KPMG Steals the Exam

The Public Company Accounting Oversight Board (PCAOB) was form in 2002 by the Sarbanes Oxley Act. The PCAOB is an independent non-profit entity which is funded by all U.S. public companies (companies which have sold their securities to the investing public) based on each public company's relative market capitalization.

The primary function of the PCAOB involves the regulation of the independent accountants (auditors) of public companies. The PCAOB is responsible for setting auditing, quality control, ethics, independence and other standards relating to the preparation of audit reports of public companies. In carrying out these duties, the PCAOB conducts inspections of PCAOB registered public accounting firms. These inspections involve a review of the audit working papers for selected clients of these accounting firms.

The PCAOB issues detailed Inspection Reports detailing their findings related to the inspection process. Portions of their report are released to the public. The portions of the inspection reports that deal with criticisms of, or potential defects in, the audit firm's quality control systems are not made public, if the firm addresses those matters to the PCAOB's satisfaction within 12 months after the report date. Auditing firms are extremely sensitive to these "report cards" issued by the PCAOB.

KPMG LLP (KPMG) is a Delaware limited liability partnership and one of the Big Four accounting firms within the United States. As a national accounting firm, KPMG is subject to regulation by the PCAOB.

Chronology:

KPMG was going through a rough patch with the PCAOB. According to the PCAOB inspection reports, the failure rate for KPMG's audits were 46% in 2013 and 54% in 2014. These statistics served as a wakeup call for the firm. Audit quality at KPMG must improve or they would experience a loss in business!

The responsibility for improving audit quality fell squarely on the shoulders of David Middendorf, KPMG's National Managing Partner in the Audit Quality and Professional Practice Group. One action that Middendorf took was to hire some accountants currently working at the PCAOB to help shore up the audit quality. In April 2015, KPMG hired Brian Sweet, who was working as an Associate Director in the PCAOB's inspections group, to be a partner at the firm at a substantial increase in salary.

On Sweet's last day at the PCAOB, he copied a voluminous amount of confidential information from the PCAOB's records, a clear violation of PCAOB rules.

Early in Sweet's tenure at KPMG, he was pressured by Middendorf and Thomas Whittle, KPMG's National Partner-in-Charge for Qualify Measurement (and Sweet's immediate boss) to divulge information about upcoming inspections for KPMG's audit clients. Sweet succumbed to the pressure of his superiors and gave them a listing of the upcoming inspections. Additionally, Sweet corresponded with Cynthia Holder at the PCAOB to obtain additional insider information. Holder was subsequently hired by KPMG. Once Holder joined KPMG, Jeffrey Wada, Inspections Leader at the PCAOB became KPMG's new source of inside information. Wada was never hired by KPMG (much to Wada's chagrin).

Once KPMG became aware of which audit clients were scheduled to be inspected by the PCAOB, they undertook a concerted effort to "shore up" the audit working papers for these clients. According to PCAOB rules, there is a 45 day period following the issuance of an audit report when an accounting firm is allowed to review their audit files and amend their working papers where appropriate. Once this period passes, the audit files are "locked down" for editing.

All was looking good for KPMG and the PCAOB inspection process until February 2017, when Sweet began informing audit teams that their clients were slated for inspection by the PCAOB. One unnamed whistleblower became appalled that the firm had acquired and planned to act on inside information. She reported this fact up her chain of command. KPMG then initiated an internal investigation.

The ultimate outcome of this was a mass firing at KPMG, criminal prosecution and the payment of a $50 million civil penalty to the SEC by KPMG. Middendorf, Whittle, Holder, Wada and one other KPMG partner were charged in a criminal case. Sweet took a plea deal and became a cooperating witness.

Recommended Readings:

1. How Accountants Took Washington's Revolving Door to a Criminal Extreme. This is an article written by the Chief Investigative Reporter for the Project on Government Oversight. This is a great overview of the case and provides some interesting detail.

2. Civil complaint In the Matter of KPMG LLP (34-86118). This is a legal pleading which lists the detail of the case against KPMG. It also lists and additional issue regarding KPMG personnel cheating on their CPE.

3. Wall Street Journal article, Ex-KPMG Partner Gets a Year and a Day in 'Steal the Exam' Scandal.

4. Compliance Week article Former KPMG, PCAOB leader gets prison time in inspections scandal.

5. Any other interesting items that may come up in your research.

Case Prompts/Questions:

1. What is your impression of the ethical culture at KPMG? Support your conclusion with facts gleaned from the recommended readings.

2. Do you think it is a good idea for the audit firms to hire personnel from the PCAOB? What are the pros and cons of this practice?

3. There are many different parties who are at fault in this case. Who do you think bears more blameKPMG personnel or the PCAOB people? Support your conclusion.

4. Imagine that you are David Middendorf. You are the second highest ranking partner on the audit side of the business for one of the four largest accounting firms in the country. You are not that far from the mandatory retirement age and you are probably fixed for life financially. What pressures might entice you to act on illegally obtained inside information?

5. Imagine that you are an auditor at KPMG and have just received an email from Brian Sweet informing you that your audit client will be a party to a PCAOB inspection. What action will you take?

6. Make any other observations that you find interesting.