Quindell and the FRC’s Role

There was a very good article written by Cliff Weight and published on the ShareSoc blog yesterday about the fines on KPMG over the audit of Quindell. Cliff points out the trivial fines imposed on KPMG in that case, the repeated failings in corporate governance at large companies and he does not even cover the common failures in audits at smaller companies. The audit profession thinks they are doing a good job, and the Financial Reporting Council (FRC) which is dominated by ex-auditors and accountants, does not hold them properly to account.

Perhaps they lack the resources to do their job properly. Investigations take too long and the fines and other penalties imposed are not a sufficient deterrent to poor quality audits when auditors are often picked by companies on the basis of who quotes the lowest cost.

Lots of private investors were suckered into investing in Quindell based on its apparent rapid growth in profits. But the profits were a mirage because the revenue recognition was exceedingly dubious. One of the key issues to look at when researching companies is whether they are recognizing future revenues and hence profits – for example on long-term contracts. Even big companies such as Rolls-Royce have been guilty of this “smoke and mirrors” accounting practice although the latest accounting standard (IFRS 15) has tightened things up somewhat. IT and construction companies are particularly vulnerable when aggressive management are keen to post positive numbers and their bonuses depend on them. Looking at the cash flow instead of just the accrual based earnings can assist.

But Quindell is a good example where learning some more about the management can help you avoid potential problems. Relying on the audited accounts is unfortunately not good enough because the FRC and FCA don’t seem able to ensure they are accurate and give a “true and fair view” of the business. Rob Terry, who led Quindell, had previously been involved with Innovation Group but a series of acquisitions and dubious accounting practices led to him being forced out of that company in 2003. The FT has a good article covering Mr Terry’s past business activities here: https://www.ft.com/content/62565424-6da3-11e4-bf80-00144feabdc0 . They do describe Terry as “charismatic” which is frequently a warning sign in my view as it often indicates a leader who can tell a good story. But as I pointed out in a review of the book “Good to Great”, self-effacing and modest leaders are often better for investors in the long-term. Shooting stars often fall to earth rapidly.

One reason I avoided Quindell was because I attended a presentation to investors by Innovation Group after Terry had departed. His time at the company was covered in questions so far as I recall, and uncomplimentary remarks made. They were keen to play down the past history of Terry’s involvement with the company. So the moral there is that attending company presentations or AGMs often enables you to learn things that may not be directly related to the business of the meeting, but can be useful to learn.

The ShareSoc blog article mentioned above is here: https://www.sharesoc.org/blog/regulations-and-law/the-quindell-story-and-the-frc/

Note though that subsequently the FRC have taken a somewhat tougher line in the case of the audit of BHS by PWC in 2014. Partner Steve Dennison has been fined half a million pounds and banned from auditing for 15 years with PWC being fined £10 million. But the financial penalties were reduced very substantially for “early settlement” so they are not so stiff as many would like. I fear the big UK audit firms are not going to change their ways until their businesses are really threatened as happened with Arthur Anderson in the USA over their audits or Enron. That resulted in a criminal case and the withdrawal of their auditing license, effectively putting them out of business. The UK needs a much tougher regulatory regime as they have in the USA.

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

You can “follow” this blog by clicking on the bottom right.

© Copyright. Disclaimer: Read the About page before relying on any information in this post.

Lack of Transparency at the FRC

The Financial Times ran an interesting article on Friday (13/4/2018) headlined “FRC criticised over transparency”. It reported that the Financial Reporting Council answered only 6 out of 52 Freedom of Information requests since 2013. Atul Shah, Professor of Accounting at the University of Suffolk, was reported as saying: “This shows that there is a real problem within the soul of the FRC. It is a public regulator and not a private members’ club, and it has clear duties of transparency, accountability and reliability which it has been avoiding over many years”. He went on to say they have been fobbing of public queries over a long period and that it was really shocking.

How can they reject so many requests? Because only certain parts of their operations are covered by the Freedom of Information Act and they can claim they cannot comment on on-going investigations.

