Weatherford International The oilfield services industry includes thousands of companies large and small that provide drilling, seismic testing, transportation, and a wide range of other services to firms directly involved in the exploration and recovery of oil and natural gas. In terms of annual revenues, Schlumberger and Halliburton rank as the two largest oilfield services companies. Ranking among the top five firms in the industry on several metrics is Weatherford International, a company that, in recent decades, has arguably been the most confrontational and controversial in the rough and tumble world of oilfield services. Weatherford's prior corporate executives historically viewed their company as the "perpetual underdog of the full-service oil patch players" with "something to prove."* Those executives' "volatile" management style and willingness to dismiss underperforming subordinates "on a whim" allegedly created a corporate culture in which Weatherford's employees routinely adopted an anything-goes, "eager to please" mindset.* That mindset produced rapid growth for the company but also resulted in repeated clashes with Weatherford's larger competitors and regulatory authorities around the globe. Nothing as Certain as ... Growth and Taxes In 1998, Bernard Duroc-Danner merged his oilfield equipment company with Weatherford Services to create Houston-based Weatherford International. The native of France had emigrated to the United States a decade earlier at the age of 34. Duroc-Danner's father, a wealthy executive with the large French petroleum company Total, reportedly gave his son $20 million and encouraged him to go to the United States to seek his fortune. Because of his familiarity with oil and gas exploration, Duroc-Danner ultimately decided to pursue a career in oilfield services. Following the merger creating Weatherford International, the new company's board chose Duroc-Danner as its chief executive officer (CEO). The young executive immediately set out to enhance the stature of his company in the global and highly competitive oilfield services industry, a goal he would fiercely pursue over the next two decades. Duroc-Danner constantly preached a message of growth to his subordinates and focused relentlessly on that theme when communicating with financial analysts and the investing public. "Growth is who we are and what we do. The day we stop growth, you won't see me around ... I hate plateaus."* From 1998 through 2011, Duroc-Danner dramatically increased Weatherford's total revenues and expanded its global footprint to more than 100 countries by acquiring almost 300 companies. The fiery CEO also frequently reshuffled Weatherford's management team as he searched for like-minded individuals to carry out his "take-no-prisoners" approach to doing business. Duroc-Danner exerted such pervasive control over Weatherford that one observer suggested he served not as the company's CEO but rather as its "absolute monarch."* In 2008, Ernst & Young recognized Duroc-Danner's skill as a corporate executive by presenting him with its "Entrepreneur of the Year Award." That same year, Weatherford's stock reached a split- adjusted record price of nearly $50 per share, which was more than ten times higher than the company's stock price in 1998.

Duroc-Danner relied heavily on Weatherford's stock to finance the company's worldwide acquisition spree. To keep the company's stock price rising and attractive to potential takeover candidates, he recognized that he had to grow Weatherford's earnings as well as its revenues. A strategic initiative the company implemented to achieve that goal was reducing one of its largest expense items, namely, income tax expense. To drive down Weatherford's effective tax rate (ETR) and thus lower its income tax expense, the company's executives began shifting revenues from relatively high-tax jurisdictions, such as the United States and Canada, to low-tax jurisdictions such as Bermuda, Hungary, Ireland, Luxembourg, and Switzerland. To accelerate Weatherford's revenue-shifting strategy, Duroc-Danner reincorporated the company in Bermuda in 2002. Over the next several years, Duroc-Danner reincorporated the company two more times when significant tax-reduction opportunities arose in other low-tax jurisdictions. In 2009, he made Switzerland the company's corporate home base and then five years later transferred that home base to Ireland. Despite these legal maneuvers, Houston remained Weatherford's de facto worldwide headquartersfollowing the 2009 relocation, the television news serial 60 Minutes reported that Weatherford maintained "little more than a nondescript mail drop"* in Switzerland. Another key feature of Weatherford's revenue-shifting strategy was the use of "hybrid instruments." According to the Securities and Exchange Commission (SEC), "hybrid instruments are structured to incorporate features of both debt and equity, such that an instrument typically qualifies as debt in one jurisdiction and equity in another."* The SEC reported that Weatherford used hybrid instruments to "facilitate the movement of revenue" from high-tax jurisdictions to corporate tax havens. The "interest payments" on these securities would be deducted from taxable income by a Weatherford entity in a high-tax jurisdiction, while the "dividends receipts" on these same securities by another Weatherford entity in a low-tax jurisdiction would be either exempt from taxes or taxed at a very modest rate. The aggressive taxation strategies employed by Weatherford during Bernard Duroc- Danner's early years as CEO significantly reduced the company's annual income tax expense and increased its reported profits. From 2001 to 2006, those strategies lowered the company's ETR from approximately 36 percent to 25 percent. The company's taxation strategies were so successful that they became a focal point of Weatherford's quarterly earnings conferences with financial analysts tracking the company. In April 2007, a Bear Stearns analyst noted that the company exceeded its consensus earnings forecast for the first quarter of 2007 "primarily" because it lowered its ETR.* Frequent statements by Weatherford executives that the company's ETR would continue to decline prompted financial analysts to issue favorable earnings forecasts for the company and raise their target price for the company's stock. In early 2008, as Weatherford prepared to file its 2007 Form 10-K with the SEC, two senior members of the company's tax department discovered that Weatherford's ETR for fiscal 2007 was considerably higher than the estimated ETR that had been communicated to the company's financial analysts earlier in the year. The tax officials realized that the unexpectedly high ETR would come as an unpleasant surprise to those financial analysts and, more

