case Independence Violation at PwC

PricewaterhouseCoopers (PwC) was involved in a series of independence violations in the late 1990s and early 2000s that resulted in strengthening the independence rules for auditors We discuss these situations in two parts.

Part I

On January 6, 2000, the SEC made public the report by independent consultant Jess Fardella, who was appointed by the commission in March 1999 to conduct a review of possible independence rule violations by PwC arising from ownership of client-issued securities. The report found significant violations of the firm?s, the profession?s, and the SEC?s auditor independence rules.

Background

On January 14, 1999, the commission issued an Opinion and Order Pursuant to Rule 102(e) of the Commission?s Rules of Practice, In the Matter of PricewaterhouseCoopers LLP (Securities Exchange Act of 1934, Release No. 40945) (?Order?), which censured PwC for violating auditor independence rules and improper professional conduct. Pursuant to the settlement reached with the commission, PwC agreed to, among other things, complete an internal review by Fardella to identify instances in which the firm?s partners or professionals owned securities of public audit clients of PwC in contravention of applicable rules and regulations concerning independence.

The independent consultant?s report discloses that a substantial number of PwC professionals, particularly partners, had violations of the independence rules, and that many had multiple violations. The review found excusable mistakes, but also attributed the violations to laxity and insensitivity to the importance of independence compliance. According to Fardella?s report, PwC acknowledged that the review disclosed widespread independence noncompliance that reflected serious structural and cultural problems in the firm.

Results of the Independent Consultant?s Report

The report summarizes results of the internal review at PwC, which included two key parts: PwC professionals were requested in March 1999 to self-report independence violations; and the independent consultant randomly tested a sample of the responses for completeness and accuracy. The results are as follows:

1. Almost half of the PwC partners?1,301 out of a total of 2,698?self-reported at least one independence violation. The 1,301 partners who reported a violation reported an average of 5 violations; 153 partners had more than 10 violations each. Of 8,064 reported violations, 81.3 percent were reported by partners and 17.4 percent by managers; 45.2 percent of the violations were reported by partners who perform services related to audits of financial statements.

2. Almost half of the reported violations involved direct investments by the PwC professional in securities, mutual funds, bank accounts, or insurance products associated with a client. Almost 32 percent of reported violations, or 2,565 instances, involved holdings of a client?s stock or stock options.

3. A total of 6 out of 11 partners at the senior management level who oversaw PwC?s independence program self-reported violations. Each of the 12 regional partners who help administer PwC?s independence program reported at least 1 violation; one reported 38 violations and another reported 34 violations.

4. In addition, 31of the 43 partners who comprise PwC?s Board of Partners and its U.S. Leadership Committee self-reported at least 1 violation. Four of these had more than 20 violations; one of these partners had 41 violations and another had 40 violations.

These random tests of the self-reporting process indicated that a far greater percentage of individuals had independence violations than were reported. Despite clear warnings that the SEC was overseeing the self-reporting process, the random tests of those reports indicated that 77.5 percent of PwC partners failed to self-report at least one independence violation. The combined results of the self-reporting and random tests of those reports indicated that approximately 86.5 percent of PwC partners and 10.5 percent of all other PwC professionals had independence violations.

The independent consultant?s report identifies key weaknesses in the systems PwC had used to prevent or detect independence violations.

1. Reporting systems relied on the individuals themselves to sort through their own investments and interests for violations.

2. Efforts to educate professionals about the independence rules and their responsibilities to the client to comply with the rules were insufficient.

3. Resolution of reported violations was not adequately documented.

4. Reporting systems did not focus on the reporting of violations that were deemed to be resolved before annual confirmations were submitted.

