Re:Balance -- Jim Peterson

Luckin Coffee – What’s Brewing In China?

With the echoes still ringing from China-based Luckin Coffee’s $ 300 million accounting scandal in 2019, the company is reportedly planning to relist its shares in the United States.

The American regulators –- the Securities and Exchange Commission and the Public Company Accounting Oversight Board –- might actually buy this remarkable assertion of restored corporate virtue. It will be a test of the policy and enforcement commitment of these erstwhile gate-keepers.

There’s ample room for doubt. My own views are well recorded: American policy toward Chinese companies has been incoherent and inconsistent for years, most recently with the Holding Foreign Companies Accountable Act of last year, with its can-kicking three year extension before Chinese companies with uninspected auditors might face de-listing.  

Looking back:

• The wave of reverse mergers by which Chinese companies gained access to US listings in this century’s first decade caught the SEC on the back foot.
• The agency was played like a chump in its 2015 smoke-and-mirrors “settlement” regarding enforcement subpoena responses by the large accounting firms.
• Meanwhile the PCAOB has been stymied since its launch in 2002 by the inability to inspect and access the working papers of auditors reporting on enterprises in China.

As for Luckin’s post-scandal history: 

• The company’s NASDAQ-traded American Depository Shares were de-listed in June 2020; its founder/controlling shareholder was forced out; and it filed for bankruptcy in February 2021.
• It was recapitalized with the injection of $ 250 million from two Chinese private equity groups, reportedly connected to the company’s earlier history, ahead of the availability of audited financial statements.
• Under an agreement announced by the SEC on December 16, 2020, the company agreed to pay $ 180 million to settle securities fraud charges based on $ 300 million of fabricated sales and $ 190 million of inflated expenses.
• In October 2021 it agreed to pay $ 175 million to settle shareholder class litigation –- with a court approval hearing scheduled for July 22, 2022.

On September 21, 2021, the company filed its annual report on SEC Form 20-F, covering the years 2019 (as re-stated) and 2020, supported by the clean audit opinion of Centurion ZD CPA & Co.  That firm, a one-office operation in Kong Kong, described on its website as formed by the April 2016 merger of Dominic K.F.Chan and AWC (CPA) Limited, succeeded Marcum Bernstein & Pinchuk, which had replaced EY post-scandal but resigned for its reported inability to audit and report on the company’s results for 2019 and 2020.

Which is where things should get interesting for the American regulators.

Centurion states that it “provides a comprehensive range of services on a global perspective,” across the range of “audit and accounting services, taxation, risk assessments services, corporate finance consultancy and business advisory services.”

To offer such a range, the demands on Centurion’s personnel and modest size are considerable. Its website names just six directors including Managing Partner Chan. Its report to the PCAOB for the year ended June 30, 2021 (Form 2), shows a total of 52 accountants of whom 18 are certified.

The Form AP filed with the PCAOB on October 26, 2021, for Luckin shows the engagement partner to be Managing Director Chan himself. Chan spreads himself widely: for the firm’s US registrant clients (see the SEC’s listing of companies for which inspection reports are not available), he and his colleague Wing Wai Lai are named as the engagement partners on 25 of the 35 Form AP reports filed with the PCAOB in the last twelve months.

As for Centurion’s capacity to handle the demands of auditing a company the size of Luckin, its resources must measure against the currently-reported size of the company: third-quarter 2021 revenue increased 106% to $ 370 million, derived from 5,671 stores, mostly on the Chinese mainland, and a market valuation above $ 2.5 billion. 

History provides ready examples that serious financial malfeasance can be facilitated by the over-reaching of small practitioners:

• The multi-year scheme by which Rita Crundwell embezzled $ 54 million from the city coffers of Dixon, Illinois –- where a regional firm issued compilation reports, while the principal of a two-person local accounting practice signed the audit opinions (and was eventually able to contribute a modest $ 1 million in litigation settlement).
• Bernie Madoff’s flamboyant Ponzi scheme, abetted by a sole practitioner practicing out of a suburban strip mall office, who in his plea of guilty to securities fraud acknowledged simply “rubber stamping” Madoff’s fictitious filings.