importantly, to their superiors, particularly Bernard Duroc-Danner. The unsettling discovery panicked the two men and sent them in search of a solution. Tax Fix, Tax Fiasco In 2002, Andrew Becnel, an attorney in his early thirties, joined Weatherford and was given the title Associate General Counsel. The ambitious Becnel moved rapidly up Weatherford's corporate hierarchy. In 2005, he became the company's Vice President of Finance, and the following year added the title of Chief Financial Officer (CFO). After assuming the CFO position, Becnel reorganized the departments under his control. The reorganization included making Weatherford's tax department a "finance function ... focused on tax strategy and planning, and not tax accounting."* Under this new organizational scheme, the tax department operated independently of the company's accounting and financial reporting functions. "Thus, beginning in October 2006 ... Weatherford's tax department no longer reported directly to Weatherford's accounting department or to senior management with sufficient knowledge or experience to assess whether Weatherford's income tax accounting was being fairly and accurately presented in accordance with GAAP. As a result, the tax department had virtually no accounting oversight." James Hudgins served as Weatherford's Vice President of Tax from 2000 through March 2012, although he was not officially elevated to true "officer status" within the company until February 2009. Hudgins' principal subordinate in Weatherford's tax department was Darryl Kitay, who successively held the titles of Tax Manager, Senior Manager, and Tax Director during his tenure with the company. Both men were CPAs, although Kitay allowed his Texas CPA license to expire in 2004. In a 2016 enforcement release, the SEC provided the following summary of Hudgins' and Kitay's principal responsibilities. "As the then Vice President of Tax, Hudgins was the architect of Weatherford's tax structure, tax planning, and was responsible for executing tax strategies designed to reduce Weatherford's ETR and tax expense. Hudgins was also responsible for ensuring that Weatherford's consolidated income tax accounts were properly maintained and that the consolidated tax provisions, underlying expenses, and related financial disclosures were accurately and fairly presented in all material respects in accordance with GAAP. Kitay, who reported to Hudgins, was responsible for preparing and reviewing Weatherford's consolidated income tax accounts and underlying expenses that were reported in Weatherford's financial statements." The SEC determined that the work environment within Weatherford's tax department under James Hudgins was less than ideal. In addition to the department being "perpetually understaffed," its employees were overworked: "Hudgins pressed his employees to work long hours to make Weatherford's tax structure extremely competitive."* Hudgins also "quickly gained a reputation with the company's external auditor as ... challenging and demanding" and "for taking aggressive accounting positions."*

Through 2007, Weatherford accounting employees within the company's operating units used Microsoft Excel spreadsheets to prepare year-end income tax data, which they then forwarded to the company's Houston-based tax department. Hudgins' subordinates reviewed these data and then compiled them to arrive at a consolidated year-end income tax provision for the company.* At the same time, those subordinates determined the appropriate year-end balances for the company's current and deferred income tax assets and liabilities. Fiscal 2007 was a troubling year for the company financially. Throughout that year, "emails among senior management reflected that the company was under pressure to meet Wall Street expectations and to offset shortfalls in its quarterly earnings targets by lowering its ETR."* In late February 2008, just days before the company filed its 2007 Form 10-K with the SEC, Hudgins and Kitay reviewed the year-end tax data that had been collected and consolidated a short time earlier by their subordinates for the purpose of incorporating it in Weatherford's 2007 financial statements. Those data shocked Hudgins and Kitay because the company's ETR for the year was much higher than previously estimated. That estimate had been conveyed to financial analysts and investors during Weatherford's quarterly earnings conferences. To bring Weatherford's ETR for 2007 more closely in line with the previous estimate, Hudgins and Kitay made a bogus post-closing adjustment to the company's accounting records. "Faced with what they considered to be an immovable deadline for reporting earnings, Hudgins and Kitay falsified the year-end consolidated tax provision by making an unsubstantiated manual $439.7 million post-closing "plug" adjustment to two different Weatherford Luxembourg entities ... To do so, they intentionally reversed accounting data that had been correctly input to Weatherford's consolidated tax provision via the company's accounting system." This unauthorized "plug" adjustment produced a $154 million bogus tax benefit for Weatherfordneither Hudgins nor Kitay disclosed the true reason for this adjustment to anyone outside of the company's tax department. The $154 million tax benefit, along with several smaller misstatements, inflated the company's net income for 2007 from $941 million to $1.07 billion, an increase of approximately 14 percent. More importantly, the post-closing adjustment, which Hudgins and Kitay referred to as a "dividend exclusion" adjustment, allowed the company to surpass its consensus Wall Street earnings forecast for 2007.* (Despite understating its income tax expense for financial reporting purposes, Weatherford paid the appropriate amount of income taxes.) On February 21, 2008, Weatherford filed its 2007 Form 10-K with the SEC. In that document, the company's senior management drew attention to the decrease in Weatherford's ETR from 26 percent in 2006 to 23 percent in 2007. "The decrease in our effective tax rate during 2007 as compared to 2006 was due to benefits realized from the refinement of our international tax structure and changes in geographic earnings mix."* Of course, the decline in Weatherford's ETR was primarily due to the undisclosed post-closing accounting adjustment made by Hudgins and Kitay. Several financial analysts complimented Weatherford for the impressive 2007 earnings report. An analyst with Morgan Stanley commented on the company's

