The shake-up of the UK’s audit market, proposed via a draft bill in May, has been a long time coming.
It is the result of three separate reviews conducted into audit and corporate governance that followed a series of accounting scandals – the repercussions from which are still emerging to this day. Carillion's auditor, KPMG, was fined a record £14.4mn last month, with former partners banned from the accounting profession for periods between 7-10 years after the Financial Reporting Council (FRC) said they had attempted to mislead its investigators by falsifying meeting minutes.
The rot went deeper than just note-taking. Carillion paid more than £625mn in dividends between 2007-16, according to company filings, before collapsing in early 2018 with £6.9bn of debts.
The draft law includes measures aimed at preventing this. Companies deemed to be public interest entities (PIEs) – those with a turnover of at least £750mn, or 750 employees – will need to disclose the amount of distributable reserves they have. Directors will also have to declare that the payment of a dividend won’t threaten the solvency of a business.
Arga saga
The most significant part of the changes – due to be passed into law in early 2023, current government upheaval notwithstanding – is the establishment of a new regulator, the Audit, Reporting and Governance Authority (Arga).
Arga will replace the FRC, whose remit has been deemed to be too limited. It only has the power to sanction members of the accounting profession and currently receives its funding from that industry. Arga will be funded by a statutory levy on market participants.
Whereas the FRC only has a mandate “to look at the back end” of a company’s annual report – the audited financial statements – Arga will be able to scrutinise the entire annual report, noted Miranda Craig, the FRC’s director of strategy and change, on a recent webinar.
Auditors themselves are still the subject of industry worries, however. In response to concerns expressed by the Competition and Markets Authority about the fragility of the audit market, with the ‘Big Four’ – Deloitte, EY, KPMG and PwC – dominating, the bill includes a provision for FTSE 350 firms to conduct at least part of their audit with a so-called ‘challenger’ firm to boost market resilience.
Inexperienced auditors can bring problems of their own, should they prove too inexperienced – and while the Institute of Directors is “broadly” supportive of the reforms overall, its policy and corporate governance head Dr Roger Barker has concerns about the shared audits plan, querying whether challenger firms will play a “meaningful role” in the audit process. If they don’t, the fear is that it could end up merely duplicating costs.
Lord Sikka, a Labour peer and an emeritus professor of accounting at the University of Essex, says the proposals fail to address concerns about audit quality and transparency.
Too often, auditors delegate most of the work to junior staff and are more concerned with selling higher-value consultancy services to clients, he argues.
“You don’t hire and remunerate your own income tax or VAT inspector. We don’t permit that anywhere else. It is just in financial audits," Sikka says.
He adds that if shareholders are paying for an audit, they should be able to see the files and be given more information on who carried out the work, how long it took and what questions were asked. As he puts it: “Why on earth are audit files so secret?”
Making up the numbers
Michael Izza, chief executive of the Institute of Chartered Accountants in England and Wales, cautions not to expect too much from the new rules.
“Companies don’t fail because of auditors, they fail because of managers and directors,” he says.
One thing removed from initial proposals is a strengthening of reporting requirements about a company’s internal controls – billed as a UK version of the Sarbanes-Oxley Act, introduced in the US in 2002 following the Enron and Worldcom scandals. Rather than take full responsibility for internal controls, and detail the actions they and auditors have taken to ensure fraudulent activity isn't occurring, company directors must instead provide a statement as to the effectiveness of those controls. The government described the change as a “more incremental approach”.
Carson Block, the founder of US-based short seller Muddy Waters Research, says investors’ expectations of auditors can be unrealistic.
“The role of auditors is not to look for fraud,” he says. “There’s a massive disconnect between what 99 per cent of investors think auditors do and what they actually do” – which is to merely make sure the right accounting standard is being applied, and correctly.
Sometimes, though, they fail to do even that. And as the US shows, even the likes of Sarbannes-Oxley have not fully eliminated accounting scandals. Investors must ensure they have the right tools to spot such issues themselves.
Speaking at the IC’s recent Future of Private Investing event, Stephen Clapham, who runs financial training company Behind the Balance Sheet, noted that companies can go to “amazing lengths” to hide nefarious practices. For investors, though, the saving grace is they often fail to cover their tracks. “If you commit a fraud, you always leave a trail,” he said.
For investors, outright fraud isn’t the only concern. Sometimes, even the biggest blue-chip companies have taken an aggressive approach to accounting to meet short-term targets, which later led to profit warnings triggering share price plunges. At other times, they have ignored good governance rules.
