PwC Fined over Audit at Redcentric

Audit firm PwC have been fined £4.5 million by the Financial Reporting Council (FRC) for the defective audits of Redcentric (RCN) in 2015/2016. Two audit partners at the firm were also fined £140,000 each.

Redcentric is an IT services company which had to restate its accounts when a £20 million hole was discovered. Assets were written down and the profit of £5.3 million in 2016 was restated to be a loss of £4.2 million. Professional scepticism by the auditors was apparently missing so that management were able to present fictitious figures and get them through the audits.

The current Chairman of Redcentric appears to be reluctant to pursue legal action on behalf of shareholders against PwC which is surely unfortunate. Shareholders would have difficulty in pursuing an action for their losses directly because of the Caparo legal judgement, but a “Derivative” action can be pursued I suggest.

But this is yet another case where the audit profession has failed to pick up serious defects in the accounts of a company. It’s yet another example of why the audit profession needs to improve its game to meet the reasonable needs of investors and other stakeholders.

I have never held shares in this company but I feel for those who were duped by the company and its management into investing in it.

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

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Paying Illegal Dividends, Burford Capital, Woodford Patient Capital Trust and Zero Carbon Objective

A group of investors including Sarasin, Legal & General, Hermes and the UK Shareholders Association (UKSA) has written to Sir Donald Brydon who is undertaking a review of the audit market. They have yet again raised the question of whether the International Financial Accounting Standards (IFRS) are consistent with UK company law. In particular they question whether profits are sometimes being recognised, thus allowing the payment of illegal dividends. The particular issue is whether profits can arise on certain transactions under IFRS from transactions between parent and subsidiary companies or by the use of “mark to market” accounting. The problem is “unrealised profits” that might turn into cash in the future, but may not.

This may appear a somewhat technical question, but it can in practice lead to over-optimistic reporting of profits, leading to excessive bonus payments to managers, and the general misleading of investors. Actually calculating when a dividend can be paid as dividends are not supposed to be paid out of capital is not easy and is not self-evident to investors. The published accounts do not make it obvious. Regular mistakes are made by companies requiring later “whitewash” resolutions to be passed by shareholders. The ICAEW has previously rejected complaints on this issue but it is surely an area that requires more examination.

Incidentally I was reading a book yesterday entitled “White Collar Crime in Modern England” (from 1845-1929) which is most enlightening on common frauds that arose when limited companies became popular – many of the frauds still persist. In the “railway mania” of the 1840s it was common to set up companies and raise the capital to build a railway when the chance of it operating profitably was low. To keep the share price high, and the directors in jobs, dividends were paid out of capital. To quote from the book: “unscrupulous directors could easily pay dividends out of capital undetected – projecting a false image of profitability and enticing further investment in their lines”. That was an era when auditors did not have to be accountants and were often simply the directors’ cronies. Standards and regulations have improved since then, but there are still problems in this area that need solving.

There was an interesting discussion on Twitter recently on Burford Capital (BUR) with regard to their accounting methods. Not that I am an expert on the company as I do not hold shares in it, it but as I understand it they recognise the likely future settlements from the litigation funding cases they take on. In other words, they estimate future cash flows based on projections of likely winning the case and the possible settlements. As I said on Twitter, lawyers will often tell you a case is winnable but they will also tell you the outcome of any legal case is uncertain.

It’s interesting to read what Burford say in their Annual Report under accounting policies where it spells it out: “Owing to the illiquid nature of these investments, the assessment of fair valuation is highly subjective and requires a number of significant and complex judgements to be made by management. The exit value will be determined for each investment by the contractual entitlement, the underlying risk profile of the litigation, a trial or an appellate outcome or other case events, any other agreements in respect of settlement discussions or negotiations as well as the credit risk associated with the investment value and any relevant secondary market activity”.

The auditors no doubt scrutinise the reasonableness of the estimates but any outside investor in the shares of the company will have great difficulty in doing so.

