Public Accounting Lessons from Ethical Violations

Lessons from Ethical Violations in Public Accounting

Public accounting is a field faced with ethical issues similar to any area of practice. Unethical practices in accounting are often motivated by management greed, incentives, bonus, management pressure, and more. These practices only lead to short-term gains (Finn, Chonko & Hunt, 1988). The long-term impacts are usually negative consequences. Ethical behavior and practices are critical aspects of good accounting. Accounting regulations and rules exist to ensure that users stay objective as they make decisions by utilizing accurate financial statements at the end of business operations and practices. The AICPA is the primary body that guides accountants in the public sector. The IIA and the IMA govern accountants and auditors in the private sector. This paper is a case study of a South African firm involved in a scandal due to ethical violations, and the impacts of the negative publicity were detrimental. The case study and a report compiled on the relevant findings will examine various ethical issues and challenges.

Forms of Ethical violations (Money Laundering)

Ethical violations take various forms, including fraudulent practices, improper management of records, and violation of federal and state laws that can be manifested in multiple practices. Such practices include money laundering. Money laundering is an illegal practice used by criminals to hide their illegal income sources from the prying eyes of the law. It is one of the most organized criminal activities in the world. With money laundering, illegal money is acquired and turned into legal money and tenders. Large organizations usually result in money laundering if they engage in organized criminal practices that result in large quantities of cash that cause the authority to question their activities. As a result, they seek ways of concealing this money to avoid attracting the attention of legal authorities. Money laundering occurs in three stages, namely, placement, layering, and integration. Placement involves placing the dirty money into the legal systems through activities such as blending of legal and illegal funds and invoice fraud, which involves techniques such as under-invoicing and over-invoicing, and fraudulent documentation. It can also be done through smurfing, breaking the large illegal quantities of money into smaller, less suspicious transactions, offshore accounts that involve hiding dirty cash in foreign accounts to evade tax payment, and aborted transactions.

The next stage of money laundering is layering which generally involves transactions that move the illegally-earned money into the legal, financial system, usually through offshore techniques, making it difficult for the authority to detect the activity, and can be done through investing in shell companies or real estate, converting the money into stocks, and moving money into offshore accounts. The final stage is integration which is ideally the absorbing of the money into the economy. The cash is integrated back into the legal systems as legal tenders through investments into high-end cars, artwork, property markets, jewelry, and other highly-priced commodities. Looking at this specific case study, in exhibits 3 and 4, money laundering occurred following these three stages (Holtzblatt, Foltin & Tschakert, 2020). The government granted Estina, a subsidiary connected to the Gupta family, the contract to be part of the Verde Dairy project without outing the project for bidding. The state government provided the company with 84 million rands to complete the project’s first year. The money was later transferred to an offshore account in Dubai into a Gupta-controlled UAE shell company called Gateway Limited.

Then, about 75 percent of that money was then sent back to two subsidiaries of the Gupta business empire in South Africa and included the money that paid for the luxurious Gupta wedding. The invoices show that a substantial amount was spent at the Sun City celebrations totaling 30 million rands (USD 3,333,400), an amount significantly different from the one initially presented for the wedding celebrations, equivalent to USD 15,811. From these figures, there is evidence of foul play that involved concerting illegally acquired money to an offshore account in Dubai, to a subsidiary of the Gupta family, and wiring the money back to two other subsidiaries, including paying for the wedding. Eventually, the family turned the state money into their legitimate assets.

The KMPG SA was also involved in this laundering scheme by disregarding the 30 million rands set aside for the dairy farm but funding the luxurious Gupta wedding. Also, a subsidiary of the Gupta Empire, Linkway Trade, involved in the laundering scheme was a client of the KPMG and was the company that managed and paid for the wedding celebrations in which foul play was evident, especially after recording the celebration as a business expense. Additionally, the firm failed to pay income tax, a practice that the KPMG SA did not question. Hence, the KPMG SA audit of the company was short of the expected quality as reported by KPMG International. The auditing firm was found to have violated several ethical codes of accounting. Moreover, IRBA and SAICA concluded that it was negligent of the operations surrounding the Gupta money laundering and the failure of the president of the KPMG SA to be responsible for the failed duties of the auditing firm.

