In chapter 4 we discussed the rules for independence. Auditor violations of independence can cause legal liability issues for the individual auditor and, perhaps, the audit firm. Describe situations where auditor legal liability has occurred as a result of independence violations and identify other situations addressed in the AICPA Code that could lead to legal liability.

Question

What will be an ideal response?

Answer 1

Two examples of insider trading were discussed in Chapter 4 - Scott London at KPMG and Thomas Flanagan at Deloitte. Scott London, an audit partner at KPMG who traded on inside information and violated audit independence by leaking confidential information to his friend, Brian Shaw, about Deckers, Pacific Capital Bancorp, Skechers, and Herbalife - all audit clients of KPMG. The leak of information about quarterly earnings information led to Shaw's unjust enrichment of $1.27 million. Shaw, a jewelry store owner and country club friend of London, repaid London with $50,000 in cash and a Rolex watch, according to legal filings.

London settled administrative proceedings with the Securities and Exchange Commission that includes SEC sanctions and forfeiture of the right to appear or practice before the SEC as an accountant. On the criminal side, London was convicted of insider trading in June 2014, and is serving a 14-month sentence for his crime.

In 2010, Deloitte and Touche was investigated by the SEC for repeated insider trading by Thomas P. Flanagan, a former management advisory partner and a Vice Chairman at Deloitte. Flanagan traded in the securities of multiple Deloitte clients on the basis of inside information that he learned through his duties at the firm. The inside information concerned market moving events such as earnings results, revisions to earnings guidance, sales figures and cost cutting, and an acquisition. Flanagan's illegal trading resulted in profits of more than $430,000. In the SEC action, Flanagan was sentenced to 21 months in prison after he pleaded guilty to securities fraud. Flanagan also tipped his son, Patrick, to certain of this material non-public information. Patrick then traded based on that information. His illegal trading resulted in profits of more than $57,000.

A number of additional situations can cause an actual breach of independence, or—just as serious—the appearance of such a breach. These include the following:

1. Employment relationships. AICPA and SEC independence rules both provide that an audit firm's independence will be impaired if former firm professionals are subsequently employed by or associated with an attest client in a key position, unless certain conditions are met. In addition, the SEC rules, being the more restrictive, include shareholders as covered members and require a one year cooling-off period before a company can hire an individual formerly employed by its auditor for a position involving oversight of the financial reporting process at the registrant entity.

2. Direct or material indirect financial interests. The AICPA and SEC independence rules both explicitly state that a member or a member's firm may not have or be committed to acquire any direct or material indirect financial interests in a client. Further, both the AICPA and SEC independence rules provide similar, but not identical, language regarding guidance on situations in which serving as a trustee or executor of an estate that has a direct or material indirect financial interest in the client will impair independence.

3. Loans to and from clients. AICPA guidance provides that all loans to or from clients, without regard to materiality, impair independence (unless the loan is from a financial institution and certain criteria are met).

4. Business relationships. AICPA and SEC independence rules provide that business relationships with clients - such as joint ventures, limited partnership agreements, investments in supplier or customer companies and sales by the member of items other than professional services - will impair independence. AICPA rules regarding business relationships with clients provide that if a member or a member's firm has a material joint, closely held business investment with a client, independence is impaired. A joint closely held business investment refers to an investment that is subject to the control of the member or the member's firm, the client, the client's officers, directors or principal stockholders or any combination thereof. The AICPA rules address such situations as creating a threat to independence that must be mitigated by specific safeguards to avoid violating the independence rules.

The foregoing are certainly not the only instances in which auditor independence could be lost or threatened. Importantly, since the appearance of independence must be maintained, various permutations of these fact patterns, even if not expressly addressed by SEC or AICPA rules, could give rise to allegations of breaches making auditors vulnerable to assertions of malpractice.

As further scrutiny is placed on auditor independence, in both fact and appearance, it is probable that auditor liability due to violations of auditor independence will remain an area ripe for litigation.