Luckin Coffee: Anatomy of an auditor response to fraud allegations
April 22 was the one year anniversary of Luckin's IPO and what a year it's been!
I am often asked, “Why doesn’t the auditor do something about the accounting fraud going on at XYZ Company?”
Investors press me even more to explain the typical auditor silence and inaction when a whistleblower’s accounting fraud allegations are made public or an activist investor publishes a research report that alleges fraud or “aggressive accounting” and announces a short position in the stock.
So, I thought I would use the Luckin Coffee case as a template to explain what an auditor can, should, and typically does do — in public and behind the scenes—when allegations of accounting fraud are made public.
On January 31, 2020, Muddy Waters Research tweeted the firm had a short position on Luckin based on what it said was a “credible” anonymous 89-page report that alleged accounting issues and a broken business model.
Luckin Coffee vehemently denied the allegations.
The stock plunged 20% that Friday, and another 23% on the following Monday.
During February 2020 the share price recovered to levels seen at the beginning of 2020.
The coffee chain, which competes with Starbucks in China, then saw its share price decline again in March.
On April 2, the company acknowledged the issues raised by the anonymous report, via a press release that said its board was investigating reports that senior executives and employees had fabricated transactions. The company’s Chief Operating Officer, Jian Liu, and some employees who reported to him were suspended.
It also said its previous financial statements for the nine months ended Sept. 30, should not be relied on by investors. The questionable transactions had occurred in 2019 and were estimated to total about 2.2 billion yuan ($310 million), according to the filing.
Luckin shares sunk 75% on the news.
The stock has been halted since April 7.
I started getting questions on Twitter about Luckin’s auditor almost immediately on April 2 after the company announced it was investigating
On April 4, The Wall Street Journal obtained a statement from Ernst & Young for a story in the print edition claiming that the Luckin auditor had “uncovered the problems.”
"Accounting firm Ernst & Young said it uncovered the problems at China's Luckin Coffee Inc., which hammered the stock price of the upstart challenger to Starbucks Corp. in the country and cast doubt over a large part of its sales last year.”
“Luckin's Nasdaq-listed shares fell more than 75% Thursday after it said an internal investigation indicated its chief operating officer and others had fabricated much of its reported revenue in 2019. Shares were up slightly Friday morning.”
“The accounting firm said that while auditing Luckin’s financial statements for 2019, it found that some "management personnel engaged in fabricated transactions which led to the inflation of the Company's income, costs and expenses" from the second quarter to the fourth quarter of 2019.”
"Based on such findings, EY made a report to the Company's Audit Committee," Ernst & Young said in an emailed statement Friday.”
The report to the Audit Committee prompted Luckin's board to start an internal investigation, the firm said in the statement according to the WSJ.
The WSJ article also stated, "EY, which has audited Luckin since the coffee group's founding in 2017…”
That statement was inconsistent with the information in the firm’s opinion in Luckin’s annual report for 2018.
/s/ Ernst & Young Hua Ming LLP We have served as the Company's auditor since 2019. Shanghai, the People's Republic of China February 22, 2019
I asked the WSJ reporters via email which EY entity actually made the statement. Quentin Webb, the Asia Markets Editor in Hong Kong replied via email, “The statement came from an EY spokesperson in Hong Kong…”
The WSJ reporters, I believe, misunderstood the firm’s comment about which financial statement years were audited versus when the auditor was actually engaged to do the work.
It matters.
Vivian Lo, spokesperson for Ernst & Young Greater China, who is located in Hong Kong, responded to my inquiry. She said she spoke on behalf of Ernst & Young Hua Ming LLP:
“Ernst & Young Hua Ming LLP was appointed by Luckin Coffee (“the Company”) as the Company’s auditor in 2019.”Once engaged in 2019, “Ernst & Young Hua Ming LLP performed the audit on the Company’s financial statements covering the periods since its establishment on 16 June 2017 to 31 December 2017 as well as for the full fiscal year of 2018, and issued the audit reports accordingly.”
Just as I had tweeted.
Finally, the WSJ quotes the spokesperson, saying EY “wouldn't comment further, citing client confidentiality.”
It is highly unusual for an audit firm to put out a very detailed statement about its client’s “problems” that points to senior executives —ones the firm relied on to vouch for the authenticity of the company’s transactions and account balances — engaging in “fabricated transactions which led to the inflation of the Company's income, costs and expenses.”
It’s even more unusual for a Chinese Big 4 audit firm to put out such a statement about a company that has the backing of a Chinese state-backed investment bank, China International Capital Corp., CICC.
