IMG_1259Today, I continue my exploration with Joe Howell about the Public Accounting Oversight Board (PCAOB), its scrutiny of public company auditors and how its work impacts the corporate compliance function. Yesterday, I ended with a discussion about goodwill, how hard it may be to calculate, its impairment and what that might mean for a Chief Compliance Officer (CCO) and how difficult it is to test for both goodwill and a proper impairment calculation. Today I want to continue to explore why any write-downs are significant for the compliance function as it might be a mechanism to hide money to fund bribes and engage in corruption.

I asked Howell about write-downs and how they might be used to hide monies generated to fund a bribe, in the context of an acquisition. Howell noted, “anytime you have to calculate what that original value is, if you have a spin-off, if you have some sort of massive write-down, then they’re going to want to take a look at that to see, How did you do that write-down? Did you do it to dress up your balance sheet, to make it a little prettier because you got rid of some intangibles because you didn’t want to have them anymore for other purposes? Or there was some sort of thing that was out of the ordinary that you did? Then they really want to look at that to make sure that there’s support for it.”

I then inquired about joint ventures (JVs) and asked if the same or similar rules would apply. Howell began by noting that an audit is focused on the external financial statements for the company taken as a whole as presented to financial statements. While that statement is in the context of what the final opinion focuses upon, it is important to recall that an audit builds up from its parts.

That means an auditor must build up from any JVs a company has and these areas that have the opportunity to create misstatements, mistakes, or completely fraudulent statements. The issues can go so far as to include Enron type of concerns where the company used fraudulent accounting to get “bad stuff” off of their balance sheet. I asked Howell if you have a JV that has engaged in transactions that were based on fraud and the profits from that JV roll up into the parents, i.e. the US Corporation’s balance sheet, that would be an appropriate inquiry for an external auditor? He said “Absolutely. If an auditor finds fraud that’s not material to the financial statements taken as a whole, their job is not over. They don’t pass on stuff because it’s immaterial. If they find fraud, they’re obligated to report it. Also, that they find fraud, then they’re obligated to explore to see if the weaknesses and the controls that permitted that fraud are found elsewhere.”

One of the key inquiries from a Securities and Exchange Commission (SEC) Foreign Corrupt Practices Act (FCPA) investigation or enforcement action is around the issue of systemic failures of internal controls. Such failure is a sure remedy for the finding by the SEC for violation of the FCPA, even absent an affirmative finding of bribery. Howell said that a systemic inquiry from the auditing perspective is critical as well.

Howell said that if management is somehow involved in the colluding, then the auditors must “step back and take a hard look at what they’re going to be able to believe, if anything, that management has told them. If management is not involved and they have reason to believe that this is a bad actor somewhere in the organization, they’re not permitted to stop because it’s not material. They have to “move forward” with the inquiry.”

Interestingly, Howell not only draws a line from the FCPA to the Sarbanes-Oxley Act of 2002 (SOX) to the Dodd-Frank Act of 2010; but also draws a line from the PCAOB to corruption risk because of the pronouncements from the PCAOB about what the auditors have to look for in terms of risk. This is because he believes “every PCAOB inspection report to date has mentioned fraud. That the purpose of mentioning fraud is that the failures in the accounting control environment that permitted a transaction to go unreported or misreported are the kinds of things that undermine the entire credibility of the financial statements and mean that you’re not going to be able to rely on that control environment. Fraud is central to all of this.”

Howell went on to explain that fraud usually occurs because there are weaknesses in controls which are exploited by bad actors to get the money or the resources, if not money, to actually then pay a bribe that is the focus of the FCPA. The PCAOB’s focus on fraud is because the controls need to be in place and they focus on internal controls over financial reporting. Howell noted he has not seen any FCPA settlement that did not have a material impact on the company in one way or another. He concluded by stating, “how can you say that you’’re not dealing with material misstatements of the financial statements if you fail to report something that clearly is going to result in tens or hundreds of millions of dollars of penalties, disgorgement of profits, investigations, and tearing the company inside out in order to do the final remediation?”

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© Thomas R. Fox, 2016