Friday, July 29, 2022

A Lesson from the Accounting Profession: Don’t Cheat on the Ethics Test

SEC Order

Accounting, like many professions, requires practitioners to regularly demonstrate competence and familiarity with relevant knowledge and practices.  One requirement for Certified Public Accountants (CPAs) is to take an on-line, multiple-choice test covering professional ethics.  Sounds easy but the passing grade is relatively high so it’s not a slam dunk.  Some Ernest & Young (EY) audit accountants found it was easier to pass if they cheated by using answer keys and sharing the keys with their colleagues.  They were eventually caught and got into big trouble with the U.S. Securities and Exchange Commission (SEC).  Following is a summary of the scandal as it evolved over time per the SEC order* and our view on what the incident says about EY’s culture.

During 2012-15, some EY employees were exploiting weaknesses in the company’s test software to pass tests despite not having a sufficient number of correct answers.  EY learned about this problem in 2014.  In 2016, EY learned that professionals in one office improperly shared answer keys.  EY repeatedly warned personnel that cheating on tests was a violation of the firm’s code of ethics but did not implement any additional controls to detect this misconduct.  The cheating continued into 2021.

In 2019 the SEC discovered cheating at another accounting firm and fined them $50 million.  As part of the SEC’s 2019 investigation, the agency asked EY if they had any problems with cheating.  In their response, EY said they had uncovered instances in the past but implied they had no current problems.  In fact, EY management had recently received a tip about cheating and initiated what turned out to be an extensive investigation that by late 2019 “confirmed that audit professionals in multiple offices cheated on CPA ethics exams.” (p. 6)  However, EY never updated their response to the SEC.  Eventually EY told the Public Company Accounting Oversight Board (PCAOB)** about the problems, and the PCAOB informed the SEC – 9 months after the SEC’s original request for information from EY.

In the U.S., the relationship between government regulators and regulated entities is based on the expectation that communications from the regulated entities will be complete, truthful, and updated on a timely basis if new information is discovered or developed.  Lying to or misleading the government, either through commission or omission, is a serious matter.

Because of EY’s violation of a PCAOB rule and EY’s misleading behavior with the SEC, the company was censured, fined $100 million, and required to implement a host of corrective actions, summarized below.

Review of Policies and Procedures

“EY shall evaluate . . . the sufficiency and adequacy of its quality controls, policies, and procedures relevant to ethics and integrity and to responding to Information Requests” (p. 9)  In particular, EY will evaluate “whether EY’s culture [emphasis added] is supportive of ethical and compliant conduct and maintaining integrity, including strong, explicit, and visible support and commitment by the firm’s management” (p. 10)

Independent Review of EY’s Policies and Procedures

“EY shall require that the Policies and Procedures IC [Independent Consultant] conduct a review of EY’s Policies and Procedures to determine whether they are designed and being implemented in a manner that provides reasonable assurance of compliance with all professional standards . . . . EY shall adopt, as soon as practicable, all recommendations of the Policies and Procedures IC in its report. . . . EY’s Principal Executive Officer must certify to the Commission staff in writing that (i) EY has adopted and has implemented or will implement all recommendations of the Policies and Procedures IC in its report . . .” (pp. 10-12)

Independent Review of EY’s Disclosure Failures

“EY’s Special Review Committee shall require that the Remedial IC conduct a review . . . of EY’s conduct relating to the Commission staff’s June 2019 Information Request, including whether any member of EY’s executive team, General Counsel’s Office, compliance staff, or other EY employees contributed to the firm’s failure to correct its misleading submission.” (p. 12)  Like the Policies and Procedures review, EY must adopt the recommendations in the Remedial IC Report and EY’s Principal Executive Officer must certify their adoption to the SEC.

Notice to Audit Clients, Training, and Certifications

“Within 10 business days after entry of this Order, EY shall provide all of its issuer audit clients and SEC-registered broker-dealer audit clients a copy of this Order. . . . all audit professionals and all EY partners and employees who, at any time prior to March 3, 2020, were aware (i) of the Division of Enforcement’s June 19, 2019 request, (ii) of EY’s June 20, 2019 response, and (iii) that an employee had made a tip on June 19, 2019 concerning cheating shall complete a minimum of 6 hours every 6 months of ethics and integrity training by an independent training provider . . . . EY’s Principal Executive Officer shall also certify that the training requirements . . . have been completed.” (pp. 14-15)

Our Perspective

A company’s culture includes the values and assumptions that underlie daily work life and influence decision making.  What can we infer about EY’s culture from the behavior described above?

First, what managers did after they discovered the cheating – issuing memos and waving their arms – did not work.  Even if EY terminated some employees, perhaps the worst offenders or maybe the least productive ones, EY did not make their testing process more robust or secure.

Second, senior leadership has not suffered from this scandal.  There is no indication any senior managers have been disciplined or terminated because of the misconduct.  The head of EY’s U.S. operations left at the end of her 4-year term, but her departure was apparently due to a disagreement with her boss, EY’s global chief executive. 

Third, there has been no apparent change in the employees’ task environments, e.g., their workload expectations and compensation program.

Conclusion: EY management tolerated the cheating because their more important priorities were elsewhere.  It’s safe to assume that EY, like other professional service firms, primarily values and rewards technical competence and maximizing billable hours.

We see two drivers for possible changes: the $100 million fine and the mandated review by “Independent Consultants.”  (EY’s self-review will likely be no more useful than their previous memos and posturing.)

What needs to be done? 

To begin, senior leadership has to say fixing the cheating problem is vitally important, and walk the talk by adjusting company practices to reinforce the task’s importance.  Leadership has to commit to a company corrective action program that recognizes, analyzes, and permanently fixes all significant company problems as they arise – not after their noses are rubbed into action by the regulator.  

In addition, there have to be visible changes in the audit professionals’ task environment.  The employees need to get work time, in the form of unbilled overhead hours, to prepare for tests.  The compensation scheme needs to add a component to recognize and reward ethical behavior – with clients and internally.  The administration of ethics tests needs to be made more secure, on a par with the accounting exams the employees take.

*  Securities and Exchange Commission, Other Release No.: 34-95167 Re: Ernst & Young LLP (June 28, 2022).  All quotes in our post are from the SEC order.  There is also an associated SEC press release.

**  The Public Company Accounting Oversight Board establishes auditing and professional practice standards for registered public accounting firms, such as EY, to follow in the preparation of audit reports for public companies.  PCAOB members are appointed by the SEC.

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