The Local Authority Pension Funds Forum (LAPFF) sent a long submission to the public consultation on the Corporate Governance Code echoing many of those complaints and adding others and saying that the FRC suffers from “internal cultural problems”. They are clearly very unhappy with the activities of the FRC. The FRC has seen fit to respond with a 5-page rebuttal letter which they have published on their web site.

I have of course covered this issue of the culture and processes of the FRC in two previous blog posts which are here: https://roliscon.blog/2017/12/10/brexit-hbos-globo-and-the-frc/ and here: https://roliscon.blog/2017/11/22/standard-life-uk-smaller-companies-and-frc-meetings/

My view is that although the FRC is under-resourced, the approach that it takes should be reformed. Too many times major accounting and audit issues take years to investigate, and often simply result in no action. For smaller companies, complaints can disappear into a black hole with no response being received at all to complaints. Reform is required.

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

You can “follow” this blog by clicking on the bottom right.

© Copyright. Disclaimer: Read the About page before relying on any information in this post.

Audit Quality and the Caparo Judgement

There was a very good letter from Guy Jubb and Mark Solomon on the subject of the Caparo legal judgement in the Financial Times yesterday (6/2/2018). It was headlined “It is time the curse of Caparo was broken”. Here is some of what it said:

….the joint inquiry into Carillion by the parliamentary Work and Pensions Committee, and Business, Energy and Industrial Strategy Committee, must examine closely the little-known consequences of the Caparo judgment (Caparo Industries plc v Dickman [1990] 2 AC 605), which, in summary, ruled that auditors do not owe a duty of care to any one shareholder but rather to the body of shareholders as a whole, represented by the board of directors. The court decided that it would not be fair to visit what was viewed as indeterminate liability to investors for purely financial loss upon auditors and their firms. This all means that, as a practical matter, the auditors of listed companies are, in the normal course, immunised from the risk of being sued by investors for audit failure. It just never happens.”

The Caparo judgement overturned the previously assumed responsibility of auditors to the shareholders of a company and the general public to ensure that the accounts of a company could be depended upon. The judgement seemed to rely on the fact that shareholders have no contractual relationship with the auditors but only with the company who appoints them.

This judgement made it exceedingly difficult for shareholders to pursue auditors, and although there are possible “derivative” actions there are other obstacles that have been introduced over the years that reduce the potential liability of auditors. One is that they are now mostly not simple partnerships with the partners being individually and personally liable, but Limited Liability Partnerships. Secondly auditors write their contracts with companies and these now limit the scope of liability substantially – they frequently exclude liability for omissions that one would expect auditors to identify.

With the declining quality of audits, and the lack of competition between the big four audit firms, it is surely time to revisit the whole legal framework under which auditors operate. With companies often more interested in reducing audit costs than ensuring the accounts can be relied upon, one can see why and how the standard has been reduced over the years.

It’s not just Carillion that has shown how dubious are current audit standards but the problems in the banking crisis faced by RBS and HBOS were a direct result of lax audit reports. It also extends to numerous smaller companies – indeed too many to mention.

How to fix these problems? These are my suggestions:

  1. Auditors should have a statutory responsibility to the owners (i.e. the shareholders) in a company.
  2. Auditors should personally be liable for failings and not be able to hide behind LLP structures.
  3. Contracts between auditors and companies should be based on “model” contracts as laid down by the Financial Conduct Authority or the Financial Reporting Council, and drawn up based on the advice of investors.

I shall write to my Member of Parliament on this subject as this is something the Government needs to take in hand. I suggest readers do the same. How do you contact your M.P.? Simply go here for contact information: https://www.parliament.uk/mps-lords-and-offices/mps/

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

You can “follow” this blog by clicking on the bottom right.

© Copyright. Disclaimer: Read the About page before relying on any information in this post.

Revenue Recognition, Patisserie Valerie, Utilitywise and Cryptocurrencies

Revenue recognition is a hot topic at present as folks have come to realise that this is a frequent cause of company accounts misrepresenting the true state of the business. Quindell and Blancco are two examples and I cover Utilitywise below. But first let me report on the Annual General Meeting of Patisserie Valerie (TIDM:CAKE) which I attended this morning (as a shareholder of course).

