the environment, and then present that data to persuade readers that they are responsible stewards of the natural world.

Volkswagen’s notorious collection of falsified emissions testing data is an obvious and egregious illustration of greenwashing behavior. Other illustrations are more subtle in nature, generating healthy debates over whether the content is misleading at all.

Consider, for instance, the pledge that was made by E. Neville Isdell, Chairman and CEO of The Coca-Cola Company. In 2007, he declared that “Our goal is to replace every drop of water we use in our beverages and their production.

On the one hand, the firm produced data that indicated the successful achievement of that goal. But on the other hand, investigative reporters have noted that “… ‘every drop’ includes only what goes into the bottle. The company does not count water in its supply chain — including the water-guzzling sugar crop — in its ‘every drop’ math.

Indeed, a public accountant may be able to provide assurance that the “drop for drop” phrase is (technically speaking) an accurate description of Coca-Cola’s water utilization patterns. But a behavioral accountant may protest that the vaguely defined phrase invites selective interpretation.

A Universally Admired Example of Behavioral Accounting

Ben & Jerry’s provides a contrasting illustration to the controversial food and beverage example of Coca-Cola’s environmental accounting practices. The ice cream manufacturer is often credited with producing the world’s first Corporate Stakeholder report (i.e. Integrated Report) more than two decades ago.

Using an internally developed proprietary format that the firm called Social & Environmental Assessment Reports (SEARs), Ben & Jerry’s published sustainability data on its web site for many years until concluding the practice in 2018. The reports employed colorful graphic imagery to express its core values, its focus on its social mission, its multiple year planning processes, its goal setting practices, and its outcomes. It also hired an independent public accounting firm to prepare annual independent review reports on the information.

The playful graphics, the earnest social messaging, and the metrics all served to reinforce the impression of Ben & Jerry’s as a socially conscious firm that made business decisions in support of the public interest. The behavioral impressions that were produced by the SEAR Reports undoubtedly supported the decision by Unilever to purchase the firm on friendly terms.

From The Past To The Future

Why did Abraham Lincoln begin his 1863 Gettysburg Address by noting an event that occurred “four score and seven years ago,” instead of simply beginning with the phrase “in 1776”? He must have known that his audience would have leaned into the arithmetic calisthenics of computing the year, thereby placing them in an appropriate frame of mind to focus on his intellectual argument about the war’s threat to democracy.

And why did he end his Address by vowing to protect the “government of the people, by the people, for the people”? Why didn’t he simply vow to protect “democracy”? Once again, he must have anticipated that the repetitive rhythmic triadic cadence would be more memorable to his audience. It’s also why Martin Luther King repeated “I Have A Dream” nine times in his immortal address, and “Free At Last” three times at the very end of the speech.

Lincoln and King both knew that the levels of the persuasiveness of the information that they conveyed to their audiences were just as important as the objective validity of their logical arguments. Such knowledge continually inspires today’s behavioral accountants to redefine traditional profitability measurements into more esoteric metrics like Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) and Adjusted Consolidated Segment Operating Income (ACSOI).

From Abraham Lincoln to the Chief Financial Officer of Groupon, the principles of behavioral accounting have been widely used to influence the decisions of stakeholders. Indeed, it is not sufficient for an accountant to simply “get the numbers right.” It is also important for an accountant to “persuade the user of the numbers to behave in a desirable manner.”

Saturday, May 23, 2020

Once Again, A Lost Generation

Editorial Note: We are delighted to present this essay by contributing columnist Michael Kraten, Professor of Accounting, Houston Baptist University. The piece has also been published on the Blog of the Sustainability Investment Leadership Council (see silcmedia.blogspot.com) and Dr. Kraten's personal blog (see SaveTheBlueFrog.com).

When you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.

We welcome contributions by all members of the academic and business communities who maintain an interest in Accounting and the Public Interest. Please direct your queries to Michael Kraten at mkraten@hbu.edu.

Precisely one century ago, Ernest Hemingway was living in Chicago and attempting to readjust to civilian life after experiencing the horrors of service as an ambulance driver for the Italian Army in World War I. F Scott Fitzgerald was drinking excessively and wooing his future wife Zelda while attempting to transition from an unsuccessful career in advertising to a lucrative one in writing novels and short stories. And the United States, as a nation, was struggling to recover from its loss of human life during the Spanish Flu pandemic, its failure to permanently “make the world safe for democracy” in World War I, and its inability to prevent the economic collapse of the 1920 Depression.

Hemingway’s and Fitzgerald’s subsequent tales illustrated the plight of The Lost Generation, the demographic cohort that came of age at a time when national leaders and the general public were asking serious questions about the sustainability of American society and its capitalist economy. Although the 1920s are now remembered as a time of prosperity, the decade also represented a time of escalating income inequality, debt-fueled business transactions, racial and religious bigotry, and political turmoil.

Today, much praise is bestowed on America’s Greatest Generation, the demographic group that came of age during the Great Depression and World War II. Much less attention is paid to the Lost Generation, though, the preceding generation that (according to Hemingway) believed that “if you have a success you have it for the wrong reasons. If you become popular it is always because of the worst aspects of your work.”

What caused such a pessimistic, fatalistic, and almost nihilistic perception of American business and society to be adopted by an entire generation? It could not have been a mere single catastrophic event; after all, many American generations experience such events. Perhaps, instead, it was the impact of a wide variety of catastrophic events that generated such cynicism, catastrophes that affected many different types of institutions that supported American society.

And what of today’s youthful generation? What of Gen Z, the demographic cohort that was born after 1996 and is now entering the work force? Their collective memories encompass the national security failure of 9/11, the military quagmire of the Middle Eastern wars, the economic collapse of the Great Recession, the radicalization of contemporary political movements, and the social and medical convulsions of the coronavirus pandemic.

Today, some citizens are calling for dramatic new investments in national programs, arguing that the failure to make such investments will result in severe economic losses. Others reply that massive increases in federal debt will be required to finance such investments, and that excessive spending will impose even more severe economic losses in the long term. 

But neither side is factoring the risk of the emergence of a new Lost Generation into its Return On Investment analyses. If we believe that the potential cost of a climate collapse must be factored into analyses of proposed environmental sustainability investments, perhaps we should likewise conclude that the potential cost of producing another Lost Generation must be factored into analyses of proposed social sustainability investments.

After all, a century ago, the Spanish Flu pandemic helped to produce a group of “Lost” authors who shaped the generation that stumbled into the Great Depression. What will the Coronavirus pandemic do today?

Wednesday, April 8, 2020

Accounting For Coronavirus Risk

Editorial Note: We are delighted to present this essay by contributing columnist Michael Kraten, Professor of Accounting, Houston Baptist University. The piece has also been published on the Blog of the Sustainability Investment Leadership Council. See SILCNY.com.

When you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.

We welcome contributions by all members of the academic and business communities who maintain an interest in Accounting and the Public Interest. Please direct your queries to Michael Kraten at mkraten@hbu.edu.

As Queen Elizabeth makes her emergency address to the British people from her safe zone in Windsor Castle, and as the U.S. Surgeon General Jerome Adams warns the American people of an impending “Pearl Harbor Moment,” is it reasonable to ask why governments and businesses were caught blindsided by the coronavirus catastrophe?

Perhaps it’s unfair to expect foresight in the face of such a menace. But why weren’t health care providers and other organizations prepared to respond promptly? Why the shortages of such basic items as face masks and nasal swabs? Where was the contingency plan to increase production of such essentials at a time of dire need?

If we review the reporting standards of the Global Reporting Institute (GRI), we can find disclosure requirements that address these readiness considerations. GRI Standard 204 on Procurement Practices, for instance, states that:

“When reporting its management approach for procurement practices, the reporting organization can … describe actions taken to identify and adjust the organization’s procurement practices that cause or contribute to negative impacts in the supply chain … (these) can include stability or length of relationships with suppliers, lead times, ordering and payment routines, purchasing prices, changing or cancelling orders.”

Consider the many health care providers that rely on unstable Asian suppliers to provide face masks under terms that permit long lead times, uncertain ordering routines, and the imposition of extreme price increases when products are scarce. If they are required to disclose these procurement relationships under GRI Standard 204, we would be aware of the resulting social risk.

Likewise, GRI Standard 403 on Occupational Health and Safety states that:

“The reporting organization shall report … whether the (occupational health and safety management) system has been implemented based on recognized risk management and/or management system standards / guidelines and, if so, a list of the standard guidelines.”

Consider the employees of our food and delivery companies who are now protesting that their employers are not providing satisfactory protections against the coronavirus. If the employers are required to disclose the standards and systems that they utilize to keep their employees healthy and safe, we would be aware of the extent of their preparedness (or lack thereof) in the face of pandemic threat.

There are other GRI Standards that come close to addressing pandemic concerns, but that fall just short of the mark. GRI Standard 201 on Economic Performance, for instance, states that:

“The reporting organization shall report … risks and opportunities posed by climate change that have the potential to generate substantive changes in operations, revenue, or expenditure, including a description of the risk … a description of the impact associated with the risk … the financial implications of the risk … the methods used to manage the risk … (and) the costs of actions taken to manage the risk.”

Although Standard 201 refers to climate change, it would represent an ideal disclosure requirement for pandemic preparedness if the GRI simply adds the words “and pandemics” to “climate change.”

It may be comforting to know that disclosure defining entities like the GRI have issued standards that address our readiness to fight the current pandemic. But we cannot reap the benefits of these disclosure requirements if organizations simply ignore their reporting responsibilities.

Thursday, March 26, 2020

Economic Consequences of Relaxing the Rule for Small Companies to Audit ICFR

Editorial Note: We are delighted to present this essay by contributing columnist Steve Mintz, Professor Emeritus, Cal Poly, San Luis Obispo. When you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.

We welcome contributions by all members of the academic and business communities who maintain an interest in Accounting and the Public Interest. Please direct your queries to Michael Kraten at mkraten@hbu.edu.

When economic and political considerations enter into accounting standard setting, a whole new range of public interest issues arise. The SEC just announced that it is relaxing its requirement for small companies to have an auditor examine their internal control systems and issue a report on their findings. This requirement has been in place since the Enron and WorldCom scandals of the early 2000s.

Why Relax the Rules?

The reason given for relaxing the rules for companies with annual revenue below $100 million and public shares worth less than $700 million is concerning to say the least. According to SEC Commissioner Hester Pierce, with this change a company trying to develop a vaccine for the fast-spreading coronavirus “will be able to pour resources and – importantly – management’s time and attention into that effort rather than into obtaining an internal-controls audit.” This is a knee-jerk reaction to the current spread of the virus and unworthy of being a goal of standard setting.

The Commission also rationalizes its decision by saying it is consistent with the practice of scaling disclosure and other requirements for smaller issuers. The problem is small businesses have more challenges with respect to fraud than larger ones. Writing in the Journal of Accountancy, “Report Finds Big Fraud Problems for Small Businesses,” Jeff Drew reviews the 2018 Report to the Nations on Occupational Fraud and Abuse by the Association of Certified Fraud Examiners (ACFE) and concludes that the “lack of a control makes small businesses more vulnerable to fraud.”

The findings in the ACFE Report include the following.

  • 25% of frauds at larger companies were due to a lack of controls compared to 42% at smaller businesses.
  • Owner/executives committed 16% of frauds at larger companies compared to 29% at smaller businesses.
  • Some frauds occurred more frequently at smaller companies versus larger ones including check and payment tampering (22% vs 8%) and skimming and payroll fraud (20% vs 8%).

In the past, the SEC relaxed some regulations, especially in the finance and banking world, to send a signal to Wall Street that regulatory requirements will be lessened and these firms should look to use the money saved to expand economic development and the investment in new plant and equipment. The purpose of SEC regulations should not be to stimulate the economy.

It also seems that the SEC believes more companies will be able to raise money in public markets by easing regulations. The SEC may be on to something here but standards should not be set or relaxed based on a desire to stimulate the financial markets.

Costs of Relaxing the Rules

Four accounting professors reviewed the comment letters sent to the SEC about the initial proposal to ease the rules for internal control audits. They found that at least a dozen companies that wrote letters of support to relax the rule had disclosed accounting problems of their own. Some had to restate earnings reports due to errors, while other company auditors flagged “material weaknesses” in their internal controls over financial reporting (ICFR).