What is the ostensible purpose of such an unusual and frank statement from an audit firm about the allegedly illegal goings-on at its client uncovered during its audit, one that’s full of accusations and impact for the executives and the ongoing viability of the company itself?
The purpose seems only to be to claim credit for having uncovered the “problems” and acted correctly to bring them to the attention of the Audit Committee of the Board of Directors.
Certainly there was no legal risk to the Ernst & Young Shanghai firm from U.S. investors or regulators.
Just this week SEC chairman Jay Clayton and Bill Duhnke, the chairmen of the PCOAB, the U.S. audit industry regulator reminded investors, yet again, Chinese companies listed on U.S. exchanges do so with impunity.
In a statement co-signed by Clayton, Duhnke, SEC Chief Accountant Sagar Teotia, Division of Corporation Finance Director William Hinman, and Division of Investment Management Director Dalia Blass, the top regulators of financial accounting and disclosure highlighted that, “The PCAOB's Inability to Inspect Audit Work Papers in China Continues.”
Our ability to promote and enforce these standards in emerging markets is limited and is significantly dependent on the actions of local authorities—which, in turn, are constrained by national policy considerations in those countries. As a result, in many emerging markets, including China, there is substantially greater risk that disclosures will be incomplete or misleading and, in the event of investor harm, substantially less access to recourse, in comparison to U.S. domestic companies.
The regulators also mentioned, in bold in case you’ve forgotten, that, “The Ability of U.S. Authorities to Bring Actions in Emerging Markets May Be Limited.”
In other words, “The SEC, U.S. Department of Justice (“DOJ”) and other authorities often have substantial difficulties in bringing and enforcing actions against non-U.S. companies and non-U.S. persons, including company directors and officers, in certain emerging markets, including China.”
Also, “Shareholders Have Limited Rights and Few Practical Remedies in Emerging Markets.”
What that means is, “Shareholder claims that are common in the United States, including class action securities law and fraud claims, generally are difficult or impossible to pursue as a matter of law or practicality in many emerging markets,” like China.
It’s a mystery why the SEC and the PCAOB are making a fuss about the China audit issues again.
It was a mystery when they mentioned it in December, 2018, too.
At that time, Jim Peterson, a former attorney for Arthur Andersen in Europe and author of “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms,” told me:
“Their long-standing impotence in the face of Chinese resistance has been well known and fully on display since the passage of the Sarbanes/Oxley law back in 2002.”
It must feel a little squirmy for Clayton and Duhnke when they keep making these statements.
After all, the PCAOB is the regulator that allowed the Chinese audit firms to register to audit U.S. listed companies, despite never having an agreement that allowed the PCAOB to inspect their work auditing public companies, unlike everywhere else in the world.
More than one SEC chair and stock exchange CEO has allowed Chinese companies with un-inspectable audit firms to list on U.S. exchanges, in violation of their own SEC and exchange rules. In Clayton’s case, he was actually the lawyer who got paid to do so, helping bring Alibaba public, a China-based company that is audited by the China member firm of PwC.
And yet, this week
Caveat emptor!
What actions do Big Four audit firms typically take when a highly detailed report alleging financial fraud is published or a whistleblower’s allegations of financial shenanigans is made public?
In public, the auditor, if questioned at all by media, declines comment, citing client confidentiality. During the financial crisis, when media started asking the U.S. Ernst & Young firm, for example, about Lehman Brothers’ Repo 105 accounting that a bankruptcy examiner’s report said was used to “window-dress” its balance sheet, the firm stood by its audit but did not discuss its details:
“Our last audit of the company was for the fiscal year ending Nov. 30, 2007. Our opinion indicated that Lehman’s financial statements for that year were fairly presented in accordance with Generally Accepted Accounting Principles (GAAP), and we remain of that view.”
When the first lawsuits against the auditor are threatened after an accounting fraud, the Big 4 often mount a victim defense.
In a 2009 interview in Business Today in India, PwC chairman at the time Dennis Nally dodges the question of whether the audit is designed to detect frauds like Satyam:
Interviewer: Your predecessor (Samuel A. DiPiazza, Jr, see interview, BT, March 23, 2008) who was in India a few months back, talked of PwC being a victim of Satyam as much as anyone else. Is PwC a victim?
Nally: “I think what Sam was referring to as being misled was the fact that even the auditor is into a process. (Being) a victim means the knowledge we had at that stage was no different than that many others had.”
That’s what PwC did, also, when the Tesco-related tomatoes were hurled in their direction.
