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Contemporary Auditing
Real Issues
and
Cases
Twelfth Edition
Michael C. Knapp
University of Oklahoma
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BRIEF CONTENTS
Prefacexxi
SECTION
1
Comprehensive Cases
Wells Fargo & Company
Weatherford International
Caterpillar Inc.
Gemstar
Enron Corporation
Lehman Brothers Holdings, Inc.
Just for FEET, Inc.
Health Management, Inc.
The Leslie Fay Companies
Le-Nature’s Inc.
Navistar International Corporation
Livent, Inc.
ZZZZ Best Company, Inc.
DHB Industries, Inc.
New Century Financial Corporation
Madoff Securities
AA Capital Partners, Inc.
2
Audits of High-Risk Accounts
Jack Greenberg, Inc.
Golden Bear Golf, Inc.
Take-Two Interactive Software, Inc.
General Motors Company
Lipper Holdings, LLC
CBI Holding Company, Inc.
Bankrate, Inc.
Belot Enterprises
Powder River Petroleum International, Inc.
LocatePlus Holdings Corporation
Overstock.com, Inc.
Parker-Halsey Corporation
Hampton & Worley
235
237
245
253
261
267
275
281
287
293
303
309
317
331
3
Internal Control Issues
The Trolley Dodgers
Howard Street Jewelers, Inc.
Avon Products, Inc.
339
341
343
345
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
1.9
1.10
1.11
1.12
1.13
1.14
1.15
1.16
1.17
SECTION
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
2.9
2.10
2.11
2.12
2.13
SECTION
3.1
3.2
3.3
1
3
19
35
45
55
73
89
103
119
131
139
153
167
181
197
215
225
v
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vi
Brief Contents
First Keystone Bank
Goodner Brothers, Inc.
Buranello’s Ristorante
Saks Fifth Avenue
The Boeing Company
Walmart de Mexico
Blakely Markets
Equifax Inc.
353
357
365
369
373
379
383
389
4
Ethical Responsibilities of Accountants
Creve Couer Pizza, Inc.
F&C International, Inc.
Suzette Washington, Accounting Major
Aaron Elrod, Sole Practitioner
Wiley Jackson, Accounting Major
Arvel Smart, Accounting Major
Zane Corbin, Accounting Major
Dell Inc.
395
397
401
405
407
413
415
417
423
5
Ethical Responsibilities of Independent Auditors
AmTrust Financial Services, Inc.
Herbalife International
Antoine Deltour
Universal American Corporation
Zero Tolerance
Cardillo Travel Systems, Inc.
American International Group, Inc.
Caesars Entertainment Corporation
IPOC International Growth Fund, Ltd.
Le-Nature’s Inc., Part II
Richard Grimes, Staff Accountant
427
429
433
441
447
453
457
463
467
471
477
479
6
Professional Roles
Kayleigh Caudell, Audit Senior
Brian Reynolds, Audit Senior
Madison Wells, Audit Manager
Tillman Rollins, Office Managing Partner
Leigh Ann Walker, Staff Accountant
Bill DeBurger, In-Charge Accountant
Hamilton Wong, In-Charge Accountant
Tommy O’Connell, Audit Senior
Avis Love, Staff Accountant
Charles Tollison, Audit Manager
481
483
489
493
501
507
509
513
517
521
525
3.4
3.5
3.6
3.7
3.8
3.9
3.10
3.11
SECTION
4.1
4.2
4.3
4.4
4.5
4.6
4.7
4.8
SECTION
5.1
5.2
5.3
5.4
5.5
5.6
5.7
5.8
5.9
5.10
5.11
SECTION
6.1
6.2
6.3
6.4
6.5
6.6
6.7
6.8
6.9
6.10
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Brief Contents
SECTION
7
7.1
7.2
7.3
7.4
7.5
7.6
7.7
7.8
7.9
7.10
SECTION
8.1
8.2
8.3
8.4
8.5
8.6
8.7
8.8
8
Professional Issues
Ligand Pharmaceuticals
Sarah Russell, Staff Accountant
Washington Council Ernst & Young
Internet Infamy
Fred Stern & Company, Inc.
(Ultramares Corporation v. Touche et al.)
First Securities Company of Chicago
(Ernst & Ernst v. Hochfelder et al.)
Texas Drug Warehouse
Frank Coleman, Staff Accountant
Olivia Thomas, Audit Senior
The Red Carpet
529
531
537
541
547
International Cases
Longtop Financial Technologies Limited
Kaset Thai Sugar Company
Republic of Somalia
Republic of the Sudan
Shari’a
Olympus Corporation
Razia
The Bank of Tokyo
591
593
599
603
607
611
621
631
635
551
559
565
569
573
581
Index639
Summary of Topics by Case
651
Summary of Cases by Topic
669
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vii
1
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SECTION
1
COMPREHENSIVE
CASES
Case 1.1
Wells Fargo & Company
Case 1.2
Weatherford International
Case 1.3
Caterpillar Inc.
Case 1.4
Gemstar
Case 1.5
Enron Corporation
Case 1.6
Lehman Brothers Holdings, Inc.
Case 1.7
Just for FEET, Inc.
Case 1.8
Health Management, Inc.
Case 1.9
The Leslie Fay Companies
Case 1.10
Le-Nature’s Inc.
Case 1.11
Navistar International Corporation
Case 1.12
Livent, Inc.
Case 1.13
ZZZZ Best Company, Inc.
Case 1.14
DHB Industries, Inc.
Case 1.15
New Century Financial Corporation
Case 1.16
Madoff Securities
Case 1.17
AA Capital Partners, Inc.
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CASE 1.1
Wells Fargo & Company
Henry Wells and William Fargo, two East Coast businessmen, recognized that the
California Gold Rush in the Sierra Nevada Mountains east of San Francisco had created a wealth of lucrative business opportunities for investors willing to accept a high
risk of failure. After raising $300,000 from friends and business associates, the two
adventurous entrepreneurs established San Francisco-based Wells Fargo & Company
in 1852. At the time, San Francisco was a rapidly growing and largely lawless boomtown populated by 35,000 residents, including a ragtag collection of con artists, hustlers, and other ne’er-do-wells with shady backgrounds. Just four years earlier, San
Francisco had been a sleepy fishing village with fewer than 500 residents.
A Wild West Mindset
Henry Wells, William Fargo, and their partners decided the two business services
most needed by San Franciscans were transportation and banking. After acquiring a
building near the intersection of present-day California and Montgomery Streets, the
new company plunged headfirst, if not blindly, into those lines of business. Despite
the lack of considerable forethought—or a comprehensive business plan—hard
work and ingenuity allowed Wells Fargo to thrive.
Wells Fargo initially made a name for itself in the San Francisco Bay Area by providing rapid and reliable freight, courier, and mail delivery services. In the late 1850s, the
company’s founders helped organize the famous Butterfield Overland Mail Route that
connected San Francisco with St. Louis. In a little more than three weeks, the company’s stagecoaches could deliver mail, freight, and bone-weary travelers from the banks
of the Mississippi River to the City by the Bay. Prior to the development of the first intercontinental railroad in 1869, Wells Fargo’s fleet of six-horse stagecoaches served as
the largest and most important transportation network west of the Mississippi River.
(In 1862, the business assumed control of the iconic but short-lived Pony Express.)
Wells Fargo’s banking operations expanded more slowly than its transportation
services. However, the federal government’s decision to nationalize major interstate freight and transportation lines during World War I forced Wells Fargo to focus
almost exclusively on the banking industry. An aggressive acquisition strategy and
the success of other key strategic initiatives implemented by successive generations
of opportunistic, if not freewheeling, senior executives made Wells Fargo the largest banking firm globally in terms of collective market value by 2015. At the time,
the company operated nearly 9,000 retail branches in 35 countries and had over
70 ­million customers.
In addition to its impressive size and unparalleled growth in the banking industry,
Wells Fargo ranked, until recently, among the most admired and respected companies in both the United States and around the globe. In 2015, for example, Wells Fargo
placed seventh in Barron’s annual survey of the world’s most respected multinational
companies. Disaster struck in late 2016 when a federal agency revealed Wells Fargo
had been fined $185 million for “unfair, deceptive, and abusive” banking practices.
The resulting headline-grabbing scandal caused Wells Fargo to plummet to the bottom of Barron’s annual survey.
3
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Section One
Comprehensive Cases
Growth at All Costs
During the early years of the twenty-first century, two strategic initiatives contributed
heavily to Well Fargo’s dramatic growth: a continually expanding product line of
financial services and the “cross-selling” of those services to the company’s e
­ xisting
customers. In fact, cross-selling eventually became the lynchpin of Wells Fargo’s
­industry-leading business model.
“Financial products per customer household” rates among the most important metrics in the retail banking industry. By 2013, Wells Fargo provided an average of 6.15
financial products to each of its customer households, four times greater than the
industry average. A noted bank consultant reported that “Wells Fargo is the master
of this . . . no other bank can touch them.”1 The bank’s long product line of services
for retail consumers included checking and savings accounts, credit card accounts,
automobile loans, student loans, retirement accounts, mortgage services, investment
portfolio management services, among others.
Wells Fargo’s cross-selling of its products was particularly successful from 2000 through
2013 when the company’s financial-products-per-customer-household measure rose by
approximately 50 percent. During this time frame, published reports in the Los Angeles
Times and various business publications suggested that intense pressure imposed
by Wells Fargo’s branch managers on lower-level employees to reach unrealistic sales
quotas accounted for the company’s cross-selling success. The branch managers, themselves, also faced heavy pressure from Wells Fargo’s regional managers and senior executives to reach or surpass the sales goals for their operating units each reporting period.
A 2013 Los Angeles Times article entitled “Wells Fargo’s Pressure-cooker Sales
Culture Comes at a Cost” prompted federal and local regulatory officials to begin
investigating the company’s marketing tactics. A former Wells Fargo entry-level
employee quoted in the article recalled how superiors had belittled subordinates
who failed to reach their assigned sales quotas. “We were constantly told we would
end up working for McDonald’s. If we did not make the sales quotas . . . we had to
stay for what felt like after-school detention, or report to a call session [to telephone
customers] on Saturdays.”2 A former Wells Fargo branch manager reported that if his
branch failed to reach its periodic sales goal, he was “severely chastised and embarrassed in front of 60-plus managers”3 from his sales region.
Even more troubling was an allegation that the extreme pressure exerted by Wells
Fargo management on the company’s entry-level salespeople drove them to routinely sign up customers for unwanted services. In one case, a former Wells Fargo
employee described how a homeless woman had been goaded into opening six
accounts—those accounts produced $39 in monthly fees for the given Wells Fargo
branch. Another former employee told a Los Angeles Times reporter she resigned her
position rather than continuing to force “unneeded and unwanted” financial products on customers “to satisfy sales targets.”4
A common deceptive practice used by Wells Fargo sales staff was transferring a
modest amount of funds from an existing customer account, such as, a checking
account, to a new, unauthorized account, a practice referred to internally as “simulated funding.” This tactic helped employees reach their periodic sales quotas while
also generating additional fees for Wells Fargo.
1. E. S. Reckard, “Wells Fargo’s Pressure-cooker Sales Culture Comes at a Cost,” Los Angeles Times
(online), 22 December 2013.
2. Ibid.
3. Ibid.
4. Ibid.
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CASE 1.1
Wells Fargo & Company
The pressure on Wells Fargo salespeople to market additional financial services
or products to customers was exacerbated by the company’s incentive compensation program.5 Employees in entry-level sales positions earned significant bonuses
each year if they met or surpassed their assigned sales quotas. In turn, Wells Fargo’s
branch managers and the company’s more senior managers and executives received
large bonuses if their subordinates achieved their sales goals.
Inattentive customers who did not monitor their Wells Fargo accounts became
unwilling accomplices of their bank’s scheming employees. If customers complained
about unauthorized accounts opened in their names, branch managers would typically step in and assuage their concerns with disingenuous explanations. “When
customers complained about the unwanted credit cards [or other unauthorized
accounts], the branch manager would blame a computer glitch or say the card had
been requested by someone with a similar name.”6
In early September 2016, the Consumer Financial Protection Bureau (CFPB), a
federal watchdog agency created by the 2010 Dodd-Frank Wall Street Reform and
Consumer Protection Act, announced Wells Fargo had been fined $185 million.
That figure included a $35 million fine imposed by the Office of the Comptroller of
the Currency and a $50 million fine levied by the County of Los Angeles. The fines
stemmed from “illegal” business practices employed by the banking giant, principal
among them signing up customers for financial services and products they had not
requested. The CFPB sanctions required Wells Fargo to refund customer fees linked
to the unauthorized accounts—the refunds were expected to be no more than $5 million. Wells Fargo was also required to hire an independent consultant to identify measures to prevent self-serving employees from taking unfair advantage of customers.
Wells Fargo’s senior management responded to the CFPB announcement by revealing that the individuals who had created the unauthorized customer accounts had
been fired. In total, the bank had dismissed 5,300 individuals involved in the scam—
the company’s workforce included more than 250,000 employees. Nearly all of the
fired employees occupied entry-level positions in Wells Fargo branches. The company also announced it was discontinuing the controversial cross-selling policy as of
January 1, 2017.
“Nothing Could Be Further from The Truth”
The CFPB reported that between 2011 and 2016, alone, Wells Fargo employees had
issued 600,000 credit cards and established 1.5 million bank accounts for customers
who had not requested them. Those figures shocked and enraged not only the Wells
Fargo customers who had been directly impacted by the scandal but also elected
officials and the general public.
The response of Wells Fargo’s senior executives to the scandal further infuriated the company’s critics. In the days and weeks following the CFPB’s stunning
announcement, company spokespeople rejected insinuations that the underhanded
banking practices were attributable to a high-pressure sales culture cultivated by top
management. Similar denials had been made in 2013 when the Los Angeles Times
leveled accusations of misconduct against Wells Fargo’s sales staff. The company’s
chief financial officer (CFO) at the time had bluntly claimed he was “not aware of
any overbearing sales culture”7 within the firm.
5. To stress the importance of branch employees “selling” new services to customers, Wells Fargo
began using the term “stores” rather than “branches” when referring to its operating units.
6. Reckard, “Wells Fargo’s Pressure-cooker Sales Culture Comes at a Cost.”
7. Ibid.
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Section One
Comprehensive Cases
John Stumpf, Wells Fargo’s chief executive officer (CEO), angrily dismissed allegations
that the deceptive banking practices emerged from a mercenary, if not corrupt, internal
culture within the company. In one statement, he insisted those activities were not the
result of an “orchestrated effort, or scheme as some have called it, by the company.”8 In
responding to a 2015 lawsuit alleging improper sales practices by Wells Fargo’s branches,
Stumpf snapped, “Nothing could be further from the truth on forcing products on customers . . . Did some things go wrong – you bet and that is called life. This is not systemic.”9
Following the announcement of the CFPB sanctions, a former Wells Fargo branch
manager said he was “disgusted” by John Stumpf’s effort to divert responsibility for the
scandal from the company’s senior management to the 5,300 lower-level employees
fired by the company. “Corporate executives designed the sales quota systems and
created the culture of harassment and fear when we did not meet them. When John
Stumpf blamed the frontline workers for the unauthorized accounts, I was disgusted.”10
Critics of John Stumpf were quick to point out that he had maligned the new banking regulations prompted by the massive financial crisis of 2008–2009 that had undercut the stability of the U.S. banking system. That crisis had been attributed, in part, to
high-risk, if not reckless, policies implemented by the nation’s largest banks, including Wells Fargo. While accepting the 2013 “Banker of the Year Award” from a major
trade publication, Stumpf, the nation’s highest-paid banker, denounced the “plethora
of new banking regulations”11 that he believed were inconsistent with a free market
economy. Ironically, Stumpf had failed to criticize the federal government’s decision
a few years earlier to suspend free-market conditions by providing Wells Fargo with
$25 b
­ illion in “bailout” funds to help it weather the enormous economic crisis.
As the controversy over Wells Fargo’s unlawful banking practices continued to
grow, the U.S. House Financial Services Committee and the U.S. Senate Banking
Committee held hearings in late September 2016 to investigate the scandal. In his testimony before those committees, John Stumpf “stuck to the same script he had used
throughout the crisis. The problem, he explained, was an ethical lapse limited to the
5,300 employees, most of them low-level bankers and tellers, who had been fired for
their actions since 2011.”12
Members of both political parties verbally battered Stumpf during the congressional hearings. His most relentless critic was U.S. Senator Elizabeth Warren. Senator
Warren pointed out that in addition to the tens of millions of dollars in salary and
other compensation benefits Stumpf had received during the time frame covered
by the CFPB investigation, the value of his ownership interest in Wells Fargo had
increased by $200 million during that five-year period. After telling Stumpf he should
resign, Warren added angrily, “You should give back the money you took while this
scam was going on, and you should be criminally investigated by the Department of
Justice and the Securities and Exchange Commission.”13
8. M. Corkery, “Wells Fargo’s John Stumpf Has His Wall Street Comeuppance,” New York Times (online),
19 September 2016.
9. W. Frost and D. Giel, “Wells Fargo Board Slams Former CEO Stumpf and Tolstedt, Claws Back
$75 Million,” www.cnbc.com, 10 April 2017.
