A Level Economics 30: Profit

Difference between Normal and Abnormal Profits:

Normal Profits: Normal profits, also known as zero economic profits, refer to the minimum level of profits necessary to keep a business operating in the long run.
Normal profits are the amount of profit that covers all costs, including both explicit costs (such as wages, rent, and materials) and implicit costs (opportunity costs of using the resources).
When a firm earns normal profits, it means it is earning a return that is just sufficient to keep the owners or shareholders satisfied and willing to continue investing in the business.
In this case, the firm is neither making above-average profits nor incurring losses. It is essentially covering all costs and earning a reasonable return on investment.

Abnormal Profits: Abnormal profits, also known as economic profits or supernormal profits, occur when a firm earns more than the normal level of profits.
Abnormal profits represent a situation where a business is earning revenue that exceeds both explicit and implicit costs.
In other words, abnormal profits are above and beyond what is required to cover all costs and provide a normal return on investment.
Abnormal profits indicate that the firm has a competitive advantage, such as unique products, innovative processes, or significant market power, allowing it to generate higher revenues and outperform its competitors.

Example: Let's consider a hypothetical bakery. In a competitive market, several bakeries are operating, and each bakery is earning normal profits. They are covering their explicit costs (wages, ingredients, rent) and implicit costs (such as the opportunity cost of the owner's time and capital invested) while earning a reasonable return.

However, one particular bakery introduces a new and highly popular line of pastries that quickly becomes a favorite among customers. Due to the high demand for these pastries, this bakery starts generating significantly higher revenue compared to its competitors. As a result, it earns abnormal profits.

The bakery's abnormal profits indicate that it is earning more than the minimum necessary to cover all costs and provide a normal return. This exceptional performance could be attributed to its unique product offering or its ability to capture a significant market share. The abnormal profits act as an incentive for the bakery to continue investing in its business and potentially expand operations.Difference between Accounting Profit and Economic Profit:

Accounting Profit: Accounting profit refers to the profit calculated using traditional accounting methods. It is the revenue generated minus explicit costs, such as wages, rent, materials, and other operating expenses.
Accounting profit does not consider implicit costs, which are the opportunity costs associated with using the resources, including the owner's time and capital invested.
Accounting profit provides a financial measure of a firm's performance according to the accepted accounting principles and is primarily used for financial reporting and tax purposes.

Economic Profit: Economic profit is a broader measure of profit that considers both explicit and implicit costs, providing a more comprehensive view of a firm's profitability.
Economic profit subtracts both explicit and implicit costs from total revenue to calculate the true economic benefit or return on investment.
Implicit costs include the opportunity costs of resources, such as the foregone earnings from alternative uses of capital or the owner's time.
Economic profit represents the net benefit of using resources in a particular business venture compared to their next best alternative use.

Example: Let's say an entrepreneur starts a business and calculates an accounting profit of $100,000 per year. This profit is derived by subtracting explicit costs, such as $300,000 in operating expenses (wages, rent, materials), from total revenue of $400,000.

However, when considering economic profit, the entrepreneur realizes that the implicit costs of the business are significant. They estimate that if they were not running their own business, they could earn an annual salary of $80,000 in a similar industry. This opportunity cost of their time and potential earnings is an implicit cost that must be factored in.

Therefore, the economic profit would be calculated as total revenue ($400,000) minus both explicit costs ($300,000) and implicit costs ($80,000), resulting in an economic profit of $20,000.

In this example, the accounting profit is $100,000, reflecting the revenue left after deducting explicit costs. However, when considering the implicit costs or the opportunity cost of the entrepreneur's time, the economic profit becomes $20,000, indicating the true net benefit of running the business compared to the next best alternative use of resources.

How to treat the Fraud Epidemic!

Kelly Richmond Pope in The Economist

It marks a spectacular fall from grace for a one-time Silicon Valley star. This week a court in California ruled that, Hail Mary appeals notwithstanding, Elizabeth Holmes must report to prison on May 30th to begin serving an 11-year sentence for fraud. Theranos, the startup Ms Holmes had founded in 2003, was worth $9bn at its peak but crashed after its much-vaunted blood-testing technology was shown not to work, and she ended up in the dock for deceiving investors.

Theranos is one of a long list of financial scandals that have made headlines in recent years. Also among these are the frauds at Wirecard, a German payments processor, and Abraaj, a Dubai-based private-equity firm, various crypto-heists, and a bonanza of misappropriation of government handouts to businesses during the covid-19 pandemic. So many frauds are there, and so big are the biggest, that pilfering a billion dollars does not guarantee a global headline. Chances are you haven’t heard of Outcome Health, a Chicago-based health-tech firm whose former ceo and president were recently convicted of defrauding clients, lenders and investors of roughly that amount of money.

Beneath the blockbuster frauds in the billions of dollars is an alarmingly long tail of smaller financial scams. Taken together, these add up to a huge global problem. Research by Crowe, a financial-advisory firm, and the University of Portsmouth, in England, suggests that fraud costs businesses and individuals across the world more than $5trn each year. That is nearly 60% of what the world spends annually on health care.

The drivers of fraud are many and complex. Sometimes it is down to pure greed. Sometimes it begins with a relatively innocuous attempt to paper over a small financial crack but spirals when that initial effort fails; some believe that’s how it started with Bernie Madoff’s giant Ponzi scheme. Market pressure and a desire to exceed analysts’ expectations can also play a part: after the global financial crisis of 2007-09, ge was fined $50m for artificially smoothing its profits to keep investors sweet. Accounting ruses like this, which fall in a grey area, are more common than outright fraud. Among tech startups there is even an established term for manipulating the numbers to buy you time to navigate the rocky road to financial respectability: “fake it till you make it.”

Fraud is an all-weather pursuit. Economic booms help fraudsters conceal creative accounting, such as exaggerated revenues. Recessions expose some of this wrongdoing, but they also spawn fresh shenanigans. As funding dries up, some owners and managers cook the books to stay in business. When survival is at stake, the line between what is acceptable and unacceptable when disclosing information or booking sales can become blurred.

World events can stoke fraud, too. At the height of the pandemic, an estimated $80bn of American taxpayer money handed out under the Paycheck Protection Programme, set up to assist struggling businesses, was stolen by fraudsters. The covid-induced increase in remote working has created new opportunities for miscreants. The 2022 kpmg Fraud Outlook concludes that the surge in working from home has reduced businesses’ ability to monitor employees’ behaviour. Geopolitics affects fraud, too. nato countries experienced four times as many email-phishing attacks from Russia in 2022 as they did in 2020. Cybercrimes such as ransomware attacks have already transferred a staggering amount of wealth to illicit actors. The costs to businesses range from the theft of data, intellectual property and money to post-attack disruption, lost productivity and systems upgrades.

It is panglossian to think fraud can be eliminated, but more can be done to reduce it. Corporate boards and investors need to ask more questions. Investors are often too quick to take comfort from the presence of big names on the list of owners and directors. Some were clearly wowed by Theranos’s star-studded board, whose members included two former us secretaries of state and the ex-boss of Wells Fargo, a big bank.

Regulators need to be more sceptical, too. America’s Securities and Exchange Commission brushed aside a detailed and devastating analysis of Madoff’s business provided by a concerned fund manager, Harry Markopolos. Germany’s financial-markets regulator was similarly dismissive of the short-sellers and journalists who called out Wirecard.

The most effective change would be to do more to encourage whistleblowers. Falsified financial statements must start with someone who notices fraudulent acts. When fraud happens, many people ask “Where were the auditors?”. But the question should be “Where were the whistleblowers?”

As important as sceptical investors, regulators and journalists can be, much fraud would be undetectable without someone on the inside willing to spill the beans. Research shows that more than 40% of frauds are discovered by a whistleblower. The Wirecard scandal came to light largely because of the bravery of Pav Gill, one of the company’s lawyers, who went to the press with his concerns. The Theranos fraud was brought to the attention of the authorities and the Wall Street Journal by whistleblowing employees (one of whom was the grandson of a former political bigwig on the board).

