The recent financial crashes of, amongst others, British Home Stores, Carillion and House of Fraser have rightly raised public concerns about the actions and responsibilities of company directors, their accountants and auditors.
On the face of it, all three companies appear to have been publishing accounts which did not reflect the financial reality, trading whilst they were insolvent, and been carrying huge pension deficits.
Working backwards, it is absolutely clear that the Pensions Regulator – who is meant to be acting on our behalf to ensure that companies comply with their legal obligations – has been asleep on the job and has simply failed to intervene to protect pensioners and the public purse.
19,000 workers fearing for their retirement incomes following the sale of the store by retail tycoon Sir Philip Green to former bankrupt Dominic Chappell for £1. It was only after intense parliamentary and media scrutiny that Philip Green paid £363 million into the pension fund to fill part of the gap. But not even that will happen in the case of Carillion and House of Fraser.
Further, It is quite extraordinary that, it is only in the last 6 months, for the first time, the Regulator has used its enforcement powers under the 1995 Pensions Act to deal with issues such as pension scams, scheme valuations and automatic enrolment and, in an investigation into pension fraud, secured production orders under the Proceeds of Crime Act 2002.
Incidentally, councils used to be required to keep their pension provision 100% funded at all times. However, when Mrs Thatcher was implementing the poll tax, she was so desperate to keep the level down that she changed the law and then told councils to cut their funding to 75%. So much for financial prudence!
It is quite clear that companies should not be allowed to seriously underfund their pension schemes. Not only does it put the pensioners at risk of seriously reduced pensions and add millions to public expenditure to compensate, but underfunding companies are also enjoying an unfair competitive advantage and disadvantaging companies which do the right thing.
Trading whilst insolvent can be a criminal offence (fraudulent trading) or a civil offence (wrongful trading). Basically, a company is insolvent when it can’t pay its debts, either because it can’t pay its bills when they become due, or it owes more than it has assets on its balance sheet. Company directors may be able to take some actions that allow the company to continue trading.
The law says that It is incumbent on a director to be aware of their company’s financial position at all times; saying “I didn’t realise guv’ is not a defence. Failing to realise that a company is in financial difficulties should be regarded as negligent, irresponsible, or a clear indication of being unfit to be a director.
Hard-working low-waged workers - struggling to keep their heads above water, and who would undoubtedly face disciplinary action, even dismissal, if they didn’t do their jobs properly – are fully entitled to ask why the same standards aren’t being applied to company directors who are often paid exceptionally well and then walk away from company car-crashes without a scratch.
Given the low numbers of investigations in to director failure, let alone action to pursue civil or criminal action for obvious failure, people are entitled to believe that the law is implemented unfairly. In 2017, 1214 directors were banned for periods of up to 5 years, but these were nearly all directors of small companies. To misquote John Maynard Keynes, “If you owe the bank £100 they will pursue you to the end of the world; if you owe the bank £100 million, it will make you a director.”
Finally, very serious questions are now being asked about the performance of auditors in their responsibility to verify that a company’s accounts are true and fair, in accordance with accounting standards. In a survey of chief financial officers in 2012, nearly 50% of them said that “massaging the accounts” (for example, by taking very optimistic views on the value of stock or the ability to get money from debtors) would be justified to help a company survive an economic downturn. It is in that context that auditors ought to be questioning and challenging the information they are given.
Audit has a community governance function. It isn’t just to protect shareholders. It’s also to provide transparency to employees, pensioners, suppliers, customers and the public at large.
Of course, accounting and audit scandals are not new. Older readers will remember Robert Maxwell and Mirror Group Newspapers, Asil Nadir and Polly Peck, and the Bank of Credit and Commercial International (BCCI). The 2001 collapse of Enron, the US energy giant, provided the spectacular example of large-scale accounting fraud. More recently, Bernie Madoff tricked investors out of almost $65 billion, the biggest Ponzi scheme in history.
A decade ago, the global financial collapse demonstrated that the auditors as well as the bank directors hadn’t the faintest idea about the real values (and risks) of many complex financial products, like derivatives.
American Upton Sinclair had written presciently in 1935 “It is difficult to get a man to understand something when his salary depends upon his not understanding it.” And economist JK Galbraith concluded his history of the 1929 Great Crash by warning of the reluctance of men of business to speak up “if it means disturbance of orderly business and convenience in the present”.
Just four major global firms – Deloitte,
PricewaterhouseCoopers (PwC), Ernst & Young (EY) and KPMG – audit 97% of US public companies and all the UK’s top 100 corporations. They don’t have any real competition for the audit of global corporations or the largest national companies. Just eight of the FTSE 350 companies are not audited by the Big Four. It’s an effective cartel in a guaranteed market – companies are legally required to be audited. In what is now taken for shareholder protection and a proxy for competition, the big four companies now exchange clients every 10 years.
Despite the cartel and the lack of effective fee-competition, the auditors know that their most profitable income comes from advice and consultancy services. If ever there was an opportunity to persuade auditors to be generous, if not compliant, in their assessments of the business’s financial status, this is it.
And, despite the high fees, the quality isn’t as high as it should be. Currently, none of the Big Four audit firms meet the 2018/19 target of no more than 10% of FTSE 350 audits requiring improvements.
Finally, some companies are playing fast and loose with accounting standards. Simply changing the way in which work in progress is valued (say, on long contracts) can make dramatic differences to the accounts and to the perception of the company’s health. For example, in its 2016 accounts, Capita stated that it had equity of £483 million at the year-end; but, in its 2017 accounts, Capita stated that, on the same date of 31st December 2016, it had negative equity of £553 million. A £1+ biliion difference, just by changing the way revenue was booked.
Similarly, Carillion directors failed to review and reflect the real value of ‘goodwill’ in its accounts. It kept the same value of goodwill in the accounts for five years, despite the evidence being that it was virtually worthless. And then the auditors simply failed to properly challenge the directors’ value.
So, what is to be done?
- a Pensions Regulator who takes the job seriously and is intervening early to ensure appropriate amounts of contributions are being paid in to funds and deficits are not being allowed to build up, who is using all the existing powers to take action on pension scams, scheme valuations and automatic enrolment and get money back from fraudsters;
- fearless investigations into the performance of company directors, not just where they have been clearly acting against the law, but also where they have failed to do their job by being negligent or irresponsible for failing to understand the company’s real financial position and taking the appropriate action;
- bigger fines and stronger sanctions on audit firms and partners who are failing to challenge the accounts in accordance with the expected standards and are not clarifying or qualifying the accounts where there are significant issues relating to pension fund deficits, and the valuation of goodwill, work-in-progress and assets; and
- action to increase the number of practices and firms which have the capacity to audit big global and national companies. As part of this strategy, there is a very strong case that accountancy firms should simply be banned from providing any non-audit services to their audit client.