Leftovers: AmTrust and BDO, Macy's and KPMG
I didn't have much ambition today beyond sitting on the sofa and typing out these recaps. It's my last newsletter for November and it is free for all.
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In the news: AmTrust and BDO
Bernstein Litowitz Berger & Grossmann LLP’s Jesse Jensen, a partner, and Thomas Sperber, an associate, wrote for Law360 about something dear to their hearts and mine: The AmTrust case and BDO.
2nd Circ. AmTrust Decision Shows Audit Reports Still Matter
By Jesse Jensen and Thomas Sperber (November 26, 2024)
In the article Jesse and Thomas highlight a different quote from U.S. v. Arthur Young & Co. than the one I usually use when talking to Masters of Accounting students:
As the U.S. Supreme Court recognized four decades ago in U.S. v. Arthur Young & Co., independent audits "obviate the fear of loss from reliance on inaccurate information, thereby encouraging public investment in the Nation's industries."
Accordingly, an auditor can be subject to liability under the securities laws for misrepresentations in its reports included in publicly filed financial statements.
What case are they referring to?
In August last year, the U.S. Court of Appeals for the Second Circuit in New England Carpenters Guaranteed Annuity & Pension Funds v. Decarlo "rejected investor claims against the auditor that blessed years of public misstatements concerning the high-profile accounting meltdown of AmTrust Financial Services Inc."
Most disturbingly, the Second Circuit rejected such claims on materiality grounds — _the appeals court held that the audit reports were "so general" that they did not matter to investors.[2] The alarming implications of this ruling rippled across the investing community and the mainstream press, with the Wall Street Journal writing, "Burned Investors Ask 'Where Were the Auditors?' A Court Says 'Who Cares?'"[3]
The plaintiffs urged the Second Circuit to reconsider its decision, joined by past U.S. Securities and Exchange Commission officials and — at the request of the court — the SEC itself.
I wrote about the case here after the Second Circuit rejected the claims.
Fortunately, after SEC veterans and the SEC itself pleaded their case to keep giving the usefulness of the audit opinion the benefit of the doubt, on Oct. 31, the Second Circuit granted reconsideration and reversed its earlier ruling...
... now holding that audit reports are material to investors, and reinstating dismissed claims against the auditor defendant.[4] Thus, under the law, audit reports still matter to investors — for now, at least.
Jesse and Thomas give a lot of great background to the case and its implications. I am grateful that, in their conclusion, they give me, via several cites, the last word.
The capital markets are the economic lifeblood of the U.S., and — as the amici submissions in AmTrust reinforced — trust in the independent auditor is the backbone of that system.
However, that trust has increasingly frayed, and while the Second Circuit's affirmance in AmTrust that audit reports do matter is a positive development, that ruling is hardly the end of the story. That the saga occurred at all further confirms the seriousness of the ongoing crisis of confidence in the audit report. Indeed, that BDO was arguing against the materiality of its own reports to investors[22] speaks to the conflicted state of the audit profession today.
In recent years, regulators have increasingly spoken publicly about increasing their focus on addressing audit shortcomings, with former SEC Enforcement Director Gurbir Grewal acknowledging that civil penalties are "sometimes viewed as a cost of doing business" by major audit firms.[23] As AmTrust makes clear, the tough talk needs to be followed with enforcement: It is crucial that regulators continue their efforts to address the systemic issues in the auditing industry that have repeatedly harmed investors.
[23] Francine McKenna, The SEC, and PCAOB, slam Marcum LLP over SPACs, but it's too little way, way too late, The Dig, June 25, 2024, https://thedig.substack.com/p/the-sec-and-pcaob-slam-marcum-llp;
Francine McKenna, Here's a target list if SEC Enforcement really wants to "hammer" the gatekeepers, The Dig, Dec. 27, 2021, https://thedig.substack.com/p/heres-a-target-list-for-if-sec-enforcement?s=w;
see also, e.g., U.S. Securities & Exchange Commission, Responsibilities of Lead Auditors to Conduct High-Quality Audits When Involving Other Auditors [Statement], Mar. 17, 2023, https://www.sec.gov/newsroom/speeches-statements/munter-statement-responsibilities-lead-auditors-031723.
And let’s not forget that, as a result of this reversal, the audit firm that is now facing a case of auditor liability is BDO. That’s the firm that just agreed to take on the audit at Super Micro where EY left in a huff because it could not trust the executives or audit committee.
Macy's: What we know and what comes next
From the New York Times:
Macy’s Discovers Employee Hid Millions in Delivery Expenses
The department store chain said it had found the erroneous accounting entries while preparing its results for the third quarter.
