Initial Decision of an SEC Administrative Law Judge
In the Matter of
In the Matter of
JAMES THOMAS McCURDY, CPA
August 13, 2002
|APPEARANCES:||Karen Matteson for the Division of Enforcement and
Office of the Chief Accountant, Securities and Exchange Commission
Charles M. Carberry of Jones, Day, Reavis & Pogue for Respondent James Thomas McCurdy, CPA
|BEFORE:||Carol Fox Foelak, Administrative Law Judge|
This Initial Decision clears CPA James Thomas McCurdy of charges of improper professional conduct in his 1999 audit of a now-defunct small mutual fund. He was charged with engaging in reckless or highly unreasonable conduct that did not conform to professional standards in assessing the probable collectibility of a receivable that comprised 25% of the fund's assets. McCurdy had investigated the receivable and judged it to be collectible. The Initial Decision concludes that he should have obtained more evidence from additional sources, but that failing to do so was neither reckless nor highly unreasonable, and dismisses the charges against him.
A. Procedural Background
The Securities and Exchange Commission (Commission) initiated this proceeding by an Order Instituting Proceedings (OIP) on June 14, 2001. The proceeding was authorized pursuant to Rule 102(e) of the Commission's Rules of Practice, 17 C.F.R. § 201.102(e) (Rule 102(e)).
The undersigned held a hearing on October 3, 2001, in Washington, D.C. The Division of Enforcement and Office of the Chief Accountant (Division) called two witnesses from whom testimony was taken, Respondent McCurdy and an expert witness, and Respondent McCurdy called two, himself and an expert witness. Twenty-three exhibits were admitted into evidence.1
The findings and conclusions in this Initial Decision are based on the record. Preponderance of the evidence was applied as the standard of proof. See Steadman v. SEC, 450 U.S. 91 (1981). Pursuant to the Administrative Procedure Act, 5 U.S.C. § 557(c), the following posthearing pleadings were considered: (1) the Division's November 29, 2001, Proposed Findings of Fact and Conclusions of Law and Posthearing Memorandum; (2) Respondent's November 30, 2001, Proposed Findings of Fact and Conclusions of Law and Post-Hearing Brief; (3) the Division's December 13, 2001, Posthearing Reply Memorandum; and (4) Respondent's December 13, 2001, Reply Memorandum. All arguments and proposed findings and conclusions that are inconsistent with this Initial Decision were considered and rejected.
B. Allegations and Arguments of the Parties
The OIP alleges that McCurdy engaged in improper professional conduct within the meaning of Rule 102(e)(1)(ii) in connection with his audit of the financial statements of JWB Aggressive Growth Fund (Fund) for the year ending December 31, 1998. The financial statements and McCurdy's unqualified audit report were filed with the Commission. The financial statements reported a receivable that, the OIP alleges, was improperly reported as an asset, because its collectibility was not probable, as required by generally accepted accounting principles (GAAP).2 McCurdy failed to comply with generally accepted auditing standards (GAAS) regarding its collectibility, the OIP alleges, by failing to obtain sufficient competent evidence, to maintain an attitude of professional skepticism, to render an accurate report, and to exercise due professional care.3 Thus, the OIP alleges, McCurdy's unqualified audit report falsely represented that the financial statements conformed to GAAP and that his audit conformed to GAAS. The Division requests that he be denied the privilege of appearing or practicing before the Commission for one year. McCurdy argues that he took reasonable steps to gather reliable information concerning the collectibility of the receivable and argues that the Division failed to meet its burden of proof to establish that McCurdy engaged in improper professional conduct within the meaning of Rule 102(e).
II. FINDINGS OF FACT
A. Respondent McCurdy
James Thomas McCurdy has been a certified public accountant (CPA) since 1980, and is licensed to practice in Ohio. Tr. 7. His firm, McCurdy & Associates CPA's, Inc. (McCurdy & Associates), specializes in auditing mutual funds and fully disclosed broker-dealers; it audits 135 to 150 mutual funds and thirty-five to forty broker-dealers per year. Tr. 7-8. McCurdy spends approximately 50% of his time performing such audits; management of the firm occupies a substantial amount of his time. Tr. 8. McCurdy was the chief financial officer (CFO) of a savings and loan for seven years before he founded McCurdy & Associates. Tr. 71. He has never been subject to professional discipline or previously accused by the Commission of misconduct. Tr. 71-72.
