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From Securities Regulation Daily, October 18, 2016

EY to pay $11.8M for audit failures linked to ‘adversarial’ client

By Mark S. Nelson, J.D.

The SEC announced that Ernst & Young LLP will pay $11.8 million to settle charges that audit failures permeated the firm’s work for risky oil services client Weatherford International. EY assurance and coordinating partner Craig Fronckiewicz and former tax partner Sarah Adams were barred from practicing before the Commission for their roles in the Weatherford audits. EY also must comply with a lengthy set of undertakings aimed at improving its tax practice. The respondents agreed to the settlement without admitting or denying the Commission’s findings (In the Matter of Ernst & Young LLPRelease No. 34-79109, October 18, 2016).

At a media call, SEC Enforcement Director Andrew Ceresney said the settled enforcement proceeding against EY was the first audit failure case against a Big 4 audit firm since 2009 (as compared to other auditor independence cases). He also said this was the first case brought against a tax partner who participated on the audit team. An SEC press release noted the many "red flags" EY missed in its audits of Weatherford.

Audit failures. The SEC’s order portrayed EY, especially its Houston office, as beset by lax supervision and inexperienced personnel despite the need for experienced staff to handle a high-risk and "very adversarial" client in Weatherford International. EY internally-designated Weatherford for "close monitoring" (EY’s highest risk category) because of EY’s potential exposure to financial and reputational risks from its work for Weatherford. Much of the case centered on EY’s audits of Weatherford’s tax accounting practices, which the company used to overstate its earnings and understate its effective tax rate.

Ceresney explained to reporters that the Commission charged EY because of its failure to fix known deficiencies in its tax practice and because of its failure to deal with related staffing and training issues. Specifically, the SEC said EY understood it had firm-wide deficiencies in its auditing of income tax accounting based on internal and external inspections. Recurring problems included poor supervision, lack of professional skepticism, and poor audit documentation. Changes to the firm’s policies and procedures did little to prevent recurrence of these issues.

The SEC also said EY’s Houston office lacked sufficient numbers of quality assurance mangers and its personnel were poorly trained. According to the order, EY’s audit engagement team for Weatherford was staffed by inexperienced tax personnel despite the complexity of the Weatherford audits. Moreover, Weatherford was such a difficult client, the SEC said, that EY managers often threatened to quit if they were assigned to the engagement, a situation that further complicated the firm’s ability to audit the company.

Weatherford, a NYSE-listed multinational Exchange Act reporting company, recently paid $140 million to settle accounting fraud charges. The SEC’s order detailed Weatherford’s aggressive growth strategy based on mergers and re-domestication transactions that formed the core of its tax avoidance plan. Weatherford had for a period of years issued false financial statements that inflated its earnings and produced multiple financial restatements within an 18-month time frame. The order also listed EY as a relevant entity, and an SEC press release noted the ongoing nature of the Weatherford investigation.

Penalties. EY was charged with violating Exchange Act Section 4C and Rule 102(e) of the Commission’s Rules of Practice for conducting audits of Weatherford that fell short of PCAOB standards. The Commission alleged that had EY followed these standards, the firm could have identified the Weatherford fraud earlier.

Specifically, EY was censured and ordered to stop engaging in the charged conduct. EY must pay $9.0 million in disgorgement (plus prejudgment interest of $1.8 million) and a civil money penalty of $1.0 million. In reply to a reporter’s question about why the matter was settled without any admissions, Ceresney said EY’s cooperation and remedial efforts played a role in the Commission’s decision that admissions were not required. Ceresney also said the case itself sent a "strong message" and that the significant undertakings and financial penalty also factored into the terms of the Commission’s order.

Fronckiewicz and Adams were barred from practicing before the Commission as accountants, although Fronckiewicz can seek reinstatement after two years and Adams can do the same after one year. Both Fronckiewicz and Adams are further subject to cease and desist orders.

According to Ceresney, the SEC will continue to look at audit firms and companies and, when appropriate, hold all entities and individuals accountable for securities violations. In the Weatherford and EY cases, both the company and its audit firm were charged, as were two of the company’s executives and two of the auditor’s partners. Weatherford and EY will pay combined penalties of nearly $152 million.

The release is No. 34-79109.

Companies: Ernst & Young LLP; Weatherford International

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