Neil Woodford’s Equity Income Fund has a big holding in Burford Capital. I commented on the Woodford Patient Capital Trust yesterday here: https://roliscon.blog/2019/06/11/woodford-patient-capital-trust-is-it-an-opportunity/ and suggested the Trust made a mistake in naming the Trust after him. It makes it more difficult to fire the manager for example. But the FT reported this morning that the Trust has indeed had conversations about doing just that. Woodford’s firm has a contract that only requires 3 months’ notice which is a good thing. At least they can keep the “Patient Capital” moniker because investors in this trust have already had to wait a long time for much return and it could take even longer to improve its performance under a new manager. But as Lex in the FT said, “patience is now in short supply” so far as investors are concerned.

Another major item of news yesterday was soon to be ex-Prime Minister May’s commitment to enshrine in law a target for net zero carbon emissions in the UK by 2050. This is surely a quite suicidal path for the UK to follow when most other major countries, including all the big polluters, will be very unlikely to follow suit. Even Chancellor Philip Hammond has said it will cost about £1 trillion. It will effectively make the UK completely uncompetitive in many products with production and jobs shifting to other countries. We might become the first really “de-industrialised” country which is not a lead that many will follow, and it will actually be practically very difficult to achieve if you bother to study what is required to achieve zero emissions. It will completely change the way we live with the transport network being a particular problem (trains, planes and road vehicles).

As I have said before, if we really want to cut air pollution and CO2 emissions, then we need to reduce the population as well as rely on such wheezes as electrification of the transport and energy systems. Mrs May’s last act as Prime Minister might be to commit the UK to economic suicide. It might not be a good time to invest in UK manufacturing companies.

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

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Share Plc Offer and Improving Corporate Reporting

There was a surprise announcement this morning of a possible offer for Share Plc (SHRE) who run the Share Centre. That is a very popular platform with private investors because it is low cost and administratively efficient but also because it is one of the few investment platforms that makes it easy to vote your shares held in nominee accounts such as ISAs. Takeovers of investment platforms are never popular with customers because it means having to learn one’s way around a new web/IT system and charges may also change. More consolidation of platforms will also reduce competition in this sector.

The offer is from Interactive Investor but it looks like they may have some difficulty even if founder Gavin Oldham supports it. He, his family and associated trusts held 69% of the share in December 2018 but there was also 18% held by staff and customers.

Yesterday I attended a roundtable at the Financial Reporting Council (FRC) to discuss the “Future of Corporate Reporting”. It was mainly attended by experienced private investors who I won’t name individually. But there was a consensus on many of the issues discussed. I will highlight some of the interesting points that arose:

  • There was widespread concern about the size of Annual Reports and the excessive “padding” and use of “boiler-plate” content. It was clear that most of the investors attending skipped large sections of most Annual Reports.
  • One even went so far to say that he always went to the accounts filed by a company at Companies House which often differed from that in the Annual Report and also contained more information. This is surely an issue that should be looked at by the FRC. It is surely not acceptable that there should be any difference.
  • There was a general view that commentary by the Chairman or CEO tended to be over-optimistic and that risk reporting was full of platitudes while ignoring the really big risks that a company faced. The Macando oil-well disaster at BP and the recent problems at Boeing with the 787Max were mentioned as examples.
  • Other particular issues raised were the valuation of intangibles on the balance sheet, the long-standing complaint that IFRS standards were inconsistent with Company Law (but the FRC has limited input to IFRS standards), the lack of disclosure of long-term debt terms, and the failure to disclose banking covenants.
  • There were also complaints about private investors being excluded from receiving some information disclosed to analysts by companies, and refusal for attendance at company presentation events. The lack of an equivalent rule to that in the USA (Regulation FD on Fair Disclosure) was a major problem.
  • As regards excessive size of Annual Reports, the FRC staff suggested that splitting up the Annual Report into sections might assist although I said that did not really solve the problem of excessive size and irrelevant content.
  • Reporting of ESG factors was discussed but this seemed to be a difficult area due to the lack of standards and the ability of companies to only present positive information.
  • The FRC does undertake quality reviews on large company audits and perhaps a scoring system for Annual Reports could be introduced to raise standards. But it is all too easy at present for company directors to throw masses of superfluous information into the Annual Report to distract investors from the really important facts. I suggested that there be a word or page limit on sections of the Annual Report to ensure that only key information was communicated. For example, do we really need 30+ pages of Remuneration Report as we are now getting at some companies? Where companies wished to provide more detailed information, that could perhaps be given on their web site.