B. The Fund and John W. Bagwell
The Fund was a registered investment company (that is, a mutual fund), organized as a Massachusetts business trust, during the time at issue.4 Tr. 9; Div. Ex. 24 at 1190. It was registered with the Commission as a diversified, open-end management investment company in November 1995 and commenced operations in March 1996; at its height it had approximately sixty investors and total net assets of $456,000. Answer at 1, to OIP ¶ II.B. John W. Bagwell was the chief executive officer and a trustee of the Fund. Div. Ex. 24 at 1186. The Fund's five-member board of trustees also included two independent trustees. Div. Ex. 151 at 1388-89. Bagwell was also its investment adviser, doing business under the name JWB Investment Advisory & Research, Inc. (Advisor); the Fund was his only advisory client.5 Answer at 1, to OIP ¶ II.B.
Bagwell's management fee was 1% of average daily net assets. Div. Ex. 24 at 1191. Bagwell voluntarily agreed to reimburse the Fund for any expenses over 2.35% of the Fund's average daily net assets; he could terminate the agreement at any time, on prior notice to the board. Tr. 25; Div. Ex. 24 at 1191, Div. Ex. 151 at 1394. Until 1998 Bagwell waived the management fee and absorbed all expenses of the Fund; the Fund paid the expenses as they were incurred, and Bagwell reimbursed the Fund at the end of the year for the total amount, entered in the "Due From Advisor" account. Div. Ex. 147 at 1345, Div. Ex. 151 at 1395. The "Due From Advisor" amount was $3,783 for the year ended December 31, 1997; Bagwell reimbursed the Fund and waived fees and expenses totaling $32,320 for that year. Tr. 26-27; Div. Ex. 147 at 1340, 1345.
In 1998 the "Due From Advisor" account grew to $80,000. Div. Ex. 151 at 1395. To reduce costs, the Fund changed its transfer agent, accountants, custodian, and independent auditor to new service providers recommended by Bagwell. Div. Ex. 151 at 1391-93, Div. Ex. 157 at 1445-48. Bagwell also gave notice at a December 3, 1998, board meeting that he was terminating his agreement to absorb expenses. Div. Ex. 151 at 1394.
Bagwell asked the board for time to pay the $80,000 balance due in installments. Div. Ex. 151 at 1395-96. He showed the board a balance sheet and income statement and his written agreement to pay at least $5,000 per month, starting in November 1998, until the balance due was paid. Div. Ex. 148 at 1357, Div. Ex. 151 at 1395-96. Bagwell had already missed the first payment. Tr. 59. The board consulted its attorney and questioned Bagwell at length concerning his ability to pay the amount due. Tr. 56-57; Div. Ex. 151 at 1395-96. The board concluded that the Advisor had the financial capability to pay off the account by June 30, 1999, and gave the Advisor until then to do so. Div. Ex. 151 at 1396.
C. McCurdy's Audit
As part of the Fund's cost-cutting, McCurdy & Associates was engaged for the first time to audit the Fund's financial statements for the year ending December 31, 1998. Tr. 9; Div. Ex. 151 at 1392-93. McCurdy & Associates, which had an excellent reputation, charged lower rates than the previous auditor, and out-of-pocket expenses could be minimized due to its location near the Fund's other service providers. Div. Ex. 151 at 1392. McCurdy's engagement letter promised that every effort would be made to hold fees to a minimum, consistent with the requirements of the engagement, and specified that fees for the first year's audit would be capped at $5,000 plus out-of-pocket expenses. Div. Ex. 144 at 1212.
McCurdy performed the field work in January 1999. Tr. 9, 65. The audit was completed in March 1999. Tr. 41, 66; Div. Ex. 145 at 1222; Resp. Ex. 1 at Tabs A-M, O-X. The work papers show that the audit was well-documented and the auditor was well-versed in auditing mutual funds.6 Resp. Ex. 1 at Tabs A-M, O-X. The Fund's 1998 annual report, filed with the Commission on March 8, 1999, contained an Independent Auditor's Report, dated January 25, 1999, of McCurdy & Associates that stated that it had audited the accompanying financial statements in accordance with GAAS and gave an unqualified opinion that the financial statements conformed with GAAP.7 Div. Ex. 24 at 1193-94. The financial statements reported the Advisor's balance due as a receivable of $83,399 (Receivable). Tr. 18; Div. Ex. 24 at 1188. Because the Receivable was included as an asset, it was taken into account in computing the Fund's net asset value. Tr. 28; Div. Ex. 24 at 1187-88.
At the time McCurdy completed his field work, January 25, 1999, Bagwell had missed the November and December payments, and was thus at least $10,000 in arrears. Tr. 59, 66-68. Bagwell paid $12,000 in early 1999. Tr. 60, 66-68; Div. Ex. 157 at 1443.
