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.”  

Jim Chanos: ‘We are in the golden age of fraud’

Harriet Agnew in The FT 

Jim Chanos has been cast as the “Darth Vader of Wall Street”, the “Catastrophe Capitalist” and the “LeBron James of short selling”. The 62-year-old titan of the $3.2tn global hedge fund industry predicted the downfall of US energy giant Enron almost two decades ago, making a fortune in the process. But the course of true riches, it seems, never did run smooth. On the day of our encounter, Tesla, which Chanos has bet against for the past five years, overtakes Toyota as the most valuable carmaker in the world, leaving him nursing heavy losses. But more about that later. 

I am ensconced at Oswald’s, an elegant London members’ club for oenophiles. It’s the first time I’ve set foot in a restaurant in four months. But where more appropriate to interview the short-seller than an antique mirrored dining room in Mayfair, the heart of the European hedge fund industry? It’s three days before “Super Saturday”, when London’s restaurants and bars can reopen. I’ve been granted an exception and am the sole diner. Social distancing would not be a problem here, however. The round tables are generously spaced apart, designed with discretion in mind. 

I am to have early dinner — Chanos is to have lunch. He is in Miami Beach, where he has been stuck since the start of lockdown in early March. For our encounter, he has persuaded Prime 112 steakhouse, his go-to place on Friday nights, to allow him to use its private room. When he comes on screen, his air is more benevolent academic than pantomime villain, dressed in a white open-necked shirt and blazer. Chanos likes to present himself as a “real-time financial detective who is incentivised to root out fraud”. Or, more prosaically, a “forensic financial statement junkie”. 

To critics, short selling represents the scourge of modern capitalism. Whereas so-called value investors such as Warren Buffett try to buy shares in companies that the market is underestimating, short-sellers such as Chanos seek out overvalued companies. They borrow shares and then sell them, hoping to buy them back later for less. In short, “they are profiting when others are losing money”, says Chanos — and this makes some people uncomfortable. 

Chanos is buoyant. A week earlier, one of his largest short positions — the German payments company Wirecard — filed for bankruptcy, after admitting that €1.9bn of its cash probably did “not exist”. This followed a five-year FT investigation into its accounting practices. Chanos’s funds made almost $100m from the trade, according to an investor. He laughs: “It’s bittersweet, Harriet, because short-sellers put up with weeks and months of misery, and you feel good for hours and days.” 

Even its detractors acknowledge that short selling, in a normal environment, helps the markets to question conventional wisdom. But a sharper complaint, usually heard from targets, is that short-sellers acting together to sow FUD (fear, uncertainty and doubt) about a company’s accounting or financial position can become a self-fulfilling prophecy. In the past, investors such as Chanos have moved markets just by revealing a bet against a particular company. 

Chanos happily concedes that he talks frequently to other short-sellers. He shorted Luckin Coffee, once touted as China’s answer to Starbucks, after Carson Block of Muddy Waters encouraged him to look at it. (The company is now being investigated for accounting fraud.) But it’s “a myth” that short-sellers act together, he tells me from Prime 112’s private room. “If there were conspiracies, we’d be in something much more profitable than short selling.” 

I mention Canadian insurer Fairfax Financial. It sued a group of hedge funds, including those run by Chanos, Dan Loeb and Steve Cohen, for allegedly driving down its stock under a short selling scheme. “That was the perception, but it wasn’t true,” says Chanos. “The case was thrown out [in 2018] on jurisdictional grounds. Our allegation was that the company was overstating their earnings, and during the process they restated their earnings.” 

Chanos’s hedge fund manager Kynikos Associates is named after the ancient Greek word for “cynic”. His pitch is that he can identify corporate disasters-in-the-making. The New York-based outfit employs 20 people and has $1.5bn in assets under management. Chanos also teaches a course on the history of financial fraud (“how to detect it, not how to commit it”, he quips) at Yale University, his alma mater. The syllabus stretches back to the 17th century. Today, he says, “we are in the golden age of fraud”. 