PwC went to the media suggesting to journalists and regulators, via non-attributed sources at the Deloitte investigation, that the firm had been “duped”.
The investigation into the £250m accounting scandal at Tesco is understood to have uncovered evidence that a “small group” of people within Britain’s biggest retailer deliberately misled its auditors and accountants to flatter its financial results.
Tesco has dumped its auditors of 32 years, PwC, in the wake of the £263m accounting scandal that hit the supermarket last year…PwC has agreed not to put itself forward for consideration, coming after The Independent revealed last year that directors at the supermarket were said to be furious with auditors after sources at PwC attempted to distance themselves from the scandal.
PwC did escape any regulatory sanction for its work at Tesco, not because it had been proven that the firm had not violated audit standards and betrayed the public’s trust but because the regulator gave up.
“…there was ‘not a realistic prospect’ a tribunal would find PwC guilty of misconduct at Tesco. A person familiar with the inquiry said the FRC had concluded it could not credibly contend that the Big Four firm had failed to ask the right questions, or that its auditors had failed to act appropriately on the information they were given.”
Given the business consequences and potential for the perception you have breached client confidentiality, it is very rare for an auditor to speak out, take credit, via a statement to the media, for finding a fraud at a client. That’s especially true when you are still on the rolls as the auditor of record, where an investigation is ongoing and where the annual report and auditor’s opinion has been delayed as a result.
Behind the scenes, auditors are supposed to do — and investors expect them to do —exactly what Ernst & Young China said it did in the Luckin case.
The firm told the WSJ it found the “problems” while auditing Luckin’s 2019 financial information. This work typically begins after the year-end, December 31, 2019, and was not likely to have been performed in person given the COVID-19 restrictions in place in China at the beginning of 2020.
While doing this initial work, remotely, Ernst & Young Shanghai auditors say they came across executives fabricating transactions, according to the firm’s statement to the WSJ, and immediately made a report to the Audit Committee.
The company’s press release published before the market opened April 2 at 9:00 am ET told the same story.
“…the Company’s Board of Directors has formed a special committee to oversee an internal investigation into certain issues raised to the Board’s attention during the audit of the consolidated financial statements for the fiscal year ended December 31, 2019.”
On April 17, the WSJ quoted Drew Bernstein, co-chairman and co-lead of the China practice at accounting firm Marcum Bernstein & Pinchuk saying the anonymous report circulated earlier in the year and could have prompted Ernst & Young Shanghai to look at Luckin’s accounting more closely.
But there were red flags…
At the time of its IPO, the company, waved a big red flag that the company was vulnerable to fraud.
On April 22, 2019, when Luckin filed its F-1 registration to go public, the company disclosed two material weaknesses in internal control over financial reporting.
In connection with the audit of our consolidated financial statements as of and for the year ended December 31, 2018, we and our independent registered public accounting firm identified two material weaknesses in our internal control over financial reporting.
A "material weakness" is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis.
The material weaknesses identified by Luckin?
“lack of sufficient accounting and financial reporting personnel with requisite knowledge and experience in application of U.S. GAAP and the Securities and Exchange Commission, or the SEC, rules, and lack of financial reporting policies and procedures that are commensurate with U.S. GAAP and the SEC reporting requirements.”
In September 2019 I reported at MarketWatch that 20% of IPOs year to date audited by Big 4 U.S. firms had voluntarily disclosed serious issues with internal controls over accounting, financial reporting and the systems.
Luckin said in its registration statement on April 22, 2019 that it was in the process of implementing a number of measures to address the material weaknesses and deficiencies. However, given the delay in issuance of the annual report because of the ongoing investigation and the significant potential that 2019 and prior years financials will have to be restated, we may not know for a while how that’s going.
Luckin is considered an "emerging growth company" per the JOBS Act. Emerging-growth companies are exempt for the requirement for up to five years, or until they exceed $1.07 billion in revenue. The EGC classification was created by the JOBS Act for companies that have total annual gross revenue of less than $1.07 billion.
Despite Ernst & Young Shanghai’s clear knowledge, and prompting to the company to voluntarily warn investors that the fundamental accounting and reporting controls were hugely deficient at the time of IPO, it’s not clear if Ernst & Young had an inkling that a senior executive level fraud was already going on.
Even if they did, it is still rare for the external auditor to find a fraud perpetrated by high-level executives who have colluded to hide it from everyone and then to raise it to the Board.
The 2018 Report to the Nations – Asia Pacific edition, published by the Association of Certified Fraud Examiners, says the most frequent way fraud is detected in the region is via tips.
