Earnings Per Share and Is It Well Defined?

Most investors rely on Earnings Per Share (EPS) as a measure of the performance of a company. In theory it’s a simple calculation based on post-tax earnings divided by the number of ordinary shares in issue as defined by the IAS 33 accounting standard (see link below).

But the number of shares can be affected by the future exercise of options, convertibles and warrants so in addition to the “basic” figure a “diluted EPS” figure is also required to be published. The EPS figure is also calculated not on the simple number at the end of a period but on the average over the time period to reflect the fact that earnings accrue over the period. This can create complications when there has been restructuring of a company involving share issuance or consolidation.

Another point to note is that only profits or losses from “continuing operations” are included in the basic EPS figure so as to reflect the fact that only those operations will be generating profits in future.

The Financial Reporting Council (FRC) has recently undertaken a thematic review of EPS to identify any possible issues in how EPS is calculated and reported – see link below.

They have identified some problems in practice and say “Certain requirements of IAS 33 appear to have been overlooked or not well understood by companies” and they are concerned that as judgements are sometimes used on share reorganisations the lack of disclosure on how EPS has been calculated is of concern.

EPS can also be used as a performance measure in bonus or LTIP calculations but it seems that sometimes EPS is calculated in a different way for that purpose. The FRC suggests any difference needs to be explained.

They also discuss the problem of “adjusted” EPS which are commonly reported. The FRC expects these to be reported in accordance with the ESMA Guidelines on Alternative Performance Measures – see link below. But what adjustments are included and how tax is taken into account can often be unclear. What is a reasonable adjustment is also often a subject of management opinion and this is surely an area where tougher standards could be introduced.

Companies where adjusted earnings are wildly different to basic figures should be viewed with suspicion in my opinion and a close examination of the adjustments is worthwhile in those cases (usually given in the Notes to the accounts).

The FRC Review is worth reading to get some understanding of the issues but a detailed study may be of more interest to accountants and auditors.

In summary, EPS can be a useful measure but it is only one measure of the performance of a company. It should not be relied on alone to judge the quality of a business and it is necessary to have some understanding of how it has been calculated.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson  )

IAS 33 Standard: https://www.ifrs.org/issued-standards/list-of-standards/ias-33-earnings-per-share/

FRC Thematic Review: https://www.frc.org.uk/news/september-2022/frc-publishes-review-of-earnings-per-share

ESMA Guidelines: https://www.esma.europa.eu/sites/default/files/library/2015/11/2015-esma-1057_final_report_on_guidelines_on_alternative_performance_measures.pdf

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Another Fine for Grant Thornton over Audits at Sports Direct

Back to more serious issues after my last blog post on selecting a Prime Minister. The FRC have issued penalties against Grant Thornton for their audit work at Sports Direct in 2015-16 and 2017-18. One concern was about the failure to recognise that contracts with a delivery company were probably “related party” transactions.

To quote from the FRC announcement: “The audit failings in this case were serious and relate to fundamental auditing standards. It is particularly important that auditors follow up with due rigour where they have identified potential related party transactions as a significant audit risk. Auditors must adopt a mindset of professional scepticism, and exercise good judgment based on sufficient and properly documented evidence. The package of financial and non-financial sanctions imposed by the FRC on the auditors in this case will help to drive improvements at the firm and the wider industry.”

See https://www.frc.org.uk/news/july-2022/sanctions-against-grant-thornton-uk-llp-and-philip  for more information.

This is of course not the first time Grant Thornton has been involved in defective audits – see the cases of Patisserie Valerie and Globo for example.

Grant Thornton may be more careful in future but as I keep on saying, even audited accounts cannot be trusted at present. I don’t think that will change until the penalties for failed audits are made larger and the penalties for errant directors who publish misleading accounts made a lot more severe.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson  )

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Restoring Trust in Audit – A Long Way to Go Yet

The Financial Reporting Council (FRC) have recently published a “Position Paper” entitled Restoring Trust in Audit and Corporate Governance. It sets out how the FRC will be supporting the Government’s reforms under the new ARGA regime.

This is not a very exciting document as it’s very short on specifics. For example under Corporate Governance and Stewardship is says “including a provision for boards to consider how audit tendering undertaken by the company takes account of the need to expand market diversity…”. What exactly does that mean?

