“ACCOUNTANCY” August 2018

Beginning of the end for the status quo of accounting – and auditing!

“That which is crooked cannot be made straight” (Ecclesiastes 1,15). I am not suggesting that accounting is inherently crooked, but it is currently plagued by a “disconnect” between compliance and truth – hardly reflected in the Institute’s motto: “recte numerare” (“to count, or reckon, correctly”).

Rules that allow preparers to account for key issues subjectively invite distortion. This outcome became inevitable once time-honoured “generally accepted accounting principles” (GAAP) were systematically replaced by international standards (IFRS) fixated with unverifiable “fair value” measurements that effectively abolished “prudence” and “fair presentation” as self-standing principles.

 

Yet many IFRS-compliant valuations include phantom profits

 

It has always been unlawful for companies to make distributions to members out of unrealised profits – a rule that protects an entity’s creditors and its capital base. Yet many IFRS-compliant valuations include phantom profits that are neither identified nor separately disclosed.

Assets whose very existence is questionable cannot be objectively verified, and are therefore highly susceptible to the risk of overvaluation. “Intangibles” such as development costs would, under GAAP, be written off in the year in which they are incurred. Under IFRS, however, consideration is given to whether the asset (R & D, licences, trademarks, software, etc) has a “future economic benefit, reliably measured”.

If directors did not believe there would be a future economic benefit they would hardly have incurred the cost in the first place. But reliable measurement? Under GAAP what would count is what they could sell it for! And even a non-accountant knows that the value of unlisted shares, for instance, is variable and resides largely in the mind of the beholder.

Auditing has lost its focus

Technical accounting departments that “interpret” these dubious standards often work for the same firms that audit the results. It should therefore cause no surprise that box-ticking “compliance” with these interpretations is deemed by the auditors to equate to truth and fairness.

Nor will you be surprised by KPMG’s acceptance of £1.5 billion of “goodwill” in Carillion’s balance sheet – over 70% of the group’s non-current assets. That balance sheet was also heaving with debt, and hedge funds had already “shorted” over 20% of their holdings by the time the accounts were signed. No wonder so many “going concerns” are gone by teatime!

Even within the LLP culture responsibility must lie with people. Firms may establish a culture for members to follow but when, as is usual, firms indemnify individuals for penalties imposed on them, the key principle of personal accountability is extinguished.

When PwC was handed a record penalty of £10 million following FRC’s probe into its audit of BHS accounts before Sir Philip Green sold the group for £1, a spokesman for the firm said that it was “sorry that our work fell well below the professional standards expected of us and that we demand of ourselves.”

Really? So what happened to that “demanding”?

This year the Auditor-General of South Africa terminated all KPMG’s public sector audit mandates when the firm admitted that its audits for the powerful Gupta family, close allies of former president Jacob Zuma, “fell considerably short of its [KPMG’s] standards”. Yet every professional in South Africa knew that before being tainted by association with the Guptas you need your brains tested! Ask Bell Pottinger – assuming you can find anyone there to talk to.

 

Try asking a Big-4 auditor how their work adds value

 

These failures are not just technical. Try asking a Big-4 auditor how their work adds value. When, for example, did you see something useful, such as an audited reconciliation between the latest management accounts and published financial statements? Instead, IFRS rules might produce financial statements that, without some fundamental unraveling, are utterly disconnected from any decision-making process.

Commercial interests compromise objectivity

The auditor’s only commercial consideration should be receipt of a reasonable fee. An unqualified audit opinion should be untainted by conflicting interests.

While firms are permitted to pitch to their own audit clients for lucrative consultancy work carrying rewards that dwarf audit fees, independence and objectivity are compromised.

 

A drop from “Big 4” to “Big 3” may seem unthinkable

 

A drop from “Big 4” to “Big 3” may seem unthinkable now. But remember Big-5 Andersens? They were brought down, not by courtroom findings (subsequently reversed), but by their own clients fleeing the reputational contagion of the Enron connection – it was both lethal and irreversible. Watch this space!

————————————————————————————————–