On a global basis, the ACFE says external auditors only detect about 4% of frauds, less than the percentage 7%, discovered by accident. Slightly more than half of all tips (53%) that led to the discovery of frauds were provided by employees of the victim organizations. Nearly one-third (32%) of the tips that led to fraud detection came from people outside the organization: customers, vendors, and competitors.
How long were investors, activist and otherwise, suspicious of Luckin’s numbers?
The anonymous report that Muddy Waters Research relied on to decide to make a short call was put together during 2019 and circulated among short sellers and others early in 2020.
But Luckin was one of the most heavily shorted stocks even before the Muddy Waters tweet. Matthew Unterman, a director of S3 Partners, a New York-based financial data provider, said there had been “elevated demand” from hedge funds to short Luckin’s stock since the IPO, according the WSJ article from April 4.
Recent short interest was equivalent to 35% of Luckin’s U.S. securities leading to nearly $700 million in gains, on paper on April 2, according to Unterman via the WSJ.
One short seller, Andrew Left’s firm Citron, stuck by a long position, even after the January 31st Muddy Waters position was made public.
Left based his confidence partially on another report from the ominously named Biz Con China, which he said contradicted the anonymous report.
Ironically, Left had told CNBC in 2016 he was done with China after a Hong Kong tribunal ruled against him in a case related to his negative report on one of the China territory’s biggest property developers. “I have zero plans on commenting on anything in China or Hong Kong in the future,” the Citron Research executive editor told CNBC.
Veteran short-seller Jim Chanos told CNBC on April 2, “We were short thanks to Muddy Waters who urged me to take a look back in February.”
Chanos told the interviewer that he covered his short, that morning before the market opened.
The Luckin press release went out at 9am ET on April 2, 30 minutes before the market opened.
It’s even more rare to have an immediate publicly announced result—share impact be damned—including news of formation of a special committee, hiring of a law firm and forensic accountant, and quick termination of culpable executives.
The terminations were especially quick, considering the company said on April 2, “The internal investigation is at a preliminary stage.”
Does new information about a fraud have a different impact when the audit firm is in the midst of the annual audit when report?
Yes, since as we have seen, the auditor is expected to complete the audit and in this case the announcement has caused the annual report and its opinion to be delayed.
The actual audit will likely take longer, since such a “discovery” by the audit or the credible report by a whistleblower or a short seller, may necessitate a broader audit scope, more evidence gathering, or even redoing previous work, since executives you’ve relied on for documents and assurances have been revealed to be committing fraud.
One thing to remember is that an auditor’s responsibility is not to investigate whether a whistleblower or short seller is a credible figure, or even to support management in investigating the allegations. To maintain its independence, the auditor should never be involved in internal investigations of fraud, especially if they implicate senior executives. That’s why companies hire outside law firms who hire independent forensic accountants.
In this case, Luckin say it hired U.S. law firm Kirkland and Ellis, who hired FTI Consulting.
If a whistleblower tip comes to the audit firm first, it is the audit firm’s duty to turn it over to the company. The auditor’s role is only to determine—based on what the company tells them—if the allegations, if true, would have a material effect, qualitatively or quantitatively, on the accuracy and completeness of the financial statements and to adjust their audit approach accordingly.
What types of additional procedures are they likely to undertake and would there be any staffing or oversight changes if the audit team has reason to believe that there is a risk of material misstatement due to error or fraud?
From Auditing Standard 2401 - Consideration of Fraud in a Financial Statement Audit
Whenever the auditor has determined that there is evidence that fraud may exist, that matter should be brought to the attention of an appropriate level of management. This is appropriate even if the matter might be considered inconsequential, such as a minor defalcation by an employee at a low level in the entity's organization.
Fraud involving senior management and fraud (whether caused by senior management or other employees) that causes a material misstatement of the financial statements should be reported directly to the audit committee in a timely manner and prior to the issuance of the auditor's report.
In addition, the auditor should reach an understanding with the audit committee regarding the nature and extent of communications with the committee about misappropriations perpetrated by lower-level employees.
In early 2018, the audit regulator mandated changes to the audit report, adding a phrase to explicitly clarify that the obligation to obtain reasonable assurance about whether financial statements are free of material misstatements includes “whether due to error or fraud.”
How do the Big 4 determine when a particular client is too toxic to continue to audit?
