WELLS FARGO COMPANY

Case 1.1 Wells Fargo & Company 1 © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

CASE 1.1

WELLS FARGO & COMPANY

Synopsis

Wells Fargo & Company got its start in 1852 in the midst of the California Gold Rush.The company’s two founders raised the capital to finance a new company to be based in the Wild West boomtown of San Francisco after realizing that the Bay Area provided a wealth of business opportunities for investors willing to accept a high risk of failure. The company’s founders decided that transportation and banking services were desperately needed in San Francisco so they decided that Wells Fargo would pursue those two unrelated lines of business. The company initially made a “name” for itself by providing rapid and reliable freight, courier, and mail delivery services. But, when the federal government nationalized major freight and transportation lines during World War I, Wells Fargo’s management shifted its focus almost exclusively to the banking industry.Throughout much, if not most, of Wells Fargo’s history successive generations of senior executives have embraced the high-risk, “Wild West” mindset around which the company was created. That mindset or company culture triggered a massive, high-profile scandal that surfaced in September 2016 when a federal agency announced that Wells Fargo had been fined nearly $200 million for engaging in improper sales practices on an enormous scale.Critics of Wells Fargo eventually turned their attention to the company’s longtime audit firm, KPMG. Several U.S. senators, in particular, harshly criticized the prominent audit firm. The senators demanded that KPMG explain how it could issue a “clean” opinion each year on Wells Fargo’s internal control over financial reporting (ICFR) while the company was involved in the massive fraud involving improper sales practices.Central to this case are three lengthy letters that are included as exhibits. Exhibit 1 presents a letter sent by four U.S. senators to KPMG in which the senators demand that the audit firm respond to a series of questions including whether the Wells Fargo auditors were aware of the improper sales practices being applied by their client. The senators also demanded to know whether KPMG continued to stand by its opinions that Wells Fargo had maintained “effective internal control over financial reporting” during the timeframe that the sales fraud was ongoing.KPMG’s letter in response to the senators is contained in Exhibit 2—in the letter KPMG indicated that it did, in fact, still stand by its earlier opinions that Wells Fargo had maintained effective ICFR.Finally, Exhibit 3 presents a letter that the senators sent to the PCAOB—the senators had been troubled by much of the information conveyed to them by the KPMG letter shown in Exhibit 2.In this final letter, the senators suggested that the PCAOB review KPMG’s audits of Wells Fargo’s ICFR and that the agency review its “rules and guidance” relevant to public company auditors’ consideration of ICFR weaknesses and illegal acts perpetrated by their clients.

(Contemporary Auditing , 12e Michael Knapp) (Solution Manual all Chapters) 1 / 4

Case 1.1 Wells Fargo & Company 2

© 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Wells Fargo & Company--Key Facts

• In 1852, Henry Wells and William Fargo organized Wells Fargo & Company because they

were convinced that the California Gold Rush provided a wealth of business opportunities in the San Francisco Bay Area.

• Banking and transportation services were the two lines of business Wells Fargo’s founders

decided their new company would pursue.

• After the federal government nationalized major freight and transportation lines during

World War I, Wells Fargo’s executives focused the company’s operations almost exclusively on the banking industry.

• Beginning in the early twentieth century, successive generations of Wells Fargo senior

executives relied on a relentless acquisition strategy and aggressive marketing initiatives to expand the company’s banking operations.

• By 2015, Wells Fargo was the largest global bank in terms of collective market value; at

the time, the company operated nearly 9,000 retail branches in 35 countries and had over 70 million customers.

• In addition to its impressive size, Wells Fargo consistently ranked among the most

respected multinational companies in annual surveys by Barron’s.

• In September 2016, the Consumer Financial Protection Bureau (CFPB) announced that

Wells Fargo had been fined $185 million for improper sales practices between 2011 and 2016; those illegal activities had resulted in the creation of millions of unauthorized customer accounts.

• In response to the widely-publicized scandal, Wells Fargo’s executives typically attributed

the illegal practices to self-interested lower-level employees.

• KPMG, Wells Fargo’s longtime audit firm, issued “clean” opinions on the company’s

internal control over financial reporting (ICFR) throughout the time frame in which the illegal sales practices were being applied.

