EY makes a strategic move in a tight audit market by dropping clients, says Deep Quarry
Olga Usvyatsky uses detailed data to examine whether EY's client losses were concentrated among riskier clients. Or is something else going on?
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What happens when a Big 4 firm trims its portfolio of public company audit clients?
WSJ reported that EY lost 84 and gained 21 clients between January 1, 2023, and August 15, 2024, resulting in a net loss of 63 clients, based on data from Audit Analytics. The other Big 4 firms had a net client gain during this period.
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According to EY’s statement to the WSJ, the firm severed ties with dozens of clients to “accelerate transformation efforts” and focus on audit quality.
“The reduction is largely by design and is intended to “accelerate our transformation efforts,” said Dante D’Egidio, the firm’s Americas vice chair for assurance. A regulator found that EY’s rate of audit shortfalls, or deficiencies, had soared, leading the firm to simplify and improve its approach, the firm has said.”
While EY’s efforts to provide better audits for the remaining public clients are commendable, not everyone was impressed. Francine McKenna, the author of The Dig, questioned in a LinkedIn thread whether EY is being honest about what transpired:
This question is fair. EY had its share of negative publicity following its failed attempt to split up and given its last years’ rate of audit deficiencies. On the surface, the shrinking client count suggests that EY is losing the market share competition to the rival Big 4 firms. However, I find EY’s statement plausible because the tight market for audit services makes it more difficult for companies to switch auditors, mitigating the consequences of any hypothetical reputational damage to EY.
Suppose EY’s resignations were voluntary, as claimed by the firm. If that’s so, an interesting question would be: “Which clients are more likely to be affected?”
Amanda Iacone at Bloomberg reported that audit risk could be a consideration in the decision of which clients to keep:
“Deciding which clients to work with is a key aspect of how firms manage their audit practices. New international audit rules and similar pending US requirements task firms with establishing guardrails to address the risks they face in their routine practices.”
Certainly audit firms are supposed to, according to Generally Accepted Auditing Standards, continuously assess the risk of acceptance and continuance of all clients. Additionally, academic research finds that accounting firms will raise the bar for continuing the firm-client relationship in response to increased auditing workloads.
From the abstract of Hollingsworth, International Journal of Auditing, 2011:
“Since the initial disclosure of accounting irregularities at Enron in late 2001, the landscape of audits for both domestic and foreign companies listed in the United States has undergone substantial change… These changes have significantly increased the amount of work required to issue an audit report for US registrants and resulted in an unprecedented increase in the number of auditor resignations. I extend the audit literature by investigating how Big 4 audit firms make client continuance decisions in the post-SOX era. My findings indicate that Big 4 audit firms have become more critical of the client continuance decision and this heightened concern and/or the additional audit requirements of SOX has resulted in the threshold for client continuance increasing post-SOX.”
Adding the two together, I wondered whether the widely discussed shortage of accounting personnel and regulatory pressure from the PCAOB could have prompted the accounting firm to prioritize resources and part ways with riskier clients.
Let’s look at the breakdown of the audit clients that EY dropped/lost over the past year. The analysis is based on data from the Audit Analytics Auditor Changes Database.
Five EY departures cited independence issues as a reason for EY’s resignation.
Over 40% of EY’s departures cited at least one reportable event, most commonly ineffective internal control over financial reporting (ICFR). For historical comparison, about 20 to 25% of EY resignations of the past decade cited a reportable event. Generally, only about ten percent of approximately 600 ICFR reports signed by EY in 2024 stated that controls are ineffective.
Independence-related resignations are mandatory. They may upset the clients but they are not driven by the clients’ dissatisfaction or audit firm’s level of risk tolerance. However, the high percentage of ineffective ICFR among EY’s departures is interesting and consistent with EY voluntarily dropping risker engagements. Clients with ineffective control environments are, on average, riskier because ineffective controls may not detect a material misstatement, increasing the risk of inaccurate financial statements and subsequent restatements.
Let me be clear: I am not saying there is a causal relationship between ineffective ICFR and EY’s resignations, or that every company with ineffective ICFR risks losing their auditor. I use ineffective ICFR as a crude and noisy measurement of risk and I conjecture that – on average – we will see a reduction in risk exposure.
A few words about why the ICFR measurement is noisy. Client acceptance and continuation assessments involve multiple factors, most of which are unobservable. Suppose EY decided to right-size its portfolio and prioritize larger clients or overweight certain industries. Smaller and younger companies tend to have a higher propensity of ineffective ICFR, often because of underdeveloped IT controls or shortage of accounting personnel. Say it differently - ICFR weaknesses are correlated with other factors. While high percentage of departures with reportable events would still point to shifting priorities, it may not be causally related to risk. Note also that this is a quick cut of the data and is not an academic-level time series analysis.
