Dirty Secrets Fester in 50-Year Relationships: Jonathan Weil

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June 9 (Bloomberg) -- Another financial scandal. Another cover-up by regulators. Four years ago, inspectors for the auditing industry's chief watchdog discovered that KPMG LLP had let Motorola Inc. record revenue during the third quarter of 2006 from a transaction with Qualcomm Inc., even though the final contract wasn’t signed until the early hours of the fourth quarter. That’s no small technicality. Without the deal, Motorola would have missed its third-quarter earnings target.

The regulator, the Public Company Accounting Oversight Board, later criticized KPMG for letting Motorola book the revenue when it did. Although KPMG had discussed the transaction’s timing with both Motorola and Qualcomm, the board said the firm “failed to obtain persuasive evidence of an arrangement for revenue-recognition purposes in the third quarter.” In other words, KPMG had no good reason to believe the deal shouldn’t have been recorded in the fourth quarter.

The oversight board didn’t tell the public that this happened at Motorola, though. The maker of wireless-communications equipment, now known as Motorola Solutions Inc., didn’t restate its earnings for the period in question. And there’s no sign the Securities and Exchange Commission ever followed up with an investigation of Motorola’s accounting, even though it oversees the board and had access to its findings.

All of this is business as usual for America’s numbers cops. Since the board’s creation by the Sarbanes-Oxley Act in 2002, its inspectors have found audit failures by large accounting firms at hundreds of U.S.-listed companies. Yet its policy is to keep the identities of those clients secret.

‘Issuer C’

Likewise, in August 2008 when the board released its annual inspection report on KPMG, it referred to Motorola as “Issuer C” in the section on the auditor’s work for the company. For what it’s worth, Motorola paid the firm $244.2 million from 2000 to 2010.

This is the third column I’ve written revealing the name of a client whose accounting practices were a subject of a major auditing firm’s inspection report. Motorola is the biggest yet. I hope a whistleblower comes forward someday to leak many more. This is information investors need to know.

The Sarbanes-Oxley Act authorizes the oversight board to disclose “such confidential and proprietary information as the board may determine to be appropriate” in the public portions of its inspection reports. So it’s the board’s call whether to disclose clients’ names, although the SEC could overrule it. The board never does, bowing to the wishes of the accounting firms.

Identity Revealed

Motorola’s identity was disclosed in public records last month as part of a class-action shareholder lawsuit against the company in a federal district court in Chicago. The plaintiffs in the case, led by the Macomb County Employees’ Retirement System in Michigan, filed a transcript of a September 2010 deposition of a KPMG auditor, David Pratt, who testified that Issuer C was Motorola. KPMG isn’t a defendant in the lawsuit.

Pratt also identified the Motorola customers cited in the board’s inspection report. It’s his deposition that allows me to describe the report’s findings using real names.

The oversight board said a significant portion of the company’s earnings for the 2006 third quarter came from two licensing agreements that were recorded during the last three days of the quarter. One was the Qualcomm deal that wasn’t signed until the fourth quarter. The board also cited other deficiencies in KPMG’s review of Motorola’s accounting for the transactions.

Making the Numbers

Motorola booked $275 million of earnings during the 2006 third quarter as a result of the Qualcomm deal, according to estimates by the plaintiffs in the shareholder suit. The plaintiffs allege that all of it was recorded in violation of generally accepted accounting principles. That’s 28 percent of the net income Motorola reported for the quarter.

A Motorola spokesman, Nicholas Sweers, said the company’s accounting complied with GAAP, and that the financial statements for the periods covered in the inspection report have never been the subject of an SEC investigation. He declined to discuss details of Motorola’s accounting, citing the litigation. A KPMG spokesman, George Ledwith, declined to comment. So did an oversight board spokeswoman, Colleen Brennan, and an SEC spokesman, John Nester.

The story doesn’t end there. Last week the board’s new chairman, James Doty, gave a speech in which he said the board should consider setting mandatory term limits for auditors at public companies. To prove his point, he cited two instances that were “galling in their simplicity” where auditors “have failed to exercise the required skepticism and have accepted evidence that is less than persuasive.”

Making a Match

One of his examples matched the fact pattern of KPMG’s 2006 review at Motorola exactly. “PCAOB inspectors found at one large firm that an engagement team was aware that a significant contract was not signed until the early hours of the fourth quarter,” Doty said. “Nevertheless, the audit partner allowed the company to book the transaction in the third quarter, which allowed the company to meet its earnings target.”

Doty finished the anecdote by saying: “The company had been an audit client of the firm for close to 50 years.” KPMG has been Motorola’s auditor since 1959; it had been Motorola’s auditor for 47 years at the time of the Qualcomm deal.

If Doty and his colleagues are genuinely interested in protecting investors, they should stop being so timid and start naming names.

(Jonathan Weil is a Bloomberg View columnist. The opinions expressed are his own.)

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To contact the writer of this column: Jonathan Weil in New York at jweil6@bloomberg.net

To contact the editor responsible for this column: James Greiff at jgreiff@bloomberg.net