Too often, companies seek to silence whistleblowers, or portray them as mad, bad or both: Wirecard, for instance, fought back ferociously against Mr Gill’s allegations and the journalists who investigated them. Organisations need to create safe spaces where employees can voice their concerns about wrongdoing. Internal reporting channels need to be robust, and employees educated on how to use them. Creating an environment where whistleblowers are celebrated, not vilified, is critical. Companies should worry more about anyone who can circumvent the controls, such as senior leaders or star employees, than about those inclined to raise concerns.

Governments, too, could do more. Protections for whistleblowers have been recognised as part of international law since 2003 when the United Nations adopted the Convention Against Corruption, and this has since been ratified by 137 countries. In reality, legal protections are patchy. They are strongest in America, which offers bounties to whistleblowers who provide information that leads to fines or imprisonment. In much of Europe, and elsewhere, the law is still too soft on those who muzzle or retaliate against alarm-ringers.

Fraud can be reduced. But first we must better understand who commits it, educate people on how to report it, and then ensure that policies protect those who choose to come forward. Until we do, financial crime will remain a multi-trillion-dollar scourge.

Why we trust fraudsters

From Enron to Wirecard, elaborate scams can remain undetected long after the warning signs appear. What are investors missing? Tom Straw in The FT

In March 2020, the star English fund manager Alexander Darwall spoke admiringly to the chief executive at one of the largest investments in his award-winning portfolio. “The last set of numbers are fantastic,” he gushed, adding: “This is a crazy situation. People should be looking at your company and saying ‘wow’. I’m delighted, I’m delighted to be a shareholder.” 

Seated in a swivel chair at his personal conference table, Markus Braun sounded relaxed. The billionaire technologist was dressed all in black, a turtleneck under his suit like some distant Austrian cousin of the late Steve Jobs, and he had little to say about swirling allegations the company had faked its profits for years. “I am very optimistic,” he offered, when Darwall voiced his hope that the controversy would amount to nothing more than growing pains at a fast expanding company. 

“I haven’t sold a single share,” Darwall assured him, doing most of the talking, while also acknowledging how precarious the situation was. The Financial Times had reported in October 2019 that large portions of Wirecard’s sales and profits were fraudulent, and published internal company documents stuffed with the names of fake clients. A six-month “special audit” by the accounting firm KPMG was approaching completion. “If it shows anything that senior people misled, that would be a disaster,” Darwall said. 

His assessment proved correct. Three months later the company collapsed like a house of cards, punctuated by a final lie: that €1.9bn of its cash was “missing”. In fact, the money never existed and Wirecard had for years relied on a fraud that was almost farcical in its simplicity: a few friends of the company claimed to manage huge amounts of business for Wirecard, with all the vast profits from these partners said to be collected in special bank accounts overseen by a Manila-based lawyer with a YouTube following. Braun, who claims to be a victim of a protégé with security services connections who masterminded the scheme and then absconded to Belarus, faces a trial this autumn alongside two subordinates that will examine how the final years of the fraud were accomplished. 

Left behind in the ashes, however, is a much larger question, one which haunts all victims of such scams: how on earth did they get away with it for so long? Wirecard faces serious questions about the integrity of its accounts since at least 2010. Estimates for losses run to more than €20bn, never mind the reputation of Frankfurt as a financial centre. Why did so many inside and outside the company — a long list of investors, bankers, regulators, prosecutors, auditors and analysts — look at the evidence that Wirecard was too good to be true and decide to trust Braun? 

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In 2019 I worked with whistleblowers to expose Wirecard, using internal documents to show the true source of its spellbinding growth in sales and profit. As I faced Twitter vitriol and accusations I was corrupt, the retired American short-seller Marc Cohodes regularly rang me from wine country on the US west coast to deliver pep talks and describe his own attempts to persuade German journalists to see Wirecard’s true colours. “Keep going Dan. I always say, ‘there’s never just one cockroach in the kitchen’.” 

He was right on that point: find one lie and another soon follows. But short-sellers who search for overvalued companies to bet against are unusual, because they go looking for fraud and skulduggery. Most investors are not prosecutors fitting facts into a pattern of guilt: they don’t see a cockroach at all. 

Think of Elizabeth Holmes, another aficionado of the black turtleneck, who persuaded a group of experts and well-known investors to back or advise her company, Theranos, based on the claim it had technology able to deliver medical results from an improbably small pinprick of blood. The involvement of reputable people and institutions — including retired general James Mattis, former secretary of state Henry Kissinger and former Wells Fargo chief executive Richard Kovacevich as board members — seemed to confirm that all was well. 

Another problem is that complex frauds have a dark magic that is different to, say, “Count” Victor Lustig personally persuading two scrap metal dealers he could sell them a decaying Eiffel Tower in 1925. As Dan Davies wrote in his history of financial scams, Lying for Money, “the way in which most white-collar crime works is by manipulating institutional psychology. That means creating something that looks as much as possible like a normal set of transactions. The drama comes much later, when it all unwinds.”  

What such frauds exploit is the highly valuable character of trust in modern economies. We go through life assuming the businesses we encounter are real, confident that there are institutions and processes in place to check that food standards are met or accounts are prepared correctly. Horse meat smugglers, Enron and Wirecard all abused trust in complex systems as a whole. To doubt them was to doubt the entire structure, which is what makes their impact so insidious; frauds degrade faith in the whole system. 

Trust means not wasting time on pointless checks. Most deceptions would generally have been caught early on by basic due diligence, “but nobody does confirm the facts. There are just too bloody many of them”, wrote Davies. It makes as much sense for a banker to visit every outpost of a company requiring a loan as it would for the buyer of a pint of milk to inquire after the health of the cow. For instance, by the time John Paulson, one of the world’s most famous and successful hedge fund managers, became the largest shareholder in Canadian-listed Sino Forest, its shares had traded for 15 years. Until the group’s 2011 collapse, few thought of travelling to China to see if its woodlands were there. 

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Yet what stands out in the case of Wirecard are the many attempts to check the actual facts. In 2015 a young American investigator, Susannah Kroeber, tried to knock on the doors at several remote Wirecard locations. Between 2010 and 2015 the company claimed to have grown in a series of leaps and bounds by buying businesses all over Asia for tens of millions of euros apiece. In Laos she found nothing at all, in Cambodia only traces. Wirecard’s reception area in Vietnam was like a school lunchroom; the only furniture was a picnic table for six and an open bicycle lock hung from one of the internal doors, a common security measure usually removed at a business expecting visitors. The inside was dim, with only a handful of people visible and many desks empty. She knew something wasn’t right, but she also told me that while she went half mad looking for non-existent addresses on heat-baked Southeast Asian dirt roads, she had an epiphany: “Who in their right mind would go to these lengths just to check out a stock investment?” 

Even when Kroeber’s snapshots of empty offices were gathered into a report for her employer, J Capital Research, and presented to Wirecard investors, the response reflected preconceived expectations: these are reputable people, EY is a good auditor, why would they be lying? The short seller Leo Perry described attending an investor meeting where the report was discussed. A French fund manager responded by reporting his own due diligence. He’d asked his secretary to call Wirecard’s Singapore office, the site of its Asian headquarters, and could happily report that someone there had picked up the phone. 

The shareholders reacted at an emotional level, showing how fraud exploits human behaviour. “When you’re invested in the success of something, you want to see it be the best it can be, you don’t pay attention to the finer details that are inconsistent”, says Martina Dove, author of The Psychology of Fraud, Persuasion and Scam Techniques. She adds that social proof and deference to authority, such as expert accounting firms, were powerful forces when used to spread the lies of crooks: “If a friend recommends a builder, you trust that builder because you trust your friend.” 

Wirecard’s response, in addition to taking analysts on a tour of hastily well-staffed offices in Asia, was to drape itself in complexity. Like WeWork, the office space provider that presented itself as a technology company (and which wasn’t accused of fraud), Wirecard waved a wand of innovation to make an ordinary business appear extraordinary. 

At heart, Wirecard’s legitimate operations processed credit and debit card payments for retailers all over the world. It was a competitive field with many rivals, but Wirecard claimed to have become a European PayPal and more, outpacing the competition with profit margins few could match. Wirecard was “a technology company with a bank as a daughter”, Braun said, one using artificial intelligence and cutting-edge security. As the share price rose, so did Braun’s standing as a technologist who heralded the arrival of a cashless society. Who were mere investors to suggest that the results of this whirligig, with operations in 40 countries, were too good to be true? 

It seems to me Wirecard used a similar tactic to the founder of software group Autonomy, Mike Lynch, who charged that critics simply didn’t understand the business. (Lynch has lost a civil fraud trial relating to the $11bn sale of the group, denied any wrongdoing, said he will appeal, and is fighting extradition to the US to face fraud charges. Autonomy’s former CFO was convicted of fraud in separate American proceedings.) 

When this publication presented internal documents describing a book cooking operation in Singapore, Wirecard focused on the amounts at stake, which were initially small, rather than the unpunished practices of forgery and money laundering, which were damning. 

Then there was the thrall of German officials. Three times, in 2008, 2017, and 2019, the financial market regulator BaFin publicly investigated critics of Wirecard, taken by observers as a signal of support. Indeed, BaFin fell for the big lie when faced with an unenviable choice of circumstances: either foreign journalists and speculators were conspiring to attack Germany’s new technology champion using the pages of a prominent newspaper; or senior executives at a DAX 30 company were lying to prosecutors, as well as some of Germany’s most prestigious banks and investment houses. Acting on a claim by Wirecard that traders knew about an FT story before publication, regulators suspended short selling of the stock to protect the integrity of financial markets. 

Proximity to the subject won out, but the German authorities were hardly the first to fail in this way. Their US counterparts ignored the urging of Harry Markopolos to investigate the Ponzi schemer Bernard Madoff, a former chairman of the Nasdaq whose imaginary $65bn fund sent out account statements run off a dot matrix printer. 

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For some long-term investors, to doubt Wirecard was surely to doubt themselves. Darwall first invested in 2007, when the share price was around €9. As it rose more than tenfold, his investment prowess was recognised accordingly, attracting money to the funds he ran for Jupiter Asset Management, and fame. He knew the Wirecard staff, they had provided advice on taking payments for his wife’s holiday rental. Naturally he trusted Braun. 

Darwall did not respond to requests for comment made to his firm, Devon Equity Management. 

In the buildings beyond the shades of Braun’s office, staff rationalised what didn’t fit. Wirecard was a tech company, yet in early 2016 it suffered a tech disaster. On a quiet Saturday afternoon, running down a list of routine maintenance, a tech guy made a typo. He entered the wrong command when decommissioning a Linux server. Instead of taking out the one machine, he watched with rising panic as it killed all of them, pulling the plug on almost the entire company’s operations without warning. 

Customers were in the dark, as email was offline and Wirecard had no weekend helpline, and it took days for services to recover. Following the incident, a small but notable proportion of clients left and new business was put on hold as teams placated those they already had, staff recalled. Yet the pace of growth in the published numbers remained strong. 

Martin Osterloh, a salesman at Wirecard for 15 years, put the mismatch between claims and capabilities down to spin. Only after the fall was the extent of Wirecard’s hackers, private detectives, intimidation and legal threats exposed to the light. Haphazard lines of communication, disorganisation and poor record keeping created excuses for middle-ranking Wirecard staff and its supervisory board, stories to tell themselves about a failure to integrate and start-up’s culture of experimentation. 

It was perhaps not as hard to believe as we might think. Facebook, which has probed the legal boundaries of surveillance capitalism, famously encouraged staff to “move fast and break things”. Business questions often shade grey before they turn black. As Andrew Fastow said of his own career as a fraudster, “I wasn’t the chief finance officer at Enron, I was the chief loophole officer.” 

Braun’s protégé was chief operating officer Jan Marsalek, a mercurial Austrian who constantly travelled and struck deals, with no real team to speak of. Boasting that he only slept “in the air”, he would appear at headquarters from one flight with a copy of Sun-Tzu’s The Art of War tucked under an arm, then leave a few hours later for the next. Questions were met with a shrug, that strange arrangements reflected Marsalek’s “chaotic genius”. As scrutiny intensified in the final 18 months, the fraudulent imitation shifted to problem solving, allowing board members and staff to think they were engaged in procedures to improve governance. 

After the collapse I shared pretzels with Osterloh on a snowy day in Munich and he seemed embarrassed by events. He and thousands of others had worked on a real business, until they were summarily fired and learned it lost money hand over fist. Osterloh spoke for many when he said: “I’m like the idiot guy in a movie, I got to meet all these guys. The question arises, why were we so naive? And I can’t really answer that question.”  

General Electric’s accounting tactics bared in SEC settlement

 Industrial powerhouse underlines risk of short-term, market-orientated approach to management writes Sujeet Indap in The FT 

In 2015, Larry Fink, the BlackRock founder and chief executive, released a public letter pressing fellow CEOs to eschew making business decisions based on short-term considerations. 

“It is critical, however, to understand that corporate leaders’ duty of care and loyalty is not to every investor or trader who owns their company’s shares at any moment in time but to the company and its long-term owners,” he wrote. 

One company that BlackRock was a major shareholder at the time was General Electric with a stake of nearly 6 per cent. Around then, Jeffrey Immelt, the chief executive of GE, appears to have been overseeing just the kind of instant market gratification management effort that Mr Fink was condemning. 

The industrial group “misled investors” and “violated antifraud, reporting [and] disclosure controls”, according to a recent US Securities and Exchange Commission order. In early December, GE agreed with the regulator to pay $200m to settle charges that it had misled investors about its financial condition in between 2015 and 2017.  

In statement, the company noted that no financial statements required correction and that it had neither admitted nor denied guilt as a part of the SEC settlement. 

Five years after Mr Fink’s letter, there has been a continued rise in “stakeholder capitalism” and investing for better environmental, social and corporate governance standards. But this coda to the GE saga of the 2010s is an ugly reminder of the world these new principles are attempting to replace. 

The SEC’s order alleged GE pulled forward future profits and cash flow and, separately, delayed reporting big losses in order to boost immediate results. Damningly, the SEC described how Wall Street pressure and undue attention to the company’s stock price appeared to drive the company’s actions. 

In 2015, GE announced that its once high-flying but controversial GE Capital unit would shrink by $200bn worth of assets. While highly profitable at times, the banklike entity was volatile and its heavy losses during the 2008 financial crisis had nearly sunk the entire company.  

Mr Immelt wanted to reposition GE as an industrial powerhouse with aviation, healthcare, energy and oil and gas units that were supposed to help the developing world become urbanised. In late 2015, the group would close its $15bn acquisition of France’s Alstom to boost its power plant business. 

The power division, according to the SEC, would become the home of accounting mischief. Maintenance contracts with customers that ran several years required estimates of costs and the reduction of such inputs allowed GE to boost its book profits. Separate alleged manoeuvres included selling receivables to GE Capital, allowing for commensurate gains in cash flow. 

The company had announced in 2015 that it would seek to hit $2 per share of earnings in 2018. It appears that precise and ambitious figure effectively became the central organising principle of the company. 

“GE was aware of investor and analyst concerns that its cash collections were not keeping pace with revenue and that its unbilled revenue was growing in its industrial business,” wrote the SEC. 

It said executives at GE Power and GE Power Services cited analyst reports when they discussed internally the need to show improved cash performance. In one 2016 presentation to GE senior management, the SEC said, one executive posited that GE’s stock price could reach $40 if operating cash flow performance improved. It averaged about $30 during that year.

At the same time, the pieces of GE Capital the parent company had retained would prove to be another time bomb. GE kept an interest in long-term healthcare insurance policies that had been sold decades earlier. Those policies proved to be more expensive than had been anticipated, a reality that became clear in 2015. 

In 2016, as it became evident that higher losses were going to need to be realised, one executive called the situation in the insurance business a “train wreck”. 

It seems GE only came clean with investors about its accounting practices in the power division in 2017 while also eventually taking a $22bn impairment to goodwill related to the Alstom buyout. 

And it finally took a $9.5bn charge related to insurance liabilities in 2018 and committed to plug another $15bn of capital into shoring up the GE financial services unit. 

