October 2009

Audit firms in the UK left unprotected against claims of negligence

Published on: 21 Oct 2009

It was announced recently in the UK media that Britain’s Big 4 auditing firms have been left exposed to a surge in negligence claims, after the Government refused to limit further the damages they could face.

The Big 4 have been lobbying hard for a cap on payouts, but although Lord Mandelson, the Business Secretary, appeared sympathetic to their concerns, he indicated that he was not prepared to change the law at this stage.

This decision has come as a great blow to the accounting firms, believing that there may not be another opportunity for a change in the law for some time. There fear is that they will be targeted by investors and liquidators looking to recover losses from big company failures and Madoff-type frauds.

Under existing company law, directors can agree, with shareholder approval, to restrict their auditors liability, but to date, no leading companies have done so.

Three of the Big 4 face litigation in relation to Bernard Madoff’s $65 billion fraud.

In 2005 Ernst & Young was sued for £700 million by Equitable Life, the claim was eventually dropped, but would have bankrupted the firm in the UK if successful.

Earlier this year KPMG were sued for $1 billion by creditors of New Century, a failed sub-prime lender.

Big 5 became Big 4 of course following the collapse of Arthur Andersen in the wake of the Enron scandal.

Some fear that Big 4 dominance of the audit market is such that British business would be subject to a state of disarray if a massive court action were to reduce Big 4 to Big 3! It was announced in the UK media that Britain’s Big 4 auditing firms have been left exposed to a surge in negligence claims, after the Government refused to limit further the damages they could face.

Auditors cleared in landmark negligence case

Published on: 18 Oct 2009

This was one of the headlines that recently caught my eye, remembering that auditor’s liability is one of the few ‘new topics’ in ACCA P7.

In August 2009, the UK Law Lords on a split decision (3:2) upheld an earlier ruling by the Court of Appeal in a multi-million pound action brought by the liquidator of Stone & Rolls (a commodity trader) against their auditors Moore Stephens.

The Law Lords ruled that the auditors were not liable for failing to detect a £58 million fraud perpetrated over a number of years.

The fraud involved the CEO of Stone & Rolls, a Croatian businessman called Zvonko Stojevic, using the firm as a means of defrauding banks by means of a letter of credit scam.

The split decision perhaps provides less clarity than the auditing profession might have wished for in relation to the court’s view on an auditor’s liability for the detection of fraud.

The senior Law Lord, Lord Phillips, said “It does not seem just that in these circumstances, Stone & Rolls should be able to bring about a claim that it had set about inducing.”

Lord Manse, dissenting said “the world has sufficient experience of Ponzi schemes ….. for it to be questionable policy to relieve from all responsibility auditors negligently failing in their duty to report on such companies’ activities.”

We could be seeing a whole number of new claims against auditing firms worldwide as companies go into liquidation in the current economic crisis.

What’s your view on this case? Who knows the examiner might ask you!

Are accountants to blame for the global crisis?

Published on: 14 Oct 2009

A few accounting standards arguably have an unfortunate tendency to exaggerate the economic cycle.  During a time of economic downturn, the chances of a company having impaired assets is increased.  This has the unfortunate effect of taking poor trading results and augmenting them with impairment losses.  In other words, accounting conventions take a bad situation and make it worse.

Or so some people would say.

Some financial instruments are also shown at fair value.  Fair value is primarily decided by reference to market values. During a slump, this also makes reported results worse.

The argument advanced by many is that we ought to amend accounting standards to introduce some sort of dampening effect – requiring companies to impair assets or make provisions during times of boom and release these provisions during a slump.  This, it is argued, is only the equivalent of making hay while the sun shines.

There’s only one problem with this idea of “dynamic provisioning”. Mostly, it flies in the face of the definition of a liability in the Framework. Also, it’s precisely the opposite of what IAS 37 and IFRS 4 (insurance contracts) aimed to do. Fiddling with the accounts to save people from unjustifiable optimism and excessive, groundless pessimism might be politically popular in the current  market turbulence, but arguably it would only reduce the reliability of financial reporting in the long term.  Investors ought to be smart enough to use other information provided to them, such as the statement of cash flows, before reaching judgement on the desirability of a company’s shares.