In summary this was a useful meeting to raise the concerns of experienced and knowledgeable investors. Let us hope that the FRC will take up some of these issues.

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

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Horizon Discovery – Defective Accounting Discovered

Horizon Discovery Group (HZD) announced their full year results this morning. Horizon is a biotechnology company focused on cell engineering and CRISPR screening. Revenue was up by 68% to £58.7 million helped by an acquisition. But the “reported loss” increased to £35.8 million due to the exceptional write-off of past investment in “In Vivo”. Although this is a non-cash impairment it suggests that there was past over-optimism in the viability of that business unit and excessive capitalisation of development expenditure. This follows from a strategic review of the company last year by new CEO Terry Pizzie.

They also have a new CFO. There has been a review of revenue recognition policies that has led them to restate 2017 revenue down from £36.5 million to £35.0 million. This is what the company has to say about that: “In 2019, the Group became aware of potential revenue recognition matters in connection with certain license revenue contracts. As a result, the Group undertook a detailed review of all such contracts and determined that the terms and conditions in some of those contracts had been misinterpreted and as a consequence, the accounting periods in which the revenue is recognised have been reassessed, due to license revenues being recognised before they were committed”. Who were their auditors you may ask? Answer: Deloitte. This looks like yet another case of a basic accounting failure that the auditors failed to pick up.

At the last AGM of the company, which I attended as a small shareholder, I questioned why the company was losing money on services. Surely if services were unprofitable, they don’t need to be provided to customers? Good to see that in the latest announcement they are withdrawing from “investment” in parts of the services portfolio. Another interesting comment in the announcement is this: “Our ‘Investing for Growth’ strategy will see the business shift from a scientifically-led life sciences company to a fully commercial tools company, which will mean that Horizon is increasingly well placed to capitalise on its market-leading position to drive sustained top-line growth”.

Apart from the above issues, the company does seem to be moving in the right direction and the comments about future prospects from the CEO are positive. The share price was unmoved at the time of writing.

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

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Audit Market Shake-Up, Ocado on TV, and Judges Scientific Presentation

The Competition and Markets Authority (CMA) have issued their final recommendations to improve competition in the audit market after an earlier public consultation. This follows widespread concerns over the dominance of the big four audit firms, the lack of apparent competition on price or quality, and repeated complaints about the quality of audits following several big and small company failures. Audit firms seem to have got off relatively lightly if the CMA’s recommendations are implemented by the Government. Here’s a brief summary of the proposed changes:

  1. Audit firms will have to operationally split their auditing operations from their consulting operations. This is not a requirement to totally split their businesses but to have separate management, accounts and remuneration.
  2. Mandatory joint audits are proposed for large companies where a big four firm is involved, with a few exceptions. This will enable smaller audit firms (“challengers” as they are referred to), to increase their capacity and credibility.
  3. Audit committees of companies will come under closer scrutiny with the audit regulator having powers to mandate standards, monitor those standards and issue public reprimands where appropriate. But the latter is surely going to be a somewhat ineffective remedy to incompetent audit committees. The CMA have rejected the idea of an independent body to select auditors as proposed by John Kingman due to legal barriers to that change, although they suggest it might be worth keeping under consideration.

