Tag: FRC

Restoring Trust in Audit – A Long Way to Go Yet

The Financial Reporting Council (FRC) have recently published a “Position Paper” entitled Restoring Trust in Audit and Corporate Governance. It sets out how the FRC will be supporting the Government’s reforms under the new ARGA regime.

This is not a very exciting document as it’s very short on specifics. For example under Corporate Governance and Stewardship is says “including a provision for boards to consider how audit tendering undertaken by the company takes account of the need to expand market diversity…”. What exactly does that mean?

However it does say that the Government intends to put Actuarial Regulation on a statutory footing which is long overdue and the intention is to put ARGA on a new funding basis with market participants paying a levy to meet its regulatory function costs. So perhaps auditors should read this Position Paper carefully.

The Position Paper can be obtained from here: https://www.frc.org.uk/news/july-2022/frc-sets-out-next-steps-in-transition-to-new-regul

There might have been more information provided in a webinar on the 14th August but I missed it for two reasons: 1) they sent the login information but it ended up in a spam folder on my BT server; and 2) They sent it as a Teams invite but even though I chose the web browser option it blocked me with an incomprehensible error message. Is it just me that has endless problems with Teams? I wish people would use other products such as Zoom for webinars which I never have problems with.

Incidentally the latest example of the failures of the audit profession was an announcement by the FRC of sanctions against UHY Hacker Young LLP and their audit partner in relation to Laura Ashley Holdings.

To quote: “LAH’s shares were listed on the main market of the London Stock Exchange. As at 30 June 2019, the Group had 155 UK stores, employing over 2,700 people. The Group’s revenue, operating profit, profit before tax and profit after tax consistently declined between FY2016 and FY2019, and the Group’s loss after tax increased ten-fold from £1.4m in FY2018 to £14m in FY2019. Against this backdrop, the audit reports for FY2018 and FY2019 were unmodified and noted no material uncertainty related to the use of the going concern assumption”. Laura Ashley went into administration in April 2020.

The fine imposed by the FRC was only £217,500, a trivial amount!

See https://www.frc.org.uk/news/july-2022/sanctions-against-uhy-hacker-young-llp-and-martin for details.

There is certainly a long way to go to restore trust in the audit profession after a whole series of failures in the last few years.

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

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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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Brydon Audit Review and FRC Update

Readers probably don’t need to be reminded of the poor reputation of auditors and accountants. The announcement yesterday from Staffline Group (STAF) reiterates the point. They note the latest analysis indicates that 2018 profits were overstated by about £4 million. The CFO, Mike Watts, has left with immediate effect.

Sir Donald Brydon has published his review of the audit market and makes recommendations for significant changes. This is what he says in a preface:

“The quality and effectiveness of audit has become an increasingly contested issue, with the result that this Review has been commissioned. Some consider that audit is good enough but the starting place of this Report is that it is not.

At a time when information is everywhere and there is no obligation on users of the internet to be truthful, it matters even more that shareholders, and others, can trust what directors are communicating. Auditors have a unique advantage in having the right to see everything that goes on in a company and to assess whether that trust is deserved”.

The recommendations encompass:

  • A redefinition of audit and its purpose;
  • The creation of a corporate auditing profession governed by principles;
  • The introduction of suspicion into the qualities of auditing;
  • The extension of the concept of auditing to areas beyond financial statements;
  • Mechanisms to encourage greater engagement of shareholders with audit and auditors;
  • A change to the language of the opinion given by auditors;
  • The introduction of a corporate Audit and Assurance Policy, a Resilience Statement and a Public Interest Statement;
  • Suggestions to inform the work of BEIS on internal controls and improve clarity on capital maintenance;
  • Greater clarity around the role of the audit committee;
  • A package of measures around fraud detection and prevention;
  • Improved auditor communication and transparency;
  • Obligations to acknowledge external signals of concern;
  • Extension of audit to new areas including Alternative Performance Measures; and
  • The increased use of technology.

Comment:

Many of the proposals may improve the information available to investors and help prevent fraud or false accounts. But they will add a substantial burden on auditors, and hence costs on companies. I can see some opposition from the latter when the details are consulted upon.

Some of the proposals will increase engagement with shareholders and the role of the Annual General Meeting so are to be welcomed.

The proposals are likely to be taken forward by the new ARGA body which will replace the Financial Reporting Council (FRC) and which was included in the Queen’s Speech today.

You can read the Brydon Report here: https://tinyurl.com/t7va5fl – 120 pages of Christmas reading to fill the days when there is no news and little to do.

The FRC have also published a revised version of their “Ethical Standard” so as to strengthen auditor independence and ban conflicts of interest. See  https://tinyurl.com/soc8hq3 – that’s another 102 pages for Christmas reading although this may be more of interest to auditors than investors.