However it does say that the Government intends to put Actuarial Regulation on a statutory footing which is long overdue and the intention is to put ARGA on a new funding basis with market participants paying a levy to meet its regulatory function costs. So perhaps auditors should read this Position Paper carefully.

The Position Paper can be obtained from here: https://www.frc.org.uk/news/july-2022/frc-sets-out-next-steps-in-transition-to-new-regul

There might have been more information provided in a webinar on the 14th August but I missed it for two reasons: 1) they sent the login information but it ended up in a spam folder on my BT server; and 2) They sent it as a Teams invite but even though I chose the web browser option it blocked me with an incomprehensible error message. Is it just me that has endless problems with Teams? I wish people would use other products such as Zoom for webinars which I never have problems with.

Incidentally the latest example of the failures of the audit profession was an announcement by the FRC of sanctions against UHY Hacker Young LLP and their audit partner in relation to Laura Ashley Holdings.

To quote: “LAH’s shares were listed on the main market of the London Stock Exchange. As at 30 June 2019, the Group had 155 UK stores, employing over 2,700 people. The Group’s revenue, operating profit, profit before tax and profit after tax consistently declined between FY2016 and FY2019, and the Group’s loss after tax increased ten-fold from £1.4m in FY2018 to £14m in FY2019. Against this backdrop, the audit reports for FY2018 and FY2019 were unmodified and noted no material uncertainty related to the use of the going concern assumption”. Laura Ashley went into administration in April 2020.

The fine imposed by the FRC was only £217,500, a trivial amount!

See https://www.frc.org.uk/news/july-2022/sanctions-against-uhy-hacker-young-llp-and-martin for details.

There is certainly a long way to go to restore trust in the audit profession after a whole series of failures in the last few years.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson  )

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Accounting in Alternative Energy Suppliers

No doubt like many of my readers, I have been buying a few shares in alternative energy suppliers – those that own solar and wind farms or grid stabilisation/battery operations. The move to decarbonise the economy has been made even more urgent by the likely reduction in gas supplies from Russia.

I have been studying the accounts of The Renewables Infrastructure Group (TRIG) in which I own a few shares, and I have some concerns. This company is an investment company which owns wind and solar farms (one example is above). A wind farm is in essence a facility where a windmill is installed to generate electricity which is then sold on to the grid, i.e. a capital asset is purchased and installed which then generates revenue. This is rather like a manufacturing company so one might expect that the traditional accounting for such a business is used, i.e. the assets are capitalised on the balance sheet and then written off through the P&L statement over the life of the asset. Income is simply the sales of the electricity.

But this model is not used at TRIG. It actually owns 50 wind projects, 32 solar PV projects and one battery storage project. There are some minority interests but most of them are 100% owned. The ownership is structured via independent companies in which TRIG has equity investments.

Those investments are valued in the accounts on the directors estimates of future revenues and cash flows. This is actually what is said in the last Annual Report on page 62:

For non-market traded investments (being all the investments in the current portfolio), the valuation is based on a discounted cash flow methodology and adjusted in accordance with the European Venture Capital Association’s valuation guidelines where appropriate to comply with IFRS 13 and IFRS 10, given the special nature of infrastructure investments.

The valuation for each investment in the portfolio is derived from the application of an appropriate discount rate to reflect the perceived risk to the investment’s future cash flows to give the present value of those cash flows. The Investment Manager exercises its judgement in assessing the expected future cash flows from each investment based on the project’s expected life and the financial model produced by each project entity. In determining the appropriate discount rate to apply to a given investment the Investment Manager takes into account the relative risks associated with the revenues which include fixed price per MWh income (lower risk) or merchant power sales income (higher risk). Where a project has both income types a theoretical split of future receipts has been applied, with a different (higher) discount rate used for an investment’s return deriving from the merchant income compared to the fixed price income, equivalent to using an appropriate blended rate for the investment”.

In summary, the profits that the company declares, and its net asset value, are based on the managers future estimates of cash flows.