One interesting statement in the CMA’s report is this: “In light of the consultation responses, we are recommending a combination of joint audits for most FTSE 350 companies and peer review for others”. That is important because previously it was suggested that only large companies be covered by either rule.

The key question is whether this will improve the quality of audits which is the major issue. I suspect not because more price competition might simply result in more bids at minimum cost with the result of cutting corners on the audit itself. Improved regulation is the key to improving audit quality. But improving competition by reducing the dominance of the big four is otherwise surely to be welcomed.

For more information on the CMAs report, go to https://www.gov.uk/cma-cases/statutory-audit-market-study#final-report . You can see what I said in my response to the original consultation here: https://www.roliscon.com/CMA-Audit-Market-Review-Response.pdf

There was an interesting glimpse into the operations of on-line supermarket operator Ocado (OCDO) on BBC television last night (programme entitled “Supermarket Secrets”). It showed their automated warehouse picking system although the final bagging up is still done manually – however that might change in future. Ocado is of course different to other on-line supermarket operations who mainly pick from in-store stock whereas Ocado have only central distribution operations with no physical retail outlets. Apparently most supermarkets have lower profits on their on-line sales as opposed to their in-store sales because the costs of delivery are not fully recovered in delivery charges. There are also more replacement items when delivery is from local supermarkets rather than from Ocado’s system.

There was an interesting review of Ocado’s business by Ian Smith in an FT supplement a month ago under the title “Pick of the Bunch”. It covered how Ocado moved from being a favourite of short-sellers to one of the best performing stocks in 2018. The change has been brought about because it is now perceived as more of a technology company than a simple retailer. That’s because it is selling its automated systems to other companies. That includes sales to Casino in France and Kroger in the USA.

Ocado lost money last year and is still forecast to lose money in the next two. But I bought a few shares regardless recently. It is interesting to see how the shopping habits in our family have changed. My wife does most of our food shopping and used to go to our local Sainsburys supermarket a couple of times per week. She started to occasionally use their on-line service when she was unwell. But now she uses it most of the time for her big weekly shop with only occasional visits to the store. If the habits of other families change in this way, one can see supermarkets adapting to the Ocado model.

A more long-standing holding of mine is Judges Scientific (JDG). This is a company that is an acquirer of small scientific instrument makers, and as with all good companies the management has a strong focus on return on capital. An interesting breakfast presentation after the results announcement can be seen here: https://www.piworld.co.uk/2019/03/26/judges-scientific-jdg-2018-full-year-results-presentation/ . It explains a lot about how the company operates.

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

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Grant Thornton, Interserve and Arc Fund Management

The Financial Reporting Council (FRC) have announced an investigation into the audits by Grant Thornton of the accounts of Interserve (IRV) in the years 2015-2017. Interserve was a large outsourcing company with most of its business from Government contracts. It ran out of cash and went into administration on the 15th March with debts of £738 million. Readers will no doubt be aware that Grant Thornton were also the auditors of Patisserie Holdings and Globo, both cases where very substantial fraud took place.

I received a rather odd letter recently from a company called Investment Recovery Services Ltd. It suggested that I might have been mis-sold an investment in the Arc EIS 5 Growth Fund promoted by Arc Fund Management Ltd in 2006. The letter was odd for two reasons:

  1. I have never invested in that EIS fund or indeed with Arc Fund Management.
  2. Civil claims are time barred after 10 years so it seems unlikely that claims from 2006 could be pursued.

I know nothing about Investment Recovery Services Ltd although they seem to have been in existence for some years.

As regards Arc Fund Management Ltd the company itself was dissolved in 2017 but Arc Fund Management (Holdings) Plc changed its name to Consolidated Asset Management (Holdings) in 2008 and it subsequently delisted from AIM in late 2009. It again changed its name to SUSD Asset Management (Holdings) in 2011 and seems to be now a property development business with assets of £4.6 million.

