Financial failures and scandals from enron to carillion

This concise volume evaluates the cause and significance of recent corporate failures and financial scandals, and how they reflect on the fitness for purpose of the external auditors, fi

Enron and Carillion are household names, not because of what they were, but because of the way they failed The extent to which the auditors can be blamed for these and many other corporate failures is an important public policy issue This interesting and well-researched book highlights the role of accounting and auditors in some of the highest profile failures of recent years It is a useful contribution to the current debate on what needs to change in accounting and auditing practice.

—Geoff Wilkinson held a range of senior economic and financial

positions with the British Steel Corporation before moving into investment banking He was finance director and subsequently managing director of Laird plc, an FTSE 250 company, and chair of the Audit Committee for the Eden Project.

This book is a first in that it examines a number of recent financial scandals and corporate failures in the UK and further afield Placing earlier pivotal cases in perspective, it then con- centrates on current cases, culminating in a forensic financial dissection of the Carillion collapse, using a variety of analytical techniques including financial modelling By critically analyzing the Carillion collapse, and other recent cases, it sets out a detailed analysis of what went wrong, and who was to blame An accompanying online resource also updates recent cases such as Patisserie Valerie.

—Vaiz Karamatullah, former CFO of Arab conglomerates

in various Middle Eastern countries; presently trustee of the Graham Layton Trust, a UK charity supporting free

eye care overseas.

This concise volume evaluates the cause and significance of recent corporate failures and financial scandals, and how they reflect on the fitness for purpose

of the external auditors, financial reports, financial watchdogs, boards, directors and senior management Failures like the disastrous collapse of Carillion, examined at length, have ultimately led to a crisis of confidence not only in the audit process but in the entire process of financial reporting.Revealing the shortcomings in audit quality, independence, choice and

the growing expectation gap, Financial Failures and Scandals questions if the

profession, its regulators or government watchdogs are adequately prepared for the challenges of increasing regulation, public outcry and political scrutiny in the face of inevitable future financial failures The fundamental structures of financial reporting, annual reports, boards of directors and senior management are often found to have failed Tighter regulation and new requirements for reporting will inevitably result

Drawing on extensive research and interviews with insiders, users and experts, this unique book provides a compelling account of the profoundly disruptive impact of financial failures on corporate and financial accountability Topical and readable, this book will be of great interest to students, researchers and professionals

in accounting and auditing, as well as to policy makers and regulators

Krish Bhaskar was founding Professor of Accounting at the University

of East Anglia, UK and previously held positions at the London School of Economics and the University of Bristol He is the author of over 50 books and has also worked extensively in the IT, consulting, investment banking, automotive and forecasting sectors

John Flower, now retired, was formerly Professor of Accounting at the

University of Bristol, UK and Director of the Centre for Research in pean Accounting, Brussels

Euro-Rod Sellers, OBE, FCA, has spent almost 50 years in senior financial and

corporate roles in industry

Financial Failures and Scandals

Following the global financial crisis and the growing number of major corporate collapses and financial scandals, confidence in the corporate sector, and more importantly, the professionals who audit them, is at an all-time low Based on the authors’ extensive experience and unique research (including interviews with hundreds of professionals, regulators and whistleblowers) this topical series provides a uniquely accessible insight into the criticisms and challenges currently facing the financial reporting and auditing industry, and examines possible solutions.

At a time of unprecedented scrutiny and technological change, the four

complementary volumes (Disruption in the Audit Market, Financial Failures

and Scandals, Disruption in Financial Reporting and Disruption in Auditing)

critically examine the key debates, drawing on expert opinions from top industry professionals Together the four volumes combine into an unparalleled contemporary overview and evaluate the future challenges facing this vital part of our economy and society

Disruption in the Audit Market

The Future of the Big Four

Krish Bhaskar and John Flower

Financial Failures and Scandals

From Enron to Carillion

Krish Bhaskar and John Flower

For more information about this series, please visit: www.routledge.com/Disruptions-in-Financial-Reporting-and-Auditing/book-series/DFRAOr

See the online companion volume with current updates: http://www.fin-rep.org/

Edited by Krish Bhaskar

Financial Failures and

Scandals

From Enron to Carillion

Krish Bhaskar and John Flower

with contributions from Rod Sellers

by Routledge

2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN and by Routledge

52 Vanderbilt Avenue, New York, NY 10017

Routledge is an imprint of the Taylor & Francis Group, an informa business

© 2019 Krish Bhaskar and John Flower

The right of Krish Bhaskar and John Flower to be identified as authors of this work has been asserted by them in accordance with sections 77 and 78 of the Copyright, Designs and Patents Act 1988 All rights reserved No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical,

or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers.

Trademark notice: Product or corporate names may be trademarks

or registered trademarks, and are used only for identification and explanation without intent to infringe.

British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library

Library of Congress Cataloging-in-Publication Data

Names: Bhaskar, Krish N., 1945– author | Flower, John,

1934– author.

Title: Financial failures and scandals : from Enron to Carillion / Krish Bhaskar and John Flower ; with contributions from Rod Sellers.

Description: Abingdon, Oxon ; New York, NY : Routledge, 2019 | Series: Disruptions in financial reporting and auditing | Includes bibliographical references and index

Identifiers: LCCN 2019004492 (print) | LCCN 2019006565 (ebook) | ISBN 9780429270611 (E-Book) |

ISBN 9780367220730 (hardback : alk paper)

Subjects: LCSH: Business failures—Case studies | Corporations— Finance—Case studies | Corporations—Corrupt practices— Case studies.

Classification: LCC HG3761 (ebook) | LCC HG3761 B445 2019 (print) | DDC 338.7/1—dc23

LC record available at https://lccn.loc.gov/2019004492

ISBN: 978-0-367-22073-0 (hbk)

ISBN: 978-0-429-27063-5 (ebk)

Typeset in Bembo

by Apex CoVantage, LLC

1 About this book 1

3 Manipulating reports and creative accounting 25

4 Landmark scandals: the impact of earlier cases 38

Glossary 120

Contents

1 About this book

Background and focus of the failures in this book

This book is about financial scandals and failures Financial or accounting scandals are usually business scandals arising from intentional manipula-tion of the financial statements In this book we concentrate on misdeeds

by companies and their management

The Competition and Markets Authority (CAM) and Kingman report were published post-publication Reactions to the CMA on the audit market and the Kingman report on the replacement of the FRC can

be found in the online companion volume www.fin-rep.org The CMA only considered what we regard as ineffective solutions The Kingman Review was, in our opinion, far more effective, scrapping the Financial Reporting Council (FRC) in favour of the Audit, Reporting and Gov-ernance Authority (ARGA) with statutory powers making it a stronger regulator with harsher penalties and the ability to investigate all company directors ARGA will also be able to make changes to accounts, have a wider set of sanctions and can publish reports into a company’s con-duct and management The Government has said it would implement the Review.1

The cases we deal with concentrate on more recent ones and involve one of two main symptoms:

1 Misappropriation of assets (possibly theft) and then hiding the results

in the financial reports;

2 Intentional manipulation of accounts by management to improve financial reports and the annual reports

Who is involved in preparing financial reports?

