The SEC’s Enforcement Record against Auditors

by Simi KediaUrooj Khan, and Shivaram Rajgopal

Given the high incidence of financial misrepresentation over the past two decades, there is continued interest in understanding the contribution of different gatekeepers in deterring and detecting financial misrepresentation. There is little agreement, however, on the role and responsibility of these gatekeepers, especially that of the auditor.  On the one hand, the audit industry asserts that it is not possible for the auditor to detect intentional fraud by company executives.  On the other hand, is the view exemplified by Steven M. Cutler, former Director of the SEC’s Division of Enforcement, following the collapse of Enron: “While I believe the causes of this phenomenon [seemingly unprecedented corporate fraud] are multiple, a significant contributing factor was the laxity of the so-called gatekeepers — the accountants, lawyers, research analysts, board members and others controlling access to our capital markets. Perhaps foremost among these is the auditor.

Investors rely on the auditor’s attestation of the financial statements.  Hence, the auditor’s effort, or lack thereof, in flagging reporting concerns has the potential to impact confidence in the capital markets and the financial system.  A key motivation for the auditor to detect financial misrepresentation is the possibility of regulatory action by the SEC and private litigation.  In our paper, The SEC’s Enforcement Record against Auditors, we examine the effectiveness SEC oversight over auditors. This reveals that enforcement against auditors is relatively mild, as the SEC is less likely to name Big N audit firms as defendants and, when it does, is less likely to name individual partners, pursue tougher civil proceedings, or impose harsh penalties. We supplement our analysis of SEC enforcement by investigating the disciplinary role of private litigation, finding that audit firms lose market share when they face private class actions but not after being charged by the SEC.

Our sample consists of 533 SEC enforcement actions, over the years 1996 to 2009, against companies that have allegedly engaged in accounting misrepresentation and for whom we can find an associated audit firm that has signed off on the allegedly irregular financial statements.  Using this dataset, we investigate and answer several questions.

First, we assess the propensity of the SEC to charge auditors, especially the Big N audit firms.  We find that the auditor who signed off on the misrepresented financial statements is charged by the SEC in only 17% of the cases.

Second, the data show that the SEC is significantly less likely to name a Big N auditor as a defendant.  Of course, this could simply imply that Big N firms provide better quality audits and their client firms are less likely to misrepresent their financial statements.  However, contrary to this conjecture, the incidence of misreporting among companies audited by Big N auditors is proportional to the representation of Big N clients in the population of firms in COMPUSTAT.  Further, in multivariate regressions that explain the likelihood of an auditor being charged by the SEC, after controlling for (i) the severity of the fraud; and (ii) the nature of clients that are likely to choose a non-Big N auditor, we find that Big N audit firms are less likely to be named by the SEC.  Interestingly, this tilt is not observed when the experiment is repeated with class action lawsuits.  That is, class action lawyers are equally likely to pursue Big N or other auditors.

Having decided to charge an auditor, the SEC faces three key choices when it initiates an enforcement action: (i) whether to name the individual partner or the audit firm; (ii) whether to pursue an administrative or civil action; and (iii) what kind of penalty to impose on the auditor?  With respect to the first question, the data show that the SEC tends to favor charging individual partners, as opposed to the audit firm.  Of the 93 cases where an auditor was charged, only the partner was named in 69%. In contrast, only the audit firm was charged in just 5% of the cases. In the remaining 26% of the cases, both the partner and the audit firm were charged.  In multivariate analyses that control for the severity of the misreporting and the nature of the violations with which the SEC charges the auditor (such as unethical or unprofessional conduct or charges under antifraud provisions), we observe that the SEC is less likely to name a Big N audit firm.

The second dimension of SEC enforcement relates to whether to bring an administrative proceeding, a more onerous civil litigation, or both against the auditor.  We find that the SEC overwhelmingly relies on administrative actions against auditors.  In 78% of the 93 cases where the auditor is charged by the SEC, the auditor/audit firm was subject only to an administrative proceeding.  This is significantly higher than the usage of administrative proceedings by the SEC in related enforcement actions against corporate offenders.  Specifically, only 15% of the 533 client firms charged by the SEC for misreporting were subject to administrative action.

Conditional on being charged by the SEC, we examine the severity of the penalties imposed by the SEC on auditors.  We find some evidence that the penalties imposed on Big N auditors are milder than those imposed on other auditors.  This is despite the absence of a statistical difference in the frequency and type of violations with which Big N and other auditors are charged.

Finally, we examine the efficacy of private enforcement against the auditor via the product market.  We investigate whether auditors who are charged by the SEC subsequently lose market share.  We find no evidence suggesting that clients defect in significantly large numbers after the audit firm is charged by the SEC.  Moreover, the clients that do defect are not the bigger and the more visible ones, limiting the reputational damage stemming from such defection.  This evidence is inconsistent with the reputational penalties suffered by culpable managers when they are accused of filing fraudulent financial statements.  In contrast to the evidence of lack of reputation consequences from SEC actions, there is some evidence that audit firms lose clients when their tainted clients are sued by class action lawyers.

Overall, our evidence is consistent with milder SEC enforcement against auditors, especially Big N auditors. However, we acknowledge that evaluating the SEC’s enforcement record against auditors is inherently complex and our evidence should be viewed as suggestive not definitive. Our full paper is available.

Simi Kedia is a Professor of Finance and Economics Rutgers Business School, Rutgers University. Urooj Khan is an Associate Professor of Business at Columbia Business School, Columbia University. Shivaram Rajgopal is the Roy Bernard Kester and T.W. Byrnes Professor of Accounting and Auditing at Columbia Business School, Columbia University.

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