A spokesperson for Mr Immelt said GE sought to comply with all standards for financial accounting. “To achieve this goal, it put in place strong processes with multiple checks and balances,” the spokesperson added. 

BlackRock continues to hold a stake of about 6 per cent in GE shares, which currently hover around $10. A recovery to the peak of nearly $33 seen in 2016 will undoubtedly require a very long-term orientation.

After Wirecard: is it time to audit the auditors?

The industry’s failure to spot holes in the accounts of several collapsed companies has led to clamour for reform writes Jonathan Ford and Tabby Kinder in The FT


At the end of 2003, the Italian dairy company Parmalat descended into bankruptcy in an eye-catchingly abrupt manner. A routine bank reconciliation revealed that €3.9bn of cash which Parmalat was supposed to have at Bank of America did not actually exist.

The scam that emerged duly blew apart one of Italy’s best-known entrepreneurial companies, and sent its founder, Calisto Tanzi, to prison for fraud. Dubbed Europe’s Enron, it humiliated two large auditing firms, Deloitte and Grant Thornton, and ended up costing the former $149m in damages. 

Yet it rested on an apparently simple deception: the reconciliation letter on which the auditors were relying had been forged. 

There were shades of Parmalat’s collapse again last week when, nearly two decades later, another fast-growing European entrepreneurial company blew up in strikingly similar circumstances. 

After years of public questions about the reliability of its accounts, primarily from the FT, the German electronic payments giant, Wirecard, was forced to admit to a massive hole in its balance sheet. 

Rattled by the failure of an independent probe by KPMG to verify transactions underpinning “the lion’s share” of its reported profits between 2016 and 2018, and unable to publish its results due to issues eventually raised by its longstanding auditors EY, Wirecard finally capitulated. It announced that purported €1.9bn cash balances at banks in the Philippines probably did “not exist” and parted company with its chief executive Markus Braun. Evidence relied on by EY had been bogus. 

It remains unclear exactly how the crucial confirmation slipped through the cracks. According to one EY partner: “The general view internally is that confirming historic cash balances is auditing 101, and [that] ordinary auditing processes were followed, including third party verification, in which case the fraud was sophisticated in its use of false documents.” 

Others, however, take a less charitable view of such slip-ups, especially when, as with both Wirecard and Parmalat, they were preceded by so many questions about the reliability of the figures. 

“The integrity of the cash account [which records cash and should reconcile to all the other items in the accounts] is totally central to the whole system of double-entry bookkeeping,” says Karthik Ramanna, professor of business and public policy at Oxford’s Blavatnik School of Government. “If there is no integrity to the cash account, then the whole system is just a joke.” 

Shareholder support 

Wirecard’s collapse is the latest in a wave of accounting scandals that has swept through the corporate world, including UK outsourcing group Carillion and Abu Dhabi-based hospital group NMC Health, as well as alleged frauds at the mini-bond firm London Capital & Finance (LCF) and the café chain Patisserie Valerie. 

Many fear a further surge as the Covid-19 lockdown washes away those companies with weakened balance sheets or business models in the coming months. 

Questions about “softball” auditing have dogged many recent high-profile insolvencies. Carillion’s enthusiasm for buying companies with few tangible assets for high prices led it to build up £1.5bn of goodwill on its balance sheet. Despite vast losses at some of those subsidiaries, it had written down the value of just £134m of that goodwill when the whole edifice caved in. 

Similar questions hang over LCF, where close reading of the notes in the last accounts it published show how the estimated fair value of its liabilities far exceeded that of its assets in 2017, making it technically insolvent roughly 18 months before it collapsed taking with it more than £200m of savers’ cash. Yet EY gave the accounts a clean bill of health. 

Such cases have raised concerns about the independence of auditors, and their willingness to challenge the wishes of management at the client, who are often driven by their own desire for self-enrichment or survival. 

“It’s so important if you want to keep the relationship to have a rapport with the finance director,” says a financier who once worked at a Big Four auditing firm. “It is basically sometimes easier to swallow what you are told.” 

It is a problem that has deepened with the adoption of modern accounting standards. Over the past three decades, these have progressively dismantled the traditional system of historical cost accounting with its emphasis on the verifiability of evidence and using prudent judgment, replacing it with one based on the idea that the primary purpose of accounts is to present information that is “useful to users”. 

This process has allowed managers to pull forward anticipated profits and unrealised gains, and write them up as today’s surpluses. Many company bonus schemes depend on the delivery of the “right” accounting numbers. 

In theory, shareholders are supposed to provide a check on the influence of self-interested bosses. They choose the auditors and set the terms of the engagement. But in practice, investors tend not to assert themselves in the relationship. Scandals rarely lead to the ejection of auditors. 

So after UK telecoms group BT announced a £530m writedown in 2017 because of accounting misstatements at its Italian business, the auditors, PwC, were not sanctioned by investors. Far from it, the firm was reappointed with more than 75 per cent support. And when EY came up for re-election at Wirecard in the summer of 2018, despite rumblings about the numbers, it was voted back by more than 99 per cent. 

Tight budgets and timetables 

 It is not only an auditor’s desire for an easy life that can drain audits of that all important culture of challenge. There are practical issues too. Tight budgets and timetables limit the scope for investigation. 

Audit fees in Europe are far below those in the US. Audits of Russell 3000 index companies in the US cost 0.39 per cent of company turnover on average. Those in Europe average just 0.13 per cent, while for German companies it is a feeble 0.09 per cent. 

With fees low, auditing teams are often stretched thin, with only limited support from a partner out of a desire to limit costs and maximise the number of audits done. Audit is traditionally the junior partner in a big accountancy firm, with around four-fifths of the Big Four’s profits coming from the non-audit consultancy side. 

Take the last audit of BHS under the ownership of Philip Green, who sold the failing UK retailer to a little known entrepreneur, Dominic Chappell, in 2015. The chain subsequently collapsed the following year. 

The PwC partner, Steve Denison, recorded only two hours of work auditing the financial statements. The number two, an auditor with just one year’s post-qualification experience, recorded 29.25 hours, and the more junior team members 114.6 hours. Mr Denison was later fined for misconduct and effectively banned by the audit regulator. 

According to Tim Bush, head of governance and financial analysis at the Pensions & Investment Research Consultants, a shareholder advisory group, this reliance on juniors tends to result in “box checking” rather than an investigative approach to audit processes. “Audit teams are less likely to have a feel for the company’s business model,” he says. 

This in turn can open the door to abuse. Scams often hinge on faith in some implausible business activity. Parmalat’s €3.9bn cash pile, for instance, was supposed to have come from selling milk powder to Cuba. But an analysis of the volumes claimed suggested that if the company’s numbers were accurate, each of the island’s inhabitants would have needed to be consuming 60 gallons a year. 

As the author Richard Brooks noted in his book The Bean Counters: “It shouldn’t have been difficult for a half-competent audit firm to spot.” 

No ‘golden age’ 

The academic Prem Sikka rejects the idea that auditing has gone downhill in the past few decades. “Go back into history and you will find there was never a golden age,” he says. 

He argues that most of the weaknesses are of longstanding vintage, and are down to a lack of accountability. “On the audit side, there is no transparency. You have no idea as a reader of accounts how much time the auditors spent on the task and whether that was reasonable,” says the professor of accounting at the University of Sheffield. 

While there are signs that the UK regulator is getting tougher, it is down to shareholders to provide stronger governance, Prof Sikka says. If they won’t do it, the government should consider setting up a state agency to commission audits of firms and set fees. “It wouldn’t have to be everyone. You could just do large companies and banks.” 

Britain has recently been through a comprehensive review of audit, including how it is regulated and competition in the market, plus a review by the businessman Donald Brydon of its purpose. This devoted many pages to establishing it as a distinct new profession and coming up with new statements to include in already groaning company reports. 

Far from creating new tasks, many observers think that audit should reconnect with its original purpose. This is to assure investors that companies’ capital is not being abused by over-optimistic or fraudulent managers. “At their heart, audits are about protecting capital, and thereby ensuring responsible stewardship of capital,” says Natasha Landell-Mills, head of stewardship at the asset manager Sarasin & Partners. 

