1 About this book

Background and focus of the failures in this book

This book is about financial scandals and failures. Financial or accounting scandals are usually business scandals arising from intentional manipulation of the financial statements. In this book we concentrate on misdeeds by companies and their management.

The Competition and Markets Authority (CAM) and Kingman report were published post-publication. Reactions to the CMA on the audit market and the Kingman report on the replacement of the FRC can be found in the online companion volume www.fin-rep.org. The CMA only considered what we regard as ineffective solutions. The Kingman Review was, in our opinion, far more effective, scrapping the Financial Reporting Council (FRC) in favour of the Audit, Reporting and Governance Authority (ARGA) with statutory powers making it a stronger regulator with harsher penalties and the ability to investigate all company directors. ARGA will also be able to make changes to accounts, have a wider set of sanctions and can publish reports into a company’s conduct and management. The Government has said it would implement the Review.1

The cases we deal with concentrate on more recent ones and involve one of two main symptoms:

1 Misappropriation of assets (possibly theft) and then hiding the results in the financial reports; 2 Intentional manipulation of accounts by management to improve financial reports and the annual reports.

Who is involved in preparing financial reports?

The external auditors (referred to as auditors here) are the main external check and balance for all companies over a certain size including both private and non-listed organizations. The Big Four accounting firms (PwC,

EY, Deloitte and KPMG) dominate the auditing of Public Interest Entities (PIEs) and have a stranglehold over the FTSE 350.2 We estimate that by 2025 or shortly after, they will have close to 100% share of this audit market. In simple terms, the auditors usually have a pass or fail type of sign off. A negative audit report is indicated by ‘qualified’ or by no audit opinion.

The Audit Committee (AC) is also significant in the accounts preparation with often continuous interaction with the auditors. The AC comprises some non-executive directors (NEDs) and the Audit Committee Chairperson (ACC). The AC usually provides a report in the annual report. The Audit Engagement Partner (AEP) is the senior auditor, usually a senior partner of one of the Big Four, and it is he or she that signs the audit report in the annual report. This is separate from the Audit Committee report which is part of the Annual Report.

Typical interactions in the reporting process

The AEP has interactions with the AC and also, depending on culture, with the Company Financial Officer (CFO) and/or the ACC. The ACC often takes a lead role in solving disputes between the CFO and the AEP. Box 1.1 shows an example of a typical interaction for a specific issue.

Box 1.1 Interactions between AEP, ACC and AC3

Issue: identification of intangibles on acquisition

Arising from: IFRS implementation

• Following acquisition, AEP stated position clearly despite doubts from CFO; • CFO engaged an external valuer for the work; • Valuation considered by AEP, then technical department and AC; • AEP questioned valuation, so AC agreed to revise downwards.

Issue: presentation of cash flow statement

Arising from: IFRS implementation

• AEP proposed presentation based on guidelines included in relevant standard for first year of IFRS; • Company accepted in first year but did not like the format – so adopted alternative for subsequent year;

• AEP warned CFO of risk of regulatory action and discussed with ACC; • CFO and AC adopted revised format – subsequently discovered other companies had also used this format.

Issue: accounting for a complex transaction Arising from: solutions for unusual transactions

• Passed up by more junior staff for discussion by CFO and AEP but no initial agreement; • ACC aware of problem at pre-AC meeting; • CFO acquired more evidence to support his view based on similar cases elsewhere; • AEP checked with technical department and accepted the proposal; • Following agreement between AEP and CFO, then CFO met with ACC to ensure he supported it; • CFO and AEP jointly presented solution to AC, who asked questions before accepting.

There is some merit for these interactions to be reported on and summarized. Unresolved disputes can be clearly identified. Exactly how much should be revealed needs further discussion, but nevertheless, we are in favour of the disclosure of such interactions between these important players in the reporting process.