The consultant?s report concludes that the numbers of violations alone, as PwC acknowledged, reflect serious structural and cultural problems that were rooted in both its legacy firms (Price Waterhouse and Coopers & Lybrand). Although a large percentage of the reported and unreported violations is attributable solely to the merger, an even larger portion is not; thus, the situation revealed by the internal investigation is not a one-time breakdown explained solely by the merger. Nor can the magnitude of the reported and unreported violations be attributed simply to less familiar independence rules such as those pertaining to brokerage, bank, and sweep accounts. At least half of the reported and unreported violations consisted of interests held by a reporting PwC professional himself or herself, and most of the violations arose from either mutual fund or stock holdings. Independence compliance at PwC and its legacy firms was dependent largely on individual initiative. This system failed, as PwC has acknowledged.

Changes Needed

As accounting firms have grown larger, acquired more clients, and provided more services, and as investment opportunities and financial arrangements have increased in number and complexity, well-designed and extensive controls are needed both to facilitate independence compliance and to discourage and detect noncompliance. The violations discussed in the consultant?s report had come to light as a result of a commission-ordered review after professional self-regulatory procedures failed to detect such violations. As a result, the SEC requested the then-current Public Oversight Board (largely replaced by PCAOB) to sponsor similar independent reviews at other firms and oversee development of enhancements to quality control and other professional standards. The firm also agreed in a settlement to conduct the review and create a $2.5 million education fund after the SEC alleged that some of its accountants compromised their independence by owning stock in corporations they audited.

PwC promised at the time to take steps to ensure that it didn?t happen again. As a result of the inquiry, five partners of the firm and a slightly larger number of other employees had been dismissed, and other employees were disciplined but not fired.

Two changes that resulted from the problems at PwC were (1) to clearly define family members and other close relatives of members of the attest engagement team that might create an independence impairment for the auditors because of the formers? ownership interests in a client and/or their position within the client including having a financial reporting oversight role (Interpretation 101-1); and (2) to restrict the ability of audit personnel from having loans to or from banks and other financial institution clients (Interpretation 101-5).

Questions

1. In commenting on the findings in the consultant?s report, the then-chief accountant of the SEC, Lynn E. Turner, said, ?This report is a sobering reminder that accounting professionals need to renew their commitment to the fundamental principle of auditor independence.? Why is it so important for auditors to be independent of their clients? Explain the nature of the independence impairments at PwC with respect to the threats to independence discussed in the chapter.

2. Review question 19 at the end of the chapter and the PeopleSoft case in the chapter. What are the commonalities between the facts of these two cases with respect to independence violations and the facts of PwC?s independence violations? How might the independence violations in these cases negatively affect the ability of an auditor to be objective in performing professional services and maintain her integrity?

Part II

On July 17, 2002, the SEC announced a settlement with PricewaterhouseCoopers LLP (PwC) and its broker-dealer affiliate, PricewaterhouseCoopers Securities LLC (PwCS), for violations of the auditor independence rules. The auditor independence violations spanned a five-year period from 1996 to 2001 and arise from (1) PwC's use of prohibited contingent fee arrangements with 14 different audit clients for which PwC provided investment banking services, and (2) PwC's participation with two other audit clients, Pinnacle Holdings Inc. and Avon Products Inc., in the improper accounting of costs that included PwC's own consulting fees.

The SEC's order found that, by virtue of PwC's independence violations, the firm caused 16 PwC public audit clients to file financial statements with the SEC that did not comply with the reporting provisions of the federal securities laws. The order also found that, in connection with the improper accounting of its consulting fees, PwC caused two of those clients to violate the reporting, recordkeeping, and/or internal controls provisions of the federal securities laws. PwC and PwCS agreed to pay a total of $5 million and PwC agreed to comply with significant remedial undertakings as a result of its settlement with the SEC. PwC also agreed to cease and desist from violating the auditor independence rules and to be censured for engaging in improper professional conduct.

