The third volume entitled:
Disruption in Financial Reporting: A Post-pandemic View of the Future of Corporate Reporting
is now out and can be found on Amazon at:
Updates can be found on:
The online appendices amounting to some 150,000 words are here online:
The endnotes and references which can be clicked directly to take you to the most opf the relevant references can be found here:
Audit/Reporting Breaking news November 2020
New FRC investigations and other events (November 2020)
2 November (FRC): launch event to discuss the Future of Corporate Reporting on 11 November.
30 October: Logistics Group Holdings(owned by the billionaire Barclay family), which is behind the Yodel and ArrowXL businesses, has cautioned in its latest set of accounts for 2019 that there is a “material uncertainty” over its status as a going concern. This could be the first of many such similar statements due to the pandemic.
20 October (FRC): a) KPMG and Silentnight; b) Findings into local council audit inspections raised new concerns. C) A senior executive at PwC has been identified in a £63m court case against the Big Four accounting firm in which it is accused of leaking confidential client information.
25 October: The set of banks that steered The Hut Group towards its stock market listing have raised red flags over the company’s governance – a month after sharing £35 million in fees.
21 October (FRC): FRC review reveals where company reporting needs to improve,
20 October (FRC): consultation on the proposed revision of its UK auditing standard ISA (UK) 240 (Updated January 2020) – The Auditor’s responsibilities Relating to Fraud in an Audit of Financial Statements.
19 October (FRC): Amendments to UK and Ireland accounting and reporting standards dealing with IFRS 17, FRS102/105 COVID rent concessions, and FRS104 on going concern.
16 October (FRC): Big Four’s fees for non-audit work for audited entities continue to decline
15 October (FRC): Reporting in times of uncertainty – a look forward
14 October (FRC): Tips on S172 for benefiting all stakeholders and not just shareholders.
8 October (FRC): FRC released a discussion paper proposing a future for corporate reporting based on a principles-based framework. See:
4 October: Restructures on the cards as firms attempt to ring fence audit practices from their consulting arms.
3 October: KPMG is facing a damages claim over an accounting scandal at the insurance services group Quindell.
30 September (FRC): Consultation on changes to the governance codes.
Auditing the ‘most ghoulish companies’ (November 2020).
There are two issues. a) Not only is there limited choice among the Big Four, but there is clear evidence that the Big Four and even the smaller challenger are unwilling to take on some audits, b) Secondly as Oliver Shah from the Sunday Times says:
“…do we really want small firms — possibly smaller than BDO or Mazars — taking on complex companies run by difficult founders, and sometimes becoming dependent on them?”
Reluctant audit firms (November 2020)
Deloitte, KPMG and BDO have declined to become the auditor for Lex Greensilll ahead of a possible float, the Financial Times said last week — despite a rumoured multi-million-a-year fee. Lex Greensill, is a leading financer of working capital finance and other supply chain finance. As such the company has lent substantial funds to the less than transparent Liberty House and Liberty Steel Group chaired and run by Sanjeev Gupta. As the Sunday Times succinctly put it:
“…the Australian financier with a ghoulish proclivity for helping the steel tycoon Sanjeev Gupta spin his financial spiders’ webs. Greensill’s eponymous supply-chain finance firm may count David Cameron as an adviser and Japanese giant SoftBank as its backer, but its reputation has scared off big accountants Deloitte and KPMG, as well as the challenger BDO.”
There is some background to this which includes some suspicion about the Gupta empire. GFG Alliance is the umbrella group that includes Liberty House/Steel, AlvanceAluminium and SIMEC renewable energy. The story goes:
“Greensill played a central role in the 2018 scandal in which Swiss asset manager GAM was forced to close a fund stuffed with illiquid bonds issued by Gupta’s companies. Greensill had arranged the securities, which were bought by star GAM fund manager Tim Haywood, who was later sacked for gross misconduct, including due diligence failings. Last year, Bloomberg said German regulator BaFin was broadly scrutinising Greensill over its exposure to Gupta’s family empire, GFG Alliance.”
So the cross-selling of consultancy into audit clients has gone. The worst case that has come to light involved BHS where PwC carried out eight times more advisory than audit work for Sir Philip Green’s BHS in 2014.
Other companies to have difficulty finding an audit firm include Boohoo, which has suffered the departure of PwC and deemed by this Big Four firm as too risky to audit. Mike Ashley’s Sports Direct was ‘momentarily a member of this club until it managed to get RSM to replace Grant Thornton(GT), which had been unimpressed with the discovery of a potential €674m tax liability on the eve of its results last year’.
The new majority owners of Asda, the EG Group (owned by Issa brothers) has run into problems with their auditors, Deloitte, resigned due to governance issues. I suspect we will see more of such resignations as the pandemic stretches profitability and funding.
Rising audit fees (November 2020)
Although audit fees are rising rapidly, auditing is still not so profitable as consultancy. There is also the reputational risk and the heavier fines now imposed by the FRC on audit firms. So expect more problematic companies to have difficulty finding an audit partner especially as the pandemic has made the future uncertain. Though a large fee from a new client is ‘irrelevant if you’re at risk of being fined many multiples of that by the FRC when it goes wrong.’
In terms of audit fees just one possible outlier is PZ Cussons annual report for May 2020 showed an exceptional audit fee of £2 million up from an historical low figure of £0.5million (audit Deloitte). Is this just a pandemic abnormality or an increase which will become more normal with the new operational split of audit from consultancy and both divisions having to be stand on their own and be profitable? With PZ Cussons there may well have been good reasons for this increase. Or will this herald a new era of rapidly rising fees. May be a bit of both?
Can the smaller challenger firms cope? (November 2020)
The second issue is less clear cut though Oliver Shah thinks the answer is ‘No’. It is true that the smaller firms have had their fair share of auditing scandals. There is also the view that the challenger firms are unable to gear up on new technology and audit systems to cope with the larger audits. For example, Engine B is a new complex artificial intelligence (AI) system which will aid audits to spot fraud and to prevent further scandals. AI requires a level of sophistication and staffing which may be beyond the reach of the challenger firms who are not only in computation for IT personnel with the Big Four but also the big tech companies.
Oliver Shah also questions whether the smaller challenger firms (still quite large) want to maximise growth. Shah thinks that many of the smaller ones are lifestyle maximisers: the partners want to earn enough to pay the mortgage and their children’s school fees; they might not be particularly interested in ambitious expansion.”
This is reinforced by Grant Thornton (GT) deciding to end a long-running legal battle over its failure to expose a fraud at a former client, AssetCo, leaving it facing a bill of £28.6m. The FRC report into local council audits found two challenger firms, GT and Mazars, where the level of audit quality requires significant improvement.
ICAEW audit monitoring report finds a quarter of audits are substandard (October 2020)
The ICAEW which supervises more than 12,000 firms found that 18 percent of audits required improvement and 8 percent needed significant improvement.The annual inspection reviewed 960 audits from a wide range of businesses last year. It does not review audits of public interest entities, broadly defined as listed and large private companies, which are monitored by the FRC.
Audits typically needed to improve because they lacked sufficient evidence, reached inappropriate decisions in key areas, failed to challenge management,or lacked adequate documentation. Areas of particular concern included the audit of property valuations (little or no evidence).
Deloitte first with plans for break-up (October 2020)
Deloitte has become the first of the Big Four accountancy firms to devise plans for a new governance structure to comply with its regulator’s demands for a break-up of their operations.
The firm will establish an audit governance board in January that will provide independent oversight of the UK audit practice. The board will ensure that the firm complies with a plan by the Financial Reporting Council for the operational separation of the audit divisions in Deloitte, KPMG, PWC, and EY.
The Big Four have until the end of next month to tell the regulator how they plan to implement proposals announced in July. The regulator wants firms to pay auditors in line with profits of the audit division. It has told them to sever the financial links between auditors and other parts of their business. The firms will have to complete the separation by the end of June 2024.
FRC says companies must improve COVID-19 reporting (October 2020)
UK companies should have disclosed more information to their investors about the impact of the pandemic. The FRC has found, in its first review of corporate reporting since the onset of the pandemic. In a study of financial statements covering periods to the end of March — across eight sectors including retail, real estate, and aviation — the FRC judged that most contained “sufficient” information on the effect of Covid-19 on performance. But some, especially half-year results, needed “more extensive disclosure” to help shareholders understand how the virus had changed the outlook for months and years ahead.
FRC Audit Inspections (October 2020)
In July 2020, the FRC ‘lambasted’ the UK’s largest accounting firms. The FRC’s Executive Director of Supervision, David Rule said:
“We are concerned that firms are still not consistently achieving the necessary level of audit quality. While firms have made some improvements and we have observed instances of good practice, it is clear that further progress is required. The tone from the top at the firms needs to support a culture of challenge and to back auditors making tough decisions.”
Basically, the FRC has criticised the UK’s biggest accounting firms for the ‘unacceptable’ quality of their audits after their review found one in three was substandard. The Financial Reporting Council’s annual inspection of the seven biggest firms — KPMG, EY, PWC, Deloitte, Grant Thornton, BDO, and Mazars — reviewed 88 audits, including those for 45 FTSE 350 companies. It found that 29 of the 88 audits reviewed required more than limited improvements, while seven of these required significant improvements. Of the FTSE 350 audits, 13 were found wanting, with two requiring significant improvements.
Select Committee urges more urgency on audit reform (October 2020)
Darren Jones, chairman of the Commons business select committee, said the business department needed to show “far more urgency” after it declined to give a date for primary legislation on audit reform.
The legislation is required to turn the Financial Reporting Council (FRC) into a new body able to impose greater sanctions in cases of corporate failure. The long-trailed Audit, Reporting, and Governance Authority will also have new powers to direct changes to accounts, require prompt explanations from companies, and in the most serious cases publish a report about the company’s conduct and management.
Wirecard (October 2020)
More and more information is coming to light. It seems that everyone warned everyone. There was a failure of the auditors, of the regulators, and of the German government. Everyone bought into the Wirecard success story which, as it happens, was built on sand.
It turns out that McKinsey warned Wirecardman agent one year earlier to take immediate action on internal controls. But then management failed to act and then passed the consultancy project over to PwC. Nice, if you do not like the conclusions of your consultants, just hire another consultancy firm. Of Course, EY also warned that Wirecard that the KPMG special audit, delivered a few month before the collapse, risked misinterpretation and needed more information on payments group’s third-party business. Olaf Scholz, Germany’s finance minister, defended his handling of the Wirecardscandal insisting the authorities had done all in their power to uncover irregularities at the company. Something that is patently untrue. German politics was solidly behind Wirecard. There were also plans for Wirecard to takeover Deutsche Bank. Though it now appears that there have been whistleblowers from as far back as 2016.
The picture that emerges of the Wirecard businesses that did exist is a stark contrast to the one painted by former chief executive Markus Braun, who hailed the group as a highly profitable pioneer in the payments industry. It reveals the scale on which the company, Germany’s biggest corporate fraud in decades, also misled investors about its real businesses. In fact, the non-Asian business racked up huge pr-=tax losses.
The problem left local business and people scrambling as they were locked out of their payment processing systems. Cafés, restaurants, hotels, and mobile network providers were left with no payment processing systems after the Monetary Authority of Singapore, the de facto central bank, ordered Wirecard to cease payment services in Singapore.
Some good may come of this as PwC pledges to review fraud detection after Wirecard scandal shakes their industry. But shouldn’t they have done that anyway?
However, EY faces mounting backlash after Wirecard whistleblower revelation: one of the accountancy firm’s own employee’s flagged potential fraud at Wirecard four years before the company collapsed. Even they missed their own investigation in March 2017 (Project Ring).