By Jordyn Holman and Danielle Kaye Nov. 25, 2024 ~9:30 am ET
Macy’s said on Monday that an employee had “intentionally” misstated and hidden up to $154 million in delivery expenses over the past few years, forcing the retailer to delay a much-anticipated earnings report that Wall Street uses to gauge the strength of holiday shopping.
The New York Times says, based on an anonymous source, that the employee that was fired "did not take the money" that was understated for three years in Macy's audited financial statements.
I am not convinced of this, yet, since they cite an anonymous source and the investigation has not yet been completed.
The employee did not take money from the company, a person familiar with the matter said, but the company delayed releasing its full quarterly financial results until it completes an investigation.
NYT's Jordyn and Danielle do a nice job of putting the understated expense amount in perspective. I will say more about this in a bit.
In the same three-year period of the accounting issue in which the employee hid up to $154 million, the retailer said it had recorded about $4.36 billion in delivery expenses — the cost to a business in order to transport goods. Macy’s declined to comment further. A spokesman for KPMG, Macy’s auditor, declined to comment.
While amounting to a small percentage of the retailer’s total delivery expenses, the millions of dollars that the employee misstated is comparable to Macy’s total net income in 2023: roughly $105 million. The retailer reported a profit of $150 million for the second quarter of 2024, a figure that fell within the range of the hidden delivery costs.
A commenter raises a few good questions and suggest an innocent explanation:
“It is so strange because I’m trying to imagine why an accountant, who’s responsible for this small package delivery expense account, would do this,” said Blake Oliver, a certified public accountant and founder of the mobile app Earmark. “It doesn’t make sense to me. Could it have been a mistake? Could they have been making the wrong journal entry for years and it just went completely unnoticed? It’s a mystery.”
“This just is strange because I don’t see a motive,” he said.
Mr. Oliver also said that with a large company like Macy’s, which does billions of dollars in sales in a year, small errors can compound over time and become big issues.
They identify KPMG as Macy's auditor and ask for a comment, which it declines to give, but don't say anything else about KPMG.
Ben Glickman and Suzanne Kapner at the WSJ don't say much that's different, just with different sources/commenters.
Macy’s Says Accounting Employee Hid Up to $154 Million in Delivery Expenses
Retailer delays quarterly results after finding accounting problem dating back to 2021
By Ben Glickman and Suzanne Kapner Updated Nov. 25, 2024 12:35 pm ET
WSJ also claims that the employee didn't "pocket" the money but without attribution. WSJ also raises question of how the auditor missed the understated expenses. I will say more about that in a bit.
The individual didn’t pocket the amounts in question and the company declined to say how it uncovered the erroneous entries or how it went undetected by the company’s auditor, KPMG. Macy’s said it would provide details on its investigation when it reports quarterly results on Dec. 11.
WSJ says a little bit more about KPMG, including that it has been around at Macy's for a long time, and gets a commenter to ask, more or less, "Where were the auditors?"
“While Macy’s cannot control the actions of every employee, it is worrying that these are intentional accounting errors that go back to 2021,” said Neil Saunders, managing director of research firm GlobalData. “It also raises the question as to the competence of the company’s auditors.”
A KPMG spokesman declined to comment. The accounting firm has served as Macy’s auditor since 1988.
WSJ also gets some accounting professionals to dig in the weeds a bit, about internal controls and about the relationship between the delivery expense metric, and talk about possible incentives for the understatement of expenses.
“Clearly there was a breakdown in the company’s internal controls in this area,” said Jeffrey Johanns, an associate accounting professor at University of Texas at Austin.
Macy’s said there was no evidence the accounting errors had affected its cash management or payments to vendors. The company hasn’t identified involvement by any other employees, and the person who was responsible for the errors is no longer employed by the company.
Retailers have been under pressure to lower delivery expenses in the face of rising costs and an increase in online shopping that have eaten into profits, said Ron Friedman, a managing director at CBIZ, formerly Marcum, an accounting and advisory firm. One possibility is the employee was trying to boost the profitability of their department to increase compensation, Friedman said.
I spoke to Business Insider's Dakin Campbell early in the day. I laid out three increasingly more serious scenarios for how this might have happened. In the end only one, the most innocuous, was used as the last word for the piece.
Macy's $132 million mystery has auditing experts scratching their heads
Dominick Reuter and Dakin Campbell Nov 25, 2024, 8:40 PM EST
Without more details, the accounting experts who spoke to BI said it is hard to understand exactly what happened.