"truly remarkable"* earnings growth while another analyst congratulated the company for once more topping Wall Street's consensus earnings forecast. In 2008, Weatherford changed its income tax accounting procedures by acquiring tax software that "automatically populated" or "mapped" the quarterly and year-end income tax amounts to the company's accounting records. This new software provided for more uniformity in the tax calculations across the company's operating units by eliminating the Microsoft Excel spreadsheets previously prepared by tax personnel within those units. During the fourth quarter of each fiscal year, Hudgins required his headquarters tax department staff to perform a "pretend hard close" to determine that the tax software was properly functioning. "The purpose of the pretend hard close was to ensure that Weatherford's tax accounting controls were in place for the end of the year. Essentially, the pretend hard close was a 'dry run' of all the steps Weatherford would later perform to finalize its consolidated tax provision at year-end. Accordingly, the pretend hard close process would provide information regarding the effectiveness of Weatherford's ICFR [internal controls over financial reporting] for the accounting of income taxes, but the results themselves would not be incorporated into Weatherford's financial statements" Weatherford's senior management suggested, in fiscal 2008 quarterly earnings conferences with financial analysts, that the company's ETR for the year would be in the range of 17 to 18 percent, sharply lower than the 23 percent ETR achieved in fiscal 2007. However, the pretend hard close in late 2008 revealed that Weatherford's projected ETR was between 22 and 23 percent. To align the projected ETR for 2008 with senior management's prior reported estimate for the year, Hudgins and Kitay directed certain of their subordinates to "override" the new income tax software and manually reduce the income tax expense yielded by the pretend hard close. This manual override resulted in an ETR of between 17 and 18 percent for the year- to-date period. In January 2009, the company's tax department used the new income tax software to determine the actual ETR and income tax expense for the entire year. Again, that ETR "far exceeded" the estimate previously communicated by senior management to analysts and the investing public. Faced with the prospect of disappointing Weatherford's senior management, financial analysts, and investors, "Hudgins and Kitay opted to perpetuate the fraud."* The two men once more prepared a manual post-closing accounting adjustment to manufacture a bogus tax benefit for Weatherford. That $106 million tax benefit lowered the company's ETR to 17.1 percent for fiscal 2008 and increased the company's net income by approximately 8 percent. James Hudgins "actively lobbied" his superiors during 2008 "for officer status and the higher compensation it brought."* As the year-end approached, Hudgins sent the following email to Bernard Duroc-Danner: "I'm very upset that I'm not an officer yet. I achieved a 17% rate [ETR] this year, and all of you treat me like sh__."* In early 2009, after Weatherford released its 2008 earnings and ETR to the public, Hudgins received his wish and was upgraded to officer status with the company.

During 2009 and 2010, Hudgins and Kitay continued to intentionally understate Weatherford's ETR and income tax expense. Exhibit 1 presents a table prepared by the SEC that summarizes the "unsupported manual entries" and resulting "plugged tax benefits" Hudgins and Kitay produced for Weatherford from 2007 through 2010. That exhibit also reports the net income amounts initially reported by Weatherford for each of the affected years, amounts inflated by the impact of the improper tax benefits. A pesky artifact of the tax accounting fraud for the two conspirators was the steadily increasing "phantom income tax receivable" that it produced. "This phantom income tax receivable occurred because the current income tax payable accounts annually recorded from the consolidated income tax provision were understated by the amount of each year's fraudulent tax benefit."* Consequently, when Weatherford made tax payments each yearthroughout the accounting fraud, the company continued to pay the proper amount of income taxes that it owedthe amount debited to the income tax payable account exceeded the existing credit balance of that account, resulting in a steadily rising debit balance in the income tax payable account. The total of the phantom tax receivable reached approximately $460 million by late 2010. To obscure the nature of the receivable for financial reporting purposes, Weatherford reclassified it to a generic "Prepaid Other" account during the fourth quarter of 2009. Throughout the fraud,