FRC one again finds quality of all top audit firms unacceptable July 2020
The FRC’s Audit Quality Review team reviewed 88 audits across these firms and concluded that only two thirds of the audits were of a good standard or required limited improvement. The individual reports for each firm (as well as the mid-tier and smaller firms) can be found on the FRC site.
Tabby Kinder of the FT points out that its sharpest criticism was reserved for PwC, the UK’s largest audit firm by revenue, as well as KPMG and Grant Thornton. These are the firms have come under fire for their involvement in high-profile corporate failures at Thomas Cook, Carillion, Patisserie Valerie, and earlier BHS. The FRC focused their activities on the following issues: going concern and the viability statement, the other information in the annual report, long-term contracts, the impairment of assets and fraud risk assessment.
The Times referred to these results as damning:
The damning results come amid pressure on the government to bring forward reforms of audit firms and regulation after a string of corporate collapses including Carillion, BHS and Thomas Cook. The delay has raised concerns at a time when Covid-19 has accelerated the risk of corporate failure.
FRC dictates operational split of Big Four July 2020
6 July 2020, the FRC announced its principles for operational separation of the audit practices of the Big Four firms. A first in the world. The objectives of operational separation are to ensure that audit practices are focused above all on delivery of high-quality audits – in theory anyway.
Interesting that the existing FRC is initiating this split rather than the new replacement ARGA. This may mean that the enhanced FRC will continue – perhaps. The timetable is:
- An implementation plan should be submitted to FRC by 23 October 2020.
- The transition timetable should be to complete implementation by 30 June 2024 at the latest.
The FRC 22 point plan lays out the details of the operational split of the Big Four (PwC, Deloitte, KPMG, and EY) audit/accounting firms – though their consulting divisions far exceed their audit counterparts (being only around one fifth of the total). There have been a series of reviews (CMA, Kingman and Brydon) since the collapse of Carillion in 2018 which has led the severe criticism of the Big Four.
The FRC’s plan seeks to ensure the Big Four pay auditors in line with the profits of their audits, ringfencing the finances of the audit division with a separate profit and loss account, and introduce an independent audit board to oversee the practice. This will significantly
increase the cost of audits as there can be no cross-subsidy from the more lucrative consulting divisions.
The FRC stopped short of a full break-up of the firms such as the spinning off audit teams into independent legal entities, that had been mooted by some politicians in the wake of the collapse of Carillion.Since then there have been further high-profile corporate collapses, such as Thomas Cook, Patisserie Valerie, NMC Health, LCF, Kaloti (Dubai) and, most recently, German payments processor Wirecard. The challenger mid-tier firm Grant Thornton was the auditor for Patisserie Valerie and another failure Conviviality,
We fell that this however does not provide a sufficient number of auditors to provide choice –
See our book Bhaskar K., and Flower J., with Sellers R., Disruption in the Audit Market: The Future of the Big Four. Routledge, 2019.We simulated the audit markets under a variety of different splits of the audit firms and tested for independence and quality. Our conclusions were that such an operational split is insufficient to improve audit quality.
Also such an operational split still maintains the inherent conflict of interest in audit market structure where auditors are paid by the very groups that hire them.
Tabby Kinder in the FT noted that:
But some commentators said the measures did not go far enough. “It is a semi-split that is unlikely to be the last reform that will be needed,” said Erik Gordon, professor at the University of Michigan.
Others criticised the four-year “lag” for implementing the changes. “If this is held out as the solution to audit quality then we’re all kidding ourselves,” said one senior industry executive.
An individual at a Big Four firm pointed to the logistical challenges, calling the requirement for separate audit balance sheets a “nightmare” as it would require the firms to “untangle” central administrative costs.
Revisions to Going Concern, Risk and Viability statements (COVID-19) June 2020 FRC
During the 2007-2009 crisis, we were told by a number of interviewees that a cross-sector wave of warnings didnot happen, This is confirmed by Tabby Kinder in the FT. The FRC obviously heeded her warnings that auditors have a backlog of annual reports that are likely to question the ability of companies in the hardest hit sectors during the pandemic to continue trading as a going concern for the next 12 months. Tabby Kinder writes:
A flood of going concern warnings or qualified audit opinions — in which an auditor says there are misstatements or that they could not obtain enough evidence to sign off the accounts with a clean bill of health — could spook markets. There is also expected to be a rise in “emphasis of matter” audit reports, which highlight serious uncertainties around matters such as property or inventory valuations.
Tabby goes on to report:
The head of audit at one large firm said some major businesses had approached the government’s department for business in recent weeks to complain that their auditors
were putting too much pressure on them. “They have complained that we’re being overly prudent,” the auditor said, adding: “However, it’s clear that none of the stress tests we forced companies to do back in February and March look so crazy now.”
He said his firm was forcing all consumer-facing companies it audits to stress-test being closed until September and a phased recovery for a further 12 months. He said that travel and leisure companies had been told to “assume no European summer revenues and no winter sun revenues at all”.
So firms believe the auditors are putting too much pressure on them in what is often regarded as a pass or fail type test (going or not going concern). The FRC has clarified that there are ways in which the survival of a company can be graded with different possibilities.
The FRC responded with two reports: Covid 19 – going concern, risk and viability and Covid 19 – resources, action, the future
The reports consider that investors are fully aware that the levels of uncertainty are unprecedented and, to a large extent, outside companies’ control. The FRC encourage Boards of companies to consider plausible scenarios and report on how they intend to respond to these going forward. Examples of good practice reporting were included to assist companies.
Specific elements of uncertainty relevant to the next 12 months might include (but are not limited to): a) Timing of resumption of operations. b) Further restrictions that limit the return to normal operations.c) Restrictions placed on government (or other) capital.d) Timing and continuation of government schemes and support packages. e) The outcome of capital raising actions, discussions with banks, and landlords.f) Short-term impacts of pricing changes to revenue and expenses. g) Impacts on human capital, the supply chain and customers.
