PCAOB penalises PW India

PW India violated its most fundamental duty as a public watchdog - say the SEC and the PCAOB of Pricewaterhouse India's role in the Satyam fraud. The two American regulators have imposed their largest ever penalties on PW India, USD 6 million by the SEC and USD 1.5 million by the PCAOB.

The PCAOB or Public Company Accounting Oversight Board - an Audit Super regulator created by the Sarbanes-Oxley Act, 2002 and working under SEC's oversight - has also imposed other sanctions on 5 PW India firms including a bar on accepting any new US based clients for six months. All this while Indian authorities struggle to build a case against the firms or their partners.

So how did PCAOB arrive at these charges, how did they determine the penalty and the limitations and what does this mean for PW India and the audit fraternity in the country? In their first ever interview to Indian media Jay Hanson, a Board Member of the PCAOB and Claudius Modesti, PCAOB's Director of Enforcement and Investigations speak to CNBC TV18's Menaka Doshi.

Below is a verbatim transcript of the interview. Also watch the video.

Doshi: You have found at PW India's five firms deficient cash confirmation procedures as well as a failure to detect a general practice in the cash confirmation process that was not in accordance with PCAOB standards, that is a general quality control failure. Can you describe to me based on your experience of prosecuting hundreds of cases, audit standards across the world, how severe you think these violations are?

Modesti: This is a very significant matter. When the Satyam fraud was revealed, its stock plummeted and US investors realized losses of over USD 450 million. That number does not include the losses suffered by Indian and other global investors. The failure by the auditors in this case goes to a bedrock audit principle and it relates to the confirmation of cash and how to control those confirmations. Those failures by the auditors contribute to their failure to detect the significant fraud perpetrates by Satyam over a multiple years. The PCAOB believes its orders send a strong, deterrent message that audit firms have to get it right.

Doshi: Audit firms have to get it right and I understand that. In the words of your Chairman, James Doty, "Two of the PW India firms, PW Bangalore and Lovelock, repeatedly violated PCAOB rules and standards in conducting the Satyam audits. These confirmation deficiencies contributed directly to the auditors' failure to uncover the Satyam fraud". Is it your contention that had the five Indian affiliates maintained quality standards as prescribed by the PCAOB and those two specific firms, that have been penalized, in fact done their work as it was meant to be, they would have in fact uncovered this fraud before Ramalinga Raju obliged us with a confession?

Hanson: The standards that the PCAOB issues for conducting audits and the actual procedures that the auditors do, our design detects what we refer to as material misstatements in the financial statements and that includes whether they caused by just a simple oversight or caused by frauds. So the answer is yes that if the PwC auditors would have conducted the audits according to our standards, they should have detected the fraud. Now as Mr Modesti alluded to the basic procedures that the auditors did not do are things that are very easy to understand and that is the confirmation process and by confirmation what I mean is the auditor should independently verify the items in the financial statements; so cash is a simple thing for anybody to understand.

So if you went to a bank to get a loan and the bank was concerned about how much money do you have before we give you a loan, they would verify what you tell them and so the simple step of verifying the cash that the management said was in the accounts was not done and in fact the procedures that were done raised questions that were not appropriately followed up on. So the act of, what we call controlling the confirmation, so the auditor themselves sending the letter to the banks and getting those letters back directly, without letting management essentially interfere in their process, is a core principle that every auditor understands or should understand and that was not done. So, if our standards had been followed, we believe that fraud would have been detected long before it was revealed.

Doshi: This question goes to both of you whoever chooses to answer it. Did you, in your investigations detect, let us say, conditions in India that made it difficult for auditors, specifically these five, to be able to follow those simple procedures as you put it because I have been talking to the audit fraternity  the last few days to get a sense of what their reaction is to this settlement and they say that often it has been tough, especially before the Satyam fraud came to light, now of course everyone has spruced up their act but it has been tough as the fiscal year comes to an end to be able to get those confirmations from banks. Often banks have questioned auditors as to why should we reveal details to you, there are no prescribed forms, I am told, by the Central Bank that allow for auditors to follow a prescribed format in being able to receive these external independent confirmations. So did you think that the weaknesses lied in the system itself and that may have been part of the cause or the reason why PW was not able to comply with such simple standards?

Modesti: I think the best way to answer this is to focus on the audit violations and to keep in mind that the PW India firm's own audit plan contemplated and required that they control the confirmation process over cash and fixed deposits. To the extent that the auditors ran into difficulties about attending those confirmations that they needed to make adjustments so that audit plan to get sufficient evidence to support their audit opinion. In fact in some cases, the auditors received confirmations from some of the branches of the Indian banks from which they sought confirmations and it showed significant differences from what Satyam revealed in its confirmations that it gave to the auditors about what the balances were. I believe in one case there was a Mumbai branch of a bank that according to Satyam confirmation it had USD 176 million on deposit, the confirmation received from another branch indicated that there was nothing under deposit. And that is the type of evidence auditors needs to consider in deciding whether they can issue an audit report.

Hanson: In other words, even though there were difficulties in doing the step, what was performed was not properly followed up on for the exceptions that were critically evident in the steps that were done.

Doshi: Was PW able to offer an explanation as to why if the bank's external confirmation did not show up that deposit, they were not able to investigate it further or they did not come up with any qualification of sorts?