Hudgins and Kitay fabricated excuses to justify the tax receivable that was growing progressively larger. Hudgins told multiple parties, including the company's auditors, that he was attempting to recover the overpaid tax amounts. Of course, Hudgins knew the receivable was completely fictitious and would never be collected. In February 2011, a review of Weatherford's intercompany accounts by Ernst & Young revealed that the large income tax receivable was a direct result of the annual post-closing adjustments prepared by Hudgins and KitayErnst & Young had been aware of these adjustments since early 2008 but did not understand their purpose. At this point, Hudgins and Kitay admitted that those adjustments had misstated Weatherford's income tax expense and related accounts over the period 2007-2010. However, the two men did not disclose the fraudulent nature of the adjustments to the Ernst & Young audit team or Weatherford's senior management and instead maintained that they were simply accounting errors. Weatherford's senior management attributed the required restatement of the company's 2007-2010 financial statements to "an error in determining the tax consequences of intercompany amounts over multiple years."* That restatementfiled with the SEC on March 8, 2011slashed Weatherford's previously reported net income amounts by approximately $500 million and drove down the company's stock price by 11 percent, costing stockholders $1.7 billion. The bulk of the restatement was necessary to eliminate the impact of Hudgins and Kitay's bogus post-closing adjustments. The remaining portion corrected other errors discovered in Weatherford's income tax accounts. Bernard Duroc-Danner and Andrew Becnel hosted a conference call on March 2, 2011, to disclose the coming restatement of Weatherford's prior operating results. In the conference call, Becnel reassured financial analysts tracking the company's stock that the accounting glitch that had made the restatement necessary was "nothing other than ... an honest mistake."* Following the March 2011 restatement, Bernard Duroc-Danner placed James Hudgins in charge of a "large-scale effort" to revamp and improve Weatherford's income tax accounting policies and procedures. During this "remediation" project, Hudgins and his subordinates discovered numerous overt deficiencies in Weatherford's income tax accounting process. In late February 2012, Weatherford disclosed in an SEC filing that a second restatement would be necessary to correct "hundreds" of additional income tax accounting errors discovered in the company's accounting records. This second restatementissued on March 15, 2012resulted in a collective reduction of $256 million in the company's already restated 2007-2010 net income amounts and the net income figure for 2011 that had been released the prior month. One week following the issuance of the second restatement, Weatherford announced that Andrew Becnel and James Hudgins had voluntarily resigned from the company. At the same time, Weatherford relieved Darryl Kitay of all "supervisory responsibilities" in the company's tax department. Following the departure of Becnel and Hudgins and the release of the second restatement, Weatherford discovered more uncorrected errors in its income tax accounting records. On December 17, 2012, the company issued a third financial restatement to correct those errors. This final restatement reduced Weatherford's previously reported net income amounts by an additional $186 million.

Overtaxed Auditors Weatherford's Ernst & Young auditors didn't learn that the series of post-closing accounting adjustments recorded by Hudgins and Kitay were fraudulent until company officials passed that information to them in August 2012. The company had apparently determined several months earlier that those adjustments were bogus.* Poor communication with client accounting and financial personnel plagued Ernst & Young's tenure as Weatherford's independent audit firm, which was surprising since many of those individuals were Ernst & Young alumni. Among others, those former Ernst & Young employees included the CFO who preceded Andrew Becnel, Weatherford's Director of Internal Audit, two individuals who served as the company's Chief Accounting Officer, and, most notably, James Hudgins. Weatherford employed so many former Ernst & Young auditors one observer referred to the relationship between the client and audit firm as "virtually familial."* Weatherford retained Ernst & Young as its independent auditor in 2001. Three years later, Ernst & Young designated Weatherford as a "close-monitoring"* client, the firm's highest- risk category for audit clients. Ernst & Young reserved close-monitoring status for clients that might cause "damage to its reputation, monetarily or both." Exhibit 2 lists the five specific "risk factors" that justified tagging Weatherford as a high-risk audit client. Weatherford remained a close-monitoring audit client throughout the remainder of Ernst & Young's tenure as the company's audit firm. This designation had significant implications for the Weatherford audit team, particularly the senior personnel assigned to that team. "Ernst & Young's policies and procedures ... required more detailed review by senior engagement professionals when auditing close-monitoring clients, in recognition of basic audit and quality control standards that required heightened professional due care and scrutiny when faced with a higher risk of material misstatement."