The FRC summaries of the these issues are provided below:
Locating and obtaining short-term cash resources is often about building resilienceand flexibility but, for some, it is ultimately about survival. In such circumstances,reporting on going concern and uncertainties becomes more important. Thedisruption to business models in the short-term might mean that the goingconcern assessment is more complex task. However, going concern is not a simplebinary or pass/fail concept. A company can be a going concern even when one ormore material uncertainties exist. In such circumstances what becomes importantis the disclosure about the uncertainties and management’s consideration of these.
Reporting by companies on principal risks provides investors with key informationabout the resilience and adaptability of a company’s business model and strategyto internal and external shocks.COVID-19 has created risks for many companies and caused a reconsideration ofrisk profile and appetite. Investors
therefore want to understand how those riskshave changed and how they specifically affected companies, and how managementhave responded.
The viability statement was introduced following the 2008 financial crisis to provide investors with a better view on the longer term prospects and viability of acompany’s future. The current crisis is a test of the value of viability statements. Aviability statement with realistic scenarios and clear assumptions provides boards an opportunity to communicate their longer-term prospects, even when the short-term outcome is less certain.
Financial Failures Breaking news July 2020
Wirecard (July 2020)
The jury is out as to exactly what happened with Wirecard. The company offers its customers electronic payment transaction services and risk management, as well as the issuing and processing of physical cards. From 2006, Wirecard moved into banking. It was licensed by Visa and Mastercard, meaning it can both issue credit cards and handle money on behalf of merchants. This unusual hybrid of banking and non-banking operations makes its accounts harder to compare with peers, and helps persuade investors to rely on the company’s adjusted versions of financial statements.
Wirecard: History of earlier warnings (July 2020)
The full history can be seen in the FT article on Wirecard’s timeline. Wirecard became one the 30 companies in the DAX.
2008: The head of a German shareholder association publishes an attack on Wirecard, suggesting balance sheet irregularities. EY is appointed to conduct a special audit, and the following year replaces the small Munich firm that had previously acted as group auditor. The German authorities eventually prosecute two men in connection with the attack, who had not disclosed positions in Wirecard stock.
2010-2014: Rapid expansion in Asia. Investors are drawn to Wirecard’srapid growth and claims of superior payments technology.
2015: FT raising questions about inconsistencies in the group’s accounts and a €250m hole in the group’s balance sheet. Wirecard made its largest-ever takeover, of Indian payments businesses in a €340m deal. J Capital Research reports that Wirecard’s operations dotted across Asia are far smaller than it claims.
2016: Short-sellers and the FT start a campaign. Allegations of money laundering were denied by Wirecard and BaFin (Our equivalent of the FCA). Wirecard announces it is buying a prepaid payment card business from Citigroup, entering the US market.
2017: AEY clean audit and better reported cash generation leads to renewed investor enthusiasm. Bought Citigroup’s Asian payment processing operations.
2018: Wirecard’s Singapore HG triggers an investigation into members of their team following a whistle-blower’s allegations. By August Wirecard is valued at €24bnand claims it has 5,000 employees, who process payments for about 250,000merchants, issue credit and prepaid cards and provide technology for contactless smartphone payments. Whistle-blowers contact FT.
2019: The Singapore police raid Wirecard’s offices. BaFin announces a two-month ban on short selling, citing Wirecard’s importance for the economy. The FT reports that half of Wirecard’s business is actually outsourced, with the payments processing handled by partners who pay Wirecard a commission. FT find further detrimental material and Wirecard threatens to use the FT. Wirecard raises nearly €1bn. FT finds most of the profits are generated by three partner companies in Philippines, Singapore and Dubai. EY approves accounts. FT continues its campaign and Wirecard responds saying ‘nothing to see here’.
Late 2019: Wirecard raises new bonds. Wirecard uses FT. The FT publishes documents indicating that profits at Wirecard units in Dubai and Dublin were fraudulently inflated, and that customers listed in documents provided to EY did not exist. Under pressure from investors Wirecard appoints KPMG to conduct a special audit, which it says will clear it of wrongdoing – but in fact in 2020 KPMG reports negatively. FT finds other issues.
2020: KPMG report delayed then published. it can not verify that arrangements responsible for “the lion’s share” of Wirecard profits reported from 2016 to 2018 were genuine, citing “obstacles” to its work. Then Markus Braun (CEO) reports to investors that EY have no problem at all to sign off the audit 2019. But publication of results is postponed to June. Any wrongdoing is denied.
2020 June 16 onwards: The Philippine banks BPI and BDO inform EY that documents supposedly detailing €1.9bn in balances are missing, CEO resigns. He and other are arrested. Wirecard acknowledges for the first time the potential scale of a multiyear accounting fraud. 25 June Wirecard files for insolvency. Markus Braun bailed but under possible criminal charges. The CFO, head of Paycard Payments Unit in Dubai and others were arrested.
One issue that cropped up during these arrests was that of Jan Marsalek, the COO, who has now disappeared although there is an international arrest warrant out for him. As the FT reported he has led multiple lives, with complicated and overlapping commercial and political interests. Sometimes those interests cleaved to Wirecard’s aggressive expansion plans in frontier markets. Sometimes they coincided with his own sprawling and unusual range of personal investments. And sometimes they seemed to fit neatly with the work of Russia’s intelligence agencies. He was known to be recruiting 15,000 Libyan militiamen.
Wirecard: Profitability in doubt?
These are the accusations. Money laundering. Profits made from a few customers. Most of the business loss making in Europe.Many customers being pornographic or gambling sites. In addition, it now it transpires there are possibly all sorts of other errors. Financial planning undertaken on large spreadsheets with errors (duplicate clients and wrong currency conversion are rumoured) and the bulk of the business coming from clandestine pornographic sites: with the bulk of the business coming from a handful of large clients.