The company operates a chain of cake+coffee shops under the company name but they also have several other brands. However they seem to be concentrating on the Patisserie Valerie one in terms of new openings. This is a typical “retail roll-out” story where they just open more outlets – fixed costs do not increase in proportion so profits grow rapidly. They plan to open about another 20 stores per year at present. The company is run by Executive Chairman Luke Johnson who owns 38% of the company.

Having read the Annual Report I asked a question on revenue recognition because on page 16 it says “revenue recognition has been identified by the audit team as a significant risk”. Perhaps the auditors are now hedging their bets by putting that in all company reports but I found it rather surprising bearing in mind that I expected most customers would be paying cash in the cafes. Indeed the CFO indicated 80% of revenue is in cash. They do issue promotional vouchers but these are not recognised as revenue until used. However they do have some wholesale customers and franchise deals with companies such as Sainsbury where payments are delayed. This explains why they have significant trade accounts receivable at £12.3 million on revenue of £114 million. So I don’t think revenue recognition is likely to be an issue in this company.

Otherwise the AGM was fairly routine and we did get some cake at the end. There were about a dozen shareholders present in the City at one of their outlets. Luke Johnson is not a greatly impressive figure physically (first time I had met him) but answered questions openly. He noted profits were up 19% at £16.4 million. He said they opened 20 new stores and all were immediately profitable. Net cash was £25 million at the year end so they are well positioned for acquisitions if they arise, he noted. A couple of interesting questions from shareholders were:

  1. Is there any difficulty in attracting staff, particularly in London and the South-East. Answer: probably as hard as it has ever been, but they expect a lot of foreign staff to stay in the UK after Brexit and many are non-EU citizens anyway.
  2. Media have reported a possible acquisition of Gails, a similar chain (and partly owned by Luke Johnson I believe). Answer: cannot comment.

In summary, Patisserie Valerie is riding on the popularity of cake and coffee of late, but they are differentiated slightly from common coffee shops. They are also vertically integrated which keeps costs of the cakes low and as a result have good profit margins. Defending that position could be tricky but the business seems to be well managed.

Utilitywise (UTW), a reseller of utility power contracts, has had its shares suspended after failing to file accounts within the timescale required by the AIM market rules. To quote from the company’s announcement: “This delay is due to the volume of work still required to be completed by the Company and its auditor to cater for the proposed change in the Company’s revenue recognition policy, as announced on 17 January 2018. This work includes amendments to the Company’s financial reporting systems in order to analyse energy contract data in accordance with that new policy, alongside associated work by the Company’s auditor, for the audit of its results for FY17 to be completed.”

Now I don’t currently hold this company’s shares but I did briefly from December 2013 to July 2014. The more I learned about the way revenue and profits from contracts entered into that covered future periods were recognised, the more concerned I became. Revenue was still reportedly growing rapidly in 2014 but I sold at about 260p. The share price recently was near 40p.

In my book, revenue and the associated profits from long-term contracts should not be recognised until the cash comes in. But that’s not the way accountants like to handle matters at present. Part of the difficulty lies in costs expended in the short term to obtain or develop the contracts so matching costs with revenue, a basic accounting principle, is a problem.

Lastly I think it is worth mentioning cryptocurrencies, initial coin offerings, bitcoin and blockchain technology. These are all hot subjects that I do not think I have covered before which is probably a gross omission.

Blockchain technology is interesting. It’s basically an “open ledger” which might have many applications, although whether it is really any good for really high volume transaction processing seems to be in doubt. Many banks and other financial institutions seem to be looking at it but it is not altogether clear why they need it (are not existing systems and software adequate enough? Perhaps they are just a bit archaic?). It may be lower cost and simplify development but it potentially has great weaknesses.

For example, Coincheck, the “Leading Bitcoin and Cryptocurrency Exchange in Asia” as they style themselves, recently suffered a hack that meant $500 million has disappeared into the hands of the perpetrators. They have promised to reimburse affected customers but it seems highly unlikely that they have the financial backing to do so.

This is not the first such time this has happened. Another case was that of MtGox which became bankrupt after a similar fraud. So it seems bitcoin systems are not as secure as one might have hoped.

