Regulatory scrutiny is an expensive waste of time and money if it focuses on the form but completely misses the substance. One wonders about the quality of diligence that preceded (and the audit work that followed) Olympus’s takeover of the UK Gyrus Group, when so-called “advisory payments” of $687 million, one-third of the entire acquisition cost, appear to have been passed by toothless watchdogs. Only Japan’s refusal to extradite its nationals has frustrated the SFO’s recent criminal action against key Olympus bosses. The latest inspection report of the US Public Company Accounting Oversight Board on the quality of Big 4 audits found that in 35% of audits investigated there were serious deficiencies, notably the placing of unwarranted reliance on management assurances that all relevant internal controls are in place – leading in turn to misdirected substantive testing of samples that were inadequate in terms of both materiality and population selection. This chimes with my own experience throughout 25 years as an expert witness in auditors’ negligence actions, suggesting that so many of the most basic lessons remain unlearned.
The huge charity, Kids Company, was renowned for doling out packets of cash totalling tens of millions of pounds to children on the dreamy pretext of never turning the needy away. Yet it remained viable only as long as its meagre reserves held out and government grants and corporate donations kept streaming in. Does that sound like a sustainable business plan? Confronted with that spectre any amount of transaction-based testing by auditors could prove, too late, to be utterly pointless.
Latest Bank report on HBOS
And then, as ever, there’s HBOS, where KPMG’s assessment of loan book deterioration was blighted by IFRS rules that allowed management to decide when even a patently troubled loan should finally be written off. The latest Bank of England report on the Lloyds takeover of HBOS confirms that HBOS lent far too much to high-risk property developers and relied for liquidity on the short-term wholesale market – an unsustainable mix. Prior to the takeover, Lloyds allowed for losses on the HBOS loan book of £10 billion – which, in the end, spiralled to £52 billion, £34 billion of which was concentrated on only 30 clients, several of whom were already in administration or restructuring. What kind of internal governance ignores the risk implicit in such gross and systemic imbalance?
Can misguided accounting rules ever excuse it?
Can misguided accounting rules ever excuse it? When running for cover in the wake of failed regulation, complicit banking authorities feign penance and then install another round of remedial rule-making, such as having to hold minimum tiers of reserve capital (the “rainy-day” syndrome) or other protective mechanism under a Basel configuration or, even better, some abstruse stress-testing that is incapable of being stress-tested itself, and is therefore of unproven validity.
Deflating bubbles before they burst
The premise underlying this periodic ritual is that it has now been sorted – and will not happen again. The Bank of England’s Financial Policy Committee, formed five years ago to keep banks prudent and deflate credit bubbles before they burst, has now devised stress tests for the UK’s seven largest lenders predicated on an assumed emerging markets crisis. And, would you believe it, they all passed. So all’s well? Less gullible observers might note a few caveats. Even the Bank of England is installing plans to impose a collective buffer tier of £10 billion across the sector, just to be “on the safe side”. Speaking of a rainy day, that is far too small to withstand anything worse than a light drizzle. For my part, the real worry is that these tests were based on banks’ 2014 IFRS-compliant accounts – and that takes us back to the accounting for impairment in the banks’ loan portfolios. Instead of adopting a robust full-life impairment model, based on a bank’s own measure of probable loss (reflected in its risk-based interest charges), the banks – and their auditors – are accounting for loan losses only after they have crystallized in debts that are already bad beyond redemption. The auditors’ perennial “get out of jail” card: what a shame that they need it.