Financial crises are as old as the financial industry itself, but the number of high-profile corporate collapses in 2018, allied with a trio of major reviews into the audit industry, are placing the issue of accounting scandals firmly in the spotlight. The downfall of high street names including Ted Baker and Patisserie Valerie and the ongoing fallout from the BHS implosion are all highlighting issues that are now under intense scrutiny in the form of the Kingman Report, the Competition and Market Authority’s study and the forthcoming Donald Brydon review. All are designed to bring greater clarity to the industry, define more clearly what is expected of auditors and how to avoid a potential clash of interests as well as trying to prevent further accounting fraud, amongst much else.
The first of these two both released their findings on the industry in December last year. Legal & General chairman Sir John Kingman’s review of the Financial Reporting Council (FRC), the independent regulator of auditors, accountants and actuaries, had harsh words to say about its subject, calling for it to be scrapped altogether and replaced by the Audit, Reporting and Governance Authority (ARGA). The Government has accepted these proposals. “Having spent most of its life in obscurity,” he said, “the FRC now finds itself subject to tough and persistent criticism [placing it under] unprecedented spotlight.”
It had taken an “excessively consensual” approach to its regulatory work and needed to be rebuilt from the ground up, he said, not least because it had serious problems about how it recruited top staff. Funding needs to change: currently the FRC is partially reliant on a voluntary levy from audit firms, potentially rendering it unwilling to “bite the hand that feeds it”; ARGA should have statutory recognition and funding. Further recommendations were for a “duty of alert” for auditors to report “viability of other serious concerns”, and for the watchdog to have increased powers such as making recommendations to shareholders to cut dividends or fire senior staff where they felt it was merited.
Rising concerns
In the wake of rising concerns, the Department of Business, Energy and Industrial Strategy (BEIS) has also launched its own review into the sector, while its Select Committee is now looking into the implementation of the CMA reports. The latter outlines serious concerns about competition and suggests changes to legislation to improve the sector.
Major issues include the fact that companies choose their own auditors, which means they go for those with a “cultural fit” or with whom they had “chemistry” rather than choosing a firm that was going to offer the toughest scrutiny. Another problem was limited choice, with the Big Four firms conducting 97 per cent of the audits. There were worries that the focus of quality could be compromised by the fact that 75 per cent of the Big Four’s revenue came from other services including consulting.
The ‘expectation gap’
The proposed measures were as drastic as Kingman’s. The CMA recommended legislation to separate audit from consulting services, with the two split into separate operating entities with separate management, accounts and remuneration.
It also recommended the introduction of measures to substantially increase the accountability of those chairing audit committees in firms and the imposition of a “joint audit” regime, which would involve firms outside the Big Four having a role in auditing the UK’s biggest companies. It proposed that audits of the FTSE 350 should be carried out by at least two firms, one outside the Big Four, allowing mid-tier firms to develop expertise while ensuring a cross check on quality. This was followed up in February this year when the Independent Review into the Quality and Effectiveness of the UK Audit Market led by Sir Donald Brydon announced its advisory board and terms of reference: expected to be complete by the end of this year, it will examine the “audit expectations gap,” the difference between what users expect an audit to deliver and what it actually entails. This was prompted in part by some of the high-profile cases below.
Carillion
What happened
Construction giant Carillion collapsed under the weight of a £1.5 billion debt. Created in July 1999 following a demerger from Tarmac, it grew to become the UK’s second largest construction company, employing around 40,000 in the UK and abroad and with a vast number of government contracts from building hospitals to managing nearly 900 schools. Concerns about its mounting debt first emerged in March 2015 and in July 2017 it fell out of the FTSE 250 after a negative trading statement. That year it issued three profit warnings in five months and wrote down more than £1 billion in value of contracts. In early 2018 it was announced that the UK Financial Conduct Authority was to investigate its announcements from December 2016 regarding its finances; after days of high-level governmental talks and attempts to find a rescuer, the company was placed in liquidation, with a £900 million debt pile and £600 million pension deficit.
When it happened
On January 15 2018.
What it means for the industry
In May 2018 a parliamentary committee said its collapse was due to “recklessness, hubris and greed.” Accountants KPMG, which earned £1.5 million a year from the Carillion account, came in for very heavy criticism, accused of rubberstamping figures that “misrepresented the reality of the business” as well as incurring a conflict of interest due to its work advising the pension scheme. In the wake of the fiasco there were calls to break up the Big Four and make auditors accountable to Parliament.
Patisserie Valerie
What happened
Founded in 1926, the café chain Patisserie Valerie was acquired in 2006 by Luke Johnson’s Risk Capital Partners. Rapid expansion followed, with the chain growing from eight shops in the year of acquisition to 192 by May 2017. In 2018 trading in the shares of Patisserie Holdings, the parent company, was suspended following the discovery of potentially fraudulent accounting irregularities. The next day the company announced that there was a material shortfall between the reported financial status and the current financial status of the business, after which a man was arrested on suspicion of fraud by false representation. In January this year the company announced it had collapsed into administration following failed rescue talks with banks. In February administrators KPMG agreed a management buyout funded by Causeway Capital Partners.