One reason internet fraudsters like payments in Bitcoins is allegedly because they cannot be traced. So does that mean there is no audit trail so one cannot trace where the funds come from and where they go to? This is a major defect in any transaction system which suggests to me that Bitcoins and other similar currencies based on blockchain technology should be promptly regulated by all countries as soon as possible. There may be a need to have a “virtual” currency not controlled by any one Government, but unless it is secure with proper audit trails on its movement, it is not fit for purpose.

The Financial Conduct Authority (FCA) should be looking at this area and pronto before the wide boys of the financial world exploit gullible folks and fraudsters take advantage of its defects.

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

You can “follow” this blog by clicking on the bottom right.

© Copyright. Disclaimer: Read the About page before relying on any information in this post.

Quindell, Carillion and Brexit

The Financial Reporting Council (FRC) have announced that they have fined audit firm Arrandco (formerly RSM Tenon) £750,000 and the Audit Partner Jeremy Filley £56,000 in relation to the audit of the financial statements of Quindell for the 2011 accounts. They also “reprimanded” both parties and Tenon had to pay £90,000 in costs. Both parties admitted liability. Two of their errors were a “failure to obtain sufficient appropriate audit evidence and failure to exercise sufficient professional scepticism”. In other words, quite basic failings. The FRC is still looking into other issues that do not affect those parties.

So after seven years shareholders in Quindell have finally seen some action. But the penalties are hardly sharp enough to cause the targets any great suffering. Quindell which was primarily a claims management company, and a favourite of many private investors, had accounts that were in essence grossly misleading. For example, the FRC reported in 2015 that the restatement of its accounts in 2013 turned a post-tax profit of £83 million into a loss of £68 million. Revenue recognition of future contracted profits was one issue.

Now I never held Quindell despite having looked at it more than once. One thing that put me off was talking to someone about the previous involvement of Rob Terry, CEO of Quindell, in Innovation Group. The FT have a good article on his previous career here: https://www.ft.com/content/62565424-6da3-11e4-bf80-00144feabdc0 . I also did not like the look of the accounts at all and the recognition of revenues. Paul Scott, that well-known commentator on small companies, said yesterday: “…its accounts were fairly obviously highly suspect. Excessive debtors, excessive capitalisation into intangible assets, and a flurry of acquisitions to muddy the waters, are the usual give-aways of fake profits, so these dodgy companies are really terribly easy to spot.”

In essence, just a little background research combined with some understanding of accounting, would have put off most investors. But both private and professional investors (even institutions were fooled by Quindell) do not put in the work, or get carried away by the management and company promoters. Rob Terry has yet to be brought to account for the events at Quindell.

There was an interesting letter in the Financial Times yesterday signed by a number of people including Martin White of UKSA. It said the blame for Carillion’s demise was causing fingers to be pointed in all directions, but most are missing the real culprit – namely that faulty accounts appear to have allowed Carllion to overstate profits and capital. This enabled them to load up on debt while paying cash dividends and big bonuses to the management.

One problem again was recognition of future revenue from signed contracts, but the letter says “anticipated revenues from long-term contracts cannot count as distributable capital, and foreseeable losses and liabilities need to be taken into account”. Carillion effectively reported profit that was “anticipated”. They suggest KMPG’s audit should be investigated as I also said in a previous blog post.

The letter writers suggest that faulty standards mean that today accounts cannot be relied upon and the results for all stakeholders can be devastating. Indeed the fall-out from Carillion is going to be really horrendous with potentially thousands of small to medium size businesses that relied on sub-contract or supply work from Carillion likely to go bust. The letter writers suggest that Carillion is yet another “canary in the coal mine”. Perhaps when MPs get deluged with letters from disgruntled business owners and their out of work employees, they will actually get down and demand some reform of the accountancy and insolvency professions.

Incidentally I never held Carillion either probably because it was mainly in the “construction” sector which I avoid because of low margins, unpredictable and “lumpy” revenue and high risks of projects or contracts going wrong. It also had the Government as a major customer which can be tricky. So from a “business perspective”, such companies are bound to be risky investments.

