Although I have forgotten most of my own auditing experiences, a few still stand out.

A client company that was in business as a confectionary retailer sold cakes over the counter, either whole or in weighed-out portions. The principal internal control was reconciling the weight of cakes leaving the bakery with the weight of portions sold, which was always a shade less. Cutting cakes into slices leaves crumbs, and the difference in weight was loosely termed “crummage”. Reconciliations were meticulously recorded and there was a “Crummage Control Account” (CCA) in the nominal ledger, to which each day’s monetary equivalent of crummage loss was debited.

To the audit team this was a mere curiosity. The trifling sums in question fell so far below our “materiality” threshold that we never paid any attention to crummage when conducting audits.

Exploiting lack of scrutiny

This fact was not, however, lost on the company’s chief accountant, who took advantage of the absence of scrutiny by entering other unreconciled accounting mismatches in the CCA. Whenever, for example, cash received turned out to be less than the value-by-weight of portions sold, that cash shortfall never manifested anywhere, having found its way into the CCA, which was eventually moved to a drawer in the accountant’s desk for “safe-keeping”.

Diverse infractions….

 

Several years later a colleague told me that the accountant’s infractions had become more diverse and brought the business close to insolvency. By then the CCA’s debit balance had mushroomed – but what the accounts showed as a material asset turned out to be (literally) “immaterial” in the sense of being non-existent, even though it appeared on the balance sheet as an overseas bank account. Soon after that the firm broke up, its insurers having had to settle a substantial negligence action.

And now Wirecard

These antics came to mind while reading about missing cash of £1.7 billion shown in the balance sheet of Wirecard, now believed by regulators and auditors EY never to have existed. I doubt that the missing billions had much to do with crummage losses, but certain thematic similarities are striking: when it comes to fraud, size is a variable that is independent of method. Many frauds are simply variations on a theme, which is why it is vital that auditors are able to recognise “red-flags”, such as reported earnings unmatched by cash.

The potential fallout from the Wirecard debacle is now being likened in the press to what happened 19 years ago to the energy trader Enron, which led to the demise of auditors Arthur Andersen, at that time a member of the “Big-5”. In Enron’s case these were among the most striking red flags: (i) in one quarter reported earnings of more than $700 million were unrealized; (ii) margins were plummeting; (iii) cash flows had all but dried up; and (iv) the return achieved on its own capital was less than it paid on its external borrowings.

Rules-based aberrations

A “joined-up” audit would have linked these giveaways to the accounting aberration that facilitated the deception. When, for example, Enron contracted with the state of Oregon to supply several million kilowatt hours of electricity in five years’ time in return for $100 million, it was able to enter as earnings, on day one, an amount representing the “present value” of the market’s anticipation of what that contract would yield on delivery – say $15 million, reflecting the market’s own embedded assumptions on electricity price fluctuations over that period.

“mark-to-market” fantasy

 

You guessed it: it’s called “mark-to-market” accounting, and it would have explained to an alert auditor why, in four of its five previous years, Enron paid no taxes: the US tax code, unlike the accounting code, based its assessments on realized income only. Yet these deceptive, yet compliant, accounting methods are still permitted.

It’s obvious that Enron’s disclosed earnings figure was a mere discounting calculation that assumed it would remain a going concern for a further five years. However, the four red flags listed above would have made it obvious to any alert auditor that its business model was unsustainable.

Accounting prescriptions that add no value

It is extraordinary that a business, patently on the slippery slope to extinction, can be made to appear stable by academic prescriptions unconnected to the real world. Indeed, the most startling revelation in the Enron aftermath was the fact that, despite questionable practices galore, there were no proven illegalities.

Accounting distortion is everywhere

 

Distortion-prone rules are now ubiquitous. International standard IFRS 16, for example, fudges reality by bringing assets hired, but not owned, onto the lessee’s balance sheet as “right of use” assets matched by “obligations” to make rental payments.

As these are essentially operating leases, there are no clearly applicable discount rates, and so analysts have learnt to add back the ratio-distorting numbers and substitute something that makes sense. All that this nonsense achieves is obfuscation and clutter, adding no value.

For as long as technical departments in the big firms are able to generate huge fees by devising theoretical accounting rules against which the same firms’ audit teams are paid to box-tick compliance, a truly independent audit remains a far-off dream.

At least we had some fun with crummage!

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