I suggest anyone else who received such a letter and thinks they might have a potential claim should be very wary of such an approach. They key is never to pay money up-front on the basis that a claim will be pursued and it seems highly unlikely to me that such a claim could be pursued at this late date.

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

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LCF – Another Audit Failure & the latest on Brexit

I have not covered the events at London Capital & Finance (LCF) before although the national press has done so extensively. LCF sold “mini-bonds” to 11,500 people who invested £236 million in them and are likely to recover very little. These “bonds” were promoted as being “ISAs” in some cases when they were not, and that they were FCA regulated when in fact they were not – only the company was FCA “authorised” for certain activities but that did not include selling these bonds.

The company paid very generous commissions on the sale of the bonds, as much as 25%, and the money raised was invested in small companies with few assets and who are very unlikely to provide a return.

But it has now been disclosed in the Financial Times that based on the 2017 accounts of LCF it appears that the company was technically insolvent even then. However it received a clean audit report from auditors EY. Administrators Smith & Williamson report on a series of “highly suspicious transactions” linked to a number of individuals where money appears to have been diverted to them.

I have written repeatedly on the failures of the audit profession, and the lackadaisical approach of the Financial Conduct Authority (FCA) to improve standards and enforce them. Reforms are in progress (see https://roliscon.blog/tag/arga/ ) but it cannot be too soon. In the meantime, as always, the underlying problem is the gullibility of the public and their lack of financial education. Anyone who had undertaken more than a cursory look at the background of LCF and its finances would have shied away rapidly. But certainly being able to claim FCA authorisation was misleading and that is an issue that needs resolving.

Brexit

It seems Prime Minister May could have another attempt at passing her preferred EU Withdrawal Agreement which got defeated for the third time yesterday. Not that MPs managed to get any majority for alternative solutions in previous indicative votes. I supported the Prime Minister’s solution as a reasonable compromise although it was some way from being a perfect Agreement. However, with no time remaining to renegotiate it, refusal of the EU to countenance changes, and the general desire of the public to see the matter closed with no more debate, it was the best option available. However it was clear from watching yesterday’s debate that there are many MPs, both remainers and brexit supporters who had fixed opinions on the subject and were not going to change them. Mrs May’s problems were compounded by the Northern Irish DUP contingent, the awkward squad one might call them, and by Jeremy Corbyn doing all the could to obtain a general election by opposing any compromise in the hope of winning power.

What would I do if I were Prime Minister now? Decisive action is required which could include I suggest the following options: a) Ensure we exit the EU with no deal a.s.a.p. so as to force both the remainers and brexiteers to face up to reality, and the EU likewise – a rapid agreement on a free trade deal might then be concluded or the wisdom of Mrs May’s compromise would be made plain; or b) call a General Election with a new Conservative party leader and with a manifesto that is pro-Brexit. That would force all Conservative MPs to support the manifesto or be de-selected, i.e. they either support the manifesto or quit. The Labour party and other parties would also need to clarify their position on Brexit in their manifestos thus thwarting any more bickering about where they stand. With a bit of luck the outcome would be a clear majority in Parliament for a Government not beholden to minorities.

The EU might permit an extension of Article 50 to allow time for a General Election – at least 2 months is probably required, although there is no certainty on that. Some EU bureaucrats still seem to think that if they are awkward enough the UK will decide Brexit is not worth pursuing after all, but that ignores the political split that will remain in the UK with the Conservative party still disunited.

Will Mrs May take any decisive steps such as the above? I doubt it.

There is one advantage arising from the Brexit debate. The pressure on Parliamentary time has meant that the massive increase in Probate Fees for larger estates has been delayed. They won’t now take effect from the 1st April as proposed. Now might be a good time to die if you are fed up with this world so as to avoid more Brexit debates and save on probate fees!

Rather than finish on that depressing note, let us welcome a sunny Spring day that will lift all spirits, and with the pound falling (which helps many UK companies) and the stock market rising, life is not so bleak as politicians would have us believe.

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

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