If markets move on stories and momentum, who needs an audit?

Until something goes wrong, hardly anyone reads the 10-Ks or wants an audit

Almost all buyers and sellers of equities, large and small, seem to be just fine with trading trillions dollars of private and public company shares based on unaudited earnings press release information filled with never-to-be audited non-GAAP metrics.

So why bother mandating external audits by CPA firms at all?

In October of 2018, I wrote for MarketWatch that a very long list of sophisticated investors including my boss at the time, Rupert Murdoch of News Corp., made the decision to invest hundreds of millions of dollars in the private company Theranos but did not insist on reviewing audited financial statements as part of their due diligence.

The Dig
Do Investors Care At All About Audits Anymore?
This was originally published at re: The Auditors. Back in October I wrote here that a very long list of sophisticated investors including my ultimate boss, Rupert Murdoch of News Corp., and business partners like Walgreen’s made the decision to invest hundreds of millions of dollars in the private start-up Theranos but didn’t insist on seeing audited f……
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Theranos was a big, bad wolf at the auditors’ door, ready to blow the whole house down, but the audit industry has publicly ignored the open threat.

I wrote in January 2019 about research that says investors would rather have any annual information immediately even if the audit is not yet complete:

A majority of companies announce annual earnings before auditors sign off on the numbers, but new research suggests the practice increases pressure on auditors to stick to the announced numbers rather than suggesting any final corrections or adjustments.

Approximately 70% of U.S. public companies announce annual earnings prior to the completion of an annual audit, by about 16 days on average. The practice has exploded in the past 15 years: Prior to 2004, approximately 75% of annual earnings announcements were released on or after the audit report date, but the Sarbanes-Oxley Act of 2002 added additional audit requirements related to internal control audits and audit workpaper documentation that resulted in audits taking 16 days longer to complete, on average, according to other research published in 2010.

There have been many more examples of this phenomenon since I wrote these stories at MarketWatch. We know about them because they’ve ended badly.

For example, the rise of the meme stocks and gamification of trading by new public trading platforms such as Robinhood has shown that it’s not just the billionaires who can lose millions on a flyer. Some retail investors are buying shares and fractions of shares with minimal money down and on margin without looking at any financial statements at all, let alone waiting for audited ones.

This is why:

“Let’s separate the two things,” [former SEC chairman Jay] Clayton said. “The meme stocks and the non-fundamental activity around meme stocks, that’s something regulators, and we all, need to be cognizant of,” he said. “We do need to look at meme stocks and departure from fundamentals, but if part of it is earlier investing and broader participation, it is needed.”

What’s the point of boatloads of SEC reporting and disclosure rules, and an audit, if active market participants have no interest or aptitude for reading a 10-Q or a 10-K before investing and don’t care if the financials are audited?

Here’s JPM analyst Stephen Tusa, talking about GE in February of 2019, saying “the stock could go up based on narrative and sentiment,” and no one is reading the 10-K, starting at the 6:15 mark.

Tusa was right about GE but not about a $6 target. In December of 2020, the SEC announced that GE had agreed to pay a $200 million penalty to settle charges for disclosure failures in its power and insurance businesses. The stock never went below $40 and is now trading around $100.  (Editor’s note: GE had a recent 8:1 reverse split and the $100 price is after the reverse split. The price target of $6 was before the split, so it would close to $48 post-reverse split. Reverse splits are extremely unusual in large cap such as GE.)

Active investors rarely read 10-K/As or amended 10-Ks, either, and that’s why companies are hiding bad news in these filings, hoping you’ve already made your trade and will never see it.

The Dig
Watchdog Research: Why Are Companies Using 10-K/As to Disclose Bad News in 2021?
For more about SPACs see: Are the dominant SPAC auditors up to the job? There's a lot of work primarily flowing to only two firms. Are they getting paid enough to perform their market gatekeeper duties? Outtakes: Are the dominant SPAC auditors up to the job…
Read more

Now we have the rise of the blank-check company, or SPAC, where the audits of the acquiring shell companies are audited by two next-next tier firms that specialize in small cap and penny stocks, Chinese reverse mergers, and other not-ready-for-prime-time transactions. The SEC is approving listings for companies that have active civil and criminal investigations pending and has been satisfied in the past with companies’ promises to disclose questionable accounting or business practices and legal woes, rather than telling them to just “Stop it” or you can’t go public.