So, what should investors be looking out for? We present 10 of the most common red flags.
1. Become a keyboard warrior
Sometimes it's important to go not just behind the balance sheet, but beyond it. Professional investors and analysts who have doubts about whether a company is telling the truth can spend big sums investigating their hunches.
When The Analyst, a London-based equity research firm, was probing collapsed German fintech Wirecard, it sent investigators to Mumbai to check whether acquisitions made by the company were worth what it claimed it had paid (they weren’t).
Although private investors may not have the time or money to go to such lengths, there are things they can do from the comfort of their own home, says Mark Hiley, founder and managing partner of independent researcher The Analyst.
“It is about sense checking – does the product exist, can you find the factory on Google Maps...does it have its headquarters [where it says it does]?”. Even professional short-sellers make full use of the opportunities presented by the internet: employing 'Boolean' search terms to produce more accurate search engine results, identifying and verifying external sources of company information, and checking and cross-referencing company and employee information on sites such as LinkedIn.
2. Revenue recognition
But financial statements remain at the heart of an investor's work. The revenue recognition section, which explains how and when a company decides when to book sales, is typically a lengthy and technical affair but one that must be got to grips with. Revenue recognition has been a particular problem for construction and support services companies, with managers making overly optimistic assumptions about the income they were generating on certain projects before receiving the cash. A parliamentary report into Carillion’s collapse, for instance, found it recognised revenue that was “traded not certified”.
“This was revenue that clients had not yet signed off, such as for claims and variations, and therefore it was inherently uncertain whether payment would be received,” the report said.
In the case of both Carillion and Interserve (which was taken over by its lenders in 2019), balance sheets deteriorated because costs continued to mount at projects on which revenues had already been banked.
'Round-tripping' – the practice of sending money to a different part or region of the business, where it is then booked as external revenue – is another common revenue recognition fraud. The FT raised questions about round-tripping at Wirecard ahead of its collapse in 2020. But identifying this particular issue can be tricky. Fortunately, there are more basic sense checks to be made on a company's accounts.
3. Too much profit?
If a company’s margins are consistently much bigger than peers, it’s worth asking why.
Muddy Waters Research’s initial report on NMC Health, which sparked a series of revelations that eventually led to the then FTSE 100 company calling in administrators, highlighted the fact that the its cash profit margin was over 20 per cent, while peers in the same market struggled to generate margins in the low teens.
“Your competition is not run by high school kids,” Block says. “What makes you so magical? If you can’t soberly answer that question satisfactorily, then yes, it’s a red flag.”
It was a similar story at Patisserie Valerie, the cake and coffee chain that collapsed in 2019: its margins were far higher than comparable peers.
4. Earnings vs cash
Ultimately, the most important part of a company's accounts is not the profit/loss statement, but the cash flow. Investors value cash generation more highly than profits because it is less easy, albeit not impossible, to fake.
In its last four full accounting periods, Carillion booked a combined operating profit of over £620mn at the same time as its cash pile dwindled by over £200mn.
“You can’t hide from the cash flow,” Hiley says. “You can tell the market for a few years that cash flow is not very good because we’ve got a long contract and the government is going to pay us in three years’ time and we’re doing all of this capex, but eventually gravity has to take hold.”
As that comment implies, capital expenditure should also be watched carefully. Capex can be a good reason why the likes of operating cash conversion (see box below) looks poor in the short term. In the worst cases, high levels of capex can be a sign that a company is artificially inflating expenditures to mask the lack of cash being produced elsewhere.
Merger activity has also been used as a tool to disguise fake profits. Wirecard claimed it was paying up to €330mn for businesses in India that were worth nothing like that.
Fake profits create the problem of generating fake cash and one way around that is “by doing deals with friendlies”, Block said.
“You really pay like $3mn for something, but you and the seller sign the paperwork making it look like you paid $50mn. And so now, you just burned off $47 million of fake cash.”
But a constant barrage of merger and acquisition activity is not necessarily a cause for concern on its own – companies like safety equipment specialist Halma (HLMA) have developed proven business models by successfully bolting on a series of acquisitions.
5. Non-exceptional exceptionals
The use of adjustments to permitted accounting measures is now so ubiquitous that it barely raises an eyebrow. Whole sections of financial statements are dedicated to explaining how the adjustments managers like to make to the numbers they prefer to present tally with actual profits.
The biggest difference between the two is often an adjustment for 'exceptional' items – often costs relating to restructuring or any provisions made. Again, investors should tread carefully if these numbers appear too high or start cropping up too frequently.
