Auditor Resignations and Consternation

Key Takeaways

It's not often that an audit firm walks away from a client, but there's always a story when it happens. Mike Disabato, host of the MSCI podcast ESG Now, breaks down auditor resignations with the Off the Books crew. Tune in:

Season 3, Episode 22: Auditor Resignations and Consternation | Transcript

Steve Soter: Hello and welcome to Off the Books where we surf the unchartered waters of accounting, finance, risk, and wherever else the waves take us. This episode is brought to you by Workiva, the risk, reporting, ESG, and compliance platform that simplifies your complex work from financial reporting, to auditing, to ESG reporting, to baseball card collecting, and so much more. Check it out at Workiva.com/podcast. My name is Steve Soter, accounting enthusiast and Diet Coke aficionado. I'm looking forward to debiting a great conversation, and I'm happy to have you with us. I'm also happy to have Catherine Tsai joining me. Catherine, can you please tell the fine folks who you are?

Catherine Tsai: I’m not an accountant or Diet Coke aficionado, but I like asking questions, learning new things, and writing about them later. So I'm here to learn.

Steve: Well, we listen to a lot of podcasts here at Off the Books. So when I started learning more about ESG, I came across the ESG Now podcast with Mike Disabato, and I've been a loyal subscriber and listener ever since. Between that and the ESG Talk podcast by our very own Mandi McReynolds, I feel like my personal "E" in ESG now stands for every day. On a recent ESG episode, Mike brought up auditor resignations in China, and the intersection of auditors and ESG was just too tempting to pass up.

Catherine: So we brought in Mike to tell us a little more about what's going on. Here we go. Mike, thanks for joining us today. We'll start off with an easy question. Tell us a little bit about the ESG Now podcast.

Mike Disabato: Thanks so much for having me. Really appreciate it. So the ESG Now podcast is all about discussing some research that MSCI ESG research does. So usually what happens is throughout the week, my colleagues and I will have done research, written research throughout on a certain ESG topic, and we'll meet an editorial committee meeting we have and we'll decide, you know, this this research sounds very interesting. We should kind of dive into a more than a written paper allows. You know you can't have like a candor and a conversation in the same way on a research paper that you can obviously when you're being recorded and talking. So we'll kind of see what we want to dive into more that was more difficult to dive into in the paper. And what do we want to explore more? What's an indication of a larger issue going on in, I guess, society or the economy or just any kind of global consideration that has to do with kind of like an ESG lens. And we do it weekly, and you can get to in anywhere that you get your podcasts. I can just plug there really quick, but really it's a chance for myself and for my colleagues to kind of discuss some of the things that we're really passionate about and explore more ESG issues than could be seen anywhere else.

Steve: Mike, I listened to episode 175. It's called "Resignations and a Looming Crisis in China." And I'll you know, I've got, you know, a little bit of a backstory here. I actually started listening to ESG Now at least a year, maybe a year and a half ago, because I myself was actually interested in keeping up on just what's happening within ESG generally, not just with respect to some of the things happening with the SEC, which of course I look at quite closely for my work at Workiva, and I would actually add to your plug for audience. It is great. It comes out weekly. The episodes aren't long. It's fast paced. You actually have this kind of cool sort of beat music sort of going in the background, which is fairly distinctive. I will say when I listened to that episode—I won't make fun of you too much—but I believe you called the auditing profession "austere." But you were very clear to clarify that the people probably aren't that way, but maybe the work is. So I'll give you a hard time on that just a little.

Mike: Yeah. I mean, you know, I took those words from my colleague who was an auditor, so he discussed the austere nature of it, so I took that from insider knowledge. I didn't want to take that from outside. I've never been an auditor. It does seem like it is serious work. And he confirmed it. He was telling me about his day to day. He used to be a financial auditor of sorts, and I kind of went to him and asked him about a lot of the interworkings that were probably happening behind the scenes since he actually delved into that. But yes, it sure seems austere to me for sure.