Chanos describes the current environment as “a really fertile field for people to play fast and loose with the truth, and for corporate wrongdoers to get away with it for a long time”. He reels off why: a 10-year bull market driven by central bank intervention; a level of retail participation in the markets reminiscent of the end of the dotcom boom; Trumpian “post-truth in politics, where my facts are your fake news”; and Silicon Valley’s “fake it until you make it” culture, which is compounded by Fomo — the fear of missing out. All of this is exacerbated by lax oversight. Financial regulators and law enforcement, he says, “are the financial archaeologists — they will tell you after the company has collapsed what the problem was.” 

All in all, it’s “a heady witch’s brew for trouble”. 

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A waiter arrives to take his order. Chanos knows the menu by heart and picks a wedge salad of iceberg lettuce, bacon, tomatoes and Roquefort dressing, followed by a strip steak (medium) with a baked potato. He doesn’t normally eat or drink like this at midday but says he will make an exception for Lunch with the FT, and orders a glass of Cabernet Sauvignon. 

At Oswald’s, the general manager Michele greets me with a glass of champagne and explains that the chef will prepare his own selection of dishes for me. I’m out of practice with ordering, so this comes as something of a relief. 

Chanos’s mission is focused on understanding a company’s business model and then ascertaining if its financial statements reflect it. Certain themes crop up time and again in his hunt for short positions: technological obsolescence, consumer fads, single-product companies, growth via acquisitions and accounting games. Notably he looks for “legal fraud” — where companies adhere to the accounting rules and regulations but there’s still an “intent to deceive”. Enron epitomised this — Chanos identified that it was using aggressive accounting to front-load profits and hide debt in its subsidiaries. 

He wasn’t the first short-seller to the Wirecard party. Chanos initiated a short in the German payments company last year and increased the position last autumn, when the FT published documents indicating that profits at Wirecard units in Dubai and Dublin were fraudulently inflated and that customers listed in documents provided to auditor EY did not exist. 

Wirecard’s collapse, when it finally came, was dramatic. But, says Chanos, most fraud is on the edges. And these days, often it is “staring at you right in the face through the use of company-designed metrics” through which they are “gaming the system”. He is referring to creative accounting measures used to flatter companies’ books, notably office-space provider WeWork’s now infamous community-adjusted ebitda. The coronavirus crisis has spawned “ebitdac”, or earnings before interest, taxes, depreciation, amortisation — and coronavirus — where companies are adding back profits they say they would have made but for the pandemic. 

Regulators, he says, could be much firmer in clamping down on metrics “that just are increasingly unmooring themselves from reality”. 

Growing up as the son of Greek and Irish immigrants who ran a chain of dry-cleaning shops in Milwaukee, Chanos says he was interested in stock markets at an early age. After Yale, he worked for an investment bank in Chicago and then retail brokerage Gilford Securities, where he began writing research on individual stocks. He had a baptism by fire: “The first major company I looked at and wrote up turned out to be an immense accounting fraud.” 

Baldwin-United was a piano company that had morphed into a financial supermarket. Chanos’s research pointed out inconsistencies with its numbers and recommended that investors sell the stock. It went bankrupt the following year, in 1983, at the time the largest-ever US corporate bankruptcy. Baldwin’s collapse piqued the interest of Gilford’s hedge fund clients who followed its stock recommendations, notably George Soros and Michael Steinhardt. “What else does the kid not like?” they asked, Chanos recalls. 

Soon afterwards, he joined Deutsche Bank in New York. It was a shortlived affair. In September 1985, The Wall Street Journal ran a front-page investigation into the “aggressive methods” of a network of short-sellers that it alleged was driving down the shares of US companies. The then 27-year-old Chanos was portrayed as an enfant terrible at the centre of the network. “People think I have two horns and spread syphilis,” he quipped in the article. Deutsche fired him and his boss. “The postscript is that nine of the 10 companies mentioned [in the article] either went bankrupt or were prosecuted for fraud,” he says. 

Chanos’s wedge salad and my own starter (a plate of oysters, deliciously juicy, with a glass of crisp white Burgundy) arrive. 

It must take a certain personality type to be a perma-bear, I venture. 