The external auditors (referred to as auditors here) are the main external check and balance for all companies over a certain size including both pri-vate and non-listed organizations The Big Four accounting firms (PwC,

EY, Deloitte and KPMG) dominate the auditing of Public Interest Entities (PIEs) and have a stranglehold over the FTSE 350.2 We estimate that by

2025 or shortly after, they will have close to 100% share of this audit ket In simple terms, the auditors usually have a pass or fail type of sign off

mar-A negative audit report is indicated by ‘qualified’ or by no audit opinion.The Audit Committee (AC) is also significant in the accounts prepara-tion with often continuous interaction with the auditors The AC com-prises some non-executive directors (NEDs) and the Audit Committee Chairperson (ACC) The AC usually provides a report in the annual report The Audit Engagement Partner (AEP) is the senior auditor, usually

a senior partner of one of the Big Four, and it is he or she that signs the audit report in the annual report This is separate from the Audit Com-mittee report which is part of the Annual Report

Typical interactions in the reporting process

The AEP has interactions with the AC and also, depending on culture, with the Company Financial Officer (CFO) and/or the ACC The ACC often takes a lead role in solving disputes between the CFO and the AEP Box 1.1 shows an example of a typical interaction for a specific issue

Box 1.1 Interactions between AEP, ACC and AC3

Issue: identification of intangibles on acquisition

Arising from: IFRS implementation

• Following acquisition, AEP stated position clearly despite doubts from CFO;

• CFO engaged an external valuer for the work;

• Valuation considered by AEP, then technical department and AC;

• AEP questioned valuation, so AC agreed to revise downwards

Issue: presentation of cash flow statement

Arising from: IFRS implementation

• AEP proposed presentation based on guidelines included in relevant standard for first year of IFRS;

• Company accepted in first year but did not like the format – so adopted alternative for subsequent year;

About this book 3

• AEP warned CFO of risk of regulatory action and discussed with ACC;

• CFO and AC adopted revised format – subsequently ered other companies had also used this format

discov-Issue: accounting for a complex transaction

Arising from: solutions for unusual transactions

• Passed up by more junior staff for discussion by CFO and AEP but no initial agreement;

• ACC aware of problem at pre-AC meeting;

• CFO acquired more evidence to support his view based on similar cases elsewhere;

• AEP checked with technical department and accepted the proposal;

• Following agreement between AEP and CFO, then CFO met with ACC to ensure he supported it;

• CFO and AEP jointly presented solution to AC, who asked questions before accepting

There is some merit for these interactions to be reported on and marized Unresolved disputes can be clearly identified Exactly how much should be revealed needs further discussion, but nevertheless, we are in favour of the disclosure of such interactions between these important players in the reporting process

sum-The role of the regulators

The FRC introduced the requirement for the strategic report which is a description of the business model, as well as a narrative section in the ‘front half’ of UK annual and corporate reports Note the Kingman Review has rec-ommended that the FRC be replaced with an independent statutory regula-tor called ARGA We agree with the ICAEW4 assessment that the quality of narrative and non-financial disclosures in the ‘front half’ of the annual report has improved significantly in the UK in recent years Of particular note are improvements in relation to the business model, strategy, non-financial key per-formance indicators (KPIs) and alternative performance measures (financial) and drivers of long-term value creation There is also a strong sense that the

‘front half’ has continued to evolve in response to the introduction of the gic report and changing market expectations (That is not to say that there aren’t major problems with many of the top front halves of typical annual reports.)

strate-The FRC (although not without its own critics [now replaced]) has reported a fall in audit quality We maintain that this fall is due to the convergence of a number of disruptive factors:

• Continuing government austerity policies eroding government expenditure (and those firms depending on public spending);

• Brexit changing the focus for firms, and creating a fall in the value of sterling;

• Low interest rates causing higher leverage and trapping highly geared firms into a false sense of security whilst interest rates are low;

• Disruptive industries and sectors causing the growth in some and the fall-off in demand for brick-and-mortar retail outlets and restaurants;

• Other disruptive effects, e.g new technologies, the internet and IT

Carillion – a pivotal event

A financial failure (and arguably scandal) which is pivotal to the future

of the audit market is the failure of Carillion, which took place in early

2018 Carillion takes a significant portion of our attention in this book Not since Enron has there been a case which has attracted such severe criticism More significantly, it argues for a major change to financial reporting, watchdogs and auditing

Its failure left a mountain of debt, job losses in the thousands, a giant pension deficit and hundreds of millions of pounds of unfinished pub-lic contracts with vast ongoing costs to the UK taxpayer How could a company that was signed off by KPMG as a going concern in Spring

2017 crash into liquidation only a few months later with a reported £5+ billion of liabilities and just £29 million left in cash? Moreover, all of the Big Four were involved in Carillion in some way: one was the external auditor; one was the internal auditor; two were tasked with reviews or specialist help; and one became the administrator

Stephen Haddrill, ex-chief executive of the FRC, said the CMA should investigate the case for ‘audit-only’ firms in an effort to bolster competition and stamp out conflicts of interest in the sector This radical idea would force the Big Four firms – Deloitte, EY, KPMG and PwC – to spin off their UK audit arms into separate businesses (explored in depth

in Disruption in the Audit Market) Mr Haddrill’s intervention follows a

string of corporate accounting scandals, ranging from Carillion to hoff in South Africa and Petrobras in Brazil “There is a loss of confidence

Stein-in audit and I thStein-ink that the Stein-industry needs to address that urgently”, he said “In some circles, there is a crisis of confidence.”5

Three of the four now say they will ban non-audit work for their largest audit clients This is entirely different from splitting the firms into separate audit-only and consulting firms

About this book 5

Even this brief overview shows that much is left to be desired from current audit practice, despite attempts to improve quality We posited in Volume 1 that the way that the current audit sector is configured makes

it unable to cope with current economic and disruptive conditions This volume explores in detail how, why and when auditing fails, sometimes to catastrophic effect Al so see Appendix 2.02.01

Recent financial failures and scandals – an overview

Table 1.1 sets out a selection of the largest recent global scandals We have concentrated on companies based in the UK, US, Canada and those with

a UK connection Note, some famous UK cases are excluded as they are discussed in detail in later chapters Table 1.2 summarizes all the current cases being investigated by the FRC (as of May 2018)

Table 1.1 Selection of the largest recent global scandals

Company Country Period Auditor Issue

Lehman

MF Global US 2010 PwC Poor trading decisions and fines

Kept bonds off its balance sheet PwC paid out of court settlement of $3 billion Colonial

Bank US 2009, 2018 court case PwC Ghost mortgages PwC found negligent Possible claim of

$5.5 billion (Now settled for

$335m).

Connaught UK 2009/10 PwC PwC fined £1.5 million over

misconduct in their audit Miller Energy

Resources US 2011 KPMG Assets overvalued by more than 100 times Fine of $6 million Wells Fargo

Bank US 2011 to 2018 KPMG Aggressive cross-selling without permission Sino-Forest

Japan 2011 EY Tobashi 1 using acquisitions.

misconduct in their audit See Chapter 4.

Panasonic

Avionics US 2012 onwards Possibly KPMG Panasonic to pay $280+ million for bribery law and

accounting fraud violations.

misconduct in their audit.

(Continued)

Company Country Period Auditor Issue

Gol US-Brazil 2012 Deloitte False audit reports Deloitte

fined $8 million See Chapter 4.

2017 Not relevant Fine of $9 million for: a) insider trading, b) six revolving

door cases and c) improper relationships.

Merrill Lynch US 2014 PwC Fined $1 million for failing to

collect sufficient evidence for compliance.

Quindell UK 2013 KPMG Fined £3.15 million for audit.

audit See Chapter 8.

Association Canada 2016 N/A Fraudulent invoices.

fraud accusations (with government).

Steinhoff Global 2018 Deloitte See Chapter 8.

