Renold Accounts, Audit Quality and Abnormal Price Movements

Chain maker Renold (RNO) has provided the latest example of sloppy accounting work. On the 9th July it reported that it had identified accounting issues in the three years ending March 2017, 2018 and 2019. Assets and profits were overstated and liabilities were understated in the Torque Transmission division. In total adjusted operating profits were overstated by £1.8 million. As a result the AGM is being postponed to give time for revising the Annual Accounts. Their auditors are Deloitte.

The Financial Reporting Council (FRC) have reported on their latest assessment of audit quality and it makes for dismal reading. Their target for assessed audits is 90% being “good or requiring limited improvements” but only 75% of FTSE 350 audits met that target. Overall there has been no improvement on last year.

Grant Thornton and PwC came in for particular criticism. Scrutiny of Grant Thornton has been increased and PwC is required to take “prompt and targeted action” to address their decline in performance. KPMG also continues to be subject to increased FRC scrutiny. The FRC suggests that all audit firms suffer from failing to challenge management sufficiently on judgmental issues, and need to work harder to solve this problem.

Comment: this has certainly been a long-standing issue that is driven by the desire of audit firms to reduce their prices to win business and reluctance to challenge management. Renewal of audit contracts with the same firm over many years contributes to the problem. The only way to break this system is to change how auditors are hired. At least that’s my personal opinion.

But the good news for investors is that the Financial Conduct Authority (FCA) have reported that abnormal price movements before deals are announced were down last year. In other words, market abuse has fallen by 12% and is now at its lowest level since 2006.

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

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Redcentric – Devasting Report on Audit Quality

I have commented on the accounting problems at Redcentric (RCN) before – see https://roliscon.blog/2019/06/13/pwc-fined-over-audit-at-redcentric/ . Mark Bentley of Sharesoc has written a good article on the audit issues at this company on their blog here: https://www.sharesoc.org/blog/regulations-and-law/redcentric-rcn-campaign-important-developments/

He covers the report from the Financial Reporting Council (FRC) on the audit which has only taken them two years to produce – that’s fast for the FRC. But if you read the report you will see that it is a devastating critique of the quality and professionalism of the audit by PwC.

An investigation by the Financial Conduct Authority (FCA) is still on-going apparently and ShareSoc is talking to lawyers about possibly legal action to recover losses suffered by investors from reliance on clearly inaccurate accounts.

But there are simply too many such cases and shutting the stable door several years after the horse has bolted is not good enough. The Government needs to look at how to prevent such problems by improving the standards of accounts, and improving the auditing of them. Some reforms have already been proposed in that regard but whether they will have an impact on the activities of smaller AIM companies, where a lot of the problems occur, has yet to be seen.

At the core of the problem is the failure to make the individuals (i.e. the directors and senior management) in such companies personally responsible. Pursuing the companies or their auditors is only a limited solution and shareholders often bear the costs when the individuals concerned need to be deterred by prison sentences I suggest. But that means changes to the law to make it easier to prosecute such cases.

And the FCA needs much more resources to enable them to pursue such cases quickly and forcefully. There is so much fraud taking place in the financial world that most goes undetected, unrecognised and unprosecuted.

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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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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FRC Revolution to Fix Audit and Accounting Problems

A major announcement that will impact investors was made yesterday by the Government. You may not have noticed it in the midst of political turmoil, but it’s worth studying.

The Kingman review of the Financial Reporting Council (FRC) was published last December. It was a quite damning criticism of many aspects of the current regulatory regime that had resulted in so many audit failures and poor-quality financial reporting. See my previous blog post on this subject here: https://roliscon.blog/2018/12/18/all-change-in-the-audit-world/

There are few experienced investors who have not suffered from audit failures in the last few years. Accounts need to be accurate, reliable and trustworthy but they have been far from that in the last few years. It is now proposed that the FRC, which regulates the audit world and sets accounting and corporate governance standards, be scrapped and replaced by a new body to be called the Audit, Reporting and Governance Authority – ARGA as it will no doubt be abbreviated to. ARGA will have stronger powers, a new mandate and new leadership.

There is a public consultation on the proposed new body and supporting legislation which can be obtained from here: https://tinyurl.com/y55a376d . Anyone with an interest in improving auditing, and preventing company failures such as those at Patisserie or Carillion and major banks in 2008 should respond. But there are so many changes proposed that the document may take time to digest. I pick out some of the more important ones below:

A new Chairman and Deputy Chairman are being recruited to head ARGA so there will be change at the top. Let us hope they manage to change the culture of the FRC even if many of the FRC’s staff move into the new body. It needs to be more than a change of name.