Providing color to the lurking questions of Centurion’s resource and expertise adequacy are indicators that its relationship with its regulators is generously described as uneasy at best:

• On October 27, 2011, the PCAOB’s inspection report on the predecessor Chan firm found actionable audit deficiencies at two of its then four SEC-registered clients, including failures to obtain sufficient audit evidence relating to the accounting for convertible debt and preferred stock and also compensation expense –- also noting that the Chan firm did not respond when offered the opportunity to comment on a draft.
• On May 19, 2016, one month after the Chan/AWC merger that formed Centurion, the PCAOB announced sanctions against AWC and related parties, including its principal, “Albert” Wong Chi Wai. Among other things, “AWC improperly relied on management representations in auditing cash and revenue and ignored numerous red flags indicating potential fraud and undisclosed related-party transactions.” AWC and Wong were censured, each was penalized $ 10,000, the firm’s PCAOB registration was revoked, and Wong was given a two-year practice bar.
  • According to the Centurion Form 3 filed with the PCAOB on November 29, 2017, the Hong Kong Institute of Certified Public Accountants reprimanded the Centurion firm and imposed a penalty of HK$ 25,000 and costs of HK$ 10,000, apparently related to the above PCAOB proceeding.
• On September 26, 2017, Centurion reported (PCAOB Form 3) that Chan and his predecessor firm were reprimanded by the HKICPA and jointly fined HK$ 30,000 and costs of HK$ 10,000, for breach of the standards relating to non-recognition for deferred tax liabilities in connection with a client acquisition.
• On June 24, 2019, the firm reported (Form 3) the HKICPA’s personal reprimand of Chan and a penalty of HK$ 80,000 and costs of HK$ 36,630, for a client on which Chan was the engagement partner, responsible for mistakes in calculating the company’s loss per share.
• In its press release dated January 15, 2001, the HKICPA announced action against Chan as sole proprietor of the Chan firm in connection with a review report for the period ended December 31, 2018 –- two years after the Chan/AWC merger –- relating to misclassifications and related deficiencies, reprimanding Chan and the firm and imposing a penalty of HK$ 50,000 and costs of HK$ 15,000.

 If Luckin does pursue its re-listing attempt, it will rest with the SEC and the PCAOB whether all or any of this should move the agencies into action.

They could, of course, choose the passive course, deferring under the HFCAA’s three-year non-inspection trigger, leaving investors in the meantime to pour their funds into a hole as black as Luckin’s darkest expresso.  

But should they? The agencies’ tools under the Sarbanes/Oxley regime are all at hand: With its 2021 annual report in plain sight, Luckin’s business plan remains criticized -- its ambitious growth plans fueled by customer discounts at levels that guarantee long-running losses, and little chance to convert to profitability by raising prices, with competition fierce and customer loyalty fickle. 

 While the PCAOB has not reported on an inspection of Centurion since that of its predecessor in 2011, the firm if asked today would presumably deny inspection and workpaper access. De-registration could promptly follow as a matter of course. No re-listing of Luckin would happen -- instead a potential new scandal averted.

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are invited and welcome, and subscription sign-up is easy and free – both at the Main page.        

PwC’s UK Head Is Unhappy -– There Could Be Relief

“When sorrows come, they come not single spies, but in battalions.”

                    -- Claudius, Shakespeare’s Hamlet (IV, v)

How much concern do we feel for Kevin Ellis? He should sit pretty -- senior partner of the UK firm of PwC, which in 2021 clocked up record global revenue of $ 45 billion. The average profit of his UK partners was a league-leading £ 868,000, and Ellis himself in 2020 took home a handsome £ 4.4 million.

Instead, this week’s press attention finds him in a double bind, triggered by the UK’s audit regulator, the Financial Reporting Council. Even in paralysis over its structure and its remit, with the whole topic of “audit reform” on hold as the Boris Johnson government totters for survival between the fiascos of Brexit and COVID, the FRC has seen fit to widen its investigation of PwC’s audits of Babcock International –- expanding from 2017 and 2018 to sweep in the last two years before the firm was replaced by Deloitte.