10. L. Shen, “Former Wells Fargo Employees to CEO John Stumpf: It’s Not Our Fault,” http://fortune.com,
19 September 2016.
11. Corkery, “Wells Fargo’s John Stumpf Has His Wall Street Comeuppance.”
12. S. Cowley, “Wells Fargo’s Reaction to Scandal Fails to Satisfy Angry Lawmakers,” New York Times
(online), 29 September 2016.
13. J. Puzzanghera, “Sen. Elizabeth Warren Rips into Wells Fargo CEO’s ‘Gutless Leadership,’”
Los Angeles Times (online), 20 September 2016.
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CASE 1.1
Wells Fargo & Company
In early October 2016, shortly after he testified before Congress, John Stumpf
resigned as Wells Fargo’s CEO. A few months later, the company dismissed four other
executives linked to the cross-selling scandal.
Senators Take Aim at KPMG
After berating John Stumpf, congressional investigators turned their attention to
other parties associated with Wells Fargo, who they believed shared some measure
of responsibility for the company’s massive scandal. KPMG, Wells Fargo’s independent audit firm since 1931, soon found itself in Congress’s crosshairs.
Because independent auditors serve as the final line of defense against shortsighted corporate executives, legislative and regulatory authorities often examine
the role auditors played—or failed to play—in high-profile financial scandals. In
the decade prior to the Wells Fargo fiasco, the spectacular collapses of Enron and
WorldCom within 12 months of each other cost investors and creditors $200 billion.
Andersen & Co., which had served as the audit firm of both companies, faced fierce
criticism from numerous parties, including Congress, for not warning the public of
the criminal conduct that had undermined those two well-known companies.14
In the summer of 2002, public outrage stemming from the Enron and WorldCom
disasters spurred Congress to hurriedly pass the Public Company Accounting Reform
and Investor Protection Act, commonly referred to as the Sarbanes–Oxley (SOX) Act.
Among other wide-ranging corporate reforms—including the creation of the Public
Company Accounting Oversight Board (PCAOB)—SOX requires large public companies to have their internal control over financial reporting (ICFR) audited annually
by their independent accounting firm.15 The existence of one “material weakness” in
a company’s ICFR mandates the issuance of an “adverse” opinion on those controls.
Congress expected that annual ICFR audits would discourage unscrupulous business practices such as those that had brought down Enron and WorldCom.
Beginning in 2004, when the SOX-mandated ICFR rules went into effect, KPMG
issued an unqualified or “clean” opinion each year on the effectiveness of Wells
Fargo’s ICFR, including 2011–2015, the time period covered by the CFPB’s investigation. Those unqualified ICFR opinions stood in stark contrast to harsh indictments of
Wells Fargo’s internal controls by other parties. The New York Times reported that the
“widespread nature of the illegal behavior [within Wells Fargo’s operations] showed
that the bank lacked the necessary controls and oversight of its employees.”16 In an
apparent reference to KPMG’s reports on Wells Fargo’s ICFR, a former federal regulator asked, “How does a bank that is supposed to have robust internal controls permit
the creation of [a large number of] dummy accounts?”17
Wells Fargo’s apparent internal control deficiencies caused several U.S. senators to demand KPMG explain why it had issued a clean opinion each year on the
14. A criminal conviction stemming from the Enron bankruptcy effectively forced Andersen & Co. to
cease operations. Although the U.S. Supreme Court subsequently overturned the conviction, the former
Big Five firm’s reputation had already been undermined.
15. SOX requires the management of each large public company to issue an annual report on the effectiveness of the organization’s ICFR. Technically, auditors are required to then issue a report commenting
on the accuracy of client management’s ICFR assessment. Since the adoption of these requirements, the
auditing profession has treated the latter mandate effectively as a requirement to “audit” a client’s ICFR.
16. M. Corkery, “Wells Fargo Fined $185 Million for Fraudulently Opening Accounts,” New York Times
(online), 8 September 2016.
17. M. Egan, “5,300 Wells Fargo Employees Fired Over 2 Million Phony Accounts,” www.cnn.com,
9 September 2016.
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8
Section One
Comprehensive Cases
company’s ICFR while the CFPB was finding evidence of pervasive fraud. Those four
senators, which included Senator Elizabeth Warren, sent a letter to KPMG’s CEO in
late October 2016—see Exhibit 1. In the letter’s prologue, the senators suggested that
KPMG’s failure to report Wells Fargo’s “illegal behavior” cast doubt on the “quality” of
the firm’s annual audits of the company’s ICFR.
The senators asked KPMG to respond to five questions. The key issue raised by those
questions was whether KPMG was “aware of any of the illegal sales practices committed
by Wells Fargo employees.” If KPMG had not been aware of those activities, the senators
EXHIBIT 1
October 27, 2016,
Letter Sent by
Members of U.S.
Senate to KPMG
Chairman
Lynne Doughtie
Chairman and Chief Executive Officer
KPMG U.S.
345 Park Avenue
New York, NY 10154
Dear Ms. Doughtie:
We are writing regarding KPMG’s role as the independent auditor of Wells Fargo’s financial
statements from 2011-2015, years in which the company was unable to detect and prevent
illegal sales practices by thousands of employees. Wells Fargo recently settled with federal
regulators for the company’s misbehavior in this massive fraud involving the creation of more
than one million unauthorized deposit accounts and over 560,000 fraudulent credit card
applications.
Wells Fargo dismissed 5,300 employees over a five-year period for these actions. But each
year during what the Consumer Financial Protection Bureau’s (CFPB) investigation concluded
to be “fraudulent conduct . . . on a massive scale,” KPMG conducted audits assessing Wells
Fargo’s internal control over its financial statements. These detailed audits were conducted
by “obtaining an understanding of internal control over financial reporting, assessing the
risk that a material weakness exists, and testing and evaluating the design and operating
effectiveness of internal control based on the assessed risk.” But none of KPMG’s audits
identified any concerns with illegal behavior that resulted in the creation of over two
million unauthorized accounts by thousands of employees – and that ultimately resulted
in the resignation of Wells Fargo’s CEO and a decline in the company’s stock price of more
than 10% in the days after the settlement with federal regulators. In fact, in each of your
audits, your firm concluded that Wells Fargo “maintained . . . effective internal control over
financial reporting.”
The Sarbanes-Oxley Act of 2002 was passed into law in part to address the problem of
companies like Enron whose internal auditors’ lack of independence enabled them to produce
unreliable public financial reports and obscure problems with their companies. That is why
the Act requires financial statements of public companies to be audited by an independent
accountant and filed with the Securities and Exchange Commission (SEC). But your firm’s
failure to identify the illegal behavior at Wells Fargo raises questions about the quality of
your audits and the effectiveness of the implementation of these Sarbanes-Oxley requirements
by the Public Company Accounting Oversight Board (PCAOB).
Therefore, we request answers to the following questions:
1) Was KPMG aware of any of the illegal sales practices committed by Wells Fargo employees
from 2011-2015 and addressed in the CFPB settlement?
If yes:
a. Did KPMG communicate this knowledge with top executives at Wells Fargo? If so,
please provide electronic or paper copies of any and all communications.
(continued)
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CASE 1.1
Wells Fargo & Company
9
b. Did KPMG have any internal discussions about Wells Fargo’s illegal sales practices and
their potential impact on the company’s financial statements and on the outcome of
the annual audits? If so, please provide all electronic or paper documents relating to
these discussions.
If no:
a. Please provide a detailed explanation of why KPMG failed to contemporaneously
identify or otherwise learn of Wells Fargo’s illegal activity during your audits.
b. Did you assess whether Wells Fargo had controls in place to prevent this illegal
activity? What was your assessment about the quality of these controls and how well
they were executed?
EXHIBIT 1—
continued
October 27, 2016,
Letter Sent by
Members of U.S.
Senate to KPMG
Chairman
2) Did any employee of Wells Fargo mislead any employee of KPMG about the extent and
impact of the unauthorized account creation addressed in the CFPB settlement during
your audits?
3) Has KPMG conducted any internal reviews, reexaminations, or reassessments of its Wells
Fargo audits in light of the information revealed in the settlement?
4) Has KPMG faced any disciplinary action or queries from the Public Company Accounting
Oversight Board (PCAOB) in relation to your audits of Wells Fargo? If so, please provide
details on these actions or queries.
5) Based on your present knowledge of the creation of unauthorized accounts at Wells Fargo,
does your firm stand by its conclusions from 2011-2015 that “Wells Fargo maintained, in
all material respects, effective internal control over financial reporting?”
Please provide complete answers to these questions by November 28, 2016. Thank you for
your attention.
Sincerely,
U.S. Senator Elizabeth Warren
U.S. Senator Bernard Sanders
U.S. Senator Mazie K. Hirono
U.S. Senator Edward J. Markey
Note: The original letter from the U.S. senators included extensive footnotes identifying the sources of
the quoted passages. Those footnotes can be found in the original version of the letter that is available
online. (https://www.warren.senate.gov/files/documents/2016-10-27_Ltr_to_KPMG_re_Wells_Fargo_
Audits_FINAL.pdf)
asked the firm to explain why its Wells Fargo auditors had “failed” to identify them. The
senators’ final question asked KPMG to indicate whether it stood by “its conclusions
from 2011–2015” that Wells Fargo had “maintained, in all material respects, effective
internal control over financial reporting” given the subsequent findings of the CFPB.
After multiple news services published the letter sent by the four U.S. senators to
KPMG, several parties came to the accounting firm’s defense. A Forbes article entitled “Elizabeth Warren Sends Misguided Letter to KPMG about Wells Fargo” insisted
that Senator Warren, her colleagues, and certain elements of the press did not understand the nature and purpose of the independent auditor’s ICFR-related responsibilities. The article took particular issue with a statement by CNN that “Each year, KPMG
put a stamp of approval on the procedures that Wells Fargo had in place to guarantee
the integrity of its financial statements.”18 Rather than “guaranteeing” the reliability of
18. R. Berger, “Elizabeth Warren Sends Misguided Letter to KPMG about Wells Fargo,” www.forbes.com,
31 October 2016.
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10
Section One
Comprehensive Cases
a client’s financial statements, the Forbes article stressed that auditors only provide
“­reasonable assurance” that an entity’s ICFR are operating effectively.
The Forbes article also rejected the premise that Wells Fargo’s improper sales practices were de facto evidence of a material weakness in the company’s ICFR. The financial
statement impact of those activities, which the article implied was limited to the few million dollars of customer fees Wells Fargo was forced to refund, was clearly “not material”
because it was “pocket change”19 compared to the company’s key financial benchmarks.
Those benchmarks included the $90 billion in revenues and the $22.9 billion net income
reported by the company for 2015. The article went on to reason that because Wells
Fargo had fired 5,300 employees who engaged in the illicit sales practices, the company’s
internal controls, in fact, appeared to have been “effective,” as reported by KPMG.
KPMG responded to Senator Warren and her colleagues in a letter dated November
28, 2016—see Exhibit 2. In that letter’s opening paragraph, KPMG stressed its commitment to “audit quality” and assured the senators it took “very seriously its role as
independent auditor of Wells Fargo’s financial statements and internal controls over
financial reporting.” KPMG then made an important observation that was reinforced
later in the letter: “At the outset, it is important to emphasize that not every illegal act
has a meaningful impact on a company’s financial statements or its system of internal controls over financial reporting.”
EXHIBIT 2
November 28,
2016, Letter Sent
to Members of
U.S. Senate by
KPMG Chairman
The Honorable Elizabeth Warren
317 Hart Senate Office Building
United States Senate
Washington, DC 20510
The Honorable Bernard Sanders
332 Dirksen Senate Office Building
United States Senate
Washington, DC 20510
The Honorable Mazie K. Hirono
330 Hart Senate Office Building
United States Senate
Washington, DC 20510
The Honorable Edward J. Markey
255 Dirksen Senate Office Building
United States Senate
Washington, DC 20510
Dear Senators Warren, Sanders, Hirono, and Markey:
Thank you for your letter dated October 27, 2016.
KPMG is committed to audit quality and to preserving the integrity of our capital markets and
takes very seriously its role as independent auditor of Wells Fargo’s financial statements and
internal controls over financial reporting. KPMG also takes very seriously the conduct described
in the Consumer Financial Protection Bureau (CFPB) settlement and other reports. At the
outset, it is important to emphasize that not every illegal act has a meaningful impact on a
company’s financial statements or its system of internal controls over financial reporting. From
the facts developed to date, including those set out in the CFPB settlement, the misconduct
described did not implicate any key control over financial reporting and the amounts reportedly
involved did not significantly impact the bank’s financial statements. Most importantly, KPMG
is confident that its audits and reviews of Wells Fargo’s consolidated financial statements were
appropriately planned and performed in accordance with applicable professional standards.
Listed below are your questions and our responses to your questions.
1) Was KPMG aware of any of the illegal sales practices committed by Wells Fargo employees
from 2011-2015 and addressed in the CFPB settlement?
(continued)
19. Ibid.
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CASE 1.1
Wells Fargo & Company
11
As part of KPMG’s audits of Well Fargo’s financial statements, KPMG performed procedures
to identify instances of unethical and illegal conduct. The audit team interviewed the
company’s chief auditor, members of the company’s primary investigative department known
as the Corporate Investigations Unit, the company’s controller’s office, attorneys in the legal
department, and, at times, outside counsel. KPMG also inspected regulatory reports and
interviewed the banking regulators, and reviewed reports provided to executive management
and board members. These included the chief compliance officer’s report to the audit committee,
and reports to the bank’s Audit & Examination Committee (A&E Committee) containing
investigations that related to accounting, internal accounting controls, auditing, whistleblower
claims and claims of retaliation under the Sarbanes-Oxley Act of 2002. [The A&E Committee
consists of a minimum of three Board members and meets regularly at least nine times per year.]
EXHIBIT 2—
continued
November 28,
2016, Letter Sent
to Members of
U.S. Senate by
KPMG Chairman
As a result of these procedures, KPMG became aware of instances of unethical and illegal
conduct by Wells Fargo employees, including incidents involving these improper sales
practices, and we were satisfied that the appropriate members of management were fully
informed with respect to such conduct. In 2013, the company initiated an investigation into
potential sales misconduct (referred to as “simulated funding”) in Southern California. The
investigation into this “simulated funding” continued into 2014, and led to the termination
of a number of employees, including branch managers and an area manager. In 2015, KPMG
became aware that the City Attorney of Los Angeles had initiated a lawsuit over improper
sales practices, and that the company had hired an outside consultant to review its entire
sales incentive program. The audit team monitored the progress of this lawsuit and reviewed
the consultant’s report and the conclusions therein.
a) Did KPMG communicate this knowledge with top executives at Wells Fargo? If so, please
provide electronic or paper copies of any and all communications.
KPMG has not identified any information known to us that was not also known to executive
management through its internal processes. Importantly, the banks A&E Committee received
reports describing instances of employee misconduct, including the sales practices issues.
The A&E Committee meetings were attended by the bank’s executive management, and the
materials KPMG auditors obtained were provided to executive management as well. Moreover,
the 2013 investigation and the 2015 lawsuit were widely reported in the press and well
known to the bank’s executives.
b) Did you assess whether Wells Fargo had controls in place to prevent this illegal activity? What
was your assessment about the quality of these controls and how well they were executed?
As the independent auditor of Wells Fargo’s financial statements and management assessment
of its internal controls over financial reporting, KPMG considered the bank’s controls over
these practices from a financial reporting perspective. And, from a financial reporting
perspective, the improper sales practices did not involve key controls over financial reporting.
From the financial statement perspective, its effects were not financially significant.
The opening of an unauthorized account did not itself have an impact on Wells Fargo’s
financial statements. If a bank employee placed a customer’s funds in one authorized
account, or in many unauthorized accounts, the total amount of deposits remained constant.
Only the total amount of deposits is reported in the bank’s financial statements. KPMG
analyzed the potential impact on the financial statements of setting up unauthorized
accounts, whether caused by an improper sales practice or otherwise. The audit team
concluded that the potential impact of any such errors would likely be insignificant. They
received additional support for this conclusion when an outside consultant calculated the
potential financial impact of the improper sales practices. That consultant concluded the
fees associated with unauthorized accounts were less than $5 million, and that amount had
accumulated over a five-year period.