• In a letter sent to KPMG in late 2016, four U.S. senators posed a series of questions to the

firm, including whether the Wells Fargo auditors had been aware of the illegal sales practices and whether the firm continued to stand by its prior opinions that the company had maintained effective ICFR.

• KPMG responded to the senators by indicating that the Wells Fargo auditors had been

aware of the illegal sales activities but had concluded that they did not involve the company’s ICFR and did not have a significant impact on the company’s financial statements. 2 / 4

Case 1.1 Wells Fargo & Company 3

© 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

• After receiving the letter from KPMG, two of the senators wrote the PCAOB and asked

the agency to review KPMG’s audits of Wells Fargo’s ICFR and its “rules and guidance” relevant to auditors’ consideration of ICFR weaknesses and illegal acts perpetrated by their clients.

Instructional Objectives

• To identify the different types or classes of internal controls.

• To identify the nature and scope of internal controls over financial reporting (ICFR).

• To define a “material weakness in internal control” and to identify the factors auditors should

consider when determining whether a deficiency in internal control qualifies as a material weakness.

• To define a “material weakness in ICFR” and to identify the factors auditors should consider

when determining whether a deficiency in ICFR qualifies as a material weakness in ICFR.

• To examine the responsibility of public company auditors to search for illegal acts committed

by their clients.

• To identify public company auditors’ responsibilities after determining that a client has engaged

in an illegal act.

• To consider how the length of an audit firm’s tenure with a public company client may impact

its ICFR assessment for that client.

Suggestions for Use

Consider launching this case by requiring your students to either individually or in groups research and report on a recent ICFR material weakness reported by a public company. If you want to ensure that each individual or group reports on a unique material weakness, then use a Google search to identify a sample of material weaknesses to be used for this exercise. After the students have made these presentations, ask them to compare and contrast the material weaknesses they researched with the internal control deficiencies that were evident within Wells Fargo. After completing this exercise, students will be better equipped to provide an informed opinion on whether KPMG should have reported an ICFR material weakness for Wells Fargo.

Suggested Solutions to Case Questions

• Internal controls can be categorized several different ways. For example, we could classify

internal controls by transactions cycles, by cost, or by complexity. The key scheme that the accounting profession has historically used to categorize internal controls is by their overarching objective. According to the COSO’s internal control framework, an entity’s internal control process is designed to achieve three broad classes of objectives. Those classes of objectives 3 / 4

Case 1.1 Wells Fargo & Company 4

© 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.include “reliability of financial reporting,” “effectiveness and efficiency of operations,” and “compliance with applicable laws and regulations.” Obviously, the key distinction between internal controls over financial reporting (ICFR) and the other two types or classes of internal controls is the underlying intent or purpose of ICFR.The PCAOB notes that ICFR are intended to “provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP” [AS 2201.A5]. In this same context, the PCAOB auditing standards note that ICFR include those “policies and procedures that— (1) Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.” [AS 2201.A5]

The other two classes of internal controls address differing control objectives. For example, the intent or objective of internal controls relating to “effectiveness and efficiency of operations” involve operational issues such minimizing waste on a production line. An example of the final category of internal controls would be ensuring compliance with the Americans with Disabilities Act (ADA).

• This is a question that has diametrically opposed answers, each of which could be supported

with at least somewhat reasonable arguments. In its November 28, 2016, letter to the four U.S.senators, KPMG defended its position that the improper sales practices “did not involve key controls over financial reporting” by arguing that (1) those activities had no significant impact on the company’s financial statements and (2) none of the individuals involved in the improper sales practices “worked in financial reporting or had the ability to influence the financial reporting process.” There is certainly a basis for countering KPMG’s argument. AS 2201.21 requires auditors to use a “top-down approach” in auditing a client’s ICFR: “A top-down approach begins at the financial statement level and with the auditor’s understanding of the overall risks to internal control over financial reporting. The auditor then focuses on entity-wide controls and works down to significant accounts and disclosures . . .” (Note the reference to “disclosures.” One could certainly argue that Wells Fargo’s internal sales “fraud” was a significant disclosure item for users of the company’s financial statements.) AS 2201.23 and 24 identify a variety of entity-wide controls “that are important to the auditor’s conclusion about whether the company has effective internal control over financial reporting” [paragraph 23]. One group of such controls are “controls related to the control environment” [paragraph 24]. Following is the complete text of AS 2201.25:

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