The strategy that once worked for Keynes and Buffett has performed badly writes Robin Wigglesworth in The Financial Times
When Joel Greenblatt went to Wharton Business School in the late 1970s, the theory of “efficient markets” was in full bloom, approaching the point of becoming dogma among the financial cognoscenti. To the young student, it all felt bogus.
Mr Greenblatt had already developed a taste for calculated gambles at the dog racing tracks. Reading the wildly fluctuating stock prices listed in newspapers also made him deeply sceptical of the supposed rationality of markets. One day he stumbled over a Fortune article on stockpicking, and everything suddenly fell into place.
“A lightbulb went off. It just made sense to me that prices aren’t necessarily correct,” recalls Mr Greenblatt, whose hedge fund Gotham Capital clocked up one of the industry’s greatest ever winning streaks until it was closed to outside investors in 1994. “Buying cheap stocks is great, but buying good companies cheaply is even better. That’s a potent combination.”
The article became his gateway drug into a school of money management known as “value investing”, which consists of trying to identify good, solid businesses that are trading below their fair value. The piece was written by Benjamin Graham, a financier who in the 1930s first articulated the core principles of value investing and turned it into a phenomenon.
One of Graham’s protégés was a young money manager called Warren Buffett, who brought the value investing gospel to the masses. But he isn't the only one to play a role in popularising the approach. Since 1996, Mr Greenblatt has taught the same value investing course started by Graham at Columbia Business School nearly a century ago, inculcating generations of aspiring stock jocks with its core principles.
Mr Greenblatt compares value investing to carefully examining the merits of a house purchase by looking at the foundation, construction quality, rental yields, potential improvements and price comparisons on the street, neighbourhood or other cities.
“You’d look funny at people who just bought the houses that have gone up the most in price,” he points out. “All investing is value investing, the rest is speculation.”
However, the faith of many disciples has been sorely tested over the past decade. What constitutes a value stock can be defined in myriad ways, but by almost any measure the approach has suffered an awful stretch of performance since the 2008 financial crisis.
Many proponents had predicted value investing would regain its lustre once a new bear market beckoned and inevitably hammered the glamorous but pricey technology stocks that dominated the post-2008 bull run. This would make dowdier, cheaper companies more attractive, value investors hoped.
Instead, value stocks have been pummelled even more than the broader market in the coronavirus-triggered sell-off, agonising supporters of the investment strategy.
“One more big down leg and I’m dousing my internal organs in Lysol,” Clifford Asness, a hedge fund manager, groused in April.
Value investing has gone through several bouts of existential angst over the past century, and always comes back strongly. But its poor performance during the coronavirus crisis has only added to the crisis of confidence. The strength and length of the recent woes raises some thorny questions. Why has value lost its mojo and is it gone forever?
Search for ‘American magic’
Berkshire Hathaway’s annual meeting is usually a party. Every year, thousands of fans have flocked to Omaha to lap up the wisdom of Mr Buffett and his partner Charlie Munger, the acerbic, terse sidekick to the conglomerate’s avuncular, loquacious chairman. Last weekend’s gathering was a more downbeat affair.
A shaggy-haired Mr Buffett sat alone on stage without his usual companion, who was stranded in California. Instead of Mr Munger, Greg Abel, another lieutenant, sat at a table some distance away from Berkshire’s chairman. Rather than the 40,000 people that normally fill the cavernous CHI Health Center for the occasion, he faced nothing but a bunch of video cameras. It was an eerie example of just how much the coronavirus crisis has altered the world, but the “Oracle of Omaha” tried to lift spirits.
“I was convinced of this in World War II. I was convinced of it during the Cuban missile crisis, 9/11, the financial crisis, that nothing can basically stop America,” he said. “The American magic has always prevailed, and it will do so again.”
Berkshire’s results, however, underscored the scale of the US economy’s woes. The conglomerate — originally a textile manufacturer before Mr Buffett turned it into a vehicle for his wide-ranging investments — slumped to a loss of nearly $50bn in the first three months of the year, as a slight increase in operating profits was swamped by massive hits on its portfolio of stocks.
A part of those losses will already have been reversed by the recent stock market rally triggered by an extraordinary bout of central bank stimulus, and Mr Buffett’s approach has over the decades evolved significantly from his core roots in value investing. Nonetheless, the worst results in Berkshire’s history underscore just how challenging the environment has been for this approach to picking stocks. After a long golden run that burnished Mr Buffett’s reputation as the greatest investor in history, Berkshire’s stock has now marginally underperformed the S&P 500 over the past year, five years and 10 years.
