How Big Four audit failures let Ukrainian corruption slip by
By all appearances, the Mriya Agro Holding was a powerhouse. Its land bank neared 300,000 hectares. Its shares were listed on the Frankfurt Stock Exchange, six years running. It launched its own agronomy training center for its employees.
Then, in 2014, the company abruptly failed to pay its creditors and announced a technical default. It turned out that Mriya’s owners had allegedly embezzled $300 million of investors’ money. The company owed $1.3 billion in debt. Its CEO, Mykola Huta, landed on an Interpol wanted list and fled Ukraine.
Large-scale corruption is not out of the ordinary in Ukraine. But Mriya’s books were audited by Big Four accounting firm Ernst & Young. EY had given the company its stamp of approval — for several years running.
“Ultimately, I think it’s negligent that they didn’t pick it up,” says Simon Cherniavsky, Mriya’s current CEO, who was appointed by the creditors.
Oleksiy Kredisov, EY's country manager in Ukraine, refused to respond, citing "contractual confidentiality clauses" with clients and former clients.
Mriya is not Ukraine’s only outlying audit failure.
Significant corruption has been found in Ukrainian companies that were audited by the Big Four — a term which refers to the firms EY, Deloitte, PricewaterhouseCoopers and KPMG — that audit 99 percent of the top 100 companies on the London Stock Exchange.
And the problem is not confined to Ukraine. Big Four auditors increasingly face criticism for their failure to detect fraud. This raises a difficult question: who’s to blame — negligent auditors or a public that expects too much from accountancy firms? Founded in 1992 by the Huta family, the Ternopil-based Mriya rapidly grew to be the largest agroindustrial company in Ukraine. In 2008, it debuted on the Frankfurt Stock Exchange, soon after releasing millions in Eurobonds.
Yet the company had a dark side.
In 2011 and then in 2013, Mriya began raising large amounts of debts. It appears the firm was suffering operational losses, says Cherniavsky, while the Hutas were living luxuriously. Soon, they found themselves in a situation where Mriya had to take on more and more debt to finance the losses and deliver the key performance indicators the investors expected, the current management says. Eventually the scheme collapsed. “How did the investors not see it coming? Here there’s an element of trust that was put into the audited statements,” Cherniavsky says. “They were audited by a Big Four company. For many investors, that is sufficient compliance for them to invest.”
When new management arrived, they were in for an unpleasant surprise. Mriya’s land bank was actually only 180 thousand hectares. The previous owners had stripped and sold off the harvest of 2014 and a significant amount of farming machinery. And several other businesses owned by the Hutas — a sugar-processing factory, a logistics company, and a port-construction firm — were never transferred to the new Mriya, despite being financed with creditor money.
It wouldn’t be the last such case in Ukraine.
Vanishing $5 billion
In December 2016, amid rumors of massive insider lending, the Ukrainian government nationalized PrivatBank, whose assets then amounted to 20 percent of the country’s banking sector. It found a hole in the bank’s ledger of Hr 148 billion ($5.5 billion).
After the state took control of PrivatBank, more details came out. National Bank Governor Valeria Gontareva announced that the bank’s entire corporate loan portfolio had gone to companies closely tied to its previous owners, oligarchs Igor Kolomoisky and Gennady Bogolyubov.
The National Bank also accused the two men of embezzling money from PrivatBank through loans to shell companies backed by faulty collateral.
Like Mriya, PrivatBank was audited by a Big Four firm, PricewaterhouseCoopers (PwC), whose audits failed to uncover serious issues. In response, the Ukrainian authorities stripped PwC of the right to audit Ukrainian banks. This month, PrivatBank sued PwC for $3 billion for its failure to uncover the fraud.
Who’s to blame?
In both of these cases, the companies’ new management places the blame on the audit firms. But not everyone agrees that’s a fair assessment. Even international auditing standards can fall short of the craftiness of Ukraine’s corrupt actors.
Illia Neskhodovsky, a tax expert at the Reanimation Package of Reforms, says there are two sides to the problem. In the case of PrivatBank, he believes the bank used extremely complex schemes to conceal its loans’ end beneficiaries.
Because of this, he says, it’s difficult to blame PwC. “By law, PwC did everything correctly,” Neskhodovsky says. “It did the audit in accordance with international standards.”