Wirecard: failure of the auditors (EY)
The FT reported thatEY failed for more than three years to request crucial account information from Singapore;sOCBC bank where Wirecard claimed it had up to €1bn in cash. This is normally a routine audit procedure that could have uncovered the fraud. The FT also reported that the auditor between 2016 and 2018 did not check directly with the OCBC Bank to confirm that the lender held large amounts of cash on behalf of Wirecard. The FT claimed that instead, EY relied on documents and screenshots provided by a third-party trustee and Wirecard itself. The FT quoted:
“The big question for me is what on earth did EY do when they signed off the accounts?” said a senior banker at a lender with credit exposure to Wirecard. A senior auditor at another firm said that obtaining independent confirmation of bank balances was “equivalent to day-one training at audit school”.
The head of audit at a rival accounting firm to EY said: “It is beyond the realms of reality that EY wouldn’t have had [the bank balance confirmations] unless they did a very poor audit. Cash is easy to audit. If investors can’t trust the cash number, what can they trust?”
Hansrudi Lenz, professor of accounting at Würzburg University, told the Financial Times that it was “not sufficient” for an auditor to rely on account confirmations that were provided by third parties. “The auditor needs to have full control over the delivery of account confirmation,” he said, adding that this was stipulated by procedural guidelines.
Wirecard: Failure of the regulators
Germany in the aftermath of the Wirecard scandal is doubling down and rewarding the regulator that seemed to turn a blind eye. This seems to be a backwards step rewarding the authority that failed to notice any warning signs despite numerous indications. At least in the UK, when something has gone wrong it is noticed and mostly investigated and revealed. This looks to me as if the errors are being swept under the carpet.
BaFin is the financial supervisory authority in Germany equivalent to our FCA. The other two bodies are the Financial Reporting Enforcement Panel [FREP] and the German Audit Oversight Body (Abschlussprüferaufsichtsstelle [APAS]). These two bodies cover the enhanced role of our FRC.
BaFin that banned investors from short-selling against Wirecard shares for two months. This was the first such restriction on an individual company in German stock market history. And as the press reports that was quickly followed by a criminal complaint against two FT journalists who had reported the whistleblower allegations about the payments company.
The head of the equivalent of our FCA (BaFin) now claims that it was not his agency’s job as Wirecard was classified as a technology company rather than a financial services provider. Pretty weak as the same agency bent over backwards to help Wirecard previously. Even if now it appears the company was engaged in money laundering activities. Yet BaFin backed Wirecard previously in an unpresented move to defend Wirecard`.
The Economist’s view
Apart from extolling the virtues of short-sellers, who started the rumours back in 2008, their view is:
Wirecard’s rise and fall is a case study in the carnage possible when a firm’s accounting goes awry but national regulators and big investors are so seduced by the company’s narrative that they cannot, or will not, see it. It is also a reminder of how markets stand to benefit from short-sellers—who try to make money betting against listed firms, by selling borrowed shares and buying them back later at a lower price. Had the warnings from Cassandras who detected a bad smell around Wirecard years ago been heeded, billions of dollars of losses, many of them borne by pension-fund investors, could have been avoided.
Big banks and investors, including Deutsche Bank and its DWS fund-management arm, backed Wirecard and kept the faith, in some cases doubling down, even as more and more red flags popped up. Many did scant due diligence, instead relying on puff pieces churned out by sell-side analysts right to the end: half a dozen still had buy recommendations on the stock when Mr Braun resigned. Wirecard’s auditor, EY, faces scrutiny, too. German media, for the most part, swallowed Wirecard’s line that it was the victim of a nefarious plot by Anglo-Saxon marauders.
When so many supposedly clever people can get it wrong, anything that injects scepticism is welcome. Such counterweights to market consensus are especially helpful when politicians and central banks are boosterish on asset prices, as they are now, and in countries with a corporatist mindset. Even as Germany has embraced shareholder capitalism, the view that company managers are more trustworthy than their shareholders, especially less patient ones, has proved stubbornly persistent.
FinTech, City, Schadenfreude, Brexit and Wirecard
As Simon Duke in The Times (on Tuesday 30 June 2020) said Schadenfreude (originally German), joliemaligne (in French) represent the happiness we feel when someone else fails. Wirecard failed and perhaps there could have been some of that feeling in the City. How the German financial institutions fell after solidly sticking behind Wirecard.
That is not all. The Times (James Hurley again) claimed that the FCA was given details of an operation whereby allegedly bogus ecommerce sites were used as a front for channeling online gambling proceeds through the international payments system. Fintech – will they benefit from Wirecard’s fall? The big surprise is that there are over 100 newish FinTech companies. Everyone must have seen the Starling’s bank’s advert of a helicopter garden shed. However, there are many more and the number is still rising. See this link for a list. They can’t all survive and prosper surely?
The next problem for financial services is that current Brexit negotiations are not going well and time has run out. Equivalence of rules and the European Court of Justice are sticking points which may mean the City loses its financial supremacy. In my opinion that is Europe’s loss as the winner will be New York, Singapore, and Shanghai.
That however is not the point as Donald Brydon (as in his audit review) has said: “[Audit] firms should have the obligation to find fraud rather than stumble over it”. As reported by the notable Tabby Kinder:
The final conclusion? Nothing may happen. If anything it will probably come down to the regulatory authorities in Germany not being powerful enough or sufficiently sceptical of management. And that includes the auditors. The same criticism has been levelled against the FRC and FCA over previous failures of which Carillion probably caused the most criticism. These failures can never be fully eliminated but I believe they can be reduced. One again, the reliance investors can place in the audit process as being the final check on management is thrown into doubt – regardless of how sophisticated fraud. And Wirecard does not seem to be that sophisticated. Everyone just believed their public statements and news releases.
Breaking news June 2020
The Big Four audit firms earn their keep June 2020
Both KPMG and EY are to be congratulated on going against the market and corporate opinion in giving negatives reviews on probably what was the jewel of the Germany stock market. Frequently the Big Four may have passed private communications about their concerns in non-public correspondence with hope that explanations and/or action would be undertaken to rectify the situation. Whatever happened in private, the impact of these opinions sent the value of Wirecard into a nosedive and may threaten the survival of the company (and perhaps a share of their fees).