D. Audit of the Receivable
McCurdy recognized the Receivable as "very material" to the Fund; it constituted approximately 25% of the Fund's total assets, as well as being a significant related party transaction.8 Tr. 16-18, 21, 24, 28; Div. Ex. 24 at 1188; Div. Ex. 145 at 1228, 1232, 1251. Thus, he recognized that the Receivable required additional audit procedures. Tr. 21-22; Div. Ex. 145 at 1245.
McCurdy obtained confirmation of the receivable directly from Bagwell but did not ask him about his ability to pay it. Tr. 58-59, 63; Resp. Ex. 1 at Tab W, pp. 1, 4. McCurdy reviewed the minutes from the board's December 3, 1998, meeting and spoke with the Fund's attorney, David D. Jones.9 Tr. 28, 37-38, 40-41, 46-52, 56-57; Div. Ex. 151 at 1387-97; Resp. Ex. 1 at Tab C (original work papers highlighted). McCurdy obtained more details about the board's discussion of the Receivable's collectibility from Jones, who attended the board meeting as a guest and participated in the discussion. Tr. 41, 56-57; Div. Ex. 151 at 1388, 1395-96. McCurdy did not talk with any board members. Tr. 57. He did not obtain the financial statements that Bagwell showed the board; at the time he judged it unnecessary. Tr. 63-64. McCurdy did not review any financial statements for Bagwell or the Advisor, or any other documents bearing on Bagwell's or the Advisor's financial condition, such as credit reports or tax returns. Tr. 62.
McCurdy ascertained from the Fund's prior auditor that the Advisor had previously paid amounts due the Fund on a current basis, within twelve months. Tr. 26-27, 29-30. The amount due from the Advisor for the prior year, 1997, however, was $3,783, much less than the $83,399 Receivable. Tr. 26-27; Div. Ex. 147 at 1340. In McCurdy's experience, most advisors owing receivables to mutual funds pay them off within three months, but about 10% carry them for longer periods. Tr. 61-62.
McCurdy also considered the fact that Gulf Insurance Company renewed the Fund's Registered Investment Company Bond. Tr. 30; Div. Ex. 151 at 1393; Resp. Ex. 1 at Tab H. He did not investigate how the insurance company evaluated the Fund's financial position when he confirmed the renewal, but considered it an indication of collectibility since an insurance company does its own financial analysis before bonding. Tr. 30; Resp. Ex. 1 at H. McCurdy also reviewed previous board minutes that showed that the Advisor switched service providers to lower expenses. Tr. 30-31. McCurdy also considered evidence that the amount of the Receivable would no longer increase because Bagwell terminated his agreement to absorb expenses. Tr. 30-31, 73-74; Div. Ex. 151 at 1394.
A Commission examination of the Fund took place at the same time as McCurdy's audit. Tr. 41. As a result of McCurdy's discussions with the Commission's examiner and the Fund's accountant, adjustments to the Receivable were made for prior years to write-down about $19,500 of organizational expenses. Tr. 41-42, 76-79; Resp. Ex. 1 at M, W. McCurdy took comfort from the fact that the examiner did not question the collectibility of the Receivable. Tr. 42-43. McCurdy acknowledged that the examiner did not affirmatively approve the status of the Receivable as reported on the Fund's financial statements. Tr. 44.
McCurdy considered that the dollar amount of the Receivable was not large, and that it was 95% current according to AICPA standards. Tr. 70-71. He also drew on his experience. As CFO of a savings and loan, he sat on loan committees and judged collectibility. Tr. 71. According to his experience, one or two missed payments did not make a loan's collectibility really questionable. Tr. 71. In sum, McCurdy felt that he had employed sufficient audit procedures regarding the Receivable. Tr. 36-37.
E. Expert Evidence
Loreto T. Tersigni, a CPA and certified fraud examiner, testified as an expert witness for the Division and was accepted as an expert on auditing. Tr. 85-117; Div. Ex. 175. Michael S. Groomer, who is a CPA and teaches accounting and auditing at Indiana University, testified as an expert witness for Respondent and was accepted as an expert on auditing.10 Tr. 126-58; Resp. Ex. 2.
