Accountancy-online – February 2020

My last article focused on the susceptibility of purchased “goodwill” to manipulation, and I cited instances in which its overvaluation had destroyed accounting reliability, causing severe losses to investors. This time let’s take a look at the ease with which another asset, year-end stock of goods, can wreak havoc with a set of accounts when overvalued.

This should happen: a trader’s gross profit is the excess of amounts received for goods sold during the year, over the cost of their initial purchase, ignoring the cost of unsold items still on the shelves at the year-end.

Those unsold items at the year-end constitute the entity’s “stock” or “inventory” and, having been paid for, they must appear in financial statements as an asset, shown at cost, or market value if lower. Any overvaluation will have the effect of inflating profits and assets, and it is therefore crucial that the year-end stocktaking is scrupulously planned, overseen and conducted. I well recall the regimentation of “counts” I was obliged to observe as a young auditor.

Material overstatement

However, at fashion retailer Ted Baker something went seriously awry. It has now disclosed that the (previously reported) £25 million overstatement of its January 2019 inventories should actually have been more than double that figure at £58 million – that’s not the inventory itself, note; it’s the overstatement! To provide some context, the company’s audited accounts showed pre-tax profits of £50.9 million. The impact on its stock market valuation has been dramatic, three-quarters of its value being lost since January 2019.

innocent error or deliberate deception

 

How could that happen? Some might be tempted to put it down to, say, innocent error; or deliberate deception; or sheer incompetence. But can we seriously rule out the possibility that the auditors’ investigative acuity might have been “blunted” by a serious conflict of interest? Perception is critical when considering independence. Now note: in 2018 Ted Baker’s auditors KPMG were fined £3 million for compromising their independence by agreeing to undertake expert witness work for Ted Baker at the same time that it was responsible for auditing its accounts. And the fees paid to KPMG for the expert engagement “significantly exceeded the audit fees in the relevant years”, per the FRC!

Lure of billionaire clients

Another item also caught my eye. It concerns PwC’s links with Africa’s richest woman, Isabel Dos Santos, daughter of the former President of Angola. She is now facing corruption charges for siphoning off more than $1 billion from the government-owned oil company, as well as land, oil and diamonds, into companies under her family’s control – all revealed in a dossier of 700,000 leaked documents. PwC, retained to audit the accounts of Dos Santos entities while collecting fees for advising on restructuring, now claims it is taking action to terminate work for entities controlled by the Dos Santos family. You couldn’t make it up!

enforced resignation of KPMG’s SA hierarchy

 

Remind you of anything? In 2018 KPMG’s acceptance of audit work for the infamous Gupta brothers, then in league with the deeply corrupt regime of South Africa’s ex-president Zuma, led to the ignominy of enforced resignation of KPMG’s entire senior South African hierarchy, and being dropped by audit clients and government agencies, all citing “reputational risk” as their reason. Even the head of South Africa’s Internal Revenue disclosed a wish to blacklist KPMG for its conduct. No monetary penalty can compete with that for “deterrence”.

The massive regulatory fines imposed by the FRC and others don’t provide an answer, especially as they leave the victims of such wholesale greed and incompetence totally uncompensated.

A practical recommendation

My own view is that recent recommendations by successive committees would prove equally ineffective and unworkable because they ignore this crucial fact: the risk/reward relationship applicable to competently executed public company audits has become irretrievably uncommercial.

a practical solution…..

 

Preserving the integrity of financial statements is critical for investors in a free market economy. However, leaving such an important policing role in the hands of the private sector is misconceived – and clearly ineffective in practice.

A detached state body comparable to the National Audit Office is a feasible alternative. Let’s call it the Public Company Audit Office (PCAO). It would be free to subcontract audit work to any firm with requisite expertise and credentials, but the PCAO would issue audit reports in its own name. It would agree fees with subcontractor firms for settlement by PCAO on completion of satisfactory work. An “audit levy” on all plcs would pay for the service.

Interposing such a powerful intermediary, with a mandate for maintaining high standards of public company audit practice, would shield firms from the ordure and ignominy that now dogs them. They should welcome the lifting of this burden.

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