SEC Charges KPMG with Auditor Independence Violations

By Cydney Posner

The SEC has charged KPMG with violating the auditor independence rules.  The investigation found that KPMG provided prohibited non-audit services, such as restructuring, corporate finance, bookkeeping, payroll and expert services to affiliates of companies whose financial statements they were auditing. Despite these violations, "KPMG repeatedly represented in audit reports that it was ‘independent' despite providing services to three audit clients that impaired KPMG's independence." In addition, the SEC questioned KPMG's loaning of employees to its audit clients; although no enforcement action was taken, the SEC issued a Section 21(a) Report of Investigation, to "address uncertainty" regarding the SEC's interpretation of "acting as an employee" under Rule 2-01.

According to the SEC Order  in the enforcement action, at various time over a four-year period, "KPMG provided prohibited non-audit services to affiliates of three of its SEC audit clients [all NYSE-listed companies]….With regard to Company A, KPMG hired an employee who had recently retired from a senior position at Company A's affiliate, and then loaned him back to that affiliate to do the same work he had done as an employee of that affiliate. This engagement involved the loaned employee acting as a manager, employee and advocate for the affiliate, causing KPMG to violate Rule 2-01 of Regulation S-X of the Exchange Act. With regard to Company B, KPMG was its audit firm, but also provided various prohibited non-audit services, including restructuring, corporate finance, and expert services, to an affiliate of Company B. With regard to Company C, KPMG was its audit firm, but also provided prohibited non-audit services, including bookkeeping and payroll services, to affiliates of Company C. These non-audit services caused KPMG to violate the independence rules in relation to Company B and Company C. Finally, certain KPMG employees also owned stock in Company A and affiliates of Company B resulting in a further violation of the independence rules." According to the press release, the SEC found that KPMG "violated Rule 2-02(b) of Regulation S-X and Rule 10A-2 of the Exchange Act, and caused violations of Section 13(a) of the Exchange Act and Rule 13a-1. The order further finds that KPMG engaged in improper professional conduct as defined by Section 4C of the Exchange Act and Rule 102(e) of the Commission's Rules of Practice."

While KPMG will pay $8.2 million to settle the SEC's charges –pretty small potatoes for KPMG—the key issue for companies is that the independence violations cause the affected companies to violate the Exchange Act and call into question the audited financial statements these companies filed with their 10-Ks. As a result, independence determinations are important, not just for audit firms, but also for companies and audit committees. As noted in the Section 21(a) Report:

"The legal consequence of an auditor lacking independence is that it violates, and causes its audit clients to violate, various provisions of the federal securities laws. For example, Rule 2-02(b) of Regulation S-X requires that each accountant's report state "whether the audit was made in accordance with generally accepted auditing standards ["GAAS"]." GAAS, in turn, requires auditors to maintain strict independence from their audit clients. Consequently, issuing an audit report falsely stating that the audit was performed in accordance with GAAS violates Rule 2-02(b). Likewise, Exchange Act Rule 10A-2 separately provides that it shall be unlawful for an auditor not to be independent under Rule 2-01(c)(4). In addition, any time that non-independent audit reports are filed with an SEC audit client's annual reports, this causes the audit client not to comply with Section 13(a) of the Exchange Act and Rule 13a-1 thereunder (requiring that financial statements included in annual reports filed with the Commission be audited by an independent accountant). Under such circumstances, the auditor may also be held liable for causing such violations. [footnotes omitted]"

The press release also noted that the SEC also "considered whether KPMG's independence was impaired by the firm's practice of loaning non-manager tax professionals to assist audit clients on-site with tax compliance work performed under the direction and supervision of the clients' management. While the SEC did not bring an enforcement action against KPMG on this basis, it has issued a report of investigation noting that by their very nature, so-called ‘loaned staff arrangements' between auditors and audit clients appear inconsistent with Rule 2-01 of Regulation S-X, which prohibits auditors from acting as employees of their audit clients." Other points raised in the report include the following:

• "An auditor may not provide otherwise permissible non-audit services (such as permissible tax services) to an audit client in a manner that is inconsistent with other provisions of the independence rules.
• An arrangement that results in an auditor acting as an employee of the audit client implicates Rule 2-01 regardless of whether the accountant also acts as an officer or director, or performs any decision-making, supervisory, or ongoing monitoring functions, for the audit client.
• Audit firms and audit committees must carefully consider whether any proposed service may cause the auditors to resemble employees of the audit client in function or appearance even on a temporary basis."

The SEC's order does not identify the clients whose audits were potentially compromised by loaned tax staff arrangements, even though no enforcement action was brought. However, this article in Bloomberg, "Is the SEC Going Easy on General Electric?," first cited in thecorporatecousnel.net blog, suggests that, based on previous reporting, "it's a safe bet that one of them was GE." The author observes that KPMG has audited GE's financials for over 100 years, and former SEC chief, Mary Schapiro, recently joined the GE board.

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