1 A Tobashi scheme is a fraud where a client’s losses are hidden by an investment firm by shifting them between the portfolios of other clients Any real client with portfolio losses can therefore have their accounts flattered by this process This cycling cannot continue indefinitely and so the investment firm itself ends up picking up the cost As it is ultimately expensive, there must

be a strong incentive for the investment firm to pursue this activity on behalf of their clients.

Table 1.2 Current FRC cases under accountancy and audit schemes (as of July 2018)

KPMG LLP – Carillion plc Audit Enforcement Procedure

and Accountancy Scheme 19-Mar-1829-Jan-18

Case Investigation type Announced

Deloitte LLP – Mitie Group plc Audit Enforcement Procedure

and Accountancy Scheme 20-Nov-1731-Jul-17 PricewaterhouseCoopers LLP’s

audit of BT Group plc Audit Enforcement Procedure 29-Jun-17KPMG Audit plc’s audit of

Rolls-Royce Group Audit Enforcement Procedure 04-May-17Sports Direct International plc Accountancy Scheme and Audit

Enforcement Procedure 28-Nov-18KPMG LLP – Carillion plc Audit Enforcement Procedure

and Accountancy Scheme 19-Mar-1829-Jan-18 Mitie Group plc Audit Enforcement Procedure

and Accountancy Scheme 20-Nov-1731-Jul-17 Preparation and audit of the

financial statements of

Redcentric plc

Audit Enforcement Procedure and Accountancy Scheme 25-Jul-1727-Feb-17 Sports Direct International plc Audit Enforcement Procedure

and Accountancy Scheme 28-Nov-1605-Dec-16 Equity Syndicate Management

Limited (Accountancy

Scheme)

07-Sep-16 05-Mar-12 Coats Group plc Accountancy and Actuarial

BHS Limited and the audit by

PricewaterhouseCoopers LLP Accountancy Scheme 27-Jun-16 11-Jun-18 Serco Group and the audit by

KPMG Audit plc and Ted Baker

Globo plc and the audit by

Grant Thornton UK LLP Accountancy Scheme 21-Dec-15

05-Aug-15 KPMG Audit plc in connection

AssetCo plc and the audit by

Grant Thornton UK LLP Accountancy Scheme 24-Apr-1725-Jan-17

12-Aug-14

31-Aug-16 22-Dec-14 The Co-operative Bank plc and

the audit by KPMG Audit plc Accountancy Scheme 28-Oct-1620-Jan-14

11-Feb-13 RSM Tenon and the audit by

PricewaterhouseCoopers LLP Accountancy Scheme 16-Aug-1714-Dec-16

13-Aug-12 Tanfield Group and the audit by

Baker Tilly UK Audit LLP Accountancy Scheme 11-Jun-14SIG plc and Deloitte Audit Enforcement Procedure 28-Jun-18 Sanctions against RSM Tenon Accountancy Scheme 21-Jun-18 Conviviality plc and KPMG Audit Enforcement Procedure 03-Jul-18

The team behind this series

Professor Krish Bhaskar6 is the principal author of this book He has lished more than 50 books and many refereed articles He has also worked

pub-in the IT, consultpub-ing, pub-investment bankpub-ing, automotive and forecastpub-ing tors He has experience of running companies, preparing reports and auditing7 – though mainly computer auditing, as it used to be called.Krish has been aided and abetted by Professor John Flower, whose major role is as an auditor and researcher into multinational financial reporting John would probably classify himself as left of centre and lean-ing towards anti-capitalism and environmentalism He has published

sec-scholarly critiques of the profession, including Global Financial

Report-ing, with Dr Gabi Ebbers, Palgrave, 2002, and two more radical books, Accounting and Distributive Justice (2010) and The Social Function of Accounts: Reforming Accountancy to Serve Mankind (2017) He has undertaken sub-

stantial research on financial reporting and standard setting He also duced modern auditing methods for the Common Agricultural Policy8

intro-and undertook a number of innovative techniques in auditing what was and is massive-scale mega audits.9

Rod Sellers, OBE,10 FCA,11 has spent almost 50 years in senior cial and corporate roles in industry Rod has given his time, written mate-rial, and given his views relentlessly, unstintingly and without complaint But he does not want to be regarded as an author – just a contributor He

finan-is deemed part of the auditing establfinan-ishment (as he sat on the advfinan-isory board of one of the Big Four accounting/auditing/consulting firms) and was financial director and then chief executive of an FTSE 25012 com-pany For the last 20 years, he has been a portfolio NED/chairman with

a dozen companies – from private family businesses to PIE entities His role has often included serving on audit committees and working closely with the financial departments He defends the accounting and auditing profession and, although he realizes the impact of disruption, he does not believe that very much has gone wrong or usually requires anything more than evolutionary change However, in terms of solutions and scenarios to correct problems facing the audit market, he appreciates that something more radical might be appropriate He also believes that, in most cases, management is honest and trustworthy His motivation to be involved in this series of books is to make sure his viewpoint and that of the profes-sion is taken into account Rod came to many of the interviews and col-lected considerable amounts of written evidence (emails, etc.)

All three of us have extensive and varied experience in the accounting profession Two of us are broadly pro-Big Four in some shape or form and one of us is against All three of us have experience both from the

About this book 9

reporting viewpoint and audit experience One of us has had a lifetime career in industry with preparer experience including audit committees and shareholders But we all agree that the current disputes between the FRC, the users of reports, the government and the Big Four has to lead to re-evaluated audit experience, not least because of the gap between what the public expects and what the auditors actually currently deliver This expectations gap is currently widening and unstable, especially after the plethora of failures in 2018 In addition, the rate of increase of financial failures from 2017 onwards seems to be accelerating Recent improve-ments to financial reporting and auditing seem not to be working.However, although we share a common view of what the problem is,

we do not all share the same opinion of what has caused the problem, or the best way to address it

• John Flower, despite his extensive audit experience, is negative towards the role of auditors, financial reporting and current account-ing rules John is disillusioned with the public interest notion of auditing and wants radical change

• Rod Sellers believes that in general the preparers of financial reports

do so honestly and fairly He believes that the available published evidence tends to concentrate on the frauds and scandals, thereby negating much of the good work which is undertaken between a company’s financial team and its auditors out of the public eye But

he recognizes that change is coming and may be necessary

• Krish Bhaskar takes the middle ground and keeps a balanced view However, he is aware that in a situation like Tesco, for example, there

is high motivation for senior management to manipulate financial reports, however slightly, to their advantage, for financial gain (salary, bonuses and share options, etc.) or face-saving reasons

There are also many other contributors to this book: managers, board members and practitioners with the Big Four who prefer to remain anon-ymous but who have provided significant input In the main they sup-port the profession, but some see issues and problems within it Some are ardent critics of the growing UK approach to audits via checklists rather than intuition and a profound in-depth knowledge about the entity being audited Their input amounts to hundreds of hours of partner time, hun-dreds of pages of input and thousands of emails

We also draw on the views of a variety of groups, companies and tutions These views range from support for the current status quo to being critical of it or in some cases highly critical of the status quo and ardently wishing for change Boards and management of the FTSE and

insti-larger AIM companies feel that they are under much pressure from an ever-changing set of rules and regulations This demonstrates our key aim:

to ensure that this book is relevant, fair and transparent You know whose view it is you are reading

