By Laura H. Posner
The health of the US financial markets and investors is dependent on auditors fulfilling their critical gatekeeping function. While the Sarbanes-Oxley Act led to great improvement in financial reporting, it didn’t go far enough to ensure auditor independence, says Laura H. Posner, a partner in Cohen Milstein’s Securities Litigation & Investor Protection and Ethics and Fiduciary Counseling practices. Prior to joining Cohen Milstein in 2017, Posner was the Bureau Chief for the New Jersey Bureau of Securities.
Last month, the Sarbanes-Oxley Act turned 20 years old. Sarbanes-Oxley, a landmark piece of legislation that transformed auditing and financial reporting in the wake of the Enron and Arthur Andersen scandal, has proven to be one of the most effective pieces of financial legislation passed since the enactment of the Securities Act of 1933 and the Securities Exchange Act of 1934.
Among other things, Sarbanes-Oxley led corporations to adopt and implement significantly more robust financial controls, leading to fewer and smaller restatements. But since it was enacted, both the financial markets and the Big Four accounting firms have transformed dramatically. Audit firms have expansive consulting arms, and financial products are significantly more complex. Legal developments have also made it increasingly difficult to hold fraudsters accountable when they run afoul of auditing rules and the securities laws. Perhaps most alarming is the dangerous pattern of auditors lacking independence from their clients, creating conflicts of interest that we must not ignore.
While Sarbanes-Oxley led to great improvement in financial reporting, it didn’t go far enough to ensure auditor independence. Hopefully, the necessary changes will be made before the next auditing scandal rocks the markets and harms investors.
Sarbanes-Oxley attempted to ensure auditor independence, requiring engagement partners to rotate off clients every five years and audit firms to bar certain consulting work for audit clients. But the concept of the independent auditor in the US has blurred as accounting firms have become increasingly ensconced in their clients, leading to erosion of investor confidence and opening the door to corporate misstatements, breaches of fiduciary duties, or worse—fraud.
An illustration of this is the recent report that Ernst & Young devised elaborate—and what federal authorities now claim were sham—tax shelters that allowed Perrigo, a leading maker of nonprescription drugs, to avoid more than $100 million in federal taxes. When Perrigo’s outside auditor, BDO, questioned the legality of the tax shelters, Perrigo replaced BDO with Ernst & Young, which then blessed the transactions its consulting arm helped create. This is a prime example of why there must be a bright line defining what it means to be an independent auditor and proscribing what activities are permitted and which run afoul of auditor independence rules.
While the Securities Exchange Commission has released some guidance on what kinds of relationships accounting firms and their auditing divisions can and cannot have with clients, it is not surprising that this activity still takes place. The client, after all, is the one who pays the bills.
Role of Litigation
Auditor independence issues often play an important role in private litigation, too. For example, investors recently settled securities litigation against Mattel Inc. and its auditor, PwC, for $98 million. According to Mattel’s own audit committee, PwC’s lead audit partner for the engagement violated auditor independence rules by providing recommendations on candidates for Mattel’s senior finance positions. A Mattel whistleblower referenced in the complaint also alleged that PwC then helped cover up Mattel’s valuation allowance misstatement that ultimately led to the need for a restatement. Mattel had improperly understated its net loss by approximately $109 million, effectively overstating earnings by $0.32 per share.
While Sarbanes-Oxley attempted to prevent such compromises of independence, the Mattel/PwC case demonstrates that the legislation did not go far enough and that further regulatory action and civil litigation is necessary to protect investors.
Call for Regulators to Get Tough
In the US, accounting firms are regulated by both the SEC and the Public Company Accounting Oversight Board, a quasi-public agency created by Sarbanes-Oxley. SEC and PCAOB rules require audit firms to keep an arms-length relationship with the companies they oversee. In 2020, the SEC clarified the auditor independence rule under then-SEC Chairman Jay Clayton. Under the revised rules, companies are required to limit the number of services they provide to a single client to ensure objectivity and impartiality in their audit work.
Unfortunately, since the fall of Arthur Anderson in the wake of the Enron scandal, the SEC and PCAOB have often failed to go after auditors playing fast and loose with the rules. The death knell of Arthur Andersen—which was one of the “Big Five” auditing firms—was a massive blow to the accounting industry and gave many regulators cold feet in bringing claims against audit firms. When the Supreme Court later overturned the government’s obstruction of justice case against Arthur Andersen, it further dampened enforcement efforts.
The SEC recently rolled out a new enforcement initiative aimed at investigating conflicts of interest in nation’s largest accounting firms—a key step to ensure auditors are acting as the independent gatekeepers. One suggestion is for the SEC and PCAOB to look across the pond at the Competition and Markets Authority and Financial Reporting Council’s recent hardline efforts to regulate the separation of the audit and non-audit practices of the UK’s largest auditing firms—the same Big Four as in the US—as a part of the UK’s “Restoring Trust in Audit and Corporate Governance.”
In addition to the Big Four establishing a separate regulatory audit board, FRC’s April 2022 proposed revisions to the Audit Firm Governance Code stipulates a maximum tenure of nine years to guard against threats to independence and requires an independent non-executive to participate in the auditing process alongside the audit board. The INE would be entirely independent from the auditor and audited entities. It also would be meant to represent the public interest and act for the benefit of the common good, including that of the shareholder and other stakeholders.
The health of the US financial markets and investors is dependent on auditors fulfilling their critical gatekeeping function. To do so, accounting firms must be truly independent from the companies they are auditing.
Read the article on Bloomberg Tax.