Steve: But you bring up a good point about how important the work is. And I found the episode so interesting because as a former auditor myself, and certainly I think a lot of our audience are probably maybe auditors themselves or at least work with their own auditors. That, of course, struck a chord with me. But then the intersection between that and ESG reporting and that significance, you know, now all of a sudden, kind of like the light bulbs went on my head and I was like, okay, you know what? Yeah, this would be an interesting topic because I don't think you see those two worlds intersecting very often. They probably will more and more going forward. But you know, this is one of the first times that I saw that again listening to this episode. And boy, we were just we're really excited to bring on and have you talk a little bit.

Mike: Yeah, great. Yeah. Fire away.

Catherine: What was it about the auditor resignations in China that made you want to talk about it on ESG Now?

Mike: So the episode itself really, you know, I was forefront and center because I host the podcast, but really all the work, all the research was done by my colleagues Sophia Cheng and Yan Zhou because they cover the sector. And so they're really knowledgeable about what's going on in China. They actually are based out of China, so they understand the Chinese real estate market, both through a regulatory perspective, but also kind of, you know, a cultural perspective, which is, from what they tell me, the real estate market is a big part of the culture of China. I think it employs 10% of the people in China. You have to check that number, but I think it's around there. So it's kind of this behemoth both in the country economically but also culturally, people getting a house. I think that's everywhere. And it's in general a question of governance at these property companies. And since governance is the linchpin of ESG, we want to talk about, and so what Sophia and Yan saw was that PwC quit as an auditor at three developers: Ronshine China Holdings, Powerlong Real Estate Holdings—I apologize if I'm pronouncing these wrong—and Shimao Group Holdings. And then PwC quit at two linked property management companies: Ronshine Services Holdings and Powerlong Commercial Management. And this is all going on, and then we're paying attention to the rumors of this debt crisis spreading in the Chinese real estate market. So, we saw these kind of moves by Chinese real estate markets to establish risk committees to show that they have good governance, that they're dealing with the debt influx. But then all of a sudden, those committees started to say, well, we can't release audited reports yet for the year. And people started to get worried. And there was a company that we were looking at that kind of symbolized this. And, you know, not just for us, but I think for a lot of people. And that's Evergrande, and Evergrande is this giant, you know, for anybody that's isn't aware, it's one of the biggest real estate companies in China. It's actually one of the most indebted companies in the world. And that's because it was both growing really fast and there was this hunger that we saw from foreign investment to put capital into the Chinese real estate market because they saw its opportunity for growth. And, you know, that's what the capital markets did. And so we saw that people weren't really worried about this leverage because they were saying, well, China would never let a company like that fail. And we saw so, you know, it's not like China was unaware of this. The Chinese government was aware of this problem. They were aware that the industry was growing too quickly, that companies like Evergrande were becoming like the Lehman Brothers in the financial crisis in the U.S. And Sophia and Yan were writing about this all throughout this crisis. So, when they wrote about the fact that in 2020 that the Chinese government told companies to slow down their mortgage issuances and created that policy that we talked about on the podcast called the three red line policy, where there are these three debt ratios that these Chinese real estate developers had to meet if they wanted to gain access to those foreign bank loans that were allowing them to grow. And then all of a sudden, once those three debt ratios were issued, no one could get access. So it was really hard to get access, and the loan market dried up really quickly. And then we saw these auditors resign. So Sophia and Yan were watching this writing about it. They reached out to me and they said, you know, this is a huge looming problem. China's one of the economic drivers of the world. Let's do an episode on it.

Catherine: And I take it auditor resignations are not all that common, is that right?