(continued)
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12
Section One
Exhibit 2—
continued
November 28,
2016, Letter Sent
to Members of
U.S. Senate by
KPMG Chairman
Comprehensive Cases
KPMG’s audit team, however, did not limit their consideration to the numbers. They also
looked at who was involved in the improper sales practices. None worked in financial
reporting or had the ability to influence the financial reporting process.
It should be noted that a special committee of independent directors of the Board
is conducting an investigation into this matter. In accordance with our professional
responsibilities, KPMG’s audit team is closely monitoring this investigation to determine its
impact on our assessment.
2) Did any employee of Wells Fargo mislead any employee of KPMG about the extent and impact
of the unauthorized account creation addressed in the CFPB settlement during your audits?
KPMG has not reached a conclusion as to whether any Wells Fargo employee misled our
auditors about the extent and impact of the conduct described in the CFPB settlement. Any
conclusion on that question will be made on the basis of all the facts developed in this
matter, including the results of the special committee investigation.
3) Has KPMG conducted any internal reviews, reexaminations, or reassessments of its Wells
Fargo audits in light of the information revealed in the settlement?
In accordance with our professional obligations, we have evaluated the information in the
CFPB settlement and other reports and continue to monitor new information to determine
the impact on our prior and current audits. To date this information supports KPMG’s
conclusions with respect to the effect that improper sales practices had on the company’s
financial statements and internal controls over financial reporting. The CFPB found that the
fees improperly charged to customers amounted to less than $2.5 million over a five-year
period, and directed Wells Fargo to place $5 million in reserve for all affected customers.
These numbers are to be considered in context of the bank’s reported results, which included
approximately $23 billion in net income in 2015 alone. Furthermore, the CFPB settlement
attributed the misconduct to employees seeking to obtain credit under the incentivecompensation program, and did not identify any person involved in the improper sales
practices who was involved in or had influence over financial reporting.
As stated above, the special committee’s investigation into the issues raised by the CFPB is
currently ongoing. Any conclusions that KPMG reaches, including any reconsideration of the prior
work, will be informed by the facts developed by that investigation. Even prior to the completion
of that investigation, the facts described in the CFPB settlement and ensuing investigation are
being closely monitored by KPMG’s audit team and will inform KPMG’s ongoing audit approach.
4) Has KPMG faced any disciplinary action or queries from the Public Company Accounting
Oversight Board (PCAOB) in relation to your audits of Wells Fargo? If so, please provide
details on these actions or queries.
KPMG has not been subject to any discipline by the PCAOB with respect to the Wells Fargo
audit engagements. The Wells Fargo audit engagements are covered by the PCAOB inspection
program. Since the announcement of the CFPB settlement, KPMG has had appropriate and
relevant communications with the PCAOB consistent with what I have described in this letter.
5) Based on your present knowledge of the creation of unauthorized accounts at Wells Fargo,
does your firm stand by its conclusions from 2011-2015 that “Wells Fargo maintained, in all
material respects, effective internal control over financial reporting”?
Yes. Accordingly, KPMG has not withdrawn its reports on the bank’s financial statements or
management’s assessment of the effectiveness of its internal controls over financial reporting.
(continued)
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CASE 1.1
Wells Fargo & Company
As detailed above, the facts developed thus far with respect to the improper sales practices
do not implicate the effectiveness of internal controls over financial reporting. Of course, in
accordance with our professional obligations, KPMG will continue to monitor the situation,
with particular attention to the investigation by the special committee.
Thank you for your letter. I appreciate the opportunity to respond to your questions.
13
EXHIBIT 2—
continued
November 28,
2016, Letter Sent
to Members of
U.S. Senate by
KPMG Chairman
Sincerely,
Lynne M. Doughtie
Chairman and CEO
KPMG LLP
In the November 2016 letter, KPMG revealed that its Wells Fargo auditors had learned
of “instances of unethical and illegal conduct” within the company involving “improper
sales practices.” The auditors had also been aware of an internal investigation of “simulated funding” that had resulted in the dismissal of several employees. The auditors did
not report those matters to Wells Fargo’s senior management because they determined
that the executives had already obtained the relevant information via “internal [company] processes” and from related disclosures “widely reported in the press.”
KPMG explained in the letter that the improper sales practices identified by the
CFPB and other parties did not involve key financial reporting controls and thus were
not relevant to the annual ICFR audits performed for Wells Fargo. To support this
argument, the audit firm pointed out that none of the employees involved in those
activities “worked in financial reporting or had the ability to influence the financial
reporting process.” KPMG also maintained that the financial statement impact of the
unauthorized sales practices had been insignificant, meaning that they were not a
source of material errors in the company’s financial statements.
The final question that had been posed to KPMG by the group of U.S. senators was
whether the firm continued to stand by its conclusions that Wells Fargo had maintained effective ICFR from 2011 through 2015. The firm responded definitively to that
question in the November 28, 2016, letter.
Yes. Accordingly, KPMG has not withdrawn its reports on the bank’s financial statements or management’s assessment of the effectiveness of its internal controls over
financial reporting. As detailed above, the facts developed thus far with respect to the
improper sales practices do not implicate the effectiveness of internal controls over
financial reporting.
Senators Encourage PCAOB to Investigate KPMG
In April 2017, five months after receiving the KPMG letter shown in Exhibit 2, Senator
Elizabeth Warren and Senator Edward Markey wrote a letter to the PCAOB encouraging the federal agency to examine KPMG’s role in the Wells Fargo scandal—see
Exhibit 3. The senators reminded the PCAOB chairman that his organization had
been created “to oversee the audits of public companies in order to protect investors
and the public interest by promoting informative, accurate, and independent audit
reports.” They suggested that “KPMG’s failure” to publicly report Wells Fargo’s illegal
sales practices raised “significant questions” about the conduct of the Big Four firm
as well as the “PCAOB’s role as overseer of public company auditors.”
In their letter to the PCAOB, the two senators characterized as “troubling” much of
the information conveyed to them by KPMG, including the firm’s awareness “for several
years” of the ongoing “illegal activity” by a large number of Wells Fargo employees.
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14
Section One
EXHIBIT 3
A pril 25, 2017,
Letter Sent by
Members of U.S.
Senate to PCAOB
Chairman
Comprehensive Cases
The Honorable James R. Doty
Chairman
Public Company Accounting Office [sic] Board
1666 K St. NW
Washington, DC 20006
Dear Mr. Doty:
We are writing to you to bring your attention to questions raised by KPMG’s role and findings
as the independent auditor of Well Fargo’s financial statements from 2011-2015, years in which
thousands of Wells Fargo staff engaged in fraudulent behavior affecting millions of accounts.
The Sarbanes-Oxley Act of 2002, passed in the wake of the Enron scandal, established the
Public Company Accounting Office [sic] Board (PCAOB) “to oversee the audits of public
companies in order to protect investors and the public interest by promoting informative,
accurate, and independent audit reports.” KPMG’s failure to publicly identify the Wells Fargo
scandal or its risk to investors raise significant questions about the conduct of both Wells
Fargo and KPMG, and the PCAOB’s role as overseer of public company auditors.
We wrote to KPMG on October 27, 2016, to ask for an explanation of how, in its role as
independent auditor of Wells Fargo’s financial statements from 2011-2015, KPMG failed to
identify fraud and mismanagement that affected millions of customer accounts, cost the
company billions of dollars in market capitalization, and resulted in the dismissal of over
5,000 Wells Fargo employees and the retirement of the Wells Fargo CEO.
KPMG provided a response to our letter on November 28, 2016. This response explained that
Wells Fargo’s “misconduct . . . did not implicate any key control over financial reporting and the
amounts reportedly involved did not significantly impact the bank’s financial statements. . . .
KPMG is confident that its audits and reviews of Well Fargo’s consolidated financial statements
were appropriately planned and performed in accordance with applicable professional standards.”
This response provided us with three pieces of troubling new information regarding the Wells
Fargo scandal and KPMG’s role as auditor. This new information reveals that (1) KPMG, for
several years prior to the CFPB and DOJ settlement, became aware of and analyzed in detail
the illegal activity at Wells Fargo; (2) that the Wells Fargo Board had extensive knowledge of
the wrongdoing, and that KPMG was aware that the Board had obtained this knowledge; and
(3) despite the fact that a detailed investigation conducted by Wells Fargo’s independent
board members found that the problem was caused by the Bank’s basic corporate structure
and the top executives responsible for it, KPMG continues to stand by its conclusion that
the “improper sales practices do not implicate the effectiveness of internal controls over
financial reporting.”
Findings and Concerns from the KPMG Response
The response indicated that KPMG, as part of its routine audit activities, became aware and
analyzed in detail the illegal activity at Wells Fargo as early as 2013. According to KPMG,
the auditor “interviewed the company’s chief auditor . . . the Corporate Investigations
Unit, the company’s controller’s office, attorneys in the legal department, and . . . outside
counsel. KPMG also inspected regulatory reports, interviewed the banking regulators,
and reviewed reports provided to executive management and board members. The letter
continues, noting that “as a result of these procedures, KPMG became aware of instances of
unethical and illegal conduct by Wells Fargo employees, including incidents involving these
improper sales practices.”
(continued)
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CASE 1.1
Wells Fargo & Company
15
In fact, the KPMG letter indicates that the auditor scrutinized the misbehavior in detail,
including reviewing the work of an additional outside consultant: “KPMG analyzed the
potential impact on the financial statements of setting up unauthorized accounts . . . [and]
concluded that the potential impact of any such errors would likely be insignificant. [KPMG’s
audit team] received additional support for this conclusion when an outside consultant
calculated the potential financial impact of the improper sales practices.”
EXHIBIT 3—
continued
A pril 25, 2017,
Letter Sent by
Members of U.S.
Senate to PCAOB
Chairman
Second, the KPMG response also indicates that the Wells Fargo Board had extensive
knowledge of the wrongdoing. According to KPMG, the auditor did not provide key
information about the scandal to top executives at the bank because these individuals
already had the information: “the bank’s A&E committee received reports describing . . . the
sales practices issues . . . the materials KPMG’s auditors obtained were provided to executive
management as well.”
Third, the KPMG response indicates that the auditor still continues to believe that the illegal
sales practices were irrelevant to their charge of identifying problems with financial reporting.
According to the company, “from a financial reporting perspective, the improper sales
practices did not involve key controls over financial reporting.” In fact, in the conclusion to
their response, KPMG stated that “the facts developed thus far with respect to the improper
sales practices do not implicate the effectiveness of internal controls over financial reporting.”
This response from KPMG raises numerous questions. Principally, it is difficult to comprehend
the KPMG conclusion that the scandal “did not involve key controls over financial reporting.” In
the month after the scandal broke, Wells Fargo’s stock valuation declined by 12%; in the first
quarter after the news broke, “new credit card applications were down 43 percent in the fourth
quarter of 2016 from a year ago, and . . . new checking account openings fell 40 percent.” Wells
Fargo’s CEO retired shortly after news of the scandal broke, and four other senior executives
at the bank were terminated for cause.” And according to an independent consultant’s review,
“the bank stands to lose $99 billion in deposits, $4 billion in revenue and a customer base that
could dwindle by up to 30 percent,” because “[t]he breach of trust the scandal created has
fundamentally changed the way that [Wells Fargo customers] think about . . . the bank.”
Moreover, KPMG’s conclusions about the integrity of financial reporting appear to conflict
with the conclusion of a review conducted by Wells Fargo’s independent board members. This
review, which was released in April 2017, found that one root cause of the scandal was the
Bank’s basic corporate structure and the top executives responsible for it. A summary of the
report noted that “the Bank’s decentralized organizational corporate structure gave too much
authority and autonomy to the Community Bank’s senior leadership . . . Community Bank
leadership resisted and impeded outside scrutiny or oversight, and when forced to report
minimized the scale and nature of the problem.” The review also found that “[c]orporate
control functions were constrained by the decentralized structure and a culture of substantial
deference to the business units.” This was the same corporate structure that was deemed by
KPMG to have “maintained . . . effective internal control over financial reporting” in every
year between 2011 and 2015.
We have attached a copy of the KPMG letter for your review.
Questions
KPMG, in its role as Wells Fargo’s independent auditor, failed to prevent or even publicly
disclose the fraud that affected hundreds of thousands of customers, and cost the company
CEO his job. In response to questions about this failure, KPMG denied any wrongdoing,
standing by their conclusion that Wells Fargo – during the entire time the scandal was
ongoing – “maintained effective internal control over financial reporting.”
(continued)
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16
Section One
Exhibit 3—
continued
A pril 25, 2017,
Letter Sent by
Members of U.S.
Senate to PCAOB
Chairman
Comprehensive Cases
The PCAOB’s role is to oversee and establish rules for independent auditors like KPMG. But
the Wells Fargo incident raises significant questions about whether PCAOB is doing its job
effectively. Given these concerns, we ask that you provide us with the following information:
1.Has the PCAOB conducted any review of KPMG’s conclusions with regard to its conclusions
about Wells Fargo’s financial reporting from 2011-2015? If so, what were the findings of
these reviews?
2.In response to the Wells Fargo crisis, has the PCAOB established any updated rules or guidance
to help auditors determine whether actions undertaken by employees of public companies
result in incorrect financial reporting or undermine the integrity of financial reporting?
3.In the case of Wells Fargo, KPMG indicated that the size of fraudulent accounts or the
fines imposed by the CFPB and other regulators for the fraudulent accounts was the sole
factor affecting the integrity of financial reporting. KPMG ignored factors such as the
impact of the fraud on the company’s stock price, the reputational harm to the firm,
and the flawed corporate structure that the independent board members identified as a
root cause of the scandal. Were these decisions by KPMG appropriate and consistent with
PCAOB rules and guidance?
4.KPMG did not publicly report the widespread fraud, despite now acknowledging that
its auditors were aware of it prior to the 2016 settlement. Do PCAOB rules or guidance
indicate whether auditors have a responsibility to publicly report or otherwise act on their
knowledge of illegal or inappropriate activity by their clients?
We ask that you provide us with written answers to these questions no later than May 15,
2017. We also ask that you or your staff provide us with a briefing on this matter and our
questions relating to it no later than May 26, 2017.
Sincerely,
Senator Elizabeth Warren
Senator Edward J. Markey
Note: The original letter from the U.S. senators included extensive footnotes identifying the sources of
the quoted passages. Those footnotes can be found in the original version of the letter that is available
online. (https://www.warren.senate.gov/files/documents/2017_04_25_Letter_%20to_PCAOB.pdf)
Given that knowledge, the senators were clearly d
­ ismayed by the clean opinions
KPMG had issued on Wells Fargo’s ICFR and by the firm’s ­declaration in its November
2016 letter that it continued to stand by those opinions.
Senators Warren and Markey found it “difficult to comprehend” KPMG’s contention
that the Wells Fargo scandal did not involve or “implicate” the company’s internal control
over financial reporting. The senators used several metrics to support their position that
the failure of Wells Fargo and KPMG to report the illegal sales practices had concealed
critical information from third parties relying on the company’s financial statements and
accompanying disclosures. After the CFPB sanctions were announced, for example, the
senators reported that Wells Fargo’s credit card applications and new checking accounts
had plummeted by 40 percent. Even more compelling were the results of an independent study by a consulting firm that projected the scandal would ultimately cost Wells
Fargo $99 billion in deposits, $4 billion in revenues, and 30 percent of its customers.
The two senators also argued that KPMG’s decision to not reference Wells Fargo’s
improper sales practices in its ICFR audit reports was inconsistent with a study released
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CASE 1.1
Wells Fargo & Company
17
by the independent members of the company’s board of directors in early April 2017.
Those directors found that a major cause of the scandal was Wells Fargo’s “decentralized corporate structure,” which undercut the company’s “corporate control functions”
and created a “culture” of “substantial deference” to Wells Fargo’s branch managers.
That deference or lack of rigorous oversight apparently gave the branch managers
the freedom to alter the company’s operating policies and procedures as they saw fit,
including the use of the unauthorized sales practices. These conclusions by the independent directors suggested that Wells Fargo’s flawed “corporate culture” impacted the
effectiveness of its ICFR and the reliability of its periodic financial statements.
Senators Warren and Markey concluded their letter to the PCAOB by urging the federal agency to investigate KPMG’s role in the Wells Fargo scandal. The senators asked
the PCAOB to provide four items of information, including an indication of whether
the agency had initiated an investigation of KPMG’s “conclusions about Wells Fargo’s
financial reporting from 2011-2015.” They also asked the PCAOB to review KPMG’s
decision to ignore, in its Wells Fargo financial statement audit and ICFR reports, the
potential impact “of the fraud on the company’s stock price,” the “reputational harm”
that might be inflicted on the company by the fraud, and the “flawed corporate structure” that the independent board members identified as a “root cause of the scandal.”