Once a not-ready-for-prime-time company is public the SEC is allowing itself to be held hostage. For example, in the Tesla case, Jay Clayton was unwilling to rein it back in because of the collateral damage that would cause. Former SEC Chairman Clayton admitted he was not coming down too hard on Tesla or its CEO because he wanted to avoid hurting investors and employees by taking out its CEO.

Speaking more broadly about the SEC’s enforcement efforts that involve the misconduct of officers, directors and companies, it often is the case that the interests of ordinary shareholders — who had no involvement in the misconduct — are intertwined with the interests of offending officials and the company. For example, corporate fines often are financed with funds that could otherwise benefit shareholders…

At the Commission, the interests of ordinary investors are at the front of our minds and, in matters involving misconduct, we seek to serve those interests to the extent practicable while also ensuring that we remediate and deter misconduct.

The Dig
Looking for red flags in an S-1/ prospectus?
When hotly anticipated private companies, especially unicorns, finally debut on the public markets, media typically greets them with sunbeams and rainbows…
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A Wall Street Journal article in early August said big money-management firms are expanding their dominance in Silicon Valley tech start-up investing, “crowding out venture capitalists in a once-niche business…”

The large asset firms have massive pools of capital, move quickly and are less likely to ask for board seats or involvement in company decisions, often making them more appealing to founders, according to interviews with investors and startup executives. The result has been a dizzying pace of deal making.

"It's like speed dating but more extreme," said Peter Fishman, a longtime Silicon Valley tech professional who last year co-founded data-automation startup Mozart Data Inc.

The article says traditional venture firms are “scrapping old practices to keep pace.” They have abandoned pricing discipline and some venture capitalists said they are cutting back due diligence such as audits and customer checks, essentially taking a startup's word on profit and loss, according to the article.

Taking the founder’s word for profit and loss is nothing new, for media at least, even in the media startup environment. In this recent New York Times article, the revenue and profitability numbers quoted are according to anonymous “people familiar with the company” not based on audited financial statements seen by the reporter. BuzzFeed’s “prospectus” provides only unaudited information — essentially a promo piece — but it is linked to as a scoop. Even though all of the media companies mentioned are talking about imminent go-public transactions that require at least two years of audited financial statements to be provided in the prospectus filed with the SEC, we see none and the reporters apparently do not see them either or ask for any. 

Does that mean the mandated audits for pre-IPO companies happen overnight? Well, sometimes they do. See Coinbase, or Snowflake, or SmileDirect Club.

What’s the point of having an audit at all if investors invest, media reports, and markets move on unaudited information — “taking the manager’s word”  — for financial results dominated by non-GAAP metrics that are never audited, or by numbers managers can make up, stretch, or that leave out material information every quarter and even at year end? What’s the point of demanding an audit if auditors feel pressured not to insist on adjustments or report material weaknesses in internal controls?

And what’s the point if even an SEC Commissioner says there’s little value to an audit for no or low revenue companies and investors don’t want their money spent on audits?

In fact, it’s worse than that. Peirce dreams of a libertarian future when she was queen of the markets, not just “Crypto Mom”.

“But, that being said, if I were king or queen for a day, I would make it optional for everyone.”

Why doesn’t Peirce push a formal proposal of a full repeal of the Sarbanes-Oxley Section 404(b) requirement?

The audit firms may “take me out,” Peirce quipped.

No one writes or talks about auditors unless something goes wrong, and even then if the auditor is not sued or charged, they go nameless.

Maybe there’s a glimmer of hope to be gleaned from the actions of at least one sharp-eyed investor in Headspin. From the SEC’s complaint against the company’s former CEO:

In particular, Investor 1 noticed in around May 2019 that HeadSpin’s financial statements included tens of millions of dollars of “unbilled revenue,” meaning that HeadSpin had not yet sent its customers invoices to charge them. Investor 1 asked Lachwani to explain why HeadSpin was not billing its customers…

Lachwani’s Fraud Unraveled When His ARR Inflation Came to Light. 39. In March 2020, the company’s Board of Directors was alerted to concerns about the accuracy of the financial and customer information provided to investors and discovered, through an investigation, significant issues with HeadSpin’s reporting of customer deals. HeadSpin then determined, based on a subsequent review of its financial information, that HeadSpin’s ARR at the end of 2019 was closer to $10 million, as opposed to the $80 million represented to investors. 40. In May 2020, HeadSpin forced Lachwani to resign, and Lachwani also returned approximately $2 million to Investor 1, which had purchased some of his personal HeadSpin stock in May 2019.

Investor 1 seemingly wanted to know why billing was delayed, not why Lachwani was reporting revenues for deals that had not been billed, in violation of GAAP. In another example of a huge red flag that it seems everyone, including Investor 1, was willing to ignore, Lachwani “was able to carry out his fraudulent scheme for years because he controlled and managed all the key aspects of HeadSpin’s financials and sales operations, and he kept HeadSpin employees in those different departments isolated from each other. For instance, virtually all the information provided to HeadSpin’s bookkeeper, including the supporting documentation for claimed revenue amounts, flowed through Lachwani,” according to the SEC’s complaint.

The company did not have a CFO or Controller, only a “bookkeeper” and Lachwani did not have a CPA or even a financial background. An audit firm, hired by the company for an investigation after it was alerted to the issues, likely by Investor 1, is referred to in the Department of Justice complaint as confirming the revenue discrepancies. However, there was no audit prior and none of these investors insisted on it.

Who are Headspin’s investors? According to a report in CRN.com:

Twenty-nine unnamed investors had purchased HeadSpin stock at prices based on its inflated $1.1 billion valuation. HeadSpin returned approximately 70 percent of principal to investors in its Series B and C funding rounds, and it further offered to return the remaining funds in the form of promissory notes with 1 percent interest. Approximately 31 investors retained their shares in the company.

HeadSpin investors included Dell Technologies Capital, ICONIQ Capital, Tiger Global Management, Kearny Jackson and Alpha Square Group, according to a company press release.

Regulators and exchanges are perpetuating a government-mandated oligopolistic exclusive franchise for the Big 4 global audit firms and a few additional firms that produce information investors ignore and investors are increasingly unwilling to pay for unless they absolutely have to. Would private company individual or institutional institutional investors ever pay for an audit if it weren’t legally mandated? Would public companies pay if it was not mandated? I doubt that the Reddit meme stock traders would band together to pay for audits.

Eliminating the audit mandate altogether is an idea that has been floated periodically as the ultimate solution to the problems that plague the accounting profession. Here’s former SEC Chief Accountant Lynn Turner quoted in Fortune Magazine in 2015, in an article with the blunt title, “Should companies eliminate audits?”

[Lynn] Turner argues that, for the system to work and investors to get the information they’ve paid for, major changes must be made. His first suggestion: provisions of the Securities Act of 1933 and the Securities Act of 1934 should be amended to remove the requirement that companies be audited.

The audit firms are a “subsidized industry, like the credit rating agencies,” Turner told me, and companies are required to pay for “audits no matter the quality.”

Turner argued again for elimination of the audit mandate in December of 2020, in an article, “Reforms of the Auditing Profession: Improving Quality Transparency, Governance and Accountability.”

  • Remove the current requirement in the Securities Laws that a Company must have an audit by an independent auditor, thereby eliminating the federal government mandate.

  • Replace it with a market based requirement, that every 5 years, a shareholder proposal be included in the annual proxy, asking if the investors want an independent audit of the financial statements by the independent auditors…I would expect that investors most often would vote for an independent audit, unless they saw little value in having one.

I doubt anyone would pay for an audit if it wasn’t mandated. That’s especially true since auditors still say, every time they’re caught, that the audit is not designed to look for fraud. Sometimes the auditors do “no audit at all.”

It now seems only a matter of time before the big bad wolf — complete relief for public companies from all audit-related mandates and expense — blows the audit industry’s whole house down.

© Francine McKenna, The Digging Company LLC, 2021