FRC Seminars, Lookers Results, Caparo Judgement and Autonomy Case

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Record Fine on Deloitte, But It’s Not Enough

 The Financial Report Council (FRC) has fined accounting firm Deloitte £20.6 million (including costs) for its defective auditing of Autonomy. Deloitte is the largest of the big four audit firms and this is what the head of the firm said when talking about their 2019 results: “Our FY 2019 results are a validation of Deloitte’s strategy to deliver high-quality, globally consistent service to our clients while continuing to serve the public interest and working to restore trust in capital markets”.

Revenue of the firm in 2019 was $46.2 billion. The average payout to UK partners was £882,000 and there were 699 partners (i.e. a total paid of £616 million). That size of fine therefore will not worry them much. The fine should surely have been much greater!

The fine is the biggest yet issued by the FRC which at least means it’s a step in the right direction, but still not far enough.

This is some of what the FRC said about the case:

“The Tribunal found that each of Deloitte, Mr Knights and Mr Mercer [the two responsible audit partners] were culpable of Misconduct for failings in the audit work relating to the accounting and disclosure of Autonomy’s sales of hardware during FY 09 and FY 10.  They failed to exercise adequate professional scepticism and to obtain sufficient appropriate audit evidence.  Deloitte should not have issued unqualified audit opinions in these years based on the audit evidence obtained. Deloitte, Mr Knights and Mr Mercer fell seriously short of the standards to be expected of a reasonable auditor.

Similarly, in relation to certain of Autonomy’s sales to VARs, the Tribunal found that Deloitte, Mr Knights and Mr Mercer were culpable of Misconduct for failing to obtain sufficient appropriate audit evidence and for a lack of professional scepticism in relation to the nature of these sales.  Deloitte and Mr Knights should not have issued an unmodified audit opinion in FY 09 without obtaining further audit evidence.

The Tribunal commented that ‘…it is the wholesale nature of the failure of professional scepticism in relation to the accounting for the hardware sales and the VAR transactions as well as our findings of Misconduct and of breaches of Fundamental Principles that make this case so serious’.

The Tribunal also made findings of Misconduct in relation to the consideration by Mr Knights and Mr Mercer of Autonomy’s communications with its regulator, the FRC’s Financial Reporting Review Panel (FRRP), in January 2010 and March 2011 respectively.  Mr Knights acted recklessly and thus here with a lack of integrity. Mr Mercer failed to act with professional competence and due care”.

Autonomy was acquired by HP who relied partly on the audited accounts no doubt but subsequently had to write off $8.8 billion related to the acquisition. Both criminal and civil law suits over the accounts of Autonomy are still live.

Altogether a disgraceful example of how the auditing profession is being brought into disrepute of late.

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

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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 )

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Standard Life UK Smaller Companies and FRC Meetings

Yesterday I attended two meetings in the City of London. Here are brief reports on each.

Standard Life UK Smaller Companies Trust Plc (SLS) held a meeting for investors to “meet the manager” in London as their AGM was in Edinburgh this year – only about 10 people attended the latter so there were more in London. I have held this trust for some years and the manager, Harry Nimmo, who has been with the company for 33 years has been a consistently good performer. The management company has recently merged with Aberdeen and is now called Aberdeen Standard Investments but apparently there have been no significant changes internally as yet. Mr Nimmo’s comments are summarised below.

He said they have a discount control policy which is unique to UK smaller companies trusts. They buy back shares if the discount gets about 8%. The investment policy is unchanged and they are not keen on blue-sky or concept stocks. AIM is now a better place than 5 years ago as it is now more broadly based and no longer dominated by mining stocks and blue sky tech stocks.

They have put a new debt facility in place which will ultimately replace their CULS (Convertible Unsecured Loan Stock). The final date for conversion is coming up and investors need to pay attention to that as they are “well in the money”.

The trust shows a ten year CAGR dividend growth of 23.7% and the capital return since 2003 is 851% (plus dividends of course). But there have been some bear markets during his management which one needs to allow for as investors. However, if you had sold the trust after the Brexit vote you would have made a terrible mistake – the company is up 54% since June 2016.

The trust looks for companies that can grow irrespective of the economic cycle, and those with good cash flow and strong balance sheets. Mr Nimmo covered their investment process which is somewhat formulaic using a screening process (I have covered it in past articles) but they do meet investee companies twice a year. They have about 50 holdings in the fund which is a “bottom-up” stock selection actively managed fund.