The authors did a preliminary analysis of earnings restatements in 2018 of 11 companies that the Commission proposed to exempt from internal control audits and found they restated over $65 million in net income that destroyed more than $294 million in shareholder wealth. They concluded that this destruction in wealth, caused by only a handful of restatements, dwarfs the proposal’s total cost savings of $75 million across all 358 affected companies.

Furthermore, a MarketWatch analysis of SEC filing data provided by research firm Audit Analytics shows that of 100 initial public offering filings in 2019 year-to-date, companies that use a Big 4 audit firm found 20 that have voluntarily disclosed serious issues with internal controls. So, by easing the rules fewer red flags will be raised on deficiencies in internal controls making it, presumably, easier to go public. How does this protect the public interest?

PCAOB Inspections

The problem is more pronounced when we look at deficiencies cited in ICFR as a result of the annual inspection of audits by PCAOB. Writing in The CPA Journal, Thomas Calderon, Hakjoon Song and Li Wang investigated 1,025 PCAOB inspection reports for years 2002 through 2012 and found about 50 percent had audit deficiencies, 131 of which were due to ICFR-related deficiencies. This is greater than a 25 percent deficiency rate in ICFR.

Deficiencies in ICFR can indicate there are errors in the financial reports that went undetected or material misstatements of the financial statements. Now that certain small companies are exempt from auditing the controls, it is possible that fraud will go undetected. As a result, a firm may give reasonable assurance about the accuracy and reliability of financial statements when a modified opinion should have been issued. In such cases, the public interest is at stake and the reputation of the accounting profession hangs in the balance.

By allowing economic consequences to influence whether certain companies must audit ICFR, the SEC has introduced bias in the PCAOB inspection process. The rationalization given that it will help companies invest in research and human capital makes no sense. How do they know companies will use the funds saved to develop a vaccine for the coronavirus or any other health-saving activity? What prevents these companies from using the funds to buy back stock or increase executive compensation?

What is the Public Interest?

The accounting profession exists because of the 1933 SEC requirement for public company audits that can only be conducted by independent CPAs. The franchise given to the profession is designed to best serve the public interest through independent audits that provide reasonable assurance that the financial statements are free from material misstatements including fraud. Given the important role of ICFR to prevent and detect fraud, the loosening of the rules for audits of the controls can only serve the interests of those companies affected by the rule change.

The SEC should not set rules designed to be an engine for economic development. The rule change is nothing less than a crack in the ethics wall that protects the public interest. Issues such as objectivity, representational faithfulness, due care and reliability are at stake. Changes in the rules to serve a particular political or economic interest has no place in accounting standards.

Friday, February 28, 2020

Peer Review: Stepping Forward!

In our continuing efforts to better serve our existing stakeholders and to expand our audience, the Public Interest Section of the American Accounting Association is delighted to announce its new peer review practice for contributors to its professional blog.

Upon request by a contributing author, two blind reviewers will be asked to review a submission and to reply with comments within three weeks. Given that a blog post is a much “lighter” document than a journal article, a three week review period should prove to be a manageable task.

After this original review, the finalization of a blog post should not require more than three additional weeks. Thus, blog posts are expected to require no more than six weeks “from submission to publication” in most circumstances. Submissions that address breaking news stories and other extremely topical events may be published much more quickly.

We expect that the publication of peer reviewed blog submissions will result in more submissions from a wider array of authors. Although a peer reviewed blog post is clearly not equivalent to a traditional journal publication, it is nevertheless recognized as a valid second tier intellectual contribution by many academic institutions.

Please contact Michael Kraten at Houston Baptist University if you wish to contribute a post, to discuss a topic for a potential blog post, or to volunteer to serve as a reviewer. Most importantly, thank you for your continuing interest in our section!

Wednesday, January 1, 2020

A Little Optimism For The Upcoming Decade

Editor’s Note: We are pleased to begin the new decade by publishing the following editorial piece by Michael Kraten, Professor of Accounting at Houston Baptist University. It is the third of a series of three columns that address the theme of The Evolution of the Public Interest in Accounting.

