PCAOB penalises PW India
PW India violated its most fundamental duty as a public watchdog - say the SEC and the PCAOB of Pricewaterhouse India’s role in the Satyam fraud. The two American regulators have imposed their largest ever penalties on PW India, USD 6 million by the SEC and USD 1.5 million by the PCAOB.
The PCAOB or Public Company Accounting Oversight Board - an Audit Super regulator created by the Sarbanes-Oxley Act, 2002 and working under SEC’s oversight - has also imposed other sanctions on 5 PW India firms including a bar on accepting any new US based clients for six months. All this while Indian authorities struggle to build a case against the firms or their partners.
So how did PCAOB arrive at these charges, how did they determine the penalty and the limitations and what does this mean for PW India and the audit fraternity in the country? In their first ever interview to Indian media Jay Hanson, a Board Member of the PCAOB and Claudius Modesti, PCAOB’s Director of Enforcement and Investigations speak to CNBC TV18's Menaka Doshi.
Below is a verbatim transcript of the interview. Also watch the video.
Doshi: You have found at PW India’s five firms deficient cash confirmation procedures as well as a failure to detect a general practice in the cash confirmation process that was not in accordance with PCAOB standards, that is a general quality control failure. Can you describe to me based on your experience of prosecuting hundreds of cases, audit standards across the world, how severe you think these violations are?
Modesti: This is a very significant matter. When the Satyam fraud was revealed, its stock plummeted and US investors realized losses of over USD 450 million. That number does not include the losses suffered by Indian and other global investors. The failure by the auditors in this case goes to a bedrock audit principle and it relates to the confirmation of cash and how to control those confirmations. Those failures by the auditors contribute to their failure to detect the significant fraud perpetrates by Satyam over a multiple years. The PCAOB believes its orders send a strong, deterrent message that audit firms have to get it right.
Doshi: Audit firms have to get it right and I understand that. In the words of your Chairman, James Doty, “Two of the PW India firms, PW Bangalore and Lovelock, repeatedly violated PCAOB rules and standards in conducting the Satyam audits. These confirmation deficiencies contributed directly to the auditors’ failure to uncover the Satyam fraud”. Is it your contention that had the five Indian affiliates maintained quality standards as prescribed by the PCAOB and those two specific firms, that have been penalized, in fact done their work as it was meant to be, they would have in fact uncovered this fraud before Ramalinga Raju obliged us with a confession?
Hanson: The standards that the PCAOB issues for conducting audits and the actual procedures that the auditors do, our design detects what we refer to as material misstatements in the financial statements and that includes whether they caused by just a simple oversight or caused by frauds. So the answer is yes that if the PwC auditors would have conducted the audits according to our standards, they should have detected the fraud. Now as Mr Modesti alluded to the basic procedures that the auditors did not do are things that are very easy to understand and that is the confirmation process and by confirmation what I mean is the auditor should independently verify the items in the financial statements; so cash is a simple thing for anybody to understand.
So if you went to a bank to get a loan and the bank was concerned about how much money do you have before we give you a loan, they would verify what you tell them and so the simple step of verifying the cash that the management said was in the accounts was not done and in fact the procedures that were done raised questions that were not appropriately followed up on. So the act of, what we call controlling the confirmation, so the auditor themselves sending the letter to the banks and getting those letters back directly, without letting management essentially interfere in their process, is a core principle that every auditor understands or should understand and that was not done. So, if our standards had been followed, we believe that fraud would have been detected long before it was revealed.
Doshi: This question goes to both of you whoever chooses to answer it. Did you, in your investigations detect, let us say, conditions in India that made it difficult for auditors, specifically these five, to be able to follow those simple procedures as you put it because I have been talking to the audit fraternity the last few days to get a sense of what their reaction is to this settlement and they say that often it has been tough, especially before the Satyam fraud came to light, now of course everyone has spruced up their act but it has been tough as the fiscal year comes to an end to be able to get those confirmations from banks. Often banks have questioned auditors as to why should we reveal details to you, there are no prescribed forms, I am told, by the Central Bank that allow for auditors to follow a prescribed format in being able to receive these external independent confirmations. So did you think that the weaknesses lied in the system itself and that may have been part of the cause or the reason why PW was not able to comply with such simple standards?