The SEC's order found that PwC's independence violations involved 16 separate audits of 16 public companies:

• From 1996 to 2001, PwC and one of its predecessors, Coopers & Lybrand, entered into impermissible contingent fee arrangements with 14 public audit clients. In each instance, the client hired the audit firm's investment bankers, either PwCS or Coopers & Lybrand Securities, to perform financial advisory services for a fee that depended on the success of the transaction the client was pursuing. These fee arrangements violated the accounting professions' own prohibition against contingent fee arrangements with audit clients and violated the SEC's independence rules. As a result, the SEC found that PwC lacked the requisite independence when it performed audits for these 14 public companies.
• In 1999 and 2000, PwC participated in and approved of the improper accounting of its own non-audit fees by two public audit clients, Pinnacle and Avon:
  • In 1999 and 2000, while accounting for a 1999 acquisition of certain assets of Motorola, Inc., PwC assisted Pinnacle in establishing more than $24 million in improper reserves and in improperly capitalizing approximately $8.5 million in costs, including $6.8 million in fees paid to PwC for consulting and other non-audit services that should have been expensed. In April and May 2001, Pinnacle restated its accounting for the 1999 acquisition, and in December 2001, the SEC issued a settled cease and desist order against Pinnacle. See In the Matter of Pinnacle Holdings, Inc., Exchange Act Release No. 45135 (Dec. 6, 2001).
  • In the first quarter of 1999 and in its 1999 audit of Avon's financial statements, PwC assisted in and approved of Avon's improper accounting of an impaired asset that included PwC's non-audit consulting fees. In April 1999, after nearly three years and an investment of approximately $42 million, Avon stopped an uncompleted order-management software project that PwC consultants had attempted to develop for Avon's internal use. Instead of writing off all of the project's costs in the first quarter of 1999, however, Avon improperly retained $26 million, which was comprised mostly of PwC's own consulting fees. PwC participated in and approved of Avon's improper accounting, and also contributed to Avon's misleading disclosures concerning the accounting.
  • For both Pinnacle and Avon, the SEC found that PwC failed to exercise the objective and impartial judgment required by the independence rules.

Questions

3. What are the dangers of accepting contingent fees from audit clients for performing non-audit services? Assume in such situations the auditor can, in fact, make independent audit decisions regardless of the contingent fee arrangements. Would independence be impaired in such situations?

4. How did Avon?s accounting for the project costs on the abandoned order-management software project violate GAAP? How did PwC?s role in the capitalized costs for consulting services violate its ethical obligations?