Included as our own text are sections written by a variety of ees including partners from the Big Four, senior auditors, accountants, analysts, investment bankers, other professional investors, sharehold-ers and senior and lower level managers of the FTSE 350 Many have required anonymity so there are only a handful of attributions given

interview-We have not always identified quotes separately, especially if they came from several sources, even though we may have used the actual words from a single source Credit should be given to those people who have given much time and effort in providing input to this volume We do indeed thank them very much Of course, as these written sources have requested anonymity, we are not at liberty to release their names How-ever, many of the ideas incorporated here include input and sometimes their actual words Where we have incorporated ideas into our own thinking, then we adhere to the normal observation to the effect that the views expressed here are our own, notwithstanding the comments

of others

Where possible we have also referenced press reports Usually these articles are published contemporaneously with the business failure or event Most importantly, where possible, we always try to provide a bal-anced view

Many of the comments we received have been added for balance to reflect the many comments received from reviewers and practitioners, some of which have been involved in the various cases we consider Often their response is to disagree with our conclusions in the strongest possible terms However, our conclusions are based on evidence and are often reinforced by others; those references have been given

Other books and volumes in this series

The volumes which make up the Disruptions in Financial Reporting and

Auditing series are:

1 Disruption in the Audit Market: The Future of the Big Four;

2 Financial Failures and Scandals: From Enron to Carillion;

3 Disruption in Financial Reporting;

4 Disruption in Auditing.

References to these companion volumes are made throughout this book

About this book 11

Websites and online material

There is a complementary companion set of material to this volume online available at www.fin-rep.org Some material may be updated over time The glossary is listed first on the website and material is then by book title (Which Book?) There is a short glossary of the most relevant terms at the end of this book Online, there is also the (full) glossary, which takes longer to look through but has more than 400 terms As there are so many abbreviations, you may find it useful to keep the glossary open whilst reading this book On mobile devices, just enlarge by zoom-ing This companion site can be accessed via www.fin-rep.org

The reader can access the two glossaries on the home page and will

be provided with options as to where to go for which book Instructions are on the site This site is available as a free-of-charge companion site to this book There are details of how to obtain passwords (if implemented) Each book has its own space Updates and new analyses may be provided

A blog may be added at a later date Each book in this series has its own space on the site Access to each book’s area is restricted to purchasers of that book Multiple access by several users for one book is not permit-ted unless licensed The rule is one book = one right to access This is enforced through software The Big Four and PIEs can purchase multiple access licenses Instructions are again on the site Use by research students using university library copies may be allowed However, it is expected that the library will purchase multiple copies of each volume

Many of the references in the text are also available online on rep.org The references are given as links to a specific URL Press Control and left click simultaneously on your mouse or equivalent on the link and you will be taken directly to the reference if it still exists Note that some

www.fin-links and URLs require fees or provide limited access (e.g The Times and

the FT) There is also an adjacent site at www.fin-rep.com, which has additional relevant information, updates and new research results Feed-back from researchers, regulators, the government, the Big Four, other audit firms, professional investors and the preparers of reports will be posted here Multiple user licenses can be arranged

Although the title of the book mentions Enron to Carillion The book and its online appendices deals with later cases such as Conviviality, SIG, Patisserie Valerie and so on

Notes

1 Marriage, M., 2019, UK accounting watchdog to be replaced by stronger

regula-tor, Financial Times, 11 March 2019 Available at: https://www.ft.com/content/

d6580162-4416-11e9-b168-96a37d002cd3 Accessed March 2019.

2 FTSE 350 The top 350 companies listed on the FTSE, the Financial Times Stock Exchange 350 index – that is the top 350 companies by market capitalisa- tion Most of these are classified by as Public Interest Entities which means they have the highest level of reporting and external audit requirements The FTSE

100 is the top 100 listed companies The FTSE 250 is the 101st to the 350th top listed company

3 Beattie, V., Fearnley, S., and Hines, A., 2011, Reaching Key Financial Reporting Decisions – How Directors and Auditors Interact, John Wiley & Sons Available at:

www.wiley.com/en-us/Reaching+Key+Financial+Reporting+Decisions%3A+How+ Directors+and+Auditors+Interact-p-9780470748749 Accessed July 2018, or available at: www.amazon.co.uk/Reaching-Key-Financial-Reporting-Decisions- ebook/dp/B005HF3OBK/ref=sr_1_1?ie=UTF8&qid=1528106773&sr=8- 1&keywords=Key+Financial+Reporting+decisions Accessed July 2018.

4 Institute of Chartered Accountants for England and Wales (ICAEW), considered the most prestigious of the accounting bodies, and the organization that usually entitles an accountant to audit (in England and Wales) There are Scottish and Irish equivalents.

5 Marriage, M., 2018, ‘Probe Urged into Break-Up of Big Four Accountants: UK Financial Reporting Council Wants Inquiry into Case for Creating Audit-Only

Firms’, Financial Times, 16 March Available at:

www.ft.com/content/911e8184-283d-11e8-b27e-cc62a39d57a0 Accessed July 2018.

6 Brother of philosopher Roy Bhaskar, now deceased and previously leader of the realist movement (the Realist Theory of Science, amongst others).

7 Although he has no formal accounting qualification, he has been an examiner, written books for the ICAEW and CIMA and undertaken and supervised audits for those with ICAEW and ACCA qualifications, and undertaken national and country audits; in addition he has helped one of the Big Five with certain aspects

of FTSE 100 audits, and undertaken numerous assurance reviews for investment banks He also taught auditing and computer auditing as part of continual profes- sional development programmes for qualified ACAs and others, nationally and internationally He has a close association with US and French universities and runs two boutique consulting companies.

8 From 1981 to 1991 In the early days of the Common Market, agricultural ing absorbed 80% of the budget It is now a significantly lower share, as the EU has developed other budget lines, but still accounts for 38% of the EU budget of

spend-155 billion euros as of 2016.

9 Ibid.

10 UK Royal Honour: Officer of the Most Excellent Order of the British Empire.

11 Fellow of the ICAEW, rather than just ACA, of which he is a chartered accountant.

12 The Financial Times Stock Exchange 250 Index, also called the FTSE 250 Index FTSE 250 is a capitalization-weighted index consisting of the 101st to the 350th largest companies listed on the London Stock Exchange Rod describes it as a share index of mid-sized companies (after the top 100) listed on the London Stock Exchange by market capitalization.

• “Every company in the country is fiddling its profits.”

This conundrum is referred to as the expectation gap Identified by Porter

in 19932 (and others), it refers to the gap between expectation and actual performance This can be divided into deficient performance, deficient standards (together making a performance gap) and unreasonable expec-tations Expectations, reasonable or otherwise, continually change They only grow, not diminish Auditors and standard setters consistently lag behind

We know that accounting and the preparation of financial reports is like portraying dynamic n-dimensions into static two-dimensions – many interpretations and tricks are possible Originally the financial reports consisted of:

1 The balance sheet, a snapshot of the business at a specific date;

2 An income statement or profit and loss account measured over a period of time and the cash flow statement;3

3 Various notes to these statements and accounting policies

Not so now It has been expanded with various additional reports and narrative reporting (sometimes referred to as the strategic report and

director’s report) and various non-financial information (NFI) and reports.

Flexibility and judgement – leads to misstatements?