The Big Four and the Challenger Accounting/Audit firms June 2020
According to the Financial Times (FT), the BDO is doing well and is the fifth largest accounting firm by revenues, and now audits more listed companies than EY, Deloitte or KPMG – with 15 clients in the FTSE250. KPMG’s descent into third place after the other Big Four from it first place in 2018 has been expected – given its troubles over numerous audits including Carillion. Though the Big Four have tied up the audits of the FTSE100.Grant Thornton (GT) ran into issues and is in the process of retrenching. Growing pains.
Wirecard Accounting Saga June 2020
Wirecard finally admitted its errors. It was 1st February 2019, when the FT and then Bloomberg first reported the story of a decline in share value amidst allegations of accounting irregularities in Singapore and other countries in Asia and the Far East. Wirecard’s management has consistently denied any accounting wrongdoing or lack of internal controls. In May 2020, the results of a company-commissioned special audit by KPMG were released. KPMG found that they could not verify the lion’s share of Wirecard’s operating profits between 2016 and 2018 were genuine.
Until now Wirecard has categorically denied any impropriety and have consistently claimed that the conclusions drawn by the FT about the files were incorrect. The auditors (EY) came up trumps and warned that they had found evidence that related parties of the Wirecard bank had attempted to deceive the auditor and had provided spurious bank balances – and refused to sign off the annual results in June 2020. On the 16th June, they postpone issuing their annual accounts. On the 18th Wirecard admitted that €1.9bn of cash was missing. The next day Wirecard’s chief executive Markus Braun has resigned. It is alleged that the two Asian banks where some funds were supposed to have been transferred claim they never received the money. Now a criminal investigation is being launched in Germany and Markus Braun has been arrested.
Shares crashed from a high of €192 at its they day. Wirecard was a German financial technology group. The company joined the exclusive DAX 30 stock market index in 2018 on a wave of investor interest which valued it at €24bn, more than Deutsche Bank, and earned it a place in pension funds around the world. A meritorious and important rise for Germany (post SAP the software company’s much earlier rise).
Shares fell as low as Euros 12 towards the end of June 2020 valuing the company at less than €5bn. The FT reported that missing cash was equivalent to all the profits the group had declared since2012. This puts Wirecard at the mercy of potential recalls of loans.SoWirecard’s future is now in doubt. The company had a m monumental and glittering rise but the accounting and financial controls failed to keep up with its meritorious rise (shades of Patisserie Valerie?).
Knock-on effects may be to hit British financial tech companies using Wirecard’s services such as Revolut and Monzo. British users of Wirecard’s services may have to move their payments business elsewhere.
Reporting landscape: Other Cases in June 2020
Barclays Bank is in the news again. Although the SFO gave up on the prosecution of Barclays over the finance and other deals with Qatar back in 2008, Amanda Staveley’s PCP Capital Partners has launched a high-profile civil trial for £1.5bn.
Other companies in trouble or trying to raise emergency funding include Ted Baker, Warehouse, Oasis, Monsoon, Quiz, Go Outdoorsand others. Many might be disposed of in pre-pack administration. Boohoo has done well in the pandemic (rapid response, youth appeal, new athleisure-wear and celebrity input?) came under fire for the value of its shares in Pretty Little Things and to resolve the issue bought the entire company and also went on to buy Oasis and Warehouse. Boohoo is now worth more than combined market capitalisations of Marks & Spencer and Asos.
Contraction and closures continue on the aftermath of the pandemic. This includes the Restaurant Group (including the chain Frankie & Benny’s), Carluccio’s, Pizza Express, and other. Cath Kidston closed in May.
Simec Atlantic Energy half owned by steel tycoon Sanjev Gupta is looking for Chinese partners.
Tesco is in the news again, this time trying to resitsresisting pressure to axe a £1.6 million bonus for its departing boss (Dave Lewis) as shareholders prepare to inflict a humiliating defeat on the supermarket.
The founders of a failed peer-to-peer lending platform, Lendy, have had their assets frozen after administrators alleged that they had channelled £6.8 million to offshore companies for their own benefit.
The London Capital & Finance(LCF)scandal has put two companies connected with the failed mini-bond business into administration. These were London Power & Technology and LPE Enterprises. Both businesses were part of a complicated web of companies linked to London Capital & Finance. (This company was accused as one of the biggest scandals to have hit investors in recent times).
Metro Bank among other banks may experience a large rise in bad debts.
SIG roofing specialist was rescued by a US private equity company (Clayton, Dubilier& Rice).
FRC June 2020
The FRC closed its case on Tesco(£250m overstatement of profit in 2014) without any report or penalties. The FRC, however, launched an enquiry into PwC and KPMG in the audits of Eddie Stobart.
FRC is also expected to investigate into the audits carried out by PWC, EY, and by Oliver Clive & Co (a small, London-based firm). All separately signed off on LCF’s accounts without raising concerns.
Sanctions (but no fine) were imposed on KPMG for the audit of Foresight 4 VCT plc in relation to shortcomings in its audits of figures relating to the company’s distributable reserves.
Private equity June 2020
Handful of mainly US groups on spending spree despite worldwide lockdowns to halt coronavirus. For example KKR snapped up cosmetics firm Coty. In fact it has been reported that the top 10 ranking private equity groups by deal count have announced deals worth more than $40bn since the beginning of March 2020.
The dash to raise equity June 2020
According to the FT and others publications, new equity has risen to more than 33% of share capital and discounts have widened. At the moment it seems that large companies have access to liquidity and secured waivers to debt covenants. That said the FT commented that: “a solvency crisis looms once groups drawdown on overdrafts and jack up their balance sheets with borrowings they can’t pay off”.
