Tag: Fraud

Preventing Fraud in Accounts – FRC Tightens Audit Rules

There have been repeated examples of the accounts of public companies being fraudulent in recent years. Wirecard was probably the latest and biggest example. I have seen examples of such misdeeds twice in my investment career in my own holdings although losses have been minimal in both cases, the last example being Patisserie (£95 million missing from their accounts). But I have avoided a lot of others where the losses to some investors have been enormous. There have simply been too many such cases for investors to avoid them all however careful you are in analysing the accounts of companies. There can often be hints that something is wrong, but in many cases the fraud is so well concealed it is very difficult to detect. In both the examples I mention, the cash that was claimed to be on the balance sheet was not there, which should be a simple thing for auditors to verify.

The Financial Reporting Council (FRC)) have announced that they are tightening up the rules followed by auditors to impose more responsibility on them for detecting fraud. In the past it was unclear that auditors had any responsibility to detect fraud and some have even denied it.

The FRC claim they are making the auditor’s obligations clearer – specifically to try and identify fraud. The FRC is running a public consultation on the proposed new audit standard which you can read about here: https://www.frc.org.uk/news/october-2020/consultation-on-revised-auditing-standard-for-the

It makes for interesting reading and it actually spells out the kind of problems that auditors should be looking for. In general the proposed changes to the audit standard make sense.

Will it solve the problem of too many frauds altogether? No for three reasons:

  1. Because audit work is bid for by audit firms, while companies pay their fees, there is a strong incentive by both parties to keep the cost of the audit as low as possible. This brings pressure to bear to not do more work than is absolutely necessary.
  2. Auditors cannot challenge management too much if they are going to retain the audit brief, and there is a tendency to build a cosy trusting relationship.
  3. Auditors are protected from being sued by shareholders for incompetence by the Caparo legal judgement, and their liability even to the company can be undermined by the contracts they require signing. In other words, the legal framework under which they operate enables them to escape responsibility for incompetence.

How might these problems be solved? It has been suggested that auditors be appointed by an independent body rather than by the directors of a company. Perhaps another solution might be to set up an independent fund that rewards auditors when they identify and report fraud, with big bonuses for the individuals that do so. That would give them a strong financial incentive to discover it.

That would provide a carrot. But the stick needs to be change in the regulatory framework and the law so that auditors cannot escape financial penalties when they do not do a competent job. A simple change would be to require audit contracts to be based on a standard set by an independent body such as the FRC and not written by auditors as at present.

I hope readers will respond positively to the consultation because I can see many objections from audit firms to the imposition of new obligations, however reasonable they appear to investors.

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

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How to Spot a Fraud (Wirecard)

There was a very good article on Wirecard by fund manager Barry Norris on Citywire yesterday. It was headlined “Wirecard raised more red flags than a communist rally” and explained how he thought it was probably a fraud as long ago as March 2018.

He met the former CFO of the company Burkhard Ley in that year but he seemed unable to answer the basic question of “Precisely from which activities did they generate revenue”. One particularly telling comment from my knowledge of the payments sector was this: “When pressed for a specific response on how much of the company’s revenues came from online pornography and illegal casinos, Burkhard claimed ignorance and just grinned, like a well-coiffed cat who not only had just had the cream but who had also just eaten the family pet hamster”.

The Financial Times published allegations about false accounts at the company in January 2019, and again later. But the German financial regulator took no action and even banned short selling of the company’s shares.

Another very negative sign was in early 2020 when the company raised more debt even though it had high profits margins, limited capital expenditure, paid minimal dividends and according to its accounts was generating cash.

The latest news is that former Wirecard CEO Markus Braun has been arrested based on allegations of false accounting.

What can be learned from this case? Firstly that company management who are reluctant to answer detail questions about the business are not people you can trust. The bullshitters who wish to talk about market dynamics and their position in a hot sector rather than the details on how they actually make money (i.e. the business model) are particularly suspect. Secondly that accounts cannot be trusted – not even the cash figures even though they should be simple to verify. See also Patisserie and Globo for examples of where the cash was simply not there. Where there are international businesses with multiple auditors involved, they are even more likely to be unreliable.

Frauds rarely come out of the blue but there are warning signs much earlier than the final disclosure of unexplained problems and company collapse. So it took 4 years at Wirecard for the truth to be generally acknowledged even though issues with the accounts were widely publicised. Why did investors stay faithful to the company? Because investors are always reluctant to admit to their own blind faith in the business particularly when the share price has handsomely rewarded them in the past. People do by nature trust management of companies when the correct approach should be the contrary. Charismatic leaders who dominate their companies are frequently the ones to be wary about.

But it’s never too late to change your mind about a company and sell. A reluctance to sell on negative news is a common psychological trait – it’s called loss aversion. Wirecard investors certainly had plenty of opportunity to do so.

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

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SFO Difficulties and Barclays Case

This morning the Financial Times ran a full-page article over the problems with prosecuting fraud under the headline “The legal fight over a company’s controlling mind”. This covered the difficulty that the Serious Fraud Office (SFO) has in prosecuting fraud with particular reference to the Barclays case. That arose from the escape by Barclays from involvement with Government funding after the financial crisis in 2008. They simply borrowed a pile of money from Qatari investors instead. But it was alleged that they had paid additional consultancy fees as a sweetener for the deal which were not disclosed to investors at the time.

As a Barclays shareholder at the time, I thought that it was a very wise move to avoid Government involvement as the Government seemed to be intent on taking control of the banking sector by forcing recapitalisation on the major UK banks, i.e. forcing them to issue equity or take loans on onerous terms which they certainly did with RBS and Lloyds, much to shareholders disadvantage.  It has always seemed to me that the legal case against Barclays was politically motivated from the very beginning with the objective of teaching Barclays a lesson.

Last week, the last of three Barclays defendants were acquitted. The former CEO John Varley had been previously discharged by the judge on the grounds that there was insufficient evidence and no corporate charges were brought. The deal had been approved by the board of Barclays after legal advice had been taken so the latest acquittal is hardly surprising.

But the FT article explains well why it is difficult for the SFO to obtain convictions in fraud and bribery cases even when the evidence is better because it is very difficult to identity a “directing” or “controlling” mind in large companies. The current law might have worked with small companies in times gone by but the complexities of modern corporations make it difficult to apply. As a result the SFO has tended to rely on Deferred Prosecution Agreements (DPAs) where the company pays a fine to avoid prosecution but without conceding anything. However, the individuals involved have often then been declared not guilty in subsequent trials (e.g. in the Tesco case).

It’s worth reading the FT article to see how the legal framework is such a mess in the UK. It’s also not helped by the FCA and FRC also being involved with overlapping and confusing responsibilities for corporate financial affairs.

It’s certainly makes a good case for reform. It’s worth pointing out also that the Barclays case stemmed from 2008 (i.e. 13 years ago) and it is surely unjust to have the defendants under the stress of a major prosecution, incurring very large legal costs and probably making them unemployable for that length of time when the legal case seemed to be very weak.

However much some sections of the public would like bankers who were around in 2008 put in prison, this is not justice.

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

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