The ARGA will have clear statutory powers with a clear purpose and objectives, supported by a “remit letter” from the Government. One objective will be “to protect the interests of users of financial information and the wider public interest…” which is a positive statement and replaces the unclear historic accumulation of limited powers by the FRC.

The new board responsible for the ARGA will be smaller, more diverse and less representative of “stakeholder” interests. Let us hope that this means less dominated by major audit firms and the audit profession.

The Audit Firm Monitoring Approach will be put on a statutory basis and with enhanced skills and seniority in the team. There are also proposals to improve the Audit Quality Review system which sound promising although such reviews only affect large companies. There will also be expansion of Corporate Reporting Review activity focused on higher risk companies and the new regulator will have the power to change accounts without going to Court.

The “audit expectation gap” where, for example, investors expect auditors to detect false accounting or even fraud whereas auditors don’t perceive that as part of their job will be reviewed. There is indeed a problem with the failure of auditors to challenge the information they receive from management and the latter’s forecasts and interpretation. Let us hope that is a meaningful independent review that results in some changes.

A new “pre-clearance” system will be introduced to enable companies and their auditors to obtain approval for “novel and contentious matters in accounts in advance of their publication”. This may assist auditors to “pass the buck” to someone else if they have doubts about how to present the financial figures.

More transparency in the new body is encouraged on such matters as disclosure of undertakings from concluded cases and it will become subject to the Freedom of Information Act. There will also be more publication of information on complaints and improved handling of them. Such changes are to be encouraged to stop the current secrecy under which the FRC operates which frustrates investors.

The oversight of the accountancy profession is proposed to be improved although the details are unclear and it may require primary legislation. The wording suggests that audit firms may escape substantial change.

The prevention of corporate failure is to be tackled by developing a market intelligence system to identify emerging risks in companies. This will enable a change from a purely historic analysis of corporate failures which is rather like shutting the stable door after the horse has bolted to a more proactive, future-looking approach. Auditors may also be required to warn of concerns about viability.

The AARG will be able to commission a “skilled person review” where concerns are raised about a company. Details of how this will operate are to be determined, but this appears to be a useful step forward. The cost would be charged to the companies where it is invoked.

The Government accepts that there is merit in improving internal company controls by something along the lines of the US Sarbanes-Oxley regime. They will explore options in this area and do a consultation on it in due course. This is a welcome move and I covered the benefit of such a change in a previous blog post: https://tinyurl.com/yxmx9gzg

It is proposed to improve “viability” (i.e. “going concern”) statements and the FRC has been tasked with taking that on immediately. Such statements are certainly ineffective at present and could be improved in several ways, e.g. to avoid the “all or nothing” approach at present. Such questions are not simple black and white issues in most cases.

It is proposed to replace the existing, and most peculiar, voluntary funding arrangement of the FRC with a new statutory levy for the ARGA. This is surely welcomed as money is the key to improving many of the regulatory functions. It is clear that the FRC is under-resourced in terms of the numbers and skills of staff.

In summary, most of the recommendations in the Kingman review are being taken forward.

Comment: These long-overdue reforms are certainly welcomed and the Government does seem to be applying some urgency to them, although with a log-jam in Parliament at present it may take time to get some of the needed statutory law changes in place. But cultural changes in organisations are never easy. Old bad habits in the FRC may persist, while it remains to be seen whether adequate funding will be put in place for the ARGA. There is also a lot of detail yet to be worked out. Let us hope it is a case of welcome to ARGA and not AARGH when we learn the details.

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

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AssetCo Case and the Grant Thornton Defense

I mentioned in a previous blog post yesterday the judgement in the case of the alleged breach of duty by Grant Thornton (GT) when acting as auditors of AssetCo Plc (ASTO) in 2009/10. See https://www.bailii.org/ew/cases/EWHC/Comm/2019/150.html for the full judgement. For those who have not had the opportunity to read all 300 pages of the judgement, here are some interesting points from it:

It was conceded that the audit was negligent in a number of respects, but GT’s defense against the damages claim was based on what it asserted were six “insuperable obstacles”. Some of the key points they made are below:

  1. They deny that if the true accounting position had been known they could have avoided an insolvent liquidation. Indeed they claim that AssetCo was better off not knowing, in 2009 and 2010, the truth of its own position.
  2. They claim that the steps that AssetCo took (a scheme of arrangement) mitigated all their losses and otherwise avoided all harm.
  3. That none of the damage claimed by AssetCo was caused by Grant Thornton but by the directors of the company.
  4. That the Letter of Representation supplied by AssetCo as part of the audits contained falsehoods and hence GT should be relieved of all liability.

