United States: SEC Charges PwC With Independence Violations

Last Updated: October 3 2019
Article by Cydney Posner

Last week, the SEC announced settled charges against PwC and one of its audit partners for violations of the auditor independence rules. As described in the Order, the violations included "performing prohibited non-audit services during an audit engagement, including exercising decision-making authority in the design and implementation of software relating to an audit client's financial reporting, and engaging in management functions." PwC was also charged with "improper professional conduct" in connection with 19 engagements by failing to comply with PCAOB rules requiring an auditor to "describe in writing to the audit committee the scope of work, discuss with the audit committee the potential effects of the work on independence, and document the substance of the independence discussion." According to the Order, the failure to properly advise these audit committees prevented them from examining whether the non-audit services affected PwC's independence. Notably, because it issued an audit report stating that it was independent when it was not, PwC was also charged with having caused its audit client to violate the Exchange Act by filing with the SEC an annual report that contained materially false or misleading information and that failed to include financial statements audited by an independent public accountant, as required. The SEC concluded that these violations reflected "breakdowns in [PwC's] system of quality control to provide reasonable assurance that PwC maintained independence." In addition to requiring PwC to pay disgorgement and penalties, the SEC censured PwC. For companies, it is important to keep in mind that the consequences of violations of the auditor independence rules apply not just to the audit firm, but also to the audit client. An independence violation may cause the audit client to violate the Exchange Act, as in this case, and/or lead the auditor to withdraw its audit report, requiring the audit client to have a re-audit by another audit firm. Audit committees need to be on the alert for the possibility of auditor independence violations and be vigilant regarding the performance of non-audit services.

Applicable Rules

Reg S-X Rule 2-01(c) provides a non-exclusive list of circumstances and relationships that are considered to be inconsistent with auditor independence, including the performance of certain non-audit services for audit clients. In determining which non-audit services could impair independence, the SEC took into account several basic principles, including that an auditor cannot perform management functions and that an auditor cannot audit his or her own work. Among the specific proscribed non-audit services are prohibitions against the independent auditors' "engaging in the design or implementation of systems that are significant to the audit client's financial statements or other financial information systems taken as a whole, [performing] any internal audit service related to the internal control over financial reporting, or [performing] management functions for audit clients." These prohibitions are subject to specific exceptions, including where it is reasonable to conclude that the results of the service will not be subject to audit procedures.

Under PCAOB Rule 3525, an auditor, in seeking audit committee pre-approval to perform non-audit services for an audit client related to internal control over financial reporting, "must describe in writing to the audit committee the scope of the work, discuss with the audit committee the potential effects of the work on independence, and document the substance of the independence discussion." The rule is designed to provide the audit committee sufficient information to adequately consider how the services might affect auditor independence and otherwise carry out its oversight responsibilities.

The Order—Independence Issues

In 2014, for one audit client, PwC assisted with the design and implementation of Governance Risk and Compliance software used to monitor controls over financial reporting, including generating control-related information and data that would help in assessing the effectiveness of internal controls related to financial information systems. According to the Order, SEC

"independence rules prohibit independent auditors from designing and implementing systems such as GRC where the software aggregates source data, or generates information significant to the clients' financial statements or other financial systems as a whole. Designing, implementing, or operating systems affecting the financial statements may also place the accountant in a management role, or result in the accountant auditing his or her own work or attesting to the effectiveness of internal control systems designed or implemented by that accountant. The independence rules also prohibit an independent auditor from performing management functions."

Nevertheless, when the audit client asked PwC to submit a proposal to design and implement the GRC system and expressly inquired whether performance could impair independence, an audit partner (who was a member of the audit engagement team and responsible for supervising the performance of non-audit services) responded "no issues." However, when he sought internal approval to perform the non-audit services, the audit partner provided PwC's Risk Assurance Independence group with a draft engagement letter describing the services only as performing assessments and "providing observations and recommendations," not design and implementation. The audit client was understandably perplexed, having expected PwC to design and implement the GRC system, quite a different animal. To address that inconsistency, the audit partner apparently confirmed orally to the company, engagement letter notwithstanding, that PwC would still be providing design and implementation services.