Tersigni opined that the Fund's financial statements did not comply with GAAP and McCurdy's audit did not comply with GAAS because he failed to perform additional audit procedures concerning collectibility of the Receivable. Div. Ex. 175. As Tersigni opined, a common audit procedure to test collectibility is subsequent cash collections; Bagwell had missed two payments by the end of McCurdy's field work, but McCurdy did not investigate the missed payments. Tr. 59, 111-12; Div. Ex. 175 at 5-6. Tersigni opined that McCurdy's failure to request and evaluate the financial statements that Bagwell showed the board at the December 3, 1998, meeting and his failure to obtain an explanation of the missed payments were a failure to obtain sufficient competent evidential matter in violation of AU §§ 326 and 334. Div. Ex. 175 at 3, 5-7. Further, he opined that McCurdy failed to exercise professional skepticism and due professional care. Div. Ex. 175 at 7-8. He also opined that McCurdy's conduct constituted a reckless disregard for professional standards, or, at a minimum, a highly unreasonable departure from professional standards. Div. Ex. 175 at 9-13.
As the Division recognizes, Tersigni opined on a number of issues that were beyond collectibility of the Receivable and thus beyond the scope of the OIP. Tersigni also expressed opinions based on incorrect assumptions of fact. His ultimate opinion that McCurdy's conduct was reckless or an extreme departure from the standards of ordinary care was partly based on such opinions.
Tersigni opined that McCurdy violated AU § 330 by failing to confirm the Receivable directly with Bagwell. Div. Ex. 175 at 4-5, 9. McCurdy had, however, confirmed the Receivable directly with Bagwell. Tr. 58-59, 63; Resp. Ex. 1 at Tab W, pp. 1, 4. Tersigni also quibbled with the wording of Bagwell's agreement to pay the Receivable. Div. Ex. 175 at 5; Resp. Ex. 1 at Tab W, p. 4. It was clearly reasonable, however, for McCurdy to accept Bagwell's written agreement as his acknowledgement of his obligation to pay the Receivable. Tersigni assumed as a fact that Bagwell's payment record included failing to pay receivables in 1996 and 1997. Div. Ex. 175 at 10. The record evidence shows, however, that Bagwell was current until 1998. Tersigni opined that the notes to the Fund's financial statements were misleading in stating that the Advisor reimbursed the Fund and waived fees and expenses totaling $98,639. Div. Ex. 175 at 11. "Reimbursed," however, was used correctly, pursuant to the AICPA Audit Guide for Investment Companies, to calculate accurately an expense ratio that is reported in investment companies' financial statements.11 Tr. 79-81. Tersigni faulted McCurdy for failing to perform any audit procedures concerning the possibility that the Receivable might be an illegal loan. Div. Ex. 175 at 10. This opinion is irrelevant to the issues in this proceeding; the OIP does not charge that the Receivable was an illegal loan. Tersigni testified that the Receivable should have been recorded at $19,524 higher than $83,399.12 Tr. 107-109; Div. Ex. 175 at 11. This opinion is irrelevant to the issues. The OIP does not allege that the $83,399 value of the Receivable was incorrect.
Groomer opined that McCurdy's audit was conducted in a manner consistent with GAAS. Resp. Ex. 2. He noted that auditing is an art, not a science, and that auditor judgment informs the process of evidence-gathering. Tr. 154-55; Resp. Ex. 2.
III. CONCLUSIONS OF LAW
McCurdy was charged, pursuant to Rule 102(e)(1)(ii) of the Commission's Rules of Practice, 17 C.F.R. § 201.102(e)(1)(ii), with improper professional conduct. The charge was based on his alleged improper practices related to accounting for the Receivable. The Division argues that his conduct was reckless, or, in the alternative, highly unreasonable, and resulted in GAAS and GAAP violations. McCurdy contends that his audit of the Receivable was within professional standards. In this section it is concluded that McCurdy's conduct was neither reckless nor highly unreasonable.
A. Rule 102(e)(1)(ii)
Rule 102(e)(1)(ii) provides for sanctions against accountants who "have engaged in . . . improper professional conduct."
[W]ith respect to persons licensed to practice as accountants, "improper professional conduct" under Rule 102(e)(1)(ii) means:
(A) intentional or knowing conduct, including reckless conduct, that results in a violation of applicable professional standards; or
(B) . . . negligent conduct [consisting of]:
(1) a single instance of highly unreasonable conduct that results in a violation of applicable professional standards in circumstances in which an accountant knows, or should know, that heightened scrutiny is warranted.