He mentioned they have 10% in animal care and still hold NMC although as it is now a FTSE-100 stock they have been selling out. They still have a large holding in Abcam and have bought RWS recently. Their second largest holding is First Derivatives where most profits come from outside the UK. They generally do not hold oil/gas/mining stocks and are very light on real-estate [note: I agree with the former and many of my individual holdings overlap with the trusts but I do hold some real estate companies]. An exception though is Workspace who recently produced an excellent set of results with a rapid growth in dividends.

They have also been selling Fevertree as it exceeded 5% of their portfolio value.

I did not manage to stay until the Q&A session as I had to go to a meeting organised jointly by ShareSoc and UKSA with the Financial Reporting Council (FRC). This was a long meeting and I hope one or other organisations will produce a lengthier report on it because it was an exceedingly useful meeting. I will simply highlight a few points of particular interest.

FRC Meeting

The FRC is responsible for audit policy, standard setting and audit quality including investigation and enforcement of past transgressions. So it is a rather important body for those private investors who have come unstuck on an investment because the accounts of the company turned out to be misleading – for example the recent debacle at Carillion was mentioned by one attendee, but I can think of numerous other examples.

The speakers covered the role of audits, both currently and how they might develop in the future (partly as a result of technology changes such as the use of data analytics). After Brexit it is likely there will be a broadly equivalent regime as investors are opposed to “unpicking”.

The FRC reviews about 150 audits every year and grades them into four categories (the reviews are listed on the FRC web site). By 2019 they want 90% to be in the top two ratings which they are not at present. It was noted that KPMG come out worse of the big audit firms. A common reason for audits falling short are lack of professional scepticism.

The FRC also undertakes thematic reviews of particular issues. I raised the issue of the lack of common standards for “adjusted” data commonly reported by companies (such as earnings, or return on capital that I mentioned in previous recent blog posts). The response was it was mandated to explain the definitions of such adjustments but I pointed out this did not help with comparability (e.g. of broker forecasts). The FRC said they will be consulting on this issue shortly, which is good news.

The role of the FRC in “enforcement” was covered. They stressed that their remit does not cover crime, they merely regulate accountants and actuaries although it is of course true that the failure of auditors to identify false accounts is one area they often investigate. It was mentioned that the size of the team on this had grown from 11 people in 2013 to 30 now and they are still looking for more bodies. This really just shows how under-resourced the FRC has been in the past. A total budget of £15m per year was mentioned. Comment: this seems hopelessly inadequate to me bearing in mind the number of public companies (and other organisations) and the number of auditors they have to monitor. It explains partly why complaints to the FRC often seem to disappear into a black hole, or why investigations often take so long as to be pointless. A list of cases under formal investigation is on the FRC web site (See here for that and two linked pages for the full list: https://www.frc.org.uk/auditors/enforcement-division/current-cases-accountancy-scheme which of course will tell you that Globo was commenced in December 2015 and Quindell in August 2015 and have yet to report).

I did suggest to the speaker that the FRC should be a party to the Code of Practice for Victims of Crime (as some audit failures involve the crime of fraud) as the Police, the SFO and FCA are, and which has improved their disclosure culture. This might assist those who report failings to get some feedback on the progress of a case. But the FRC argue that their role is not to investigate crime as such and they are inhibited by legislation/regulation on what they can disclose. However it is very clear to me that too often complaints get made to the FRC, but the complainants are not advised of progress and often have no idea on the outcome. This is an issue they will be looking at.

They hope the extra staffing will speed up investigations. The investigation process was discussed, but for example, Carillion had not even been placed under formal investigation as yet. It was suggested by audience members that the FRC was quite ineffective but recent cases such as AssetCo and Healthcare Locums were mentioned as demonstrating strong action and they have issued fines of £12 million in the last year which is the biggest ever. It was mentioned that fines go to the Treasury which is not ideal.

Confusion between the different regulatory bodies (e.g. the FRC, FCA, SFO, etc) was mentioned by attendees and the speakers, not helped by similar three letter acronyms. One attendee suggested that a unified regulatory body would help (such as the SEC in the USA). Comment: I agree at present it is unclear except to experts on who is responsible for what and the accountability of these bodies to the Government or to any democratic body of investors.

The FRC also has an interest in the UK Corporate Governance Code and the Stewardship Code. A consultation on a new Corporate Governance Code is imminent. There was also a session on the role of the Financial Reporting Lab where both ShareSoc and UKSA members have been involved in the past.

I’ll have to stop here because the budget speech by the Chancellor will commence soon and I wish to listen to it as there may be some major changes on investment tax reliefs. I’ll do another blog post later on it.

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

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