But the Nebraskan is not alone. The Russell 3000 Value index — the broadest measure of value stocks in the US — is down more than 20 per cent so far this year, and over the past decade it has only climbed 80 per cent. In contrast, the S&P 500 index is down 9 per cent in 2020, and has returned over 150 per cent over the past 10 years.
Racier “growth” stocks of faster-expanding companies have returned over 240 per cent over the same period.
Ben Inker of value-centric investment house GMO describes the experience as like being slowly but repeatedly bashed in the head. “It’s less extreme than in the late 1990s, when every day felt like being hit with a bat,” he says of the dotcom bubble period when value investors suffered. “But this has been a slow drip of pain over a long time. It’s less memorable, but in aggregate the pain has been fairly similar.”
Underrated stocks
Value investing has a long and rich history, which even predates the formal concept. One of the first successful value investors was arguably the economist John Maynard Keynes. Between 1921 and 1946 he managed the endowment of Cambridge university’s King’s College, and beat the UK stock market by an average of 8 percentage points a year over that period.
In a 1938 internal memorandum to his investment committee, Keynes attributed his success to the “careful selection of a few investments” according to their “intrinsic value” — a nod to a seminal book on investing published a few years earlier by Graham and his partner David Dodd, called Security Analysis. This tome — along with the subsequent The Intelligent Investor, which Mr Buffett has called “the best book about investing ever written” — are the gospel for value investors to this day.
There are ways to define a value stock, but it is most simply defined as one that is trading at a low price relative to the value of a company’s assets, the strength of its earnings or steadiness of its cash flows. They are often unfairly undervalued because they are in unfashionable industries and growing at a steadier clip than more glamorous stocks, which — the theory goes — irrational investors overpay for in the hope of supercharged returns.
Value stocks can go through long fallow periods, most notably in the 1960s — when investors fell in love with the fast-growing, modern companies like Xerox, IBM and Eastman Kodak, dubbed the “Nifty Fifty” — and in the late 1990s dotcom boom. But each time, they have roared back and rewarded investors that kept the faith.
“The one lesson we’ve learnt over the decades is that one should never give up on value investing. It’s been declared dead before,” says Bob Wyckoff, a managing director of money manager Tweedy Browne. “You go through some uncomfortably long periods where it is not working. But this is almost a precondition for value to work.”
The belief that periodic bouts of suffering are not only unavoidable but in fact necessary for value to work is entrenched among its adherents. It is therefore a field that tends to attract more than its fair share of iconoclastic contrarians, says Chris Davis of Davis Funds, a third-generation value investor after following in the footsteps of his father Shelby MC Davis and grandfather Shelby Cullom Davis.
“If you look at the characteristics of value investors they don’t have a lot in common,” he says. “But they all tend to be individualistic in that they aren’t generally the type who have played team sports. They weren’t often president of their sororities or fraternities. And you don’t succeed without a fairly high willingness to appear wrong.”
But why have they now been so wrong for so long? Most value investors attribute the length of the underperformance to a mix of the changing investment environment and shifts in the fabric of the economy.
The ascent of more systematic, “quantitative” investing over the past decade — whether a simple exchange-traded fund that just buys cheap stocks, or more sophisticated, algorithmic hedge funds — has weighed on performance by warping normal market dynamics, according to Matthew McLennan of First Eagle Investment Management. This is particularly the case for the financial sector, which generally makes more money when rates are higher.
The usual price discount enjoyed by value stocks was also unusually small at the end of the financial crisis, setting them up for a poorer performance, according to Mr Inker. Some industries, especially technology, are also becoming oligopolies that ensure extraordinary profit margins and continued growth. Moreover, traditional value measures — such as price-to-book value — are becoming obsolete, he points out. The intellectual property, brands and often dominant market positioning of many of the new technology companies do not show up on a corporate balance sheet in the same way as hard, tangible assets.
“Accounting has not kept up with how companies actually use their cash,” he says. “If a company spends a lot of money building factories it affects the book value. But if you spend that on intellectual property it doesn’t show up the same way.”
As a result, GMO and many value-oriented investors have had to adapt their approach, and focus more on alternative metrics and more intangible aspects of its operations. “We want to buy stocks we think are undervalued, but we no longer care whether it looks like a traditional value stock,” Mr Inker says.
Mr McLennan points out that while the core principles won’t change, value investing has always evolved with the times. “It’s not a cult-like commitment to buying the cheapest decile [of stocks]. We invest business-by-business,” he says. “I don’t know what the alternative is to buying businesses you like, at prices you like.”