17 C.F.R. § 201.102(e)(1)(iv).
1. Reckless Conduct
The Commission defines recklessness under Rule 102(e) the same as recklessness under the antifraud provisions (for the purpose of consistency in the federal securities laws; "professional standards" are not fraud-based). Thus, recklessness is "an extreme departure from the standards of ordinary care, . . . which presents a danger of misleading buyers or sellers that is either known to the [actor] or is so obvious that the actor must have been aware of it." Amendment to Rule 102(e) of the Commission's Rules of Practice, 68 SEC Docket 707, 710; 63 Fed. Reg. 57164, 57167 (Oct. 26, 1998) (Rule 102(e) Amendment). It is "a lesser form of intent," "not merely a heightened form of ordinary negligence." Id. (internal citations and quotations omitted).
Rule 102(e)(1)(iv)(A) codified the Commission's longstanding recklessness standard in 1998. See Russell Ponce, 73 SEC Docket 442, 465 n.52 (Aug. 31, 2000), appeal pending, No. 00-71398 (9th Cir.) (holding that the 1998 amendment adding new subsection (iv)(A) to Rule 102(e)(1) merely codified the Commission's longstanding recklessness standard); accord Albert Glenn Yesner, CPA, 70 SEC Docket 2743, 2748 (Oct. 19, 1999).
Recklessness is more than a misapplication of accounting principles; the Division must prove that Respondent's "accounting practices were so deficient that the audit amounted to no audit at all, or an egregious refusal to see the obvious, or to investigate the doubtful, or that the accounting judgments . . . were such that no reasonable accountant would have made the same decision if confronted with the same facts;" reasonable accountants can differ, and evidence indicating that questioned accounting decisions were reasonable negates an attempt to establish scienter. See Worlds of Wonder Sec. Litig., 35 F.3d 1407, 1426 (9th Cir. 1994), quoting SEC v. Price Waterhouse, 797 F. Supp. 1217, 1240 (S.D.N.Y. 1992) (internal quotations omitted); accord Software Toolworks Inc., 50 F.3d 615, 627 (9th Cir. 1994) ("The mere publication of inaccurate accounting figures, or a failure to follow GAAP, without more, does not establish scienter.") (citations and internal quotation marks omitted). Violations of GAAP or GAAS in themselves do not constitute recklessness. See Chill v. General Elec., 101 F.3d 263, 270 (2d Cir. 1996) ("Allegations of a violation of GAAP provisions or SEC regulations, without corresponding fraudulent intent, are not sufficient."). "Subjective good faith is inconsistent with knowing, intentional, or reckless conduct." Rule 102(e) Amendment, 68 SEC Docket at 713, 63 Fed. Reg. at 57170.
2. Highly Unreasonable Conduct
"Highly unreasonable" is a new concept, first defined in Rule 102(e) Amendment. It is higher than ordinary negligence but lower than recklessness. It is measured by the degree of departure from professional standards and not the intent of the accountant. It is not judged by hindsight, but compares actions taken by an accountant at the time of the violation with the actions a reasonable accountant should have taken. Rule 102(e) Amendment, 68 SEC Docket at 710-11, 63 Fed. Reg. at 57167-68. A single instance of highly unreasonable conduct when an accountant knows, or should know, that heightened scrutiny is warranted conclusively demonstrates a lack of competence to practice before the Commission. Rule 102(e) Amendment, 68 SEC Docket at 707, 63 Fed. Reg. at 57164. A single judgment error, even if unreasonable when made, may not indicate a lack of competence to practice before the Commission and not pose a future threat to the Commission's processes requiring Commission action. Rule 102(e) Amendment, 68 SEC Docket at 709 & n.28, 710, 63 Fed. Reg. at 57166 & n.28, 57167.
3. Applicable Professional Standards
An auditor does not guarantee that financial statements are free of material misstatement. His "responsibility [is] to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud." AU § 110.02. Applicable professional standards include GAAP, GAAS, the AICPA Code of Professional Conduct and Commission Regulations.13 Rule 102(e) Amendment, 68 SEC Docket at 709; 63 Fed. Reg. at 57166.
Thus, to conclude that McCurdy engaged in improper professional conduct within the meaning of Rule 102(e), it is necessary to conclude, first, that he violated GAAS or GAAP and, second, that the GAAS or GAAP violation resulted from reckless or highly unreasonable conduct by him. A GAAS or GAAP violation in itself is not improper professional practice within the meaning of Rule 102(e).
B. Conformity with GAAP and GAAS
The Division argues that the Receivable did not meet the GAAP definition of an asset and that the audit did not conform with GAAS in that McCurdy did not comply with specified auditing standards regarding collectibility of the Receivable.14 McCurdy argues that the steps he took regarding collectibility of the Receivable fell well within professional standards.
