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EY Thought the Weatherford Audit Could Turn Out Badly; It Turned Out Badly

I'm not sure if there's a pattern or not, but it sure seems like the Big 4 take turns being the poster child of sloppy auditing. Sometimes the stretch is long and sometimes it's short, but it's inevitable that something blows up and one firm will be back on top as the King of Failed Audit Mountain while another falls off. 

Lately, the firm at the top of this heap has been Ernst & Young. Although this particular reign is only about a month old, it's pretty spectacular. It started last month when the SEC charged the firm and a number of its partners with violating independence rules thanks to some chummy and romantic relationships with clients. The slump continues this month with news that the SEC is fining EY $11.8 million over its failed audit of Weatherford International. Between the two, it's a shade over $20 million in fines which the firm can probably find in a couch at 5 Times Square, but then again, these SEC enforcements are never really about the fines; it's about firms that rely on their reputation as gatekeepers getting egg on their face. 

And, holy Moses, is that ever the case with this Weatherford audit. EY knew that this audit was an accident waiting to happen and yet they foolishly soldiered on, seemingly thinking that, in the end, everything would be fine. It was not. In fact, it was worse because Weatherford went beyond just crappy accounting, their executives were committing fraud and EY missed it.

Here's a selection from the SEC order that describes EY's early assessment of Weatherford:

I wonder what the circumstances have to be for an audit firm to drop a client that is "[a] significant risk to the firm" that could cause "the firm […] damage to its reputation, monetarily, or both."? Would the client have to be openly engaging in and admitting to fraud? Even then, I'm not so sure an audit firm would drop the client in every scenario. In EY's case, this just earned Weatherford an extra watchful eye as a "close monitoring client."

So what prevented EY from leaving Weatherford? Money, of course! When the fraud began in 2007, Weatherford, "was, based on audit fees, Ernst & Young's 14th largest close monitoring client firm-wide and the fourth-largest close monitoring client in its Southwest Region." In 2008, the company was the 13th and 3rd largest close monitoring client nationally and in the Southwest Region, respectively. And in 2009, Weatherford ranked 8th and, yep, 1st nationally and in the Southwest as a close monitoring client. Year after year, the fee pressure was building.

The two EY partners charged in the SEC action were Craig Fronckiewicz (still with the firm) and Sarah Adams (left the firm in 2014). And in Adams's case, the order shares at least one instance where a perplexed staff member spoke up about aspects of the company's tax accounting that made no sense:

That was for the 2007 audit. For the 2008, it gets even worse:

Just think about the nightmares that tax manager must've been having. I imagine a dividend exclusion adjustment jumping out of a computer screen to eat her alive.

In 2009, again, things got worse as the tax manager had quit and "the audit work for Weatherford's consolidated tax provision principally fell to two tax seniors who had previously worked on the Weatherford engagement, one of whom had not yet passed the CPA exam." Things continued to be awful.

To the firm's credit, they finally got it right during the 2010 audit when Weatherford's VP of tax started getting extra sloppy. By then it was already too late and in early 2011 the firm started announcing restatements. Five years later, here we are!

These SEC orders are insightful in a lot of ways but the human element is by far he most interesting to me. The conflict here is incredible. And I'm not talking about good ol' fashioned audit firm conflict, I'm talking about the conflict a partner must feel when he/she knows a client is a ludicrously risky and has a good chance of blowing up, but also has some LOB leader breathing down his/her neck to make it work because MONEY.

When faced with a scenario like Weatherford, partners are bound to lose no matter which choice they make.

[SEC Press Release, Order]