We hope that the IASB stick to their guns and resist the pressure to codify creative accounting and massaging figures by bogus provisions. We’re confident that they will.

How could Bernie Madoff make off with so much cash?

Published on: 11 Oct 2009

Bernie Madoff is in prison and he handsomely deserves to be.  Over years, he ran a private investment fund that took deposits from rich investors and delivered consistently great returns of 10% real terms each year or more.

The only problem is that the whole thing was a vast fraud. He was stealing funds and using new depositors’ funds to hide the hole his pilfering was creating.  It’s called a ponzi scheme and is strictly illegal.   Total investor losses are estimated to be in the region of £18 billion.

Can you even imagine such a figure?

The question is – how did he get away with it?  There’s no single answer, but these features are significant:

• There was a very excessive degree of authority and power vested in one man (Bernard Madoff himself).

• There was a lack of scrutiny by directors and senior management and investors themselves.

• A whistleblower had contacted the regulator ten years before the scandal broke saying that the returns made were mathematically impossible. The regulator did nothing.

• The auditor was too close to the client and generally showed a deep lack of professional scepticism.

So, Madoff was a colossal failure of corporate governance.  Almost every significant principle of the Combined Code was broken. Yet this happened in the USA – home to the stringent Sarbanes-Oxley Act. How could this happen? Well, SOx only applies to listed companies and Madoff was a private equity investment, so outside its scope. There appeared to be no appetite for voluntary compliance with best practice.

Perhaps the biggest lesson is that when investors are being given apparently huge returns, they become unwilling to ask questions.  Indeed, investors who asked too many questions were dropped by Madoff as being a nuisance.  Maybe the victims of the Madoff scandal became victims of their own credulousness and greed?

When is a non-executive not a non-executive? Ask Stelios!

Published on: 07 Oct 2009

You may have heard of easyJet. You may have flown with easyJet. You may be Stelios, in which case the public thinks that you own easyJet, but you actually only own a minority interest. The public also thinks that you’re the CEO, but actually you’re not even an executive director.

What you do own, if you happen to be Sir Stelios Haji-Ioannou is approximately 66 million easyJet shares and the easyJet brand, which you licence to easyJet.

Sir Stelios is the public face of a company that he founded and grew to a state of financial health where it could buy its most bitter rival, list on the London Stock Exchange and generally grow up rather quickly.  He resigned as an executive director in 2003, becoming a non-executive.

In 2008/09, he had a major difference of opinion with the executive directors over the strategy of the company.  Having been outvoted, Sir Stelios (a non-executive director, remember) sought to increase his equity ownership of the company again to a level where he could appoint some favoured nominees of his own as executive directors; thus giving him (a non-executive director) effective control once again.

Sir Stelios was naturally acting in the best interests of the company as he saw them. The Tyson report lists four duties of a non-executive director (see our ExPress notes if these don’t trip off your tongue! /expand/14-p1_professional_accountant.html) These include scrutinising executives, but not sacking them if they disagree.

It all makes it easier to see why the UK Combined Code requires that non-executives should be paid a basic salary only and have no shares or share options in the company, as well as requiring you to wait at least five years outside the company if you’d previously been a senior executive there!

Marks vs revenue

Published on: 04 Oct 2009

We know the allocation of marks in the exam between the various taxes but what about the revenue generated?

ACCA F6 students will be well aware that the vast majority of marks available in the exam are in connection with income tax and corporation tax. Other taxes such as CGT and VAT also play an important part but not to the extent that income tax and corporation tax do.

Whilst these two taxes represent the bulk of the marks in the exam, how does it compare with the split of revenue generated by the various taxes?

HMRC have published their statistics for 2008/09 which provide the following information:

Total £439bn 100%
Income tax £148bn 33%
National insurance £97bn 22%
VAT £78bn 18%
Corporation tax £43bn 10%
CGT £8bn 2%

Over 50% of revenue is generated from income tax and national insurance alone. CGT on the other hand only generates 2% of the revenue.

I’m sure however that the key % in students minds at the moment is the 50% they need in the exams next month so good luck with your studies in the next couple of weeks!

The ExP Group