Case 4-10 Independence Violations at PricewaterhouseCoopers PricewaterhouseCoopers (PwC) was involved in a series of independence violations in the late 1990s and early 2000s that resulted in strengthening the independence rules for auditors We discuss these situations in two parts. Part I On January 6, 2000, the SEC made public the report by independent consultant Jess Fardella, who was appointed by the commission in March 1999 to conduct a review of possible independence rule violations by PwC arising from ownership of client-issued securities. The report found significant violations of the firm's, the profession's, and the SEC's auditor independence rules. Background On January 14, 1999, the commission issued an Opinion and Order Pursuant to Rule 102(e) of the Commission's Rules of Practice, In the Matter of PricewaterhouseCoopers LLP (Securities Exchange Act of 1934, Release No. 40945) (\"Order\"), which censured PwC for violating auditor independence rules and improper professional conduct. Pursuant to the settlement reached with the commission, PwC agreed to, among other things, complete an internal review by Fardella to identify instances in which the firm's partners or professionals owned securities of public audit clients of PwC in contravention of applicable rules and regulations concerning independence. The independent consultant's report discloses that a substantial number of PwC professionals, particularly partners, had violations of the independence rules, and that many had multiple violations. The review found excusable mistakes, but also attributed the violations to laxity and insensitivity to the importance of independence compliance. According to Fardella's report, PwC acknowledged that the review disclosed widespread independence noncompliance that reflected serious structural and cultural problems in the firm. Results of the Independent Consultant's Report The report summarizes results of the internal review at PwC, which included two key parts: PwC professionals were requested in March 1999 to self-report independence violations; and the independent consultant randomly tested a sample of the responses for completeness and accuracy. The results are as follows: 1. Almost half of the PwC partners1,301 out of a total of 2,698self-reported at least one independence violation. The 1,301 partners who reported a violation reported an average of 5 violations; 153 partners had more than 10 violations each. Of 8,064 reported violations, 81.3 percent were reported by partners and 17.4 percent by managers; 45.2 percent of the violations were reported by partners who perform services related to audits of financial statements. 2. Almost half of the reported violations involved direct investments by the PwC professional in securities, mutual funds, bank accounts, or insurance products associated with a client. Almost 32 percent of reported violations, or 2,565 instances, involved holdings of a client's stock or stock options. 3. A total of 6 out of 11 partners at the senior management level who oversaw PwC's independence program self-reported violations. Each of the 12 regional partners who help administer PwC's independence program reported at least 1 violation; one reported 38 violations and another reported 34 violations. 4. In addition, 31of the 43 partners who comprise PwC's Board of Partners and its U.S. Leadership Committee self-reported at least 1 violation. Four of these had more than 20 violations; one of these partners had 41 violations and another had 40 violations. These random tests of the self-reporting process indicated that a far greater percentage of individuals had independence violations than were reported. Despite clear warnings that the SEC was overseeing the selfreporting process, the random tests of those reports indicated that 77.5 percent of PwC partners failed to self-report at least one independence violation. The combined results of the self-reporting and random tests of those reports indicated that approximately 86.5 percent of PwC partners and 10.5 percent of all other PwC professionals had independence violations. The independent consultant's report identifies key weaknesses in the systems PwC had used to prevent or detect independence violations. 1. Reporting systems relied on the individuals themselves to sort through their own investments and interests for violations. 2. Efforts to educate professionals about the independence rules and their responsibilities to the client to comply with the rules were insufficient. 3. Resolution of reported violations was not adequately documented. 4. Reporting systems did not focus on the reporting of violations that were deemed to be resolved before annual confirmations were submitted. The consultant's report concludes that the numbers of violations alone, as PwC acknowledged, reflect serious structural and cultural problems that were rooted in both its legacy firms (Price Waterhouse and Coopers & Lybrand). Although a large percentage of the reported and unreported violations is attributable solely to the merger, an even larger portion is not; thus, the situation revealed by the internal investigation is not a one-time breakdown explained solely by the merger. Nor can the magnitude of the reported and unreported violations be attributed simply to less familiar independence rules such as those pertaining to brokerage, bank, and sweep accounts. At least half of the reported and unreported violations consisted of interests held by a reporting PwC professional himself or herself, and most of the violations arose from either mutual fund or stock holdings. Independence compliance at PwC and its legacy firms was dependent largely on individual initiative. This system failed, as PwC has acknowledged. Changes Needed As accounting firms have grown larger, acquired more clients, and provided more services, and as investment opportunities and financial arrangements have increased in number and complexity, welldesigned and extensive controls are needed both to facilitate independence compliance and to discourage and detect noncompliance. The violations discussed in the consultant's report had come to light as a result of a commission-ordered review after professional self-regulatory procedures failed to detect such violations. As a result, the SEC requested the then-current Public Oversight Board (largely replaced by PCAOB) to sponsor similar independent reviews at other