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July 1993

An analysis of SEC disciplinary proceedings. (Auditing)

by Calderon, Jeanne A.

    Abstract- The SEC consults Rule 2(e) of its Rule of Practice to determine what disciplinary actions to take against malpracticing auditors. As of 1989, a total of 156 Rule 2(e) decisions have been released by the SEC. General auditing-related errors that were punished by the SEC included lack of independence, lack of skepticism, inappropriate reliance on management and lack of adequate evidential materials. General accounting-related errors include material misstatements and misrepresentations. Aside from these general errors, a number of more specific errors were also penalized. Although Rule 2(e) contains only three sanctions, including permanent disbarment of practice, temporary disbarment from practice and public censure, the SEC also takes significantly varied and personalized sanctions against auditors. Auditors and auditing firms should review past SEC disciplinary actions in order to avoid repeating the mistakes of others.

An analysis of the types of alleged errors and the resulting sanctions that were imposed by the SEC against accountants who practice before it may be helpful to all auditors. We believe an understanding of audit problem areas and errors identified by the SEC will serve all auditors well in planning and conducting audits.

Risk of Disciplinary Action

The SEC maintains control over the competence and integrity of auditors and accountants who practice before the Commission by using Rule 2(e) of its Rules of Practice. Rule 2(e) generally provides that the SEC may suspend any accountant it finds who lacks the qualifications to represent others, has engaged in unethical or improper professional conduct, or has willfully violated any of the Federal securities laws. In addition, any accountant who has been convicted of a felony or a misdemeanor involving moral turpitude, has been enjoined by a court from violation of any of the Federal securities laws, or has been the subject of a revocation or suspension of his license to practice, may be suspended under the Rule.

Rule 2(e) disciplinary proceedings are purely administrative. The matter is handled completely within the SEC, and not in court. Being disciplined, or 2ed," is a dreaded event because of the sanctions that can be imposed, as well as the negative publicity and potential litigation that may accompany or follow the investigation. This is particularly true for accountants whose practice is dependent on or highly concentrated on SEC-regulated companies.

Rule 2(e) decisions are published in SEC Releases. A total of 156 Rule 2(e) decisions concerning accountants has been released by the SEC between 1935 and 1989, excluding releases that describe dismissal of Rule 2(e) proceedings against accountants. This analysis of the diverse Rule 2(e) decisions identifies 1) significant characteristics of the decisions, 2) types of errors that have served as the basis for disciplinary actions, 3) types of sanctions that have been imposed by the SEC, and 4) publicity generated by these decisions in the general press.

SEC Releases and their


Although the SEC has released 156 Rule 2(e) decisions against accountants, this number expands to 174 actions considering that in some situations the Commission reviewed several audits conducted by the accounting defendant in one release. (For example, in Accounting Series Release No. 173, five different audit engagements of the same firm were reviewed.) Exhibit 1 presents a tabular analysis of the 156 releases in terms of periods of issuance and other important characteristics. The 1970s was clearly the beginning of increased SEC activity. Of the 156 releases, almost 90% were published from 1970 through the end of the 1980s. The last two decades clearly dominate in terms of SEC activity in this area whether the classification is based on the date of the release (as in Exhibit 1) or on the period during which the misconduct alleged in the release occurred. In addition, since the 1970s the overwhelming number of accounting defendants have consented to publication of the Rule 2(e) release without admitting guilt rather than contesting their alleged misconduct through the SEC administrative procedures.

The SEC's policy whether to name an entire firm as a defendant or only the responsible accountants has evolved over the years. Initially, the SEC believed that accounting firms should be named because under the legal concept of respondeat superior, a partnership is legally responsible for the negligent acts of its partners and employees and holding firms accountable is a practical way to ensure that deficiencies in personnel and quality control are corrected. More recently, the SEC has decided that there must be evidence of firm wide culpability to name the entire firm. Firm wide culpability could be established by evidence of a breakdown in the firm's quality control system, repeated audit failures, or high level involvement in the wrongdoing. This change in Commission policy has reduced the number of times that firm are named and increased the emphasis on naming individual accountants.