The Annual Report also contains this statement in the Audit Committee Report: 

Valuation of Investments – key forecast assumptions

 The Audit Committee considered in detail those assumptions that are subject to judgement that have a material impact on the valuation. The key assumptions are:

Power Price Assumptions. A significant proportion of the wind and solar projects’ income streams are contracted subsidy receipts and power income under long-term PPAs; some of which have fixed price mechanisms. However, over time the proportion of power income that is fixed reduces and the proportion where the Company has exposure to wholesale electricity prices increases. The Investment Manager considers the forecasts provided by a number of expert energy advisers and adopts a profile of assumed future power prices by jurisdiction. Further detail on the assumptions made in relation to power prices and other variables that may be expected to affect these are included in the Valuation section of the Strategic Report.

Macroeconomic Assumptions. Macroeconomic assumptions include inflation, foreign exchange, interest and tax rate assumptions. The Investment Manager’s assumptions in this area are set out and explained in the Valuation section of the Strategic Report.

Other Key Income and Cost Assumptions. Other key assumptions include operating costs, facility energy generation levels and facility remaining operating life assumptions.

The Audit Committee considers the remaining operating life assumptions in light of public information provided by the Company’s peer group and reports provided by the Operations Manager during the year considering the remaining operational lives for investments and considering any potential extension of those lives and the recognition of additional value resulting to be appropriate. The independent valuation carried out in June 2021 also supported the assumed operating lives.

The Investment Manager has discussed and agreed the valuation assumptions with the Audit Committee. In relation to the key judgements underpinning the valuation, the Investment Manager has provided sensitivities showing the impact of changing these assumptions and these have been reviewed by the Investment Manager and the Audit Committee to assist in forming an opinion on the fairness and balance of the annual report together with their conclusion on the overall valuation.

Valuation Discount Rates. The discount rates adopted to determine the valuation are selected and recommended by the Investment Manager. The discount rate is applied to the expected future cash flows for each investment’s financial forecasts derived adopting the assumptions explained above, amongst others, to arrive at a valuation (using a discounted cash flow methodology). The resulting valuation is sensitive to the discount rate selected. The Investment Manager is experienced and active in the area of valuing these investments and adopts discount rates reflecting its current extensive experience of the market. It is noted however that this requires subjective judgement and that there is a range of discount rates which could be applied. The discount rate assumptions and the sensitivity of the valuation of the investments to this discount rate are set out in the Valuation section of the Strategic Report.

The Audit Committee discussed with the Investment Manager the process adopted to arrive at the selected valuation discount rates (which includes comparison with other market transactions and an independent review of valuation discount rates by a third-party valuation expert both at December 2020 and at December 2021) and satisfied itself that the rates applied were appropriate. The Company uses a bifurcated discount rate approach (as more fully explained on page 62)”.

The key point arising from this is that the valuations (and hence reported profits of the company), are very dependent on the discount rates applied to future cash flows.

In summary we have a business where reported profits are based on estimates of future cash flows and the discount rates that are applied, not on actual historic profits or cash flows. To my mind this creates a great deal of uncertainty.

What would the accounts look like if all the investments the company has were consolidated? That’s not an easy question to answer because the information is not readily available, and neither am I an accountant. But perhaps TRIG could supply such an answer.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson  )

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Good Articles in Investors’ Chronicle

There were several good articles in this week’s Investors’ Chronicle. I cover them briefly below.

The Editor, Rosie Carr, reported on feedback on readers’ views on taxation. Should the wealthy readers of the IC pay more was one question previously posed and the consensus answer seemed to be Yes. For pensioners it was suggested that they should pay National Insurance on their income and that there should be harmonisation of income and capital gains tax rates. It was also suggested that property taxes should be raised and Inheritance Tax raised.

I would support most of those suggestions but not the last. Inheritance Tax is typically a tax on created wealth which has already been taxed in one way or another. Double taxation on the same assets should be avoided in my view although perhaps some loopholes should be closed.

There was a good article by Chris Dillow on the problems created by the “decades-long attempts to cut inventories”. He points out that the adoption of “just-in-time” production methods had a positive impact as inventory is expensive. That is particularly so when debt is expensive and interest rates high. This of course is the result of MBAs like me being taught at business schools that cutting inventory was always a good thing. Now we find that the smallest hiccup in the supply chain such as transport delays proves to be very expensive.

There is a good analysis of the audit issues at Patisserie Valerie by Steve Clapham. He concludes that the sanctions imposed by the FRC “are woefully inadequate” which I also suggested in a previous blog post. I said Grant Thornton was “fined a trivial amount”.