According to the auditing standards, AS 2405: Illegal Acts by Clients:
When the auditor becomes aware of information concerning a possible illegal act, the auditor should obtain an understanding of the nature of the act, the circumstances in which it occurred, and sufficient other information to evaluate the effect on the financial statements. In doing so, the auditor should inquire of management at a level above those involved, if possible. If management does not provide satisfactory information that there has been no illegal act, the auditor should—
Consult with the client's legal counsel or other specialists about the application of relevant laws and regulations to the circumstances and the possible effects on the financial statements. Arrangements for such consultation with client's legal counsel should be made by the client.
Apply additional procedures, if necessary, to obtain further understanding of the nature of the acts.
The auditor should consider the implications of an illegal act in relation to other aspects of the audit, particularly the reliability of representations of management. The implications of particular illegal acts will depend on the relationship of the perpetration and concealment, if any, of the illegal act to specific control procedures and the level of management or employees involved.
If the auditor concludes that an illegal act has a material effect on the financial statements, and the act has not been properly accounted for or disclosed, the auditor should express a qualified opinion or an adverse opinion on the financial statements taken as a whole, depending on the materiality of the effect on the financial statements.
A discussion with a client that includes a warning that the auditor will be issuing a qualified or adverse opinion on the financial statements will typically result in the auditor being fired or forced to quit.
Disclosure of an illegal act to parties other than the client's senior management and its audit committee or board of directors is not ordinarily part of the auditor's responsibility, and such disclosure would be precluded by the auditor's ethical or legal obligation of confidentiality, unless the matter affects his opinion on the financial statements.
However…
Auditors may be required, under certain circumstances, pursuant to the Private Securities Litigation Reform Act of 1995 (codified in section 10A(b)1 of the Securities Exchange Act of 1934) to make a report to the Securities and Exchange Commission relating to an illegal act that has a material effect on the financial statements.
Disclosure to the Securities and Exchange Commission may be necessary if, among other matters, the auditor withdraws because the board of directors has not taken appropriate remedial action. (For more about auditors and 10A, go here.)
How do the politics between the local affiliate (in China or otherwise) and the head office typically play out?
(For more on this subject, see this post at reThe Auditors.com or this one I wrote for Forbes.)
A US member audit firm is required to join the SEC Practice Section and comply with the Section’s membership requirements, if it audits “SEC clients”. (The definition of an SEC client is found in SECPS §1000.38 Appendix D.) The SEC Practice Section adopted some procedures that are intended to enhance the quality of SEC filings by SEC registrants whose financial statements are audited by foreign associated firms. These rules are a membership requirement for the audit firms that belong as described in SECPS §1000.08(n). SECPS members are required to adopt policies and procedures for their international organizations or individual foreign associated firms that audit SEC registrants.
Procedures for Certain Filings by SEC Registrants—The policies and procedures should address the performance of procedures with respect to certain SEC filings by SEC registrants that are clients of foreign associated firms by a person or persons knowledgeable in accounting, auditing, and independence standards generally accepted in the U.S., independence requirements of the SEC and ISB, and SEC rules and regulations in areas where such rules and regulations are pertinent (the “filing reviewer”).
The procedures are performed to provide assistance to the partner of the foreign associated firm responsible for the audit (the “audit partner-in-charge of the engagement”) and the foreign associated firm. Such filings are limited to registration statements, annual reports on Form 20-F and 10-K, and other SEC filings that include or incorporate the foreign associated firm’s audit report on the financial statements of an SEC registrant.
When a Chinese audit firm signs a final audit report for a US exchange-listed company, the Chinese audit firm and its partners must perform all engagement quality review in China. That includes supervising, reviewing and consolidating work done by audit firms outside of China, including possibly the US firm, and making sure the work complies with US GAAS, the PCAOB auditing standards. The Chinese member firms of the largest global firms often have US expats in China that can perform this service and their National Office colleagues in the US are just a phone call or email away for any consultation. In either case the firm must have this expertise available to assist with required engagement quality review and the Appendix K review.
The Chinese audit firm engagement for a US-listed company is also subject to PCAOB inspection, but that’s the part that’s been disputed by the Chinese audit firms who say that the Chinese government won’t allow it. Unfortunately, with all due credit to recent shiny MOUs and subtle diplomacy, the PCAOB is still prohibited from inspecting Chinese audit firms and their engagements for audits of US listed companies on the ground, whether they’re signed by a mainland China firm or a Hong Kong firm. A Chinese partner of a Chinese audit firm is the responsible engagement partner and, we assume, he has the last word before the audit report is final.
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© Francine McKenna, The Digging Company LLC, 2020