Types of Alleged Audit Failures

For purposes of analysis, we have separated the types of misconduct that auditors were alleged to have committed into two categories: auditing-related and accounting-related errors. Although the distinction between accounting and auditing is not always clear, we found it to be a useful distinction for analyzing the releases. Also, some releases covered more than one audit engagement. The counts reported below treat each action separately, even though some of these actions were combined and reported in one release.

Auditing-Related Errors. Two general categories of auditing related errors were cited extensively: 1) lack of independence (29 actions) and 2) lack of skepticism (39 actions). Both categories of errors are fundamental to auditing, with independence a necessary condition for entering into an audit and skepticism, a necessary condition for performing an audit. The SEC's citing of these two types of efforts differed significantly over the years. The inverse relationship between the two over time--in recent years, 1980-89, for example, independence has been cited less (seven) while skepticism has been cited more (22)-- might not be that surprising. Independence in an audit setting is more objectively determined than the requisite level of skepticism, and both the profession and the SEC have considerably strengthened the rules for independence over the years. Because of this, it appears that for identifying errors in complex audit situations the SEC recently has turned its attention to the more amorphous (and less definable) of these two hallmarks of an audit.

On a similar level of generality as independence and skepticism, improper reliance on management was cited in 61 actions, and lack of sufficient evidential matter in 67 actions. An analysis by time periods indicates that both types of errors were cited more often in the 1980s than the 1970s, probably for the same reason skepticism was cited extensively in the 1980s--the vagueness of the concepts adapts to the generality of many SEC Releases.

Although these four categories dominate--lack of independence, lack of skepticism, improper reliance on management, and lack of sufficient evidential matter--audit misconduct relating to six, more specific, issues was identified throughout the actions. Of these six, two recurred significantly more often than others: lack of adequate supervision (24 actions) and failure to disclose related-party transactions (39 actions). The four additional issues, specific in nature and identified more than once throughout the actions, were 1) failure to make an adequate physical observation of work in process (seven actions), 2) failure to adequately document procedures performed or evidence obtained (11 actions), 3) failure to perform adequate auditing procedures related to subsequent events (eight actions), and 4) failure to adequately communicate with and review the work of prior auditors (14 actions). Regarding the 11 citations related to workpaper documentation--all cite from 1980-89--the documentation lacking often was related to the client's inadequate internal accounting controls. If responsibility evolves to include passing judgement on the adequacy of management's internal controls, as some have advocated, the importance of this misconduct would increase immeasurably.

Accounting-related Errors. The level of generalities and overlap is even greater for accounting issues associated with auditor error than with the auditing issues. The most general factor, cited in 142 actions, involved financial statements containing material misstatements and misrepresentations. Financial statement overstatement was cited 82 times and financial understatement was cited 37 times as types of accounting errors. Again, as with auditing errors, the amount of detail presented in the releases related to overstatement and understatement of financial statements varies tremendously. For example, Accounting and Auditing Enforcement Release No. 36 simply mentioned that assets were overstated, but Release No. 66 detailed the understatement problem by discussing the client's failure to accrue commissions, along with several other missing liabilities.

Improper accounting entries were cited as the error in 56 actions. Violation of revenue recognition rules was cited in 48 actions, more often than any other accounting matter. Given the central role revenue recognition plays in financial reporting, this is not a surprise. On a related level of importance, disclosure was cited as a problem in 43 actions either as improper classifications or items missing entirely. As with revenue recognition, disclosure is fundamental to the U.S. reporting system, with its prevalence as a citation also not surprising.

Finally, two issues were recur-ring that do not adapt easily to the auditing/accounting dichotomy. The auditor's failure to follow firm policy on handling a particular reporting issue was cited in eight actions. And in 16 actions, the auditor was cited for not having sufficient familiarity with the accounting and business practices of the client. In other words, the SEC cited the auditors as lacking the expertise necessary for performing the audit.

Sanctions Imposed by the SEC. Rule 2(e) provides for only three types of sanctions: permanently barring the defendant from practice before the SEC, temporarily barring the defendant from practice before the SEC, or public censure (with no limit on SEC practice). However, from our analysis it was evident that the SEC did not feel bound by a literal reading of the Rule's sanctions. The SEC's interpretation of the Rule has led to extremely varied and personalized sanctions against auditors, particularly in recent years.