The article does however suggest that there were some warning signs such as very high margins in comparison with other sector players, and high inventories in relation to the revenue. But there were reasonable explanations for the differences. One would have had to do a lot of research to figure out if there was really a problem or not. Clearly the auditors did not do that and most investors do not have the time nor resources to do such research. That’s why we rely on the audited accounts!

It is unfortunately the case that outright frauds can often be easily concealed but the audit in this case was clearly very defective and the published accounts of the company were grossly misleading.

But I do admit to failing to take my own prescription for avoiding problem companies – namely investing in a company with an Executive Chairman with too many jobs!

There is also a good article on “The flattery industry”, i.e. how management improve their reported profits by using “alternative” or “adjusted” measures. The FRC has published a report on this issue.

It is very clear that companies are addicted to alternative performance measures and that applies just as much to large companies as small ones. One company and its “adjustments” mentioned negatively in the article is GlaxoSmithKline (GSK). I sold a holding in GSK back in 2014 for that very reason – way too many adjustments in the accounts. The price of the shares then was about 1480p. It’s now 1407p. Clearly a good decision. Stockopedia currently says it qualifies for the Altman Z-Score Screen (Short Selling). Enough said I think.

But this is surely yet another example of where the FRC is falling down on its job. There should be regulation of what can be published as adjusted figures and there should be rules about how they are published. There should be consistency and not excessive emphasis on adjusted figures. At present we have a quagmire of data with no easy way to compare different companies.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson  )

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Restoring Trust in Audit and Corporate Governance

As it’s Friday afternoon with not much happening, and I have completed my latest complaint about the time it’s taking to complete a SIPP platform transfer, I decided to have a look at the public consultation on “Restoring Trust in Audit and Corporate Governance” from the BEIS Department.

This is a quite horrendous consultation on the Government’s proposals to improve audit standards and director behaviour as foretold in the Kingman and Brydon reviews, with proposals for a new regulatory body (ARGA). That’s after a growing lack of confidence in the accounts of companies by investors after numerous failures of companies, and not just smaller ones. I call the consultation horrendous because it consists of over 100 questions, many of them technical in nature, which is why BEIS have given us until the 8th of July to respond presumably.

I won’t even attempt to cover all the questions and my views on them in this brief note. But I would encourage all those who invest in the stock market, or have an interest in improving standards in corporate reporting, to wade through the questions and respond to the on-line consultation (see link below). Otherwise I fear that only those with a professional interest as accountants or as directors of public companies will be responding. The result might be a biased view of what is needed to improve the quality of financial information provided to investors.

The general thrust of the proposals do make sense and it would be unfortunate if the proposals were watered down due to opposition from professional accounting bodies and company directors.

But there is one aspect worth commenting upon. Some parts of the proposals appear to believe that standards can be improved by imposing more bureaucracy on auditors and company directors. This might add substantial costs for companies in terms of higher audit fees and more management time consumed, with probably little practical benefit.

We need simple rules, but tougher enforcement.

The audit profession appears to be already seeking to water down some of the proposals according to a recent article in the FT which reported that accountants were seeking leniency on “high risk audits”. That’s where they take on auditing a company for the first time which may prove difficult, particularly where corporate governance is poor. This looks like yet another attempt by auditors to duck liability for not spotting problems which has been one of the key problems for many years.

BEIS Consultation: https://www.gov.uk/government/publications/restoring-trust-in-audit-and-corporate-governance

Roger Lawson (Twitter: https://twitter.com/RogerWLawson  )

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Restoring Trust, After Its Long Been Lost

The Government BEIS Department have published a white paper entitled “Restoring trust in audit and corporate governance”. It’s an acknowledgement that the trust of investors in directors who manage the companies they invest in has long ago been lost. And the trust in auditors that the accounts issued by companies are accurate and give a fair view of a company’s financial position has also been lost.

There are few stock market investors who have not been affected by one or more scandals or downright frauds in the UK in recent years. However diligent you are researching companies and checking their accounts, you are unlikely to have avoided them all. Examples such as Autonomy, BHS, Carillion, Conviviality, Patisserie Valerie and numerous small AIM companies give you the impression that the business world is full of shysters while auditors are unable to catch them out. The near collapse of the Royal Bank of Scotland and other banks in 2008 was symptomatic of the malaise that had crept into the accounts of companies that has still to be rectified.