Bargain hunt
Can value investing stage a comeback, as it did in when the dotcom bubble burst in the early 2000s, or the “Nifty Fifty” failed to justify investor optimism and fell to earth in the 1970s?
There has clearly been a shift in the corporate landscape over the past few decades that could be neutering its historical power as an investing approach. It is telling that the recent stock market rebound has been powered primarily by big US technology companies, despite value investors having confidently predicted for a long time that their approach would shine in the next downturn. Value stocks tend to be in more economically-sensitive industries, and given the likelihood of the biggest global recession since the Depression, their outlook is exceptionally murky, according to an AQR paper published last week.
“If value investing was like driving my four kids on a long car ride, we’d be very deep into the ‘are we there yet?’ stage of the ride, and value investors are justifiably in a world of pain,” Mr Asness wrote. However, the odds are now “rather dramatically” on the side of value.
Redemption could be at hand. there has in recent days been a cautious renaissance for value stocks, indicating that coronavirus may yet upend the market trends of the past decade. This stockpicking approach often does well as economies exit a recession and investors hunt for bargains.
Devotees of value investing certainly remain unshakeable in their faith that past patterns will eventually reassert themselves. Citing a common saying among adherents, Mr Wyckoff argues that “asking whether value is still relevant is like asking whether Shakespeare is still relevant. It’s all about human nature”.
Mr Greenblatt, who founded Gotham Asset Management in 2008, says that his students will occasionally quiz him on whether value investing is dead, arguing that computers can systematically take advantage of undervaluation far more efficiently than any human stockpicker can. He tells them that human irrationality remains constant, which will always lead to opportunities for those willing to go against the crowd.
“If you have a disciplined strategy to value companies, and buy companies when they’re below fair value you will still do well,” he says. “The market throws us pitches all the time, as there are so many behavioural biases . . . You can watch 20 pitches go by, but you only need to try to hit a few of them.”
Showing posts with label accountancy. Show all posts
Showing posts with label accountancy. Show all posts
Monday 11 May 2020
Monday 13 April 2020
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.
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.
Thursday 4 October 2018
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.
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.
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.
Tuesday 29 May 2018
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.”
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.
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.
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.”
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.
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.
Monday 12 March 2018
Accounting watchdogs find ‘serious problems’ at 40% of audits
Madison Marriage in The Financial Times
Global accounting watchdogs identified serious problems at 40 per cent of the audits they inspected last year, raising fresh concerns about the quality of work being carried out by the world’s largest accounting firms.
Global accounting watchdogs identified serious problems at 40 per cent of the audits they inspected last year, raising fresh concerns about the quality of work being carried out by the world’s largest accounting firms.
According to the International Forum of Independent Audit Regulators, accounting lapses were identified at two-fifths of the 918 audits of listed public interest entities they inspected last year.
The audit inspections focused on organisations in riskier or complex situations such as mergers or acquisitions, according to the IFIAR, whose members include 52 audit regulators around the world.
The most common issue identified by these regulators was a failure among auditors to “assess the reasonableness of assumptions”.
The second biggest problem was a failure among auditors to “sufficiently test the accuracy and completeness of data or reports produced by management”.
The findings have intensified concerns about weaknesses in the auditing process, an issue that has been thrust into the spotlight over the past 12 months following a string of high profile accounting failures.
These include the collapse of BHS and Carillion in the UK, a corruption scandal involving oil company Petrobras in Brazil, and the share price collapse of South Africa’s Steinhoff after the retail conglomerate admitted to a series of accounting irregularities last year.
Prem Sikka, an accounting expert and emeritus professor at Essex University, said the frequency of problems identified by the IFIAR was “terrible”.
“There are a whole range of issues and there is no simple fix. There is a huge knowledge failure in the audit industry which is not being looked at. The whole industry is ripe for reform. The question is where is the political will for this?”
The accounting industry has faced significant reputational problems in the UK in particular. KPMG came under heavy criticism from politicians last year for giving HBOS a clean bill of health shortly before the UK bank collapsed during the financial crisis. KPMG has also been criticised for declaring Carillion a going concern last March, 10 months before the construction company went into liquidation.
The report showed that 41 per cent of the problems identified by audit regulators last year related to independence and ethics. These included accounting firms failing to maintain their independence due to financial relationships with clients, and failing to evaluate the extent of non-audit and audit services provided to clients.
Many firms also failed “to implement a reliable system for tracking business relationships, audit firm financial interests, and corporate family trees”, the IFIAR said. Its research was based on feedback from 33 audit regulators who inspected the work done by 120 audit firms.