They also disputed the quantum of losses suffered by the company and their entitlement to interest thereon.

The judge concluded that GT’s conduct was “not reasonable”, and upheld the claim. The defense that AssetCo were better off not knowing their true financial position is a very remarkable one indeed! How are companies expected to avoid losses if they do not know their true financial position?

But this case is a good example of how civil claims arising from company fraud are simply too expensive to pursue in most circumstances and take much too long to get into court. Expecting civil claims to discourage bad auditing and somehow police audit work is simply not a realistic proposition.

If GT’s defences had been upheld, it would effectively make it impossible to challenge any incompetent audit work however bad it was and however damaging the consequences. If the case does go to appeal, let us hope the judgement is upheld.

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

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FRC Review of Auditing Standards – They’re Looking At The Wrong Things

The Financial Report Council (FRC) have recently published a “Post Implementation Review: 2016 Ethical and Auditing Standards”. It concentrates on the changes made in 2016 to improve the independence of auditors but will that solve the lack of trust in financial accounts and audits thereof? I doubt it.

This is what I said in response to some of their questions (answers in red):

  1. Do the current ethical and auditing standards drive the auditor to deliver work that meets the expectations of users within the current scope of an audit? If there are expectations that are not being addressed, please state those along with your proposals as to how they can be addressed. The expectations of users are still not being met because simply introducing ethical rules to be followed by auditors does not tackle the basic problem that many audits do not identify false or misleading financial accounts.
  2. Are there further steps that the FRC should consider as part of this review to ensure the delivery of high-quality audit? If so, please state what they are and why. The FRC needs to spend effort to identify why fraudulent accounts can still be produced by companies and not be identified as such by auditors. In other words, they need to look at what rules or procedures could be put in place to identify such failings as false balance sheets (e.g. reported cash not being available or undisclosed overdrafts as in Globo and Patisserie), incorrect revenue recognition (Quindell et al), excessive risks being taken and poor internal controls (Conviviality, banks in 2008, etc), and other aspects of companies that cause them to fail.
  3. Do you believe the current restrictions on non-audit services are sufficient to address threats to independence, objectivity, integrity and audit quality, and address stakeholder expectations? If not, please explain why, by providing examples where audit quality has been compromised as a result of non-audit services being provided by the auditor. They do very little to affect the objectivity, integrity and audit quality or to address stakeholder expectations.
  4. Is the work required of an auditor on an entity’s compliance with laws and regulations, and those procedures to identify irregularity, including fraud, sufficient to meet the needs and legitimate expectations of users? If not, what additional work would you require and why? A lot more work would be required to identify fraud and meet the expectations of users of financial statements. What that work might be can only come out of an examination of past audit failings.
  5. Should the FRC take further steps to increase the value of extended auditor reporting to users of financial statements? If you agree, what material would you like to see included in auditor’s reports? It’s not a case of more extended auditor reporting being required – more information will just cloud the picture. We just need to have more confidence in the accounts as reported.
  6. to assess whether management’s use of the going concern basis of accounting as required by IFRS or UK GAAP is appropriate. How could auditors make their assessment of greater value to users of financial statements? Please set out what steps you believe should be required to better underpin confidence in audit and audited financial statements. The “going concern” requirement is clearly inadequate as so many companies pass the current standard and yet go into administration or have to be bailed out before the next year end. There should not be a single “black/white” comment on the financial health of a company, but a range of reported measures. One problem at present is that both auditors and companies are desperate to avoid “qualified” accounts with the undesirable consequence that minor issues (which might point to major problems) are not reported.

There was a very interesting letter in today’s Financial Times on this subject. It was from Rodger Hughes of The Family Building Society. He said that the key driver of audit quality is the ability and attitude of audit partners and managers, but he suggested that increased compliance regulations and more auditor insecurity might have made matters worse. He concludes by saying “What is lacking and urgently needed is an authoritative study of audit failures and the underlying causes”. I wholeheartedly agree with that comment as it seems the FRC has been focussed on other than the key issues.

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

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