Reputational Damage by the KPMG

Reputation and public trust in the judgments of an auditing firm are crucial in substantiating the functions of an auditor and other value-added services that lend credibility to various published financial audits or reports. A good reputation and public trust encourage and drive an auditing company to conduct transparent accounting practices and reports that the stakeholders can easily understand, including clients. This allows them to trust the eligibility of the information they receive and could lead to more potential investments and business dealings hence a consistent flow of income for the auditing firm. Any financial restatement, especially by a high profile company such as KPMG, caused by fraudulent practices regarding the financial statement erodes the confidence of the public in financial reports and any related audit function. When such an experience as the one encountered by KPMG about the SA auditing scandal happens, it becomes crucial to restoring public confidence. However, because of the dealings that have resulted in negative publicity because of the practices of the auditing firm, it may be challenging to restore the company’s reputation. However, it is not entirely impossible. It requires significant efforts by every stakeholder, including the accounting profession, the business community, standard-setting bodies, regulators, and legislators.

After the scandal, KPMA took several responsive measures to restore its lost glory, reputation, and trust in its South African Affiliate. The first step was making changes in the leadership of KPMG SA. Nhlamu Dlomu was selected to replace the former president, Mr. Wessels. The company believed she was well qualified and experienced to take back KPMG SA to quality auditing and financial reports while upholding the ethical standards. Her first step was to build a management team committed to maintaining ethical conduct and integrity to ensure high-quality service and stability to their clients. She also saw the appointment of a partner to act as a risk management partner to improve risk management and improved quality. The firm also took steps to enhance the processes of its corporate governance that included the adoption of recommendations and the appointment of a senior, non-executive, and independent director to complement the duties of the existing board members to assist the leadership team in achieving its goals of restoring the public’s trust. Also, KPMG International has been committed to supporting KPMG SA to rebuild itself after the scandals by supporting it in every way possible. KPMG SA has capitalized on the expertise of the global leaders of KPMG and specialists working in unison to restore its reputation. This has been a significant aspect of the KPMG SA recovery journey (Holtzblatt, Foltin & Tschakert, 2020).

While a change in leadership is the first and the best strategy to restore the firm’s reputation and public trust, this strategy alone is not enough. More affirmative actions can still be taken to enhance the restoration of its reputation. For instance, the firm’s marketing team can launch a campaign to win back public trust again and attract new investors and clients, especially after losing so many clients due to the scandal. The campaigns can be done periodically, with each subsequent campaign highlighting some of the key achievements the company has achieved from the previous campaign. This should allow the public to see the firm’s efforts to improve the quality of its services and how successful they are. The firm can also engage in a customer win-back program designed by the marketing team with the support of the management. This should allow the firm to win back its lost clients. This strategy has been proven to be cost-effective yet efficient. Other activities include employee motivation and strategy to build mutual trust between the management and the employees. A good relationship between the two should speed up the recovery process because a good working relationship generally improves the quality of service provided.

Professional Skepticism and its Role

This is an attitude that involves a questioning mind and a thorough assessment of audit evidence. The auditor should use the skill, knowledge, and ability required by the public accounting profession to perform tasks diligently, with integrity, and in good faith, and gather and practice objective evaluation of evidence. Gathering and evaluating evidence for an audit necessitates the consideration of the sufficiency and competency of the evidence. Since the evidence is gathered and assessed objectively through the whole audit process, professional skepticism should be evidenced and practiced throughout the entire auditing process. The primary role of professional skepticism is that it enhances the ability of the auditor to point out and respond to conditions that might show possible misstatement. In the case of KPMG SA and the scandal, the auditor failed to practice professional skepticism, and instead, it became a case of negligence by the firm. There were warning signs, but the firm could not take the necessary actions to avert the impending negative consequences. There were several red flags that the firm might have paid attention to regarding the Gupta business operations. However, as stated earlier, there was a case of negligence, which resulted in negative consequences for KPMG SA.

For starters, the 30 million rands that were initially meant to cater for the dairy firm ended up funding the Gupta wedding celebrations should have been a warning sign and led the auditing firm to question the legitimacy of their operations. Instead, KPMG chose to ignore this incident. The issue of the 30 million rands should have raised more questions when Linkway Trading, a subsidiary of the Gupta business empire, recorded the celebration and the expenses incurred as a business project instead and failed to pay income tax. KPMG auditors disregarded these activities and were unable to question the treatment of the celebration expense as a business expense despite a junior auditor having included in his report that the wedding-related costs were not in the production of Linkway’s income. My opinion is that KPMG SA’s professional skepticism was insufficient. The auditors failed to implement this practice in their dealings with the Gupta family and even ignored what should have come as a warning sign that something was not right. The management should have practiced professional skepticism, which enabled them to identify the mentioned shortcomings or red flags, address them appropriately, and avoid the negative consequences that happened later when the unmasking happened.

