by T. GormanPosted on Posted in SECActions

Operation Broken Gate, announced Monday in a press release by the SEC, focuses on holding gatekeepers accountable. Three proceedings against accounts were included in the announcement. Focusing on gatekeepers as a means of policing the markets and halting violations is, of course, nothing new. It has long been a Commission priority.

Another gatekeeper case initiated at the time Operation Broken Gate was announced is the proceeding against New Jersey based accounting firm Patrizio & Zhao LLC and one of its partners, Xinggeng (John) Zhao. In the Matter of Patrio & Zhao, LLC, Adm. Proc. File No. 3-15534 (September 30, 2013). The Order centers on alleged violations of Rule 102(e) of the Commission’s Rules of Practice in connection with professional work done for Keyuan Petrochemicals, Inc.

Keyuan is a Nevada corporation whose shares were registered with the Commission under Section 12(g) of the Exchange Act. The headquarters of the company is located in the PRC. The company is the product of a reverse merger. Prior to being delisted, its shares were listed on NASDAQ. Now the shares of the company are quoted on OTC Link.

P&Z was retained by the company in 2009 before the reverse merger as the outside, independent auditors. Prior to its replacement at the end of 2010, Keyuan prepared reports included in filings made by the company with the Commission. In October 2010 the company filed an annual report on Form 10K. Subsequently, it restated its quarterly reports for 2009 and the first three quarters of 2010. The Form 10K and the restated quarterly reports disclosed for the first time a series of related party transactions. Those involved loan guarantees, purchases of raw materials, sales of products and short term cash transfers for financing purposes as well as transactions involving the company and its CEO and controlling shareholder and other persons.

The alleged unprofessional conduct of Respondents centered on its failures in connection with the related party transactions. From the outset Respondent Zhao had reason to believe that the engagement at Keyuan was high risk. The company was new. It did not have employees knowledgeable about U.S. accounting requirements. Chinese audit clients were typically high risk. And, those companies engaged in related party transactions.

Those concerns should have been intensified when, during the work, a series of red flags were encountered. Those demonstrated that the company had not properly identified and disclosed related party transactions. The red flags included:

Audit planning: During the audit planning the vice president of accounting told Respondents that there were no related party transactions, a fact reflected in the financial statements prepared by an outside consultant.

Identifying transactions: During the course of the work the P&Z staff obtained a list of related party transactions from the company. Later Respondents determined the list was incomplete.

Specific documents: As the work progressed documents depicting related party transactions were reviewed while others suggested that additional procedures and work on the question were required.

Management representation letter: The CEO signed a management representation letter which stated that material related party transactions, including sales, payables, and guarantees, had been properly recorded or disclosed in the financial statements despite the fact that there were no such disclosures.

Respondents failed to exercise the required level of care and professional skepticism in view of these facts. Likewise, they improperly relied on the representations of management and did not obtain sufficient evidential matter and properly audit the related party transactions. Indeed, Respondents failed to properly plan, conduct and document their work in accord with professional standards, according to the Order. In this regard they were a cause of Keyuan’s violations of Securities Act Sections 17(a)(2) and (3) and Exchange Act Section 13(a).

To resolve the proceeding Respondents each consented to the entry of a cease and desist order based on the Sections cited in the Order. Each Respondent is denied the privilege of appearing or practicing before the Commission as an accountant with a right to request reinstatement after three years. The firm also agreed to implement certain remedial procedures and pay a penalty of $30,000.

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by T. GormanPosted on Posted in SECActions

Operation Broken Gate is the SEC’s effort to hold gatekeepers accountable. In announcing the initiative, the agency filed three actions involving auditors. Two were settled while a third is in litigation.

The action which will be set for hearing is against sole practitioner John Kinross-Kennedy, In the Matter of John Kinross-Kennedy, CPA, Admin. Proc. File No. 3-15536 (Filed Sept. 30, 2013). He is a PCAOB registered auditor. Since 2009 Mr. Kinros-Kennedy has served as an independent accountant for 23 public companies. The proceeding focuses largely on audits and reviews for six of those issuers. All of Respondent’s reports were issued in 2011 and 2012 while the periods range from 2009 through 2010.