firms and oversee development of enhancements to quality control and other professional standards. The firm also agreed in a settlement to conduct the review and create a $2.5 million education fund after the SEC alleged that some of its accountants compromised their independence by owning stock in corporations they audited. PwC promised at the time to take steps to ensure that it didn't happen again. As a result of the inquiry, five partners of the firm and a slightly larger number of other employees had been dismissed, and other employees were disciplined but not fired. Two changes that resulted from the problems at PwC were (1) to clearly define family members and other close relatives of members of the attest engagement team that might create an independence impairment for the auditors because of the formers' ownership interests in a client and/or their position within the client including having a financial reporting oversight role (Interpretation 101-1); and (2) to restrict the ability of audit personnel from having loans to or from banks and other financial institution clients (Interpretation 101-5). Questions 1. In commenting on the findings in the consultant's report, the then-chief accountant of the SEC, Lynn E. Turner, said, \"This report is a sobering reminder that accounting professionals need to renew their commitment to the fundamental principle of auditor independence.\" Why is it so important for auditors to be independent of their clients? Explain the nature of the independence impairments at PwC with respect to the threats to independence discussed in the chapter. 2. Review question 19 at the end of the chapter and the PeopleSoft case in the chapter. What are the commonalities between the facts of these two cases with respect to independence violations and the facts of PwC's independence violations? How might the independence violations in these cases negatively affect the ability of an auditor to be objective in performing professional services and maintain her integrity? Part II On July 17, 2002, the SEC announced a settlement with PricewaterhouseCoopers LLP (PwC) and its broker-dealer affiliate, PricewaterhouseCoopers Securities LLC (PwCS), for violations of the auditor independence rules. The auditor independence violations spanned a five-year period from 1996 to 2001 and arise from (1) PwC's use of prohibited contingent fee arrangements with 14 different audit clients for which PwC provided investment banking services, and (2) PwC's participation with two other audit clients, Pinnacle Holdings Inc. and Avon Products Inc., in the improper accounting of costs that included PwC's own consulting fees. The SEC's order found that, by virtue of PwC's independence violations, the firm caused 16 PwC public audit clients to file financial statements with the SEC that did not comply with the reporting provisions of the federal securities laws. The order also found that, in connection with the improper accounting of its consulting fees, PwC caused two of those clients to violate the reporting, recordkeeping, and/or internal controls provisions of the federal securities laws. PwC and PwCS agreed to pay a total of $5 million and PwC agreed to comply with significant remedial undertakings as a result of its settlement with the SEC. PwC also agreed to cease and desist from violating the auditor independence rules and to be censured for engaging in improper professional conduct. The SEC's order found that PwC's independence violations involved 16 separate audits of 16 public companies: From 1996 to 2001, PwC and one of its predecessors, Coopers & Lybrand, entered into impermissible contingent fee arrangements with 14 public audit clients. In each instance, the client hired the audit firm's investment bankers, either PwCS or Coopers & Lybrand Securities, to perform financial advisory services for a fee that depended on the success of the transaction the client was pursuing. These fee arrangements violated the accounting professions' own prohibition against contingent fee arrangements with audit clients and violated the SEC's independence rules. As a result, the SEC found that PwC lacked the requisite independence when it performed audits for these 14 public companies. In 1999 and 2000, PwC participated in and approved of the improper accounting of its own nonaudit fees by two public audit clients, Pinnacle and Avon: o In 1999 and 2000, while accounting for a 1999 acquisition of certain assets of Motorola, Inc., PwC assisted Pinnacle in establishing more than $24 million in improper reserves and in improperly capitalizing approximately $8.5 million in costs, including $6.8 million in fees paid to PwC for consulting and other non-audit services that should have been expensed. In April and May 2001, Pinnacle restated its accounting for the 1999 acquisition, and in December 2001, the SEC issued a settled cease and desist order against Pinnacle. See In the Matter of Pinnacle Holdings, Inc., Exchange Act Release No. 45135 (Dec. 6, 2001). o In the first quarter of 1999 and in its 1999 audit of Avon's financial statements, PwC assisted in and approved of Avon's improper accounting of an impaired asset that included PwC's non-audit consulting fees. In April 1999, after nearly three years and an investment of approximately $42 million, Avon stopped an uncompleted ordermanagement software project that PwC consultants had attempted to develop for Avon's internal use. Instead of writing off all of the project's costs in the first quarter of 1999, however, Avon improperly retained $26 million, which was comprised mostly of PwC's own consulting fees. PwC participated in and approved of Avon's improper accounting, and also contributed to Avon's misleading disclosures concerning the accounting. o For both Pinnacle and Avon, the SEC found that PwC failed to exercise the objective and impartial judgment required by the independence rules. Questions 3. What are the dangers of accepting contingent fees from audit clients for performing non-audit services? Assume in such situations the auditor can, in fact, make independent audit decisions regardless of the contingent fee arrangements. Would independence be impaired in such situations? 4. How did Avon's accounting for the project costs on the abandoned order-management software project violate GAAP? How did PwC's role in the capitalized costs for consulting services violate its ethical obligations