Big 4 CPA Firm Knew in Advance Which Audits Would Be Inspected by Government Watchdogs

This is violation of trust, and it matters!

Auditors must design their audits to look for fraud, and failure to do so may cause massive losses for stakeholders, investors, creditors and retirees. Neglecting to detect fraud can be truly life-altering — especially for retirees.

While teaching a business ethics class in Jackson, Mississippi, I was approached by an employee of the former fraud-ridden company Worldcom. “Emily Simmons” (an alias) and her husband, “Jim”, both of retirement age, had worked at Worldcom and its predecessor companies for over 30 years. Their combined retirement plans (all in Worldcom stock) previously had a value of $3 million. After the fraud was discovered, the plans were worthless.

With tears running down her face, Emily said to me, “Jim and I cannot retire. I was looking forward to a comfortable retirement and helping my daughter raise my grandchildren. Now I can only visit them twice a year. I hope that one day I’ll have some sort of retirement – although I am not optimistic – where we can spend a little time together before Jim and I die.”

Time Magazine’s 2002 “Woman of the Year” Cynthia Cooper and her team of internal auditors at Worldcom blew the whistle on Worldcom CFO Scott Sullivan and CEO Bernie Ebbers. The fraud unraveled, the perpetrators went to jail and Worldcom – along with its value – ceased to exist. Because of the Worldcom fraud, Section 404 of the Sarbanes Oxley Law was written, requiring companies to have much stronger internal controls and for those controls to be tested by auditors. But these requirements did not help Emily and Jim.

The Sarbanes Oxley Law (SoX) was enacted in 2002 by Congress in response to the massive fraud schemes that occurred at Worldcom, Enron and HealthSouth, among others. In SoX, Congress established the Public Company Accounting Oversight Board (PCAOB) as the government watchdog to oversee and regulate public accounting firms who audit and report on publicly traded companies. Previously, these firms were self-regulated. The leadership of PCAOB consists of a five-member board, appointed by the Securities and Exchange Commission, whose duty is to oversee audits of public companies with yearly exams to protect investors and the public interest.

A recent case has brought into question the integrity of both auditor (KPMG) and government watchdog (PCAOB). KPMG has been under intense scrutiny for years for failing to find problems at audit clients such as General Electric and Wells Fargo. When the PCAOB recently issued long-awaited reports on examinations of KPMG, it was disclosed that almost half of the audits had serious deficiencies. Two previous PCAOB inspections of KPMG were compromised by the firm’s advance access to the information. When the PCAOB replaced some KPMG audits it previously reviewed with new ones, the new audits had a much higher rate of problems. This illustrates the extent to which the advance access helped KPMG.

So, does it matter that “Big Four” accounting firm, KPMG, knew in advance which of its audits would be inspected by the PCAOB? You bet it does, because SoX was enacted to regulate a former self-regulated industry when it comes to publicly traded companies. Now the watchdog has been compromised.

KPMG fired David Middendorf and other KPMG partners accused of being involved when the PCAOB information leak was revealed in 2017. Middendorf was directly responsible for dealing with the PCAOB. He is now a defendant in a federal criminal trial that started February 11, 2019, in Manhattan. He faces charges of wire fraud and conspiracy. Former inspections leader at PCAOB, Jeffrey Wada, is a second defendant in the trial.

Three other defendants have pled guilty and are expected to testify against Middendorf and Wada. One of the now-convicted felons is a former KPMG partner who helped oversee audit quality at the firm and another partner who formerly worked at PCAOB before joining KPMG.

This story is important because the individuals who are supposed to be guardians of innocent people like Emily, Jim and thousands more have been let down. Auditors are supposed to ferret out frauds and protect stakeholders, creditors, investors and retirees. Unfortunately, we are now left to question those who have a duty to protect – both the auditor and the watchdog.

Last week, it was gratifying to read a post on LinkedIn by Richard Chambers, CEO of the Institute of Internal Auditors. Richard reminded internal auditors of the important role they play, and reminded them that, “I am respected and admired, because I am a guardian of trust!”