The Concept and Importance of Auditor Independence

Auditor independence is the ability of an auditor like KPMG to adopt and approach the audit process with objectivity and integrity and mainly requires the auditor to have the freedom of executing his work in an objective and free manner. This will allow the auditor to give his opinions without the influence of external pressures or any biases. This concept necessitates the auditor to be independent of the client company to ensure that the auditor’s opinion is not affected by their relationship. From the case study, it is clear that the independence of KPMG SA was compromised in its dealings with the Gupta family businesses. The auditor failed to have a different relationship with the Gupta family business, influencing its audits’ decisions. The relationship was a bit too personal than the normal business relationship the two should have been expected to have. For instance, the Gupta family wedding was attended by four KPMG SA’s partners as guests, and amongst them was the lead partner in charge of the Linkway Trading audit engagement. This indicates a relationship that goes beyond simple business transactions. Perhaps, this informal relationship clouded the auditors’ judgment on the dealings of the Gupta family business empire and, hence, the resulting consequences.

Mandatory auditor rotations (internal partner rotations and external partner rotations) have been proven through research to positively impact auditor independence by enhancing the independent relationship between the client and the audit firm and is a cost-efficient way of achieving the same. Ideally, this is the primary goal of audit rotation. The internal audit rotations are not enough since they might only solve the problem of auditor independence by appearance. This makes it necessary to have external audit rotations also. A combination of these two effectively improves the independence of the client and the audit firm. Hence, this would have the described impact on KPMG auditor independence. With the change of a lead auditor every time, the next auditor must begin from scratch with the client, which translates into a longstanding relationship between the two. That way, KPMG’s independence would not be compromised. This will allow KPMG to create unbiased opinions about its clients based on the evidence provided (Holtzblatt, Foltin & Tschakert, 2020).

The Legal Structure

Global accounting firms operate in various parts of the world, offering their services in the same. However, each firm as a subsidiary of the worldwide firm functions independently as a legal entity, and together, they form the global firm. This is also the case with KPMG, a worldwide organization with affiliate firms in parts like South Africa, New York, and the UK. Each of these firms is, however, a separate legal entity. In many countries, regulated businesses such as legal and auditing firms cannot operate as a corporate multinational because they must be independent and owned locally. Hence, in the case of KPMG, its member companies are owned and managed locally. This model was chosen because of its relevance. Since these member companies operate independently, each has to be responsible for its liabilities and obligations. In light of these events, the question of KPMG being liable for the actions stemming from its affiliated companies is one that I partially agree with and disagree with. I agree that it should be liable to a small expense if it means saving that affiliated company since the activities of these companies are a direct reflection of themselves to clients. Negative impacts on an affiliated company would portray a negative picture of KPMG International and affect its operations. However, affiliate companies should be liable for their actions. KPMG International should only help if the damage caused is too much and likely to affect every other subsidiary, as in the case of the KPMG SA scandal.

Client Acceptance and Continuance

Client acceptance and continuance refer to evaluating prospective clients before engaging in any services and business activities with the client. It also involves continuous assessment or evaluation of the clients already in business with the audit firm, which is done periodically, like one year. The continuance assessment of the existing clients would help the audit firm become aware of any significant changes that might potentially have detrimental consequences. Doing this periodically reduces the firm’s risk of incurring liability issues (Holtzblatt, Foltin & Tschakert, 2020). Implementing comprehensive client acceptance procedures helps auditing firms identify clients who might be problematic once they are committed to working together and evade them before they cause trouble. Having the relevant information, good practices of client acceptance and continuance equip audit firms with the advantage of avoiding potential risks and, therefore, turning down such prospective opportunities. It also enables them to begin the client-firm relationship, fully aware of the potential dangers that the new client presents, should the audit firm decide to still do business with them. Eventually, this helps the firm better prepare itself to implement tools that mitigate and manage risks.