Steve: They're not common at all. And actually, for the most part, I think auditors try to avoid resigning. I mean, there's I'd say a couple of categories of auditor resignation. So the first would be simply that they can't do the audit. Maybe the books and records are a mess. Maybe it's a young company trying to go public, and they brought in auditors, but maybe they weren't ready for that work yet. Or there could be some independence issues, meaning that the auditor would actually rather be a consultant to the company. But if they're consulting the company, then they can't audit because they can't audit their own work, otherwise they wouldn't be independent. So I'd say there's those reasons there. But to me this sounds like, and I guess this is just conjecture here, but it sounds like the liability risk for the auditors is going to be too high. Again, if you mentioned those, you know, kind of like three red lines or whatever, if I as an auditor sort of validated and certified as to the financial statements but then it turns out that somebody had questions about the financial statements or, you know, maybe something happens later that calls that into question. You wouldn't want to be the auditor of those financial statements simply because they may not be able to be relied upon. And probably the most recent fairly public example is actually when Mazars USA cut ties with The Trump Organization, saying that The Trump Organization's financial disclosures—I think was like nine years of financials—couldn't be relied on. And that was in the wake of the accusations that The Trump Organization had inflated the value of its real estate portfolio. Well, supposedly the auditor's opinion would have reassured everybody who was using the financials that everything had been valued correctly and whatever. And so in light of those accusations, the auditor basically had to pull out and say, "Hey, I can't cert for these anymore." I just wonder if maybe that was part of what was happening in China, if PWC got concerned about hey, this is too high profile, or these companies might be headed towards default because they can't get any additional loans. I mean, again, it would all be conjecture, but I suspect that had a lot to do with it because at the end of the day, what the auditors have to stand on is their brand and their credibility. So they are very hesitant to do anything that would put that into jeopardy.

Mike: Yeah, I mean, that's exactly what we were seeing. I think, you know, the insider details. I think when we were also thinking about it is when we look at, you know, the type of relationships that people within a company have, I think that's a big part of governance. You know, what's the compensation? What's the structure they've set up to actually deal with any conflicts of interest? Who is actually being incentivized to do what? And one of the things that we thought about was the fact that, you know, auditors get paid by the companies that they're auditing. They are an important partnership. And from our understanding, auditors do everything they can to avoid quitting. They can issue a qualified opinion, auditing opinion. And they say, you know, we don't trust these financial statements, but they still get to keep the client. They still get to keep the relationship. They try to make sure that next time they don't issue a qualified opinion. They try to work with the executives, work with management to make sure that's not going to happen. And so when all of a sudden they do quit—I think exactly what Steve said—there must be this fear of reputation. And, you know, we don't know why. I mean, I want to be really specific here with our story on the Chinese real estate market. We don't know why PwC quit. They didn't come out and say, you know, we talked with the CEO and everything's not great. They just resigned and that was it. And then that goes back to the kind of austere thing I meant, where it's not like we actually understand what happened. We can infer. We can discuss the kind of relationships there are. I think, Steve, you said well about what those relationships are, but we don't actually know in detail what was going on. We can only kind of use the data we have to make an assumption.

Catherine: We were also wondering a little bit about the background of what's all been happening. So we know that there's been a history of the Public Company Accounting Oversight Board, PCAOB, and the SEC trying to look into work papers of auditors of companies in China. Steve, I'm probably doing a bad job of explaining this, but can you talk a little bit more about the history there between U.S. authorities trying to look into the audit work that's going on with companies in China?