Indeed in the first chapter of my book “Business Perspective Investing” I said accounts don’t matter because they cannot be relied upon. I suggested other aspects of a business that should be examined to pick successful investments and went through them in some detail in the rest of the book. But would it not be better if we could trust company directors and auditors?

The failures of the existing accounting standards and corporate governance, and enforcement thereof, has been recognised in previous Government reviews. For example the Kingman Review in December 2018 made a number of proposals to reform the Financial Reporting Council (FRC) and for a replacement body to be named the Audit, Reporting and Governance Authority (ARGA) with wider powers (see: https://roliscon.blog/2019/03/12/frc-revolution-to-fix-audit-and-accounting-problems/ ). The fact that it has taken 3 years to move one step further tells you about the glacial pace of reform.

The Government has accepted most of the recommendations in past reviews of this area. They plan to tighten up the accountability of company directors and propose “new reporting and attestation requirements covering internal controls, dividend and capital maintenance decisions, and resilience planning, designed to sharpen directors’ accountability in these key management areas within the largest companies”.

The audit profession, who have been one of the barriers to change, comes under attack with these comments: “Central to achieving [reform] is the proposed creation of a new, stand-alone audit profession, underpinned by a common purpose and principles – including a clear public interest focus – and with a reach across all forms of corporate reporting, not just the financial statements. Alongside this the Government is proposing new regulatory measures to increase competition and reduce the potential for conflicts of interest, by providing new opportunities for challenger audit firms and new requirements for audit firms to separate their audit and non-audit practices”.

The Government proposes new legislation to put the new ARGA body on a statutory basis with stronger powers to be financed by a new statutory levy. You may not believe it but the FRC is financed by a voluntary levy and has limited powers over finance directors (none at all if they are not members of a professional body).

There is a new focus on the “internal controls” in a business and proposals to ensure they are adequate. A lack of internal controls is often the reason why fraud goes undetected. These proposals are similar to the Sarbanes-Oxley regulations introduced in the USA.

For investors, a big change that might have an impact is: “Companies (the parent company in the case of a group) should disclose the total amount of reserves that are distributable, or – if this is not possible – disclose the “known” distributable reserve, which must be greater than any proposed dividend; in the case of a group, the parent company should provide an estimate of distributable reserves across the group; and directors should state that any proposed dividend is within known distributable reserves and that payment of the dividend will not, in the directors’ reasonable expectation, threaten the solvency of the company over the next two years”.

There are of course existing rules that should prevent dividends being paid out of capital, which incidentally was one of the common reasons for collapse of companies in Victorian times – the ability to continue paying dividends gave a false sense of all being well to investors. But clearly the current regulations are ineffective. The BEIS report actually says “high profile examples of companies paying out significant dividends shortly before profit warnings and, in some cases, insolvency, have raised questions about its robustness and the extent to which the dividend and capital maintenance rules are being respected and enforced”.

There is also the problem of big bonuses being paid to directors when they should have known the financial position of their company was precarious. This is tackled by new proposed rules to “strengthen malus and clawback provisions within executive directors’ remuneration arrangements”.

There are proposals to reduce the dominance of the “big four” accounting firms and introduce more competition which is seen by some as the reason for the poor quality of many audits. But it is not clear that the proposals will have a major impact.

In conclusion, there are many detailed proposals in the 226 page report, which is now open to public consultation. I may make more comments later, but overall I would support the main proposals as a step forward. I just wish the Government would get on with the proposed changes before investors lose the will to live.

White Paper: https://www.gov.uk/government/publications/restoring-trust-in-audit-and-corporate-governance

Roger Lawson (Twitter: https://twitter.com/RogerWLawson  )

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FRC Seminars, Lookers Results, Caparo Judgement and Autonomy Case

I attended two seminars organised by ShareSoc and UKSA with the Financial Reporting Council (FRC) yesterday (24/11/2020) and the day before. The first session was about the “ARGA transformation”, i.e. the steps being taken to improve the audits of companies and the reporting of accounts following the Kingman review two years ago. ARGA stands for Audit, Reporting and Governance Authority which will be the new name for the FRC.