The final item of information requested by Senators Warren and Markey from the
PCAOB addressed arguably their most important concern. “Do PCAOB rules or guidance indicate whether auditors have a responsibility to publicly report or ­otherwise
act on their knowledge of illegal or inappropriate activity by their ­clients?” No doubt,
the senators would view a negative answer to that question as an indictment of the
nature and scope of the independent audit function for p
­ ublic companies as well as
the PCAOB’s regulatory role in overseeing that function.
Epilogue
The PCAOB quickly acknowledged the receipt
of the April 25, 2017, letter from Senators Warren
and Markey shown in Exhibit 3. A PCAOB
spokesperson noted that “We appreciate the
Senators’ continued interest in the important
investor protection mission of the PCAOB’s
oversight of auditors of public companies.” 20
The spokesperson implied that the PCAOB
would respond to the senators’ letter more completely in the future. To date, that response, if any,
has not been released to the public.
More pressing matters may have interfered
with the PCAOB’s dialogue with the U.S. senators. On April 11, 2017, KPMG had shocked the
business world and the accounting profession
by announcing that it had dismissed five of its
partners and one employee for failing to disclose confidential information obtained illicitly
from the PCAOB (see Case 5.5,“Zero Tolerance”).
Subsequent reports would reveal that at least
three individuals who were former or existing
PCAOB employees—two of whom had been
hired by KPMG—had conspired to provide three
longtime KPMG partners with advance notice
of the KPMG audits that would be included in
the PCAOB’s annual inspection program. At the
time, KPMG had the highest audit deficiency
rates among the Big Four firms—the PCAOB
annually reports a deficiency rate for each of
those firms. The intent of the KPMG partners
involved in the scandal was, ostensibly, to lower
their firm’s annual deficiency rate. Several individuals involved in the scandal were either convicted or pled guilty to various criminal charges
and received prison sentences. Those individuals included David Middendorf, KPMG’s former
20. M. Cohn, “Elizabeth Warren Questions PCAOB about KPMG Audits of Wells Fargo,”
www.accountingtoday.com, 27 April 2017.
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18
Section One
Comprehensive Cases
National Managing Partner of Audit Quality &
Professional Practice,21 and three former PCAOB
employees, including the two who had accepted
positions with KPMG after leaving the PCAOB.
In December 2017, the SEC unexpectedly
announced that it was replacing every PCAOB
member, including the organization’s chairman.
In February 2020, President Donald Trump suggested that the PCAOB should be absorbed into
the SEC, a move that would effectively make
the organization an SEC operating unit and,
apparently, eliminate the positions held by the
PCAOB’s five board members.
In August 2017, the Wells Fargo scandal
was reignited when the company’s new CEO
reported that an additional 1.4 million unauthorized customer accounts had been discovered. The CEO also reported that more than
500,000 of the bank’s customers had been
enrolled, without their permission, in an online
bill payment service. When asked to comment
on those new revelations, Senator Elizabeth
Warren tersely responded,“Unbelievable.”22
Wells Fargo officials negotiated settlements
in late 2018 with all fifty states to end ongoing
investigations and complaints involving the
company’s “retail sales practices.”23 The cost of
those settlements was approximately $640 million. Two years later, in February 2020, the U.S.
Department of Justice announced that it had
reached a similar agreement with Wells Fargo.
The total cost of that settlement for the company,
including reparations to be paid to affected
third parties, was $3 ­billion. Wells Fargo’s 2019
Form 10-K released in February 2020 revealed
that the company still faced numerous pending
civil lawsuits prompted by its improper business
practices.
Questions
1. Identify the different types or classes of internal controls. How do internal
controls over financial reporting (ICFR) differ from the other types or classes of
internal controls?
2. Do you agree with KPMG’s position that Wells Fargo’s improper sales practices
did not involve the company’s ICFR? Defend your answer.
3. How does the AICPA’s Auditing Standards Board define a material weakness
in internal control? How does the PCAOB define a material weakness in ICFR?
What factors should auditors consider in deciding whether an ICFR deficiency
qualifies as a material weakness in ICFR?
4. Wells Fargo’s independent board members concluded that the bank’s
“decentralized corporate structure” was “one root cause of the scandal.” Do you
believe the decentralized nature of Wells Fargo’s corporate structure qualified as
a “material weakness” in Wells Fargo’s ICFR? Why or why not?
5. Does an audit firm of a public company have a responsibility to apply audit
procedures intended to determine whether the client has committed illegal acts
that don’t directly impact its financial statements? Explain. What responsibility
does an auditor of a public company have if the auditor discovers such illegal
acts by the client?
6. While the Wells Fargo scandal was unfolding, several parties pointed out that KPMG
had served as the company’s audit firm since 1931. Explain how the length of an
audit firm’s tenure may influence its ICFR assessment for a public company client.
21. Despite an effort by certain Wells Fargo stockholders to convince the company’s board to replace
KPMG with another audit firm, in the spring of 2020, KPMG still served as Wells Fargo’s auditor. The
almost 90-year tenure of KPMG with Wells Fargo is among the longest in the auditing domain.
22. S. Cowley, “Wells Fargo Review Finds 1.4 Million More Suspect Accounts,” New York Times (online),
31 August 2017.
23. The information in this paragraph was taken from “Note 17: Legal Actions” that accompanied Wells
Fargo’s financial statements in its 2019 Form 10-K and annual report.
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CASE 1.2
Weatherford International
The hardest thing to understand in the world is the income tax.
Albert Einstein
The oilfield services industry includes thousands of companies large and small that provide drilling, seismic testing, transportation, and a wide range of other services to firms
directly involved in the exploration and recovery of oil and natural gas. In terms of annual
revenues, Schlumberger and Halliburton rank as the two largest ­oilfield services companies. Ranking among the top five firms in the industry on several metrics is Weatherford
International, a company that, in recent decades, has arguably been the most confrontational and controversial in the rough and tumble world of oilfield services.
Weatherford’s prior corporate executives historically viewed their company as the
“perpetual underdog of the full-service oil patch players” with “something to prove.”1
Those executives’ “volatile” management style and willingness to dismiss underperforming subordinates “on a whim” allegedly created a corporate culture in which
Weatherford’s employees routinely adopted an anything-goes, “eager to please”
mindset.2 That mindset produced rapid growth for the company but also resulted
in repeated clashes with Weatherford’s larger competitors and regulatory authorities
around the globe.
Nothing as Certain as . . . Growth and Taxes
In 1998, Bernard Duroc-Danner merged his oilfield equipment company with
Weatherford Services to create Houston-based Weatherford International. The
native of France had emigrated to the United States a decade earlier at the age of 34.
­Duroc-Danner’s father, a wealthy executive with the large French petroleum company Total, reportedly gave his son $20 million and encouraged him to go to the
United States to seek his fortune. Because of his familiarity with oil and gas exploration, Duroc-Danner ultimately decided to pursue a career in oilfield services.
Following the merger creating Weatherford International, the new company’s board
chose Duroc-Danner as its chief executive officer (CEO). The young executive immediately set out to enhance the stature of his company in the global and highly competitive
oilfield services industry, a goal he would fiercely pursue over the next two decades.
Duroc-Danner constantly preached a message of growth to his subordinates and
focused relentlessly on that theme when communicating with financial analysts and
the investing public. “Growth is who we are and what we do. The day we stop growth,
you won’t see me around . . . I hate plateaus.”3 From 1998 through 2011, Duroc-Danner
dramatically increased Weatherford’s total revenues and expanded its global ­footprint
to more than 100 countries by acquiring almost 300 companies. The fiery CEO also
frequently reshuffled Weatherford’s management team as he searched for like-minded
1. In Re Weatherford International Securities Litigation, “Amended Complaint for Violation of the Federal
Securities Laws,” U.S. District Court for the Southern District of New York, 11 Civ. 1646 (DLC), 26 August
2011.
2. Ibid.
3. Ibid.
19
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Section One
Comprehensive Cases
individuals to carry out his “take-no-prisoners” approach to doing business. DurocDanner exerted such pervasive control over Weatherford that one observer suggested
he served not as the company’s CEO but rather as its “absolute monarch.”4 In 2008,
Ernst & Young recognized Duroc-Danner’s skill as a corporate executive by presenting him with its “Entrepreneur of the Year Award.” That same year, Weatherford’s
stock reached a split-adjusted record price of nearly $50 per share, which was more
than ten times higher than the company’s stock price in 1998.
Duroc-Danner relied heavily on Weatherford’s stock to finance the company’s
worldwide acquisition spree. To keep the company’s stock price rising and attractive
to potential takeover candidates, he recognized that he had to grow Weatherford’s
earnings as well as its revenues. A strategic initiative the company implemented to
achieve that goal was reducing one of its largest expense items, namely, income tax
expense. To drive down Weatherford’s effective tax rate (ETR) and thus lower its
income tax expense, the company’s executives began shifting revenues from relatively high-tax jurisdictions, such as the United States and Canada, to low-tax jurisdictions such as Bermuda, Hungary, Ireland, Luxembourg, and Switzerland.
To accelerate Weatherford’s revenue-shifting strategy, Duroc-Danner reincorporated
the company in Bermuda in 2002. Over the next several years, Duroc-Danner reincorporated the company two more times when significant tax-reduction opportunities arose
in other low-tax jurisdictions. In 2009, he made Switzerland the company’s corporate
home base and then five years later transferred that home base to Ireland. Despite these
legal maneuvers, Houston remained Weatherford’s de facto worldwide ­headquarters—
following the 2009 relocation, the television news serial 60 Minutes reported that
Weatherford maintained “little more than a nondescript mail drop”5 in Switzerland.
Another key feature of Weatherford’s revenue-shifting strategy was the use of
“hybrid instruments.” According to the Securities and Exchange Commission (SEC),
“hybrid instruments are structured to incorporate features of both debt and equity,
such that an instrument typically qualifies as debt in one jurisdiction and equity in
another.”6 The SEC reported that Weatherford used hybrid instruments to “facilitate
the movement of revenue” from high-tax jurisdictions to corporate tax havens. The
“interest payments” on these securities would be deducted from taxable income by a
Weatherford entity in a high-tax jurisdiction, while the “dividends receipts” on these
same securities by another Weatherford entity in a low-tax jurisdiction would be
either exempt from taxes or taxed at a very modest rate.
The aggressive taxation strategies employed by Weatherford during Bernard DurocDanner’s early years as CEO significantly reduced the company’s annual income tax
expense and increased its reported profits. From 2001 to 2006, those strategies lowered the company’s ETR from approximately 36 percent to 25 percent. The company’s
taxation strategies were so successful that they became a focal point of Weatherford’s
quarterly earnings conferences with financial analysts tracking the company. In April
2007, a Bear Stearns analyst noted that the company exceeded its consensus earnings
forecast for the first quarter of 2007 “primarily” because it lowered its ETR.7 Frequent
4. D. Blankenhorn, “Why Does No One Ask Hard Questions of Weatherford International?”
www.seekingalpha.com, 21 November 2012.
5. In Re Weatherford International Securities Litigation, “Amended Complaint for Violation of the Federal
Securities Laws.”
6. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 3806, 27
September 2016.
7. In Re Weatherford International Securities Litigation, “Amended Complaint for Violation of the Federal
Securities Laws.”
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CASE 1.2
Weatherford International
statements by Weatherford executives that the company’s ETR would continue to
decline prompted financial analysts to issue favorable earnings forecasts for the company and raise their target price for the company’s stock.
In early 2008, as Weatherford prepared to file its 2007 Form 10-K with the SEC,
two senior members of the company’s tax department discovered that Weatherford’s
ETR for fiscal 2007 was considerably higher than the estimated ETR that had been
communicated to the company’s financial analysts earlier in the year. The tax officials realized that the unexpectedly high ETR would come as an unpleasant surprise
to those financial analysts and, more importantly, to their superiors, particularly
Bernard Duroc-Danner. The unsettling discovery panicked the two men and sent
them in search of a solution.
Tax Fix, Tax Fiasco
In 2002, Andrew Becnel, an attorney in his early thirties, joined Weatherford and was
given the title Associate General Counsel. The ambitious Becnel moved rapidly up
Weatherford’s corporate hierarchy. In 2005, he became the company’s Vice President
of Finance, and the following year added the title of Chief Financial Officer (CFO).
After assuming the CFO position, Becnel reorganized the departments under his control. The reorganization included making Weatherford’s tax department a “finance
function . . . focused on tax strategy and planning, and not tax accounting.”8 Under
this new organizational scheme, the tax department operated independently of the
company’s accounting and financial reporting functions.
Thus, beginning in October 2006 . . . Weatherford’s tax department no longer reported
directly to Weatherford’s accounting department or to senior management with sufficient knowledge or experience to assess whether Weatherford’s income tax accounting was being fairly and accurately presented in accordance with GAAP. As a result,
the tax department had virtually no accounting oversight.9
James Hudgins served as Weatherford’s Vice President of Tax from 2000 through
March 2012, although he was not officially elevated to true “officer status” within the company until February 2009. Hudgins’ principal subordinate in Weatherford’s tax department was Darryl Kitay, who successively held the titles of Tax Manager, Senior Manager,
and Tax Director during his tenure with the company. Both men were CPAs, although
Kitay allowed his Texas CPA license to expire in 2004. In a 2016 enforcement release, the
SEC provided the following summary of Hudgins’ and Kitay’s principal responsibilities.
As the then Vice President of Tax, Hudgins was the architect of Weatherford’s tax
structure, tax planning, and was responsible for executing tax strategies designed to
reduce Weatherford’s ETR and tax expense. Hudgins was also responsible for ensuring that Weatherford’s consolidated income tax accounts were properly maintained
and that the consolidated tax provisions, underlying expenses, and related financial
disclosures were accurately and fairly presented in all material respects in accordance with GAAP. Kitay, who reported to Hudgins, was responsible for preparing and
reviewing Weatherford’s consolidated income tax accounts and underlying expenses
that were reported in Weatherford’s financial statements.10
The SEC determined that the work environment within Weatherford’s tax department under James Hudgins was less than ideal. In addition to the department being
“perpetually understaffed,” its employees were overworked: “Hudgins pressed his
8. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 3806.
9. Ibid.
10. Ibid.
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Section One
Comprehensive Cases
employees to work long hours to make Weatherford’s tax structure extremely competitive.”11 Hudgins also “quickly gained a reputation with the company’s external auditor
as . . . challenging and demanding” and “for taking aggressive accounting positions.”12
Through 2007, Weatherford accounting employees within the company’s operating
units used Microsoft Excel spreadsheets to prepare year-end income tax data, which
they then forwarded to the company’s Houston-based tax department. Hudgins’ subordinates reviewed these data and then compiled them to arrive at a consolidated
year-end income tax provision for the company.13 At the same time, those subordinates determined the appropriate year-end balances for the company’s current and
deferred income tax assets and liabilities.
Fiscal 2007 was a troubling year for the company financially. Throughout that year,
“emails among senior management reflected that the company was under pressure to
meet Wall Street expectations and to offset shortfalls in its quarterly earnings targets
by lowering its ETR.”14 In late February 2008, just days before the company filed its
2007 Form 10-K with the SEC, Hudgins and Kitay reviewed the year-end tax data that
had been collected and consolidated a short time earlier by their subordinates for the
purpose of incorporating it in Weatherford’s 2007 financial statements. Those data
shocked Hudgins and Kitay because the company’s ETR for the year was much higher
than previously estimated. That estimate had been conveyed to financial analysts and
investors during Weatherford’s quarterly earnings conferences. To bring Weatherford’s
ETR for 2007 more closely in line with the previous estimate, Hudgins and Kitay made
a bogus post-closing adjustment to the company’s accounting records.
Faced with what they considered to be an immovable deadline for reporting earnings,
Hudgins and Kitay falsified the year-end consolidated tax provision by making an
unsubstantiated manual $439.7 million post-closing “plug” adjustment to two different
Weatherford Luxembourg entities . . . To do so, they intentionally reversed accounting
data that had been correctly input to Weatherford’s consolidated tax provision via the
company’s accounting system.15
This unauthorized “plug” adjustment produced a $154 million bogus tax benefit for Weatherford—neither Hudgins nor Kitay disclosed the true reason for this
adjustment to anyone outside of the company’s tax department. The $154 million
tax b
­ enefit, along with several smaller misstatements, inflated the company’s net
income for 2007 from $941 million to $1.07 billion, an increase of approximately 14
percent. More importantly, the post-closing adjustment, which Hudgins and Kitay
referred to as a “dividend exclusion” adjustment, allowed the company to surpass
its consensus Wall Street earnings forecast for 2007.16 (Despite understating its
11. Ibid.
12. Ibid.
13. The SEC reported that Weatherford applied the appropriate financial accounting standards to
determine its quarterly and year-end income tax provisions and current and deferred tax assets and
liabilities. To estimate Weatherford’s quarterly income tax provisions, the company’s tax accountants
applied FASB Interpretation No. 18, “Accounting for Income Taxes in Interim Periods.” To determine
Weatherford’s year-end income tax provision, the accountants applied Financial Accounting Standard
No. 109, “Accounting for Income Taxes.” In the FASB’s Accounting Standards Codification, those two
pronouncements are now embedded in ASC Topic 740.
14. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 3806.
15. Ibid.
16. The bogus “plug” or “dividend exclusion” adjustment was made in the subsidiary accounting record
known as the “Eliminations Region” that contained the company’s extensive intercompany accounts.
Because Weatherford had several hundred subsidiaries scattered across the globe, the intercompany
accounting records were extremely complex, if not convoluted, and thus difficult to comprehend.
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CASE 1.2
Weatherford International
income tax expense for financial reporting purposes, Weatherford paid the appropriate amount of income taxes.)
On February 21, 2008, Weatherford filed its 2007 Form 10-K with the SEC. In that
document, the company’s senior management drew attention to the decrease in
Weatherford’s ETR from 26 percent in 2006 to 23 percent in 2007. “The decrease in
our effective tax rate during 2007 as compared to 2006 was due to benefits realized
from the refinement of our international tax structure and changes in geographic
earnings mix.”17 Of course, the decline in Weatherford’s ETR was primarily due to
the undisclosed post-closing accounting adjustment made by Hudgins and Kitay.
Several financial analysts complimented Weatherford for the impressive 2007 earnings report. An analyst with Morgan Stanley commented on the company’s “truly
remarkable”18 earnings growth while another analyst congratulated the company for
once more topping Wall Street’s consensus earnings forecast.
In 2008, Weatherford changed its income tax accounting procedures by acquiring tax software that “automatically populated” or “mapped” the quarterly and yearend income tax amounts to the company’s accounting records. This new software
provided for more uniformity in the tax calculations across the company’s operating units by eliminating the Microsoft Excel spreadsheets previously prepared by tax
personnel within those units. During the fourth quarter of each fiscal year, Hudgins
required his headquarters tax department staff to perform a “pretend hard close” to
determine that the tax software was properly functioning.
The purpose of the pretend hard close was to ensure that Weatherford’s tax a
­ ccounting
controls were in place for the end of the year. Essentially, the pretend hard close was
a ‘dry run’ of all the steps Weatherford would later perform to finalize its consolidated
tax provision at year-end. Accordingly, the pretend hard close process would provide
information regarding the effectiveness of Weatherford’s ICFR [internal controls over
financial reporting] for the accounting of income taxes, but the results themselves
would not be incorporated into Weatherford’s financial statements.19
Weatherford’s senior management suggested, in fiscal 2008 quarterly earnings conferences with financial analysts, that the company’s ETR for the year would be in the
range of 17 to 18 percent, sharply lower than the 23 percent ETR achieved in fiscal
2007. However, the pretend hard close in late 2008 revealed that Weatherford’s projected ETR was between 22 and 23 percent. To align the projected ETR for 2008 with
senior management’s prior reported estimate for the year, Hudgins and Kitay directed
certain of their subordinates to “override” the new income tax software and manually
reduce the income tax expense yielded by the pretend hard close. This manual override resulted in an ETR of between 17 and 18 percent for the year-to-date period.
In January 2009, the company’s tax department used the new income tax software to
determine the actual ETR and income tax expense for the entire year. Again, that ETR
“far exceeded” the estimate previously communicated by senior management to analysts and the investing public. Faced with the prospect of disappointing Weatherford’s
senior management, financial analysts, and investors, “Hudgins and Kitay opted to
perpetuate the fraud.”20 The two men once more prepared a manual post-closing
accounting adjustment to manufacture a bogus tax benefit for Weatherford. That
17. In Re Weatherford International Securities Litigation, “Amended Complaint for Violation of the
Federal Securities Laws.”
18. Ibid.
19. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 3806.
20. Ibid.
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24
Section One
Comprehensive Cases
$106 million tax benefit lowered the company’s ETR to 17.1 percent for fiscal 2008 and
increased the company’s net income by approximately 8 percent.
James Hudgins “actively lobbied” his superiors during 2008 “for officer status and
the higher compensation it brought.”21 As the year-end approached, Hudgins sent the
following email to Bernard Duroc-Danner: “I’m very upset that I’m not an officer yet. I
achieved a 17% rate [ETR] this year, and all of you treat me like sh__.”22 In early 2009,
after Weatherford released its 2008 earnings and ETR to the public, Hudgins received
his wish and was upgraded to officer status with the company.
During 2009 and 2010, Hudgins and Kitay continued to intentionally understate
Weatherford’s ETR and income tax expense. Exhibit 1 presents a table prepared by
the SEC that summarizes the “unsupported manual entries” and resulting “plugged tax
benefits” Hudgins and Kitay produced for Weatherford from 2007 through 2010. That
exhibit also reports the net income amounts initially reported by Weatherford for each
of the affected years, amounts inflated by the impact of the improper tax benefits.23
EXHIBIT 1
Improper
Post-Closing
A djustments
R ecorded in
Weatherford
International’s
Accounting
R ecords
Fiscal Year 2007:
Total Unsupported Adjustment
Tax Rate Improperly Applied
2007 Plugged Tax Benefit
$439,728,436
35%
$153,904,953
Fiscal Year 2008:
Total Unsupported Adjustment
Tax Rate Improperly Applied
2008 Plugged Tax Benefit
$303,675,364
35%
$106,286,377
Fiscal Year 2009:
Total Unsupported Adjustment
Tax Rate Improperly Applied
2009 Plugged Tax Benefit
$290,407,796
35%
$101,642,729
Fiscal 2010:
$286,632,936
35%
$100,321,528
Total Unsupported Adjustment
Tax Rate Improperly Applied
2010 Plugged Tax Benefit
The following net income amounts were initially reported by Weatherford for 2007-2010.
These amounts include the improper “plugged tax benefit” for each year.
2007
2008
2009
2010
$1,070,600,000
1,393,200,000
253,800,000
78,300,000
Source: Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 3806,
27 September 2016.
21. Ibid.
22. Ibid.
23. In 2007, Weatherford had total assets of $13.2 billion and total revenues of $7.8 billion; the
­company’s total assets rose to $19.2 billion by 2010 while its total revenues reached $10.2 billion
that year. These amounts include the collective impact of the three financial restatements made
by Weatherford in 2011 and 2012.
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CASE 1.2
Weatherford International
A pesky artifact of the tax accounting fraud for the two conspirators was the
s­ teadily increasing “phantom income tax receivable” that it produced. “This phantom income tax receivable occurred because the current income tax payable
accounts annually recorded from the consolidated income tax provision were
understated by the amount of each year’s fraudulent tax benefit.”24 Consequently,
when Weatherford made tax payments each year—throughout the accounting
fraud, the company ­continued to pay the proper amount of income taxes that it
owed—the amount debited to the income tax payable account exceeded the existing credit balance of that account, resulting in a steadily rising debit balance in the
income tax payable account.
The total of the phantom tax receivable reached approximately $460 million by
late 2010. To obscure the nature of the receivable for financial reporting purposes,
Weatherford reclassified it to a generic “Prepaid Other” account during the fourth
quarter of 2009. Throughout the fraud, Hudgins and Kitay fabricated excuses to justify the tax receivable that was growing progressively larger. Hudgins told multiple
parties, including the company’s auditors, that he was attempting to recover the overpaid tax amounts. Of course, Hudgins knew the receivable was completely fictitious
and would never be collected.
In February 2011, a review of Weatherford’s intercompany accounts by Ernst &
Young revealed that the large income tax receivable was a direct result of the annual
post-closing adjustments prepared by Hudgins and Kitay—Ernst & Young had been
aware of these adjustments since early 2008 but did not understand their purpose.
At this point, Hudgins and Kitay admitted that those adjustments had misstated
Weatherford’s income tax expense and related accounts over the period 2007–2010.
However, the two men did not disclose the fraudulent nature of the adjustments
to the Ernst & Young audit team or Weatherford’s senior management and instead
maintained that they were simply accounting errors.
Weatherford’s senior management attributed the required restatement of the
company’s 2007–2010 financial statements to “an error in determining the tax consequences of intercompany amounts over multiple years.”25 That restatement—filed
with the SEC on March 8, 2011—slashed Weatherford’s previously reported net
income amounts by approximately $500 million and drove down the company’s stock
price by 11 percent, costing stockholders $1.7 billion. The bulk of the restatement was
necessary to eliminate the impact of Hudgins and Kitay’s bogus post-closing adjustments. The remaining portion corrected other errors discovered in Weatherford’s
income tax accounts. Bernard Duroc-Danner and Andrew Becnel hosted a conference call on March 2, 2011, to disclose the coming restatement of Weatherford’s prior
operating results. In the conference call, Becnel reassured financial analysts tracking the company’s stock that the accounting glitch that had made the restatement
necessary was “nothing other than . . . an honest mistake.”26
Following the March 2011 restatement, Bernard Duroc-Danner placed James
Hudgins in charge of a “large-scale effort” to revamp and improve Weatherford’s
income tax accounting policies and procedures. During this “remediation”
­project, Hudgins and his subordinates discovered numerous overt deficiencies in
Weatherford’s income tax accounting process. In late February 2012, Weatherford
24. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 3806.
25. Ibid.
26. In Re Weatherford International Securities Litigation, “Amended Complaint for Violation of the
Federal Securities Laws.”
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26
Section One
Comprehensive Cases
disclosed in an SEC filing that a second restatement would be necessary to correct
“hundreds” of additional income tax accounting errors discovered in the company’s
accounting records. This second restatement—issued on March 15, 2012—resulted
in a collective reduction of $256 million in the company’s already restated 2007–2010
net income amounts and the net income figure for 2011 that had been released
the prior month. One week following the issuance of the second restatement,
Weatherford announced that Andrew Becnel and James Hudgins had voluntarily
resigned from the company. At the same time, Weatherford relieved Darryl Kitay of
all “supervisory responsibilities” in the company’s tax department.
Following the departure of Becnel and Hudgins and the release of the second
restatement, Weatherford discovered more uncorrected errors in its income tax
accounting records. On December 17, 2012, the company issued a third financial
restatement to correct those errors. This final restatement reduced Weatherford’s previously reported net income amounts by an additional $186 million.
Overtaxed Auditors
Weatherford’s Ernst & Young auditors didn’t learn that the series of post-closing
accounting adjustments recorded by Hudgins and Kitay were fraudulent until
­company officials passed that information to them in August 2012. The company had
apparently determined several months earlier that those adjustments were bogus.27
Poor communication with client accounting and financial personnel plagued Ernst
& Young’s tenure as Weatherford’s independent audit firm, which was surprising
since many of those individuals were Ernst & Young alumni. Among others, those
former Ernst & Young employees included the CFO who preceded Andrew Becnel,
Weatherford’s Director of Internal Audit, two individuals who served as the company’s Chief Accounting Officer, and, most notably, James Hudgins. Weatherford
employed so many former Ernst & Young auditors one observer referred to the relationship between the client and audit firm as “virtually familial.”28
Weatherford retained Ernst & Young as its independent auditor in 2001. Three
years later, Ernst & Young designated Weatherford as a “close-monitoring”29 client,
the firm’s highest-risk category for audit clients. Ernst & Young reserved close-monitoring status for clients that might cause “damage to its reputation, monetarily or
both.” Exhibit 2 lists the five specific “risk factors” that justified tagging Weatherford
as a high-risk audit client. Weatherford remained a close-monitoring audit client
throughout the remainder of Ernst & Young’s tenure as the company’s audit firm. This
designation had significant implications for the Weatherford audit team, particularly
the senior personnel assigned to that team.
Ernst & Young’s policies and procedures . . . required more detailed review by senior
engagement professionals when auditing close-monitoring clients, in recognition of
basic audit and quality control standards that required heightened professional due
care and scrutiny when faced with a higher risk of material misstatement.
27. The SEC did not report exactly when Weatherford’s management learned that Hudgins and Kitay
had intentionally misrepresented the company’s operating results. The Houston Chronicle implied that
this determination was made in March 2012 when “Duroc-Danner allowed Hudgins and the chief financial officer [Becnel] to voluntarily resign.” See, C. Tomlinson, “Weatherford Was Caught but CEO Didn’t
Face the Consequences,” Houston Chronicle (online), 4 October 2016.
28. In Re Weatherford International Securities Litigation, “Amended Complaint for Violation of the
Federal Securities Laws.”
29. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 3814,
18 October 2016. Unless noted otherwise, the remaining quotes in this case were taken from this source.
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CASE 1.2
Weatherford International
27
EXHIBIT 2
• T he company had a history of completing significant or unusual transactions shortly before or
at year-end or quarter-end.
• Company personnel had the ability to book journal entries without multiple levels of review.
• The complexity of the company’s tax structure made it difficult to complete income tax
auditing procedures on a timely basis.
• There was significant pressure on management personnel to reach earnings targets established
by third parties.
• There was significant pressure on accounting personnel to apply “marginal GAAP.”
R isk Factors
that Justified
Classifying
Weatherford
International
as a “Close monitoring” Audit
Client
Source: Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 3814,
18 October 2016.
The risk factor that proved to be most challenging for the Weatherford auditors
was the company’s “byzantine” international tax structure. Ernst & Young’s Houstonbased audit team frequently consulted with the firm’s National Professional Practice
Group on complex income tax accounting issues that arose during annual audits
and interim reviews of the company’s financial statements.
Ironically, while Ernst & Young was serving as Weatherford’s auditor, the accounting firm’s national office identified the “auditing of income tax accounting” as a
firm-wide “specific focus” and an audit area “requiring significant improvement.”
Between 2006 and 2009, Ernst & Young’s national office “issued at least six memos . .
. to its personnel addressing deficiencies in its [Ernst & Young’s] audits of income tax
accounting.” Those intra-firm communications stressed the following three deficiencies in the auditing of income tax-related accounts:
•Ineffective supervision and review by assurance and tax professionals, especially
detailed and second-level review by assurance professionals;
•Inadequate exercise of due professional care and professional skepticism; and
•Insufficient audit documentation, including repeated observations that tax
workpapers appeared to be carried forward from year to year and failed to
include appropriate analyses and supporting documentation to support the
auditors’ conclusions.
Weatherford International ranked among the largest audit clients of Ernst & Young’s
Houston practice office. From 2007 through 2010, the time frame when Hudgins and
Kitay intentionally misstated Weatherford’s income tax accounts, Ernst & Young
earned more than $30 million in fees from the auditing, taxation, and consulting services it provided to the company. For each of those years, Ernst & Young issued an
unqualified audit opinion on Weatherford’s financial statements.
Over the course of the tax accounting fraud, Weatherford was not only among
the largest clients of Ernst & Young’s Houston office, but it was also among the
least preferred client assignments. “Because of Weatherford’s reputation as a ‘very
adversarial’ client, staffing the Weatherford audit was a perennial problem. Ernst &
Young managers resisted working on the Weatherford audit and threatened to quit if
assigned to the engagement.” Among the Weatherford officials who were most problematic for the Ernst & Young auditors was James Hudgins. One member of the Ernst
& Young audit team described Hudgins as “difficult, intimidating . . . and stubborn,
particularly with respect to the tax positions he took on behalf of the company.”
From 2006 through 2010, Craig Fronkiewicz served as the “coordinating partner”
for the Weatherford International audit engagements. In that role, Fronkiewicz “had
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28
Section One
Comprehensive Cases
final responsibility for the audits and quarterly reviews of Weatherford’s financial
statements.” Another key member of the Weatherford engagement team was Sarah
Adams. From 2001 through 2006, Adams was the senior tax manager assigned to
the Weatherford engagement. After being promoted to partner in 2007, Adams
served as the tax partner on that job from 2007 through 2013. “As the tax partner,
Adams reviewed the work of, and supervised Ernst & Young’s tax professionals on
the audit engagement team who performed audit and review procedures related to
Weatherford’s income tax accounting.”
Fronkiewicz and Adams struggled with inadequate staffing of the Weatherford
audit team while they were assigned to the engagement. Prior to the 2009 audit, for
example, Fronkiewicz requested that an audit manager “well suited to a difficult,
public company like Weatherford” be assigned to the engagement. Fronkiewicz’s
request was denied. “Ernst & Young assigned an assurance [audit] manager who
had limited previous public company experience and had little training or experience in complex international accounting. Notwithstanding that lack of experience,
Fronkiewicz assigned this manager the task of reviewing the income tax workpapers during the 2009 audit.”
Although Fronkiewicz and Adams did not control the staffing decisions made for
the Weatherford engagement, the SEC held them responsible, along with Ernst &
Young, for many of the problems that resulted from the inadequate staffing of the
company’s annual audits.