Steve: Yeah, I can give a little bit of background for the audience. I mean, one of the things that happened as part of Sarbanes-Oxley, or SOX as it's called, that's now 20 years old. But in the wake of, you know, Enron in particular, where the relationship between Enron and its auditors, Arthur Andersen at the time, of course, that was highly inappropriate for a handful of reasons. So the SEC created this regulatory body called the Public Company Accounting Oversight Board, the PCAOB, and it was their job to police the auditors. It's an independent agency. It does kind of report into the SEC, but otherwise independent, and inspects the audit firms. So in that case, that had the PCAOB been involved in let's say Arthur Andersen and Enron, they would have come in, done inspection, and said, hey, you know, the relationship was inappropriate or you weren't independent or, you know, you certified on these financial statements that we think they're full of errors or whatever. So that's been around for a long time. But recently, one of the challenges that we've been noticing is that the PCAOB has been unable to inspect the audits of Chinese companies who are listed in the U.S. So when you've got access to the U.S. capital markets, of course, and the SEC has jurisdiction, so they say, look, if you want to get access to our capital markets, you need to provide audits, and those auditors need to be inspected by the PCAOB. Well, that hasn't been happening. I actually suspect that that's maybe more of a separate thread to this whole story. I don't think that in that case that would have prompted the resignation by PwC perhaps. But I think it's an interesting question and it may go back to what was really going on behind the scenes, because if PwC was aware of maybe significant accounting issues or whatever, and then knowing that a potential inspection could, you know, introduce something, I don't know. And actually the other question would be, are these companies even listed in the U.S.? Because if they're not, then the PCAOB actually would have no jurisdiction. But I think it's an important question, Catherine. I'm not sure it's one we can find an answer to.

Catherine: Why don't we take a quick break and we'll get right back to Mike Disabato.

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Steve: Now let's get back to Mike Disabato of the MSCI podcast ESG Now. You brought up both in the episode, as well as what you shared just a little while ago, the governance issues that it appears that these Chinese companies may have had. And if this whole incident that you were talking about in the episode might help reveal why the "G" can be so important just for ESG considerations, generally.

Mike: We kind of see it as is the linchpin of everything to ESG. So if you don't have a governance, a good governance structure, you can have, for example, the most ambitious carbon reduction plan out there. But if you don't have a leadership committee that's actually either structured in the right way or in the most effective way or behind that plan, or involve the people that are trying to take account of more than just one stakeholder that have independence behind them. You're not going to be able to get that carbon reduction plan put into place. You need a structure and a body that actually can bring about all these policies, all these plans, all these ideas, and agendas that we talk about any issue that can avoid long-term financial systemic risk. And if you have a body that, let's say, is a founder and a chairman where they control the company and they own over 50% of the company, and they can kind of say where things go. It's not like that's bad inherently. There are some really good founders out there that push companies in really good directions. But there is this worry that if one person decides, you know, this isn't where I want to go and it's a publicly traded company, and you have all these shareholders that there's not going to be that kind of democratic process that we like to see. And so what we look at in governance is we look at whether or not there's that democratic process in place, whether or not they have these structures in place that will work toward the avoidance of those long-term financial risks. And so let's keep with kind of the story that we're talking about with China Evergrande and these auditors resignations. If you look at the fundamentals of the company with China Evergrande, they only have three out of nine independent directors that don't have a vested interest in other aspects of the company that can't say, "You know, hold on, maybe, maybe we shouldn't go down this path. Maybe this is going to be, you know, management's pushing for something, but maybe we should hold off. Maybe we should kind of try to assess the risks." The owner, the founder, and chairman of Evergrande, Hui Ka Yan, which I hope I pronounce that right, he owns 77% of the company. So it's a highly controlled, highly levered company that, by the way, isn't alone in the Chinese real estate market. When you look at these companies that have auditor problems and then they're also highly controlled and they also don't have independent directors, you start to see these issues of governance that might kind of be a signal of a looming long-term risk. And the best way to see that is to look at how the leadership is structured, and the way to look at how leadership structured is to look at governance. And if you want me to give you the spiel on how we look at governance, we look at corporate governance and corporate behavior. We look at ownership and control, how the board is made up, how pay incentives are put together, what the accounting structure is—do they have an independent audit committee that's actually going to be trying to make sure that what the company is telling the public is right or wrong? And then with corporate behavior, we look at things like business ethics and tax transparency. So that's kind of more minutia there. But really, in sum, what governance is used for in ESG is to make sure that the company has the structures in place for it to be run, for the best possible outcome for all stakeholders involved. That includes shareholders. In our mind, that includes the community that they are involved in and that includes the environment that they rely on. That includes their workers in the labor pool that they're trying to recruit and bring in to make themselves the company.