There is flexibility and judgement Rules can be written but to distil real-life transactions and events into a set of figures can never be exact – especially when some events are estimated such as how much of the money owed can actually be collected There is the concept of what is material Two companies with exactly the same performance and underlying reality might report very different results using the same set of basic accounting principles and standards.4 Differing estimates about the probabilities and events requiring exercise of ‘judgement’ will always cause this What is still surprising to many observers is that the auditors will say that the two dif-ferent sets of accounts can provide a true and fair view of the company.5

Note it is “[a] true and fair view”(as several commentators said to us):There is no such thing as “the” true and fair view There is always a range of views

on the financial statements and in forming the opinion in the tor’s report.6

audi-Basically, if the amount being questioned is less than this numerical rial amount, then the auditors can ignore that issue

mate-In the US, the Securities and Exchange Commission (SEC) defines what is material by using a numerical value This is currently 5% of pre-tax profits, though this cannot be a hard and fast rule If pre-tax profits are, say, £20 billion in one year, then fall back to £1 million the next year, and then return to £20 billion the year after, defining what is material as 5% of the £1 million figure is clearly misleading So, the value of what may be material has to be assessed with regards to the overall nature of the company and its business, and also taking a longer-term view Often the definition of a material value is included in the annual report under a section usually called ‘Materiality’

Regulation, regulators and reporting 15

Forward-looking statements

There is an increasing focus on NFI and a growing requirement to vide forward-looking information, including a forecast view of the busi-ness and the answers to additional ‘what if ’ questions ‘Going concern’ examines the survivability of the company over the next 12 months

pro-‘Viability’ looks forward several years However, there is now interest in not just an opinion about the future but also numerical forecast numbers

A recent survey by KPMG, the 2016 Survey of Business Reporting,

reported that 25% of the companies included (270 companies across 16 countries) provide short-term forecasts in their annual reports.7

Not just an annual report

Reporting today has an annual report, various documents for the state and for tax computations, half-yearly reports and often quarterly reports (compulsory in the US) Added to that are the various presentations and information given to analysts and shareholders These are usually found

or mentioned on the company’s website under investor relations sections

As well as giving an overview of the company, such websites will have key company announcements, news articles, press briefings and so on There may be predictions by analysts or an average of the investment analysts forecasts or buy/sell recommendations (usually only if positive, though) Also, if necessary, any profit warnings are given See Box 2.1

Box 2.1 Additional information found typically

under ‘investor relations’

For example, on BT’s website at www.btplc.com/

Sharesandperformance/Presentations/index.htm,

you will find the following headings and information:

Results Watch webcasts and download press releases,

slides, KPIs and transcripts Latest consensus

is also available

Key company

announcements Key company announcements such as BT Pension Scheme agreements, the EE

acquisition and BT sport rights auctions.Regular ‘teach-in’

events In depth teach-in events on topics such as cost transformation, pension, regulation,

network and technology

SRI events Presentations for socially responsible

investors, including the purposeful business programme

Purposeful business is less well known as a concept but according to BT it means

“putting customers first; connecting people; working for the environment; porting good causes; we’ve got big ambitions to be a more sustainable business”.

sup-True and fair concept versus fair, balanced and understandable

We know that there may be many true and fair views of the financial statements from the identical underlying physical operations and transac-tions The requirement to present a true and fair view in financial state-ments is enshrined in EU, UK and US law The concept of true and fair

is where directors must consider whether the financial statements that they approve are appropriate The external auditors are legally obliged, under the Companies Act 2006, to state, when giving their opinion on

a company’s financial statements, whether the accounts, in their opinion, give a true and fair view

Since 2014, there is a requirement for an extended front half of the annual report with a greater narrative section The new test is fair, bal-anced and understandable (FBU) Only the financial statements part of the annual report is independently assured by external auditors Direc-tors are obliged, under the UK Corporate Governance Code, to ensure that the entire report is FBU, but there is no obligation to obtain assur-ance over this – auditors do not have to carry out any additional work

in this regard but must merely consider whether the non-financial part

of the annual report is consistent with the knowledge they have gained

in the course of the audit Our evidence suggests that narrative sections often suffer from widespread lack of balance and tone, and sometimes misdirection

Regulation, regulators and reporting 17

The increasing importance of the UK’s Financial Reporting

Council (FRC)

The FRC has a role both as a standard setter and enforcer Some think that this creates an inherent conflict of interest in that it is ‘marking its own work’ The FRC has introduced a number of changes, including the strategic report having a description of the business model, and a narrative section in the front half of UK reports The FRC only has to prove breach

of a rule on the part of the external auditors However, the FRC’s tory powers do not extend to company executives who are not account-ants So, it has a somewhat asymmetric role in sanctions over misconduct

regula-or inappropriate behaviour as shown in Box 2.2

Box 2.2 FRC’s Asymmetric Sanctions

FRC sanctions on external auditor

Persons Firm, engagement partner normally

but could extend to other auditors

or accountants on the audit (with recognized qualifications)

Test Breach of FRC or regulatory rules

Sanctions for firm £10 million fine plus other actions

Sanctions for

individual Fines and possible ban from working as an accountant

FRC sanctions on company or organization

Persons with recognized qualification

We will call this type of person a preparer accountant

A person without a recognized accounting qualification, if on the board, we will call

a director-preparer If not on the board, it

is unlikely for any action to be taken other than for fraud by the Serious Fraud Office (SFO)

Test Misconduct, which is a stricter test than

breach of rule

Sanctions for firm No sanction against firm Passed to FCA or,

for criminal fraud, the SFO

Sanctions for

individual Fines and bans from working as auditor or accountant

So, in the case of a preparer accountant (a qualified accountant in the firm preparing the reports, usually a financial director or CFO), the FRC has to prove behaviour amounting to misconduct rather than breach of a rule However, the FRC has no right to sanctions over other members of the board, e.g director-preparers who are not qualified accountants This

is asymmetric as the FRC has much greater control over the auditors than the preparers

Recent and possible initiatives from the FRC include:

Recent:

• Strong encouragement of ‘clear and concise’ reporting;

• A new governance and stewardship code8 and usually periodic updates or guidance notes;

• Expansion of this code to private companies;9

• New routine reports on materiality and auditing; often under the headings of guidance, policy or thematic review;10

• New fines and penalties (now up to £10 million, though this may be raised again);

• Involvement in the senior appointments of the Big Six

Possible (from reviews into the FRC):

• Possible break-up of the Big Four into split of separate audit-only and consultancy firms;

• Stronger penalties and sanctions over management and the preparers

of reports;

• New audit rules Now partly the responsibility of the Brydon Report The new ARGA which replaces the FRC and should have stronger pow-ers and teeth But not all the powers we wanted The Kingman Review did water down some of ours and others more stringent requests.18

However, it has not all been plain sailing for the FRC In 2017 it came under criticism for closing the investigation into Tesco and its auditor, PwC The FRC said there was “not a realistic prospect”11 a tribunal would find PwC guilty of misconduct at Tesco This is their standard language for saying they could not publicly fault PwC

Regulation, regulators and reporting 19 FRC: post-HBOS and Carillion

In September 2017, the FRC cleared KPMG, the auditor of HBOS ifax and Bank of Scotland), of misconduct in relation to its work with the lender in 2007 and 2008 The FRC said the audit of HBOS’s 2007 results “did not fall significantly short of the standards reasonably to be expected” and that its assessment of the bank’s health in 2008 “was not unreasonable at the time”.17 The FRC’s decision prompted concern over accountability for the downfall of the bank (and in general all banks), which was forced into a rescue by Lloyds Banking Group in 2008.Nicky Morgan, chair of the Parliament’s treasury Select Committee (SC), sent a letter arguing that accountants should be subject to tougher rules, more like those imposed on auditors “to protect the public inter-est”.18 FRC ex-chief executive Stephen Haddrill responded by saying that the ability of the FRC to investigate audits and bring auditors to book had been hampered by the prevailing UK law, which had set the bar