The risk factor that proved to be most challenging for the Weatherford auditors was the company's "byzantine" international tax structure. Ernst & Young's Houston-based audit team frequently consulted with the firm's National Professional Practice Group on complex income tax accounting issues that arose during annual audits and interim reviews of the company's financial statements. Ironically, while Ernst & Young was serving as Weatherford's auditor, the accounting firm's national office identified the "auditing of income tax accounting" as a firm-wide "specific focus" and an audit area "requiring significant improvement." Between 2006 and 2009, Ernst & Young's national office "issued at least six memos ... to its personnel addressing deficiencies in its [Ernst & Young's] audits of income tax accounting." Those intra-firm communications stressed the following three deficiencies in the auditing of income tax-related accounts: Ineffective supervision and review by assurance and tax professionals, especially detailed and second-level review by assurance professionals; Inadequate exercise of due professional care and professional skepticism; and Insufficient audit documentation, including repeated observations that tax workpapers appeared to be carried forward from year to year and failed to include appropriate analyses and supporting documentation to support the auditors' conclusions. Weatherford International ranked among the largest audit clients of Ernst & Young's Houston practice office. From 2007 through 2010, the time frame when Hudgins and Kitay intentionally misstated Weatherford's income tax accounts, Ernst & Young earned more than $30 million in fees from the auditing, taxation, and consulting services it provided to the company. For each of those years, Ernst & Young issued an unqualified audit opinion on Weatherford's financial statements. Over the course of the tax accounting fraud, Weatherford was not only among the largest clients of Ernst & Young's Houston office, but it was also among the least preferred client assignments. "Because of Weatherford's reputation as a 'very adversarial' client, staffing the Weatherford audit was a perennial problem. Ernst & Young managers resisted working on the Weatherford audit and threatened to quit if assigned to the engagement." Among the Weatherford officials who were most problematic for the Ernst & Young auditors was James Hudgins. One member of the Ernst & Young audit team described Hudgins as "difficult, intimidating ... and stubborn, particularly with respect to the tax positions he took on behalf of the company." From 2006 through 2010, Craig Fronkiewicz served as the "coordinating partner" for the Weatherford International audit engagements. In that role, Fronkiewicz "had final responsibility for the audits and quarterly reviews of Weatherford's financial statements." Another key member of the Weatherford engagement team was Sarah Adams. From 2001 through 2006, Adams was the senior tax manager assigned to the Weatherford engagement. After being promoted to partner in 2007, Adams served as the tax partner on that job from 2007 through 2013. "As the tax partner, Adams reviewed the work of, and supervised Ernst & Young's tax professionals on the

audit engagement team who performed audit and review procedures related to Weatherford's income tax accounting." Fronkiewicz and Adams struggled with inadequate staffing of the Weatherford audit team while they were assigned to the engagement. Prior to the 2009 audit, for example, Fronkiewicz requested that an audit manager "well suited to a difficult, public company like Weatherford" be assigned to the engagement. Fronkiewicz's request was denied. "Ernst & Young assigned an assurance [audit] manager who had limited previous public company experience and had little training or experience in complex international accounting. Notwithstanding that lack of experience, Fronkiewicz assigned this manager the task of reviewing the income tax workpapers during the 2009 audit." Although Fronkiewicz and Adams did not control the staffing decisions made for the Weatherford engagement, the SEC held them responsible, along with Ernst & Young, for many of the problems that resulted from the inadequate staffing of the company's annual audits. "Adams supervised Ernst & Young tax professionals that she knew were inexperienced and untrained and did not seek additional training for these individuals. Adams and Fronkiewicz also knew that the Weatherford audit required their tax staff to perform consolidated tax provision audit work in a difficult, high-pressure environment under severe time constraints. Adams and Fronkiewicz also engaged in unreasonable conduct by requiring their junior and inexperienced tax staff to audit tax accounting that should have been conducted by assurance and tax personnel under the ultimate supervision of the assurance partners. The staffing, training, and supervision on the Weatherford engagement identified above were the responsibility of Fronkiewicz, Adams, and Ernst & Young. At the time, Ernst & Young had no mechanism to ensure that the highest-risk areas of its highest-risk clients had a team of assurance and tax professionals that was properly selected, trained, and supervised." SEC Issues Yearly Report Cards on Weatherford Audits In October 2016, the SEC issued Accounting and Auditing Enforcement Release No. 3814. That enforcement release included the federal agency's individual critiques of Ernst & Young's 2007-2010 Weatherford International audits. 2007 Weatherford Audit Because Craig Fronkiewicz and Sarah Adams had served on the Weatherford engagement for several years, prior to the fiscal 2007 audit, each of them was well aware of the company's aggressive approach to "managing" its income taxes and the related accounting, financial reporting, and internal control issues posed by that mindset. During both the 2005 and 2006 audits, Ernst & Young had identified an internal control deficiency linked to Weatherford's income tax accounting. The 2005 deficiency resulted in "numerous errors" in Weatherford's tax asset and liability accounts, while the 2006 deficiency resulted in a material understatement of