The role of the regulators

The FRC introduced the requirement for the strategic report which is a description of the business model, as well as a narrative section in the ‘front half’ of UK annual and corporate reports. Note the Kingman Review has recommended that the FRC be replaced with an independent statutory regulator called ARGA. We agree with the ICAEW4 assessment that the quality of narrative and non-financial disclosures in the ‘front half’ of the annual report has improved significantly in the UK in recent years. Of particular note are improvements in relation to the business model, strategy, non-financial key performance indicators (KPIs) and alternative performance measures (financial) and drivers of long-term value creation. There is also a strong sense that the ‘front half’ has continued to evolve in response to the introduction of the strategic report and changing market expectations. (That is not to say that there aren’t major problems with many of the top front halves of typical annual reports.)

The FRC (although not without its own critics [now replaced]) has reported a fall in audit quality. We maintain that this fall is due to the convergence of a number of disruptive factors:

• Continuing government austerity policies eroding government expenditure (and those firms depending on public spending); • Brexit changing the focus for firms, and creating a fall in the value of sterling; • Low interest rates causing higher leverage and trapping highly geared firms into a false sense of security whilst interest rates are low; • Disruptive industries and sectors causing the growth in some and the fall-off in demand for brick-and-mortar retail outlets and restaurants; • Other disruptive effects, e.g. new technologies, the internet and IT.

Carillion – a pivotal event

A financial failure (and arguably scandal) which is pivotal to the future of the audit market is the failure of Carillion, which took place in early 2018. Carillion takes a significant portion of our attention in this book. Not since Enron has there been a case which has attracted such severe criticism. More significantly, it argues for a major change to financial reporting, watchdogs and auditing.

Its failure left a mountain of debt, job losses in the thousands, a giant pension deficit and hundreds of millions of pounds of unfinished public contracts with vast ongoing costs to the UK taxpayer. How could a company that was signed off by KPMG as a going concern in Spring 2017 crash into liquidation only a few months later with a reported £5+ billion of liabilities and just £29 million left in cash? Moreover, all of the Big Four were involved in Carillion in some way: one was the external auditor; one was the internal auditor; two were tasked with reviews or specialist help; and one became the administrator.

Stephen Haddrill, ex-chief executive of the FRC, said the CMA should investigate the case for ‘audit-only’ firms in an effort to bolster competition and stamp out conflicts of interest in the sector. This radical idea would force the Big Four firms – Deloitte, EY, KPMG and PwC – to spin off their UK audit arms into separate businesses (explored in depth in Disruption in the Audit Market). Mr Haddrill’s intervention follows a string of corporate accounting scandals, ranging from Carillion to Steinhoff in South Africa and Petrobras in Brazil. “There is a loss of confidence in audit and I think that the industry needs to address that urgently”, he said. “In some circles, there is a crisis of confidence.”5

Three of the four now say they will ban non-audit work for their largest audit clients. This is entirely different from splitting the firms into separate audit-only and consulting firms.

Even this brief overview shows that much is left to be desired from current audit practice, despite attempts to improve quality. We posited in Volume 1 that the way that the current audit sector is configured makes it unable to cope with current economic and disruptive conditions. This volume explores in detail how, why and when auditing fails, sometimes to catastrophic effect. Al so see Appendix 2.02.01

Recent financial failures and scandals – an overview

Table 1.1 sets out a selection of the largest recent global scandals. We have concentrated on companies based in the UK, US, Canada and those with a UK connection. Note, some famous UK cases are excluded as they are discussed in detail in later chapters. Table 1.2 summarizes all the current cases being investigated by the FRC (as of May 2018).

Table 1.1 Selection of the largest recent global scandals

Company Country Period Auditor Issue

Lehman

Brothers US 2010 EY See Chapter 4.

MF Global US 2010 PwC Poor trading decisions and fines. Kept bonds off its balance sheet. PwC paid out of court settlement of $3 billion.

Colonial Bank US 2009, 2018 court case

PwC Ghost mortgages. PwC found negligent. Possible claim of $5.5 billion (Now settled for $335m). Connaught UK 2009/10 PwC PwC fined £1.5 million over misconduct in their audit.

Miller Energy

Resources Wells Fargo

Bank Sino-Forest

Corporation Olympus

Corporation US 2011 KPMG Assets overvalued by more than 100 times. Fine of $6 million.