To conclude, Donald Brydon included this poem in his report just to amuse you, and to show that the concerns about audits are not new (it dates from the 1930s):

The Accountant’s Report

We have audited the balance sheet and here is our report:

The cash is overstated, the cashier being short;

The customers’ receivables are very much past due,

If there are any good ones there are very, very few;

The inventories are out of date and practically junk,

And the method of their pricing is very largely bunk;

According to our figures the enterprise is wrecked….

But subject to these comments, the balance sheet’s correct.

 

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

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GB Group, Patisserie Holdings, FRC Stewardship Code and Halma

The stock market seems to be in limbo as business waits to see the outcome of Brexit politics. In my portfolio, small cap companies are drifting down and even large funds and trusts have been declining. Is this due to currency effects or the realisation that “star” fund managers such as Neil Woodford cannot be relied upon? Others are just bouncing around. However there was one exception yesterday when GB Group (GBG) jumped 14% after a positive trading statement. That company is one of my more successful longer-term holdings but there may be more growth to come from it because of the sector in which it operates. On-line id verification is becoming essential for many businesses.

The Administrator for Patisserie Holdings has issued their final report before the business moves into liquidation and another firm took over from KPMG to look into any legal recovery from the past auditors (Grant Thornton) and others. The handover was due to a conflict of interest. The Serious Fraud Office is still investigating the affairs of the company and a number of arrests have been made, but ordinary shareholders should not expect any return and it could be years before the legal processes are completed from past experience of similar situations. Even preferential creditors may not receive anything. The administration has so far cost £2.3 million.

The Financial Reporting Council (FRC) have announced a new Stewardship Code to improve the activities of institutional investors – see https://tinyurl.com/y5no8ot4 . There is more emphasis on “Purpose, values and culture” and the recognition of environmental, social and governance (ESG) factors.

This is all very worthy, but personally I would prefer the FRC concentrated on tightening up the quality of public company accounts for which it is responsible. It also needs to be a lot more forceful on patent audit failures that enable frauds to go undetected for years as at Patisserie – and there have been many other similar cases of not just downright fraud but also over-optimistic presentation of accounts.

This morning (25/10/2019) I attended a presentation by Halma Plc (HLMA) in the Investec offices. It was given by Charles King, Head of Investor Relations and it was a highly professional presentation unlike many we see. I have held shares in the company for four years and it confirmed that my choice of it as an investment was sound. But I did learn a bit more.

I’ll cover some of the key points that were made. This company has strong fundamental growth drivers. It has grown both organically and my acquisition over 45 years and now has 45 companies in the portfolio which primarily operate independently. One might call it a conglomerate. It focuses on life saving technology businesses – in essence “safer, cleaner, healthier”, in global niche markets. These are often regulated markets which helps on defensibility and growth. Demographic trends help as more people who are older and fatter promote growth and higher regulatory standards also move in. There is a lot of diversity in the products.

They aim for 15% growth per annum and have 6,000 staff in total. They bet strongly on “talent” to run the businesses. In essence there are many little companies all run by entrepreneurs who are left to operate as they wish. These people are paid on the basis of profit achieved in excess of the cost of capital but one requirement they look at when recruiting is that they must have “low egos”. There is only a small group of central staff handling some corporate functions.

Their focus is on acquiring companies with low capital intensity and ROTIC of greater than 16% when their cost of capital is about 8%. They are very diversified internationally but see opportunities to grow more in Asia/Pacific and other developing markets.

The high share price was questioned (or as one person put it: “it’s in nose bleed territory”). It’s currently on a forecast p/e of 32 according to Stockopedia which is higher than when I purchased shares in 2015 but the share price has more than doubled in that period. This company is like many high revenue/profit growth companies – they never look cheap but simply grow into their share price.

However the share price has fallen back of late like a lot of highly valued technology stocks that I hold. The speaker attributed this to market trends, not management share selling. Growth companies tend to go out of fashion as economic headwinds appear.

But if they stick to the business model, with the high return on capital and sensible acquisitions, I doubt they can go far wrong. In summary a useful and enlightening meeting for a company that until recently kept a low profile. But it is now in the FTSE-100 (market cap £7 billion).

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

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Woodford, Buffett Bot and FRC Survey

There was a very good article in the FT on Saturday on the “rise and fall of a rock star fund manager”, i.e. Neil Woodford. Essential reading for those who have lost money in his funds. A tale of hubris and obstinate conviction it seems. They report that lawyers are looking at a possible claim for investors but I cannot see any obvious grounds. But lawyers like to chase ambulances. Panorama are also covering the Woodford debacle on Monday.