Steve: And I wonder, Mike, if looking at all of these things colliding, as it were, you know, a company like PwC, who, again, their brand and their reputation is just so important, decides, you know what? The juice isn't worth the squeeze right now. This is an unacceptable level of risk potentially going forward. Hey, we've got to bow out. And it's not like an audit that we could salvage through a qualified opinion or one of those other, you know, tools that you just mentioned. And we've got to get out completely just for fear of something blowing up down the road, and then we become part of it just by association.

Mike: Yeah, for sure. And I think that's something we're always going to pay attention to when a move like that is made, when the governance structure actually decides to make such a such a public and such a disruptive move like that. It's going to immediately hit our, you know, hit our systems. We're going to immediately start to research it, and we're going to try to figure out what's going on.

Catherine: So one more speculative type of question for you. With the SEC proposing requirements for climate disclosures now, do you foresee a time, either one of you, where audits of ESG disclosures would be similar to audits for financial statement disclosures?

Steve: Catherine, I can surmise that, you know, at least with the way things are going, both with the SEC's proposal as well as other regulations across the globe, I think that audit component of ESG disclosures is going to become increasingly important. Does an ESG audit—I say that kind of in air quotes because there are, of course, could be multiple types—does that look exactly like a financial statement audit under the same kind of timelines that we're used to for the financials? I don't know. It's an interesting question. It's actually one of the things that the SEC asked for comments on is, you know, if you're a calendar year company, meaning that your accounting period goes from January to December, you're going to have your audit wrapped up and you're going to file your 10-K by February or March if you're a U.S. public company. Greenhouse gas audits and emission audits, if companies are getting those audited, you know, that's generally not happening until quite a bit later. And so that's actually something that I think it'd be interesting to see what that intersection could look like. You know, could you get an emissions audit done in time just based on the technology and the data sources that exist today? I think that's a big question. I think the other thing is that to the extent that you would put that audit inside of a 10-K, for example, let's say you had a separate company that was doing that emissions audit. You would actually still have to have your financial statement auditor go in behind that and review that work just because that audit is being included and disclosed in a 10-K. And so it actually creates a question about efficiency, cost, and timing. Does it make sense to have another company doing my emissions audit if I'm still going to have my financial statement auditor have to go in and review that? And I think those are kinds of questions that companies are answering, which, you know, I think over time we'll see how that all aligns and settles out. But I certainly think it's an interesting question. Any other kind of final thoughts or observations that you might share about the auditor resignations in China?

Mike: Just to plug the importance of, you know, good governance structures. Auditors report to an auditing committee. We in ESG look at how independent that audit committee is. You know, who do they report to? What happens when they see a problem? I think this just reinforces the fact that any governance structure is only as good as the mechanisms they have in place to kind of save a company from itself. And if there's independence, if there is good ownership in control, if there's democratic processes in place, shareholders are listened to, and if all those things could coincide, then you could take a company that has a lot of leverage and is very risky and you can weather through a lot of storm. And I think that's the exact same thing when we look at climate change, when we look at reducing emissions. It's a very difficult thing to navigate. If you're a company that has 90% of your revenue from oil and gas, you need a good, knowledgeable, effective governance structure to figure out how to decarbonize if you want to do that, if that's something you see as something you need to do. You have to have a leadership team that knows how to do that without forcing a number of layoffs or hurting people that depend on the energy that you produce that are low income or more at risk. So this whole story is a plug for the importance of governance in ESG, the importance of understanding how a company is structured, and the importance of listening to ESG Now for understanding all those things intertwined into one.