Before reporting on the meeting, it’s worth noting the latest example of how audits have failed to disclose substantial errors in accounts, including fraud, in the case of Lookers (LOOK). In their announcement on Tuesday they made it clear that profits had been wildly overstated for some years and the balance sheet was likewise overstated. To quote from the announcement: “A total of £25.5m of non-cash adjustments are necessary to correct misstatements in PBT over a number of years” and “Adjustments reduce  PBT by £10.9m in 2019 and £7.2m in 2018 with the balance cumulatively decreasing PBT by £7.4m in 2017 and earlier”. Auditors Deloitte have resigned.

It is a regular occurrence that the published accounts of public companies are subsequently shown to be wrong and that fraud goes undetected. The audit process which investors rely on to enable them to have confidence in the accounts on which they are basing investment decisions is clearly regularly failing.

The FRC seminar was presented by Sir Jon Thompson, their new CEO following a wholesale shake-up of management, and Miranda Craig, Director of Strategy and Change. They reported on the progress to implement the required changes, many of which require changes to legislation. They hope to get those implemented in the second half of 2021 with ARGA becoming live in 2022. But none of this is certain as it depends on Government co-operation and priorities. There will also need to be another consultation round on the details of the proposals.

The Kingman review proposed joint audits be introduced but the Government has decided against that but managed shared audits are being considered so as to give smaller audit firms some involvement in bigger audits.

ShareSoc Director Cliff Weight asked a question about the Caparo legal judgement and the problem of people holding shares in nominee accounts not being “members” of a company.  I followed up with some points on Caparo, which Sir John Thompson did not appear to know much about and assigned a response to someone else.

Let me explain why this issue is so important and how the Caparo legal judgement undermined the duties of auditors.

Investors in the stock market purchase shares on the basis of the published accounts of companies being a fair view of their financial position. Before the Caparo legal judgement in 1990 it was widely assumed that auditors had a duty of care to shareholders – after all what was the purpose of the audit other than to provide reassurance to shareholders? Historically that was why audits were introduced. See this ShareSoc blog for more information https://www.sharesoc.org/blog/regulations-and-law/audit-quality-caparo-judgement and there are more details of the legal case on Wikipedia.

This judgement effectively meant that no shareholder in a company could sue the auditors for incompetence or breach of duty, only the company could. But that rarely happens, when it is the shareholders that have typically lost money as a result. In fact some auditors have claimed that even the company does not have a claim if the reported accounts were false because it might not necessarily have affected what actions the company took. Sometimes when a company goes into administration the liquidators might sue, as in the recent example of Patisserie (CAKE) but there is no certainty of success or any pay-out to shareholders.

The failure to make auditors responsible financially to investors relieves them of a big financial incentive to do their work properly and to identify false or fraudulent accounts.

I put it to Miranda Craig that all that was required to fix this problem was a simple Act of Parliament to overturn the Caparo judgement. She suggested they did not have the powers to implement this but that is a weak excuse.  They could surely suggest to the Government that such an Act be introduced as it’s perfectly practical. It just needs to reinstate the duty of auditors to shareholders and overturn the somewhat perverse decision in the Caparo judgement.

Another attendee at the seminar raised the issue of the auditors being able to limit liability to the company by contractual means which is another issue that needs tackling.

The second seminar was about “Enforcement”, presented by Claudia Mortimore and Jamie Symington. There has been growth in the enforcement team – from 9 staff in 2012 to 54 now. Certainly enforcement has been more active but they are still hampered in some cases by limitations on their powers – for example they only have powers over members of regulatory bodies whereas many company directors are not such members (even finance directors or chairs of audit committees). There are plans to change this.

They have identified two main issues from past audits: 1) A failure to plan and perform audits with professional scepticism; and 2) Failure to obtain sufficient audit evidence.

Enforcement does seem to be improving, but there are still some issues as Robin Goodfellow pointed out (a failure to communicate with complainants over FRC findings or during investigations).

There is also an issue that fines on audit firms or partners are still not enough to discourage poor behaviour or match the losses incurred by shareholders due to incompetence or inadequacy. For example, one of the cases mentioned in the seminar was that of Autonomy. Deloitte was fined £15 million in September over their audit work for the company. But Hewlett-Packard (now HPE) claimed for £3.8 billion over their losses resulting from the acquisition of Autonomy, i.e. 250 times what Deloitte were fined!

