KPMG Violates Independence Rules

The SEC issued an order against KPMG last week for violating the auditor independence rules.

This topic has not been in the headlines.  "Auditor independence" is one of those arcane issues that most people ignore.  But it is fundamental to the smoothe operations of the securities markets, and the compromised independence of the auditors is a basic problem in the marketplace today.

An auditor is someone who job it is to inspect the books of account of a company and report on whether they are being properly maintained and whether the financial reports of the company are accurate.  There are, essentially, two kinds of auditors.  An internal auditor is someone who is hired by the management of the company and provides reports to management.  An external or independent auditor purportedly acts on behalf of the investors of the company and issues reports intended for those investors.  Since the enactment of the securities laws in the 1930s, all public companies are required to have an independent auditor undertake an audit to the companies and certify as to the accuracy of the financial statements of the company.  When the company issues its annual report that says its earnings were $5.00 per share in 2013, the independent auditor's job is to say "yep, that's accurate!"


Why do we require independent audits?  Well, as everyone is aware, there are incentives to companies to lie about how good they are doing.  Audits are supposed to act as checks on that.

But what does it mean to be "independent?"  Well, there are actually a whole bunch of rules on that.  Basically, it means that you can't have a financial interest in the company that you are auditing.  Here is a link to the SEC rules governing the independence requirements of auditors and a quick perusal will show they are extensive.  You and your family can't own an interest in the company you're auditing, can't be employed by them, can't provide certain services to them for a fee, etc.

However, the rules do not prevent the auditor from providing any services.  Some services are ok, although how the line between ok services and non-ok services is drawn has always been a mystery to me.  For example, it has never made sense to me that an accounting firm that provides tax services to a company should also be able to provide auditing services, and yet it is.  Drawing the line between what is permissible and not permissible is pretty difficult, but the reason this line drawing is necessary is because non-audit services are extremely lucrative and accounting firms have lobbied hard for the right to continue providing them.  Sometimes, however, they cross the line as KPMG did in this case.

An interesting aspect of this is that, at the same time it issued its order regarding KPMG's violations, the SEC also issued a report on certain tax services provided by the firm to one of its clients.  The SEC decided not to pursue an action against KPMG on this point, but issued the report because "deems it important and in the public interest...to address uncertainty regarding the Commission's interpretation" of its independence rules.   Generally, a question of line-drawing.

But, of course, all of these rules don't make the auditor truly independent of the company he is auditing because of one fundamental fact: the auditor is supposedly acting on behalf of investors (and potential investors) in the company, but they are not paying the fee for the audit.  The company is.  As one commentator has noted:

The core issue is that the statutory audit is simply a commodified cost of doing business for issuers that imposes an impossible obligation to serve an unspecified “investing public” on the auditors. Yet, this investing public neither hires, fires, nor controls the auditors. Instead, the audit relationship is managed by the board of the company being audited. The resultant conflict of interest has proven to be insurmountable even after multiple reform efforts.

This commentator suggests reforms that strengthen the relationship between the auditors and their shareholders, including (for some godawful reason I can't fathom) doing away with the mandatory audit requirement.

This is not the answer.   The answer instead is to do something that was proposed but rejected when the securities laws were passed in the 1930s:

The SEC, in an accounting series release (ASR), referred to Carter's role [Colonel Carter, president of the New York State Society of Certified Public Accountants] as at the hearings as that of "a representative of the accounting profession," and stated that the Senate committee revised the bill in accordance with Carter's "suggestions." In fact, the SEC implied that the committee was convinced by Carter's persuasion, and persons generally recall the episode that way.

In that ASR the SEC characterized Carter's testimone at the 1933 Senate hearings as part of a thorough investigation by the Senate Committee of what the role of the auditor under the 1933 Act would be:

The Committee considered at length the value to investors and to the public of an audit by accountants not connected with the company or management and whether the additional expense to industry of an audit by independent accountants was justified by the expected benefits to the public. The Committee also considered the advisability and feasibility of requiring the audit to be made by accountants on the staff of the agency administering the Act. 

This statement belies that Senate committee's lack of knowledge of and disinterest in, the work of auditors.

Carter's testimony significantly influenced the Senate committee to change a major provision of the 1933 act, from requiring issuers of securities to be audited by government auditors to rquiring those audits to be done in the private sector.

In other words, have the government audit the financial statements of public companies, just like the IRS audits their tax returns.

Sounds like a great idea to me.  Which is probably why it will never happen.