In the usual grim ritual, the firm’s response was the expected if defensive pledge of obeisance and cooperation:

“We will cooperate fully with the FRC in its inquiries,” said PwC in a statement. “Audit quality is of paramount importance, and we remain committed to our ongoing program to enhance audit quality and to the delivery of consistently high-quality audits.

“The FRC’s annual reviews of our audit work, policies, and procedures show a continued trend of improvement in our work, and we use their insights, together with our own reviews, to continuously improve how we deliver high-quality audits.”

Ellis chose at the same time a gratuitous reprise of his frustration as previously aired to the Financial Times:

“(C)riticism of the audit industry from politicians and regulators was harming the profession and risked making it more difficult to attract new recruits.

“Retaining qualified auditors also ‘becomes much harder, if there’s a current of external negativity,’ he said.”

PwC’s prosperity in the COVID era considered, critics would be tempted to charge Ellis with tone-deaf ingratitude, except that his distress lies in the inability of Big Audit to accommodate two conflicting positions: The profession’s leaders self-confidently resist the recognition of atypical but inevitable instances of sub-optimal performance, while the public’s pointed question in any case of significant scandal is, “Where were the auditors?” 

Little wonder, there is skepticism about the profession’s legitimacy -- among investors and other users, with new graduates exploring their career paths, and as maturing staff decide where to commit their energies and their fortunes.

History teaches that the accounting profession has never rested easily in its relationship with its regulators. In the 1860s, the nascent profession -- counting among its leaders both Messrs. Price and Waterhouse -- fought off legislative attempts to require that government should audit the UK railroads. Its franchise of privately-provided audits of public companies was only later secured with passage of the core American securities laws of 1933 and 1934.

It’s been downhill since. Indeed, with this month’s fourth anniversary of the collapse of Carillion, Ellis might appreciate the FRC’s pointing its limited artillery at KPMG’s former partner and staff, who have turned on each other under charges of manufacturing and post-dating Carillion working papers and other engagement documentation.

Possible relief for Ellis’s dour pessimism is available, although it would require legislation, cooperation, and deep changes in attitude on the part of all the players –- starting with the auditors and including companies, information users, legislators, and regulators.

That is, it is to the profession’s discredit that Big Audit lacks a forum in which audit performance quality can with credibility be investigated, evaluated, and if necessary sanctioned. The available tools are not serving. The FRC -- derided in the post-Carillion studies as “a ramshackle house,” and “toothless and passive” -- is perceived as non-transparent, inefficient, and ineffective. And the legal systems that continue to threaten “joint and several” liability on the scale that destroyed Arthur Andersen in 2002 are seen as ponderous, erratic, and unpredictable.

To address these issues, a tribunal could be designed for “audit failure study” -– drawing on a long and successful history among the other professions. In hospital surgeries and emergency rooms, engineering studies of infrastructure collapse, assembly line disruptions and air and rail accidents, learning emerges in the study of catastrophe, from the inadequate number of lifeboats on the Titanic to the construction deficiencies in the World Trade Center.[1]  

The outputs of a well-constructed body -- given a broad remit, a legislative mandate, and the necessary expert and staff resources –- would:

• Enhance the credibility of corporate issuers’ commitments to quality reporting.
• Support the accountants’ legitimate aspirations and claims of improved performance.
• Provide guidance for standard-setters.
• Offer clarity and transparency to investors and agencies of government.

Resistance would of course be expected. Inertia and preservation of the status quo are never easy to displace. The profession’s leaders and the communities of information issuers and users would all be required as willing participants –- endorsing the value of such a tribunal as a matter of mutual trust and appreciation of its value.

As for Kevin Ellis and his concerns, a credible body for the study of his profession’s quality issues would provide a point of reference to which he would steer the interests of his audiences –- sparing himself the impossible task of preaching to the unconverted and allowing him to focus on more productive efforts. 

 

[1] For an extended examination of the complexities, challenges, and benefits of “failure study,” please see pages 285-292 of my 2017 book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” (Emerald Books 2d ed.)

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are invited and welcome, and subscription sign-up is easy and free – both at the Main page.