Yet modern accounting practice has made audits more complicated while watering down the legal requirement to exercise the judgment needed to ensure the numbers are “true and fair”. Despite the endless mushrooming of numbers, it is no easier to know if the capital is really present and can thus justify the payment of dividends and bonuses. 

Michael Izza, chief executive of the Institute of Chartered Accountants in England and Wales says auditors need a “renewed focus on internal controls, going concern and fraud. The vast majority of business failures are not the fault of the auditor, but when audit quality is a contributory factor, the problem generally involves these three fundamental areas.” 

Mr Bush thinks a radical simplification is in order. “Without clarity there is never going to be proper accountability,” he says. “What we have is a recipe for weak auditing, and ever more Wirecards and Parmalats. In the extreme it facilitates Ponzi schemes. Stay on that route and it won’t be long before you come unstuck.”

Auditors clash with firm directors over the question of 'firms that can survive'

Businesses are under pressure to give full account of how pandemic has affected trade writes Tabby Kinder in The FT

UK companies in the retail, hospitality and construction industries are locked in a battle with auditors to prevent their accounts carrying warnings that risk making the fight to survive the coronavirus crisis harder.

The country’s accounting watchdog is pushing auditors to be tougher when judging whether a company can continue trading as a going concern for the next 12 months. The going concern test is one that companies must pass to secure a clean bill of health from their auditors. 

The increased pressure from the Financial Reporting Council is stoking tensions between audit firms and company directors, who are worried that an official question mark in their accounts over whether they can keep trading — known as a qualified audit — would automatically trigger a breach of lending agreements with banks or bondholders. 

Several of the UK’s six largest accounting firms, which include KPMG, Deloitte, PwC and EY, have put additional steps in place to review signing off companies as a going concern.

PwC has introduced a panel to sign off on its audit opinions, while Grant Thornton is sending every one of its audits through its technical review team, which is usually reserved for its riskiest or complex audit judgments, according to people familiar with the matter. Both firms declined to comment.

“If any of us are accused of not challenging management after all this is over, that will be hideously unfair,” said one senior auditor. “We are having challenging conversations [with company directors] at colossal scale.”

The pressure on auditors from the FRC comes after a series of accounting scandals led to criticism that the regulator has been too slow to act, lenient and too close to the audit firms it supervises.

“We don’t want boilerplate, we want specific circumstances and disclosure about judgments on going concern,” said a senior official close to the FRC. “For corporates that means the trading environment, and now the audit environment is tougher than ever. It is creating tensions in the system.” 

With the government expected to extend the lockdown, senior auditors at a number of the UK’s largest firms said they were asking companies in the hospitality, retail and construction sectors to stress test whether they could survive “zero revenues” for six months or longer.

“It’s not an impossible prospect,” the head of audit at a major accounting firm said of the scenario. “We’re saying you’ll breach covenants in that situation and you need to tell the world that. Directors are pushing back and telling us that’s not realistic. The issue is any consensus on how long this will last is quickly meaningless.”

The economic turmoil unleashed by the government’s effort to contain the virus has already upended the reporting calendar for companies. The Financial Reporting Council and the Financial Conduct Authority have given listed companies two extra months to file their accounts in order to better assess the impact of Covid-19 on their profitability.

The FRC is also urging lenders and investors to react sensibly if the accounts of some large listed companies end up being qualified. “[There is a worry that] markets will overreact to what is a statement of the blindingly obvious,” the senior official close to the watchdog said. 

The watchdog is holding talks with banks, shareholder groups and bondholders to warn them to prepare for a flood of going concern warnings in the companies they own or have lent to.

The Institute of Chartered Accountants in England and Wales, the profession’s trade body, is expected to put out guidance this week that will “remind” accountants working in the finance departments of listed companies of their disclosure obligations on going concern, according to a person familiar with the matter.

“Many boards are going to have to come to conclusions today that would have seemed absurd three months ago, and they are obliged to consider that in their results,” the person said.

Business schools help create a culture where the profit justifies the means

Business students learn accounting techniques, but not ethical decision-making. This is why corporate scandals persist writes Berend van der Kolk in The Guardian

 

‘When I hear about the complex transfer pricing schemes at companies such as Amazon and Starbucks, I start wondering whether the accountants knew they were avoiding tax.’ Photograph: Mike Blake/Reuters


As a university teacher of accounting, I see the world through a particular lens. When I read about the sales scandal at Wells Fargo, I can’t help but think about the people who naively designed the incentive schemes that triggered this type of unethical behaviour. When I hear about the complex transfer pricing schemes at companies such as Amazon and Starbucks that enable them to avoid tax, I start wondering which accounting techniques they used. In short, I see the strong connection between unethical business practices and accounting techniques.

One reason why these problems persist is that the textbooks used in most elementary management accounting courses ignore this connection. They tend to focus on the technical aspects of accounting – understanding the formulas, definitions, mechanics and calculations – while ignoring its ethical aspects. The ethical dimension is usually nothing more than an add-on in an isolated chapter, introduction paragraph, or in a separate course on business ethics. This makes ethics an afterthought detached from the topics it is intended to reflect on.

Take the example of transfer pricing – the practice of setting a price for a good or service delivered by one part of an organisation to another. When these units are located in different tax regions, the chosen transfer price affects the amount of tax that has to be paid. Various accounting textbooks discuss the technical aspects of transfer pricing, framed with questions such as “how can multinationals minimise their taxes payable?”. The ethics of whether it’s fair to avoid paying taxes – like how many developing companies are harmed by tax-avoiding multinationals - are rarely discussed.

This may lead students to believe that business decisions are only technical, and bear no ethical implications. In fact, business decisions almost always bear ethical implications: they may deteriorate work conditions elsewhere in the supply chain, create a profit-justifies-the-means culture or increase inequality on a global level.

We need to see a much stronger integration of ethical considerations into business education. This is how managers make real-life business decisions. This could be achieved through a discussion on the techniques and ethics of transfer pricing in one and the same accounting class, using a case that highlights both aspects. Business education should also challenge its own underlying assumptions about human behaviour, and bring in other disciplines such as the humanities to help students think critically about business practices that are taken for granted.

Of course it’s important that business students acquire technical skills, and universities shouldn’t be paternalising students by dictating what is and isn’t ethical. Instead, a more critical and integrated debate about the moral implications of financial instruments, accounting techniques and new technologies should play a central role in business education.

In the film Jurassic Park, Dr Ian Malcolm says: “Scientists were so preoccupied with whether or not they could, they didn’t stop to think if they should.” I would like us – business educators, but also students, managers and accountants – to not make that same mistake. Let’s take that step back every once in a while to reflect on the ethics of the technics.

Do not blame accounting rules for the financial crisis

Hans Hoogervorst in The Financial Times

Ten years after the outbreak of the financial crisis, there are still persistent arguments about the role that accounting standards may have played in its genesis.

Some critics of International Financial Reporting Standards argue that they gave an overly rosy picture of banks’ balance sheets before the crisis and are still not prudent enough despite improvements since then. These same critics also argue that excessive reliance on fair value accounting, which reflects an asset’s current market value, has encouraged untimely recognition of unrealised profits.

They want to require banks to make upfront provisions for all expected lifetime losses on loans and, presumably, a return to good old historical cost accounting, which values assets at the price they were initially purchased.

Though superficially appealing, these changes would weaken prudent accounting, rather than strengthen it.

The British bank HBOS, which collapsed and was taken over by Lloyds Banking Group during the crisis, has been presented as an example of failing pre-crisis accounting standards. The truth is that HBOS met bank regulators’ capital requirements, and its financial statements clearly showed that its balance sheet was supported by no more than 3.3 per cent of equity. For investors who cared to look, the IFRS standards did a quite decent job of making crystal clear that many banks had wafer-thin capital levels and were accidents waiting to happen.

