Holding auditors accountable for complicity in corporate fraud

Last month, Sarbanes-Oxley turned 20 years old. Sarbanes-Oxley, a landmark law that transformed auditing and financial reporting in the wake of the Enron and Arthur Andersen scandal, has proven to be one of the most effective financial laws passed since the enactment of the Securities Act. of 1933 and the Securities Exchange Act of 1934.

Among other things, Sarbanes-Oxley has caused companies to adopt and implement much more robust financial controls, resulting in fewer and smaller restatements. But since its enactment, the financial markets and the Big Four accounting firms have changed dramatically. Audit firms have extensive advisory services and financial products are much more complex. Legal developments have also made it increasingly difficult to hold fraudsters accountable when they violate audit rules and securities laws. Perhaps most alarming is the dangerous tendency of auditors to lack independence from their clients, creating conflicts of interest that we must not ignore.

While Sarbanes-Oxley led to a great improvement in financial reporting, it did not go far enough to ensure auditor independence. Hopefully the necessary changes will be made before the next audit scandal rocks the markets and hurts investors.

“Independent” Auditors

The Sarbanes-Oxley Act attempted to ensure the independence of auditors, requiring engagement partners to change clients every five years and auditing firms to prohibit certain consulting work for audit clients. But the concept of an independent auditor in the United States has faded as accounting firms have become more integrated with their clients, leading to an erosion of investor confidence and opening the door to statements. corporate inaccuracies, breaches of fiduciary duty or, even worse, fraud.

An illustration of this is the recent report that Ernst & Young compiled – and what federal authorities now claim is a sham – tax shelters that allowed Perrigo, a leading manufacturer of over-the-counter drugs, to avoid over $100 million in federal taxes. When Perrigo’s external auditor, BDO, questioned the legality of the tax shelters, Perrigo replaced BDO with Ernst & Young, which then blessed the transactions its advisory arm helped create. This is a great example of why there needs to be a clear line defining what it means to be an independent auditor and outlawing what activities are permitted that violate auditor independence rules.

Although the Securities Exchange Commission has issued guidance on the kinds of relationships that accounting firms and their auditing divisions can and cannot have with their clients, it’s no surprise that this activity still takes place. The customer, after all, is the one who pays the bills.

Role of litigation

Auditor independence issues also often play a significant role in private litigation. For example, investors recently settled a securities lawsuit against Mattel Inc. and its auditor, PwC, for $98 million. According to Mattel’s own audit committee, PwC’s lead audit partner for the engagement violated auditor independence rules by providing recommendations on candidates for Mattel’s CFO positions. A Mattel whistleblower mentioned in the complaint also alleged that PwC then helped cover up the inaccuracy of Mattel’s valuation allowance that ultimately led to the need for a restatement. Mattel had incorrectly understated its net loss by about $109 million, overstating its earnings by $0.32 per share.

While Sarbanes-Oxley has attempted to prevent such independence trade-offs, the Mattel/PwC case demonstrates that the legislation has not gone far enough and that further regulatory action and civil lawsuits are needed to protect investors. .

Call on regulators to get tough

In the United States, accounting firms are regulated by both the SEC and the Public Company Accounting Oversight Board, a quasi-public agency created by Sarbanes-Oxley. SEC and PCAOB rules require auditing firms to maintain an independent relationship with the companies they oversee. In 2020, the SEC clarified the auditor independence rule under then-SEC Chairman Jay Clayton. Under the revised rules, firms are required to limit the number of services they provide to a single client to ensure the objectivity and impartiality of their audit work.

Unfortunately, since the fall of Arthur Anderson following the Enron scandal, the SEC and the PCAOB have often failed to prosecute auditors who rambled with the rules. The death knell of Arthur Andersen – which was one of the ‘big five’ audit firms – was a blow to the accounting industry and sent chills down the spines of many regulators by filing lawsuits against accounting firms. ‘audit. When the Supreme Court later reversedgovernment obstruction of the obstruction of justice case against Arthur Andersen, this further hampered law enforcement efforts.

The SEC recently launched a new enforcement initiative to investigate conflicts of interest at the nation’s largest accounting firms, a key step to ensure auditors act as independent watchdogs. One suggestion is that the SEC and PCAOB look across the pond at the recent hardline efforts by the Competition and Markets Authority and the Financial Reporting Council to regulate the separation of audit and non-audit practices of the largest UK audit firms – the same Big Four as in the US, under the UK’s Restoring Trust in Audit and Corporate Governance scheme.

In addition to the Big Four creating a separate regulatory audit committee, the April 2022 FRC proposed revisions to the Code of governance for audit firms stipulates a maximum term of nine years to guard against threats to independence and requires that an independent non-executive participate in the audit process alongside the audit committee. The INE would be entirely independent of the auditor and of the audited entities. He would also be expected to represent the public interest and act for the benefit of the common good, including that of the shareholder and other stakeholders.


The health of US financial markets and investors depends on auditors performing their critical access control function. To do this, accounting firms must be truly independent of the companies they audit.

This article does not necessarily reflect the views of the Bureau of National Affairs, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Laura H. Posner is a partner in the securities litigation and investor protection and ethics and trust advisory practices of Cohen Milstein. Before joining Cohen Milstein in 2017, Posner was the bureau chief for the New Jersey Bureau of Securities.

We would love to hear your smart and original point of view: write for us

Comments are closed.