One possible explanation may be as simple as "sometimes accountants make mistakes," said Francine McKenna, a former accounting professional who now publishes The Dig newsletter about accounting topics and auditing firms.
"Sometimes errors accumulate, and then what happens is you go into preservation mode," she added. "You just keep perpetuating the error in order to hide it because you don't want to raise your hand and say, 'An error happened, I couldn't get it fixed for a year and a half, and now the number is really big.'"
While stronger internal controls could shift some of the onus off individuals to make that choice, Maginnis also said that the accounting profession depends on individuals' personal commitment to tell the truth at all times.
Dominick and Dakin did get a former KPMG partner (!) to comment, critically.
Even in a situation where someone intentionally introduced errors to a company's books, Jerry Maginnis, a former KPMG partner, said: "Your system of internal control should have caught it."
Since retiring from the accounting firm in 2015, Maginnis now serves on the audit committees of several companies and is an executive in residence at Rowan University. He said he never handled financial records for Macy's, which has been audited by KPMG since 1988.
"Somebody else should have been reviewing and catching it, and so this was a breakdown in internal control as well as bad accounting," Maginnis told BI.
And I signaled more bad news to come, since the auditor KPMG will now be forced to act.
Regulations set by the Sarbanes-Oxley Act, which require public companies to maintain effective internal controls, are intended to catch mistakes like this much earlier and provide an avenue for audit firms to issue warnings about company controls.
The pressure will now be on Macy's auditor, KPMG, to show that it's appropriately scrutinizing Macy's accounting practices and controls, McKenna said.
"I wouldn't be surprised if you'll see a material weakness in internal controls because something is not working here," McKenna said. "There was a hole somewhere."
All of the reports on the first day raised a lot of questions but no one really had any the answers, and probably won't until the company says more when it files its 10-Q, which it says will happen by Dec. 11. The company will also tell us more about what kind of investigation it is now doing.
Since only one of the possible scenarios for what I think may have really happened was highlighted in my quotes for Business Insider, I wrote a long BlueSky thread on the evening of the 25th to explain the possibilities, from an error that went very wrong and then was perpetuated to major fraud a la WorldCom/HealthSouth.
One thing to keep in mind is that KPMG has never cited a material weakness in internal controls over financial reporting, such as weaknesses in IT general controls that might point to an incomplete ERP software implementation, or lack of qualified, competent accounting personnel, or issues around tone at the top regarding internal controls or lack of segregation of duties, proper monthly closing processes, regular account reconciliations, or appropriate approvals/authorizations for journal entries and prevention of "top-side" entries by C-suite executives.
Accountants should never be incentivized to increase revenues or reduce expenses. Too bad CFOs are. I always thought this was a huge conflict.
Enough said! George Batta is an associate professor of economics at Claremont McKenna University.
Over and above not citing any material weaknesses, should we have expected KPMG to have found the misstatement/understatement in three years of audits?
And then I do some reminiscing.
Finally, the next day, Bloomberg reporter Jeanette Neuman did some second-day analysis, digging into the pressures on Macy's that may have led the individual or the whole C-suite, to allow this to happen.
Macy’s Touted a Metric That Ended Up Being Juiced for Years by Former Employee
-Cutting delivery expenses ‘key driver,’ CFO said in September
-Online sales boom boosted delivery costs in recent years
By Jeannette Neumann November 26, 2024 at 1:45 PM EST Updated on November 26, 2024 at 2:20 PM EST
What a lede!
For years, Macy’s Inc. touted its ability to boost profits by cutting delivery costs and trimming other expenses on calls with Wall Street analysts. Then on Monday, the department store chain surprised investors by revealing that those very costs had become the source of an internal investigation into what the company has described as a multimillion-dollar employee plot to manipulate the metrics.
And then we get to the meat of where things may have gone off the rails.
Cutting the cost of delivering online orders has been a focus for the retailer in recent years as it aims to shore up profitability in the face of flagging sales.
To that effect, the retailer has been diversifying shipping carriers, reducing the distance its packages are sent and spearheading what CFO Adrian Mitchell recently called “process reengineering initiatives” on the company’s August earnings call.
A month later, Mitchell called the efforts one of the “key drivers in terms of expanding gross margin” at the annual Goldman Sachs retailing conference, where investors gathered to hear about the company’s turnaround plan under a new chief executive who took the helm earlier this year.
Jeanette also mentions something I was going to look up.