(Hal-of the misconduct test unattainably high But with the EU Audit tion and Directive (ARD) implemented in 2016 and enshrined in UK law, the threshold had been lowered and the regulator would be able to make relevant enforcement This also meant that more potentially defi-cient audits would be investigated, prosecuted and ultimately sanctioned

Regula-In so doing, fines were increased to in excess of £5 million and now to

£10 million

A £10 million fine was levied on PwC but reduced to £6.5 million on settlement, with a 15-year ban for one partner plus a fine of £325,000 for that individual In 2017 there were two further large fines PwC was fined

£6 million, reduced to £5.1 million on settlement following an tion into the 2011 accounts of RSM Tenon, which collapsed in 2013 One

investiga-of PwC’s partners was fined £114,750 and PwC had to pay £500,000 in costs in 2017 This fine came after PwC was fined £5 million earlier in

2017 over its audit of Connaught in the period running up to the social housing group’s collapse in 2010 Bottom line, dismiss the numbers, but none of these sanctions were large enough to have much real effect and reports of them were confined to the specialist financial press or financial pages of the national press in the main The ones that still stand out include the collapse of HBOS and the more recent 2018 cases; although, in our interviews, the impact seems to be much greater in terms of peer group pressures and status (i.e promotions) within the audit firm

The FRC has often been criticized for being too close to the Big Four

Of the 30 board and senior FRC positions identified in Accountancy in

December 2017 (page 13), 15, or 50%, are from the Big Four (including one from Arthur Andersen, one of the Big Five firms before the Enron scandal), and two were from mid-level firms

It has also been criticized for being too slow and ineffective The FRC admitted that it should have been faster to investigate why KPMG gave HBOS’s accounts the green light just seven months before the bank had

to be rescued by Lloyds during the GFC Instead, the FRC closed its investigation into the audit, saying it had found that KPMG’s work for HBOS “did not fall significantly short of the standards reasonably to be expected”, notwithstanding that criticisms have been made elsewhere that this was a biased board and the suspicion is that this may have been a biased decision The FRC then admitted:

We should have adopted a more proactive approach to our early enquiry in relation to HBOS rather than a heavy reliance on other regulators.13

The FRC came under heavy criticism by the joint Select Committee (SC)12 and MPs for being slow and “far too passive” in its scrutiny of the financial practices of collapsed outsourcer Carillion MPs on two high-profile parliamentary committees concluded in their report that they had

“little faith in the ability of the FRC to complete important tions in a timely manner”.14

investiga-The roles of the regulators

Box 2.3 lists the main regulatory bodies in the UK

Box 2.3 Relevant watchdogs

FRC – Financial Reporting Council Probably the best known

of the watchdogs for annual reports, reporting and auditing

It regulates auditors, accountants and actuaries, not directors (unless they are qualified accountants) Concerned with the listings of companies on the stock exchanges or equivalent and false market values and areas that might affect market capitalization and share value, corporate governance and reporting, including monitoring and reviewing the actions

Regulation, regulators and reporting 21

PRA – Prudential Regulation Authority for banks and lenders.Pensions – The regulator for pensions and pension deficits

Equality and Human Rights Commission − Monitors gender pay gap data

BEIS − Department of Business Monitors payments practices and directors’ conduct (rare)

Insolvency Service − Currently takes around 1,200 directors to court and may get enhanced powers to pursue directors

SFO − Serious Fraud Office Pursues fraud in corporate cases but criticized for taking too long (e.g Tesco case) and having

a low conviction rate The latest example is Barclays Bank and their Qatari funding, the suspicion being that the deal may have been a round trip type of manoeuvre,15 but this was not proven; Barclays was found innocent

Information Commissioner’s Office − Data protection and vacy issues.16 Its ability to sanction or fine is impossibly small.Parliamentary Select Committees − These are not regulators but are becoming more prominent in a watchdog role as an external check

pri-There is some overlap in the role and remit of these regulatory bodies and we feel that the current set-up is unsatisfactory Recent government pronouncements (discussed in detail later) as well as evidence from our interviews suggest that the government may not be satisfied with the performance of the FRC and other watchdogs due to their lengthy inves-tigations and lack of action in high-profile cases

Regulatory reviews

The review of the FRC by Sir John Kingman is officially titled the pendent Review of the Financial Reporting Council’.17 Now released, it had two objectives:

‘Inde-• To ensure that the FRC structures, culture and processes; oversight, accountability and powers; and its impact, resources and capacity are

as good as they can be

• To see the FRC standing as a beacon for the best in governance, transparency and independence

The Kingman Review is limited to the FRC, with the aim of making the FRC the best in class for corporate governance and transparency.18

The review did not investigate policy or accounting standards or issues

of competition Competition, and particularly competition in the audit market, sits with the Competition and Markets Authority (CMA) The CMA update review paper was released on the 18 December 2018 The minister has asked the CMA to examine competition in the Big Four-dominated audit industry This raised the possibility that the government

would back major reforms to the Big Four (See Volume 1, Disruption in

the Audit Market.)

The Competition and Markets Authority (CAM) and Kingman report were published post-publication Reactions to the CMA on the audit market and the Kingman report on the replacement of the FRC can be found in the online companion volume www.fin-rep.org

The CMA’s report concentrates on a tightening grip and scrutiny of the audit committees (we think pie-in-the-sky), joint audits (costly and reduce audit quality, and who takes the blame in a dual audit) And bol-stering the mid-tier challenger audit firms (takes decades) Finally peer review (may be the best of a poor bunch of remedies – but not suffi-cient) We strongly challenge and disagree with the CMA conclusions and remedies

Websites and online material

Appendix 2.02.01 FRC Cases can be found at www.fin-rep.org It lists and categorizes all FRC cases and may be routinely updated

Notes

1 Jones, M J., 2011, Creative Accounting, Fraud and International Accounting, University

of Bristol, 2011 Paper given at the University of South Australia Based on the book below Available at: www.unisa.edu.au/Global/business/centres/cags/docs/ seminars/creative%20accounting%20and%20fraud(aus).pdf Accessed July 2018.

See also: Jones, M J., 2010, Creative Accounting, Fraud and International Accounting Scandals, John Wiley & Sons Available at: www.wiley.com/en-gb/

Creative+Accounting%2C+Fraud+and+International+Accounting+Scandals-p-

9780470057650 Accessed July 2018.

2 Porter, B., 1993, ‘An Empirical Study of the Audit Expectation-Performance

Gap’, Accounting and Business Research, Volume 24, pp 49–68 Available at

(pub-lished online in 2012): www.tandfonline.com/doi/abs/10.1080/00014788.1993.

9729463 Accessed July 2018.

3 A cash flow statement is a statement showing the inflows and outflows of cash and cash equivalents over a period Not to be confused with a flow of funds statement, which measures the changes in the financial position of the entity in different accounting years.

4 Even under current UK GAAP and full IFRS Also applies to US GAAP.

Regulation, regulators and reporting 23

5 Based on the stated assumptions, which can provide much leeway.

6 Wikipedia, Materiality (auditing) Available at: https://en.wikipedia.org/wiki/

Materiality_(auditing) Accessed July 2018.

7 See: KPMG, 2016, Room for Improvement: The KPMG Survey of Business Reporting,

second edition, 28 April Can be downloaded from (where there is also a link

to KPMG’s Dynamic Risk Assessment system): https://home.kpmg.com/xx/en/ home/insights/2016/04/kpmg-survey-business-reporting-second-edition.html Available at: https://home.kpmg.com/xx/en/home/insights/2016/04/kpmg- survey-business-reporting-second-edition.html Accessed July 2018.

