UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION SECURITIES EXCHANGE ACT OF 1934 RELEASE NO. 37396 JULY 2, 1996 ACCOUNTING AND AUDITING ENFORCEMENT RELEASE NO. 798 JULY 2, 1996 ADMINISTRATIVE PROCEEDING File No. 3-9035 ------------------------------ : : In the Matter of : ORDER INSTITUTING : PROCEEDINGS AND OPINION AND HEIN + ASSOCIATES LLP : ORDER OF THE COMMISSION : IMPOSING SANCTIONS UNDER and : RULE 102(e) OF THE : COMMISSION'S RULES OF PRACTICE DUANE C. KNIGHT, JR., CPA, : : Respondents. : : ------------------------------- The Commission deems it appropriate and in the public interest to institute proceedings pursuant to Rule 102(e)(1)(ii) of the Commission's Rules of Practice, to determine whether Hein + Associates LLP ("Hein + Associates") and Duane C. Knight, Jr. ("Knight") engaged in improper professional conduct. -[1]- Simultaneously with the institution of these proceedings, Hein + Associates and Knight have submitted Offers of Settlement consenting, without admitting or denying the matters set forth herein, to the issuance of the Order Instituting Proceedings and Opinion and Order of the Commission Imposing Sanctions Under Rule 102(e) of the Commission's Rules of Practice ("Order") set forth herein. ---------FOOTNOTES---------- -[1]- Rule 102(e)(1)(ii) of the Commission's Rules of Practice provides, in relevant part, that "the Commission may deny, temporarily or permanently, the privilege of appearing or practicing before it in any way to any person who is found by the Commission after notice of and opportunity for hearing in the matter . . . to have engaged in . . . improper professional conduct." ==========================================START OF PAGE 2====== The Commission has determined that it is appropriate and in the public interest to accept Hein + Associates' and Knight's offers and accordingly is issuing this Order. I. FACTS Based on the foregoing, the Commission finds that: -[2]- A. Respondents 1. Hein + Associates is a certified public accounting firm headquartered in Denver, Colorado. Hein + Associates audited the financial statements of Mallon Resources Corporation ("Mallon"), a public company, for the years ended December 31, 1990 through 1993. 2. Knight, age 35, is a certified public accountant, and was the audit manager for the 1992 year end audit of Mallon's financial statements. Knight began Mallon's 1993 audit as the audit manager, but accepted an employment offer in February 1994 to become Mallon's Treasurer. Knight resigned from Hein + Associates on March 31, 1994 and assumed his position as Mallon's Treasurer on April 1, 1994. B. The Issuer Mallon, a Colorado Corporation with headquarters in Denver, Colorado, at all relevant times, engaged in oil and gas production and precious metals mining. Mallon's stock is registered with the Commission under Section 12(g) of the Securities Exchange Act of 1934, and is listed for trading on the NASDAQ system. C. Summary This matter concerns a violation of generally accepted auditing standards ("GAAS") by Hein + Associates and Knight, an audit manager. The firm and Knight engaged in improper professional conduct by conducting an audit of Mallon's financial statements for the year ended December 31, 1993 in violation of GAAS' independence standard. The firm's independence was impaired by Knight's participation as a Hein + Associates auditor in the audit of Mallon's financial statements after he had accepted employment with Mallon. ---------FOOTNOTES---------- -[2]- The findings herein are solely for the purpose of these proceedings and are not binding on any other person named as a respondent in this or any other proceeding. ==========================================START OF PAGE 3====== D. Hein + Associates Failed To Conduct Its Audit In Accordance With GAAS 1. Mallon Engages Hein + Associates To Audit Its 1993 Financial Statements Hein + Associates issued audit reports on Mallon's financial statements for the years ended December 31, 1990, 1991 and 1992. Knight had served as audit manager and senior, respectively, for Hein + Associates's 1991 and 1992 Mallon audits. -[3]- On January 27, 1994, Mallon engaged Hein + Associates to conduct an audit of its financial statements for the year ended December 31, 1993. Clarence Hein ("Hein"), who was the managing partner of Hein + Associates, and had been the engagement partner for the 1991 and 1992 Mallon audits, was the engagement partner and Knight was the audit manager. Knight began preparation for the Mallon 1993 audit field work by drafting an audit planning memorandum, an engagement letter, and budget for the audit. The planning memorandum contained the blueprint for how the audit was to be conducted and outlined the significant issues to be addressed in the audit. Knight also began assembling the general file and selecting audit program checklist forms for the audit. In addition, Knight sent a list of schedules to Mallon's Controller that Hein + Associates required the company to prepare, and drafted a related parties memorandum. On March 10, 1994, after he had accepted an offer of employment from Mallon, Knight gave all of the work he had prepared in anticipation of the 1993 Mallon audit to the audit senior. 