In this paper I will discuss the action of the Securities Exchange Commission (SEC) against Michael Goodbread, a Certified Public Accountant (CPA) and a partner at Deloitte & Touche, then an international accounting firm (United States of America, 1996). I hope to explain the SEC’s reasons for censuring him.
The SEC charged that Goodbread violated: its own independence rules; the Code of Professional Conduct of the American Institute of Certified Public Accountants (AICPA, 2012); and Generally Accepted Accounting Principles. The cause of these charges was twofold. First, Goodbread’s ongoing ownership of stock of Koger Properties, Inc. while, as an engagement partner, he supervised Koger’s audit for the fiscal year ending March 31, 1990. He had purchased the stock (400 shares) in December of 1988. This was defined as a “direct” but “immaterial” interest in Kroger, and as such was a violation of accepted practice.
Section 602.02.b of the Codification of Financial Reporting Policies states that any stock ownership in a client impairs independence, and that “materiality is not a consideration in the case of a direct financial interest” (U.S. Securities and Exchange Commission, 1999). In other words, the amount of Goodbread’s investment was irrelevant. Any such stock ownership violated his independence. But additionally, Goodbread’s ownership of stock of an SEC registrant (Kroger, in this case) would have been a violation even if he hadn’t been the auditor. That’s because rule 2-01 of Regulation S-X (Securities Lawyer’s Deskbook, 2011) prohibits a direct financial interest (stock ownership) by partners, and Goodbread was a Deloitte partner.
In June of 1990, Goodbread signed an “unqualified” audit opinion. “Unqualified” means there were no disclaimers by the auditors as to their own independence from any self-interest in Kroger. Had he been a non-partner and made such a disclaimer but kept the stock, no action would have been brought against him. Also, upon becoming a partner, had he immediately divested himself of the Kroger stock (or the stock of any SEC-registrant client), no action would have been taken. Thus, in signing the unqualified audit opinion, Goodbread broke accepted accounting rules. In short, he lied. Accordingly, on December 10, 1996, the SEC issued its Accounting and Auditing Enforcement Release No. 861, censuring Michael Goodbread. It was an act of enforcement that required no new statutory interpretation.
Goodbread sold his Kroger stock (at a loss) one month before he signed the unqualified audited opinion, and this fact is part of the SEC’s complaint. No mention is made of whether his simply holding on to the stock would have lessened his punishment. That lack conforms to the judgment that it was not the selling of the stock that mattered, nor the timing of the sale. It was simply the legal fact of owning it as both an auditor and partner. Therefore not even a plea of honest oversight in his ownership of the stock could mitigate his punishment. As a practical matter, such an oversight would not have reflected well on Goodbread’s abilities as a practitioner of his profession. One should not forget the stocks one owns.
Part II: Britain’s 19th Century Accounting Rule
Being permitted by statute to own equity in a client would obviously argue for a fundamentally different definition of “independent” auditor. And being required to own such equity would imply a radically different enforcement-mechanism. Yet such was the case in Great Britain during the nineteenth century. However, the rationale for this rule seems clear enough: actions speak louder than words. In theory, an auditor need only inform the public of both the nature of the investment in a given firm taken on as a client, and the extent of the investment. A substantial investment by a known firm of demonstrated reliability would itself be a statement of the auditor’s opinion of the reliability of the audited firm. If all auditors were obligated to make such investments, the public could compare the different historical rates of investment by different auditors over the years; or see how long one given auditor had invested in a particular firm, and how much had been invested — had the investment gone up or down, and why?
The problem with this approach, of course, is that the public has got to trust the veracity of the stated investments. If an auditor stated that his investment was x%, how does the public really know it isn’t much less than that? And as we know very well by now, even known firms of demonstrated reliability can become corrupted during boom times, when stocks are issued willy-nilly, and auditors can make huge commissions by making recommendations and vouching for the integrity of companies that, given the euphoria of the times, might very well be profitable for another fiscal year or two.
This is why I doubt that requiring a non publically-held auditor to invest in its clients would be a good idea today, and why it could have caused problems for Britain’s 19th Century investing public. However, it might work for publically-traded firms (such as PricewaterhouseCoopers), because false information would ultimately lead to short-selling of its stock, which in turn would alert the public of a problem. But of course, that can happen without a mandated investment. This issue ultimately hinges on the greater problem of maintaining the independence of both internal and external auditors. Probably no one approach can guarantee objectivity in a field so fraught with temptations and opportunities to profit at perceived low-levels of risk. Mandating investment is one approach. Banning it is another. Ultimately a third rail is needed. A corporate Wikileaks may be it.
AICPA. (2012.) AICPA Code of Professional Conduct. Retrieved from http://www.aicpa.org/Research/Standards/CodeofConduct/Pages/default.aspx
Securities Lawyers Deskbook. (2011.) Accounting Rules Form and Content of Financial Statements, Regulation S-X. Retrieved from http://taft.law.uc.edu/CCL/regS-X/SX2-01.html
U.S. Securities and Exchange Commission. (1999.) Office of the Chief Accountant: Regarding Auditor Independence. Retrieved from http://www.sec.gov/info/accountants/noaction/aapwc.htm
United States of America. (1996.) In the Matter of Michael Goodbread, C.P.A. Retrieved from http://www.sec.gov/litigation/admin/3438035.txt