The Order alleges improper professional conduct within the meaning of Rule 102(e)(1)(iv)(B)(2) of the Commission’s Rules of Practice. The charge is based on alleged willful violations of Exchange Act Sections 10A(j) regarding audit partner rotation and 10A(k) regarding reports to the audit committee as well as the pertinent rules.

The underlying conduct centers on a failure to comply with the pertinent professional standards which include:

Due care: Respondent did not have the required degree of skill commonly possessed by auditors and failed to exercise due care. This was evidenced by his failure to communicate with the predecessor auditor and the audit committee as well as his unfamiliarity with certain changes in GAAP. In addition, at times he used outdated audit templates and used client personnel to perform audit steps.

Failure to obtain sufficient competent evidential matter: While the pertinent audit standards require that the auditor obtain sufficient competent evidential matter to afford a reasonable his for his opinion, Respondent here did not. For example for a review for one issuer he failed to perform any audit procedures prior to issuing his opinion.

Audit risk: Professional standards require that the auditor plan and perform the work to obtain a reasonable assurance about whether the financial statements are free of material misstatement due to error or fraud. For three issuers Respondent failed to obtain sufficient evidence.

Work papers: Professional standards require that the auditor document his work sufficiently to enable an experienced auditor to understand the nature, timing, extent and results of the procedures performed, the work done and the conclusions. Although Respondent performed much of the work himself, he failed to prepare adequate documentation.

Engagement quality review: Audit standards require that the auditor obtain an EQR and concurring approval to issue the engagement report for each audit and interim review engagement. While Wilfred Hanson (see related action below) was engaged to undertake this function for five of the 40 audit reports he issued for fiscal years beginning on or after December 15, 2009, for the same period he did not obtain any such reviews for 35 other engagements. In addition, he did not determine if Mr. Hanson was actually qualified to conduct the reviews assigned to him.

Communication with audit committee: Professional standards require that the auditor have certain communications with the audit committee. The subjects include the auditor’s responsibility under PCAOB standards; significant accounting policies; management’s judgment’s and accounting estimates and other items. Here Respondent failed to undertake these communications.

Communication with predecessor: The applicable standards also require that the auditor communicate with the predecessor auditor or obtain sufficient competent evidential matter to afford a reasonable basis for his report. Here, for example, Respondent included an issuer’s prior year financial statements in his report without obtaining that evidence or communicating with his predecessor so that a review of that firm’s work papers could be undertaken.

Other failures: The Order also alleges that Respondent failed to evaluate the adequacy of the issuer’s disclosure of related party transactions, to control the confirmation process and to follow the auditor rotation requirements.

In the Mater of Wilfred W. Hanson, CPA, ADm. Proc. File No. 3-15537 (Filed Sept. 30, 2013) is related to the action against Mr. Kinross-Kennedy. Mr. Hanson, who at one time was an auditor for Arthur Young & Co., has since 2009 provided forensic accounting and litigation support for a forensic firm. The Order alleges that Mr. Hanson is not qualified to serve as an engagement partner, has not participated in an audit of a public company for over 35 years, has never worked on such an engagement under PCAOB standards and is not competent to serve as the engagement quality review partner. In conducting those procedures, as noted above, he failed to exercise due professional care. The Order thus alleges violations of Rule 102(e)(1)(ii) and 102(e)(1)(iv)(B)(2). To resolve the proceeding Mr. Hanson consented to the entry of an order which denies him the privilege of appearing or practicing before the Commission as an accountant with the right to request reinstatement after five years.

The third action is In the Matter of Malcolm L. Pollard, CPA, Adm. Proc. File No. 3-15535 (Filed Sept. 30, 2013) which is a proceeding naming as Respondents Mr. Pollard and his firm, Malcolm L. Pollard, Inc. The Order centers on his work for three issuers and alleges improper professional conduct in violation of Rule 102(e)(1)(ii) and of Exchange Act Sections 10A(a)(1) and (b)(1) and the related Rules. The underling conduct centers on allegations that Respondents failed to comply with the pertinent professional standards by: Repeatedly failed to prepare and maintain adequate work papers; consider and document fraud risks; obtain engagement quality review; and obtain written management representations. Respondents resolved the proceeding by consenting to the entry of an order directing them to cease and desist form violating the statutory Sections cited in the Order as well as the pertinent Rules. Accordingly the Respondents are denied the privilege of appearing or practicing before the Commission as an accountant.

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