Adams supervised Ernst & Young tax professionals that she knew were inexperienced
and untrained and did not seek additional training for these individuals. Adams and
Fronkiewicz also knew that the Weatherford audit required their tax staff to perform
consolidated tax provision audit work in a difficult, high-pressure environment under
severe time constraints. Adams and Fronkiewicz also engaged in unreasonable conduct by requiring their junior and inexperienced tax staff to audit tax accounting that
should have been conducted by assurance and tax personnel under the ultimate
supervision of the assurance partners.
The staffing, training, and supervision on the Weatherford engagement identified
above were the responsibility of Fronkiewicz, Adams, and Ernst & Young. At the time,
Ernst & Young had no mechanism to ensure that the highest-risk areas of its highestrisk clients had a team of assurance and tax professionals that was properly selected,
trained, and supervised.
SEC Issues Yearly Report Cards on Weatherford Audits
In October 2016, the SEC issued Accounting and Auditing Enforcement Release
No. 3814. That enforcement release included the federal agency’s individual critiques
of Ernst & Young’s 2007–2010 Weatherford International audits.
2007 Weatherford Audit
Because Craig Fronkiewicz and Sarah Adams had served on the Weatherford
engagement for several years, prior to the fiscal 2007 audit, each of them was well
aware of the company’s aggressive approach to “managing” its income taxes and
the related accounting, financial reporting, and internal control issues posed by
that mindset. During both the 2005 and 2006 audits, Ernst & Young had identified
an internal control deficiency linked to Weatherford’s income tax accounting. The
2005 deficiency resulted in “numerous errors” in Weatherford’s tax asset and liability accounts, while the 2006 deficiency resulted in a material understatement of the
company’s consolidated income tax expense “that enabled Weatherford to meet its
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CASE 1.2
Weatherford International
fourth-quarter earnings projection.” In each case, the Ernst & Young auditors had
ultimately decided to characterize the deficiency as an “ICFR significant deficiency”
rather than a material weakness in internal control.
While working on the 2007 Weatherford audit, a tax senior discovered the initial
post-closing dividend exclusion (plug) adjustment made by Hudgins and Kitay and
brought the $440 million accounting entry to Adams’ attention. The SEC reported
that when members of the Weatherford audit team—presumably the tax senior and
Adams—asked Hudgins and Kitay for an explanation for the post-closing entry, they
were given an answer that “did not make sense.”30 On multiple occasions, the tax
senior flatly admitted to others, including Adams, that she didn’t understand the
entry. The tax senior also repeatedly told client personnel she didn’t understand the
entry. In an email to Darryl Kitay, for example, she observed, “I do not mean to sound
like a broken record, but I am not following this.”
Despite the flawed explanation provided by Hudgins and Kitay for the ­post-closing
adjustment and the tax senior’s repeated admissions that she didn’t understand
the entry, Adams “ultimately accepted” the client’s explanation for the entry
without obtaining “any corroborating documents.” Both Adams and Fronkiewicz
“signed off” on the “tax provision workpapers that reflected the dividend exclusion adjustment,” but only Adams signed off on the workpapers that documented
Weatherford’s baseless oral explanation for the adjustment. The SEC pointed out
that the post-closing adjusting entry had a material impact on Weatherford’s financial statements and criticized the two partners for not attempting to “substantiate”
the entry by applying “basic reconciliation or other audit procedures that likely
would have revealed” its bogus nature.
2008 Weatherford Audit
The Ernst & Young auditors faced a new risk factor during the 2008 Weatherford
audit: an SEC investigation into allegations that the company had violated the internal ­control and anti-bribery provisions of the Foreign Corrupt Practices Act (FCPA).
The specific nature and possible outcomes of that investigation were not disclosed
at the time by the SEC. Another risk factor explicitly documented in the 2008
audit planning workpapers was the “possible pressure” that might be imposed on
Weatherford’s Vice President of Tax (James Hudgins) “to decrease the effective tax
rate” to ensure that the company fulfilled the earnings “expectations of third parties.”
Despite identifying this pervasive risk factor prior to the 2008 audit, the SEC reported
that the Ernst & Young engagement team “did not modify its audit plan.”
Consistent with the 2007 audit, the audit procedures applied to Weatherford’s
income tax accounts during the 2008 audit were performed primarily by tax professionals who were supervised by other tax professionals, including Sarah Adams.
“Ernst & Young’s fiscal 2008 audit procedures for Weatherford’s income tax accounting again were conducted by its tax engagement personnel without significant assistance from, or coordination with, assurance [audit] personnel.”
The tax senior who brought the 2007 post-closing dividend exclusion adjustment
to Sarah Adams’ attention was also assigned to the 2008 engagement team—by this
point the tax senior had been promoted to tax manager. Once more, this individual
discovered a large ($304 million) post-closing dividend exclusion adjustment; once
more, the company’s tax officials stymied her efforts to audit the large entry.
30. The explanation suggested that the post-closing adjustment had been necessary “to achieve a better
matching of intercompany activity per tax” in certain of the company’s intercompany accounts.
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30
Section One
Comprehensive Cases
Ernst & Young’s first-year tax manager tried to corroborate the initial answers that
she received from Weatherford’s tax manager [Darryl Kitay] by obtaining documentation and challenging Weatherford’s tax treatment of the adjustment. However, she
was unable to corroborate Weatherford’s misleading explanations for the adjustment. The questions the first-year tax manager raised . . . remained unresolved as
Weatherford’s Form 10-K filing date drew near. As late as February 23, 2009, just one
day before Weatherford filed its fiscal year 2008 Form 10-K, she continued to receive
inconsistent and incomprehensible answers about the basis for the dividend exclusion adjustment from Weatherford’s tax manager that neither she nor Adams could
resolve. [emphasis added]
Despite the unresolved issues surrounding the $304 million dividend exclusion
adjustment, on February 23, 2009, Craig Fronkiewicz and Sarah Adams “signed off
on the engagement team’s Income Tax Review Memorandum” that summarized
the audit procedures applied during the 2008 audit to Weatherford’s income tax
accounts. The memorandum noted that “we believe all significant tax matters, tax
exposure items, and financial statement presentation and disclosure matters have
been considered during our audit . . . and appropriately addressed.” The document
went on to indicate “the income tax accounts are free of material error” and “we
believe the tax workpapers appropriately document the procedures performed, evidence obtained, and conclusions reached by us in performing our tax review.”
2009 Weatherford Audit
In December 2009, shortly after Ernst & Young began the 2009 audit, the individual
who had discovered the 2007 and 2008 dividend exclusion adjustments abruptly
resigned from the firm. Because of that individual’s resignation, Adams assigned
two tax seniors to perform most of the detailed audit procedures on Weatherford’s
income tax accounts during the 2009 audit. One of those seniors had not yet passed
all sections of the CPA exam.
For the third year in a row, the Ernst & Young audit team identified a large post-closing
dividend exclusion adjustment recorded by Weatherford. As demonstrated by Exhibit 1,
the $101 million “plugged tax benefit” resulting from the 2009 post-closing adjustment
accounted for nearly 40 percent of the company’s 2009 reported net income.
In addition to the large income statement impact of the 2009 dividend exclusion
adjustment, the SEC reported that the 2009 Ernst & Young audit team had another
reason to exercise “heightened due care and professional skepticism” while addressing that item.
By year-end 2009, concerns regarding the VP of Tax [James Hudgins], who was
by then also a Weatherford officer, rose considerably. Adams made clear to others within Ernst & Young, including Fronkiewicz, that she distrusted Weatherford’s
VP of Tax and believed he was misrepresenting the company’s ETR and net
income. However, nothing was done to increase skepticism of Weatherford’s tax
provision . . .
The SEC found no indication in the audit workpapers that the Ernst & Young auditors “questioned” the 2009 post-closing entry or “sought supporting documentation
to corroborate it.” In fact, the “sole” audit evidence included in the 2009 workpapers
for the entry did not relate directly to the entry.
The sole support for Weatherford’s 2009 dividend adjustment in the audit workpapers
consisted of an oral representation that appears to have been copied from the prior
year’s audit workpapers verbatim. The purported oral representation does not even
relate to the $290 million Bermuda adjustment . . .
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CASE 1.2
Weatherford International
Neither Fronkiewicz nor Adams signed off on the 2009 audit workpapers that
addressed the audit evidence collected for the 2009 post-closing entry. The two
partners did, however, sign the Income Tax Review Memorandum for the 2009
audit “certifying that they reviewed the work performed as a basis for their representations that Weatherford’s income tax accounts were prepared in conformity
with GAAP.”
2010 Weatherford Audit
By early 2010, the large income tax receivable that was a by-product of Weatherford’s
tax accounting fraud drew the attention of the Ernst & Young engagement team—
at this point, the auditors were unaware the receivable stemmed from Hudgins
and Kitay’s post-closing adjustments. The SEC suggested that the unusual nature of
the receivable should have drawn the attention of the auditors “long before” it did.
“While income tax receivables with debit balances may arise for short periods, such
as when a company is due a tax refund, the multi-year debit balance Weatherford
recorded should have raised red flags for the audit team.”
Sarah Adams “reviewed the large tax receivable balance during the second
quarter of 2010” and decided that its growing size “did not seem analytically possible.” After discussing the receivable with Craig Fronkiewicz, Adams asked James
Hudgins why the account was so large and why Weatherford continued to (apparently) overpay its income taxes. “When [Hudgins] did not have a response to those
questions, however, Adams did not make any additional inquiries or perform other
appropriate procedures.” Instead of pursuing the matter at that point, Adams told
Hudgins she expected him to provide a detailed analysis of the receivable balance
at year-end.
In February 2011, as the fiscal 2010 audit was nearing completion, Ernst & Young
auditors discovered that the large income tax receivable was a direct consequence
of the post-closing adjustments made by Hudgins and Kitay.31 This discovery, which
resulted from the auditors’ review of Weatherford’s intercompany accounts, ultimately led to the “first” restatement issued by the company in March 2011.
In the SEC enforcement release focusing on Ernst & Young’s Weatherford
audits, the federal agency made it clear that despite uncovering the connection
between the large income tax receivable and the series of fraudulent p
­ ost-closing
adjustments, the auditors “did not detect the four-year fraud.” In March 2012,
Weatherford’s management apparently determined that the series of post-closing
adjustments had been recorded to intentionally misstate the company’s ETR and
operating results. Five months later, when company officials told the auditors the
­post-closing adjustments were fraudulent, Ernst & Young informed those officials
that “a ­possible illegal act had occurred and requested an independent investigation of the matter.”32
Ernst & Young continued to serve as Weatherford’s independent audit firm through
the end of the fiscal 2012 audit in early March 2013. The firm issued unqualified
opinions on Weatherford’s 2011 and 2012 financial statements. On March 7, 2013,
Weatherford’s audit committee replaced Ernst & Young with KPMG. The company’s
SEC filings did not disclose a reason for the change in auditors or any “reportable
disagreements” regarding accounting, financial reporting, or auditing issues preceding the change.
31. The bogus post-closing adjustment for fiscal 2010 had been recorded by this point.
32. The report, if any, that resulted from this independent investigation was not released to the public.
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32
Section One
Comprehensive Cases
Epilogue
In September 2016, the SEC announced an
agreement with Weatherford International to
settle charges that the company had materially misrepresented its financial ­s tatements
between 2007 and 2012. The settlement
required Weatherford to pay a $140 million fine.
Weatherford’s stock price, which had been on a
downward trend for years, plunged to less than
$4 per share following the announcement of
the SEC settlement. For their role in the fraud,
the SEC suspended Hudgins from serving as an
officer or director of a public company for five
years and it suspended Kitay an equal amount
of time from serving as an accountant for an
SEC registrant. The SEC also fined Hudgins
$334,000 and Kitay $30,000. Hudgins and Kitay
agreed to the s­ ettlement with the SEC while
neither “admitting or denying” the allegations
filed against them. In 2014, Weatherford agreed
to pay $52 million to settle a class-action lawsuit prompted by the tax accounting fraud.
The following year, the company agreed to pay
$120 ­million to settle a similar lawsuit.
Three years earlier, in November 2013,
Weatherford had agreed to pay $253 million in
fines to resolve FCPA charges filed against the
firm by the SEC. In commenting on the settlement, Andrew Ceresney, the Director of the SEC’s
Enforcement Division, attributed Weatherford’s
FCPA violations to the company’s lack of internal controls.“The nonexistence of internal controls at Weatherford fostered an environment
where employees across the globe engaged in
bribery and failed to maintain accurate books
and records.”33
B e r n a r d D u r o c - D a n n e r s u r v iv e d a s
Weatherford’s CEO during the intense media
coverage of the tax accounting fraud and FCPA
investigation that battered the company’s stock
price and public image. In early October 2016,
a business reporter for the Houston Chronicle
slammed Duroc-Danner for refusing to take
responsibility for those scandals.
The chief executive is responsible for establishing a corporation’s culture and values. But
despite creating the conditions for fraud to
take place, Duroc-Danner remains in charge
of fixing the company. No executives have
paid back any of the bonuses they earned
from the inflated earnings reports, which
essentially stole from investors’ pockets.
Duroc-Danner apparently feels no responsibility for what Hudgins and Kitay did, and the
company refuses to acknowledge any guilt.
But it is exactly that impunity that disgusts the
average American.34
One month following this blistering attack,
Duroc-Danner resigned as Weatherford’s chief
executive. In a press release, a company spokesperson revealed that Duroc-Danner would
remain with the company as its “chairman
emeritus” in an advisory role.“Given Bernard’s
deep and unique knowledge of Weatherford, his
established and long-term customer relationships as well as his vast industry and business
experience, his new role will help provide continuity and facilitate a smooth transition.”35
In October 2016, the SEC reached an agreement to resolve charges filed against Ernst &
Young that stemmed from the firm’s alleged
“deficient” audits and interim reviews of
Weatherford’s 2007–2010 financial statements.
The accounting firm had submitted a settlement offer to the federal agency that became
the basis for that agreement. In commenting
on the case, Andrew Ceresney characterized
the Weatherford debacle as a “significant audit
failure.”36
33. Securities and Exchange Commission, “SEC Charges Weatherford International with FCPA
Violations,” www.sec.gov, 26 November 2013.
34. C. Tomlinson, “Weatherford Was Caught but CEO Didn’t Face the Consequences,” Houston Chronicle
(online), 4 October 2016.
35. O. Pulsinelli, “Weatherford Downgraded after CEO Departs,” Houston Business Journal (online), 15
November 2016.
36. Securities and Exchange Commission, “Ernst & Young to Pay $11.8 Million for Audit Failures,” www
.sec.gov, 18 October 2016.
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CASE 1.2
Weatherford International
33
EXHIBIT 3
• Failure to exercise due professional care and an attitude of professional skepticism (AU 230)
• Failure to obtain sufficient competent evidential matter concerning the dividend exclusion
adjustments and phantom income tax receivable balance (AU 326 and 333)
• Failure to properly supervise the audit team (AU 331)
• Failure related to adequate training, competency, and proficiency (AU 210.01/161, QC 20
and 40)
• Failure to make additional inquiries or perform additional procedures in the course of reviewing
interim financial information (AU 772)
• Failure to prepare required documentation (AS 3)
Specific
Deficiencies Noted
by the SEC in
Ernst & Young’s
Audits and
Interim R eviews
of Weatherford
International
Financial
Statements
Source: Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 3814,
18 October 2016.
Exhibit 3 lists the six specific deficiencies
the SEC identified in Accounting and Auditing
Enforcement Release (AAER) No. 3814, the
enforcement release focusing on Ernst &
Young’s Weatherford engagements. Notice that
in addition to identifying the specific deficiencies in the Weatherford audits and interim
reviews, the SEC also listed the specific sections
of the Public Company Accounting Oversight
Board (PCAOB) auditing and quality control
standards relevant to those deficiencies.
The SEC’s settlement agreement with Ernst
& Young included a fine of $11.8 million and
mandated that the firm prepare a “Validation
Plan.” Among other initiatives, the Validation Plan
required the firm to “review, test, and assess” its
“policies” for audit clients designated as “close
monitoring” and to enhance its income taxrelated auditing policies and procedures. The
settlement offer also included a stipulation that
a copy of AAER No. 3814 be provided to all
Ernst & Young “audit personnel.” Finally, the settlement included a two-year SEC suspension for
Craig Fronkiewicz and a one-year suspension for
Sarah Adams. Similar to the SEC settlement with
Hudgins, Kitay, and Weatherford, the Ernst & Young
settlement did not involve an admission of guilt
by Fronkiewicz, Adams, or the firm as a whole.37
Questions
1. What are the key audit objectives for an audit client’s income tax expense and
tax-related assets and liabilities? Identify one audit procedure that could be
applied to address each audit objective you listed.