On the other hand, he says, auditors in Ukraine are often weakly regulated. Big Four firms can use their reputations to sail through quality control.
Alexander Paraschiy, head of research at Concorde Capital, raises similar issues.
In the case of Mriya, he says that there was significant unbalanced debt from other Huta-owned companies that was not included in the agroindustrial firm’s financial statements. But Mriya also never hid that it had other assets that weren’t listed in the statements. The auditor should have paid closer attention to this, he says.
“This raises questions about the auditor…but you probably can’t make serious accusations.”
In PrivatBank’s case, says Paraschiy, there may be more fault. He suspects a conflict of interest, perhaps with the PwC auditor both auditing the bank’s financial statements, and consulting with it about defending its assets from raider attacks.
Both Mriya and PrivatBank’s failed audits, however, also indicate a larger problem in Ukraine’s business climate. Neskhodovsky says that audit firms often hesitate to point out problems in clients’ financial statements. They’re afraid of losing business.
“In our society, if you give a big client negative reports, you will lose all your clients,” Neskhodovsky says. “We have a lot of businesses in the shadows and our businesses use many schemes to minimize taxes.”
Epic audit failures are not restricted to Ukraine. In fact, Big Four firms are increasingly coming under fire around the world. Some say this has to do with changing, ill-defined demands on auditing firms.
Currently, the U. S. Federal Deposit Insurance Corporation (FDIC) is seeking $625 million in compensation from PwC after a judge ruled that PwC had been negligent by missing massive, obvious fraud while auditing Alabama’s Colonial Bank. FDIC will likely collect the largest damages in history against a global accounting firm.
In January, India banned PwC from auditing listed firms for two years after it failed to uncover $1.7 billion in fraud at Satyam Computer Services. In April, South Africa banned Big Four firm KPMG from auditing state institutions for ties to companies accused of graft.
Part of the problem is that, over time, society has consistently raised its expectations of audit firms, says accountancy expert James Peterson.
He would know. He worked for 16 years as an inside counsel at Arthur Andersen, a global accounting firm that collapsed after its client, energy trader Enron, was implicated in one of the largest fraud scandals in U.S. history.
Auditors today are expected to monitor corporate behavior, guard the public interest, predict failure, and protect investors, Peterson told the Kyiv Post.
Additionally, auditing standards state that an auditor must be alert to the possibility of fraudulent behavior by the client, but not that the auditor must search out fraudulent behavior.
“That’s a subtle difference, but enormously important,” Peterson says.
Ian Gow, director of the Melbourne Center for Corporate Governance and Regulation, believes that the standards ought to better reflect whether it is auditors’ job to detect fraud.
“There’s this notion that, because you can’t always detect fraud, it can’t be [the auditors’] obligation to detect it,” he told the Kyiv Post. “I think that’s a stretch.”
The problem also stems from the market pressures on the Big Four, he adds. A firm that offered a more intense audit for a slightly higher price would probably not find a market for its services.
Moreover, companies feel that if they hire one of the Big Four, they have covered their bases.
“Since there’s safety in numbers on the demand side, it creates a phenomenon where the Big Four don’t have an incentive to go above and beyond,” Gow says.
Since 2014, Mriya’s new management has fought to save the agro holding. The company is tied up in legislation to win back company assets — including a logistics base and a potato storage facility — that the Huta family has “repossessed” using men CEO Cherniavsky terms “bandits.” But Cherniavsky remains optimistic that his team will prevail.
The company has also reached an agreement to enter into consensual restructuring. However, the creditor’ actual recovery will only be in the range of 10–15 percent of what they originally invested.
Mriya has not sued EY for failing to uncover the fraud during its audit. In fact, to this day, they can only guess why EY missed it.
“I think it was a combination of a very well-planned fraudulent scheme that the auditor didn’t see or understand,” Cherniavsky says, “and I also think the auditor didn’t dig deep enough…and took the word of management on certain transactions.”
A window washer works at a PrivatBank branch on June 1, 2017, in Kyiv. Before being nationalized in 2016, the bank suffered $5.5 billion in losses mainly due to allegedly fraudulent insider loans benefiting former owner and billionaire oligarch Igor...