Modesti: What our enforcement order found was that there was a lack of focus on that conflicting and contradictory evidence and that they needed to consider that more carefully in deciding whether they could issue an audit report and in cases where the auditors did not have sufficient evidence to support their reports, they either have to qualify the report or refuse to issue the report and that is what we found through our investigative process.

Doshi: Then that goes beyond just simple lack of quality control standards, it goes beyond simple carelessness, it goes beyond not complying with PCAOB standards. To some degree, if I was to be able to use the legal term, this would be gross negligence, wouldn't it?

Modesti: We don't apply a standard in exactly those terms. The Board's order is based on conduct that is sufficiently violative of our standards and the facts and circumstances here indicated that there was a failure to follow those standards and that failure was significant enough for the Board to sanction the firms in a very substantial way. So I think you have to look at the entirety of the order and the violations to get appreciation for what happened here.

Doshi: I also want to ask you why you choose to penalize the firm and not take any action against the individual partners. But before I come to that, I want to know what the experience of investigating this case was like, working in India because our Indian regulators have had very little or made very little progress with building any coherent case- either against the firm or individual partners. Now there are multiple investigations going on in India, multiple authorities investigating the matter and that could, in a sense, be the cause for delay. I am not asking you for why you think the Indian regulators are delayed but I would like to understand whether you had access to the documents you needed or what was the investigating environment in India like? How much assistance you got from the SEC- all that helped you to come to this speedy decision?

Modesti: We applied our expertise in investigating audit failures in this instance and we obtained the documentation that we demanded from the PW firms and from those working at the PW India firms. We were able to examine witnesses in India, we examined numerous witnesses. Several of those witnesses refuse to speak with us and our Federal Law in United States gives us the power to sanction persons who refuse to cooperate and in this case, there were two PW Indian managers who refused to be examined and we permanently barred them from auditing public companies and our coordination with the SEC was very close. We took on a significant responsibility in terms of developing investigative records. In the United States, we are allowed to share that information with the SEC- that helped us to get through a timely and effective resolution of the matter and helped us avoid duplication of effort and that in totality was our investigative process resulting in the enforcement order.

Doshi: Did you run into any hurdles, whatsoever, in terms of the multiple investigations that were going on in India?

Modesti: We did not and we gained access to witnesses that we needed to gain access to for purposes of this investigation and like I said, the two who did not cooperate were sanctioned.

Hanson: Just to clarify, we did not have access to the Satyam records or people. It was only the PW India people and records that we had access to for our investigation there. So our authority does not extend to anything beyond the PW Firm.

Modesti: That's correct. In US Federal Law, the United States Security and Exchange Commission has the power and authority to regulate and oversee the US public companies and other companies that trade on our markets, such as Satyam, and as you know the SEC brought its case against Satyam.

Doshi: Can you explain to me why you took action against the firms and not individual partners that you may have found guilty of this negligence, so to speak, especially if they were the ones trying to reconcile the bank statement with the kind of information that Satyam offered them and couldn't find a match; yet, didn't do anything about it. I understand you went after the firms for a systemic failure of quality standards, but how come you haven't, in any sense, taken any action against individual partners?

Hanson: In addition to the 5 PW firms, we have entered into orders with individuals and as Mr Modesti mentioned that two of the individuals refuse to cooperate and so we have effectively barred them from ever working on US public company audits but we have entered into settlements with some individuals as well. Claudius you want to expand on that at all?

Modesti: As you indicated, in this case, there were quality control violations and we have addressed that through the use of the independent monitor and the undertakings in the order and that's important in terms of investor protection and the firm getting it right going forward and beyond that, I can't comment on the extent of our investigative process. That process is confidential. But I can say that we addressed the firm conduct, given the facts and circumstances here, and this was the failure to detect a significant fraud and the larger problem that we found through our investigative process related to a more general practice of failing to comply with the PCAOB standards in terms of cash confirmations and that's why we have a package of sanctions. I am including the largest penalty in our history and combined with the SEC penalties - these are largest for both regulators for non-US firm- that is in place along with these other sanctions to ensure that investors get more robust audit reports going forward.

Doshi: I understand that. What I am curious to understand is, is it that the PCAOB prefers to take action against a firm rather than individual partners although you have, like you said, already barred two partners on the basis of not cooperating with you investigation. Could it be possible that you could take future action against PW India partners? I am just curious to know why is it that you prefer to penalize the firm and not take any action against the partners.

Modesti: We under our law - our investigative process is confidential and I can just tell you as a general matter, we always look to see who the responsible parties were for the conduct that's at issue. So it is not a question of preferring or showing preference over charging a firm versus individuals. We always look to see who the responsible parties are, just as the general matter in terms of our process.

Doshi: I am told that the PCAOB, and this is unconfirmed but I would like to put it to you, had in fact inspected PW India's Satyam files before the fraud came to light. This was, I am told, a routine investigation. At that point in time, you did not discover these 'deficient cash confirmation procedures', as you have put them to be, and 'pervasive failures in quality standards', again in your words?

Hanson: Our policy is to not comment on individual findings in the firms, so we can't comment on the specifics. But the report that we issued on the PW India firm was just by the nature of this investigation, we decided to release it at the same time and with respect to the procedures that we perform on any of the non-US firms, we are always looking to improve our process and improve our identification of what we actually look at. For any inspection of any firm or any given company, we don't look at everything whenever we do an inspection. We look at selected items that are typically the higher risk items. Therefore we don't identify the actual issues that we look at nor what we chose to look at those issues.