However, the crisis did reveal that the existing standards gave banks too much leeway to delay recognition of inevitable loan losses. In response, the International Accounting Standards Board developed an “expected loss model” that significantly lowered the thresholds for recognising loan losses. The new standard, IFRS 9, requires banks to initially set aside a moderate provision for loan losses on all loans. This prevents them from recognising too much profit up front. Then if a loan experiences a significant increase in credit risk, all the losses that can be expected over the lifetime of the loan must be recognised immediately. Normally, that will happen long before actual default.

In developing this standard, the IASB did consider whether to require banks to recognise full lifetime losses from day one. We rejected this approach for several reasons.

First, accounting standards are designed to reflect economic reality as closely as possible. Banks do not suffer losses on the very first day a loan has been made, so recording a full lifetime loss immediately is counter-intuitive. Moreover, in bad economic times, when earnings are already depressed, banks would have an incentive to cut back on new lending in order to avoid having to recognise large day one losses. Just when you need it most, the economy would probably be starved of credit.

Second, future losses are notoriously difficult to predict, so any model based on expected losses many years later would be subjective. Before the crisis, Spanish regulators required their banks to provision for bad times on the basis of lifetime expected losses. But their lenders underestimated and were still overwhelmed by the tide of bad loans. This kind of accounting also tempts banks to overstate losses in good times, creating reserves that could be released in bad times. That may seem prudent at first but could mask deteriorating performance in a later period, when investors are most in need of reliable information.

Critics also allege that IFRS has been too enamoured of fair value accounting. In fact, banks value almost all of their loan portfolios at cost, so the historical cost method remains much more pervasive.

Fears that fair value accounting lead to improper early profit recognition are also overblown. IFRS 9 prohibits companies from doing that when quoted prices in active markets are not available and the quality of earnings is highly uncertain. Moreover, fair value accounting is often quicker at identifying losses than cost accounting. That is why banks lobbied so actively against it during the crisis.

This does not mean that the accounting standards are infallible. Accounting is highly dependent on the exercise of judgement and is therefore more an art than a science. Good standards limit the room for mistakes or abuse, but can never entirely eliminate them. The capital markets are full of risks that accounting cannot possibly predict. This is certainly the case now, with markets swimming in debt and overpriced assets. For accounting standards to do their job properly, we need management to own up to the facts — and auditors, regulators and investors to be vigilant.

The financial scandal no one is talking about

Accountancy used to be boring – and safe. But today it’s neither. Have the ‘big four’ firms become too cosy with the system they’re supposed to be keeping in check?

By Richard Brooks in The Guardian


In the summer of 2015, seven years after the financial crisis and with no end in sight to the ensuing economic stagnation for millions of citizens, I visited a new club. Nestled among the hedge-fund managers on Grosvenor Street in Mayfair, Number Twenty had recently been opened by accountancy firm KPMG. It was, said the firm’s then UK chairman Simon Collins in the fluent corporate-speak favoured by today’s top accountants, “a West End space” for clients “to meet, mingle and touch down”. The cost of the 15-year lease on the five-storey building was undisclosed, but would have been many tens of millions of pounds. It was evidently a price worth paying to look after the right people.

Inside, Number Twenty is patrolled by a small army of attractive, sharply uniformed serving staff. On one floor are dining rooms and cabinets stocked with fine wines. On another, a cocktail bar leads out on to a roof terrace. Gazing down on the refreshed executives are neo-pop art portraits of the men whose initials form today’s KPMG: Piet Klynveld (an early 20th-century Amsterdam accountant), William Barclay Peat and James Marwick (Victorian Scottish accountants) and Reinhard Goerdeler (a German concentration-camp survivor who built his country’s leading accountancy firm).

KPMG’s founders had made their names forging a worldwide profession charged with accounting for business. They had been the watchdogs of capitalism who had exposed its excesses. Their 21st-century successors, by contrast, had been found badly wanting. They had allowed a series of US subprime mortgage companies to fuel the financial crisis from which the world was still reeling.

“What do they say about hubris and nemesis?” pondered the unconvinced insider who had taken me into the club. There was certainly hubris at Number Twenty. But by shaping the world in which they operate, the accountants have ensured that they are unlikely to face their own downfall. As the world stumbles from one crisis to the next, its economy precarious and its core financial markets inadequately reformed, it won’t be the accountants who pay the price of their failure to hold capitalism to account. It will once again be the millions who lose their jobs and their livelihoods. Such is the triumph of the bean counters.

The demise of sound accounting became a critical cause of the early 21st-century financial crisis. Auditing limited companies, made mandatory in Britain around a hundred years earlier, was intended as a check on the so-called “principal/agent problem” inherent in the corporate form of business. As Adam Smith once pointed out, “managers of other people’s money” could not be trusted to be as prudent with it as they were with their own. When late-20th-century bankers began gambling with eye-watering amounts of other people’s money, good accounting became more important than ever. But the bean counters now had more commercial priorities and – with limited liability of their own – less fear for the consequences of failure. “Negligence and profusion,” as Smith foretold, duly ensued.

After the fall of Lehman Brothers brought economies to their knees in 2008, it was apparent that Ernst & Young’s audits of that bank had been all but worthless. Similar failures on the other side of the Atlantic proved that balance sheets everywhere were full of dross signed off as gold. The chairman of HBOS, arguably Britain’s most dubious lender of the boom years, explained to a subsequent parliamentary enquiry: “I met alone with the auditors – the two main partners – at least once a year, and, in our meeting, they could air anything that they found difficult. Although we had interesting discussions – they were very helpful about the business – there were never any issues raised.”

 

A new ticker about the Lehman Brothers collapse in New York in 2008. Photograph: Alamy

This insouciance typified the state auditing had reached. Subsequent investigations showed that rank-and-file auditors at KPMG had indeed questioned how much the bank was setting aside for losses. But such unhelpful matters were not something for the senior partners to bother about when their firm was pocketing handsome consulting income – £45m on top of its £56m audit fees over about seven years – and the junior bean counters’ concerns were not followed up by their superiors.

Half a century earlier, economist JK Galbraith had ended his landmark 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”. (In this, he thought, “at least equally with communism, lies the threat to capitalism”.) Galbraith could have been prophesying accountancy a few decades later, now led by men of business rather than watchdogs of business.

Another American writer of the same period caught the likely cause of the bean counters’ blindness to looming danger even more starkly. “It is difficult to get a man to understand something”, wrote Upton Sinclair, “when his salary depends upon his not understanding it.”
For centuries, accounting itself was a fairly rudimentary process of enabling the powerful and the landed to keep tabs on those managing their estates. But over time, that narrow task was transformed by commerce. In the process it has spawned a multi-billion-dollar industry and lifestyles for its leading practitioners that could hardly be more at odds with the image of a humble number-cruncher.

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, verifying that their accounts present a trustworthy and fair view of their business to investors, customers and workers. They are the only players large enough to check the numbers for these multinational organisations, and thus enjoy effective cartel status. Not that anything as improper as price-fixing would go on – with so few major players, there’s no need. “Everyone knows what everyone else’s rates are,” one of their recent former accountants told me with a smile. There are no serious rivals to undercut them. What’s more, since audits are a legal requirement almost everywhere, this is a state-guaranteed cartel.

Despite the economic risks posed by misleading accounting, the bean counters perform their duties with relative impunity. The big firms have persuaded governments that litigation against them is an existential threat to the economy. The unparalleled advantages of a guaranteed market with huge upside and strictly limited downside are the pillars on which the big four’s multi-billion-dollar businesses are built. They are free to make profit without fearing serious consequences of their abuses, whether it is the exploitation of tax laws, slanted consultancy advice or overlooking financial crime.

KPMG abandons controversial lending of researchers to MPs


Conscious of their extreme good fortune and desperate to protect it, the accountants sometimes like to protest the harshness of their business conditions. “The environment that we are dealing with today is challenging – whether it’s the global economy, the geopolitical issues, or the stiff competition,” claimed PwC’s global chairman Dennis Nally in 2015, as he revealed what was then the highest-ever income for an accounting firm: $35bn. The following year the number edged up – as it did for the other three big four firms despite the stiff competition – to $36bn. Although they are too shy to say how much profit their worldwide income translates into, figures from countries where they are required to disclose it suggest PwC’s would have been approaching $10bn.