A long time ago, Chanos believed that going short was just “the mirror image of going long”. He has changed his tune on this, however, “because there is a lot of behavioural finance at work in the markets”. On Wall Street, he says, “the bull case is everywhere” — optimistic management projections, takeover rumours that boost targets’ stock prices, and company earnings estimates revised upwards. 

“So I think that it does take a certain peculiar personality — and I’ll leave it at that — to say ‘OK, here’s my facts and here’s the conclusions I draw from my facts, and that’s why I think there’s an opportunity on the short side here.’” 

Many can’t stomach it. Less than a year after the 1985 launch of Kynikos — amid “the rip-roaring bull market” of the time — Chanos’s business partner declared that he wasn’t comfortable with the pure short selling side of the business. He said his accountant had advised him to sell back his stake to Chanos for a nominal amount of $1. “And I paid him right there on the spot out of my wallet,” says Chanos. “It was the greatest trade I think I ever did,” he adds with a chuckle. 

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Chanos has put the remains of his salad to one side to make way for the steak. I’m delighted by my main course: deep red toro tuna carpaccio, garnished with avocado mousse. 

My guest has one of the best track records in the hedge fund industry. The Kynikos Capital Partners fund, a long/short equity strategy, has gained 22 per cent a year on average over the past 35 years — double that of the S&P 500 index. In the same period, against the backdrop of rising equity markets, its US short-only Ursus strategy — named after the Latin for “bear” — has lost 2 per cent a year. 

The past decade has been a difficult one for short-sellers in general, as trillions of dollars of central bank stimulus have lifted prices of assets indiscriminately across the board. How do you trade that? “Very carefully and painfully,” he says. 

Fundraising has been tough. Kynikos’s assets peaked at around $7bn after 2008, when short-only Ursus gained 44 per cent, net of fees. They have slumped to $1.5bn since then. This year Chanos sold a minority stake in the management company to boutique investment firm Conlon & Co and the family office of Richard M Daley, former mayor of Chicago. 

Prolonged periods of quantitative easing — most recently to ease the economic pain of the coronavirus crisis — is “adding to inequality” by benefiting the people who own financial assets, says Chanos. He believes that the Federal Reserve ought to cut credit card rates for consumers, which are still 15-18 per cent in the US, and sees a potential political backlash against the central banks for their part in how “the rich have gotten much richer and the vast majority of people have not”. 

Political risk is one of the reasons that Chanos is shorting gig economy comp­anies such as ride-hailing apps Uber and Lyft and online food-delivery platforms Grubhub and Just Eat Takeaway. Not only are they losing money, but he believes that there is going to be a greater political focus on low-wage workers, which poses an existential threat to their business models. 

Chanos sits on the finance committee of US presidential hopeful Joe Biden, who is supporting a new California law to strengthen legal protections for gig economy workers. A Biden administration raises the prospect of higher taxes. “I think it’s fair that rates of taxation on capital probably should go up, relative to rates of taxation on earned income. I know that makes me a communist on Wall Street but I’ve always felt that.” 

Chanos declines a second glass of wine, joking that “I don’t want to be drunk for this.” Defeated by his huge steak and salad, he asks the waiter to put them in a doggy bag. On my encouragement, he decides to be a good sport and orders the “decadent” fried Oreos that the restaurant is famous for. My own dessert is a coconut choc ice. 

I return to the subject of Tesla, whose shares have surged around six-fold in the five years since Chanos began shorting the company. What is going on here? “I think Elon Musk has personified the hopes and dreams of this bull market,” he says, setting out his bear case against Tesla, which he sees as unprofitable, highly leveraged and facing increasing competition. Tesla “burnishes its results through aggressive accounting”, in his view. He also describes it as “a culture of deception” because it is selling self-driving to consumers, which as yet “doesn’t exist”. 

What, I ask, is Chanos’s main motivation: to be rich or to be right? 

“I want to do this until they pull me out of the seat,” he replies. When Wirecard filed for insolvency, there was “an electricity” that ran through Kynikos. “That keeps you going.” And so, he says, does his belief that “this market is setting up to be one of the great short opportunities of all time”. 

“Trouble’s coming, I don’t know when, but it’s coming.”

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.”