2. Mallon Offers Knight A Position As Treasurer The president and chief executive officer of Mallon ("CEO") first telephoned Knight about taking a position as Mallon's Treasurer and principal financial officer on February 15, 1994. Knight understood that, as Treasurer, he would be in charge of Mallon's financial department and report directly to the CEO. After his conversation with the CEO, Knight became concerned about his position as an auditor for a company from which he was actively considering an employment offer. Knight mentioned his conversation with the CEO to another audit manager at Hein + Associates, telling the manager that he believed he had an independence problem. Knight and the other manager then consulted the American Institute of Certified Public Accountants' ("AICPA") Professional Standards-[4]- and concluded that ---------FOOTNOTES---------- -[3]- Knight also performed an audit of certain properties acquired by Mallon in the summer of 1993. -[4]- ET, Section 191.77. ==========================================START OF PAGE 4====== Knight did, indeed, have an independence problem although a formal offer had not, as yet, been made. Nevertheless, Knight did not contact either Hein or the concurring partner to notify them of his employment discussions with Mallon. On February 17, 1994, Knight received a written offer of employment from Mallon, and informed the concurring partner at Hein + Associates. At that time, Knight and the concurring partner agreed that Knight could not work on the Mallon audit while an employment offer was pending. Hein agreed with the concurring partner and Knight that Knight could not work on the Mallon audit. Between February 17 and February 24, 1994, Knight negotiated his possible employment with the CEO. On February 24, 1994, Knight received a revised written offer of employment from Mallon, which he signed and accepted the same day. On February 24, 1994, Knight informed Hein + Associates that he had accepted Mallon's offer. 3. Knight Assumes A Dual Role As A Hein + Associates Auditor And Mallon Treasurer Knight's participation in the Mallon audit did not conclude after he accepted the employment offer from Mallon on February 24, 1994. Instead, Knight continued to play a role in the audit on behalf of both Hein + Associates and Mallon. Knight continued to work as a Hein + Associates full-time employee until March 31, 1994. Knight began working full-time at Mallon on April 1, 1994. However, from April 1 to April 15, 1994, Knight also worked part- time for Hein + Associates, billing 55 hours to Hein + Associates as an "independent contractor," purportedly on matters not related to the Mallon audit. a. Knight Violates The Independence Rules By Preparing Mallon Schedules For The Audit Knight violated GAAS and Commission independence rules by continuing to provide professional services to Mallon after February 24, 1994. After he had accepted Mallon's offer of employment and before March 28, 1994, Knight prepared three "prepared-by-client" tax accrual schedules for the purpose of determining whether Mallon could record a deferred tax asset in its financial statements. Those three schedules were audited by Hein + Associates as part of its audit procedures for the 1993 Mallon audit, and included in Hein + Associates workpapers. Further, between February 24, 1994 and March 30, 1994, Knight prepared schedules in support of unaudited pro forma information related to Mallon's acquisition of certain properties. Hein + Associates reviewed these schedules to determine their reasonableness. The schedules were attached as ==========================================START OF PAGE 5====== exhibits to Mallon's Annual Report on Form 10-K. Knight's preparation of Mallon tax accrual and pro forma schedules while still employed by Hein + Associates placed the firm in the improper position of auditing its own work. b. Knight Performs Other Audit-Related Functions Hein called Knight on March 29, 1994 at Hein + Associates to review several substantive open audit issues, including the accounting treatment of certain volumetric production payments to Mallon. Hein told Knight that the issue was a gray area on which Hein wanted to consult the Commission's staff. Indeed, the volumetric production payments issue required resolution prior to the issuance of the audit report. Although Hein knew that Knight was still a Hein + Associates employee, he told Knight that he should represent Mallon's perspective in a telephone call with the Commission staff. On March 29, 1994, Knight went to Mallon's offices where a telephone call was placed to the staff of the Commission's Division of Corporation Finance. During that telephone call, Knight, Hein, and the new audit manager, among others, discussed the volumetric production payments accounting issue with the Commission staff. During the conversation, Knight represented himself to the Commission staff as a future Mallon employee. After the telephone call had been concluded, Hein told Knight that he should write a memorandum from Mallon's perspective explaining Mallon's accounting treatment of the payments. Knight wrote the memorandum on March 30, 1994 while still a Hein + Associates employee. On April 14, 1994, Knight, now acting as Mallon's Treasurer, sent the memorandum to Hein + Associates, where it was included in the audit workpapers for the year end audit of Mallon's 1993 financial statements. On March 7, 1994, Knight called Mallon's Controller to check on the status of the package of schedules from Mallon needed for the audit. During the audit field work, Knight spent a number of hours at Mallon's offices before officially commencing employment there on April 1, 1994. Finally, on March 28, 1994, Knight discussed the content of the "Management Discussion and Analysis" section with Mallon's general counsel. E. Events Leading To Hein + Associates' Dismissal 