Among the challenges PwC faced, said Nally, was the “compulsory rotation” of auditors in Europe, a new game of accountancy musical chairs in which the big four exchange clients every 10 years or so. This is what passes for competition at the top of world accountancy. Some companies have been audited by the same firms for more than a century: KPMG counts General Electric as a 109-year-old client; PwC stepped down from the Barclays audit in 2016 after a 120-year stint.

As professionals, accountants are generally trusted to self-regulate – with predictably self-indulgent outcomes. Where a degree of independent oversight does exist, such as from the regulator established in the US following the Enron scandal and the other major scandal of the time, WorldCom – in which the now-defunct firm Arthur Andersen was accused of conspiring with the companies to game accountancy rules and presenting inflated profits to the market – powers are circumscribed. When it comes to setting the critical rules of accounting itself – how industry and finance are audited – the big four are equally dominant. Their alumni control the international and national standard-setters, ensuring that the rules of the game suit the major accountancy firms and their clients.

The long reach of the bean counters extends into the heart of governments. In Britain, the big four’s consultants counsel ministers and officials on everything from healthcare to nuclear power. Although their advice is always labelled “independent”, it invariably suits a raft of corporate clients with direct interests in it. And, unsurprisingly, most of the consultants’ prescriptions – such as marketisation of public services – entail yet more demand for their services in the years ahead. Mix in the routine recruitment of senior public officials through a revolving door out of government, and the big four have become a solvent dissolving the boundary between public and private interests.
There are other reasons for governments to cosset the big four. The disappearance of one of the four major firms – for example through the loss of licences following a criminal conviction, as happened to Arthur Andersen & Co in 2002 – presents an unacceptable threat to auditing. So, in what one former big-four partner described to the FT as a “Faustian relationship” between government and the profession, the firms escape official scrutiny even at low points such as the aftermath of the financial crisis. They are too few to fail.

The major accountancy firms also avoid the level of public scrutiny that their importance warrants. Major scandals in which they are implicated invariably come with more colourful villains for the media to spotlight. When, for example, the Paradise Papers hit the headlines in November 2017, the big news was that racing driver Lewis Hamilton had avoided VAT on buying a private jet. The more important fact that one of the world’s largest accountancy firms and a supposed watchdog of capitalism, EY, had designed the scheme for him and others, including several oligarchs, went largely unnoticed. Moreover, covering every area of business and public service, the big four firms have become the reporter’s friends. They can be relied on to explain complex regulatory and economic developments as “independent” experts and provide easy copy on difficult subjects.

Left to prosper with minimal competition or accountability, the bean counters have become extremely comfortable. Partners in the big four charge their time at several hundred pounds per hour, but make their real money from selling the services of their staff. The result is sports-star-level incomes for men and women employing no special talent and taking no personal or entrepreneurial risk. In the UK, partners’ profit shares progress from around £300,000 to incomes that at the top have reached £5m a year. Figures in the US are undeclared, because the firms are registered in Delaware and don’t have to publish accounts, but are thought to be similar. (In 2016, when I asked a senior partner at Deloitte what justified these riches, he sheepishly admitted that it was “a difficult question”.)

Targeting growth like any multinational corporation, despite their professional status, the big four continue to expand much faster than the world they serve. In their oldest markets, the UK and US, the firms are growing at more than twice the rate of those countries’ economies. By 2016, across 150 countries, the big four employed 890,000 people, which was more than the five most valuable companies in the world combined.

The big four are supremely talented at turning any change into an opportunity to earn more fees. For the past decade, all the firms’ real-terms global growth has come from selling more consulting services. Advising on post-crisis financial regulation has more than made up for the minor setback of 2008. KPMG starred in the ultimate “nothing succeeds like failure” story. Although – more than any other firm – it had missed the devaluation of subprime mortgages that led to a world banking collapse, before long it was brought in by the European Central Bank for a “major role in the asset quality review process” of most of the banks that now needed to be “stress-tested”.

The big four now style themselves as all-encompassing purveyors of “professional services”, offering the answers on everything from complying with regulations to IT systems, mergers and acquisitions and corporate strategy. The result is that, worldwide, they now make less than half of their income from auditing and related “assurance” services. They are consultancy firms with auditing sidelines, rather than the other way round.

The big firms’ senior partners, aware of the foundations on which their fortunes are built, nevertheless insist that auditing and getting the numbers right remains their core business. “I would trade any advisory relationship to save us from doing a bad audit,” KPMG’s UK head Simon Collins told the FT in 2015. “Our life hangs by the thread of whether we do a good-quality audit or not.” The evidence suggests otherwise. With so many inadequate audits sitting on the record alongside near-unremitting growth, it is clear that in a market with very few firms to choose from, poor performance is not a matter of life or death.

 

The ‘big four’ accountancy firms. Composite: Getty / Alamy / Reuters

These days, EY’s motto is “Building a better working world” (having ditched “Quality in everything we do” as part of a rebrand following its implication in the 2008 collapse of Lehman Brothers). Yet there is vanishingly little evidence that the world is any better for the consultancy advice that now provides most of the big four’s income. Still, all spew out reams of “thought leadership” to create more work. A snapshot of KPMG’s offerings in 2017 throws up: “Price is not as important as you think”; “Four ways incumbents can partner with disruptors”; and “Customer centricity”. EY adds insights such as “Positioning communities of practice for success”, while PwC can help big finance with “Banking’s biggest hurdle: its own strategy”.

The appeal of all this hot air to executives is often based on no more than fear of missing out and the comfort of believing they’re keeping up with business trends. Unsurprisingly, while their companies effectively outsource strategic thinking to the big four and other consultancy firms, productivity flatlines in the economies they command.

The commercial imperatives behind the consultancy big sell are explicit in the firms’ own targets. KPMG UK’s first two “key performance indicators”, for example, are “revenue growth” and “improving profit margin”, followed by measures of staff and customer satisfaction (which won’t be won by giving them a hard time). Exposing false accounting, fraud, tax evasion and risks to economies – everything that society might actually want from its accountants – do not feature.

Few graduate employees at the big four arrive with a passion for rooting out financial irregularity and making capitalism safe. They are motivated by good income prospects even for moderate performers, plus maybe a vague interest in the world of business. Many want to keep their options open, noticing the prevalence of qualified accountants at the top of the corporate world; nearly a quarter of chief executives of the FTSE100 largest UK companies are chartered accountants.

When it comes to integrity and honesty, there is nothing unusual about this breed. They have a similar range of susceptibility to social, psychological and financial pressures as any other group. It would be tempting to infer from tales such as that of the senior KPMG audit partner caught in a Californian car park in 2013 trading inside information in return for a Rolex watch and thousands of dollars in cash that accountancy is a dishonest profession. But such blatant corruption is exceptional. The real problem is that the profession’s unique privileges and conflicts distil ordinary human foibles into less criminal but equally corrosive practice.

A newly qualified accountant in a major firm will generally slip into a career of what the academic Matthew Gill has called “technocratism”, applying standards lawfully but to the advantage of clients, not breaking the rules but not making a stand for truth and objectivity either. Progression to the partner ranks requires “fitting in” above all else. With serious financial incentives to get to the top, the major firms end up run by the more materially rather than ethically motivated bean counters. In the UK in 2017, none of the senior partners of the big firms had built their careers in what should be the firms’ core business of auditing. Worldwide, two of the big four were led by men who were not even qualified accountants.

The core accountancy task of auditing can seem dull next to sexier alternatives, and many a bean counter yearns for excitement that the traditional role doesn’t offer. As long ago as 1969, Monty Python captured this frustration in a sketch featuring Michael Palin as an accountant and John Cleese as his careers adviser. “Our experts describe you as an appallingly dull fellow, unimaginative, timid, lacking in initiative, spineless, easily dominated, no sense of humour, tedious company and irredeemably drab and awful,” Cleese tells Palin. “And whereas in most professions these would be considerable drawbacks, in chartered accountancy they’re a positive boon.” Palin’s character, alas, wants to become a lion tamer.