2. What was the most pervasive internal control weakness evident in this case?
Defend your answer. Do you believe the internal control weakness you identified
qualified as a “material weakness” in internal control? Why or why not? What
implications did the internal control weakness you identified have for the
Weatherford auditors?
3. Inadequate staffing was a major problem that influenced the performance of
Ernst & Young’s Weatherford audits. Identify the profession’s quality control
standards that relate most directly to the staffing of audits. What measures
should have been taken by Craig Fronkiewicz to ensure that the Weatherford
audits were properly staffed?
37. In January 2014, a federal judge dismissed Ernst & Young as a defendant in one of the class-action
lawsuits stemming from the Weatherford tax accounting fraud. The judge ruled that the plaintiffs’ allegations against the audit firm were not sufficient to support an inference of scienter.
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34
Section One
Comprehensive Cases
4. One member of the Ernst & Young audit team described James Hudgins as
“difficult, intimidating . . . and stubborn, particularly with respect to the tax
positions he took on behalf of the company.” What measures can auditors take
to cope effectively and properly with uncooperative client personnel?
5. During the 2009 audit, Sarah Adams “made clear” to Craig Fronkiewicz that
she “distrusted” James Hudgins and “believed he was misrepresenting the
company’s ETR and net income.” What should the Ernst & Young auditors have
done at this point in the audit? Defend your answer.
6. The AICPA Code of Professional Conduct identifies six ethical principles. Which
of those principles, if any, were apparently violated by one or more members of
the Weatherford audit engagement teams? Explain.
7. James Hudgins, Darryl Kitay, Craig Fronkiewicz, and Sarah Adams neither
admitted nor denied the charges of misconduct filed against them by the SEC.
Do you believe the SEC should have sought admissions of guilt from these
individuals? Why or why not?
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CASE 1.3
Caterpillar Inc.
In November 2008, two senior PricewaterhouseCoopers (PwC) officials exchanged
emails that addressed a problem facing one of their firm’s largest and most prominent
clients.1 Similar to many multinational companies headquartered in the United States,
Caterpillar Inc. employed a “profit-shifting” strategy to reduce its corporate income taxes.
Caterpillar’s tax-avoidance plan, which PwC had designed a few years earlier, transferred
much of the profits produced annually by the company’s U.S.-based replacement parts
line of business to a Caterpillar subsidiary in Switzerland. Because the income taxes levied by Switzerland on those profits were much lower than the taxes Caterpillar would
have paid in the United States, the company realized significant tax savings each year.
A new rule announced by the Internal Revenue Service (IRS) in the fall of 2008
threatened to undercut the annual tax savings produced by Caterpillar’s Swiss tax
strategy. That rule, which the IRS implemented in early 2009, required Caterpillar to
demonstrate that the company’s Swiss subsidiary made a “substantial contribution”
to “the manufacturing process” for the replacement parts line of business. Key company insiders insisted that the subsidiary did not satisfy that requirement.
In response to the new IRS regulation, a tax partner, who had been involved in
developing Caterpillar’s profit-shifting tax plan, emailed a colleague in PwC’s consulting division who had worked on transfer pricing issues linked to that plan. The
tax partner warned his colleague that PwC needed to “create a story” to justify the
existence of Caterpillar’s Swiss subsidiary, given the new IRS rule. The last line of the
tax partner’s email advised his consulting colleague to “Get ready to do some dancing.”2 The PwC consultant replied, “What the heck. We will all be retired . . . when
this . . . comes up on audit.” The consultant went on to joke that subsequent generations of PwC staffers would ultimately be forced to deal with the issue. “[We have all
the] fun and leave it to the kids to pay for it.”
Six years later, in 2014, the email exchange between the two PwC officials came
back to haunt them when they were called to testify before an angry investigative subcommittee of the U.S. Senate. During the Senate hearing that focused on
Caterpillar’s Swiss tax plan, the officials testified that their emails were an “attempt at
humor” and apologized for their “very poor choice of words.”
An Iconic American Company
Caterpillar traces its roots to the early 1900s when Benjamin Holt invented a slowmoving but functional tractor—previous efforts at developing tractors for agricultural
use had produced bulky machines whose production cost was prohibitively high. In
marveling at the new tractor, one of Holt’s acquaintances remarked that it crawled
like a “caterpillar.” Holt seized on that analogy to name his new piece of equipment. That original tractor would lead to Caterpillar Inc. becoming the world’s largest manufacturer of construction equipment. The company also became a ­leading
1. Kaimee K. Tankersley, Lecturer at the University of Oklahoma, co-authored this case.
2. This and all subsequent quotes, unless indicated otherwise, were taken from the following source:
U.S. Congress, Senate Subcommittee on Investigations of the Committee on Homeland Security and
Government Affairs, Caterpillar’s Offshore Tax Strategy (Washington, D.C., 2014).
35
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36
Section One
Comprehensive Cases
­ roducer of industrial turbines, diesel locomotives, and diesel and gas engines. By
p
2014, Caterpillar’s annual revenues exceeded $55 billion, and the company’s stock
had become a mainstay of the Dow Jones Industrial Average (DJIA).
In 2014, U.S. Senator Carl Levin of Michigan referred to Caterpillar as an “iconic
American company” but then berated the firm for using “financially engineered
transactions” to slash its income taxes. For decades, critics of the U.S. tax system
had complained of the declining proportion of U.S. income taxes paid by corporations. Senator Levin joined those critics by accusing U.S. multinational corporations
of offloading a disproportionate percentage of the nation’s tax burden to individuals
and small businesses that “don’t have an army of lawyers and accountants at their
disposal.”3 At the time, Caterpillar boasted of having the lowest effective corporate
income tax rate among the 30 companies making up the DJIA.
In the early 1950s, corporate income taxes accounted for 32.1 percent of gross U.S.
federal tax revenue. By 2014, that percentage had dropped to less than nine percent.
A major factor contributing to declining corporate tax receipts has been the efforts of
U.S. multinational companies to transfer profits to countries with modest corporate
income tax rates. “A number of studies show that U.S. multinational corporations are
moving income out of or away from the United States into low or no tax jurisdictions.”
One widely cited study referenced by Senator Levin found that “the income-shifting
of multinational firms” deprived the United States each year of nearly $100 billion in
corporate tax collections.
By 2014, U.S. multinational firms had an estimated two trillion dollars of “undistributed foreign earnings” that had gone untaxed by the IRS and other U.S. taxing
authorities. Those firms held much, if not most, of those foreign earnings in the form
of cash and cash equivalents. According to Senator Levin, Caterpillar had “indefinitely reinvested earnings held offshore,” totaling $17 billion at the end of 2013, which
accounted for approximately 20 percent of the company’s total assets. Similar to
other U.S. multinationals, Caterpillar realized that the IRS would impose large taxes
on those offshore assets if they were “repatriated” to the U.S.4
Senator Levin launched a congressional investigation of Caterpillar’s Swiss tax strategy in 2014. At the time, Senator Levin served as the chairman of the Subcommittee
on Investigations of the U.S. Senate Committee on Homeland Security and
Governmental Affairs. Over the previous decade, a stated mission of that subcommittee had been to investigate “how U.S. multinational corporations have exploited
and, at times, abused or violated U.S. tax statutes, regulations, and accounting rules
to shift profits and valuable assets offshore to avoid U.S. taxes.”
A Taxing Challenge
In 1923, more than a decade before federal securities laws mandated that public companies have their financial statements audited, Caterpillar’s management
team retained Price Waterhouse—PwC’s predecessor—to serve as the company’s
3. K. Skiba, “Caterpillar Digs in at Hearing on Taxes: We Pay Everything We Owe,” www.chicagotribune
.com, 1 April 2014.
4. In August 2016, the European Commission, the executive body of the European Union (EU), ruled
that Apple Inc. owed Ireland $14.5 billion in income taxes. Apple apparently located its European
headquarters in Ireland because of enormous income tax concessions granted to the company by Irish
taxing authorities. The European Commission effectively ruled that the tax concessions granted Apple
operated as an improper governmental subsidy. The ruling upset U.S. regulatory officials who wanted
Apple to repatriate its European profits to the United States—and, of course, pay income taxes on those
repatriated profits.
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CASE 1.3
Caterpillar Inc.
independent audit firm. Over PwC’s long tenure as Caterpillar’s auditor, the accounting firm’s tax and consulting divisions provided a broad spectrum of non-audit services to the company.
In 1997, PwC5 representatives approached Caterpillar about a new tax service the
firm had developed for its multinational clients, a service referred to as the “Global Tax
Optimization Program” (GTOP). In a presentation made to Caterpillar officials, “PwC
described the program as ‘a coordinated, tailored approach to achieving [a company’s] lowest sustainable tax rate.’” The GTOP plan PwC recommended for Caterpillar
focused on the company’s replacement parts line of business. Because Caterpillar’s
products have long lives, customers purchase replacement parts for those products
from the company over extended periods of time—periods often measured in decades. Revenues from the sale of those replacement parts are particularly important to
Caterpillar since they have profit margins several times larger than those realized on
sales of construction equipment and the company’s other primary products.
The great majority of Caterpillar’s replacement parts “are manufactured in, stored
in, and shipped from the United States.” However, the company sells parts to customers in dozens of countries other than the United States. Because the replacement
parts line of business is based in the United States, Caterpillar historically reported
the profits from that line of business in its U.S. federal income tax returns.
PwC recommended that Caterpillar establish a Switzerland subsidiary to serve as
the end seller of the company’s replacement parts to non-U.S. customers. Caterpillar’s
parent company would initially sell these replacement parts to the Swiss subsidiary
through an internal transfer pricing system. The subsidiary would then sell the parts to
Caterpillar customers outside of the United States. Under this plan, the new Swiss subsidiary would be entitled to approximately 85 percent of the profits from non-U.S. sales
of replacement parts—the subsidiary would pay 15 percent of those profits to the U.S.
parent company in the form of a “royalty.” The replacement parts profits diverted to
the Swiss subsidiary “would no longer be immediately attributable to Caterpillar Inc.,”
meaning that those profits would not be subject to U.S. income taxes—unless, or until,
they were repatriated to the United States. By negotiating a modest effective corporate
income tax rate with Switzerland, PwC assured Caterpillar’s management that it could
“double” the profits the company realized on non-U.S. sales of replacement parts.
In marketing the plan to Caterpillar executives, PwC consultants stressed that the
“Swiss tax strategy” would involve “relatively simple re-invoicing requirements” for
the replacement parts sold to non-U.S. customers and only nominal changes “in the
company’s business operations.” In fact, the new Swiss subsidiary would not manufacture any of the replacement parts that it sold and would not maintain or operate
any warehouses or distribution centers for those parts in Switzerland or elsewhere.
In sum, all of the “strategic functions” for carrying out the replacement parts line of
business would remain in the United States.
Caterpillar adopted the PwC Swiss tax strategy. For internal purposes, company
officials referred to that strategy as the Global Value Enhancement or “GloVE” program. The Swiss subsidiary that Caterpillar organized based upon PwC’s recommendation—Caterpillar SARL or simply CSARL 6 —served as the lynchpin of the GloVE
program. For “technical tax compliance” purposes, Caterpillar created a “virtual
5. At this point in time, the firm’s name was actually Price Waterhouse since PwC was not formed until
the following year when Price Waterhouse merged with Coopers & Lybrand.
6. “SARL” is an acronym for the French phrase “societe a responsabilite limitee,” which in English
­translates to “limited liability company.”
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37
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38
Section One
Comprehensive Cases
inventory” of replacement parts for CSARL. Company officials were concerned that
the IRS would object to the Swiss tax strategy if the agency learned that Caterpillar’s
Swiss subsidiary did not maintain an inventory of replacement parts.
PwC consultants were involved in the design of the CSARL inventory system,
although the system was “conceived” by Caterpillar’s “tax and accounting personnel.” This system assigned replacement parts to the CSARL subsidiary “retroactively,”
that is, after they were shipped to a non-U.S. customer. At one point, a PwC consultant
suggested that Caterpillar designate—and physically segregate—specific inventory
items in Caterpillar’s warehouses as owned by CSARL to strengthen the argument
that the subsidiary was a legitimate operating unit. According to the Senate subcommittee report, the tax consultant who made this recommendation was “laughed out
of the room” by Caterpillar officials.
The Senate subcommittee concluded that Caterpillar’s GloVE program and CSARL
subsidiary were simply “changes” that “were made on paper, but not in how the
replacement parts business actually functioned.” Reinforcing that conclusion was
the testimony of a senior Caterpillar executive stationed in Geneva, Switzerland, who
admitted that he had “not even heard of CSARL.” Regarding CSARL’s virtual inventory
system, the subcommittee’s report bluntly observed that it “was an artificial inventory system created solely for tax purposes.”
The development and implementation of Caterpillar’s GloVE program required five
years for PwC to complete with the assistance of a law firm retained by Caterpillar.
PwC billed Caterpillar $55 million for its GloVE-related services and another $25
million for ancillary tax consulting services during the same time frame.7 In 2014,
Caterpillar reported to Senator Levin’s subcommittee that the new Swiss tax strategy
had reduced its corporate income taxes by $2.4 billion—each passing year added
approximately $300 million to that figure. The difference between the U.S. marginal corporate income tax rate of 35 percent and the 4 percent effective corporate
income tax rate that Caterpillar negotiated with Swiss tax authorities accounted for
those savings.
In 2011, Caterpillar needed cash to finance various projects in the U.S. The
company’s finance department orchestrated a transaction between the U.S. parent company and CSARL that allowed Caterpillar to avoid paying taxes on $4
billion of cash transferred from Switzerland to the United States. The transaction involved “advance payments” made by the Swiss subsidiary for purchases
of certain p
­ arent company assets. Although Caterpillar apparently did not consult with PwC on the transaction, a PwC audit workpaper dated December 31,
2011, described the “intercompany transaction” and indicated that it had been
reviewed by the audit team.
Blowing the Whistle
In 2004, Caterpillar’s chief executive officer (CEO) received an anonymous letter from
an employee in the company’s tax department. That letter, an excerpt of which is
presented in Exhibit 1, insisted that Caterpillar’s Swiss tax strategy “lacked economic
substance and had no business purpose other than tax avoidance.” According to the
Senate subcommittee investigation, company executives dismissed the employee’s
allegations as being “without merit.”
7. Senator Levin’s subcommittee reported that from 2000 through 2012 Caterpillar paid PwC approximately $200 million in audit fees.
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CASE 1.3
Caterpillar Inc.
39
Exhibit 1
I do not believe Caterpillar’s transfer pricing practices (past and present) meet the IRS
tests. The Officers and Board of Directors need to examine the transfer pricing issue before
Caterpillar ends up in court and in the press. . . . [T]he Tax Code does not permit transactions
or an organizational structure that have no substantial business purpose other than tax
avoidance purposes. The CSARL reorganization, in my opinion, does not meet this test. When
you look through the reorganization, the primary purpose was to avoid taxes.
E xcerpt from
2004 A nonymous
Letter R eceived
by Caterpillar’s
CEO
Over the past few years, Caterpillar’s tax rate has dropped significantly due to very
questionable transactions and organizational changes. I work in the Tax Department and I
strongly disagree with how we have conducted our business over the past few years. I have
not spoken out before, because of fear of retribution. I am speaking out now for the long
term good of Caterpillar. An independent investigation (not PwC or our outside tax counsel)
is needed. If there is no independent investigation or if there is any retribution, I will go
to the IRS.
Source: U.S. Congress, Senate Subcommittee on Investigations of the Committee on Homeland Security
and Government Affairs, Caterpillar’s Offshore Tax Strategy (Washington, D.C., 2014).
In 2007, Daniel Schlicksup, Caterpillar’s Global Tax Strategy Manager, began questioning the propriety and legality of the company’s Swiss tax strategy. Schlicksup,
an attorney with a Master of Laws (LL.M.) degree in taxation who had previously
been an employee of PwC’s tax staff, addressed those concerns to both Caterpillar’s
ethics officer and the company’s legal department. In a September 2007 email to
Caterpillar’s ethics officer, he pointed out that “the parts business is managed from
the U.S., yet we are running the [non-U.S.] parts profits through Switzerland as if
the business was managed by CSARL.” In the email, Schlicksup expressed his opinion that Caterpillar’s Swiss tax strategy violated the judicial doctrines of “economic
substance” and “business purpose” and recommended that the company launch a
formal inquiry into the matter.
Central to Schlicksup’s argument was the decision by Caterpillar’s parent company
to “give away” the bulk of the profits attributable to non-U.S. sales of replacement
parts. The fact that the company would not have made such an arrangement with
an independent or “arm’s length” third party suggested that the creation of the Swiss
subsidiary had no express business purpose and was purely tax-motivated. “It defies
logic that Caterpillar would have entered into a licensing transaction with an unrelated party in which it gave away [the majority of the non-U.S. replacement parts]
profits while continuing to perform core functions to support those profits and continuing to bear the ultimate economic risk.”