Breaking news May 2020
a) Coronavirus actions and events
• Capital markets. Equity is bullish but we may need private equity for the recovery as well. France is locking no French predators out from buying strategic firms and industries. UK probably won’t follow as it would harm the Americans but the Chinese might be the ultimate beneficiary. Though the Middle Eastern countries and sovereign funds are looking to actively buy as well. Gilts, the primary government debt market, nearly froze with the extent of the government expenditure and guarantees during the crisis. The extent of the global recession is being debated but it is probably the worst in human history. Hedge funds so long out-of-vogue may now have an opportunity. Venture capital – jury’s is out at the moment. Boards must prepare for a new normal post crisis. Meanwhile, the number of firms going into administration is exponentially increasing despite extensive government guarantees (now small businesses can obtain 100% guaranteed loans up to £50,000 with no interest payments of a year).
• Industry sectors. Cruise lines – will they ever recover. Airlines are indicating it may take 5 years to get back to normal. Worse for Boing and Airbus. Jest from bust airlines and repossessed leased aircraft are now flooding the aviation market. No more room to store unused jets in the Mojave Desert and other dry storage locations. Other sectors equally hit especially retail fashion stores. Hospitality – jury’s out on when and if many of the brand names and smaller units will return.
• Big Four troubles. It seems that afar Deloitte and the PwC were the bad boys, in 2018 and 2019, KPMG were caught many times and went to the bottom of the group in terms of investigations and (in our view) errors in their auditing work. Now in 2020, it seems that EY has taken KPMG’s place. EY has been ordered to pay $10.8m in compensation to a former partner who blew the whistle on a client in Dubai suspected of laundering money and smuggling gold. The judge found that EY and its Middle East associate firm had “embroiled” its former partner in “seriously improper conduct” and had allowed measures designed to obscure the audit findings. EY are still denying this.
• The accounting and audit industry faces its worst crisis for some time. The Big Four, by and large, have cut the amount of profits that are distributed to their partners each month by up to 25% to build up cash reserves and help survive a downturn in work. Together the big Four employ over 74,000 people in the UK and partners earned an average of £720,000 in 2019 (numbering just over 3,000). Now, pay rises, bonuses, and promotions are being deferred or put on hold. There is no question that the Big Four are resilient and will handle the crisis. The challenger mid-tier and smaller firms are tending to furlough staff. That said there may be some major changes including restructuring and down-sizing a little; and for the smaller firms more merging and takeovers.
• Coronavirus threatens challenger mid-tier auditors. The crisis has threatened their bid to catch up and break the Big Four stranglehold. The pandemic has forced challenger firms such as BDO, Mazars and GT, and their smaller counterparts, to act swiftly to cut costs and help survive a downturn in work and a squeeze on fees. As above measures include cutting staff pay, furloughing teams, and withholding profit payments to partners. The challenger firms seem to be worse hit that the Big Four who can rely or maintain some of their income streams and have cash buffer upon which they can draw. • FRC delays audit rotation due to coronavirus disruption. The FRC has made it clear that it is open to allowing extensions on auditor rotation and partner rotation by up to two year (on 10 year tender process and 5 years for the audit engagement partner).
• Delays to audit reform. Delays to non-urgent legislative reforms is to be expected to be a prolonged period of economic uncertainty. We think it will be delayed to 2021 at the earliest and legislation will be required for such remedies as the operational split of audit and consultancy, as will the official creation of ARGA. That said the beefed-up FRC has implemented more than 20 of the 83 recommendations set out in the Kingman review, and progressing with about 35 other measures recommended.
• Delays to annual reports. The FCA asked companies to delay in publishing their annual results because of the uncertainty caused by the coronavirus crisis – a delay provisionally of 2 months but we think this will be further extended. The FCA said that this was designed to ensure listed companies and their boards are not rushed into preliminary financial statements during the fast-changing circumstances presented by coronavirus.
• FRC tightens instructions on going concern and for auditors proof from clients. Company auditors have been ordered to be more sceptical and ask for more evidence before signing off “going concern” verdicts in annual reports. The FRC instructions came as listed companies were given an additional two months (we think this may be extended) to publish annual reports by the FCA. The FRC said it expected many more companies to have to admit to material uncertainties in their reports. Because of the unprecedented level of uncertainty, more companies would have to qualify their going concern statements.
• Dividends and share buy-backs are being radically reduced as financial results worse during the crisis. This was a move applying to European banks as well as pressure on the Bank of England to block £7.5 billion of dividends to be paid out by UK banks. Although initially limited to banks, Europe, UK, and the US may place resections on dividends and share buy-back schemes as a quid pro quo for grants and loans. The list of companies and business have joined the list of quoted companies now scrapping their dividedness. Many buy-backs of share have been put on hold. The Economist divides this into three categories. Firms receiving large government handouts should not pay dividend (includes all bank, airlines, etc.). In the second category are firms that are stretched but feel that keeping up reliable dividends sends an important signal. The danger here is that they rack up debts in order to do so. Boards should think twice. In the third category are a group of businesses that have strong balance sheets and are operating near full tilt, for example, tech firms and other utilities.
• Short-selling ban. Most of Europe with the notable exception of UK and Germany has temporarily ban on bets against locally listed stocks. This may become a European wide ban for the duration of the coronavirus crisis.
b) Audit and reporting reforms (May 2020. No change since early April)
• FRC actions. The FRC has issued guidelines for the big four to separate their audit and consulting operations in the UK. This will require legislation from the government (now delayed). Nevertheless, the FRC is taking its new powers (soon to be implemented with ARGA) to press firms to embark on a voluntary (or via legislation) break up as part of efforts to improve the quality in auditing. This includes making their audit operations financially independent businesses, with separate boards led by independent chairs. Audit costs and profits would be ring-fenced. Audit partners would no longer be remunerated from a shared pool of earnings that involved the firms’ consultancy earnings. https://www.frc.org.uk/news/february-2020-(1)/frc-writes-to-audit-firms-on-operational-seperatio https://www.ft.com/content/1ddf7430-5987-11ea-a528-dd0f971febbc
• CMA threatened action. Now augmented by the possible action above. The CMA (Competition and Markets Authority) has warned of further drastic reforms of the audit market if the Big Four continue to oppose and undermine the proposed shake-up. See Operational split below. The CMA claim “The current set-up is a threat to the resilience of the entire system, in the event of a firm collapsing or withdrawing. The Big Four are too few to fail.” So the CMA is threatening one of our solutions in the audit market book and that is the direct (or independent) appointment of auditors (by ARGA presumably) – on the grounds of improving resilience and also audit quality.