Modesti: I think the best way to answer this is to focus on the audit violations and to keep in mind that the PW India firm’s own audit plan contemplated and required that they control the confirmation process over cash and fixed deposits. To the extent that the auditors ran into difficulties about attending those confirmations that they needed to make adjustments so that audit plan to get sufficient evidence to support their audit opinion. In fact in some cases, the auditors received confirmations from some of the branches of the Indian banks from which they sought confirmations and it showed significant differences from what Satyam revealed in its confirmations that it gave to the auditors about what the balances were. I believe in one case there was a Mumbai branch of a bank that according to Satyam confirmation it had USD 176 million on deposit, the confirmation received from another branch indicated that there was nothing under deposit. And that is the type of evidence auditors needs to consider in deciding whether they can issue an audit report.
Hanson: In other words, even though there were difficulties in doing the step, what was performed was not properly followed up on for the exceptions that were critically evident in the steps that were done.
Doshi: Was PW able to offer an explanation as to why if the bank’s external confirmation did not show up that deposit, they were not able to investigate it further or they did not come up with any qualification of sorts?
Modesti: What our enforcement order found was that there was a lack of focus on that conflicting and contradictory evidence and that they needed to consider that more carefully in deciding whether they could issue an audit report and in cases where the auditors did not have sufficient evidence to support their reports, they either have to qualify the report or refuse to issue the report and that is what we found through our investigative process.
Doshi: Then that goes beyond just simple lack of quality control standards, it goes beyond simple carelessness, it goes beyond not complying with PCAOB standards. To some degree, if I was to be able to use the legal term, this would be gross negligence, wouldn’t it?
Modesti: We don’t apply a standard in exactly those terms. The Board’s order is based on conduct that is sufficiently violative of our standards and the facts and circumstances here indicated that there was a failure to follow those standards and that failure was significant enough for the Board to sanction the firms in a very substantial way. So I think you have to look at the entirety of the order and the violations to get appreciation for what happened here.
Doshi: I also want to ask you why you choose to penalize the firm and not take any action against the individual partners. But before I come to that, I want to know what the experience of investigating this case was like, working in India because our Indian regulators have had very little or made very little progress with building any coherent case- either against the firm or individual partners. Now there are multiple investigations going on in India, multiple authorities investigating the matter and that could, in a sense, be the cause for delay. I am not asking you for why you think the Indian regulators are delayed but I would like to understand whether you had access to the documents you needed or what was the investigating environment in India like? How much assistance you got from the SEC- all that helped you to come to this speedy decision?
Modesti: We applied our expertise in investigating audit failures in this instance and we obtained the documentation that we demanded from the PW firms and from those working at the PW India firms. We were able to examine witnesses in India, we examined numerous witnesses. Several of those witnesses refuse to speak with us and our Federal Law in United States gives us the power to sanction persons who refuse to cooperate and in this case, there were two PW Indian managers who refused to be examined and we permanently barred them from auditing public companies and our coordination with the SEC was very close. We took on a significant responsibility in terms of developing investigative records. In the United States, we are allowed to share that information with the SEC- that helped us to get through a timely and effective resolution of the matter and helped us avoid duplication of effort and that in totality was our investigative process resulting in the enforcement order.
Doshi: Did you run into any hurdles, whatsoever, in terms of the multiple investigations that were going on in India?
Modesti: We did not and we gained access to witnesses that we needed to gain access to for purposes of this investigation and like I said, the two who did not cooperate were sanctioned.
Hanson: Just to clarify, we did not have access to the Satyam records or people. It was only the PW India people and records that we had access to for our investigation there. So our authority does not extend to anything beyond the PW Firm.
Modesti: That's correct. In US Federal Law, the United States Security and Exchange Commission has the power and authority to regulate and oversee the US public companies and other companies that trade on our markets, such as Satyam, and as you know the SEC brought its case against Satyam.
Doshi: Can you explain to me why you took action against the firms and not individual partners that you may have found guilty of this negligence, so to speak, especially if they were the ones trying to reconcile the bank statement with the kind of information that Satyam offered them and couldn't find a match; yet, didn't do anything about it. I understand you went after the firms for a systemic failure of quality standards, but how come you haven't, in any sense, taken any action against individual partners?
Hanson: In addition to the 5 PW firms, we have entered into orders with individuals and as Mr Modesti mentioned that two of the individuals refuse to cooperate and so we have effectively barred them from ever working on US public company audits but we have entered into settlements with some individuals as well. Claudius you want to expand on that at all?
Modesti: As you indicated, in this case, there were quality control violations and we have addressed that through the use of the independent monitor and the undertakings in the order and that's important in terms of investor protection and the firm getting it right going forward and beyond that, I can't comment on the extent of our investigative process. That process is confidential. But I can say that we addressed the firm conduct, given the facts and circumstances here, and this was the failure to detect a significant fraud and the larger problem that we found through our investigative process related to a more general practice of failing to comply with the PCAOB standards in terms of cash confirmations and that's why we have a package of sanctions. I am including the largest penalty in our history and combined with the SEC penalties - these are largest for both regulators for non-US firm- that is in place along with these other sanctions to ensure that investors get more robust audit reports going forward.