the company's consolidated income tax expense "that enabled Weatherford to meet its fourth- quarter earnings projection." In each case, the Ernst & Young auditors had ultimately decided to characterize the deficiency as an "ICFR significant deficiency" rather than a material weakness in internal control. While working on the 2007 Weatherford audit, a tax senior discovered the initial post- closing dividend exclusion (plug) adjustment made by Hudgins and Kitay and brought the $440 million accounting entry to Adams' attention. The SEC reported that when members of the Weatherford audit teampresumably the tax senior and Adamsasked Hudgins and Kitay for an explanation for the post-closing entry, they were given an answer that "did not make sense."* On multiple occasions, the tax senior flatly admitted to others, including Adams, that she didn't understand the entry. The tax senior also repeatedly told client personnel she didn't understand the entry. In an email to Darryl Kitay, for example, she observed, "I do not mean to sound like a broken record, but I am not following this." Despite the flawed explanation provided by Hudgins and Kitay for the post-closing adjustment and the tax senior's repeated admissions that she didn't understand the entry, Adams "ultimately accepted" the client's explanation for the entry without obtaining "any corroborating documents." Both Adams and Fronkiewicz "signed off" on the "tax provision workpapers that reflected the dividend exclusion adjustment," but only Adams signed off on the workpapers that documented Weatherford's baseless oral explanation for the adjustment. The SEC pointed out that the post-closing adjusting entry had a material impact on Weatherford's financial statements and criticized the two partners for not attempting to "substantiate" the entry by applying "basic reconciliation or other audit procedures that likely would have revealed" its bogus nature. 2008 Weatherford Audit The Ernst & Young auditors faced a new risk factor during the 2008 Weatherford audit: an SEC investigation into allegations that the company had violated the internal control and anti- bribery provisions of the Foreign Corrupt Practices Act (FCPA). The specific nature and possible outcomes of that investigation were not disclosed at the time by the SEC. Another risk factor explicitly documented in the 2008 audit planning workpapers was the "possible pressure" that might be imposed on Weatherford's Vice President of Tax (James Hudgins) "to decrease the effective tax rate" to ensure that the company fulfilled the earnings "expectations of third parties." Despite identifying this pervasive risk factor prior to the 2008 audit, the SEC reported that the Ernst & Young engagement team "did not modify its audit plan." Consistent with the 2007 audit, the audit procedures applied to Weatherford's income tax accounts during the 2008 audit were performed primarily by tax professionals who were supervised by other tax professionals, including Sarah Adams. "Ernst & Young's fiscal 2008 audit procedures for Weatherford's income tax accounting again were conducted by its tax engagement personnel without significant assistance from, or coordination with, assurance [audit] personnel." The tax senior who brought the 2007 post-closing dividend exclusion adjustment to Sarah Adams' attention was also assigned to the 2008 engagement teamby this point the tax senior

had been promoted to tax manager. Once more, this individual discovered a large ($304 million) post-closing dividend exclusion adjustment; once more, the company's tax officials stymied her efforts to audit the large entry. "Ernst & Young's first-year tax manager tried to corroborate the initial answers that she received from Weatherford's tax manager [Darryl Kitay] by obtaining documentation and challenging Weatherford's tax treatment of the adjustment. However, she was unable to corroborate Weatherford's misleading explanations for the adjustment. The questions the first-year tax manager raised ... remained unresolved as Weatherford's Form 10-K filing date drew near. As late as February 23, 2009, just one day before Weatherford filed its fiscal year 2008 Form 10-K, she continued to receive inconsistent and incomprehensible answers about the basis for the dividend exclusion adjustment from Weatherford's tax manager that neither she nor Adams could resolve." Despite the unresolved issues surrounding the $304 million dividend exclusion adjustment, on February 23, 2009, Craig Fronkiewicz and Sarah Adams "signed off on the engagement team's Income Tax Review Memorandum" that summarized the audit procedures applied during the 2008 audit to Weatherford's income tax accounts. The memorandum noted that "we believe all significant tax matters, tax exposure items, and financial statement presentation and disclosure matters have been considered during our audit ... and appropriately addressed." The document went on to indicate "the income tax accounts are free of material error" and "we believe the tax workpapers appropriately document the procedures performed, evidence obtained, and conclusions reached by us in performing our tax review." 2009 Weatherford Audit In December 2009, shortly after Ernst & Young began the 2009 audit, the individual who had discovered the 2007 and 2008 dividend exclusion adjustments abruptly resigned from the firm. Because of that individual's resignation, Adams assigned two tax seniors to perform most of the detailed audit procedures on Weatherford's income tax accounts during the 2009 audit. One of those seniors had not yet passed all sections of the CPA exam. For the third year in a row, the Ernst & Young audit team identified a large post-closing dividend exclusion adjustment recorded by Weatherford. As demonstrated by Exhibit 1, the $101 million "plugged tax benefit" resulting from the 2009 post-closing adjustment accounted for nearly 40 percent of the company's 2009 reported net income. In addition to the large income statement impact of the 2009 dividend exclusion adjustment, the SEC reported that the 2009 Ernst & Young audit team had another reason to exercise "heightened due care and professional skepticism" while addressing that item. "By year-end 2009, concerns regarding the VP of Tax [James Hudgins], who was by then also a Weatherford officer, rose considerably. Adams made clear to others within Ernst & Young, including Fronkiewicz, that she distrusted Weatherford's VP of Tax and believed he was misrepresenting the company's ETR and net income. However, nothing was done to increase skepticism of Weatherford's tax provision ..."