This may be published every year The 2017 edition concerns corporate

responsibility reporting: KPMG, The Road Ahead: KPMG Survey of Corporate Responsibility Reporting 2017 This report can be downloaded from: https://

home.kpmg.com/xx/en/home/campaigns/2017/10/survey-of-corporate- responsibility-reporting-2017.html Available at: https://home.kpmg.com/con tent/dam/kpmg/campaigns/csr/pdf/CSR_Reporting_2017.pdf Accessed July 2018.

8 Financial Reporting Council News, 2018, ‘A UK Corporate Governance Code

That Is Fit for the Future’, Financial Reporting Council, 16 July Available at: www.

frc.org.uk/news/july-2018/a-uk-corporate-governance-code-that-is-fit-for-the Accessed July 2018.

This page leads to a number of relevant documents:

‘The UK Corporate Governance Code, July 2018’ Available at: www.frc.org uk/getattachment/88bd8c45-50ea-4841-95b0-d2f4f48069a2/2018-UK- Corporate-Governance-Code-FINAL.pdf

‘Revised UK Corporate Governance Code 2018 Highlights’ Available at: www frc.org.uk/getattachment/524d4f4b-62df-4c76-926a-66e223ca0893/2018- UK-Corporate-Governance-Code-highlights.pdf

‘Guidance on Board Effectiveness, July 2018’ Available at: www.frc.org.uk/ document-library/corporate-governance/2018/guidance-on-board-effective nessThis link does not open a page, but just downloads this report.

9 See the consultation document: ‘The Wates Corporate Governance Principles for

Large Private Companies’, Financial Reporting Council, 13 June 2018 Available at:

www.frc.org.uk/consultation-list/2018/consultation-the-wates-corporate-gover nance-princ To download this report: www.frc.org.uk/getattachment/48653f86- 92c3-4cd6-8465-da4b7cac0034/;.aspx Accessed July 2018.

10 For example, Financial Reporting Council, 2017, ‘Audit Quality Thematic

Review: Materiality’, Financial Reporting Council, December Available at: www.

frc.org.uk/getattachment/4713123b-919c-4ed6-a7a4-869aa9a668f4/Audit-Quality-Thematic-Review-Materiality-(December-2017).pdf Accessed April 2018; and Financial Reporting Council, 2018, ‘Audit Culture Thematic Review: Firms’ Activities to Establish, Promote and Embed a Culture That Is

Committed to Delivering Consistently High Quality Audits’, Financial Reporting Council, May Available at: www.frc.org.uk/getattachment/2f8d6070-e41b-4576-

9905-4aeb7df8dd7e/Audit-Culture-Thematic-Review.pdf Accessed July 2018

11 Financial Reporting Council News, 2017, Closure of investigation into the

con-duct of members and a member firm as auditors of Tesco plc, Financial

Report-ing Council, 5 June 2017 Available at: https://www.frc.org.uk/news/june-2017/

closure-of-investigation-into-the-conduct-of-membe Accessed July 2017.

12 Dunkley, E., Marriage, M., Martin, K., ‘KPMG cleared over audit of HBOS before collapse: Regulator finds assessment of market conditions not ‘unreason-

able’ at time’, Financial Times, 19 September 2017 Available at: https://www.

ft.com/content/34fa0fdc-9d13-11e7-9a86-4d5a475ba4c5 Accessed July 2018.

13 Jones, H., 2017, ‘UK Watchdog Says Was Too Slow to Probe HBOS Audit’, Reuters,

30 November Available at: www.reuters.com/article/us-lloyds-accounts-hbos/ uk-watchdog-says-was-too-slow-to-probe-hbos-audit-idUSKBN1DU10Z Accessed December 2017.

14 House of Commons, Business, Energy and Industrial Strategy and Work and sions Committees Carillion Second Joint Report from the Business, Energy

Pen-and Industrial Strategy Pen-and Work Pen-and Pensions Committees of Session 2017–

19 HC 769 Published on 16 May 2018 by authority of the House of mons Relevant paragraphs or page numbers in the main report are noted in text Available at: https://publications.parliament.uk/pa/cm201719/cmselect/ cmworpen/769/769.pdf Accessed July 2018.

15 Barclays Bank was found innocent However, the suspicion might have been that Qatar invested equity in the bank in exchange for roughly an equivalent amount

in loans so the net transaction was zero But this would have helped Barclays’s equity ratio, thereby the bank avoided being taken over by the state.

16 Facebook may be fined £500,000 by the privacy regulator after the social work giant failed to prevent key user data from falling into the hands of a political consultancy that helped get President Donald Trump elected The UK’s Infor- mation Commissioner’s Office is threatening the company with the maximum penalty allowed The tech giant is accused of not properly protecting user data and not sharing how people’s data was harvested by others £500,000 to Face- book is something less than a pin prick Now, £500 million might have been

net-a more substnet-antinet-al pin prick See net-also: Bodoni, S., 2018, ‘Fnet-acebook Fnet-aces U.K

Fine over Cambridge Analytica Inquiry’, Bloomberg, 10 July Available at: www.

over-cambridge-analytica-probe Accessed July 2018.

17 Kingman Review, 2018, ‘Independent Review of the Financial Reporting

Council’, Review Secretariat Which Is Hosted by the Department for Business, Energy, and Industrial Strategy, 6 June Available at: https://assets.publishing.service.gov.

uk/government/uploads/system/uploads/attachment_data/file/717492/Inde pendent_Review_of_the_FRC_-_Call_for_Evidence_-_FINAL.pdf Accessed July 2018.

18 In April 2018, the government launched an independent review of the FRC, the regulator for auditors, accountants and actuaries The review will be led by Sir John Kingman, who has extensive private and public sector experience He will

be supported by an advisory board The root and branch review, due for tion by the end of 2018, will assess the FRC’s governance, impact and powers to help ensure it is fit for the future.

comple-3 Manipulating reports and

peri-in the eye of the beholder

As a result, management will always have the ability to move profit from one period to another depending on their view of corporate transactions

In pejorative terms, this is called ‘income smoothing’ It is all about the judgement allowed within the rules to portray a complex set of transac-tions and events To complicate matters further, inadvertent wrong presen-tation is an error, but deliberate wrong presentation is fraud Establishing

the mens rea to distinguish the latter from the former can be very difficult.

Jones1 uses the following definitions and we have added a tion between creative (borderline acceptable) and aggressive accounting (likely to be sanctioned by the FRC) though this is a spectrum and the lines between these concepts are blurred and may be movable:

distinc-1 Fair presentation is using the flexibility within accounting to give a true and fair picture of the accounts so that they serve the interests

of users This is the aim of most entities being reported on It is, after all, the law, and the requirements of accounting standards Audit firms regard a client demonstrating this clear objective as ideal as it minimizes their exposure Users might not be just actual or potential shareholders but a wider community, sometimes called stakeholders

2 Creative accounting on the other hand uses the flexibility within accounting to manage the measurement and presentation of the accounts so that they serve the interests of preparers It may be within the flexibility allowed by regulators and does not give rise to

sanctions That said, it is on the cusp of acceptability and sometimes extends beyond any red line (see Box 3.1) Creative accounting is not altogether bad It can encompass ways of presenting the informa-tion to provide a better understanding of a firm’s activities Creative accounting as described operates within the regulatory framework and is not usually illegal or in breach of FRC rules.

