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Audit Firm Sanctioned for Violating Independence Rules

An independent auditor that violated the auditor independence standards has been suspended from accepting new audit engagement clients for six months by an SEC administrative law judge. In addition, the firm was ordered to hire an independent consultant acceptable to the SEC to work with it to assure that leadership has implemented policies that can reasonably be expected to result in compliance with the auditor independence rules. A cease and desist order was also entered against the firm, which will disgorge the audit fees received from the client during the relevant period.

The SEC's Codification of Financial Reporting Policies, an authoritative discussion of auditor independence, prohibits direct and material indirect business relationship between an auditor and a client, unless the auditor is a consumer in the normal course of business. The law judge found that the auditor and the audit client entered into a licensing agreement that created a direct business relationship under which the success of a jointly developed product was in the best interests of both the auditor and the client company. For example, the greater the sales of the product, the higher the royalties that the auditor paid the company.

The auditor could not use the consumer exception, emphasized the judge, since the SEC has never found that an auditor who develops a product that contains a proprietary asset of its client and markets the product bearing the client's name to persons using the client's product is a consumer in the normal course of business. The judge also rejected the argument that the auditor's actions were justified because of the matter and its size in respect to the size of the firm and the company. The SEC has rejected the use of a materiality standard when determining auditor independence, she emphasized, and, in addition, she reasoned that accepting the logic underlying the argument would hold larger companies to a lower legal standard than smaller companies.

The auditor thus violated Rule 2-02 of Regulation S-X because it was not independent when it audited the company's financial statements for fiscal years 1994 through 1999. Moreover, the auditor's lack of independence caused the company to violate the federal securities laws.

The product in question allowed human resource managers to access existing employee information located internationally or at corporate headquarters. The intellectual assets of both the auditor and the client were the integral components of the product. According to the judge, knowledgeable people described the product in terms that reasonable people would interpret as indicating a joint business venture or joint product. Further, the record established that the audit firm and the client acted as partners in the sense that they shared a business interest and acted together in a variety of ways for their mutual benefit.

The law judge found that a reasonable investor who knew of the auditor and the client's mutual interest in the business success of the product would make an objective and pragmatic assessment that the firm would not be objective in its audit of the company.

¨ Ernst & Young LLP, Ltd. (SEC) will be published in a forthcoming REPORT