Both the company and some PwC employees appear to have considered the GRC project to involve design and implementation. For example, according to the Order, in internal PwC communications, some "PwC employees characterized the engagement as a design and implementation project." In addition, the company "considered PwC to be the system implementer and deferred to PwC on best practices for settings that needed to be included in the system." Ultimately, the Order concluded, PwC "exercised decision-making authority in designing and configuring the GRC module."

Although the company did not use the GRC software in connection with its 2014 financial statements, PwC was, at the time, performing the audit of the financial statements and internal control over financial reporting for 2014. In early November 2014, before the company's audit report was issued, the PCAOB advised PwC of its independence concerns, and PwC sought a consultation with the OCA.

At about the same time, PwC also performed pre-implementation services related to the company's upgrade of its enterprise software and related programs. As presented for internal PwC approval to the RAI, those services were described in the draft engagement letter as consulting assessments to be performed under AICPA consulting standards, with the audit client providing over 1,000 hours of assistance. When PwC's RAI raised independence concerns because the engagement appeared to be a prohibited internal audit co-sourcing arrangement, the audit partner changed the description of the services from a project providing non-audit consulting services to providing additional audit procedures. The project was then approved, without the proper internal review to assess auditor independence prohibitions. The services continued to be characterized as audit services even when it became clear that the system upgrade would not become operational for two years after the audit year, making it "impossible" for the project to be part of that audit.

PwC did not advise the company's Audit Committee that the work was now being characterized as audit work, and as result, the Audit Committee could not consider and did not authorize the services as part of the audit. The Order concludes that, for a number of reasons, the project "remained a non-audit services project related to financial information systems design and implementation upon which PwC needed to directly rely on [the company's] Internal Audit group."

The Order—Improper Professional Conduct

Separately, the Order charges that,

"[f]rom 2013 through 2016, on nineteen engagements involving fifteen SEC-registrant audit clients, PwC violated PCAOB Rule 3525 by failing to obtain proper audit committee pre-approval pursuant to the requirements thereunder. On numerous engagements, PwC mischaracterized non-audit services as audit work....PwC failed to discuss with the audit committees for fifteen issuers the scope of the services and the implications of performing the work on PwC's independence, thereby depriving the committees of their responsibilities to evaluate fully the provision of non-audit services, and to assess the potential effect of those services on auditor independence."

One example of this conduct was the failure of PwC to adequately advise the Audit Committee of the company above about the non-audit services related to the GRC project "in writing and in sufficient detail such that the audit committee would understand what was being sought to be approved." PwC gave the Audit Committee in writing only the title of the project. As a result, the Committee was unable to "make an informed decision about the scope of the work and how the work might affect PwC's independence, thus depriving the committee of its oversight responsibilities." The Order provides several examples of similar failures by PwC, including examples where it characterized non-audit services as audit services even though the services were performed on a system that was not even operational during the audit year. In some cases, PwC did not seek Audit Committee pre-approval of non-audit services as required.

The Order—Conclusions

The Order concluded that "PwC's quality control system did not effectively provide reasonable assurance that the firm and its employees maintained independence from their SEC-registrant audit clients." More specifically, PwC "did not: 1) adequately evaluate the nature and scope of proposed non-audit service engagements for permissibility; 2) properly characterize work as audit or non-audit services; 3) review and monitor non-audit work being performed for audit clients to confirm the services were permissible; and 4) properly describe to audit committees of SEC-registrant clients the nature of the audit and non-audit services to be provided."

The SEC determined that, by issuing an audit report stating that PwC had conducted its audit in accordance with PCAOB standards when it had not, PwC had violated Rule 2-02(b)(1) of Reg S-X. In addition, by failing to conduct the company's audit in accordance with PCAOB standards and issuing an audit report stating that PwC was independent when it was not, PwC had caused the company to violate Exchange Act Section 13(a). Finally, the SEC determined that PwC engaged in improper professional conduct pursuant to Section 4C(a)(2) of the Exchange Act and Rule 102(e)(1)(ii) of the SEC's Rules of Practice.

PwC agreed to undertake various remedial efforts, and the SEC imposed a censure, a cease-and-desist order, and disgorgement and penalties of almost $8 million. The SEC also imposed a cease-and-desist order on the audit partner, prohibited him from practicing before the SEC for at least four years and imposed penalties of $25,000.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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