I attended a “roundtable” event at the Financial Reporting Council (FRC) on Monday. It was primarily a discussion of audit market competition and how to improve it, with private investors attending. But as I said at the meeting the key issues in the audit market are the quality of audits and the accountability of auditors. Too many blatant frauds go undetected by auditors, and they avoid any responsibility for their errors. Being able to avoid accountability for their failings has resulted in declining audit standards over the last few decades. The Caparo legal judgement is one big reason as it prevents shareholders suing auditors for their failings. It needs overturning.
These thoughts were echoed by other speakers at the meeting although the FRC made clear that their focus is on quality.
The Kingman review of the FRC was critical of the audit sector and its regulation by the FRC while the Competition and Markets Authority (CMA) is undertaking a review of the market for audit services which is dominated by the big four audit firms.
Would improved competition for audit services improve the quality of auditing is one key question? Or simply lead to a race to the bottom as price competition was increased? Alternatively could quality be improved by improving the work of audit committees and how they select auditors? All of these questions were discussed but no specific conclusions reached.
One proposal to improve competition is to enforce “joint” or “shared” audits where all audits of larger companies would require the involvement of more than one audit firm. This might enable smaller audit firms to become more experienced and more credible to take on larger audits it is argued. But as I said in my response to the CMA consultation: “ So far as investors are concerned, joint and several liability would be a positive advantage to ensure audit quality in theory. But in practice as auditors avoid liability for most failings, it might not matter a great deal”.
I do not see how joint or shared auditing will improve the quality of audits or necessarily improve competition either. An alternative suggestion that there should simply be a cap on the market share of any one audit firm seems a better and simpler solution to the competition issue.
Apparently according to a report in the FT, audit firms have been lobbying hard to retain the status quo. The FT reported the comments of Will Hayter, a director of the CMA that those in the industry should not doubt the CMA’s resolve to go “from four to more” [audit firms].
Improving competition is undoubtedly of benefit even if it just avoids the risk of one of the big four collapsing (as happened with major audit firm Andersen a few years ago after reputational damage and criminal charges over the Enron fraud). But shareholders major concern is improving the quality of audits so that fraud is detected and dubious financial reports are not published; in other words to ensure that published accounts do indeed contain a “true and fair” view of the financial position of a company.
One example of where they might not be was mentioned in the meeting which is the accounts of Burford Capital (BUR) which I have also commented on myself negatively recently, much to the displeasure of Burford holders. All Burford shareholders should read the article by John Dizard published in the FT on the 17th February and entitled “Burford faces long wait over $1bn Argentina claim”. It questioned the valuation of the Petersen legal claim. See https://www.ft.com/content/6debcc05-e368-44b2-bb99-618b7bc0a618 . The key issue is reliance on the management to value the legal claims where any cash arising from the claimed profits based on the valuation of on-going claims may be a long time in coming, if at all.
In summary we need to improve the accounting and auditing standards if investors are to rely on the published accounts of companies. In the meantime investors will need to take a more sceptical view of the accounts of companies and not take them at face value.
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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:
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.
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.
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.
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.
This week’s Investors Chronicle edition (dated 28/12/2018) provides lots of food for thought. One of the most educational is their review of the share tips they published as “tips of the week” in 2018. Unlike some investment publications, who simply forget about their past tips that go nowhere, while lauding their hits, the IC is open about their performance.
They issued 173 “BUY” tips and 24 “SELL” tips in the year. That is quite some achievement by itself as I rarely have more than a very few good new investment ideas in any one year and tend to hold most of my investments from year to year.
How did their tips perform? Overall the “BUYs” returned minus 11.5% which they calculate as being 0.9% better on average than the relevant index. Hardly worth the trouble of investing in them bearing in mind the need to monitor such individual share investments and the transaction costs. The “SELLs” did better at -18.0% versus an index return of -8.8%.
The BUYs were depressed by some real howlers. Such as tipping Conviviality shortly before it went into administration, although they did reverse that tip to a “SELL” before it did so. The result was only a reported 12% loss. As a consequence they are making some “fundamental changes to the way we recommend shares”.
But with so many share tips, the overall performance was not impacted by one or two failures and tended to approximate to the overall market performance. Which tells us that you cannot achieve significant over or under performance in a portfolio by holding hundreds of shares.
I don’t work out my overall portfolio performance for the year until after it ends on the 31st December so I may report on it thereafter. That’s if it’s not too embarrassing. With many small cap technology stocks in my portfolio, I suspect it won’t be good. I always look at my individual gains and losses on shares at the year end, as an educational process. As Chris Dillow said in the IC, “Investing like all our dealings with the real world, should be a learning experience: we must ask what we got wrong, what we got right, and what we can learn. The end of the year is as good a time as any for a round up…”.