Altogether these were somewhat disappointing seminars for those of us looking for vigorous action and speedy revolutions in the FRC. I am not convinced the culture of the FRC has yet changed, with progress being slow and decisive actions to improve audit standards not being implemented, although others do think there is progress being made. Improvements are being implemented but not nearly as quickly as I would like and auditors are still being protected from the worst impacts of incompetent audits. The fines that are issued are still too low – for example Deloitte registered a profit of £518m for the year ended May 2020 so they probably won’t worry too much about a £15 million fine.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson  )

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Revenue Recognition in Minds + Machines

Yesterday I talked about preventing fraud in accounts and the revised standard set by the FRC for the auditing of accounts. The standard actually highlights a common problem area in company accounts. Namely the question of revenue recognition. It can be easy to fabricate revenue even if somewhat more difficult to create the cash that normally flows from revenue.

But not always as one can see in the announcement today from Minds + Machines Group (MXX). It says that the board has concluded that cash of £1.125 million that was received in connection with a specific contract and £938,000 of revenue in FY 2019 was incorrectly recognised in the accounts. In reality the cash received was an advance from the customer against future end-user sales and should have been treated as a deposit.

There were also two other contracts where receipts were incorrectly categorised as revenue. Both the CEO and CFO have resigned with immediate effect.

Comment: these are of course pretty basic accounting errors which any director of a public company should be aware of. In addition the auditors (Mazars) failed to pick up the issue. These were substantial contracts in relation to the overall revenue of the company so surely should have been reviewed in detail?

These failings may not have been deliberate fraud but they just demonstrate how it’s so easy for investors to be misled by false accounting. Not a company I have ever held fortunately.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson  )

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Preventing Fraud in Accounts – FRC Tightens Audit Rules

There have been repeated examples of the accounts of public companies being fraudulent in recent years. Wirecard was probably the latest and biggest example. I have seen examples of such misdeeds twice in my investment career in my own holdings although losses have been minimal in both cases, the last example being Patisserie (£95 million missing from their accounts). But I have avoided a lot of others where the losses to some investors have been enormous. There have simply been too many such cases for investors to avoid them all however careful you are in analysing the accounts of companies. There can often be hints that something is wrong, but in many cases the fraud is so well concealed it is very difficult to detect. In both the examples I mention, the cash that was claimed to be on the balance sheet was not there, which should be a simple thing for auditors to verify.

The Financial Reporting Council (FRC)) have announced that they are tightening up the rules followed by auditors to impose more responsibility on them for detecting fraud. In the past it was unclear that auditors had any responsibility to detect fraud and some have even denied it.

The FRC claim they are making the auditor’s obligations clearer – specifically to try and identify fraud. The FRC is running a public consultation on the proposed new audit standard which you can read about here: https://www.frc.org.uk/news/october-2020/consultation-on-revised-auditing-standard-for-the

It makes for interesting reading and it actually spells out the kind of problems that auditors should be looking for. In general the proposed changes to the audit standard make sense.

Will it solve the problem of too many frauds altogether? No for three reasons:

  1. Because audit work is bid for by audit firms, while companies pay their fees, there is a strong incentive by both parties to keep the cost of the audit as low as possible. This brings pressure to bear to not do more work than is absolutely necessary.
  2. Auditors cannot challenge management too much if they are going to retain the audit brief, and there is a tendency to build a cosy trusting relationship.
  3. Auditors are protected from being sued by shareholders for incompetence by the Caparo legal judgement, and their liability even to the company can be undermined by the contracts they require signing. In other words, the legal framework under which they operate enables them to escape responsibility for incompetence.

How might these problems be solved? It has been suggested that auditors be appointed by an independent body rather than by the directors of a company. Perhaps another solution might be to set up an independent fund that rewards auditors when they identify and report fraud, with big bonuses for the individuals that do so. That would give them a strong financial incentive to discover it.

That would provide a carrot. But the stick needs to be change in the regulatory framework and the law so that auditors cannot escape financial penalties when they do not do a competent job. A simple change would be to require audit contracts to be based on a standard set by an independent body such as the FRC and not written by auditors as at present.

I hope readers will respond positively to the consultation because I can see many objections from audit firms to the imposition of new obligations, however reasonable they appear to investors.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson  )

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