McCurdy's independent auditor's report stated his opinion that the financial statements presented the Fund's financial position in conformity with GAAP. The Division contends that this statement was false because the Receivable did not meet the GAAP definition of an asset because its collectibility was not probable. The record evidence concerns McCurdy's efforts to obtain evidence about collectibility. The only record evidence concerning the probability of collectibility is that Bagwell agreed to pay, was $10,000 in arrears at the end of January 1999, and paid $12,000 in early 1999. This is not sufficient evidence to conclude that collectibility was not probable and that the accounting treatment of the Receivable was not in conformity with GAAP, in light of the Division's burden of proof. However, a conclusion that the Fund's financial statements were in conformity with GAAP does not resolve the question of whether McCurdy engaged in improper professional conduct in auditing them.15
The Division argues that McCurdy failed to obtain sufficient competent evidential matter concerning collectibility of the Receivable, citing AU §§ 326.01 and 334.09, .10.16 For the same reasons, it argues, he failed to maintain an attitude of professional skepticism, citing AU § 230.07.17 Thus, it argues, the audit was not conducted in accordance with GAAS, contrary to the statement and unqualified opinion in his audit report. The sum of these failings, the Division contends, is that McCurdy failed to exercise due professional care, citing AU § 230.01.18
As Groomer opined, auditing is an art, not a science, and auditor judgment informs the process of evidence-gathering. Nonetheless, on balance, it is concluded that McCurdy failed to obtain sufficient competent evidential matter concerning collectibility of the Receivable.
There is no question that McCurdy considered collectibility and obtained competent evidential matter that indicated the Receivable was collectible. He confirmed Bagwell's agreement to pay, he considered the board's evaluation of collectibility by studying the minutes and speaking with Jones, and he learned from the previous auditors that Bagwell had a history of prompt payment of previous, smaller balances. In exercising his judgment not to seek further evidence, McCurdy considered the insurance renewal, evaluated Bagwell's two missed payments in light of his past experience judging debtors' ability to pay, and considered that the amount of the Receivable was not large in absolute terms. Weighing against those factors were: McCurdy's experience that investment advisers usually paid such receivables in full within three months; the Receivable represented one quarter of the Fund's assets and was too large for Bagwell to pay off immediately, as he had done in past years; and McCurdy did not know how the insurance company evaluated the Fund's financial position.
Even allowing for auditor judgment, more inquiry was called for to obtain sufficient competent evidential material, because the evidence McCurdy obtained largely derived from Bagwell. As far as McCurdy knew, the board's evaluation was based solely on evidence provided by Bagwell. It is axiomatic that an auditor should not rely solely on management representations.19 McCurdy did not obtain the financial statements that Bagwell showed the board and did not know whether they were audited.20 Obtaining the financial statements was a step that would have added virtually no cost to the audit. Had he done so, McCurdy would have been in a position to obtain greater assurance concerning collectibility. For these reasons, it is concluded that McCurdy's audit did not comply with AU § 326.01. To the extent that his failure to obtain sufficient competent evidential matter concerning collectibility was a failure to maintain professional skepticism and due professional care, the audit did not comply with AU §§ 230.07 and .01. Thus, his audit report was inaccurate insofar as it stated that the audit was conducted in accordance with GAAS.
C. Improper Professional Conduct
A violation of GAAS is not in itself "improper professional conduct" within the meaning of Rule 102(e)(1)(ii). Only reckless or highly unreasonable conduct that results in a violation of GAAS is "improper professional conduct." See Rule 102(e)(1)(iv). The Division argues that McCurdy engaged in reckless, or alternatively, highly unreasonable conduct. McCurdy maintains that his conduct was within professional standards, not reckless or highly unreasonable. It is concluded in this section that McCurdy's conduct was not reckless or highly unreasonable.
1. McCurdy's Conduct Was Not Reckless.
McCurdy's conduct was not reckless. There is no evidence in the record to indicate that McCurdy acted otherwise than in good faith. "Subjective good faith is inconsistent with knowing, intentional, or reckless conduct." Rule 102(e) Amendment, 68 SEC Docket at 713, 63 Fed. Reg. at 57170. Nor were his accounting practices so deficient that the audit amounted to no audit at all, or an egregious refusal to see the obvious, or to investigate the doubtful.
There is no question that McCurdy relied on competent evidential material that he considered provided assurance that the Receivable was collectible. While McCurdy did not go far enough in obtaining sufficient competent evidential material, he did not disregard contradictory evidence in his possession or engage in "an egregious refusal to see the obvious, or to investigate the doubtful." Potts v. SEC, 151 F.3d 810, 812 (8th Cir. 1998) (quoting Worlds of Wonder, 35 F.3d at 1426) (upholding Commission sanction of a concurring auditor who concurred with backdated accounting treatment by relying on untested representations despite much contradictory evidence). The evidence on which McCurdy relied was not "doubtful" and does not disclose an "obvious" improbability that the Receivable was collectible.