According to WSJ and Bloomberg, the remaining Big 4 audit firms are not following EY’s lead in trimming their portfolios. So let’s ask a hypothetical question – what if they did?
The audit market of large-cap issuers is highly concentrated — and for a reason. Multinational conglomerates have complex business and accounting practices, and smaller audit firms typically do not have the personnel with the required skills and experience to effectively complete these audits. If EY is the only firm cutting ties with their clients, other Big 4 and national firms — should they choose to do so — can absorb most of the EY’s departures. However, if several prominent audit market players are not interested in increasing their market share, the market may not have the capacity to absorb the losses. In that case, what are the odds that complex issuers with ineffective controls — namely, those that benefit from the Big 4 input the most — would have to engage a small firm with no required expertise?
The overall scarcity of audit services, not just for large and complex issuers, is observable in the audits of small companies. Bloomberg reported that almost half of former Borgers’ clients were still searching for an auditor as of mid-June after the SEC shut the firm down for being a sham audit mill.
Why? High replacement costs for clients, low risk appetite from other audit firms, and regulatory scrutiny of any company that had been audited by Borgers:
“Costs are an obstacle for some of the smaller former Borgers clients. Others have faced pushback from potential new auditors leery about starting financial checks from scratch, ex-Borgers clients told Bloomberg Tax.”
And also:
“Some audit firms are wary of taking on clients associated with a firm accused of fraud, even though the SEC only sanctioned the firm and its founder, Benjamin Borgers, and not any of its clients.
Regulators will closely scrutinize firms that accept former Borgers customers, said Jackson Johnson, president of Johnson Global Consultancy and former staff member at the Public Company Accounting Oversight Board, the US audit regulator.”
(I talked about the turmoil in the small audit firms market in my previous piece.)
Turmoil in small audit firms market : who is affected and what does it mean for companies and investors
Olga Usvyatsky Aug 5
Could an inconsistent approach by the PCAOB in its regulatory inspections contribute to the shrinking small audit firms market? A recent academic working paper by Bills, Kayser, Peytcheva, and Zimmerman (2024) interviewed 29 former audit partners with “direct experience with PCAOB inspection remediation” and found that smaller audit firms — more specifically, those with less than one hundred clients — often view PCAOB actions as disruptive to their established practices.
The respondents identified navigation of the remediation process of engagement deficiencies — the work to fix the issues the PCAOB identifies in the inspections — as particularly challenging. Delays in receiving inspection comments and inconsistent feedback from PCAOB teams create confusion for these smaller firms, making it difficult to understand if their remediation efforts are approved or subject to change.
Arguably, one of the most interesting observations of the paper is that smaller firms are less likely to charge clients for remediation work out of fear of losing business, absorbing more of the cost than larger firms:
“Further, respondents indicate that smaller firms are less likely to charge their clients for remediation work due to concerns about client dismissal. Interviewees thus perceive an increased regulatory burden for smaller firms relative to larger ones.”
The inability to roll costs to the clients increases the small firms’ regulatory burden compared to larger firms and, perhaps, their resentment of the regulatory process. These smaller firms just do not have the same hold over their clients that the Big 4 do, since the smaller the issuer the more likely it views the audit as a “necessary evil” not a value-added service. In my opinion, for the researchers’ finding to hold, two conditions must be met — the smaller firms' clients are more price sensitive, and there is enough competition so companies can reasonably, painlessly replace the existing firm.
While audit firms with more than one hundred public clients are inspected by the PCAOB annually, smaller firms are inspected only once every three years. A concern the researchers express is that some of the smaller audit firms may curb growth to avoid the burden of annual inspections.
We have already seen examples of firms previously prolific in the public company audit market drop clients in the wake of increased scrutiny. Steven Foley reported for FT that several mid-sized audit firms – including CliftonLarsonAllen and Armanino – exited the public companies audit market, leaving some of the clients stranded.
My take? We need balance. We need regulatory scrutiny to avoid another Borgers fiasco, but we also need small audit firms to audit small issuers that do not necessarily require the expertise of the Big 4.
For questions please contact olga@deepquarry.com.
Disclaimer: This newsletter does not provide an investment advice. The view expressed in this newsletter are personal views of the authors based on their interpretation of publicly available information.
© Francine McKenna, The Digging Company LLC, 2024
For my take on the the SEC’s Borgers enforcement action and what should happen if smaller firms, or larger ones, can’t cut it:
