Is the Coronavirus going to take down any big companies?

Will anyone warn you?

The fix is already in.

The Securities and Exchange Commission and the PCAOB have already huddled with the Big 4 audit firms more than once to discuss, together, how to address the risk the coronavirus pandemic has on their opinions on the financial statements of almost all of the public companies listed on U.S. exchanges.

We can debate when President Trump knew the coronavirus would impact U.S. companies and workers, but the SEC’s Jay Clayton was talking about growing challenges in China with his staff long before he made a statement attributing those new challenges to coronavirus on January 30:

“Yesterday, I asked the staff to monitor and, to the extent necessary or appropriate, provide guidance and other assistance to issuers and other market participants regarding disclosures related to the current and potential effects of the coronavirus.  We recognize that such effects may be difficult to assess or predict with meaningful precision both generally and as an industry- or issuer-specific basis.  This is an uncertain issue where actual effects will depend on many factors beyond the control and knowledge of issuers.  However, how issuers plan for that uncertainty and how they choose to respond to events as they unfold can nevertheless be material to an investment decision.” 

Less than a month later, on February 20th, the Corporate Counsel Blog reported that the regulators repeated warnings about the impact of the virus on companies that have operations or investments in China:

“Yesterday’s [coronavirus] statement said SEC’s Clayton, Bill Hinman, Chief Accountant Teotia and PCAOB’s Duhnke met with the leaders from the Big 4 audit firms to continue discussions around difficulties in conducting audits in China...”

But the SEC and PCAOB joint statement on February 19 also said that the regulators had spoken to the Big 4 audit firms about risks to all companies with China exposure back in November of 2019!

In November 2019, we met with senior representatives of the four largest U.S. audit firms, including certain of their network representatives, to discuss audit quality across their global networks and certain of the challenges faced in auditing public companies with operations in emerging markets, including China. 

Those November 2019 meetings, which were discussed in a contemporaneous joint press release, were part of our ongoing efforts to address the issues highlighted in our December 2018 Statement on the vital role of audit quality and regulatory access to audit and other information internationally.[2]  Significantly, among those issues is that the Public Company Accounting Oversight Board (PCAOB) continues to be prevented from inspecting the audit work and practices of PCAOB-registered audit firms in China on a comparable basis to other non-U.S. jurisdictions.[3]  PCAOB inspections are a key component of our regulatory efforts to enhance the quality of financial reporting and ensure audit quality.   

In our recent dialogue with the senior leaders of the largest U.S. audit firms, we also discussed this potential exposure of companies to the effects of the coronavirus and the impact that exposure could have on financial disclosures and audit quality, including, for example, audit firm access to information and company personnel. 

(Based on some questions, I am going to clarify. I think it was highly unusual for the SEC, PCAOB to have a live meting with Big 4 firm leadership in November and then again in February, to talk again about the ongoing China audit challenges. Lack of inspection access was a problem that had been going on for years and that the regulators had warned investors about over and over.

I think that the Nov live meeting, and subsequent live meetings with leadership such as in February, were necessitated by reports from local China member firms already having more problems getting opinions on significant portions of audits for multinationals because of illness, growing concern, and then impairment/lockdowns affecting China teams.

Recent news reports also say that U.S. intelligence had reports of the virus back in November.

As far back as late November, U.S. intelligence officials were warning that a contagion was sweeping through China’s Wuhan region, changing the patterns of life and business and posing a threat to the population, according to four sources briefed on the secret reporting.

Concerns about what is now known to be the novel coronavirus pandemic were detailed in a November intelligence report by the military's National Center for Medical Intelligence (NCMI), according to two officials familiar with the document’s contents.

From that warning in November, the sources described repeated briefings through December for policy-makers and decision-makers across the federal government as well as the National Security Council at the White House.

Those challenges also include experience of US firm secondees in China and end of calendar year discussions with U.S. firm leaderships because of U.S. involvement in Appendix K review for opinions to be signed by China member firms. Those on ground in Wuhan China and working with companies on ground in Wuhan China were already challenged by a “cluster” of something that they could not explain by late fall.  “The cluster was initially reported on 31 December 2019, when the WHO China Country Office was informed.”  

By Jan 2, 2020, 41 already admitted hospital patients were identified as laboratory-confirmed 2019-nCoV infection in Wuhan, China per an article in The Lancet.)

This recent statement by the SEC and PCAOB primed the pump for the Big 4’s excuses about the “unprecedented world-wide crisis no one could have predicted,” especially related to failures and frauds of Chinese companies. They have been doing so periodically for a while now. The SEC and PCAOB are willfully allowing unaccountable companies to list on U.S. our exchanges.

In Clayton’s case with Alibaba, he got paid to do it. Chronic frauds at Chinese companies continue.

Now they’re washing their hands of the consequences.


Just look at what Jay Clayton did when KPMG’s top audit practice partners were caught stealing the list of regulatory exams so they could subvert the protections for investors established by the Sarbanes-Oxley Act of 2002 after the Enron failure that brought down Arthur Andersen. He rushed in 2018 to reassure the stock market that there was nothing to worry about, no one needed to worry about KPMG’s audits, based on “discussions with the SEC staff,” the ones going through the revolving back to the Big 4 now. That was instead of performing a complete forensic audit of all companies whose audits KPMG partners tampered with based on stolen notice of PCAOB inspections.

I suspect the SEC and PCAOB have already given the stand down order — no going concern warnings— as they likely did in secret here in the U.S. during the financial crisis of 2008-2009, and as we found out that the the U.K government did.

Big 4 Bombshell: “We Didn’t Fail Banks Because They Were Getting A Bailout”

Leaders of the four largest global accounting firms – Ian Powell, chairman of PwC UK, John Connolly, Senior Partner and Chief Executive of Deloitte’s UK firm and Global MD of its international firm, John Griffith-Jones, Chairman of KPMG’s Europe, Middle East and Africa region and Chairman of KPMG UK, and Scott Halliday, UK & Ireland Managing Partner for Ernst & Young – appeared before the UK’s House of Lords Economic Affairs Committee yesterday to discuss competition and their role in the financial crisis.

The discussion moved past the topic of competition when the same old recommendations were raised and the same old excuses for the status quo were given.

Reuters, November 23, 2010: The House of Lords committee was taking evidence on concentration in the auditing market and the role of auditors.

Nearly all the world’s blue chip companies are audited by the Big Four, creating concerns among policymakers of growing systemic risks, particularly if one of them fails.

“I don’t see that is on the horizon at all,” Connolly said.

The European Union’s executive European Commission has also opened a public consultation into ways to boost competition in the sector, such as by having smaller firms working jointly with one of the Big Four so there is a “substitute on the bench.”

“Having a single auditor results in the best communication with the board and with management and results in the highest quality audit,” said Scott Halliday, an E&Y managing partner.

The Lord’s Committee was more interested in questioning the auditors about the issue of “going concern” opinions and, in particular, why there were none for the banks that failed, were bailed out, or were nationalized.

The answer the Lord’s received was, in one word, “Astonishing!”

Accountancy Age, November 23, 2010: Debate focused on the use of “going concern” guidance, issued by auditors if they believe a company will survive the next year. Auditors said they did not change their going concern guidance because they were told the government would bail out the banks.

“Going concern [means] that a business can pay its debts as they fall due. You meant something thing quite different, you meant that the government would dip into its pockets and give the company money and then it can pay it debts and you gave an unqualified report on that basis,” Lipsey said.

Lord Lawson said there was a “threat to solvency” for UK banks which was not reflected in the auditors’ reports.

“I find that absolutely astonishing, absolutely astonishing. It seems to me that you are saying that you noticed they were on very thin ice but you were completely relaxed about it because you knew there would be support, in other words, the taxpayer would support them,” he said.

The impact of the corona virus on financial reporting is already evident. But there are no significant uses of the “going concern” warning to highlight potential failures for investors.

Audit Analytics reports:

As of April 20, 2020, there have been 16 audit opinions on annual reports for SEC filers that have cited the COVID-19 pandemic as a contributing factor to substantial doubt about a company’s ability to continue as a going concern for the next twelve months.

Of those going concern opinions, 11 are repeat going concerns, meaning that in the past – prior to the pandemic – the company was experiencing difficulties that could impact their ability to continue operating. For those companies, the unknowns regarding the extent of future coronavirus impacts contribute additional uncertainty, but the coronavirus is not a primary reason for the going concern.

For the five companies with new going concerns for fiscal year 2019, the impacts of the COVID-19 pandemic are expected to have a material adverse effect on results of operations, cash flows, and liquidity. However, three of these companies had certain pre-existing uncertainties prior to the pandemic – such as debt covenant obligations, recurring operating losses and negative operating cash flows – so it is not surprising that impacts from the coronavirus would contribute additional uncertainty, resulting in substantial doubt about their ability to continue as a going concern.

11/16 are repeats! There’s a research paper I contributed to, “Going, going, still here?” on “zombie” companies that keep going, like energizer bunnies” despite warning every year they can’t make it. How does the SEC, and auditors, allow this to happen?

Don’t count on Jay Clayton’s SEC, or the auditors regulated by PCAOB that’s now run in service to the Big 4, to warn you that the companies you work for, invest in and count on in your communities are going to fail.

That would not be good for the stock market.

Live from the re: The Auditors archives, from September 18, 2009:

Going Concern Audit Opinions: Why So Few Warning Flares?

Lehman Brothers. Bear Stearns. Washington Mutual. AIG. Countrywide. New Century. American Home Mortgage. Citigroup. Merrill Lynch. GE Capital. Fannie Mae. Freddie Mac. Fortis. Royal Bank of Scotland. Lloyds TSB. HBOS. Northern Rock.

When each of the notorious “financial crisis” institutions collapsed, were bailed out/nationalized by their governments or were acquired/rescued by “healthier” institutions, they were all carrying in their wallets non-qualified, clean opinions on their financial statements from their auditors. In none of the cases had the auditors warned shareholders and the markets that there was “ a substantial doubt about the company’s ability to continue as a going concern for a reasonable period of time, not to exceed one year beyond the date of the financial statements being audited.”

From a speech to the AICPA Conference in December 2008 by former PCOAB Chief Auditor and Director of Professional Standards Tom Ray:

“…The auditor’s evaluation (under AU 341) is based on his or her knowledge of relevant conditions and events that exist at or have occurred prior to the date of the auditor’s report. Conditions or events that may indicate there is substantial doubt about the company’s ability to continue as a going concern for a reasonable period of time include, for example –

Negative trends – for example, recurring operating losses, working capital deficiencies, negative cash flows from operating activities, and adverse key financial ratios

Other indications of possible financial difficulties – for example, default on loan or similar agreements, denial of usual trade credit from suppliers, noncompliance with statutory capital requirements, and the need to seek new sources or methods of financing or to dispose of substantial assets

Internal matters – for example, work stoppages or other labor difficulties, uneconomic long-term commitments, and the need to significantly revise operations

If you have been reading the financial press over the past several months, I imagine these types of things sound familiar to you. I think it is reasonable to assume that more companies than in the past will exhibit one or more indicators of substantial doubt. If such indicators are present, I encourage you to engage in a dialog with your client’s management and audit committee about these matters as soon as possible.”

So I asked Don Whalen, Director of Research at Audit Analytics, to update their March of 2009 study that looked at trends in “going concern” opinions issued by auditors.  In April 2009 Compliance Week quoted Mr. Whalen as saying that:

“If filing patterns for 2008 year-end financial statements hold steady, an increasing number of accelerated filers listed on major stock exchanges will get audit opinions expressing doubts about their ability to continue as going concerns.

According to analysis of going concern opinions filed by auditors for previous years and for early 2008 results, Audit Analytics says 23 percent of all 2008 audit opinions for publicly listed entities will say there’s a question about whether the entity will still be in business a year later. To boot, a larger-than-usual number of those audit opinions will be handed out to major entities listed on major exchanges.”

Well, Mr. Whalen made a pretty damn good prediction. According to updated figuresobtained exclusively this week by re: The Auditors, the percentage of audit opinions with “going concern” opinions went up to 21.4% in 2008 versus 20.88 % in 2007 and less than 20% in all prior years going back to 2000.

Because the total number of Audit Opinions dropped by 7.2% in 2008 (15773 opinions in 2007 compared to 14641 in 2008), the absolute total number of going concerns went down in 2008 even though the percentage went up. There is also a noticeable spike in the number of “going concern” opinions for large accelerated filers.

Another interesting comment Mr. Whalen made to me explained what happened to those 2007 “going concern” opinion companies.

“I was a little surprised that only 14,161 auditor opinions were filed with the SEC in 2008.  This number is much lower than the prior year’s amount of 15773. Of the 3293 Going Concerns in 2007, here’s the overview of the status of some of those companies today:

·         826 are now a Shell, Blank Check, or Non-Operational Establishment;

·         In addition, 184 different companies filed a termination with the SEC;

·         An additional 13 uncounted companies filed a notice with the SEC of a Chapter 7 bankruptcy; and

·         This does not include an addition 49 companies that went dark (have not filed with the SEC in 18 months).

The total of the categories above equals 1072 companies. Therefore, over 1000 companies that had a “going concern” opinion in 2007 seemed to have stopped operating as a substantial entity.(Note from fm: I would say that was a pretty good early warning system! )

I also noticed that outside the group of companies listed above, an additional 64 would be characterized as emerging companies (companies that filed an S-1 or equivalent but has yet to file a periodic report such as a 10-KSB).”

So what does this tell us about the value of the “going concern” opinion to warn shareholders and the markets of companies that are fragile, in a precarious state, engaging in risky business or trying to operate with an inadequate business model in risky markets? Tells me it’s pretty damn valuable and should be encouraged even more. And when it’s not provided and should have been, the auditors should be held responsible.

And to do that, someone like Judge Jed Rakoff needs to go “all activist on their auditor tails” versus being “pragmatic” like Judge Richard Posner.

Attitudes such as those previously expressed by Judge Posner regarding the auditors’ role in the capital markets system serve us as poorly as those of the judges who used to sign off on SEC settlement with no questions before Judge Rakoff came along. Judges like Posner are letting the watchdogs for the capitalist system and the shareholders – regulators and auditors – off the hook.

Judge Richard Posner during oral arguments in Fehribach v. Ernst & Young LLP, 2007 WL 2033734 (7th Cir. 7/17/07) (pdf),

Posner: The auditor’s responsibility … so far as the company is concerned … is to make sure the [numbers] are accurate….  You don’t need an auditor to tell you your market is collapsing….  The auditors are not supposed to have business insight.  They’re counters.  They’re not supposed to make predictions about how your markets are doing.  They’re supposed to reconcile your books and indicate you’re not a going concern because your debt is too high and so on….

Do you think the auditor is supposed to know about market power?…  An auditor is not an economic consultant who goes out and figures out what the market trends in an industry are!…Your trends? That’s what the company knows. [Plantiff’s Attorney: You’re right. Here’s what the auditor’s responsibility under SAS 59…]

Posner: That is too vague for me…”

In describing the essence of the case, Judge Posner states:

“The argument has to be that had Ernst & Young included the going-concern qualification in its audit report of October 1995, Bank One would have acted sooner, precipitating an earlier liquidation.”

Unfortunately, in this case, the plaintiff’s attorney failed to convincingly explain the function of an audit report and the proper audience for it, in particular for a small private company heavily dependent on a bank credit line. This was unfortunately necessary for Judge Posner.

At the same time, Judge Posner’s renowned “pragmatism” gave him cover for his supercilious expressions of frustration and boredom with the exposition of the actual standards by which he should be judging the auditor’s performance of their duties.

Judge Posner found no connection between the auditor’s lack of performance of a proper SAS 59 analysis, which would have likely resulted in a going concern opinion, and the delay in an inevitable involuntary bankruptcy. A “going concern” opinion would have triggered a breach of loan covenants immediately, given that the company had a contractual obligation to provide the bank an audit report with an unqualified audit opinion to maintain their line of credit.

(I am assuming the minimally profitable small family owned company that was the subject of this suit would have no other reason to pay big bucks to have an audit by EY nor to delay submission of it to their bank than because a clean audit was required to maintain their bank line of credit.)

What Judge Posner found “too vague” was the description of the auditor’s responsibilities under SAS 59:

“…The auditor’s evaluation includes considering whether the results obtained in planning, performing, and completing the audit identify conditions and events that, when considered in the aggregate, indicate there could be a substantial doubt about the company’s ability to continue as a going concern for a reasonable period of time. It may be necessary to obtain additional information about such conditions and events, as well as the appropriate evidential matter to support information that mitigates the auditor’s doubt.”

Even though the standard details the kinds of internal and external factors that the auditor must consider, Judge Posner writes in his opinion:

“Elsewhere the standards emphasize that the auditor must have ‘an appropriate understanding of the entity and its environment.’ Yet nowhere is the auditor required to investigate external matters, as distinct from “discovering them during the engagement.” An accounting firm that conducts an annual audit of a multitude of unrelated firms in a multitude of different industries cannot be expected to be expert in the firms’ business environments…”

Why am I revisiting a decision from July of 2007 that the auditor won?

Well, this case was about more than just a discussion of a “going concern” opinion or the lack thereof. It is also a case where Judge Posner’s pragmatism and wish to be pithy and memorable gives us additional case law on the controversial theory of liability called “deepening insolvency.” The opinion provides a short discourse on the theory, in particular for assessing damages when an auditor fails to stop the clock with a “going concern” opinion and opens themselves up to claims of damages for “deepening insolvency.

In another more recent case that skirted around the “deepening insolvency” theory, the auditors, PricewaterhouseCoopers, lost big.

“On September 9, 2008, the United States Court of Appeals for the Third Circuit in Philadelphia affirmed a $119.9 million jury verdict and $182.9 million judgment entered in 2005 by a New Jersey federal trial court against the accounting firm PricewaterhouseCoopers, LLP (“PwC”) on behalf of Jones Day client Vermont Insurance Commissioner.

That verdict, characterized at the time by The Wall Street Journal as one of the largest ever handed down against one of the “Big Eight” accounting firms for audit failure, was in favor of the Vermont Insurance Commissioner as receiver for the insolvent Ambassador Insurance Company…PwC, was found negligent for failing to properly audit the company’s financial statements, and particularly its loss reserves, which negligence allowed the company to remain in business beyond the point of solvency…The judgment against PwC came after a nine week jury trial. The appeal raised, among others, issues concerning the scope of an auditor’s liability when there are allegations of management misconduct, as well as questions concerning the availability and appropriate measure of damages available in auditing malpractice suits brought by insolvent corporations or their receivers.

In one of the most important and extensive discussions of auditor liability by a federal appellate court in years, the Third Circuit sided with the receiver of Ambassador on both issues. The Court held that, under New Jersey law, misconduct of management cannot be asserted as a defense against the company by an auditor who participated in the misconduct. In addition, the Court clarified recent decisions concerning “deepening insolvency” damages by holding that an increase in the liabilities of a company, even if insolvent, is damage to the company and may be recovered from wrongdoers if negligence is proven.”

I’m not sure if Steven Thomas, the attorney representing the New Century Trustee intends to explore this issue when arguing their suit against KPMG US and KPMG International. I can’t think of a better case, though, to give it a shot. There’s smoking gun evidence against KPMG of potential malpractice and complicity in the fraud for the sake of their fees, which prevented them from issuing a “going concern” opinion or otherwise warning shareholders, regulators and the markets that something really, really bad was going to happen.

“To account for the risks it was taking, and to provide comfort to creditors and investors to whom it disclosed these risks, New Century hired a professional, independent well-known certified public accounting firm to audit its financial statements. The auditor was KPMG LLP. KPMG LLP was retained when the company was formed in 1995, and served as New Century’s outside auditor until April 27, 2007, when it resigned, having issued twelve unqualified audit opinions on New Century’s financial statements. These opinions certified each of New Century’s consolidated balance sheets and the related consolidated statements of income, comprehensive income, changes in stockholders’ equity and cash flows.

…Beginning in at least 2005, these loan repurchase provisions began to have an increasingly material, and ultimately overwhelming negative impact on New Century’s financial statements… the trend of increasing repurchases indicated that the most significant piece of New Century’s business – its loan portfolio – was severely weakened.

KPMG LLP was fully aware of this trend. Its own workpapers note that the repurchases had more than doubled from 2004 to 2005, going from $135.4 million to $332.1 million. Even with this increase in the rate of repurchases — a clear indicator of weakness in the loan portfolio — KPMG LLP failed to expand its procedures or testing of New Century’s reserves. Indeed, although KPMG LLP expressly acknowledged in its workpapers that the risk associated with the portfolio had gone from low to high, KPMG LLP did not expand its audit work in response to this increased risk.”

The question for all of those who can advocate on behalf of shareholders – regulators, Attorneys General, and the plaintiff’s bar – is:

Why aren’t there more “going concern opinions” issued earlier and more emphatically, and why weren’t there any for the most notorious of the “financial crisis” firms?

© Francine McKenna, The Digging Company LLC, 2020