Epic Fails

How Big Four au­dit fail­ures let Ukrainian cor­rup­tion slip by

Kyiv Post - - Front Page - BY MATTHEW KUPFER [email protected]

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.”

Global prob­lem

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.

Sav­ing Mriya

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...

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