The piece was also published on the Blog of the Sustainability Investment Leadership Council. See SILCNY.com.

We welcome contributions by all members of the academic and business communities who maintain an interest in Accounting and the Public Interest. Please direct your queries to Michael Kraten at mkraten@hbu.edu.

As always, when you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.

As the calendar flips from 2019 to 2020, it’s easy to feel a bit depressed about the metrics that have challenged us during the past decade. The aggregate debt of the United States federal government, for instance, has exploded from $13 trillion to $24 trillion. Wealth inequality has also grown, and the number of American citizens without health insurance has resumed its climb after years of decline. Meanwhile, increases in sea levels, meteorological instability, and ocean temperatures are threatening our natural environment.

It’s a grim set of trends, isn’t it? But if we choose to focus on these dismal metrics, we’ll lose sight of the broader picture. There were, after all, many events that occurred during the 2010s that should encourage optimism among those who support the public interest.

At the start of the decade, for instance, the standards of the Global Reporting Initiative (GRI) merely provided a voluntary framework of reporting guidelines. But they would not remain a purely voluntary framework for long! In 2013 and 2014, the European Union issued a pair of directives on non-financial reporting. They required many of the world’s largest corporations to begin to include a wide variety of non-financial information in their annual reports, starting in 2018.

Furthermore, at the start of the decade, the Sustainability Accounting Standards Board (SASB) didn’t even exist. Launched in 2011, the SASB now promulgates detailed sets of standards for 77 industries, including sample disclosure language for inclusion in corporate annual reports. The SASB’s framework and standards, like the European Union’s directives on non-financial reporting, have served to impose sustainability reporting requirements and expectations on the world’s largest for-profit entities.

Meanwhile, the Task Force on Climate-related Financial Disclosures (TCFD) was launched by the Financial Stability Board in 2016 to recommend voluntary practices. Chaired by Michael Bloomberg, the Task Force presented its final recommendations the following year, and then remained in place to launch a Knowledge Hub, a pair of annual Status Reports, and a Consortium. The TCFD, like the GRI and the SASB, now focuses on developing and supporting private and public initiatives to enhance financial reporting practices.

The most startling development during the past decade, though, may have been the dramatic growth of the ESG investment industry. According to Fidelity, Socially Responsible Investing assets in the United States have quadrupled since 2010, rising roughly from $3 trillion to $12 trillion; the size of this asset market now exceeds $30 trillion worldwide (see fidelity.com/viewpoints/active-investor/strategies-for-sustainable-investing).

If you believe in the power of money, this final metric may be the most impressive one of all. After all, government entities and standard setting bodies may be able to protect the public interest against public apathy and private sector opposition. However, the re-direction of billions of dollars in investment funds can only occur if public opinion and the private sector support the movement.

So let’s try to maintain an optimistic perspective as we enter the next decade of the 21st Century. After all, the decade of the 2010s have produced an impressive array of positive occurrences. It is entirely possible that the upcoming decade of the 2020s will likewise give birth to many new trends that support the public interest.

Thursday, December 26, 2019

Stop the Madness: We Need a New Approach to Split-Off Nonaudit ServicesFor Audit Clients

Editorial Note: We are delighted to present this essay by contributing columnist Steve Mintz, Professor Emeritus, Cal Poly, San Luis Obispo. It is the second of a series of three columns that address the theme of The Evolution of the Public Interest in Accounting. 

We welcome contributions by all members of the academic and business communities who maintain an interest in Accounting and the Public Interest. Please direct your queries to Michael Kraten at mkraten@hbu.edu.

As always, when you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.

The time has come to revisit the issue whether all nonaudit services should be prohibited for audit clients. The accounting profession continues to struggle with independence issues when both services are provided. The threats and safeguards approach in the AICPA Code does not seem to have reduced the instances of independence violations. Deficiencies in CPA firm quality controls and the failure to communicate independence issues with audit committees have exacerbated the problem.

Recent examples, just in 2019, illustrate a decline in basic ethics and the failure to protect the public interest.