Another good letter in yesterday’s FT was on the subject of Brexit from Dr Ian Greatorex. It said “For too long, some FT contributors have peddled the line that Brexit is the result of a “populist” backlash that might be reversed”. He restated the “remainers” causes for why they think they lost the vote, but then said “The main reason I voted to leave, often based on FT reports over the years of reported EU mess-ups, was that I believed EU institutions lacked proper democratic control and were complacently trying to create an ever-deeper political union against the instincts of the average voter………”. It’s worth reading and good of the FT to publish a more sober letter on the subject than they have been doing for some months. Perhaps the FT have finally realised that not all their readers are so opposed to Brexit and that the reason a number of educated and intelligent people supported it was for factors other than the possible trade difficulties that will need to be overcome.

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

You can “follow” this blog by clicking on the bottom right.

© Copyright. Disclaimer: Read the About page before relying on any information in this post.

Carillion, EMIS and KPMG

Now that the dust has settled somewhat after the demise of Carillion (CLLN), it’s worth adding some more comments to my previous blog post on the subject. Ultimately it went bust for the same reason most companies do – it simply ran out of cash and could not pay its debts as they became due. As I said before, it collapsed eventually because of ballooning debt, poor cash collection and risky contracts.

Unfortunately it seems that private investors were some of the biggest losers in this debacle. Big investors had either bailed out, hedged their exposure or were actually shorting the stock. According to a report in the FT retail investors held 16% of the shares through Hargraves Lansdown towards the end, 7% on Barclays platform and 7% on Halifax meaning that overall they must have held a much higher proportion of the shares than in most large companies. It would appear retail investors are suckers for a “cheap” stock, or those that are paying nominally high dividends.

As Terry Smith of Fundsmith says in his recently published newsletter to investors, which is well worth reading, he is “asked far more frequently whether a share, a strategy or a fund is cheap or expensive than I am asked about what returns the companies involved deliver and whether they are good companies which create value or not”. He looks at the latter rather than former when investing.

Why did Carillion go straight into liquidation rather than administration? Apparently there was very little cash left in the business and potential administrators were concerned about getting paid. Administration was of course devised as a way to keep companies trading and hence protect jobs and the business of suppliers while potentially enabling it be restructured and sold in due course. Liquidation is an abrupt process where the liquidator just closes everything down immediately. In both cases, trade and other unsecured creditors, plus shareholders, usually end up with nothing although there is some flexibility and more chance of repayment in an administration. In Carillion the Government is picking up responsibility for its own contracts with the company, and the associated jobs may remain, but all others are likely to face severe difficulties and many smaller suppliers may go bust. That applies even to those contracts where Carillion was only a “partner” in a larger consortium.

Now there is one similarity between the two. Administrators or liquidators, and the major secured creditors (normally banks) to which they report, are as keen to dispose of any assets as soon as possible so they can get paid (or recover their debts) quickly. Hence any assets get sold very quickly, often to related parties at prices that the original owners think are ridiculously low. I have written extensively in the past on the abuses associated with “pre-pack” administrations where this problem is particularly rife as there is often little or none “open marketing” of the assets.

Carillion is a very good example of what is wrong with insolvency law in the UK. Carillion employed many skilled staff and some parts of the business may have been viable but the whole lot was brought down by a few dubious contracts taken on at low margins by incompetent management. The damage, and associated costs, of this debacle will be enormous – and in this case will fall on the public to a large extent as the Government has had to step in. Is there a better way? It is my opinion that the Chapter 11 process in the USA is much better. It does enable a company to be protected from its creditors before it gets into an impossible situation, i.e. it allows time for restructuring. The result for ordinary shareholders may not be a lot better, and jobs will be lost, but for everyone else it is superior.

Regrettably in the UK, insolvency law seems to have been devised mainly in the interests of insolvency practitioners and bankers. It is time for a complete reform of the law and practices in this area.