Doshi: I understand that. What I am curious to understand is, is it that the PCAOB prefers to take action against a firm rather than individual partners although you have, like you said, already barred two partners on the basis of not cooperating with you investigation. Could it be possible that you could take future action against PW India partners? I am just curious to know why is it that you prefer to penalize the firm and not take any action against the partners.
Modesti: We under our law - our investigative process is confidential and I can just tell you as a general matter, we always look to see who the responsible parties were for the conduct that's at issue. So it is not a question of preferring or showing preference over charging a firm versus individuals. We always look to see who the responsible parties are, just as the general matter in terms of our process.
Doshi: I am told that the PCAOB, and this is unconfirmed but I would like to put it to you, had in fact inspected PW India's Satyam files before the fraud came to light. This was, I am told, a routine investigation. At that point in time, you did not discover these ‘deficient cash confirmation procedures’, as you have put them to be, and ‘pervasive failures in quality standards’, again in your words?
Hanson: Our policy is to not comment on individual findings in the firms, so we can't comment on the specifics. But the report that we issued on the PW India firm was just by the nature of this investigation, we decided to release it at the same time and with respect to the procedures that we perform on any of the non-US firms, we are always looking to improve our process and improve our identification of what we actually look at. For any inspection of any firm or any given company, we don't look at everything whenever we do an inspection. We look at selected items that are typically the higher risk items. Therefore we don't identify the actual issues that we look at nor what we chose to look at those issues.
Doshi: I understand that it’s impossible, despite being an oversight body, to be able to look at every small process within an audit firm but because your press release says “this pervasive failure with regards to maintaining quality standards continued for many years and went undetected by PW India’s quality control system”- I am curious to know that if you had done a routine investigation, which I am told you did, prior to this fraud coming to light- did you miss this failure or this pervasive failure in quality standards, did you come across any, maybe few instances, of these failures but were not able to establish a pattern? What did your previous investigation throw up, if at all anything, or did none of this come to light in your previous inspection?
Hanson: As I stated, we cannot comment on the individual findings that we have had on firms other than what in the report. I cannot answer that.
Doshi: But could you confirm for me that you did in fact do a routine inspection with PW India with regards to the Satyam’s files before this fraud came to light?
Hanson: We cannot confirm which issues we looked at. We cannot confirm that we did conduct an inspection of PW India firm.
Doshi: Moving to the next point and this is to do with $1.5 million penalty figure. Based on everything that we have discussed till now- the severity of these lapses- how did you arrive with this number? Is there a basis for which you are able to apportion the extent of the lapses and therefore the kind of monetary penalty- as you have pointed out this is your largest civil penalty ever?
Modesti: It is our largest civil penalty and the Board took into consideration the penalty that the United States Security Exchange Commission imposed on the five PW India firms and that combined penalty is the largest against the non-US auditor and we think when you combine that penalty along with the other sanctions that are in this order and the undertakings in this order, they are significant. They send an important return message to firms that are conducting audits and the most important thing to focus on is to function of this independent monitor is going to be a significant cost and burden on firms to have this monitor in place and we think, at the end of the day, it had that monitor in place to drive the quality control improvements that the order requires and that the quality control standards require is the most important thing for purposes of investor protection.
Doshi: I understand that’s the independent monitor bit. If either one of you would like to, in fact, help me better understand some of the other significant limitations that you imposed on the five firms- this is besides the six month bar on new US-based clients. You have also said that the PW India needs to make sweeping changes to quality control policies and procedures. How do you hope to be able to ascertain the fulfillment of what is largely a qualitative requirement and what are you hoping that all of this will achieve besides the bar which I understand is punishment of sorts. Do you believe that all of this that you have imposed on the firm will help improve audit standards in PW India?
Hanson: Let me comment a little bit upon on what the scope and scale of those undertakings are. In any business, when you reflect on what are the most important drivers or what makes a business successful- you got to have a good product and we think overall an audit is a pretty good product- but then its all about the processes, the people, the training that the people get, how they are supervised and what review process go into place before a product is issued. So the undertakings cover essentially every one of those core elements that any business would look at to improve. So we have requirements on new leadership at the firms, requirements on the people they bring in, requirements on extensive training- especially in the areas where they fail to do the job relative to confirmation procedures and fraud-detection procedures, substantial on-the-ground-review procedures relative to while the audit is being conducted- both supervising and then reviving before the audits are issued -to make sure that they do meet the standards and many of those review processes and other things involve individuals from other PW international network firms and so its not just that PW India can supervise themselves, it has to be people from outside of PW India.