The bean counter’s quest for something more exciting can be seen running through modern scandals like Enron and some of the racy early-21st-century bank accounting. One ex-big four accountant told me that if there was a single thing that would improve his profession, it would be to “make it boring again”.

Where once they were outsiders scrutinising the commercial world, the big four are now insiders burrowing ever deeper into it. All mimic the famous alumni system of the past century’s pre-eminent management consultancy, McKinsey, ensuring that when their own consultants and bean counters move on, they stay close to the old firm and bring it more work. The threat of an already too-close relationship with business becoming even more intimate is ignored. In 2016, EY’s “global brand and external communications leader” waxed biblical on the point: “You think about the right hand of greatness; actually the alumni could be the right hand of our greatness.”

The top bean counter’s self-image is no longer a modest one. “Whether serving as a steward of the proper functioning of global financial markets in the role of auditor, or solving client or societal challenges, we ask our professionals to think big about the impact they make through their work at Deloitte,” say the firm’s leaders in their “Global Impact Report”. The appreciation of the profound importance of their core auditing role does not, alas, translate into a sharp focus on the task. EY’s worldwide boss, Mark Weinberger, personifies how the top bean counters see their place in the world. He co-chairs a Russian investment committee with prime minister and Putin placeman Dmitry Medvedev; does something similar in Shanghai; sat on Donald Trump’s strategy forum until it disbanded in 2017 when the US president went fully toxic by appeasing neo-Nazis; and revels in the status of “Global Agenda Trustee” for the World Economic Forum in Davos.

The price of seats at all the top tables is a calamitous failure to account. In decades to come, without drastic reform, it will only become more expensive. If the supposed watchdogs overlook new threats, the fallout could be as cataclysmic as the last financial crisis threatened to be. Bean counting is too important to be left to today’s bean counters.

Should the Big Four accountancy firms be split up?

Natasha Landell-Mills and Jim Peterson in The Financial Times

Yes - Separating audit from consulting would prevent conflicts of interest.

Auditors are failing investors. The situation has become so dire that last week the head of the UK’s accounting watchdog said it was time to consider forcing audit firms to divest their substantial and lucrative consulting work, writes Natasha Landell-Mills. 

This shift from the Financial Reporting Council, which opposed the idea six years ago, is welcome. But breaking up the Big Four accountancy firms — PwC, KPMG, EY and Deloitte — can only be a first step. Lasting reform depends on auditors working for shareholders, not management. 

Auditors are supposed to underpin trust in financial markets. Major stock markets require listed companies to hire auditors to verify their accounts, providing reassurance to shareholders that material matters have been inspected and their capital is protected. In the UK, auditors must certify that the published numbers give a “true and fair view” of circumstances and income; that they have been prepared in accordance with accounting standards; and that they comply with company law. 

But audit is failing to meet investors’ expectations. The failure of Carillion, linked to aggressive accounting, is just the latest high profile example. And this is not just a UK phenomenon. The International Forum of Independent Audit Regulators found that 40 per cent of the audits it inspected were sub-standard. 

Multiple market failures need to be addressed. The most obvious problem is that audit quality is invisible to those whom it is intended to benefit: the shareholders. It is difficult to differentiate good and bad audits. Even with the introduction of extended auditor reports in the UK (and starting in 2019 in the US), formulaic notes about audit risks often hide more than they convey. 

Even when questions are raised about the quality of audits, shareholders almost always vote to retain auditors, with most receiving at least 95 per cent support. Last year, 97 per cent of Carillion shareholders voted to re-appoint KPMG. Lack of scrutiny creates space for conflicts of interest. Auditors who feel accountable to company executives rather than shareholders will be less likely to challenge them. These conflicts are exacerbated when audit firms also sell other services to management teams, particularly if that consultancy work is more profitable. 

The dominance of the Big Four in large company audits is another concern: when large and powerful firms are able to crowd out high quality competitors, the damage is lasting. 

Taken together, these failures have resulted in a dysfunctional audit market that needs a broad revamp. Splitting audit from consulting would prevent the most insidious conflict of interest. When non-audit work makes up around 80 per cent of fee income for the Big Four (and just over half of income from audit clients), the influence of this part of the business is huge. 

Current limits on consulting work have not eliminated this problem. They are often set too high or can be gamed, while auditors can still be influenced by the hope of winning non-audit work after they relinquish the audit mandate. 

There is quite simply no compelling reason why shareholders should accept these conflicts and the resulting risks to audit quality introduced by non-audit work. But other reforms are necessary. 

Auditors should provide meaningful disclosures about the risks they uncover. They need to verify that company accounts do not overstate performance and capital and that unrealised profits are disclosed. 

Engagement between shareholders and audit committees and auditors should become the norm, not the exception. Shareholders need to scrutinise accounting and audit performance, and use their votes to remove auditors or audit committee directors where performance is substandard. 

Finally, the accounting watchdogs must be far more robust on audit quality and impose meaningful sanctions. Even the best intentioned will struggle against a broken system. 


No — Lopping off advisory services would hurt performance 

The recent spate of large-scale corporate accounting scandals is deeply worrying and raises a familiar question: “Where were the auditors?” But the correct answer does not involve breaking up the four professional services firms that dominate auditing, writes Jim Peterson. 

Forcing Deloitte, EY, KPMG and PwC to shed their non-audit businesses would neither add competition nor boost smaller competitors. Lopping off the Big Four’s consulting and advisory services would degrade their performance, weaken them financially, and hamper their ability to meet the needs of their clients and the capital markets. 

Although the UK regulator is raising competition concerns, the root problem is global. The growth of the Big Four, operating in more than 100 countries, reflects their multinational clients’ needs for breadth of geographic presence and specialised industry expertise. 

 The yawning gap in size between the Big Four and their smaller peers has long since grown beyond closure: even the smallest, KPMG, took in $26.4bn in 2017, three times as much as BDO, its next nearest competitor. If pressed, risk managers of the smaller firms admit to lacking the skills and the risk tolerance even to consider bidding to audit a far-flung multinational. 

The suggestion that competition and choice would be increased by splitting up the Big Four is doubly unrealistic. Forcing them to spin off their non-auditing business would not create any new auditors. We would continue to see dilemmas like the one faced by BT last year when it set out to replace PwC after a £530m discrepancy was uncovered in the accounts of its Italian division. The UK telecoms group ended up picking KPMG for want of alternatives, even though BT’s chairman had previously been global chairman of KPMG. 

Similarly, Japan’s Toshiba tossed EY in favour of PwC in 2016, only to suffer disagreements with the second firm — this led to delays in its financial statements and an eventual qualified audit report. Wish as it might, Toshiba has no further choices, because of business-based conflicts on the part of Deloitte and KPMG. 

A split by industry sector — say, assigning auditing of banking and technology to Firm A-1, while manufacturing and energy go to new Firm A-2 — would be no better. Each sector would still be served by just four big firms. If each firm were split in half, the two smaller firms would struggle to amass the expertise, personnel and capital necessary to provide the level of service that big companies expect. 

Splitting auditing from advisory work is a solution in search of a problem. Many jurisdictions, including the UK, EU and US, restrict the ability of firms to cross-sell other services to their audit clients. Concerns about inherent conflicts of interest are overblown. 

The enthusiasm for cutting up the Big Four also fails to recognise how the world is changing. The rise of artificial intelligence, blockchain and robotics is reshaping the way information is gathered and verified. Auditors will need more — rather than less — expertise. 

Warehouse inventories, crop yields and wind farms will soon be surveyed rapidly and comprehensively in ways that could easily displace the tedious and partial sampling done for decades by squadrons of young audit staff. But to take advantage of these advances, auditors need to have the scale, the financial strength and the technical skills to develop and offer them. 

These tools will also deliver data that management needs for operational and strategic decision making. If auditors are to be barred from providing this kind of advisory work, the legitimacy of methods that have prevailed since the Victorian era is under threat. Investors will require some sort of audit function, but who would provide it? Splitting up the Big Four will achieve nothing if they fail and are replaced by arms of Amazon and Google. 

Auditors should be held accountable for their mistakes, but these issues are too complex for simplistic solutions. Rather than a quick amputation, we need a full-scale re-engineering of the current model with all of its parts.