One BUY tip they made was National Grid (NG.) in May 2018 on which they lost 11.8%. There is a separate article in this week’s IC edition on that company which makes for interesting reading as a former holder of the stock. I sold most of my holding in 2017 and the remainder in early 2018 – that was probably wise as you can see from the chart below (courtesy of Stockopedia).
National Grid has a partial monopoly on energy distribution and always seemed to be a well-managed business. Many investors purchase the shares for the dividend yield which is currently about 6%. But the IC article pointed out that proposals from OFGEM (their regulator) might limit allowed return on equity to 3%, which surely threatens the dividend in the long term. The share price fell 7% on the day that OFGEM announced their proposals. Bearing in mind the risks of running an electricity network, and the general business risks they face, that proposed return on equity seems to be completely inadequate to me. That’s even if one ignores the threat of nationalisation under a possible Labour Government.
Another IC article in the same edition was entitled “Brexit and the UK Economy”. That was an interesting analysis of the UK economy using various charts and tables. One particularly table worth studying was the balance of trade between the UK and our main trading partners. We have a big negative balance (i.e. import more than we export) to Germany, Spain, Belgium, Holland and Italy but positive balances with Ireland and the Rest of the World – particularly the USA. The article makes clear that our trade with EU countries has been declining – exports down from 55% in 1999 to 44% of all exports. But imports have not fallen as much so the trade gap has been widening. Meanwhile our exports to Latin America and China, which have been good economic growth areas, have remained relatively small.
The conclusions are simple. EU economies such as Germany would be severely hit by any trade disruption on Brexit. But opportunities in rapidly growing markets are currently being missed, perhaps hampered by inability to negotiate our own trade deals with them, and that might improve after Brexit.
It mentions a long list of audit failings on pages 12 onwards including banks before the financial crisis of 2008, BHS, Carillion, Autonomy (covered in a previous blog post) and Conviviality which was mentioned above.
This paragraph in their executive summary is worth repeating: “Independent audits should ensure that company information can be trusted; they provide a service which is essential to shareholders and also serves the wider public interest. But recent events have brought back to the surface longstanding concerns that audits all too often fall short. And in a market where trust and confidence are crucial, even the perception that information cannot be trusted is a problem.”
One problem they identify is that “companies select and pay their own auditors” which they consider an impediment to high-quality audits. In addition choice is exceedingly limited for large FTSE companies, with the “big four” audit firms dominating that market.
Their proposals to improve matters are 1) More regulatory scrutiny of auditor appointment and management; 2) Breaking down barriers to challenger firms and mandatory joint audits; 3) A split between audit and advisory business within audit firms and 4) Peer reviews of audits.
Their review of FRC enforcement findings suggests that the most frequent findings of misconduct include:
(a) failure to exercise sufficient professional scepticism or to challenge management (most cases);
(b) failure to obtain sufficient appropriate audit evidence (most cases); and
(c) loss of independence (three out of a total of 11 cases).
That surely indicates a major problem with audit quality, and that is backed up by the FRC’s own analysis of audits that they have reviewed with only 73% being rated as “good or requiring limited improvement”.
Auditors are primarily selected via audit committees and there is a noticeable lack of engagement by shareholders in their selection. But that’s surely because large institutional shareholders have little ability to judge the merits of different audit firms.
Would more competition improve audit quality, or simply cause a focus on the lowest price tenders? The report does not provide any specific comment on that issue but clearly they believe more competition might assist. More competition does appear to drive more quality for a given expenditure in most markets however so it is surely sensible to support their recommendations in that regard. The report does emphasise that the selection and oversight of auditors would ensure that competition is focused on quality more than price which is surely the key issue.
A previous proposal was that auditors be appointed by an independent body but that has been dropped, partly due to shareholder opposition. The new proposal is for audit committees to report to a regulator with a representative even sitting as an observer on audit committees where justified. In essence it is proposing much more external scrutiny of audit committee activities in FTSE-350 companies and decisions taken by them.
The end result, at some cost no doubt, would be that both auditors and audit committees will be continually looking over their shoulders at what their regulators might think about their work. That might certainly improve audit quality so for that reason I suggest this proposal should be supported.
The requirement for “joint” audits where two audit firms including one smaller firm had to be engaged seemed to be opposed by many audit committee chairmen and by the big four accounting firms. Some of their objections seem well founded, but the riposte in the report is that evidence from France, where joint audits are compulsory, suggests they have a positive impact on audit quality. Moreover, it would clearly increase competition in the audit market.
In summary, the report does appear to provide some sound recommendations that might improve audit quality. But investors do need to respond to the consultation questions in the report as it would seem likely that the big audit firms will oppose many of them.