KPMG SA failed to properly conduct the client continuance analysis concerning the Gupta family businesses about the case study. With these assessments, three aspects of a potential or already existing client are analyzed or assessed. These are its organizational culture, financial strength, and integrity. In terms of integrity, if the firm had conducted a proper client continuance analysis on the company, it would have identified that its practices were already corrupt. For instance, Linkway Trading failed to pay income tax on the wedding celebration expenses recorded as a business expense. Still, the company’s integrity had become corrupt when the 30 million rands meant for the dairy farm for locals were used to funding the wedding celebrations instead. In terms of financial strength, the auditing firm could have identified the lack of credibility in the financial assets statements of the company, especially Linkway Trading. The aspect of culture would also have been a key player in helping the audit firm identify the loopholes that already existed and were a red flag, indicating that something would potentially go wrong in the future. If the firm had done as expected, all the negative consequences that resulted in a stain on its reputation and loss of clients could have been evaded because it could have identified the potential risks and employed strategies to manage them on time before things blew up.

Article Review: Regulatory Framework

The article “Audit Profession Needs a New Dawn” review is about the regulatory framework in the audit profession. The article’s thesis is that the profession requires a different and new regulatory framework, covering new legislation and a more effective IRB with complete financial and legal liability for any damage the audit profession may cause to their host nations or investors. In my opinion, this should be allowed to happen. I also agree with the statement about KPMG’s violation of the code of ethics in accounting practices that resulted in the detrimental impacts. In most cases, audit firms are usually responsible for the wrong turn of events due to negligence and corruption. For instance, KMPG violated the code and the auditor’s duty of care through various activities such as negligence and completely disregarded the risk identification and mitigation implementation (Holtzblatt, Foltin & Tschakert, 2020). The results were detrimental to the company’s reputation, and the firm had to express a complete failure of its management. However, even after the change in management, the firm had not significantly improved in organizational culture since it still delayed investigations by SAICA and IRBA.

I agree that this is a disregard to the South African auditors, compared to the response when the US and the UK probed the firm. This is an indication that it chose to react differently to the regulatory bodies. The failures of the firm have escalated the firm’s harms to national matters welfare. In light of such events, I agree that there needs to be a new and more efficient body to regulate these audit firms to lower the impact of their failure on their host countries and even investors. The body should hold them accountable or liable for their actions, especially those due to contempt to the law or negligence. There should also be laws that compel them to hand in evidence from their system that would aid in the investigations by the legal bodies. In the case of KPMG SA, the South African national lost billions of money in the whole process, and the KPMG should not have been allowed to go scot-free. South Africa also suffered a blow to its economy because of the rating download that was contributed by the KPMG scandal. The firm should have been held accountable and forced to pay the legal and financial liability to South Africa and its national, including investors. The failure by IRBA to hold the firm accountable year after the incident shows that the body is ineffective, and therefore, the need for different and legislative measures regarding the issue discussed. I also agree that the audit firms should be subject to the majority of non-executive board members.

Since the structure of the audit firms is flawed, I further agree that they are open to abusive activities or practices of misconduct. Their harmful practices, especially to the economy, should come to an end. To achieve this, several regulatory changes can help auditors not knowingly become facilitators of corrupt practices in the profession. These include laws that mandate the firms to choose if they offer audit and assurance services or venture into other financial services. Any direct or indirect structures between the audit and assurance firms and providers of other financial services should be allowed. The firms should also be mandated by the law to constantly review their policies and keep records of every review subject to analysis or review by the regulatory body. This will ensure that these firms do things by the book and do as required by the law and keep evidence of the same. This may help avoid various issues arising in the audit process, such as negligence (Holtzblatt, Foltin & Tschakert, 2020).

A Similar Firm whose Case is Similar to KPMG SA

Another global accounting firm that has been in a similar spot as KPMG is a London-based accounting firm, RSM. This international firm operates in more than 120 countries around the world. The US unit of the firm was investigated by SEC and found to have violated the auditor Independence rules for 15 or more clients on around 100 reports. The US unit has about 80 offices across the United States and has its headquarters in Chicago. The SEC issued reports that the US RSM had violated auditor independence rules by offering non-audit services to its clients. Such services included investment advisor, internal audit outsourcing, bookkeeping, implementation, loaned staff, payroll outsourcing, payment facilitation, financial information system design, and corporate secretarial services. The SC established that the RSM US auditor independence was insufficient, and this caused the firm to fail in identifying and avoiding the prohibited non-audit practices or services and client-auditor relationship. The company frequently recorded that it was independent in audit reports it provided for its clients but wasn’t in an actual sense because of the ethical malpractices. (https://fcpablog.com/2019/08/28/audit-firm-rsm-charged-with-violating-independence-rules/).