When it happened
On October 10 2018
What it means for the industry
Auditor Grant Thornton came in for severe criticism for signing off the last full year accounts in November 2017 with net cash reported to be £21.5 million. Chief executive David Dunckley was called in front of a commons select committee where he asserted it was not the auditors’ role to look for fraud; MPs disagreed and the episode looks certain to strengthen the case for the CMA proposals.
Ted Baker
What happened
Ray Kelvin opened his first Ted Baker in Glasgow in March 1988 and the company expanded to become a FTSE 250-listed luxury clothing range with 490 stores and concessions worldwide. In August 2018 KPMG was fined £2.1 million by the Financial Reporting Council following an admission of misconduct on the company’s financial statements in 2013 and 2014, while KPMG partner Michael Francis Barradell was personally reprimanded by the regulator and fined an additional £46,800. The misconduct arose from KPMG providing expert witness services to Ted Baker in a London lawsuit, according to the FRC.
When it happened
On August 20 2018
What it means for the industry
As well as heralding an annus horribilis for KPMG, which was singled out for the “unacceptable” decline in the quality of its auditing, it also served to illustrate CMA concerns about the Big Four dominating the market, strengthening the case for a second, smaller firm to be brought in for FTSE 350 members, as well as illustrating the potential clash of interest between separate departments of the same firm.
BHS
What happened
BHS, the department store chain founded in 1928, was bought by Sir Philip Green in 2000 and became part of his Arcadia Group. In March 2015 it was sold for a nominal £1 to Retail Acquisitions Ltd led by the serial bankrupt Dominic Chappell; just 13 months later it entered administration, putting 11,000 jobs at risk. Duff & Phelps were appointed administrators of the business, which had £1.3 billion in debts including £571 million pension liabilities. Qatari Al Mana Group purchased the company’s international franchise stores and online presence which closed in June 2018; the insolvent part of the company went into liquidation on December 2 2016.
When it happened
The chain entered administration on April 25 2016 but the repercussions are ongoing.
What it means for the industry
PwC, which gave the business a clean bill of health for the year up to 30th August 2014, came in for a severe reprimand and record £6.5 million fine from the FRC in June 2018, reduced from £10 million after it agreed to cooperate. Steve Denison, the PwC accountant who audited the accounts, was fined £325,000, down from £500,000 after agreeing to cooperate and given a 15-year ban. The episode is certain to strengthen the case for breaking up the Big Four’s dominance and increasing the accountability of those chairing audit committees.
Gupta scandal
What happened
Brothers Ajay, Atul and Rajesh (aka Tony) Gupta moved to South Africa from Uttar Pradesh in 1993 and set up Sahara Computers, with the group expanding to mining, air travel, energy, technology and media. The family became extremely close to Jacob Zuma, leading to accusations of “state capture” and widespread corruption, but the empire began to crumble in 2018, with one Gupta business after another filing for administration. On 14th February 2018 Jacob Zuma resigned and on the same day the Gupta brothers disappeared, believed to have fled the country to Dubai. On 16th February 2018, Ajay Gupta was declared a fugitive from justice by the South African authorities after failing to hand himself over.
When it happened
The collapse happened in February 2018, although controversies date as far back as 2013 when a Gupta family plane bearing guests for a Sun City wedding landed at Waterkloof Air Base near Pretoria, a military base usually used by visiting heads of state.
What it means for the industry
KPMG (again) came in for very heavy criticism over work done for the Guptas, with whom it had worked for 15 years until stepping down in 2016, and was forced to issue a public apology as well as withdrawing findings in a report used as evidence in a police probe. Ex-KPMG auditor Jacques Wessels was a guest (among other KPMG people) at the 2013 wedding; he was subsequently charged with inappropriate conduct and tax evasion. A raft of other departures followed. This scandal highlighted the issue of relationships between company and auditor potentially being too close.
GE (US)
What happened
Founded in 1892 through a merger with one of the companies formed to support Thomas Edison’s lighting experiments, General Electric is an American colossus. However, at the beginning of 2018 it was announced that the Securities and Exchange Commission (SEC) was investigating its “aggressive accounting” practices, a probe that widened throughout the course of the year when in October 2018 its $22 billion non-cash charge related to acquisitions came under scrutiny, with the Department of Justice also launching an investigation. In June it was removed from the Dow Jones Industrial Average, the only member left of the original 1896 index and in John L Flannery stepped down as Chairman and CEO. GE’s market value fell by more than $200 billion over two years.
When it happened
January 2018 onwards
What it means for the industry
It was another unwelcome return to the limelight for KPMG, GE’s auditor for over a century. The relationship between the two companies was described as “too cozy” – emblematic of the concerns highlighted in the CMA report about choosing accountants with whom a company has “chemistry”. It will surely strengthen calls for auditors outside the Big Four to play a greater role..