Yes, Governance Matters. – When the watchdog is caught napping

INTRODUCTION

On June 08, 2022, the U.S. Securities and Exchange Commission today charged¹ audit firm CohnReznick LLP (“Firm”) with improper professional conduct on engagements for two clients in 2017. The Commission also charged three of the firm’s partners with improper professional conduct for violating numerous professional standards. All respondents have reportedly agreed to settle charges and pay penalties, which will be returned to investors.

FACTUAL MATRIX

According to the SEC’s order, the Firm improperly accepted a client’s conclusion that its goodwill was not impaired or reduced in value, in the third quarter of 2017, despite the Firm’s national office partners and own valuation specialists expressing concerns with the client’s conclusion; the firm failed to obtain sufficient evidence or conduct additional procedures. The SEC order found that the Firm’s deficient system of quality control led to failures to adhere to professional auditing standards. A second related order finds that on multiple occasions, one of the partners of the Firm accepted the management’s assertions that goodwill was not impaired despite strong indicators of impairment. The order also finds that in the third quarter of 2017, three of the partners were confronted with indications that the client’s goodwill impairment test was not supported by sufficient evidence, but they still accepted the client’s conclusion that goodwill was not impaired even though appropriate additional audit procedures had not been performed.

On the second client, the SEC order found that the Firm and its national office failed to address known issues involving related party transactions, which were used by the client to fraudulently inflate its revenues.

The SEC was able to come to a finding regarding the Firm’s deficient system and repeated failures to exercise due professional care at all levels, from the engagement team up through the firm’s national office, which allowed and were a cause of both clients’ disclosure violations. The SEC’s order was against the Firm and its individual partners. Without admitting or denying the SEC’s findings, the Firm agreed to pay a $1.9 million penalty, to be censured, and to implement undertakings to retain an independent consultant to review and evaluate certain of its audit, review, and quality control policies and procedures, as well as to abide by certain restrictions on retaining new audit clients during the consultant’s review. Without admitting or denying the SEC’s findings, the individual partners also agreed to pay civil penalties / not appear or practice before the SEC as an accountant with the right to apply for reinstatement after a specified period / censure. All respondents also agreed to a cease-and-desist order.

INDIAN CONTEXT: ROLE OF AN AUDITOR

The role of the auditor is to give a professional and independent view on financial statements. An auditor reviews and verifies the accuracy of financial records and ensures that companies complies with applicable norms. Their primary objective is to protect businesses from fraud and highlight any discrepancies in accounting methods, among other things. The auditor is a certified professional and has responsibilities to various parties and the duties that go with it. An auditor’s opinion talks to the reliability of the financial statements and the information they provide. Audited financial statements are expected to have a high degree of reliability. In fact, Investors particularly rely on the audit mechanism to invest in companies based on their financials.

Where the auditor feels that the statements do not depict a true and fair view of the financial position of the business, he is also entitled to form an adverse opinion on the same. Additionally, where he finds that he is dissatisfied with the information provided and finds that he cannot express a proper opinion on the statements, he is expected to issue a disclaimer of opinion. A disclaimer of opinion indicates that due to the lack of information available, the financial status of the entity cannot be determined. The reasons for such negative opinion are also to be specified.

The auditors are always at pain to explain that their role is not to confirm the financials, rather it is to provide reasonable assurance that the financials depict a true and accurate picture. It should also be borne in mind that from a company’s perspective, audit is not a function that contributes to its revenues. Rather, it is an expense which like any other expense they endeavour to reduce. This in turn creates pressure on the auditors to conduct the audit in limited costs, which have an impact of the time that they can spend to conduct an audit exercise.

In Tri-sure India Ltd. vs. A.F. Ferguson and Co. and Ors., the Bombay High Court held that:

“It is the directors of a company who are primarily responsible for the preparation of the annual accounts and for the information contained in it. The duty of safeguarding the assets of a company is primarily that of the management and the auditor is entitled to rely upon the safeguards and internal controls instituted by the management, although he will of course take into account any deficiencies he may note therein while drafting the audit programme. The auditor does not conduct the audit with the objective of discovering all frauds, because in the first place it would take a considerable amount of time and it would not be possible to complete the audit within the time-limit prescribed by law for the presentation of accounts to the shareholders. Further, such an audit would have to involve a detailed and minute examination of all the books, records and other documents of the company, and the cost of doing so would be prohibitive and disproportionate to the benefits which may be derived by the shareholders. Finally, even if such examinations were to be conducted, there will be no assurance that all types of frauds, omissions and forgery, etc., would be discovered. The auditor, while conducting the audit, bears in mind the possibility of existence of fraud and irregularities in the accounts of the company.”

However, still the discovery of large-scale fraud typically would question whether an auditor spotted red-flags and performed the reasonable checks in the circumstances that could have resulted in the discovery of the fraud. The Companies Act, 2013 grants auditors certain rights to access all books of accounts and vouchers and require officers of the company to provide information and explanation. The Companies Act also requires the auditor to confirm that the auditor has sought and obtained all information and explanation that is necessary for the audit. Additionally, detailed laws have been made on who could act as an auditor and how an auditor should be appointed. All this points towards the importance of the role that the auditor performs. An auditor is not required to begin his task with suspicion. However, it is required to employ reasonable skill and care while verifying the books of a company. The task of ascertaining whether an auditor has performed his duties would usually involve placing oneself in the shoes of the auditor and ascertaining whether the matters ought to have thrown up red flags to a reasonable man exercising professional skill and judgment.

TAKEAWAYS

A collapse of a company seemingly doing well, followed by an inquiry into its affairs and subsequent discovery of fraud is a usual three step process that results in auditors being in the crosshair of the authorities. In the Firm’s case, it was the collapse of cryptocurrency company Longfin. However, this is an oft repeated story. In the infamous Wirecard Scandal a similar story unfolded. Even in the Indian context examples are rife such as the decade old Satyam scam or the more recent IL&FS crash.

However, corporate frauds often follow a game of ‘pass the buck’. The management and independent directors assert that they in good faith relied upon the competence of the professional auditors who never highlighted any discrepancies. The auditors in turn pass the buck on the management, asserting that they concealed information and provided false confirmations. Effectively resulting in each of the gatekeepers disclaiming responsibility. Thus, corporate frauds often raise the question as to the role of the various gatekeepers and in particular that of the external auditor.

The ecosystem of corporate compliances envisages a world where the true and fair financial position of a company is confirmed by an independent auditor and reflected in its financials basis a comprehensive review. Audit forms an integral part of the checks and balances that are built into the ecosystem to ensure that all stakeholders, including but not limited to the shareholders, the employees, clients and even the investors are protected.

It is trite that auditors are considered to be critical gatekeepers that must employ a robust system of quality control to ensure faithful adherence to professional standards. In the public markets, such checks and balances form the bedrock of disclosures that a company is obligated to make. Failure to make such disclosures in accordance with prescribed norms means that market participants dealing with the securities of listed companies are doing so on the basis of incomplete and inaccurate information; it prejudices the viability of the ecosystem as a whole.

In India, we have seen several situations where, arguably, the auditor did not delve into concerns as they ought to have and consequently missed out in early detection of internal frauds and financial misstatements. With the passage of time, these snowballed into major issues. There is a dire need to work towards an ecosystem where an auditor’s inadequacies, whether deliberate or not, are identified and they are taken to task. This will work towards strengthening the office of the auditor and the critical work performed by the auditor.

¹ https://www.sec.gov/news/press-release/2022-102?utm_medium=email&utm_source=govdelivery