The SEC found no indication in the audit workpapers that the Ernst & Young auditors "questioned" the 2009 post-closing entry or "sought supporting documentation to corroborate it." In fact, the "sole" audit evidence included in the 2009 workpapers for the entry did not relate directly to the entry. "The sole support for Weatherford's 2009 dividend adjustment in the audit workpapers consisted of an oral representation that appears to have been copied from the prior year's audit workpapers verbatim. The purported oral representation does not even relate to the $290 million Bermuda adjustment ..." Neither Fronkiewicz nor Adams signed off on the 2009 audit workpapers that addressed the audit evidence collected for the 2009 post-closing entry. The two partners did, however, sign the Income Tax Review Memorandum for the 2009 audit "certifying that they reviewed the work performed as a basis for their representations that Weatherford's income tax accounts were prepared in conformity with GAAP." 2010 Weatherford Audit By early 2010, the large income tax receivable that was a by-product of Weatherford's tax accounting fraud drew the attention of the Ernst & Young engagement teamat this point, the auditors were unaware the receivable stemmed from Hudgins and Kitay's post-closing adjustments. The SEC suggested that the unusual nature of the receivable should have drawn the attention of the auditors "long before" it did. "While income tax receivables with debit balances may arise for short periods, such as when a company is due a tax refund, the multi-year debit balance Weatherford recorded should have raised red flags for the audit team." Sarah Adams "reviewed the large tax receivable balance during the second quarter of 2010" and decided that its growing size "did not seem analytically possible." After discussing the receivable with Craig Fronkiewicz, Adams asked James Hudgins why the account was so large and why Weatherford continued to (apparently) overpay its income taxes. "When [Hudgins] did not have a response to those questions, however, Adams did not make any additional inquiries or perform other appropriate procedures." Instead of pursuing the matter at that point, Adams told Hudgins she expected him to provide a detailed analysis of the receivable balance at year-end. In February 2011, as the fiscal 2010 audit was nearing completion, Ernst & Young auditors discovered that the large income tax receivable was a direct consequence of the post- closing adjustments made by Hudgins and Kitay.* This discovery, which resulted from the auditors' review of Weatherford's intercompany accounts, ultimately led to the "first" restatement issued by the company in March 2011. In the SEC enforcement release focusing on Ernst & Young's Weatherford audits, the federal agency made it clear that despite uncovering the connection between the large income tax receivable and the series of fraudulent post-closing adjustments, the auditors "did not detect the four-year fraud." In March 2012, Weatherford's management apparently determined that the series of post-closing adjustments had been recorded to intentionally misstate the company's