  • On September 23, 2019, PwC agreed to pay $7.9 million to settle charges that the firm violated the SEC’s auditor independence rules by performing prohibited nonaudit services during an audit engagement, including exercising decision-making authority in the design and implementation of software relating to an audit client’s financial reporting, and engaging in management functions thereby creating a self-review threat to independence.

  • On September 10, 2019, Marcum LLP, one of the largest independent public accounting and advisory services firms in the nation, settled disciplinary proceedings with the PCAOB over advocating numerous issuer auditor clients in connection with the firm’s annual MicroCap Conference. As the host, Marcum praised the presenting companies, which included many of the firm’s auditing clients, as high-quality companies that were selected via a vetting process thereby creating an advocacy threat to independence.

  • On August 27, 2019, the SEC charged RSM US LLP (formerly known as McGladrey LLP), which is the fifth largest accounting firm in the U.S., with violating SEC independence rules in connection with more than 100 audit reports involving at least 15 audit clients for which they provided prohibited nonaudit services including corporate secretarial services, payment facilitation, payroll outsourcing, loaned staff, financial information system design or implementation, bookkeeping, internal audit outsourcing, and investment adviser services. A partner also had a prohibited employment relationship in serving as a non-discretionary member of the board of an affiliate of an RSM US issuer audit client, a management participation threat to independence.

  • On February 13, 2019, the SEC announced an agreement with Deloitte Touche Tohmatsu LLC (Deloitte Japan) to pay $2 million to settle charges that the firm issued audit reports for an audit client at a time when dozens of its employees maintained bank accounts with the client’s subsidiary thereby creating a self-interest threat to independence. An investigation by the firm revealed that 88 other Deloitte Japan employees had financial relationships with the audit client that compromised their independence.

This is just the tip of the iceberg. During the past few years we’ve witnessed the KPMG-PCAOB cheating scandal whereby the firm received inside information about audits to be inspected by the PCAOB from staffers who went to work for the firm. A partner at Ernst & Young tipped off a friend about non-public actions to be taken by an audit client that had the potential of moving the stock price.

It seems the United Kingdom is taking the matter of a conflict of interests seriously. The Financial Reporting Council (FRC), the United Kingdom’s accounting watchdog, has been examining the question of whether the performance of all nonaudit services should be prohibited for audit clients in the aftermath of the liquidation of two large companies, Carillion and BHS. The impetus for the review is FRC’s claims that auditors from KPMG in both instances did not do enough to challenge management and did not maintain their professional skepticism. KPMG, for its part, indicated it would not continue to provide nonaudit services to audit clients but had some qualifiers, such as continuing to provide nonaudit services, such as consultancy, to smaller UK-listed clients, as well as private firms of all sizes. It also failed to give an end date for the changes.

Other firms, including PwC and EY, also said they would stop offering non-essential consulting services to its largest British public audit clients by 2020. The firms stated their goal is to eliminate any perception of conflict between selling audit and consulting work to the same client. The key here is what is a “non-essential consulting service?” Perhaps the firms purposefully left it vague.

Enter the UK Competition and Markets Authority, a government department in the UK, that issued a report on April 18, 2019 recommending an operational split of audit and nonaudit services. The large firms would be split into separate operating entities with respect to auditing and consultancy functions to reduce the influence of consulting practices upon auditing divisions. The split would help to prevent potential conflicts of interest from impairing audit independence and increasing the public trust in the quality of financial statements. However, the watchdog stopped short of recommending a full break-up based on firm services.

A study group chaired by Prem Sikka, a professor of Accounting and Finance at the University of Sheffield, prepared a report on behalf of the UK Parliamentary Labour Party, that concluded an operational split would not go far enough, calling instead for two legally separate organizations. In essence, it calls for a structural break-up of large firms saying that it would be more effective than other options in dealing with conflicts of interest and providing professional skepticism needed to deliver high-quality audits.

The SEC and PCAOB should closely monitor the events in the UK as regulators deal with the issue of how best to eliminate threats to independence that might occur when nonaudit services are provided for audit clients. Regardless of the method chosen, the time has come to split off nonaudit services as a separate unit, at a minimum, and study the issue of legal separation much as is being done in the UK. Nothing short of these remedies is necessary to protect the public interest.