Is your audit firm being investigated? New law may expose misdeeds

The Defense Department will soon force accounting firms it hires to disclose investigations they face, a requirement that chips away at federal protections that have long helped keep flawed audits of public companies under wraps.

The directive was slipped without notice into last August’s $716 billion defense bill by Rhode Island Senator Jack Reed. It could have a significant impact on the many accounting firms that bid for auditing and consulting work at the Pentagon.

None of the Big Four — PwC, Ernst & Young, KPMG and Deloitte — were aware of the measure when it became law, according to lobbyists and congressional staff, and now they are belatedly trying to scale it back. One major concern: The rule is slated to take effect in mid-February and the Defense Department hasn’t provided details on how it intends to implement the requirement.

Pentagon

The accountants’ main trade association, which is taking the lead on the lobbying effort, argues the provision is vague and puts audit firms at a competitive disadvantage to other Pentagon consultants. The group also points out that the law doesn’t say whether the disclosures, which will likely contain sensitive details on employees and audit clients, should be non-public. There’s a worry that short sellers will learn of probes and use the information to go after public companies.

‘Strong Confidentiality’

Many auditor investigations “are required to be kept confidential as a matter of law,” the American Institute of CPAs wrote in a September submission to the Defense Department. “It is therefore critical” that the Pentagon set up “strong confidentiality protections to the statements submitted.”

AICPA officials didn’t return phone calls and emails seeking comment.

Defense Department spokesman Christopher Sherwood said the agency is working diligently to implement the requirement.

“Once finalized, the department will share more, as appropriate,” he said.

Chip Unruh, a spokesman for Senator Reed, said, “This provision simply requires the Secretary of Defense to know whether any accounting firm looking to do work for DOD has been subject to disciplinary proceedings in the past for bad audits.’’ Ultimately, Unruh added, “taxpayers deserve to know that DOD is selecting the most qualified and reputable accounting firms.’’

Secret Cases

The debate over keeping auditor discipline secret dates back to the 2002 Sarbanes-Oxley Act, which Congress passed in response to Enron Corp.’s accounting fraud. The law called for the main U.S. auditing overseer, the Public Company Accounting Oversight Board, to keep cases private until they’re resolved. The mandate has been controversial because it allows problems with audits to remain hidden for years while firms pursue appeals.

Accounting firms, however, contend that the sensitive nature of their work reviewing major corporations’ books means that regulators need to tread carefully with unproven allegations. News about the existence of accounting probes can trigger stock sell-offs even if they never lead to enforcement actions.

Hedge funds are known for filing public record requests with government agencies to try to obtain market-moving secrets. Finding out that an accounting firm is being investigated for its audits of a specific company would certainly be valuable to traders, the accountants point out.

The new directive leaves much open for interpretation. It calls for “any accounting firm providing financial statement auditing or audit remediation services” in support of the Defense Department audit to provide “a statement setting forth the details of any disciplinary proceedings with respect to the accounting firm or its associated persons” before any entity that polices auditors.

‘Flawed Work’

Critics of the accounting industry say the measure will likely boost the reliability of audits. They also note that it could spur additional government efforts to make probes more transparent.

“Auditors have spent a lot of money during the past two decades attempting to keep the flawed work they do behind closed doors,’’ said Lynn Turner, a former chief accountant at the Securities and Exchange Commission.

The accountants’ lobbying campaign has been hindered by their unfamiliarity with the Pentagon and its vast bureaucracy, as well as the department’s own lack of urgency about the directive. The industry is focusing its efforts on getting answers from the agency’s comptroller’s office.

However, the comptroller, David Norquist, was recently made acting deputy secretary of defense in the wake of President Donald Trump’s promotion of Deputy Secretary Patrick Shanahan to the acting secretary post.

Meanwhile, other parts of the agency have already moved ahead to implement the law. The department’s inspector general, which supervises the massive Pentagon audit, included the requirement in a contract that was signed on Dec. 1, said Bruce Anderson, a spokesman for the watchdog.

Industry Flashpoint

The issue of keeping investigations secret has long been a flashpoint between the industry and its overseer, the PCAOB. The regulator asked Congress to revise Sarbanes-Oxley in 2010, saying the non-public nature of its disciplinary proceedings had adverse consequences for investors, audit committees and the public.

Reed is the ranking Democrat on the Armed Services Committee. He also sits on the Senate Banking Committee and has sponsored legislation to require the PCAOB to make its cases public when they are filed. The new Pentagon provision is modeled after that bill, which has gone nowhere in the face of industry opposition.