Schlicksup’s concerns prompted Caterpillar’s tax department to initiate a review
of the Swiss tax strategy; PwC tax consultants participated in that review. According
to PwC, the internal review resulted in a “written report,” which concluded that the
Swiss tax strategy had “sufficient substance.” When Senator Levin’s subcommittee
requested a copy of that report from Caterpillar, the company’s legal counsel asserted
attorney-client privilege. The subcommittee also asked PwC to provide a copy of that
report. “PwC advised [the subcommittee] it was unable to locate a copy in its files.”
In April 2008, Schlicksup made a presentation to Caterpillar’s board of directors
that described the company’s “high risk tax strategies,” including the Swiss tax plan
developed by PwC. During the same timeframe, he told the head of Caterpillar’s tax
department that the CSARL matter remained a “pink elephant issue” affecting the
company’s financial statements. One month later, Schlicksup sent a memorandum
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40
Section One
Comprehensive Cases
to Caterpillar’s Executive Office in which he indicated that the CSARL subsidiary
“lacked a business purpose other than tax avoidance” and that “there was no real
change in the company’s business functions as a result of the CSARL transaction.”
Schlicksup’s efforts failed to persuade Caterpillar’s senior management to investigate
the company’s Swiss tax strategy.
The legal counsel for Senator Levin’s Senate subcommittee deposed Rodney
Perkins, Caterpillar’s Senior International Tax Manager, the individual who had
“direct responsibility for CSARL.” During the deposition, Perkins was asked, “Was
there any business advantage to Caterpillar Inc., to have this arrangement [Swiss
tax strategy] put in place other than the avoidance or deferral of income taxation
at higher rates.” Perkins replied, “No, there was not.” At that point, an attorney representing Caterpillar halted the deposition ostensibly to discuss the matter with
Perkins. During the subsequent subcommittee hearing, a U.S. senator questioned
Perkins regarding his deposition testimony. Perkins insisted that he had misspoken
during his deposition when asked if the Swiss tax strategy had provided any business
advantage other than tax avoidance. He had meant to say during the deposition that
“there was no advantage in a lower effective tax rate” for the CSARL subsidiary.8 The
Senate subcommittee reported that this explanation “didn’t appear credible.”
Caterpillar demoted Daniel Schlicksup from his position as Global Tax Strategy
Manager in 2009. That decision prompted Schlicksup to file a lawsuit against
Caterpillar under the whistleblowing provisions of the Sarbanes–Oxley (SOX) Act of
2002. Schlicksup alleged that he had been demoted because he had challenged the
propriety and legality of Caterpillar’s Swiss tax strategy. In 2012, the two parties settled the lawsuit privately for an “undisclosed amount.”
Following the Senate subcommittee hearing, Caterpillar executives forcefully
rejected allegations that the company had violated ethical norms of conduct. A company spokesperson noted that Caterpillar’s Code of Conduct “is the foundation of our
company,”9 while Caterpillar’s CEO insisted that “stringent ethical standards” were a
“top priority” of his organization.10
In responding to charges that Caterpillar’s Swiss subsidiary was a bogus entity,
a company finance executive noted bluntly, “We do not invent artificial tax structures.”11 Despite that claim, the Senate subcommittee report revealed that Caterpillar
effectively ignored the CSARL subsidiary for internal decision-making purposes. To
determine the success of individual operating units and year-end bonuses, for example, Caterpillar had long relied upon an internal measure of profitability referred
to as “accountable profits.” When PwC was designing the Swiss tax strategy in the
late 1990s, company officials instructed the accounting firm not to change the way
accountable profits were computed. “In 1999, when the CSARL transaction was
being designed, the PwC consultants were told that the business lines did not want
any changes to how accountable profits were calculated. The end result was that the
company changed how the profits were split for tax purposes, but not how they were
reported for internal business purposes, such as assigning bonuses.”
8. Apparently, Perkins was suggesting that there was no advantage to a lower effective tax rate for
CSARL because the subsidiary’s profits would eventually be repatriated to the United States and taxed at
the 35 percent marginal income tax rate for U.S. corporations. If that was his argument, he ignored the
economic benefit that Caterpillar accrued by indefinitely deferring the additional taxes on those profits.
9. J. Hagerty, “Caterpillar Faces Pileup of Probes and Inquiries,” www.wsj.com, 18 February 2015.
10. Ibid.
11. Ibid.
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CASE 1.3
Caterpillar Inc.
41
PwC: One Client, Two Hats
The Senate subcommittee’s 95-page report criticized PwC’s involvement in the development of Caterpillar’s Swiss tax plan. The subcommittee reserved its harshest criticism for PwC’s willingness to serve as both independent auditor and tax consultant
for Caterpillar. “PwC auditors were responsible for auditing and approving the company’s use of the very tax strategy developed, advocated, and sold to Caterpillar by
their PwC [consulting] colleagues.” The Senate subcommittee reported that these
dual roles should have posed “significant conflict of interest concerns” for PwC, the
world’s largest accounting firm, by most metrics.
The Senate subcommittee also singled out for criticism the dual roles played by
James Bowers, a PwC tax partner, during the development of Caterpillar’s Swiss
tax strategy and his firm’s subsequent audits of the company. Exhibit 2 includes an
excerpt from the Senate subcommittee report that summarized Bowers’ overlapping roles at Caterpillar. Notice that for audit purposes, Bowers reported that he performed an “independent analysis” of the company’s Swiss tax strategy that he had
helped implement for Caterpillar.
PwC adamantly defended the tax consulting and audit services it provided to
Caterpillar. A PwC spokesperson denied that the tax consulting services were
improper and insisted instead that those services had been designed to help
Caterpillar achieve a simple goal, namely, deciding “how best to organize its expanding global operations” in the face of “U.S. tax policies.”12 This same spokesperson
also insisted that PwC’s Caterpillar audit team had “maintained its independence at
all times”13 while the firm’s tax consultants designed and implemented the company’s Swiss tax strategy. In response to criticism of James Bowers’ involvement in the
tax consulting services and subsequent Caterpillar audits, a senior PwC partner said
that he saw no conflict of interest in those two roles. “There is nothing that would
Exhibit 2
At PwC, the auditing team included a tax partner, James Bowers, who was responsible for
assisting the audit team in auditing Caterpillar’s financial statements, including Caterpillar’s
estimates of the company’s tax liabilities based in part on its implementation of the Swiss
tax strategy. Mr. Bowers told the Subcommittee that he initially introduced PwC’s GTOP team
to Caterpillar and attended the presentation. He also indicated that, for a three-year period
from 1999 to 2002, while he was assisting with the audit of Caterpillar’s financial statements,
he also spent up to one-third of his time working on “GloVE implementation,” meaning
implementation of the Swiss tax strategy. He said that his primary role involved explaining
the details of Caterpillar’s business operations and structure to PwC’s tax consultants. Mr.
Bowers said that, by 2003 or 2004, his work level on the Swiss tax strategy had “dropped
significantly.” In addition, he told the Subcommittee that, during the course of his audit
work at Caterpillar, he conferred on issues related to the Swiss tax strategy with the same
PwC tax consultants who had helped design and implement it. According to Mr. Bowers, he
performed an independent analysis of the Swiss tax strategy and concluded that it complied
with the U.S. tax code. He also told the Subcommittee that he did not memorialize his
analysis of the Swiss tax strategy by putting it into writing.
E xcerpt from
U.S. Senate
Subcommittee
R eport
Summarizing Dual
Roles Served by
James Bowers,
P wC Tax Partner,
at Caterpillar
Source: U.S. Congress, Senate Subcommittee on Investigations of the Committee on Homeland Security
and Government Affairs, Caterpillar’s Offshore Tax Strategy (Washington, D.C., 2014).
12. D. Douglas, “Caterpillar Skirted $2.4 Billion in Taxes, Senate Report Says,” www.washingtonpost
.com, 31 March 2014.
13. Ibid.
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42
Section One
Comprehensive Cases
preclude the same person from being involved with providing advice to the client
and that same person providing subject matter support to the audit team.”14
In fairness to PwC, the Senate subcommittee report pointed out that Caterpillar had
contracted for the PwC tax consulting services prior to the adoption of more restrictive policies regulating the provision of such services by auditors. For example, under
SOX, which was signed into law by President George W. Bush in July 2002, an audit
firm can provide only those tax services to a public company audit client that have
been pre-approved by the client’s audit committee.15 In 2006, the Public Company
Accounting Oversight Board (PCAOB) adopted Rule 3522, “Tax Transactions,” that
applied to future tax services provided by auditors of public companies. This rule
addresses auditor independence issues that arise when an audit firm’s tax staff recommends “aggressive tax position transactions . . . a significant purpose of which
is tax avoidance.” In such circumstances, an audit firm maintains its independence
only if “the proposed tax treatment is at least more likely than not to be allowable
under applicable tax laws.”
For the accounting profession, the most far-reaching recommendation made by the
Senate subcommittee report was to prohibit public accounting firms “from providing
auditing and tax consulting services to the same corporation.” The report noted that
such a rule would “prevent the conflict of interests that arise when an accounting
firm’s auditors are asked to audit the tax strategies designed and sold by the firm’s
tax consultants.” In late 2014, without referring specifically to the Caterpillar case, a
PCAOB spokesperson reported that her agency was “looking further at the nature of
tax services that auditors are performing for their audit clients.”16
More Bad News for PwC: The LuxLeaks Scandal
The adverse publicity focused on Caterpillar and PwC by the 2014 Senate subcommittee hearing prompted intense scrutiny of tax consulting services provided to
other multinational corporations. In November 2014, the International Consortium of
Investigative Journalists (ICIJ)17 made headlines around the globe when it revealed
allegedly abusive Luxembourg-based tax-avoidance plans that PwC had negotiated with the Luxembourg government for the benefit of 343 multinational clients.18
Information regarding those plans, which was posted to an online searchable database, had been gleaned from thousands of documents obtained by journalists from a
“confidential” source.19 Luxembourg “subsidiaries” comparable in nature and purpose
14. F. Norris, “Switching Names to Save on Taxes,” www.nytimes.com, 3 April 2014.
15. In fact, Caterpillar already had such a policy in place prior to the passage of SOX, which suggests
that the Caterpillar audit committee had pre-approved the tax avoidance services provided to the
­company by PwC.
16. M. Rapoport, “U.S. Audit Regulators Scrutinizing PwC over Caterpillar Tax Advice,” www.wsj.com,
18 November 2014.
17. On its website, the Washington, D.C.-based ICIJ describes itself as a “global network of more than
240 investigative journalists in more than 90 countries who collaborate on in-depth investigative stories.” The ICIJ’s major focus is “cross-border crime, corruption, and the accountability of power.” For
more information regarding this organization, see www.icij.org.
18. Luxembourg’s bank secrecy and business confidentiality laws have historically served as effective
barriers to shield financial transactions from the scrutiny of global law enforcement authorities and the
international press. Those laws and extremely liberal tax concessions granted to multinational corporations and wealthy individuals to induce them to establish a legal residence in the country have contributed to Luxembourg becoming the largest international tax haven by most benchmarks.
19. The source of these leaks was ultimately determined to be a former audit staff employee of PwC’s
Luxembourg City office. See Case 5.3, “Antoine Deltour.”
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CASE 1.3
Caterpillar Inc.
43
to Caterpillar’s CSARL subsidiary were the key feature of these plans. The individual
tax avoidance plans reduced the effective corporate income tax rates for the PwC clients—dozens of which were U.S. corporations—to as low as a fraction of one percent.
The ICIJ ultimately obtained and released additional documents that revealed
Luxembourg-based tax-avoidance plans designed by the three other Big Four
accounting firms, plans similar to those designed by PwC. In one of these latter
cases, a “tax deal crafted by Ernst & Young”20 for The Walt Disney Company funneled billions of dollars of profits earned in the United States to Luxembourg, resulting in substantial tax savings for the company. The “tax deal” routed those profits
to three Luxembourg-based Disney subsidiaries overseen by one Disney employee
from a residential apartment in Luxembourg City.
The “LuxLeaks” scandal erupted less than six months after Senator Levin’s congressional investigation of Caterpillar’s Swiss tax strategy and PwC’s integral role in developing and helping the company implement that strategy. When asked to comment
on the Luxembourg-based tax-avoidance schemes, an angry and frustrated Senator
Levin observed that “Americans are sick and tired of big corporations arranging
sweetheart deals with tax havens to dodge their U.S. tax obligations.”21
Epilogue
In September 2014, the SEC notified Caterpillar
that it was investigating the company’s CSARL
subsidiary and asked the company to “preserve
relevant documents” that might be useful during that investigation. In early 2016, Caterpillar
reported that the SEC had completed its investigation, however, to date, the results of that investigation have not been publicly released.
In May 2015, Caterpillar’s Form 10-Q for the
first quarter of fiscal 2015 disclosed that the
IRS had levied additional taxes and penalties
against the company totaling more than $1
billion due to its Swiss tax strategy. Company
officials reported in the SEC filing that “we
are vigorously contesting” the IRS’s decision
“through the IRS Appeals process.” These additional taxes and penalties stemmed from an IRS
audit of Caterpillar’s corporate tax returns for
the years 2007 through 2009. By early 2018, the
IRS had increased the total tax and penalties
assessed against Caterpillar to $2.3 billion.
Caterpillar’s Form 10-Q for the first quarter of
fiscal 2015 also disclosed that the company was
under investigation by a federal grand jury. That
grand jury was examining the “undistributed
profits” of certain foreign subsidiaries of the
company. It was also examining intercompany
cash transfers involving those subsidiaries and
U.S. operating units of Caterpillar. In March 2017,
agents from the Department of Commerce, the
Federal Deposit Insurance Corporation (FDIC),
and the IRS raided three Caterpillar facilities in
the U.S., including the company’s former corporate headquarters in Peoria, Illinois. Published
reports indicated that the federal agents were
searching for documents related to the ongoing
investigations of Caterpillar by the federal grand
jury and the IRS.
In late 2018, a large class-action lawsuit that
had been filed against Caterpillar was dismissed
by a federal judge. The lawsuit alleged that the
company had misled company stockholders
“about the risks it allegedly took on by using
foreign subsidiaries to avoid paying U.S. taxes.”22
In granting the dismissal, the federal judge concluded that the plaintiffs had “failed to show
20. A. Fitzgerald and M.G. Guevara, “New Leak Reveals Luxembourg Tax Deals for Disney, Koch
Brothers Empire,” www.huffingtonpost.com, 9 December 2014.
21. Ibid.
22. J. Stempel, “Caterpillar Wins Dismissal in U.S. of Post-Raid Lawsuit Tied to Tax Probes,”
www.reuters.com, 26 September 2018.
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44
Section One
Comprehensive Cases
that Caterpillar intended to defraud them, or
knowingly made false statements about criminal and civil probes into its tax practices.”23
The most recent report on Caterpillar’s ongoing legal issues can be found in the company’s 2019 Form 10-K that was issued in 2020.
Company officials reported in that filing that
they were continuing to “vigorously contest” the
$2.3 billion of “proposed increases in tax and
penalties” assessed by the IRS due to the company’s Swiss tax strategy. Company officials also
reported that they were continuing to “cooperate” with the federal grand jury investigation
launched in 2015.
Questions
1. Did PwC behave unethically or immorally in helping Caterpillar develop its
“Swiss tax strategy?” Defend your answer. What specific ethical principles, if
any, were violated by the PwC tax consulting services provided to Caterpillar?
Explain.
2. What accounting or financial reporting principles, if any, were violated by
Caterpillar’s Swiss tax strategy? Explain.
3. Identify the key differences between tax consulting services and independent
audit services. Which professional standards govern the provision of “tax
consulting” services? Do these standards require CPAs involved in such services
to act in the public interest?
4. What audit tests should PwC have applied to the Caterpillar financial statement
amounts produced or impacted by the company’s Swiss tax strategy? Identify the
underlying audit objective for each of those tests.
5. A PwC workpaper for the 2011 Caterpillar audit indicated that the intercompany
transaction involving the exchange of cash between CSARL and the U.S.-based
parent company had been “reviewed” by the audit team. What specific auditrelated risks are posed by intercompany transactions? What audit objectives
would the auditors have had in reviewing the Caterpillar intercompany
transaction? What types of audit evidence should the auditors have collected in
reviewing that transaction?
6. Was James Bowers in a position to perform an “independent” analysis of
Caterpillar’s Swiss tax strategy and the related financial statement implications?
Should the audit workpapers have included documentation of his analysis?
23. Ibid.
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