KPMG Faces Conflict of Interest Charges in Audit of JobsOhio

KPMG is at it again. In the most recent allegation of violating independence standards of the accounting profession, KPMG’s Columbus, Ohio office was auditing JobsOhio’s books while, at the same time, an out-of-state office of the firm was seeking $1 million in taxpayer money from JobsOhio for an unnamed client. As the state’s lead economic-development agency, JobsOhio is charged with recommending financial incentives for companies seeking to relocate in the state. On November 5, 2012, about the time that the audit was being conducted, KPMG was also listed on a sheet of eight pending grant commitments from the state for fiscal year 2013, one of which was for the unnamed client.

I will return to this case later on, but first a review of the recent insider trading charges against the firm. I have previously written about about insider trading at KPMG. In that case, KPMG resigned two audit accounts and withdrew its blessing on the financial statements of Herbalife for the past three years and of Skechers for the past two. KPMG withdrew its audit opinions, a serious step for any auditor, after concluding it was not independent because of alleged insider trading.

The KPMG insider trading case is a particularly egregious one because it involves an auditor tipping off a friend about stock of audit clients. Scott London, the KPMG auditor, did not trade in the stock himself but he did gain personal wealth (“unjust enrichment”) when his friend, Brian Shaw, used the inside information to trade in stock of Herbalife Ltd. and Skechers USA Inc. Shaw benefitted by $1.27 million on the trades. Shaw paid London $50,000 cash and gave him a Rolex watch.

Looking at the JobsOhio case, as KPMG was auditing JobsOhio's books in the fall of 2012 the firm also was seeking $1 million in taxpayer money from JobsOhio for an unnamed client. JobsOhio, the state's privatized development agency, said that the grant request was handled separately from and without the knowledge of the firm's auditing division.

The ethical problem for KPMG in the JobsOhio case is independence in appearance. This is an important requirement of an independent audit because factual independence is sometimes difficult to determine. Factual independence goes to the mindset of the auditor in approaching an audit with objectivity and professional skepticism. It is difficult to assess so appearances serve as a proxy in that regard.

JobsOhio denies any conflict of interest. Laura Jones, a spokeswoman for JobsOhio, said KPMG LLP's Columbus office conducted the audit, but the grant was sought by an out-of-state office. "The fact that KPMG serves JobsOhio and countless other businesses ... from the same office here in Columbus is not a conflict in our minds," she said, adding that “the state also monitors and ultimately approves taxpayer-funded incentives to companies.”

Most observers would probably conclude that the two offices of KPMG would never collude on their own to achieve some benefit for the firm. However, the more troubling issue is whether JobsOhio might perceive some pressure on them to provide financial incentives to the KPMG audit client perhaps to make it less likely that KPMG would point out problems with the JobsOhio audit, assuming any occur.

The accounting profession has strict independence standards to protect the public interest. Shareholders, creditors, and the beneficiaries of public funds rely on the honesty, trustworthiness, and responsibility of auditors to go the extra mile to ensure that the financial statements of entities that operate in the public interest are based on an independent audit – both in fact and in appearance.

KPMG is not alone in violating the most basic and cherished independence standards. As I have previously blogged, in 2010 Deloitte and Touche was investigated by the SEC for repeated insider trading by Thomas P. Flanagan, a former management advisory partner and a Vice Chairman at Deloitte. Flanagan traded in the securities of multiple Deloitte clients on the basis of inside information that he learned through his duties at the firm. The inside information concerned market moving events such as earnings results, revisions to earnings guidance, sales figures and cost cutting, and an acquisition. Flanagan’s illegal trading resulted in profits of more than $430,000. In the SEC action, Flanagan was sentenced to 21 months in prison after he pleaded guilty to securities fraud.

On January 7, 2013, the SEC announced it is investigating whether Ernst & Young violated independence rules by letting its lobbying unit perform work for several major audit clients. The SEC inquiry began shortly after Reuters reported in March 2012 that Washington Council Ernst & Young, the E&Y unit, was registered as a lobbyist for several corporate audit clients including Amgen, CVS Caremark, and Verizon Communications.

The problem for EY is that U.S. independence rules bar auditors from serving in an "advocacy role" for audit clients. The goal is to allow auditors to maintain some degree of objectivity regarding the companies they audit, based on the idea that auditors are watchdogs for investors and should not be promoting management's interests.

Finally, in December 2012, Thomson Reuters announced it signed a three-year contract with PwC, the company’s auditor, to provide use of the Thomson Reuters ONESOURCE Corporate Tax solution for China. PwC U.K. also uses this Thomson Reuters software for its tax clients. Business alliances between a company and its auditor are prohibited under U.S. and U.K. auditor regulations. Once again an independence violation exists because such arrangements create a “mutuality of interests” as a result of the business relationship between the auditor and audit client.

I am very concerned about the actions of KPMG in the JobsOhio case, Deloitte & Touche and KPMG insider trading scandals, EY serving as an advocate for an audit client, and PwC in becoming involved in a joint business relationship with an audit client. These relationships create threats to independence and taint the audit because of conflicts of interest.

The SEC needs to look into these matters, not just individually but collectively, and determine whether the Big-4 CPA firms have built adequate safeguards to protect audit independence and whether more stringent independence and ethics standards are needed to protect the public trust in the independent audit.

Blog posted by Steven Mintz, aka Ethics Sage, on May 7, 2013