The Analyst screens companies to identify those for whom non-recurring costs somehow keep recurring. Companies that claim to make a 10 per cent earnings margin but spend 30 per cent of this each year on restructuring costs, for instance. “If you do that for 10 years, you’re probably a 7 per cent margin business,” Hiley says.
6. A lack of goodwill
Goodwill is an intangible asset created when an acquirer pays more for a business than its net tangible assets – its buildings, its equipment and other physical assets – are worth. In an age where many more companies are capital-light, it isn’t unusual for most of an acquisition’s value to be made up of goodwill and for it to become the biggest single asset on an acquirer’s balance sheet. Goodwill isn’t amortised but should be tested regularly and reduced if its value on the balance sheet slips below its 'recoverable' value – that which could be generated through its use or sale.
The trouble is, such writedowns tend to be infrequent and lumpy. Thomas Cook's huge 2019 goodwill impairment of £1.1bn was its first since 2011 – which as it happens was the previous time the company had faced collapse. Difficult markets mean writedowns are likely to become more frequent, even for companies whose financial health is otherwise sound. In April, shares in one of the US’s biggest telehealth prospects, Teladoc Health (US:TDOC), dropped by 40 per cent in a single day when it announced a goodwill impairment of some $6.6bn.
7. Counting the cost (as an asset)
One way many companies have looked to hide costs has been by capitalising them and adding them as an asset to the balance sheet. Although accounting standards allow for research and development costs to be capitalised, they have to meet certain criteria to qualify and should then be amortised over the lifespan of the project on which they were incurred. In his book on accounting red flags, The Signs Were There, former fund manager Tim Steer said that up until 2017 NCC Group (NCC) “continually” capitalised development costs and that sometimes the amounts involved were large when compared to expected profits. Between 2012-16, the amount of software and development costs capitalised grew by 42 per cent a year at a time when the company’s sales growth was 24 per cent. The effect of this was that “historic profits were overstated” and once the company was forced to write some of its capitalised costs down, profit warnings followed. NCC has since recovered and is now an active IC buy idea.
8. When inventories go stale
In a similar vein to outsized capex, a company holding much higher levels of inventory than its peers is another warning sign.
Before it was placed into administration in 2018, Patisserie Holdings had very high inventory levels, which could be deducted from costs to boost profits. In the last set of results before the plug was pulled on the company, for the six months ending in March 2018, it was carrying £6mn of inventory but its total cost of sales was £13.5mn, meaning the average age of its inventory was 81 days (inventory/cost of sales x 182 days in the half year) – which seemed a little off for a business making its money from selling cakes and pastries.
“In view of the importance of the value of stock in determining profits, investors need to determine how many days of sales are in stock,” Steer said. “Too many days means there is an obsolescence issue at best and perhaps worse as was the case at Patisserie Holdings.”
Monitoring 'days' in this way also has applicability elsewhere: debtor days (indicating how quickly a company is being paid for the goods or services it says it has sold) and creditor days (how quickly a company is paying its own debts) are also useful indicators. Changing patterns, as seen in debtors, creditors or inventories as a proportion of sales, are worth giving due consideration (see chart below).
9. Take some interest
After looking at NMC Health’s balance sheet, Muddy Waters alleged that the company was inflating its cash balances and under-reporting its debt. One warning sign for the short seller was the amount of interest the company was receiving on its cash balance (net interest income), and paying on its debt.
NMC was earning less than 0.5 per cent on its cash balances, much lower than peers. Similarly, the amount of interest being paid (and its constant refinancings) suggested its debt levels were higher than it was declaring. Further investigation found other sources of borrowing, which the company had failed to disclose.
“If we can see something like that from the outside, then … there’s the strong probability that what’s going on is much worse in magnitude," Block says. By the time NMC was placed into administration in April 2021, around $4bn of previously undisclosed debt had been discovered.
10. Related-party transactions
This often appears as the last item in an annual report, but it can be the most important. If a company is declaring lots of deals between itself and its directors, such as buying and selling assets from them, it doesn’t always mean there’s something fishy going on, but it’s not a sign of good governance. Less significant, but also worth paying attention to as a sign of a company's overall approach to governance, are issues such as a single executive heading both the board and the management team. If the same person fills the chair and chief executive roles, that suggests there may be a wider problem with independent thinking at the board level.
“Investing should be pretty simple,” Clapham concluded at the IC event in June. “If something doesn't make sense, and it doesn't ring true, avoid it. There's lots of stocks to buy, don't get involved with something that doesn't seem quite right.”