ETR and operating results. Five months later, when company officials told the auditors the post- closing adjustments were fraudulent, Ernst & Young informed those officials that "a possible illegal act had occurred and requested an independent investigation of the matter."* Ernst & Young continued to serve as Weatherford's independent audit firm through the end of the fiscal 2012 audit in early March 2013. The firm issued unqualified opinions on Weatherford's 2011 and 2012 financial statements. On March 7, 2013, Weatherford's audit committee replaced Ernst & Young with KPMG. The company's SEC filings did not disclose a reason for the change in auditors or any "reportable disagreements" regarding accounting, financial reporting, or auditing issues preceding the change. Additional information: In September 2016, the SEC announced an agreement with Weatherford International to settle charges that the company had materially misrepresented its financial statements between 2007 and 2012. The settlement required Weatherford to pay a $140 million fine. Weatherford's stock price, which had been on a downward trend for years, plunged to less than $4 per share following the announcement of the SEC settlement. For their role in the fraud, the SEC suspended Hudgins from serving as an officer or director of a public company for five years and it suspended Kitay an equal amount of time from serving as an accountant for an SEC registrant. The SEC also fined Hudgins $334,000 and Kitay $30,000. Hudgins and Kitay agreed to the settlement with the SEC while neither "admitting or denying" the allegations filed against them. In 2014, Weatherford agreed to pay $52 million to settle a class-action lawsuit prompted by the tax accounting fraud. The following year, the company agreed to pay $120 million to settle a similar lawsuit. Three years earlier, in November 2013, Weatherford had agreed to pay $253 million in fines to resolve FCPA charges filed against the firm by the SEC. In commenting on the settlement, Andrew Ceresney, the Director of the SEC's Enforcement Division, attributed Weatherford's FCPA violations to the company's lack of internal controls. "The nonexistence of internal controls at Weatherford fostered an environment where employees across the globe engaged in bribery and failed to maintain accurate books and records."* Bernard Duroc-Danner survived as Weatherford's CEO during the intense media coverage of the tax accounting fraud and FCPA investigation that battered the company's stock price and public image. In early October 2016, a business reporter for the Houston Chronicle slammed Duroc-Danner for refusing to take responsibility for those scandals. One month following this blistering attack, Duroc-Danner resigned as Weatherford's chief executive. In a press release, a company spokesperson revealed that Duroc-Danner would remain with the company as its "chairman emeritus" in an advisory role. "Given Bernard's deep and unique knowledge of Weatherford, his established and long-term customer relationships as well as his vast industry and business experience, his new role will help provide continuity and facilitate a smooth transition."*

In October 2016, the SEC reached an agreement to resolve charges filed against Ernst & Young that stemmed from the firm's alleged "deficient" audits and interim reviews of Weatherford's 2007-2010 financial statements. The accounting firm had submitted a settlement offer to the federal agency that became the basis for that agreement. In commenting on the case, Andrew Ceresney characterized the Weatherford debacle as a "significant audit failure." The exhibit below lists the six specific deficiencies the SEC identified in Accounting and Auditing Enforcement Release (AAER) No. 3814, the enforcement release focusing on Ernst & Young's Weatherford engagements. Notice that in addition to identifying the specific deficiencies in the Weatherford audits and interim reviews, the SEC also listed the specific sections of the Public Company Accounting Oversight Board (PCAOB) auditing and quality control standards relevant to those deficiencies. The SEC's settlement agreement with Ernst & Young included a fine of $11.8 million and mandated that the firm prepare a "Validation Plan." Among other initiatives, the Validation Plan required the firm to "review, test, and assess" its "policies" for audit clients designated as "close monitoring" and to enhance its income tax-related auditing policies and procedures. The settlement offer also included a stipulation that a copy of AAER No. 3814 be provided to all Ernst & Young "audit personnel." Finally, the settlement included a two-year SEC suspension for Craig Fronkiewicz and a one-year suspension for Sarah Adams. Similar to the SEC settlement with Hudgins, Kitay, and Weatherford, the Ernst & Young settlement did not involve an admission of guilt by Fronkiewicz, Adams, or the firm as a whole. Questions 1. What are the key audit objectives for an audit client's income tax expense and tax-related assets and liabilities? Identify one audit procedure that could be applied to address each audit objective you listed. 2. What was the most pervasive internal control weakness evident in this case? Defend your answer. Do you believe the internal control weakness you identified qualified as a "material weakness" in internal control? Why or why not? What implications did the internal control weakness you identified have for the Weatherford auditors?

3. Inadequate staffing was a major problem that influenced the performance of Ernst & Young's Weatherford audits. Identify the profession's quality control standards that relate most directly to the staffing of audits. What measures should have been taken by Craig Fronkiewicz to ensure that the Weatherford audits were properly staffed? 4. One member of the Ernst & Young audit team described James Hudgins as "difficult, intimidating ... and stubborn, particularly with respect to the tax positions he took on behalf of the company." What measures can auditors take to cope effectively and properly with uncooperative client personnel? 5. During the 2009 audit, Sarah Adams "made clear" to Craig Fronkiewicz that she "distrusted" James Hudgins and "believed he was misrepresenting the company's ETR and net income." What should the Ernst & Young auditors have done at this point in the audit? Defend your answer. 6. The AICPA Code of Professional Conduct identifies six ethical principles. Which of those principles, if any, were apparently violated by one or more members of the Weatherford audit engagement teams? Explain. 7. James Hudgins, Darryl Kitay, Craig Fronkiewicz, and Sarah Adams neither admitted nor denied the charges of misconduct filed against them by the SEC. Do you believe the SEC should have sought admissions of guilt from these individuals? Why or why not?