SEC after Ernst & Young over PeopleSoft partnership

A business relationship with PeopleSoft Inc. has put accounting firm Ernst & Young LLP in hot water with the U.S. Securities and Exchange Commission (SEC).

Ernst & Young stands accused of violating SEC rules on auditor independence and, if found guilty, could be barred from auditing public companies and could be forced to give back audit fees it charged PeopleSoft, an SEC official said Tuesday.

The allegations against Ernst & Young constitute a "very significant violation of federal security laws," said Paul Berger, associate director of enforcement at the SEC in Washington, D.C.

Ernst & Young, the U.S. arm of Big Five accountant Ernst & Young International Ltd., put out a statement Monday denying any wrongdoing. "We are confident that our conduct was entirely appropriate and we will defend ourselves vigorously," the statement reads. A company spokesman declined to comment beyond what is said in the written statement.

Ernst & Young also provides IT services. A sanction permanently barring the firm from performing audits on public companies would cut off a major revenue stream and likely drive the firm out of business in the U.S.

PeopleSoft didn't immediately return calls seeking comment. If found guilty, Ernst & Young would be found to have caused PeopleSoft to submit financial reports with the SEC "that failed to include independently audited financial statements as required," according to an SEC statement released Monday.

The case focuses on joint business activities the two companies engaged in from 1994 until 2000 while Ernst & Young was also PeopleSoft's auditor.

Although the alleged misconduct ended in 2000, the case is still relevant, because Ernst & Young's tax consulting department, which was involved in the alleged violations, is still part of the company, the SEC's Berger said. That is why the SEC is also seeking a cease and desist order to prevent Ernst & Young from "committing or causing" these alleged violations again, he added.

Ernst & Young and PeopleSoft jointly developed and marketed between 1994 and 2000 a software product called EY/GEMS for PeopleSoft, the SEC said Monday. The product was based on software developed by Ernst & Young's tax department to which PeopleSoft source code was added. Ernst & Young agreed to pay PeopleSoft royalties of between 15 percent and 30 percent from each sale of the product, with a guaranteed minimum royalty of US$300,000, according to the SEC.

Another alleged auditor-independence violation came from Ernst & Young implementing PeopleSoft software for third-party clients, activities that generated "hundreds of millions of dollars" for Ernst & Young in IT consulting fees, the SEC said. As part of their "implementation partners agreement," the two companies engaged in a variety of joint sales and marketing initiatives, the SEC said.

Since 2000, things have changed between PeopleSoft and Ernst & Young. Ernst & Young no longer audits PeopleSoft, according to the SEC's Berger, and the business relationships highlighted by the SEC have ended, according to the Ernst & Young statement. The PeopleSoft license agreement was terminated "years ago," the software product in question "is no longer sold," and Ernst & Young's IT consulting unit, which was in charge of implementing software such as PeopleSoft's, was sold to Cap Gemini in mid-2000, Ernst & Young said in its statement.

Still, Ernst & Young continues to offer IT services. For example, as part of its tax consulting division, Ernst & Young offers "tax technology enablement" services which include "technology solutions focused on automation and optimization of tax data collection, tax sensitization of enterprise resource planning (ERP) systems and tax data management offering a company comprehensive, complete and successful solutions towards the development of a tax value center," according to the company's Web site. A quick scan of the Ernst & Young Web site shows that the company offers a wide variety of IT services from its various divisions.

For years, critics have been calling for accounting firms to stop selling consulting services, including IT services, to clients that they audit, a practice critics say creates conflicts of interest and compromises auditor independence. The issue has been in the spotlight since the collapse of energy trader Enron Corp., whose auditor Arthur Andersen LLP also provided it with nonaudit consulting services.

In the past, Ernst & Young, based in New York, has defended its practice of continuing to offer IT services by saying that it offers them in an "advisory" manner, an approach that doesn't impair its auditing independence and that is different from a more hands-on "consulting" approach.

Yet, Monday's SEC action brings up the question of whether public pressure and government actions will lead accounting firms to completely purge their portfolios from nonaudit consulting services, including IT services. Arthur Andersen is ridding itself of every service not related to auditing, as it struggles to survive and save its credibility.

The SEC's current rules on auditor independence allow accounting firms to offer some consulting services to clients they audit under certain circumstances, and forbids them from offering certain services under other circumstances.

For example, with regards to IT services in particular, the SEC's rules prohibit an accounting firm from "directly or indirectly operating or supervising the operation of the audit client's information systems or managing the audit client's local area network." The SEC also prohibits an accounting firm from "designing or implementing a hardware and software system that aggregates source data underlying the financial statements or generates information that is significant to the audit client's financial statements" unless certain conditions are met.

The SEC case against Ernst & Young will go before an administrative law judge, who will give Ernst & Young a chance to defend itself and establish what sanctions, if any, should be imposed upon Ernst & Young.

If Ernst & Young is forced to return the audit fees it charged PeopleSoft, based in Pleasanton, California, the money would most likely be returned to PeopleSoft, the SEC's Berger said.

For its part, Ernst & Young said in its statement that it stands by its PeopleSoft audits.

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