And then as Claudius mentioned and you questioned with the monitor- the monitor’s job is to make sure that all these things happen and with the monitor and all that Claudius talked a bit more about the selection and operation- but effectively that’s our way because we can’t be on the ground to see what is happening and ensure that the quality is essentially being built-in during the process and so insisting that they incur the cost to engage a monitor that is acceptable to us and the SEC is an important step in this qualitative steps. Claudius do you want to comment any more about that monitor?
Modesti: The independent monitor has to be proposed to us within 60 days of our order and the SEC order, has to be a person who has familiarity with PCAOB standards and US GAAP and once that monitor is in place, they will be ensuring that the firms are making progress under quality control improvements and that all the undertakings that Jay was highlighting actually are working effectively. At the time significant progress is being made against those improvements, the firm will be able to take on additional work, that no significant deficiencies have been identified based on the pre-opinion reviews, the post-opinion reviews, the quality-control reviews. There is a very comprehensive package for the independent monitor who report to us and the Security Exchange Commission and its also important to point out that both the Chairman and the Assurance leader for the PW India firms will be submitting compliance certificates to the monitor indicating that they are accomplishing what the order requires and that will focus the mind of those individuals who are in those leadership positions that these undertakings need to be fulfilled and need to move forward.
Doshi: I am going to put the last two questions to you. The first one has to do with how PW India has described- this is quoted in some Indian newspapers, it says- "Neither of the orders (by US SEC and PCAOB) found that PW India or any of its professionals engaged in any intentional wrongdoing or was otherwise involved in the fraud perpetrated by Satyam management.” Would you say that this is just a positive spin by PW India and it attempts to tone down the impact of these penalties or would you say that they have in fact been absolved of the worst?
Modesti: Our order addresses their audit violations and the statement you are referring to is their statement, it is not the Board’s statement, it is not the Board’s order. We made findings, as I mentioned before, it is a very significant matter that we are talking about, it is fair to detect significant fraud, and we described the conduct in the order in significant details.
Doshi: I understand all of that but, in a sense, would you agree that they have been, to some degree, absolved of the worst which was collusion with Satyam’s management?
Modesti: I don’t view the Board’s enforcement orders as absolving. I view the Board’s enforcement orders as identifying the conduct that led to the violations. So we made those findings and those are the findings that we stand on for purposes of our case. That is how I view the function of our enforcement order.
Doshi: Would you consider taking any further action against PW India or its partners if, let us say, new facts came to light? Let us say the Indian authorities in fact did discover some collusion - I am speaking hypothetically - on behalf of either the audit firm or any of its partners, would you then want to reconsider taking further action or is from the PCAOB’s point of view, this case is now closed?
Modesti: I cannot comment on the rest of our investigative process because of the confidential requirements that we operate under but I can say that in any instance and in any situation, where courts of law or other regulators are developing facts and making findings, we are always going to be mindful of that and to take that into consideration for purposes of our oversight. But beyond that, I cannot comment and in this particular situation about what we may or may not do.
Doshi: The SEC in its press release says its investigations are continuing. Would that apply to your investigations as well in the Satyam matter?
Modesti: Our investigative process is subject to the Sarbanes-Oxley’s confidentiality provisions. So we don’t comment on whether the investigation is ongoing or not; the SEC has its own laws and regulations that are applied to its process.
Doshi: Based on your investigation in this case, on your regular interaction with Indian audit firms, of the previous routine inspections that you have made and the experience that you have had with both the failures at PW India as well as the extent of this Satyam fraud- what would you make of the quality of audits in India, what do you think some of the key takeaways of this very unsavory episode will be for India’s audit fraternity?
Hanson: We have over 60 firms in India that are subject to our oversight and that means they have at least one US issuer client that they do some work on or that they are just simply registered with us and we don’t necessarily go in and look at their work and we have not previously detected specific patterns of behavior that we could draw any conclusions from but this experience certainly has made us more mindful of some of the cultural differences and the local business climate differences with respect to things like confirmation procedures and have changed our inspection procedures around the globe for the other firms that we inspect. So, I think, the biggest message to walk away from this is PCAOB is out to protect investors by ensuring that the auditors do their job and we think this order sends a really strong message and beyond that just the message for auditors around the globe of exercising their professionalism and due care, objectivity and being tough with management- that is a message it sends because they need to consider first the investors in the businesses that they audit as their ‘client’ and consider them first without regard to what management might say and that is probably the most important thing that this message sends is that they have to think about the investors first and be very objective in their procedures.