2. McCurdy's Conduct Was Not Highly Unreasonable.
McCurdy did not engage in "highly unreasonable" conduct evincing incompetence to practice before the Commission.21 McCurdy recognized that heightened scrutiny of the collectibility of the Receivable was warranted. To that end he obtained and considered some competent evidential matter. He judged that the evidential matter provided reasonable assurance of the collectibility of the Receivable. He was not in possession of contradictory evidential matter. His GAAS shortfall was in failing to obtain additional competent evidential matter regarding the Receivable. At most, this was ordinary negligence.
Tersigni's opinion that McCurdy's conduct was, at least, highly unreasonable is rejected. His ultimate opinion was partly based on assumptions of fact that were incorrect and on opinions on matters that were not at issue.
IV. ULTIMATE CONCLUSIONS
It is concluded that McCurdy did not engage in intentional or knowing conduct, including reckless conduct, that resulted in a violation of professional standards within the meaning of Rule 102(e)(iv)(A) or in a single instance of highly unreasonable negligent conduct that resulted in a violation of applicable professional standards in circumstances in which he knew, or should have known, that heightened scrutiny was warranted within the meaning of Rule 102(e)(iv)(B)(1). Thus, he did not engage in improper professional conduct within the meaning of Rule 102(e)(ii), and this proceeding must be dismissed.
V. RECORD CERTIFICATION
Pursuant to Rule 351(b) of the Commission's Rules of Practice, 17 C.F.R. § 201.351(b), it is certified that the record includes the items set forth in the record index issued by the Secretary of the Commission on March 12, 2002.
IT IS ORDERED that this administrative proceeding IS DISMISSED.
This Initial Decision shall become effective in accordance with and subject to the provisions of Rule 360 of the Commission's Rules of Practice, 17 C.F.R. § 201.360. Pursuant to that rule, a petition for review of this Initial Decision may be filed within twenty-one days after service of the decision. It shall become the final decision of the Commission as to each party who has not filed a petition for review pursuant to Rule 360(d)(1) within twenty-one days after service of the Initial Decision upon him, unless the Commission, pursuant to Rule 360(b)(1), determines on its own initiative to review this Initial Decision as to any party. If a party timely files a petition for review, or the Commission acts to review as to a party, the Initial Decision shall not become final as to that party.
Carol Fox Foelak
Administrative Law Judge
|1||Citations to the Division's and Respondent's exhibits, and to the hearing transcript, will be noted as "Div. Ex. __," "Resp. Ex. __," and "Tr. __," respectively.|
|2||GAAP are the basic postulates and broad principles of accounting pertaining to business enterprises. These principles establish guidelines for measuring, recording, and classifying the transactions of a business entity. See SEC v. Arthur Young & Co., 590 F.2d 785, 789 n.4 (9th Cir. 1979).|
|3||GAAS are the standards prescribed by the Auditing Standards Board of the American Institute of Certified Public Accountants (AICPA) for the conduct of auditors in the performance of an examination of management's financial statements. See id. at 788 n.2. Citations to GAAS will be made to the Codification of Statements on Auditing Standards, issued by the Auditing Standards Board of the AICPA, as "AU § ___."|
|4||The Fund is now defunct. Upon its March 2001 application, the Commission found that the Fund had ceased to be an investment company and ordered that its registration ceased to be in effect. See JWB Aggressive Growth Fund, 74 SEC Docket 2246 (Apr. 25, 2001).|
|5||"Bagwell" and "Advisor" are used interchangeably in the record and in this Initial Decision.|
|6||Resp. Ex. 1 consists of McCurdy's complete, original work papers for the engagement. Div. Exs. 144, 145, 147, 148, and 151 consist of photocopies of portions of the work papers. In addition to being complete, the original work papers in Resp. Ex. 1 have McCurdy's contemporaneous highlighting in places. Tr. 29, 65. Photocopying does not capture highlighting. It is easier to search for individual pages in the Division exhibits as the pages are Bates-numbered.|
|7||The Independent Auditor's Report was dated January 25, 1999, the last day of field work, in accordance with AICPA standards. Tr. 23-24, 76; Div. Ex. 24 at 1194. See AU § 530.01 Dating of the Independent Auditor's Report ("Generally, the date of the completion of the field work should be used as the date of the independent auditor's report.").|
|8||McCurdy determined materiality for the engagement to be $8,806. Tr. 19-21; Div. Ex. 145 at 1251.|