1. The Commission Staff Contacts Hein + Associates While reviewing Mallon's disclosures related to the volumetric production payments, the Division of Corporation Finance staff noted that Knight was an audit manager for Hein + Associates before accepting employment at Mallon. As a result, the Commission staff issued a comment letter to Mallon dated June 21, 1994 requesting information regarding the relationships among ==========================================START OF PAGE 6====== Knight, Hein + Associates and Mallon. By letter dated July 5, 1994, Hein + Associates advised the Commission staff that, among other things, Knight provided audit-related services to Mallon before receiving an offer of employment from Mallon; he initially discussed employment with Mallon on February 15, 1994; and he accepted an offer of employment from Mallon on February 24, 1994. Hein + Associates stated incorrectly that Knight left Hein + Associates on April 15, 1994, and commenced his employment with Mallon on the same day. Further, Hein + Associates stated incorrectly that Knight ceased the performance of audit procedures for Mallon when he received the offer on February 15, 1994, and that Knight had no direct involvement with the audit of Mallon for the year ended December 31, 1993. The Commission staff requested additional information about Knight's involvement with the Mallon audit. By letter dated July 11, 1994, Hein + Associates advised the staff that, contrary to the information it had provided previously, Knight ceased his full-time employment with Hein + Associates on March 31, 1994, commenced full-time employment at Mallon on April 1, 1994, and performed 55 hours of part-time work for Hein + Associates between March 31, 1994 and April 15, 1994. Hein + Associates' letter disclosed that Hein asked Knight to participate in the conference call to the Commission on March 29, 1994 because he knew that Knight would be responsible for dealing with those issues at Mallon. -[5]- 2. Mallon Obtains A New Audit Of Its Financial Statements On July 20, 1994, Commission staff members notified Mallon that they were unable to conclude that Hein + Associates was independent and that the December 31, 1993 Form 10-K, filed on April 4, 1994, had to be amended to delete the audit report of Hein + Associates. The Division of Corporation Finance also informed Mallon that until such time as Mallon was able to provide audited financial statements, the company's filings would be considered deficient. On August 1, 1994, staff from the Commission's Division of Corporation Finance and the Office of the Chief Accountant met with Knight, Hein, counsel for Hein + Associates and Mallon's general counsel. At that meeting, the staff was advised that Knight had assisted a secretary at Mallon in interpreting Hein's ---------FOOTNOTES---------- -[5]- By letter dated July 15, 1994, Knight informed the Commission staff that he participated in the call to the Commission on March 29, 1994 on behalf of Mallon at Hein's request. He also stated that on March 29, 1994, he had assisted Mallon employees in responding to Hein's review points on Mallon's financial statements. ==========================================START OF PAGE 7====== handwritten notes to Mallon's 1993 financial statements. However, the staff was advised incorrectly that Knight had no other involvement with either the audit or the financial statements themselves. The next day, the Commission staff contacted the audit manager who succeeded Knight through the Colorado State Board of Public Accountancy. The audit manager stated that between March 14 and March 28, 1994, Knight prepared certain schedules "on behalf of" Mallon that were audited by Hein + Associates. Mallon filed a Current Report on Form 8-K on November 16, 1994 (and an amendment thereto on November 29, 1994), disclosing the dismissal of Hein + Associates and the appointment of Price Waterhouse LLP as its new independent auditor. On December 5, 1994, Mallon filed an amended Form 10-K containing substantially the same December 31, 1993 financial statements accompanied by an unqualified audit report from Price Waterhouse dated November 30, 1994. II. OPINION A. The Commission Independence Requirements And GAAS The Commission and GAAS require audits to be performed by independent auditors; "without bias with respect to the client." See Codification of Statements on Auditing Standards (hereafter "AU")  220.02; Regulation S-X, 17 C.F.R.  210.2-01. The Commission has stated that an accountant will not be considered independent with respect to a company with which, during the period of the professional engagement, a member of his firm had or was committed to acquire a direct financial interest, or with which a member of his firm was connected as an officer or employee. Regulation S-X, 17 C.F.R.  210.01(b). The Commission has defined a "member" of the firm to include "[ii] any professional employee involved in providing any professional service to the person, its parents, subsidiaries, or other affiliates, and [iii] any professional employee having managerial responsibilities and located in [the engagement office] or other office of the firm which participates in a significant portion of the audit." Id. An independent auditor must not "audit[] decisions which he had a part in making." AU  220.03. Indeed, GAAS provides that "[i]ndependent auditors should not only be independent in fact; they should avoid situations that may lead outsiders to doubt their independence." Id. GAAS requires that "[i]n all matters relating to