US 2011 to 2018 KPMG Aggressive cross-selling without permission.

CanadaChina 2011 EY Ponzi scheme, falsifying assets.

Japan 2011 EY Tobashi1 using acquisitions.

RSM Tenon UK 2011 PwC PwC fined £5.1 million over misconduct in their audit. See Chapter 4.

Panasonic Avionics US 2012 onwards Possibly KPMG

Panasonic to pay $280+ million for bribery law and accounting fraud violations. Tech Data UK 2012 EY EY fined £1.81 million over misconduct in their audit.

Company Country Period Auditor Issue

Gol US-Brazil2012 Deloitte False audit reports. Deloitte fined $8 million. See Chapter 4.

Autonomy US 2012 onwards Deloitte See Chapter 5.

Penn West

Exploration Canada 2012 to 2014 KPMG Overstated profits.

KPMG US 2013 to 2017 Not relevant

Fine of $9 million for: a) insider trading, b) six revolving door cases and c) improper relationships. Merrill Lynch US 2014 PwC Fined $1 million for failing to collect sufficient evidence for compliance. Quindell UK 2013 KPMG Fined £3.15 million for audit. BHS UK 2014 PwC PwC fined £6.5 million for audit. See Chapter 8. Toshiba Japan 2015 EY Overstated profits. Valeant

Pharmaceuticals Canada 2015 PwC Overstated revenues. Alberta Motor

Association Canada 2016 N/A Fraudulent invoices. Odebrecht Brazil 2016 PwC Government bribes. Petrobas Brazil 2014 to 2017 KPMG after Money laundering and corruption.

PwC Caterpillar US 2017 PwC Tax and accounting fraud accusations (with government). GE US 2017/18 KPMG Accounting fraud. BT Italy 2015 to 2017 PwC Overstated profits. KPMG US 2017 KPMG Received advance notice of PCAOB inspections. Steinhoff Global 2018 Deloitte See Chapter 8. Carillion UK 2018 KPMG See Chapters 6 and 7.

1 A Tobashi scheme is a fraud where a client’s losses are hidden by an investment firm by shifting them between the portfolios of other clients. Any real client with portfolio losses can therefore have their accounts flattered by this process. This cycling cannot continue indefinitely and so the investment firm itself ends up picking up the cost. As it is ultimately expensive, there must be a strong incentive for the investment firm to pursue this activity on behalf of their clients.

Table 1.2 Current FRC cases under accountancy and audit schemes (as of July 2018)

Case Investigation type

KPMG LLP – Carillion plc Audit Enforcement Procedure and Accountancy Scheme 19-Mar-18 29-Jan-18

Announced

Deloitte LLP – Mitie Group plc Audit Enforcement Procedure and Accountancy Scheme 20-Nov-17 31-Jul-17

PricewaterhouseCoopers LLP’s audit of BT Group plc Audit Enforcement Procedure 29-Jun-17

KPMG Audit plc’s audit of

Rolls-Royce Group Audit Enforcement Procedure 04-May-17

Sports Direct International plc Accountancy Scheme and Audit Enforcement Procedure 28-Nov-18

KPMG LLP – Carillion plc Audit Enforcement Procedure and Accountancy Scheme

Mitie Group plc

Preparation and audit of the financial statements of

Redcentric plc Audit Enforcement Procedure and Accountancy Scheme Audit Enforcement Procedure and Accountancy Scheme 19-Mar-18 29-Jan-18 20-Nov-17 31-Jul-17 25-Jul-17 27-Feb-17

Sports Direct International plc Audit Enforcement Procedure and Accountancy Scheme 28-Nov-16 05-Dec-16

Equity Syndicate Management

Limited (Accountancy

Scheme) Accountancy Scheme 10-Aug-17 07-Sep-16 05-Mar-12

Coats Group plc

BHS Limited and the audit by

PricewaterhouseCoopers LLP Serco Group and the audit by

Deloitte LLP Accountancy and Actuarial

Scheme

01-Aug-17 28-Jul-16 Accountancy Scheme 27-Jun-16 11-Jun-18 Accountancy Scheme 08-Jun-16