|9||The OIP did not allege that the Receivable was illegal. However, McCurdy noted that the minutes reflected Jones's discussion of whether allowing the Advisor to pay it in installments could be considered an illegal loan; Jones advised the board to look at the totality of circumstances in that refusing the Advisor time to pay the balance could be detrimental to the Fund. Tr. 51-52; Div. Ex. 151 at 1395; Resp. Ex. 1 at Tab C. In any event, Jones's response to McCurdy's standard letter of inquiry concerning litigation, claims, and assessments did not mention any possible illegality of the Receivable. Tr. 12-14, 39-40, 52-53; Div. Ex. 144 at 1215-16.|
|10||To the extent that the evidence of the expert witnesses does not lead to findings of fact, it will be summarized here and referred to as appropriate in the Conclusions of Law section of this Initial Decision.|
|11||See AICPA, Audit and Accounting Guide, Audits of Investment Companies ¶¶ 5.13, .29 (1997). Tersigni has audited broker-dealers, but has never audited an investment company; he is aware of the AICPA Audit Guide for Investment Companies, but did not consult it before preparing his testimony. Tr. 89.|
|12||In one place the transcript incorrectly reflects $19,524 as $199,524. Tr. 108, line 16. This is an error. Tersigni discussed $19,524. Tr. 107, lines 7, 17; Div. Ex. 175 at 11. The $19,524 that Tersigni discussed is the approximately $19,500 in organizational expenses referred to infra.|
|13||The ten basic GAAS standards are listed in AU § 150.02, and detailed interpretations follow. Those at issue in this proceeding are the third general standard (Due professional care) and AU § 230 (Due Professional Care); the third standard of field work (Sufficient competent evidential matter) and AU §§ 326 (Evidential Matter) and 334 (Related Parties); and the fourth standard of reporting (Expression of opinion regarding the financial statements) and AU § 508 (Reports on Audited Financial Statements). The OIP cites Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 57 (FAS 57) and FASB Statement of Concepts No. 6 in alleging that the Fund's financial statements were not in accordance with GAAP.|
|14||The OIP specifies auditing standards that McCurdy allegedly violated in connection with the collectibility of the Receivable and alleges that accounting treatment of the Receivable was not in accordance with GAAP because its collectibility was not probable. The OIP does not charge any other auditing or accounting impropriety. Thus, for purposes of the Conclusions of Law the undersigned has disregarded any reference in post-hearing filings to practices or standards that do not relate to collectibility of the receivable.|
|15||See Rule 102(e) Amendment, 68 SEC Docket at 711, 63 Fed. Reg. at 57168. ("[A]n accountant can demonstrate a lack of competence even if his conduct did not result in the filing of a false or misleading document. An auditor who fails to audit properly under GAAS-whether recklessly or highly unreasonably-should not be shielded because the audited financial statements fortuitously turn out to be accurate or not materially misleading.").|
|16||AU § 326.01, the third standard of field work, provides, "Sufficient competent evidential matter is to be obtained through inspection, observation, inquiries, and confirmations to afford a reasonable basis for opinion regarding the financial statements under audit." AU §§ 334.09, .10 recommends that the auditor consider procedures that might not otherwise be necessary when examining related party transactions. AU § 334.09 states, "The procedures should . . . extend beyond inquiry of management."|
|17||AU § 230.07 provides, "Due professional care requires . . . professional skepticism[,] an attitude that includes a questioning mind and a critical assessment of audit evidence. The auditor uses the knowledge, skill, and ability called for by the profession of public accounting to diligently perform, in good faith and with integrity, the gathering and objective evaluation of evidence."|
|18||AU § 230.01, the third general standard, provides, "Due professional care is to be exercised in the planning and performance of the audit and the preparation of the report."|
|19||See AU § 333.02 Management Representations ("[R]epresentations from management are part of the evidential matter the independent auditor obtains, but they are not a substitute for the application of those auditing procedures necessary to afford a reasonable basis for an opinion regarding the financial statements under audit.")|
|20||AU § 334.10 notes that information about the financial capability in a related-party transaction can be obtained from audited financial statements, unaudited financial statements, income tax returns and other sources.|
|21||Only the steps McCurdy took regarding collectibility of the Receivable are at issue in this proceeding. However, as noted above, the audit work papers show that the audit was well-documented and the auditor well-versed in auditing mutual funds.|
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