Macy’s is getting “our delivery expense under control for a lot of customers that are going to be receiving deliveries to their home,” said Mitchell, who joined Macy’s in 2020 from the Boston Consulting Group. He has mentioned delivery expenses in all but one of the 16 quarterly earnings calls that he’s participated in since joining the retailer.
It was a major boon for the retailer and its finance chief, who told Wall Street in May 2021 that the “largest headwind” for profits was its delivery expense. At the time, Mitchell said that the delivery expense accounted for nearly twice the drag on profits compared to the same period in 2019. The more that people shopped online, the bigger the delivery expense line item ratcheted up.
A commenter who used to work for PwC mentions something I mentioned the night before, that maybe there was a software glitch that left a hole in the internal controls.
One possible scenario is that an accountant at Macy’s could have changed the internal coding of delivery transactions to charge those payments to the wrong account, according to Adriana Carpenter, a former accountant at auditor PwC who now serves as chief financial officer of expense management software company Emburse.
As a result, the payments may have been recorded as cash outflows, but the expense wouldn’t have been reported, said Carpenter, who does not have first-hand knowledge of Macy’s business practices.
A large company like Macy’s typically has controls in place to ensure such a scenario couldn’t occur but it’s unclear if that’s the case in this instance, she added. Macy’s declined to comment on its controls.
And then Jim Barratt points to what should be an inevitable SEC investigation.
The size and duration of the incident also makes it likely that the US Securities and Exchange Commission is investigating or will investigate, said Jim Barratt, a former SEC enforcement accountant and founder of Barratt Consulting Group.
The SEC, which regularly reviews company filings for unusual disclosures, said it doesn’t comment on the “existence or nonexistence of a possible investigation.” Macy’s declined to comment on any possible external investigations.
And also says something I wholeheartedly agree with.
The disclosure also draws attention to the company as a whole, not just the unnamed employee singled out in the press release, Barratt said. “Accounting entries aren’t made by one person,” he said. “It takes more than one person.”
But, is that all we know so far?
Michelle Leder, an SEC filings expert who makes her knowledge available on her site, Footnoted.org, wrote on LinkedIn about how the news from Macy's reminded her of something she flagged for her Friday Night Dump clients exactly one month ago.
Still, to be sure, no company wants to have to report that kind of mistake to investors. It also makes me wonder how long Macy's knew about this. Clearly, that wasn't yesterday, since they had time to initiate an independent investigation and forensic analysis. Not to mention getting rid of the single employee who was apparently responsible for this error.
And that reminded me of this filing that I had flagged for my Friday Night Dump clients exactly one month ago. After markets closed on Oct. 25, the company disclosed that director William H. Lenehan had resigned a few days earlier. Not included in the filing was the fact that Lenehan had been on the board since 2016 and was a member of the audit committee.
As is common with these sorts of filings, that filing said there had been no disputes or disagreements that prompted Lenehan's sudden resignation. That's when reality kicks in: how many people walk away from a part-time job that pays them well -- Macy's directors get $90K a year in cash and another $160K in stock -- unless there is something wrong?
Hmmmm. Lenehan is a real estate guy so maybe it was just Macy's plan announced in February to shutter 150 stores that made him feel his expertise suddenly obsolete.
One other small tidbit that the WSJ reporters who covered this story may lack institutional knowledge of is something that was reported in 2017. It doesn't help that one of the reporters is no longer its Accountancy reporter.
Fired KPMG Audit Head: How Did Scott Marcello Fall From Grace?
Scott Marcello was supposed to be the man to redeem KPMG LLP’s audit business. Instead, the 54-year-old and other top partners became the center of a scandal that tarnished the firm’s reputation
By Michael Rapoport and Dave Michaels
Updated April 16, 2017 3:36 pm ET|
Mr. Middendorf, Mr. Marcello’s deputy at KPMG, also was a star at the firm. He was a top auditor of KPMG clients such as Home Depot Inc., J.C. Penney Co. and Macy’s Inc. before becoming national managing partner of audit quality, where he was directly responsible for dealing with the PCAOB and making sure the firm’s audits were in good shape. He also sat on a PCAOB advisory panel that counsels the board on its development of new auditing rules.
Mr. Middendorf himself has voiced concerns about the accounting board’s inspections, calling them “an area for stress” for audit partners. “It is a reason some people leave our profession, because they just don’t like that stress,” Mr. Middendorf said at a May 2016 meeting of the advisory panel, according to a transcript of the meeting.
If you are the summarily executed, I mean fired, Macy’s accountant and you want to talk, get in touch!
© Francine McKenna, The Digging Company LLC, 2024