I heartily commend Richard Chambers for imparting this message to auditors, and I suggest that all auditors adopt this moniker. “Guardians of Trust” instills a sense of pride, because all business and individuals in the private and public sectors want assets safeguarded, and to know that someone is watching over the operation to see that those assets are protected. Sometimes, unfortunately, unscrupulous individuals and firms will be tempted to put their hand in the cookie jar – we call them thieves and fraudsters.

The story of the criminal trial involving the KPMG partner and PCAOB inspector is extremely relevant to those in our industry. This is a high-profile scandal which may have helped a “Big Four” accounting firm look better to its regulator — and hurt average people like Emily and Jim. It is up to the rest of us to do better, and take up the mantel of “guardians of trust.” If we fail to do this, the vicious cycle of fraud will undoubtedly continue on for years to come.

Capital Expenditures, Depreciation and Amortization in a Cash Flow Forecast and the Impact of the New Tax Law

The US Tax Cuts and Jobs Act (“TCJA”) passed by Congress on December 20, 2017, will impact forecasts of a company’s cash flow and thereby will likely impact the valuation of a company. One of the forecast elements impacted is the forecast of capital expenditures, depreciation and amortization.

The lowering of the C Corporation income tax rate from 35 percent to 21 percent will have a positive effect on the cash flow of affected corporations, all else held constant. With less cash going to pay taxes, more cash will be available for other uses, including capital expenditures (“capex”). This necessitates an increased scrutiny of a capex forecast, as recent historical expenditures may no longer be relevant as an indication of expected future expenditures.

The TCJA also allows for a first-year bonus depreciation of 100 percent — it was 50 percent prior to the TCJA — for certain qualified tangible property placed in service between September 28, 2017, and December 31, 2022, that has a depreciable life of up to 20 years. Generally, this bonus depreciation then declines in subsequent calendar years (exceptions for certain property):

2023 80%
2024 60%
2025 40%
2026 20%

The impact of these tax law changes will not be reflected in book basis depreciation calculations that appear in US GAAP financial statements; therefore, it is necessary for projections to be on a tax basis if they are being used for an income approach in a valuation of a business.

Business valuation analysts must be aware that the TCJA will cause the relationship between capex and depreciation to have an irregular pattern, and it will affect a much longer projection period than both company management and the valuator may be accustomed to preparing and analyzing. A longer forecast period is necessary due to the impact of timing differences on the present value of forecasted cash flows.

The always-important issue of normalizing capex and depreciation for the terminal period in a discounted cash flow model is further complicated by the depreciation provisions in the TCJA. A valuation analyst may address the issue by using a multi-stage model and capturing the depreciation provisions of the period 2018-2022 in the first stage, 2023-2027 in the second stage, and the length of the third stage being a function of the lives of the company’s assets. A valuator may also normalize the capex/depreciation for the terminal period in the year following the end of the projection period, and then separately adjust for the present value of the remaining TCJA induced capex/depreciation differences. The tax benefit of the amount not captured in the projection period would be calculated and then present valued over its remaining life at the terminal year. This amount would be added to the value of the company obtained from the discounted cash flow model. A valuator may use other multi-stage models customized for the type and lives of a company’s assets.

Overall considerations when forecasting capex/depreciation/amortization are as follows:

  • Normalized future capex would typically be greater than depreciation in a projection for a growing company, to allow for inflationary growth in the replacement cost of fixed assets.
  • Amortization has a limited life and should not be projected into perpetuity. The tax benefits of amortization subsequent to a projection period should be valued separately from the terminal value and added to the enterprise value.
  • The tax benefit of the depreciation on long-lived assets subsequent to a projection period would be treated and calculated similarly as amortization.
  • Due to the effects of provisions of the TCJA, valuation analysts must consider:
    • Obtaining or preparing longer-term schedules of capex/depreciation forecasts;
    • Building multi-stage models that account for the present value of changes in cash flow based on the depreciation provisions; and,
    • Reviewing all management-supplied information for reasonableness and internal consistency, as other changes in the TCJA could also impact forecasted cash flows.

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