Expanding Audit Practices Too Quickly Opens the Door to Danger

Over the past several months, there has been much discussion about the quality of audits performed on special purpose acquisition companies, particularly by two accounting firms that at one time were performing 90% of the audits on these shell companies designed to find a private company to acquire.

Marcum LLP and Withum Smith+Brown PC have dominated this space, which was advertised as providing a more direct and less expensive approach to a traditional initial public offering.

The popularity of SPACs exploded from 2020 to 2022, prompting scrutiny from the Securities and Exchange Commission and the audit firm regulator, the Public Company Accounting Oversight Board.

What was seen as an extraordinary market opportunity by these two firms has resulted in an unusual level of regulator scrutiny that led Marcum to agree to pay a settlement of $13 million to the two regulators.

There’s more than the fine to Marcum’s settlement. The firm must implement mandatory continuing education for all audit staff, form an audit oversight committee, and hire a chief quality officer. It also must hire an independent consultant to recommend quality control improvements and agree to implement all the recommendations.

The PCAOB said it was the first time it “has ever required functional change to the quality control supervisory structure of a registered firm.”

What Marcum and Withum have in common is a disproportionate acceleration of the size of their audit practice by taking on these SPAC clients. Form APs must be filed with the PCAOB to indicate the audit partner on all public company engagements. If financials are revised, this form must be filed again. So the total Form APs may overstate the number of audit engagements a partner is working on.

Still, it’s a good measure of audit partner workload. Sandy Peters of the CFA Institute reported that Withum’s Form APs grew to 1,085 in 2020 from 137 in 2019, with six different partners being identified on more than 100 Form APs each. Those six partners were cited in total on fewer than 100 Form APs the prior year. One Marcum partner had over 300 Form APs in 2020.

Much has been made about these firms (and others) getting the accounting wrong for warrants and for classifying the liabilities tied to the characteristics of the shareholders as equity, resulting in restatements of financials and reissuances of audit opinions. But if you do something the same way consistently, you’ll be right or wrong 100% of the time.

Marcum and Withum may have underestimated their exposure, because the shell SPACs really had no assets or liabilities to audit for the most part. The audits seemed like they’d be straightforward and uniform across clients, allowing for unusual efficiencies.

Quality Control Problems

The real problem unearthed by the SEC and PCAOB investigations was the lack of quality control at Marcum. A primary reason this was revealed is that Marcum underestimated the inherent nature of the clients themselves, as well as in the impact on their audit staff of managing that level of rapid growth.

Marcum not only missed the generally accepted accounting principles issues that everyone missed, but it also failed to comply with a variety of PCAOB auditing standards.

A growth orientation is likely to make a firm understate these risks. Firms such as Marcum and Withum are understandably drawn to cutting-edge companies and innovative financing strategies. But several tendencies undermine their objectivity and professional skepticism with these companies.

It’s easy to advocate for these firms and root for their success, particularly if you hope to keep them as clients after they go public.

Many accounting firms want to be identified with their clients, particularly if they’re cutting-edge companies. This is true for SPACs, crypto companies, and cannabis businesses. These are high-inherent-risk companies both because of the nature of the product or service provided and because they’re magnets for regulatory scrutiny.

Prager Metis was famously the first CPA firm to open an office in the Metaverse; it also was unfortunate enough to have FTX Trading Ltd. and its CEO, Sam Bankman-Fried, as a client. Elsewhere, a number of small firms are seeking to identify themselves as “cannabis CPAs.” In both types of companies, the variety of regulators interested in their operations is significant, exposing the firm auditing them.

Bloomberg Tax reported in October that more than 90% of SPACs were trading below their initial price of $10 a share, and one in six was trading below $1. Objectively, if 90% of SPACs have lost value, you should expect a raft of lawsuits addressing this problem.

Something systematic is going on here, either in misunderstood risk by investors or a lack of disclosure by companies. But no rational person wants to invest in a space where 90% of the companies lose value. And CPAs in this space know what that means in terms of legal exposure.

Rapid growth is great news for accounting firms. But when it takes place in situations of significant information asymmetry between companies and investors, CPA firms should beware. SPACs are a classic example because no one even knows what company will be plugged into the SPAC when the initial investments are made.

Of course, certain companies have motives to obscure information, particularly related to trade secrets and strategy. But when information asymmetry and regulatory avoidance are particularly strategic to a company’s existence or profitability, as with crypto and cannabis, CPA firms need to be careful. Because sometimes for these firms, the cutting edge can become the bleeding edge.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Michael K. Shaub is clinical professor of accounting at Texas A&M University.

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