Two of the biggest corporate scandals this year involved German payments company Wirecard AG and Chinese retail coffee company Luckin Coffee. These two companies have one other thing in common beyond their recent involvement in high profile accounting scandals – it turns out that both companies’ auditor was Ernst & Young, as was the case with several other companies involved in recent scandals. As discussed in an October 17, 2020 Wall Street Journal article entitled “String of Companies That Imploded Have Something in Common: Ernst & Young Audited Them” (here), a number of EY audit clients have faced financial issues in recent months, raising questions whether there is something about EY’s audit approach that contributed to the problems or allowed the problems to happen.
Wirecard, once a high-flying tech darling, has been referred to as “the Enron of Germany” after it became enmeshed in controversy when $1.9 billion of the company’s funds could not be located. For its part, Luckin Coffee was found to have as much as $300 million in fabricated sales.
As discussed in the Journal article, E&Y audit clients involved in high-profile accounting scandals include not only these two companies, but also hospital operator NMC Health PLC and its sister company Finablr PLC, which were found to have $5 billion in undisclosed debt. In addition, as the Journal article also notes E&Y also audited office space company WeWork, who’s planned IPO was pulled amid accounting questions surrounding the company.
While the Journal article draws a thread between these various accounting scandals because of common involvement of EY as auditor, the article does not expressly say that the scandals happened because EY was the auditor. Indeed, the article says that it “wasn’t possible to pinpoint why EY has had so many recent audit clients with financial scandals.” However, it said, there are “certain elements of EY’s business strategy” that “might help explain the cluster of blowups.”
Among these elements, the article noted the following. First, there appear to be extensive ties between EY and executives and board members at some of its troubled audit clients, raising questions about audit independence. Second, according to EY charges lower fees for its audits, a practice the article suggest might put pressure on the audit firm to lower the resources devoted to audit tasks. The article suggests that EY seeks to attract the audit business using lower fees in order to capture more lucrative consulting and other business. Third, the article says that EY, more than other accounting firms, has focused on auditing young, fast-growing technology firms.
For its part, EY says that its efforts helped uncover the fraud in connection with several of the scandals, and, the Journal article reports, is launching what the firm calls a “redesigned audit quality strategy” that will include a continuing focus on “developing a culture of professional skepticism.”
The Journal article is lengthy and interesting, and includes a detailed description of the scandals at Wirecard and Luckin Coffee and of EY’s involvement with the company.
From my days (now getting to be quite a while ago) when I was running a D&O underwriting facility, I have an almost automatic reaction to a story like this one, which is to ask myself whether there are any D&O underwriting implications.
It would be sweeping with far too broad of a brush to look at these scandals, observe the common involvement of EY, and then conclude that EY’s involvement as auditor of a company somehow represents a red flag. For starters, with the accounting world down to only four big audit firms, treating all of EY’s audit clients as suspect would encompass a large swathe of listed companies. Second, while the handful of scandals mentioned in the article all had the common element of EY’s involvement, EY does have thousands of clients not involved in scandal, suggesting that EY’s involvement alone is not sufficient by itself to raise concern. Among EY audit clients are a number of tech giants, including Google parent Alphabet, Apple, and Amazon. The Journal article notes that EY has over 150,000 audit clients.
While the common involvement at these scandal-plagued companies of EY as auditor does understandably raise the question about there is something about EY’s approach that explains what happened. However, the question overlooks the possibility that EY’s common involvement is nothing other than an unfortunate coincidence. There could be other explanations as well, such as the fact that all of the companies mentioned, other than WeWork, were based outside the U.S. For example, Luckin Coffee is far from the first China-based company to become ensnared in a financial reporting scandal. Similarly, one of the more troubling details of the Wirecard scandal is the extent to which German financial regulators turned blind eye to questions about Wirecard that were circulating in the press.
Asking the question about what EY may have to do with the companies’ scandals also raises the larger question of whether it is even a reasonable expectation that an auditor using traditional audit techniques should be expected to detect fraud – an issue that the audit industry has been debating about for many years.
It is of course interesting to note that the companies involved in the year’s biggest accounting scandals all had the same auditor. It is harder to know what to make of that fact. It is even harder to decide what the implications may be. As the Journal article itself noted, it isn’t possible to pinpoint why EY had so many audit clients involved in accounting scandals. It still is interesting, though.