That well-known phrase “Where are the customers’ yachts” comes to mind. While Woodford and his associates have made millions from his management company, the customers have lost money. That is an issue that the FCA might wish to consider but I cannot think of any immediate solution.

Another article in Saturday’s FT was on a Buffett “App” which would imitate the value investing style of Warren Buffett. Neil Woodford was once known as Britain’s answer to Buffett in the deadwood press but that is now being forgotten of course. This new App from Havelock London is aimed to imitate the investing style that is claimed to be the source of Buffett’s above average long-term performance.  They claim that App will focus on long-term value rather than short term performance which is the approach of most such “quant” investors. This was the marketing pitch of Woodford’s Patient Capital Trust in essence as you can tell from the name.

But in my view this whole approach that you can pick out sound investments by clever analysis of the historic financial numbers or of other metrics is simply misconceived. I have explained why this is so in my book “Business Perspective Investing (see https://www.roliscon.com/business-perspective-investing.html ). One reason why Buffett was so successful, which is obvious if you read about his career, is that he looked carefully at the business models of the companies in which he invested and such matters as the barriers to competitor entry. Yes you can cover some of his analysis by looking at return on capital or other metrics of a company, but that’s only half of the story. You need to understand the business from the perspective of a business analyst.

The Financial Report Council (FRC) have just published a survey on “The Future of Corporate Reporting” (see   https://www.frc.org.uk/news/october-2019/future-of-corporate-reporting-survey ). As the announcement says: “Respondents views will inform the FRC’s project which seeks to make recommendations for improvements to current regulation and practice and develop “blue sky” thinking. A key aim of the project is to challenge the FRC to think more broadly in responding to the recommendation by Sir John Kingman to promote greater “brevity, comprehensibility and usefulness in corporate reporting” moving forward”. So this is something all investors who read company reports should look at. It should take no more than 15 minutes to complete they assure us. I completed it in not much longer.

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

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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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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All Change in the Audit World

Readers don’t need to be told that the audit profession has come in for a lot of public criticism of late. Too many unexpected failures of companies and phantom profits being reported are the cause, apart from simple inability to detect fraud. There are three important announcements today that aim to tackle these issues.

The first is the Kingman Review of the Financial Reporting Council (FRC) published by the BEIS. Sir John Kingman basically says that the FRC is not fit for purpose – it should be scrapped and replaced by a new body called the Audit, Reporting and Governance Authority (ARGA). Not exactly a catchy title but the objective is certainly clear.

He wants the new body to have wider powers and a clearer remit. He also criticises the “consensual” approach the FRC takes to regulatory work, that it has an inappropriate culture and staff recruitment is often informal. In summary it’s a pretty damning report on the effectiveness of the FRC and how it currently operates.

BEIS have also announced a review of audit standards by Donald Brydon which will look at the quality and effectiveness of the audit market.

Plus the Competition and Markets Authority (CMA) have proposed new legislation that would separate auditor work from consultancy activities (the latter is 75% of their revenue at present) – what they call a “structural break-up”. They also suggest that audits of the biggest firms (i.e. FTSE-350) be done by 2 firms of which one must be outside the big four audit firms. This might reduce their stranglehold on the market. The CMA also proposes “more regulatory scrutiny” of audit firms to ensure that not just the cheapest audit firm is selected. Does this mean there will be a lot more bureaucracy involved? Perhaps so.

No doubt all these proposals will be subject to public consultation so they may get watered down. But surely these are moves in the right direction.

See https://www.gov.uk/government/news/independent-review-of-the-financial-reporting-council-frc-launches-report and https://www.gov.uk/government/news/cma-proposes-reforms-to-improve-competition-in-audit-sector for more information.

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

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Blancco AGM and Regulatory Landscape

Today I attended the Annual General Meeting of Blancco Technology Group (BLTG). This technology company is now focused on the data erasure market which is surely a growing one. I have commented on this company before (see links below), particularly as the company, and its shareholders, seemed to be a victim of false accounting – an issue that is way too prevalent of late.

The legal framework under which companies, their directors and the regulatory bodies operate just seems to be too weak to bring errant directors and auditors to account. This is not just obvious from this case but from the discussions at the recent ShareSoc/UKSA sponsored meeting with the Financial Reporting Council (FRC). See my previous comments on the Autonomy case in addition. As you will see below, no action seems to be being taken against the former directors of Blancco by the company, although complaints have been made to the FRC and to the Financial Conduct Authority (FCA) about past events and the latter may still be investigating – but as usual feedback is non-existent. As regards the complaint to the FRC, they have passed the buck to the ICAEW (the regulatory body for accountants) on the basis that it is too small a company to be bothered with.