3 Aggressive accounting (also Box 3.1) goes that bit further than tive accounting and might be considered for sanctions by the FRC and may even lead to prosecutions by the SFO and actions by the FCA (if the company is listed) – as with Tesco (see Chapter 5) Jones only makes the distinction between creative accounting and fraud

crea-We add aggressive accounting which we define as one step on the cusp or over the red line of breaching FRC rules and regulations, and accounting standards Normally aggressive accounting would lead to

an FRC investigation and sanctions, perhaps even an FCA action and

a prosecution by the SFO (as for Tesco).2 Such prosecutions by the SFO are notoriously difficult in terms of achieving a guilty verdict

by a jury not well versed in accounting or financial reporting.Frequently in the US and less frequently in the UK (for example RBS [discussed later]), such financial activities can give rise to litiga-tion It is, however, a commonly used term which lacks an agreed-upon definition and in the US is frequently associated with fraud3

while in the UK it is not normally so associated This is a source of some confusion Aggressive accounting as defined above may well

be classified as fraud in the US – as demonstrated by Autonomy cussed in Chapter 5

dis-4 Fraud is deliberately stepping outside the regulatory framework to give a false picture of the accounts This big step has to be outside the inherent flexibility and must be deliberate Usually it is significantly beyond aggressive accounting, but again this is a spectrum, so where the line is drawn, at the cusp, may be arbitrary

Box 3.1 Main methods of creative or

Manipulating reports, creative accounting 27

• especially contracts bundling goods and services and/

or spanning accounting periods

• misuse of sale and leasebacks

• enhanced brands and other intangibles

• increased closing inventory

• flexibility in overhead allocation methods

• over-estimation of net realizable values

• lengthened depreciation lives

• revalued fixed assets

• flexibly assessed market values

• Decrease of liabilities

• off balance sheet financing

• reclassification of debt as equity

Source: Partially modified from Jones 5 and related papers

Box 3.2 Manipulations as financial shenanigans

(Schilit et al.)7

Earnings manipulation shenanigans

Recording revenue too soon

Recording bogus revenue

Boosting income using one-time or unsustainable activities

Shifting current expenses to a later period

Employing other techniques to hide expenses or losses

Shifting current income to a later period

Shifting future expenses to the current period

Cash flow shenanigans

Shifting financing cash inflows to the operating section

Moving operating cash outflows to other sections

Boosting operating cash flow using unsustainable activities

Key metric shenanigans

Showcasing misleading metrics that overstate performance

Distorting balance sheet metrics to avoid showing deterioration

Acquisition accounting shenanigans

Artificially boosting revenue and earnings

Inflating reported cash flow

Manipulating key metrics

Fraud

Fraud has many meanings and can be used in many situations It occurs

in various forms in failures and/or scandals, and covers a wide range of activities We should clarify this definition

Specific examples of fraud include misappropriating assets, for example:

• Stealing cash;

• Stealing inventory

Manipulating reports, creative accounting 29

Or something akin to fictitious transactions, for example:

• Inventing a ghost creditor and logging fictitious purchases with a view to be rewarded for doing so;

• Enhancing the value of the same with a view to being rewarded;

• As above, but with a debtor where the purpose is to underpay or ate fictitious returns;

cre-• Sometimes this ghost can be an employee on the payroll or this tious action can result in the creation of entire subsidiaries

ficti-Example: Theranos

Theranos, a private US start-up based in Silicon Valley, ran into problems

in 2013 The founder, Elizabeth Holmes, claimed a revolutionary blood test, promising immediate results for a wide range of conditions She has agreed to settle charges that she raised over $700 million (£500 million) fraudulently The US SEC said Elizabeth Holmes and Theranos deceived investors about the firm’s technology The SEC also said that the firm had falsely claimed that its products had been used by the US Army in Afghanistan Theranos’s proprietary analyzer could complete only a small number of tests, and the company conducted the vast majority of patient tests on modified and industry-standard commercial analyzers manufac-tured by others

Holmes will lose control of the firm and be fined $500,000 The SEC plans to bring a case against the president, Ramesh Sunny Balwani.Falsifying claims about the product and then about its use by the US military in order to raise funds was, in our view, a clear case of fraud even though the settlement did not specify liability – though the original SEC charge was for fraud The fact that this was not for personal gain but for raising funds to pay for the research and development to produce a novel product, claiming it was already working (when it was not), is still a fraud in our view The motives, however altruistic, misled the investors in the company Meanwhile, the company will shut labs and reduce staff It may or may not survive Holmes had control despite raising equity funds through the use of dual class shares

Announcements

Any announcements including pre-close trading statements, profit ings, profit updates and preliminary announcements are governed by

warn-various regulations We should mention briefly the Financial Services and Markets Act (FSMA) Under this:

The Regulations provide that an issuer of securities to which the regime applies is liable to pay compensation to a person who acquires, continues to hold or disposes of the securities in reliance on published information to which the regime applies and who suffers loss in respect of the securities as a result of either (i) any untrue or misleading statement in that published information, or (ii) the omis-sion from that published information of any information required to

stake-Impression management

In addition to using creative accounting to affect the numbers themselves, there is a further method of influencing the reader – impression manage-ment (This seems to have been used extensively by Integrated Report-ing, which we discuss later.) Impression management uses the flexibility within wider financial reports and uses narrative, tables, diagrams, draw-ings and graphs to convey a particular view to serve the interests of pre-parers and management

Techniques used to alter the tone or balance include:

• Stressing the positive and downplaying the negative (for example, mining in South Africa; the accounts painted a rosy picture whereas

in reality there had been a series of strikes as well as the Marikana killings, where 34 miners were killed and 78 were wounded by secu-rity forces)

• Downplaying adverse situations (e.g strikes, high staff turnover, riots

or deaths)

• Baffling the readers (Enron famously did this, which we discuss in Chapter 4) Even today, we would challenge anyone to make sense of the accounts of the major UK listed legacy banks: at several hundred

Manipulating reports, creative accounting 31

pages long, clarity can be lost9 especially when combined with some

of the other techniques listed here

• Using difficult to read, ambiguous or technical language; obfuscation

• Taking credit for good news, blaming external factors for bad news

• Using misleading graphs – visual tricks include selectivity, ment distortion and presentational enhancement

measure-• Using photographs to set the tone or even mislead Just about one does this to some extent

every-• Creating or talking about initiatives, projects and programmes which have little or no meaning, or possible results

• Emphasizing company-specific jargon

• Using red herrings – introducing non-relevant topics

Companies with negative results focus on the environment, target markets and emotive words rather than on company and performance indicators.10

Clatworthy and Jones (2006) found that profitable companies focus on past results, whereas unprofitable companies focus on the future.11 Companies reporting success use the active voice whereas companies reporting failure use the passive voice.12 Their overall findings, confirmed by other studies, were:The results in this paper indicate that the chairman’s statement is subject to impression management techniques as managers’ propen-sity to associate themselves with company financial results is associ-ated with the firm’s underlying financial performance There is also some evidence that unprofitable companies focus more on the future, rather than on past performance

Our current evidence confirmed that not much has changed and, if thing, it has become worse This is especially true with the expansion of the front half of the annual report which contains the narrative sections

any-Motivation for creative and aggressive accounting

The motivation for manipulating accounts is straightforward: if a pany collapses, many groups could suffer harm These include, but are not limited to, customers, suppliers, employees and banks In general, creative accounting gives financial reporting a bad name and undermines overall confidence in financial statements However, as long as it remains legal,

com-it will continue to happen As accounting and audcom-iting are permeated by judgement, there will always be different ways to account for the same transaction, especially if estimates or inter-period allocations are involved Box 3.3 provides some of the motivations for using creative or (the even more manipulative) aggressive accounting