KPMG Audit plc and Ted Baker plc Globo plc and the audit by

Grant Thornton UK LLP Quindell plc

KPMG Audit plc in connection with BNY Mellon Accountancy Scheme 06-Jun-16

Accountancy Scheme 21-Dec-15

Accountancy Scheme 23-Jan-18 05-Aug-15 Accountancy Scheme 23-Jun-15

AssetCo plc and the audit by Grant Thornton UK LLP

Tesco plc

The Co-operative Bank plc and the audit by KPMG Audit plc Autonomy plc Accountancy Scheme 24-Apr-17 25-Jan-17 12-Aug-14 Accountancy Scheme 05-Jun-17 31-Aug-16 22-Dec-14 Accountancy Scheme 28-Oct-16 20-Jan-14 Accountancy Scheme 31-May-18 11-Feb-13

RSM Tenon and the audit by

PricewaterhouseCoopers LLP

Tanfield Group and the audit by Baker Tilly UK Audit LLP Accountancy Scheme 16-Aug-17 14-Dec-16 13-Aug-12 Accountancy Scheme 11-Jun-14

SIG plc and Deloitte Audit Enforcement Procedure 28-Jun-18 Sanctions against RSM Tenon Accountancy Scheme 21-Jun-18 Conviviality plc and KPMG Audit Enforcement Procedure 03-Jul-18

The team behind this series

Professor Krish Bhaskar6 is the principal author of this book. He has published more than 50 books and many refereed articles. He has also worked in the IT, consulting, investment banking, automotive and forecasting sectors. He has experience of running companies, preparing reports and auditing7 – though mainly computer auditing, as it used to be called.

Krish has been aided and abetted by Professor John Flower, whose major role is as an auditor and researcher into multinational financial reporting. John would probably classify himself as left of centre and leaning towards anti-capitalism and environmentalism. He has published scholarly critiques of the profession, including Global Financial Reporting, with Dr Gabi Ebbers, Palgrave, 2002, and two more radical books, Accounting and Distributive Justice (2010) and The Social Function of Accounts: Reforming Accountancy to Serve Mankind (2017). He has undertaken substantial research on financial reporting and standard setting. He also introduced modern auditing methods for the Common Agricultural Policy8 and undertook a number of innovative techniques in auditing what was and is massive-scale mega audits.9

Rod Sellers, OBE,10 FCA,11 has spent almost 50 years in senior financial and corporate roles in industry. Rod has given his time, written material, and given his views relentlessly, unstintingly and without complaint. But he does not want to be regarded as an author – just a contributor. He is deemed part of the auditing establishment (as he sat on the advisory board of one of the Big Four accounting/auditing/consulting firms) and was financial director and then chief executive of an FTSE 25012 company. For the last 20 years, he has been a portfolio NED/chairman with a dozen companies – from private family businesses to PIE entities. His role has often included serving on audit committees and working closely with the financial departments. He defends the accounting and auditing profession and, although he realizes the impact of disruption, he does not believe that very much has gone wrong or usually requires anything more than evolutionary change. However, in terms of solutions and scenarios to correct problems facing the audit market, he appreciates that something more radical might be appropriate. He also believes that, in most cases, management is honest and trustworthy. His motivation to be involved in this series of books is to make sure his viewpoint and that of the profession is taken into account. Rod came to many of the interviews and collected considerable amounts of written evidence (emails, etc.).

All three of us have extensive and varied experience in the accounting profession. Two of us are broadly pro-Big Four in some shape or form and one of us is against. All three of us have experience both from the

reporting viewpoint and audit experience. One of us has had a lifetime career in industry with preparer experience including audit committees and shareholders. But we all agree that the current disputes between the FRC, the users of reports, the government and the Big Four has to lead to re-evaluated audit experience, not least because of the gap between what the public expects and what the auditors actually currently deliver. This expectations gap is currently widening and unstable, especially after the plethora of failures in 2018. In addition, the rate of increase of financial failures from 2017 onwards seems to be accelerating. Recent improvements to financial reporting and auditing seem not to be working.