• Brydon Review published late December – split of audit and accounting profession unlike other recommendations now unlikely. See https://www.fin-rep.org/which-book/disruption-to-the-audit-market/post-publication-discussion/ Other Brydon recommendations may be introduced piecemeal by the FRC/ARGA.
• New ARGA to replace beefed up FRC seems most likely. FRC being beefed up to form the new legislated ARGA. Formation due in 2020 but will be delayed. See: https://www.accountancydaily.co/plans-arga-audit-regulator-due-end-march
• Ban of consultancy work for audit clients: a beefed upFRC has tightened ethical standards which means a banning of consultancy work for audit clients and a new list of what areas can be undertaken for audit clients – blacklist scrapped. Attempt to improve independence.
• Private companies: above ban extended to large private companies.
• Operational split of audit and consultancy: CMA trying persuasion rather than legislation to archive a split of audit and consultancy divisions. However, the Boris Johnson government less keen. But the Big Four may consider voluntary split before being pushed by legislation (jumping the gun). That said Deloitte’s won’t jump and may require legislation – so legislation for operational split more likely. See: https://www.thetimes.co.uk/article/divide-audit-and-consulting-at-deloitte-not-on-my-watch-at-least-not-voluntarily-q60jjqbc0
• Joint audits: Not in vogue but CMA pushing for a looser arrangement than previously dictated by CMA. We believe probably not going to be popular.
• Resilience of operational split. The government is interested in the resilience of the top six auditors. They want them to charge higher fees, and not be cross-subsidised by consulting.
• Audit partners’ pay: Focus to make this independent of performance and consulting by FRC/ARGA.
• Higher audit fees are being announced in general and some think this may spur auditing divisions to become more profitable in their own right.
• Cost cutting continues among all audit firms – particularly by KPMG and GT. However, some are spending resources to augment their audit divisions prior to any operational split.
• Challenger firms: There is evidence of the mid-tier challenger firms growing. That said they are experiencing some growing pains.
• Equivalence and regulations: May be for the financial institutions but the rules and regulations for the non financial and non-EU exporters will diverge. May be in some areas (e.g. audit) tighter than EU. Boris Johnson government’s ambivalent over regulations – wants a lower regulation economy but might be going in the opposite direction with tariffs, border checks, and more red tape; some tighter financial reporting requirements. Looser regulations for the analyst reports killing MFID II (which governs trading and company research), Solvency II (which applies to insurers), and other irksome regulations – though not many in number – though diverging from them is not worth the cost of losing all access to European financial markets.
• Financial scandals continue on a daily basis. For one reason or another, Company names in the oppress include Woodford, Burford, Saatchi, Sports Direct/Frasers, NMC Health, Credit Suisse, and many others. Of course collapses by retail chains, care-home groups and other, continues apace.
• Audit Quality: In October 2019, the FRC once again found audit quality had deteriorated.
• Big Four 100% domination of the FTSE 100. c) Financial failures and scandals May-2020) These case continue a pace. Wirecard and NMC are back in the news again. See: https://www.fin-rep.org/which-book/financial-failures-scandals-from-enron-to-carillion/post-publication-discussion/ The crisis will expose much corporate fraud. So the Economist reckons[i]: ‘Booms help fraudsters paper over cracks in their accounts, from fictitious investment returns to exaggerated sales. Slowdowns rip the covering off. As Baruch Lev, an accounting professor at New York University, puts it, “In good times everyone looks good, and the market punishes you harshly for not keeping up.” Many big book-cooking scandals of the past 20 years emerged in downturns. A decade before the crisis of 2007-09 the dotcom crash exposed accounting sins at Enron and WorldCom perpetrated in the go-go late 1990s. Both firms went bust soon after. As Warren Buffett, a revered investor, once put it: “You only find out who is swimming naked when the tide goes out.” This time, thanks to a pandemic, the water has whooshed away at record speed.’
The case of Hin Leong: funnily enough one of the first casualties where the coronavirus threw up a possible fraud was a Singapore company called Hin Leong an oil trading company. Auditor: Deloitte which stands by the air auditor though there are discrepancies of upwards of US$4 billion. For more on this case see: https://www.fin-rep.org/which-book/financial-failures-scandals-from-enron-to-carillion/post-publication-discussion/
Lucklin Coffee (China, listed on NASDAQ, auditors: EY)overstated sales. WeWork(IPO, auditors: EY) failure, created esoteric measure of profit which meant little and were misleading, GSX(China, listed on NYSE, auditors: Deloitte) overstated massively revenues.
Kasen International Holdings (Listed in Hong Kong, auditors: BDO) an investment company has been accused of illusory investments and transactions between the company and chairman’s family members. Nothing recently on firms operating in the UK but the above article by the Economist thinks that there will be several.
See for more on these April cases: https://www.fin-rep.org/which-book/financial-failures-scandals-from-enron-to-carillion/post-publication-discussion/
[i]Leaders.Payouts in a pandemic – Which firms should pay dividends?, The Economist, 16 April 2020. Available at: https://www.economist.com/leaders/2020/04/16/which-firms-should-pay-dividends Accessed: April 2020
[ii]Business, Who’s lost their trunks? The economic crisis will expose a decade’s worth of corporate fraud, The Economist, 18 April 2020.
Available at: https://www.economist.com/business/2020/04/18/the-economic-crisis-will-expose-a-decades-worth-of-corporate-fraud Accessed: April 2020.