The Eighth Circuit Court of Appeals recently upheld a nine-month suspension imposed on a partner in a public accounting firm by the SEC.
The case arose when the SEC suspended Robert Potts, a partner at Deloitte and Touche, for an improper review of an audit. He was concurring partner for the 1988 and 1989 audits of Kahler Corp., a company that owned and managed hotels.
For one property, University Park Hotel, the company took a particularly aggressive accounting approach. Kahler listed the hotel as an asset held for sale even though it lost money in the 1988 and 1989 audit years. This accounting treatment allowed the company to capitalize the losses on the property. As a result, Kahler posted a net gain instead of a loss of over $1 million in 1988 and a net loss of $1.8 million instead of $2.8 million in 1989.
Potts concurred both years in the firm's unqualified audit opinion on Kahler's financial statements.
Rules for assets held for sale
Under generally accepted accounting principles (GAAP), the conditions that must be met before a property can be classified as an asset for sale include the following:
- The company must commit to a formal plan to sell its entire interest in the property.
- It must determine that the sale of the property will cancel out any unreported operating losses and result in a net gain.
In Kahler's case, the SEC found the accounting treatment of the hotel improper for several reasons:
- Instead of pursuing an outright sale, Kahler repeatedly sought investors to share ownership of the hotel.
- The company did not have a formal plan to sell the hotel.
- Kahler's management had no valid basis for concluding the hotel's selling price would make up for its operating losses.
- The company backdated its treatment of the hotel as an asset held for sale to the beginning of the first audit year of 1988.
SEC faults concurring partner
The SEC found Potts' conduct deficient in several respects. First, Potts approved the Kahler audits for 1988 and 1989 despite inadequately explained documentation indicating that the company did not intend to sell the hotel outright.
Second, the University Park Hotel's value was derived using invalid methods in 1988.
Third, Potts concurred with Kahler's backdating of the hotel's accounting treatment to the beginning of the first audit year.
These factors led to the SEC's suspension of Potts for improper professional conduct. It stated that he had acted with reckless disregard of his duties as an independent auditor.
CPA denies recklessness
Potts appealed the decision. He contended that the record failed to sustain the SEC's finding of recklessness. In addition, Potts claimed that the suspension violated his due process rights because he did not have adequate notice of the SEC's standards of professional conduct for concurring reviewers.
The Eighth Circuit rejected the arguments that the record did not support the SEC's finding of recklessness or that the SEC had violated Potts' due process rights. It noted that, despite signals that Kahler's accounting treatment of the hotel was suspect and despite the company's backdating of this treatment, Potts approved the audits. Based on this conduct, a reasonable person might conclude Potts was reckless.
SEC cites GAAP standards
The SEC said it had evaluated Potts' conduct in conjunction with the well-established standards of GAAP and generally accepted auditing standards (GAAS). These standards apply to both the lead audit partner and the concurring partner. The SEC action, therefore, in suspending Potts did not violate his right to due process and acted appropriately.
This case is significant in that it holds concurring partners to a fairly high standard of conduct. A cursory review of work product that ignores discrepancies in the audit report is not acceptable in practice before the SEC.
( Robert D. Potts v. Securities and Exchange Commission, 1998 U.S. App. LEXIS 17831; Fed. Sec. L. Rep. [CCH] P90, 256)
—Edited by Wayne Baliga, CPA, JD, CPCU, CFE,
president of AON Technical Insurance Services.