However, although we share a common view of what the problem is, we do not all share the same opinion of what has caused the problem, or the best way to address it.

• John Flower, despite his extensive audit experience, is negative towards the role of auditors, financial reporting and current accounting rules. John is disillusioned with the public interest notion of auditing and wants radical change. • Rod Sellers believes that in general the preparers of financial reports do so honestly and fairly. He believes that the available published evidence tends to concentrate on the frauds and scandals, thereby negating much of the good work which is undertaken between a company’s financial team and its auditors out of the public eye. But he recognizes that change is coming and may be necessary. • Krish Bhaskar takes the middle ground and keeps a balanced view.

However, he is aware that in a situation like Tesco, for example, there is high motivation for senior management to manipulate financial reports, however slightly, to their advantage, for financial gain (salary, bonuses and share options, etc.) or face-saving reasons.

There are also many other contributors to this book: managers, board members and practitioners with the Big Four who prefer to remain anonymous but who have provided significant input. In the main they support the profession, but some see issues and problems within it. Some are ardent critics of the growing UK approach to audits via checklists rather than intuition and a profound in-depth knowledge about the entity being audited. Their input amounts to hundreds of hours of partner time, hundreds of pages of input and thousands of emails.

We also draw on the views of a variety of groups, companies and institutions. These views range from support for the current status quo to being critical of it or in some cases highly critical of the status quo and ardently wishing for change. Boards and management of the FTSE and

larger AIM companies feel that they are under much pressure from an ever-changing set of rules and regulations. This demonstrates our key aim: to ensure that this book is relevant, fair and transparent. You know whose view it is you are reading.

Included as our own text are sections written by a variety of interviewees including partners from the Big Four, senior auditors, accountants, analysts, investment bankers, other professional investors, shareholders and senior and lower level managers of the FTSE 350. Many have required anonymity so there are only a handful of attributions given. We have not always identified quotes separately, especially if they came from several sources, even though we may have used the actual words from a single source. Credit should be given to those people who have given much time and effort in providing input to this volume. We do indeed thank them very much. Of course, as these written sources have requested anonymity, we are not at liberty to release their names. However, many of the ideas incorporated here include input and sometimes their actual words. Where we have incorporated ideas into our own thinking, then we adhere to the normal observation to the effect that the views expressed here are our own, notwithstanding the comments of others.

Where possible we have also referenced press reports. Usually these articles are published contemporaneously with the business failure or event. Most importantly, where possible, we always try to provide a balanced view.

Many of the comments we received have been added for balance to reflect the many comments received from reviewers and practitioners, some of which have been involved in the various cases we consider. Often their response is to disagree with our conclusions in the strongest possible terms. However, our conclusions are based on evidence and are often reinforced by others; those references have been given.

Other books and volumes in this series

The volumes which make up the Disruptions in Financial Reporting and Auditing series are:

1 Disruption in the Audit Market: The Future of the Big Four; 2 Financial Failures and Scandals: From Enron to Carillion; 3 Disruption in Financial Reporting; 4 Disruption in Auditing.

References to these companion volumes are made throughout this book.

Websites and online material

There is a complementary companion set of material to this volume online available at www.fin-rep.org. Some material may be updated over time. The glossary is listed first on the website and material is then by book title (Which Book?). There is a short glossary of the most relevant terms at the end of this book. Online, there is also the (full) glossary, which takes longer to look through but has more than 400 terms. As there are so many abbreviations, you may find it useful to keep the glossary open whilst reading this book. On mobile devices, just enlarge by zooming. This companion site can be accessed via www.fin-rep.org.

The reader can access the two glossaries on the home page and will be provided with options as to where to go for which book. Instructions are on the site. This site is available as a free-of-charge companion site to this book. There are details of how to obtain passwords (if implemented). Each book has its own space. Updates and new analyses may be provided. A blog may be added at a later date. Each book in this series has its own space on the site. Access to each book’s area is restricted to purchasers of that book. Multiple access by several users for one book is not permitted unless licensed. The rule is one book = one right to access. This is enforced through software. The Big Four and PIEs can purchase multiple access licenses. Instructions are again on the site. Use by research students using university library copies may be allowed. However, it is expected that the library will purchase multiple copies of each volume.