An imprecise relationship exists between the type of sanctions imposed and the severity of the auditor's errors. Generally, the more egregious the error the heavier the penalty imposed by the SEC on the auditor. A clear cut mapping between severity of sanctions and errors is not possible, however, because the sanctions imposed by the SEC are so varied and their implications for the disciplined party differ among auditors.

Fifty-four auditors or auditing firms have been barred permanently from practice before the SEC. Censuring the defendant was the least severe sanction imposed by the SEC. A total of 23 releases fit this category. The SEC does not impose any time limitation on practice before the Commission pursuant to a censure. However, in some of these releases the SEC imposed work review, peer review, and/or continuing education requirements.

In recent years, the SEC has used the middle ground between permanently barring and censuring. The large number of variations makes it difficult to capture fully the SEC's actions. Four variations are discussed here to illustrate the SEC's tailoring of sanctions to fit particular situations.

Permanently Barred. In 61 releases the SEC "permanently barred" the auditor from practice-but with a reapplication period provided. The reapplication periods varied widely, ranging from 30 days to five years. In most cases, the auditor reapplied and subsequently was allowed to practice before the SEC.

Limitation on New SEC Clients. In 11 releases, the SEC limited the auditor from taking on new SEC clients and/or participating in audits of public companies. This sanction usually involved a time period, and often was tailored to the particular audit situation. For example, in Accounting Series Release No. 153, a California practicing office of a national auditing firm was limited from taking on new SEC clients for a period of one year.

Improvements to Firm Procedures. The SEC, beginning in the 1970s began requiring improvement to the firm's procedures. These included 1) installation of internal/quality control procedures at the auditing firm, 2) SEC mandated peer review by the SEC Practice Section of the AICPA's Division for Firms or a similar review body, and 3) work review of an individual auditor's work. Fifty-four releases fit within this category, with a substantial portion (40) published in the 1980's.

Continuing Education Requirements. The SEC imposed continuing education re-quirements in 34 releases. The topical coverage, reports on education completion, and length of the education requirements varied across the releases. Extensive use of this sanction probably will decline in the future, however, considering the recent AICPA ruling requiring continuing education of its members.

Coverage in the

Financial Press

We also explored whether the Rule 2(e) decisions "made news." In contrast to Rule 2(e) decisions which are contained in SEC releases published in securities law reporters and therefore read by an extremely narrow audience, the general press is read by a much wider public. We searched The New York Times (Times) and The Wall Street Journal (Journal)--our proxies for the general press--to determine how many Rule 2(e) decisions received coverage.

Although the journal's coverage of Rule 2(e) decisions was greater than that of the Times, coverage was still low relative to the total number of releases. This is little consolation for those auditors and/or auditing firms cited in the press, however, as the reports inevitably represent negative publicity for the parties involved. Thirty-seven Rule 2(e) decisions received coverage in the journal For the Times, 22 decisions received coverage. As expected, there was significant overlap in coverage by the two newspapers.

Lessons to be Learned

Being 2ed" by the SEC is a time-consuming (for both the auditing firms and the SEC staff) and potentially embarrassing event in the life of an auditor and/or auditing firm. The litigation and public exposure that often accompany the disciplinary action can be even more damaging. The point of this analysis is to identify, from the SEC's perspective, some of the problem areas in the audit process and put the auditor on notice of mistakes that in the past have led to Rule 2(e) actions.

Although the audit process is a complex one, the failed audit themes identified by the SEC are rather simple and straightforward. The SEC does not appear to "2e" auditors based on obscure aspects of the audit (although there is always room for dispute over appropriate application of the basic audit themes in complicated business settings). The SEC emphasizes the fundamentals of the audit and expects them to be met.

Furthermore, none of the audit themes identified are new to the auditor. Nor are they new themes to the auditing profession, given the close working relationship established between the SEC and the professional bodies responsible for establishing and monitoring the hallmarks necessary to assure a successful audit. What is more important, however, is that the auditor understands that the SEC, as the public monitor of the profession, expect,s audits to be conducted in accordance with these fundamental hallmarks and will take the auditor to task if they are violated.

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