There were about a dozen shareholders at the Blancco AGM in the City of London. The Chairman, Rob Woodwood, opened the meeting by introducing the board. That included new CEO Matt Jones who joined in March and new CFO Adam Maloney. Rob said the last year was a period of positive change for the company, which one can hardly dispute. He said after a turbulent year, they are on a positive track.

Shareholder Bruce Noble, first queried comments on the impact of currency movements (see page 9 of the Annual Report). The CFO admitted it could perhaps have been explained better.

Bruce then pointed out that the report made it clear that management controls had been avoided in the past as a result of which the accounts were false. This resulted in the management obtaining £400,000 and shareholders losing £135 million. The board responded that investigations were on-going and as result they were unable to comment about what is being done due to “legal privilege”. Both Bruce and I complained that we did not understand that comment, and I said that they were in breach of their legal obligations to answer questions put by shareholders at a General Meeting (see my past articles on similar issues at Abcam and Patisserie). As usual they refused to respond further due to “legal advice” so I suggested they should get better advice.

As I said to the Chairman after the meeting ended, we don’t expect him to disclose their conversations with the FCA or FRC, but there is no reason why they cannot pursue a civil case against the former management if there are justifiable grounds. They need to give reasons if they choose not to do so and simply saying they wish to concentrate on rebuilding the business is not good enough. I suggested I would be voting against his re-election in future (not on the agenda at this meeting) if he failed to take action on this matter.

The above is an abbreviated summary of what was a rather long discussion on this issue.

Bruce Noble also criticised the proposed re-election of Frank Blin, who was Chairman of the Audit Committee when the past events occurred. He asked him to do the “honourable” thing and step down, which Mr Blin refused to do. Bruce also criticised the appointment of PWC to take over from the former auditors (KPMG) when Mr Blin had a previous relationship with PWC and PWC had received criticism about other audits. Mr Blin responded that the relationship mentioned was more than 6 years ago and PWC had been appointed after an open tender process. Another shareholder suggested they might get better attention from a smaller audit firm but Blin responded that they did need a firm that could cover a complex international business particularly their operations in Finland and India. Comment: I don’t think having a smaller audit firm would help – Grant Thornton has had similar problems to larger firms. There is a more general problem with the overall quality of audits which has been recognised in the national media and by many investors.

I questioned the presentation of the income statement in the Annual Report, where “adjustments” are mixed in with normal “reported” figures and confuse the reader. They will look at this issue.

We then had a brief presentation from the new CEO Matt Jones. He is clearly an experienced manager of IT businesses. He said they have good customers and good staff but were spread too thinly. They need to focus more. He will be focusing on those with good growth opportunities, namely ITAD, mobile and enterprise solutions (note: they each represent about one third of current revenue).

There was a question about cash flow and operating margins. The response was that they are making investment this year to increase growth and hence margins will come down this year, but will grow thereafter. It was noted later that the investment will be mainly in R&D and to a lesser extent in sales and marketing. The CFO said the key was to avoid major exceptionals and improve cash flow.

One shareholder raised the issue about reliance on one customer at 11% of turnover but the board expressed no concerns and it might fall slightly this year.

I asked about the competitive landscape. Answer given was the main area for that was in mobile and they are working to improve their offering to meet that.

Another shareholder questioned their presence in 26 countries – are they spreading themselves too thinly? The answer was they are not planning any cut back in the geographic perspective. It transpired later than some of their locations are only very small sales operations, even though the CEO clearly spends a lot of time on planes (incidentally he mentioned he is based in California and works from home with an office above his garage). Modern communications methods assist a great deal.

The CEO said they have adequate sales/marketing staff and productivity is improving.

Lastly a question was raised as to the apparent votes from large shareholder M&G who abstained on some of the resolutions. Does the board know why? The answer was no, and it was not clear whether they had even been asked why although the Chairman did say he had been in communication with them and other large shareholders. Could it be I wonder that they were also unhappy with the openness of the board and their apparent failure to pursue past wrongdoing?

In conclusion, it does seem that the Chairman and the rest of the board are at least taking sensible steps to rebuild the company. The new executives seem to be good appointments but we will have to wait and see whether they can actually produce the goods. In the meantime, investor confidence in the company may take time to rebuild but even so it’s still quite highly rated on the normal financial ratios. My concern is that revenue growth does not seem particularly high for this kind of business and the current valuation. But there is certainly business opportunities to pursue given the growing populations of IT and phone equipment that need erasure or disposal at some point.

https://roliscon.blog/2018/01/15/sharesoc-takes-up-blancco-complaints/ https://roliscon.blog/2017/12/20/lse-general-meeting-and-blancco-agm/

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

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