Steve: Now, Mike, we try to end each of our episodes with maybe a more lighthearted kind of closing question of the day. And the question that I wanted to ask you is that you've been doing this for quite a while. I'm sure you have learned a lot, seen a lot, thought about a lot of these kind of ESG issues and their overall impact on the broader economy. I'm wondering if you don't mind sharing with us, is there anything that you are doing today to try to be maybe a little more ESG conscious in your own life that maybe would not have occurred to you when you kind of got started doing this sort of thought leadership? And if there is, if you would mind sharing, what is that?

Mike: Well, I actually I haven't really changed much since joining MSCI. I had kind of a circuitous kind of a linear of a chaotic route getting to the ESG space. For me, I think the biggest thing that I kind of took to heart was I don't eat as much meat as I used to. I used to be a vegetarian. Then I stopped being kind of evangelical about that, and now I just eat less meat. I think it's understanding a couple of things that you as an individual don't have a lot of control over what's going on with climate. I think climate is a big part of what people think about when they think of ESG. You know, even though climate is only a small part of ESG, but still people can help think about that. I think there's a lot of climate anxiety going around right now for good reason. I think as you start to look more and more at what companies are doing, you start to kind of feel that climate anxiety builds. Are they going fast enough? What can I do to actually make a change? Realizing that you can't really do a lot. There's a lot of responsibility in these large corporations. And so dealing with that climate anxiety, that's kind of something I've tried to have to figure out how to deal with it. And even though you might be thinking, "You know, I can't really do much if a massive utility is not going to change its energy mix." I say the thing that kind of helps me navigate that is thinking of little things that I can do in my personal life that make me just kind of a little bit less, feel a little bit less out of control than would be beforehand. But other than that, no, not that much has changed. I mean, I read about this a bunch before I joined. I like reading about everything that's going on ESG as I'm at MSCI, and I'm assuming I'm going to be interested in it for years to come.

Steve: That's an interesting sort of journey, I guess, like as you kind of think about sort of the way that you have thought about it and reacted to that. I appreciate that. Catherine, anything that comes to mind on your end?

Catherine: I think I just have a greater appreciation for consuming less, because if we talk about replacing fossil fuels with renewables, it's a great first step. But really it comes down to using less. Can I run my air conditioner less? Can I turn off lights that I don't need? Can I use an air fryer instead of my oven to cook because it uses less energy? How about for you?

Steve: Well, you need to come talk to my kids about turning off lights. That might be the most common source of conflict here in the Soter house, but more specifically, Catherine, you, of course, know this. Our audience knows this. Mike, you probably didn't. But I made a I'm a vowed Diet Coke aficionado. I probably drink way too much of the stuff. And so when I go to a restaurant, of course, I will get a soda and they will give me a cup. I have stopped getting straws and lids even when I refill that cup on my way out to take it with me. And I know that might seem like a small thing, but as I think about single use plastics, it seems fairly unnecessary for that 10 or 15 minutes or whatever that's going to take me to go through the rest of the soda. So there have been a handful of spills in the car as a result of that, but that's been something that I've been willing to put up with.

Catherine: My husband will be proud of you. He's very anti-straw So, good job, Steve.

Steve: Oh, okay. Hey. Well, there you go. For Father's Day last year, I got the the reusable straws, and we continue to use them and they're great and everybody loves them. So just a little bit at a time. Well, Mike, thank you so much for coming and for joining us for lending that insight again. I think it's just such an interesting kind of intersection of some of the things we talk about from a financial reporting perspective, but also some of the considerations from the ESG perspective overall. So we just really appreciate you joining us and sharing the perspectives of this. Thank you.

Mike: Thanks so much for having me. I really enjoyed it.

Steve: And thank you, dear listener, for surfing along with us. I'm Steve Soter.

Catherine: I'm Catherine Tsai.

Steve: And this has been Off the Books presented by Workiva.

Catherine: Please subscribe. Leave a review. Tell your buddies if you liked the show, and feel free to drop us a line at offthebooks@workiva.com to tell us what you'd like to hear us discuss on upcoming episodes.

Steve: Surf's up and we'll see you on the next wave.