Many of the references in the text are also available online on www.finrep.org. The references are given as links to a specific URL. Press Control and left click simultaneously on your mouse or equivalent on the link and you will be taken directly to the reference if it still exists. Note that some links and URLs require fees or provide limited access (e.g. The Times and the FT). There is also an adjacent site at www.fin-rep.com, which has additional relevant information, updates and new research results. Feedback from researchers, regulators, the government, the Big Four, other audit firms, professional investors and the preparers of reports will be posted here. Multiple user licenses can be arranged.

Although the title of the book mentions Enron to Carillion. The book and its online appendices deals with later cases such as Conviviality, SIG, Patisserie Valerie and so on.

Notes

1 Marriage, M., 2019, UK accounting watchdog to be replaced by stronger regulator, Financial Times, 11 March 2019. Available at: https://www.ft.com/content/ d6580162-4416-11e9-b168-96a37d002cd3 Accessed March 2019.

2 FTSE 350. The top 350 companies listed on the FTSE, the Financial Times

Stock Exchange 350 index – that is the top 350 companies by market capitalisation. Most of these are classified by as Public Interest Entities which means they have the highest level of reporting and external audit requirements. The FTSE 100 is the top 100 listed companies. The FTSE 250 is the 101st to the 350th top listed company. 3 Beattie, V., Fearnley, S., and Hines, A., 2011, Reaching Key Financial Reporting

Decisions – How Directors and Auditors Interact, John Wiley & Sons. Available at: www.wiley.com/en-us/Reaching+Key+Financial+Reporting+Decisions%3A+How+

Directors+and+Auditors+Interact-p-9780470748749 Accessed July 2018, or available at: www.amazon.co.uk/Reaching-Key-Financial-Reporting-Decisionsebook/dp/B005HF3OBK/ref=sr_1_1?ie=UTF8&qid=1528106773&sr=81&keywords=Key+Financial+Reporting+decisions Accessed July 2018. 4 Institute of Chartered Accountants for England and Wales (ICAEW), considered the most prestigious of the accounting bodies, and the organization that usually entitles an accountant to audit (in England and Wales). There are Scottish and

Irish equivalents. 5 Marriage, M., 2018, ‘Probe Urged into Break-Up of Big Four Accountants: UK

Financial Reporting Council Wants Inquiry into Case for Creating Audit-Only

Firms’, Financial Times, 16 March. Available at: www.ft.com/content/911e8184283d-11e8-b27e-cc62a39d57a0 Accessed July 2018. 6 Brother of philosopher Roy Bhaskar, now deceased and previously leader of the realist movement (the Realist Theory of Science, amongst others). 7 Although he has no formal accounting qualification, he has been an examiner, written books for the ICAEW and CIMA and undertaken and supervised audits for those with ICAEW and ACCA qualifications, and undertaken national and country audits; in addition he has helped one of the Big Five with certain aspects of FTSE 100 audits, and undertaken numerous assurance reviews for investment banks. He also taught auditing and computer auditing as part of continual professional development programmes for qualified ACAs and others, nationally and internationally. He has a close association with US and French universities and runs two boutique consulting companies. 8 From 1981 to 1991. In the early days of the Common Market, agricultural spending absorbed 80% of the budget. It is now a significantly lower share, as the EU has developed other budget lines, but still accounts for 38% of the EU budget of 155 billion euros as of 2016. 9 Ibid. 10 UK Royal Honour: Officer of the Most Excellent Order of the British Empire. 11 Fellow of the ICAEW, rather than just ACA, of which he is a chartered accountant. 12 The Financial Times Stock Exchange 250 Index, also called the FTSE 250 Index.

FTSE 250 is a capitalization-weighted index consisting of the 101st to the 350th largest companies listed on the London Stock Exchange. Rod describes it as a share index of mid-sized companies (after the top 100) listed on the London

Stock Exchange by market capitalization.