One aspect of Carillion that has been raised is whether the company should have obtained a clean audit report less than a year ago (auditors were KPMG). One thing auditors should report on is whether the company would be likely to be going concern for the foreseeable future – and that typically means more than one year. Otherwise the accounts should be “qualified”. Were the financial difficulties and potential cash flow problems not already apparent to the auditors and to the directors of the company? Is this yet another audit that the Financial Reporting Council (FRC) should be looking into?

EMIS Group (EMIS)

Yesterday, EMIS Group, issued a trading statement and a note on a “review of customer and product support processes”. The share price dropped 20% on the day. EMIS provides medical software and services to GPs and the NHS. It is one of my longer standing holdings, so I am none too happy about this. It’s one of those issues that however diligent one is as an investor, one can get caught out on.

What’s the problem? It seems that “certain service levels and reporting obligations with NHS Digital” have not been met. The financial impact might be up to £10 million which is about a third of last year’s profits.

I have sent the following note to the Chairman to try and elucidate the issues (I’ll advise subsequently on the answers):

“I was of course most disappointed to read the announcement of today’s date regarding “customer and product support processes”.

I would like to receive more information about the nature of the contracts that have resulted in the large potential liability. I understand you are still assessing the potential liability but the announcement should really have spelled out the nature of the commitments that seem to have been made by the company previously, and which have not been adhered to. I am also surprised that such a large liability is being announced when no apparent claim has been received (at least none is indicated), and no financial loss to the third party concerned is being reported.

I also question why the potential liability and risks associated with the relevant contracts were not disclosed in the Annual Report for the year ending December 2016. Indeed there is extensive discussion of “risk” in the business in that document and the risks the business face were apparently reviewed in that year by the board of directors. The risks of all kinds were generally reported as “low”, when it seems that a major undisclosed risk was being run.

One could also question why the audit by KPMG failed to identify this apparently major defect in the company’s systems and accounting for the liability. Did they not review this aspect of the company’s activities?

Lastly there is no indication in the announcement as to how long this failure which has caused the potential liability has been going on. Perhaps you could answer that question, and also indicate whether it may be necessary to restate past accounts.”

As noted above, KPMG were the auditors to EMIS as well as Carillion so this is yet another company where perhaps the FRC should look into the audit. My opinion is that investors should be able to rely on the published accounts of a company but all to frequently of late we see that this is not the case. Grossly misleading accounts resulting from incorrect if not fraudulent revenue recognition (Blancco, Redcentric, Globo, Quindell – you can probably name others), or over optimistic statements about the financial health of the business (possibly Carillion, and HBOS) are simply too common.

Auditors often say investors expectations of what an audit can achieve are too high. But surely there is something fundamentally wrong with their processes if such major failings are not identified?

One other aspect of this problem is I suggest the use of aggressive bonus schemes, particularly LTIPs, that can pay out many times the base salary of executive directors. The result is an incentive to report higher revenues and profits and to conceal the bad news from the company’s shareholders. This may have been a factor at both Carillion and EMIS. Incentives of some kind are all very good if they motivate appropriately. But when they are such a large proportion of the likely remuneration, they distort behavior in the extreme, often with perverse results.

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

You can “follow” this blog by clicking on the bottom right.

© Copyright. Disclaimer: Read the About page before relying on any information in this post.

ShareSoc Takes Up Blancco Complaints

As a small shareholder in Blancco Technology Group (BLTG) I reported on the events at their AGM in a previous blog post. This company had to restate their accounts following discovery that some of the previously recognised revenues were invalid. It calls into question the competence of the past audits of the company and the management of the business.

ShareSoc has now taken up the issues and has requested both the Financial Conduct Authority (FCA) and Financial Reporting Council (FRC) to investigate what happened. See this press release that ShareSoc issued for more information: https://www.sharesoc.org/sharesoc-news/sharesoc-requests-investigation-affairs-blancco-technology-group/

Shareholders in this company have lost substantial capital as a result of the failure to recognise revenue correctly, a failing all too common in IT companies and which, for some reason, auditors seem unable to spot.

If you were or are a shareholder in Blancco, you can register your interest in this matter on the ShareSoc web site so that you are informed of future news.

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

You can “follow” this blog by clicking on the bottom right.

© Copyright. Disclaimer: Read the About page before relying on any information in this post.