the assignment, an independence in mental attitude is to be maintained by the auditor." AU  220.01. ==========================================START OF PAGE 8====== B. Hein + Associates And Knight Violated The Independence Rules Knight was a "member" of Hein + Associates both because he was a professional employee with managerial responsibilities in the office of Hein + Associates that performed the 1993 Mallon audit,-[6]- and because Knight was involved in providing professional services to Mallon during the 1993 Mallon audit. -[7]- In spite of an employment arrangement with Mallon, Knight participated in the audit by preparing "prepared-by- client" and other schedules and by performing a substantive role in connection with a significant audit issue. Accordingly, Knight engaged in improper professional conduct by violating the GAAS independence standard. Hein + Associates failed to maintain its independence from Mallon as required by GAAS. As described above, Knight participated in the audit of Mallon's financial statements after he had accepted a position as Mallon's Treasurer. As a result, Hein + Associates issued an audit report which falsely stated that the audit of Mallon's financial statements for the year ended December 31, 1993 was performed in accordance with GAAS. Hein + Associates' failure to conduct an audit in accordance with GAAS constitutes improper professional conduct. The Commission has stated that the "independence of public accountants is critical to the Commission's reporting process and to the securities markets which the Commission regulates." In the Matter of Robert J. Iommazzo, CPA, AAER No. 437 (Jan. 12, 1993). Conduct such as that of Hein + Associates and Knight impairs the integrity of an audit and undermines the Commission's ability to rely on the auditor's report. Independent auditors must avoid even an appearance of impropriety to provide the public with an assurance that the issuer's financial statements have been audited by a completely independent, impartial third party. -[8]- When an auditor accepts employment with an issuer, any work subsequently performed by the auditor taints the entire audit, regardless of the nature of that work. Knight's participation in the audit tainted the entire auditing process thereby requiring a re-audit of Mallon's financial statements. Without question, an auditor functioning as both independent auditor and representative of the issuer lacks independence. The ---------FOOTNOTES---------- -[6]- Regulation S-X, C.F.R.  210.2-01(b)[iii]. -[7]- Regulation S-X, C.F.R.  210.01(b)[ii]. -[8]- "[P]ublic confidence . . . might also be impaired by the existence of circumstances which reasonable people might believe likely to influence independence." AU  220.03. ==========================================START OF PAGE 9====== Commission will not tolerate that situation because such conduct breaches the professional responsibility of an auditor and jeopardizes the objectives of the securities laws. Touche Ross & Co. v. SEC, 609 F.2d 570, 581 (2d Cir. 1979). While auditors are not prohibited from securing employment with audit clients of their firm, strict adherence to the independence rules is required to ensure that the transition from auditor to company representative does not impair the integrity of the audit in appearance or in fact. III. FINDINGS Accordingly, based on the foregoing, the Commission finds that Hein + Associates and Knight engaged in improper professional conduct within the meaning of Rule 102(e)(1)(ii) of the Commission's Rules of Practice. IV. OFFERS OF SETTLEMENT AND ORDER Hein + Associates and Knight have submitted Offers of Settlement in which they consent, without admitting or denying any of the above, to the issuance of this Order censuring the firm and Knight and directing that Hein + Associates retain an independent reviewer, acceptable to the Chief Accountant of the Commission, to review the firm's independence quality controls in its accounting and auditing practice and to take such further steps as described in Hein + Associates' Offer of Settlement and below. The Commission deems it appropriate and in the public interest to accept their Offers of Settlement. Accordingly, IT IS HEREBY ORDERED, effective immediately, that pursuant to Rule 102(e) of the Commission's Rules of Practice, Hein + Associates LLP and Duane C. Knight, Jr.: A. Be, and hereby are, censured; B. Hein + Associates will retain an Independent Reviewer, acceptable to the Chief Accountant of the Commission, to review the firm's independence quality controls in its accounting and auditing practice; 1. Within thirty (30) days of the issuance of this Order, the Independent Reviewer will both review the firm's independence quality controls and make recommendations for changes. Within sixty (60) days after receiving the Independent Reviewer's review ==========================================START OF PAGE 10====== and recommendations, Hein + Associates will implement all recommendations made by the Independent Reviewer; 2. Within sixty (60) days after implementation of the Independent Reviewer's recommendations, the Independent Reviewer will report to the Chief Accountant of the Commission on its initial review and on Hein + Associates' subsequent implementation of the Independent Reviewer's recommendations; and 3. Hein + Associates will provide a copy of this Order and a copy of the Independent Reviewer's report to the peer reviewer for use in Hein + Associates' May 31, 1997 peer review. By the Commission. Jonathan G. Katz Secretary