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More Audit Failures are Likely

June 22, 2018

In the wake of several accounting scandals and audit failures, regulators and investors have suddenly started to take action.

 

In the last few days, the FRC (itself the subject of a long overdue, independent review by Sir John Kingman) announced that it had sanctioned PwC and its audit partner in relation to the 2014 audit of BHS, fined KPMG for its 2013 audit of Quindell, and censured KPMG for an ‘unacceptable deterioration’ in the quality of its audits, placing it under special supervision. Separately, the FRC announced an investigation into the 2009-2011 audits of Autonomy. However, a report on the 2012 audit of the failed Co-op Bank is still awaited. Investors have also been baring their teeth, with KPMG’s appointment as BT’s new auditor following the accounting fraud at BT Italia, likely to be challenged by some shareholders, which rarely happens in the world of auditor appointments.

 

There is now widespread recognition that the external audit process and the accountancy regulatory function is systemically flawed. Although fines levied on firms by the FRC have increased, the time taken by the FRC to complete its investigations is unacceptably slow, while there are clear conflicts of interest within the FRC, comprised as it is of some former Top 4 partners responsible for examining the conduct of their former employers. Fines levied by the FRC are not distributed to those directly affected by audit failures, but are paid to the ICAEW which covers the cost of the FRC’s investigations into ICAEW member firms. This makes no sense. It seems likely that the Kingman Review will, at least, recommend that the FRC is independently funded and that fines should not be paid to the ICAEW.

 

Elsewhere, suggestions (from MP’s and others) that the Top 4 should be broken up would not, we believe, improve the quality of the external audit process. Large, multi-national corporations operating in multiple jurisdictions are complex beasts; the Top 4 accountancy firms evolved, via a series of mergers from the Top 8, to the Top 6 and now the Top 4, precisely to deal with the complexities and global reach of many companies. Breaking up the Top 4 is unlikely, in our opinion, to result in any improvement in the integrity and reliability of audited financial statements.

 

For companies and investors, the integrity and reliability of audited financial statements is fundamental. However, neither party, we believe, takes a sufficiently active role in ensuring that the highest standards and sufficient measures are applied to ensure that audited financial statements are actually reliable. A succession of audit failures, with the finger pointed firmly at the auditors, means that fundamentally wrong numbers were signed off by the auditors who failed to ask the right questions. However, the source of the numbers is the company being audited.

 

In the case of Carillion, the Board of Directors, with a number of qualified accountants among its ranks, approved a significant goodwill number based on the premise that it was capable of continued measurement and did not need to be impaired during the annual impairment review. They approved a nonsensical number because they never considered the commercial realities that might underpin the number. Similarly, the auditors, given a roasting by the Commons Select Committee, tried to justify their ratification of a nonsensical number on accounting grounds, but without any consideration paid to the commercial realities facing a contractor like Carillion. In short, neither management nor auditors applied an ounce of common sense.

 

Carillion won’t be the last auditing failure. In fact, we believe there will be a succession of audit failures over coming years. You only need to walk down a high street to realise that retailers are struggling. Toys R Us and Maplin are no longer, House of Fraser, New Look, Mothercare, Marks & Spencer, Carphone Warehouse and others have announced major store closures, while other prominent chains are struggling. The commercial realities are that high street chains are facing huge competition from on-line retailers, while fixed costs are high, partially due to onerous rents. However, a cursory look at the audited balance sheets of 5 quoted high street retailers with a combined market capitalisation of £60 billion reveals that, in aggregate, these are carrying goodwill and intangibles on their balance sheets of more than £7.3 billion, representing 25% of net assets. How much is goodwill really worth when competition is cut-throat and consumers have alternative options? Will capitalised software/IT development costs realistically have any value if consumers increasingly migrate away from the high street to on-line shopping? We think not. The nature of retailing has fundamentally changed and this change is irreversible. Will auditors recognise the commercial realities facing high street retailers and actually look beyond the numbers ? If the past is any guide, the answer is no. Short sellers must be licking their lips at the opportunities.

 

We believe that investors have a vital part to play in fostering a safer investing environment by demanding and expecting more from the senior management of companies in which they invest. Partially due to the growth of passive funds, listed companies can attract a significant investor base simply by virtue of being a constituent of a particular index. No questions asked. Companies, perhaps, do not have to fight as hard for investment capital as they once did.

 

At the other end of the investment fund spectrum, some actively managed equity funds have performed exceptionally well by having a few, concentrated holdings, averaging several hundred £million per position or more. These successful fund managers tend to have their own investment style, but appraisal of the risks involved in a concentrated portfolio tends to focus on market and commercial risks, and whether the company concerned has a defensible position and a clear strategy in a market expected to grow, with correspondent growth in cash flows and profits. When major investors push for changes within a particular company, these tend to focus on commercial/investment considerations (Whitbread bowing to investor pressure to demerge Costa being a recent example), while governance issues which investors address include the composition of the Board of Directors, succession planning and the level of executive remuneration. Shareholder revolts over excessive executive remuneration are now commonplace and challenges to auditor appointments are likely to increase. Both are positive developments, but are insufficient in themselves to prevent a major corporate disaster.  

 

Suggestions for a Safer Investing World

 

Major institutional investors have a duty to their clients and also, we argue, to those further down the investment chain, to push for the highest standards of corporate governance within their investee companies. Prevention of corporate disasters should be a priority and the remit of ESG departments should be expanded.

 

In addition to standard investment due diligence, Institutional investors should carry out a series of checks on companies before they invest, including, but not limited to:

 

  •     Extensive background checks on executive management and the Board of Directors

  •     Examination of processes for regular identification of significant integrity and fraud risks

  •     Evidence that there is committed ‘ownership’ of fraud risks by the Board of Directors

  •     Evidence that there is adequate preparation against cyber-crime

  •     Evidence that there is a clear and effective whistleblower policy, preferably managed by a third-party provider

  •    Evidence that the Chairman of the Audit Committee is independent of the Board of Directors and the external auditors

  •    Closer examination of related party transactions

  •    Examination of length of tenure of external auditors

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