Karthik Ramanna, a professor at Oxford university’s Blavatnik School of Government, said the number of firms with issues around independence and ethics was “absurdly high”. He added that the research would reinforce concerns about a lack of competition in the audit market, which is widely viewed as being dominated by the ‘Big Four’: EY, Deloitte, KPMG and PwC.
“The auditing industry is so concentrated, once the largest firms set the standard for poor conduct, the whole industry is dragged down,” he said.
Brian Hunt, chairman of the IFIAR, told the FT: “We would like the firms to focus on getting better. We need them to think about how they come at this a bit differently. The firms are making progress — we would like to see it happen a bit faster.”
Deloitte said: “We remain focused on continually improving the quality of services we provide to our clients. We look forward to continuing our constructive engagement with our audit regulators.”
Tuesday 9 December 2014
PriceWaterhouseCoopers chief Kevin Nicholson denies lying over tax deals
Nicholson stands by previous testimony to MPs, as accountants are accused of mass-marketing tax avoidance schemes
The head of tax at one of the UK’s top accounting groups was accused of lying to parliament about his firm’s role in devising controversial tax deals for clients in Luxembourg.
Kevin Nicholson, PwC UK’s head of tax, who worked as an HM Revenue and Customs tax inspector in the early 1990s, was in front of the Commons public accounts committee for the second time in two years, following last month’s revelations of aggressive tax avoidance by PwC clients published by the Guardian and more than 20 other international news outlets.
In a series of fractious exchanges on Monday, the committee’s chair, the Labour MP Margaret Hodge, said: “We’ve asked you to come back to see us because we’ve reflected on the evidence that you gave us on 31 January 2013, and tried to relate that to the revelations around the Luxembourg leaks that have been in the press. I think I have a very simple question for you: did you lie when you gave evidence to us?”
Nicholson responded: “I didn’t lie and stand by what I said.”
Hodge’s anger stemmed from Nicholson’s previous evidence that PwC did not “mass market” tax products or sell tax avoidance “schemes” to clients, when set against the new evidence of 548 letters – relating to 343 companies – showing how PwC wrote to Luxembourg tax authorities to agree on how their clients structured their businesses for tax purposes.
“It’s very hard for me to understand that this is anything other than a mass-marketed tax avoidance scheme,” Hodge said. “I think there are three ways in which you lied and I think what you are doing is selling tax avoidance on an industrial scale.”
Nicholson again denied that the tax services sold by PwC were mass-marketed schemes and said that around 80 of the Luxembourg rulings related to UK companies, which were all distinct and had been disclosed to HMRC.
He said: “At the heart of the Luxembourg economy now is an economy that is based around businesses going there to finance [and] to hold investments. The tax structure, the system that they have created, facilitates that happening, along with all the other infrastructure. I’m not here to change the Lux tax regime. If you want to change the Lux tax regime, the politicians could change the Lux tax regime.”
Last month’s analyses of the way multinational companies establish businesses in Luxembourg were based on a leaked cache of hundreds of tax rulings secured by PwC Luxembourg that showed major companies – including drugs group Shire Pharmaceuticals and vacuum cleaner firm Dyson – using complex webs of internal loans and interest payments, which have greatly reduced tax bills.
The exposure of these arrangements – signed off by the grand duchy and all perfectly legal – have triggered an emergency debate in the European parliament focusing on the track record of the new European commission president, Jean-Claude Juncker, who had dominated Luxembourg politics as prime minister between 1995 and 2013. Juncker has sought to brush aside criticisms, insisting: “I am not the architect of the Luxembourg model because this model doesn’t exist.” However, Hodge added: “Since I have uncovered all this, I have questions about if Mr Juncker is fit to be the president of the European commission. I think if this had been around during the period of his appointment, it might well be a different decision.”
Appearing alongside Nicholson was Shire’s head of tax, Fearghus Carruthers, who explained how the group had two full-time employees in Luxembourg, who earn a total of €135,000 (£106,200) a year and handle intra-company loans of around $10bn (£6.4bn).
Hodge said: “It is stretching our credulity in suggesting to us that these two employees, who are also directors of umpteen other companies, are seriously the guys taking the decisions on loans totalling $10bn. Let me put this to you, Mr Carruthers, because it is a very serious matter, because if the decisions in substance aren’t taken in Luxembourg, this isn’t just avoidance; for me, it’s fraud.”
Carruthers responded: “Madam chair, I can assure you that the decision-making in respect of that Luxembourg company is made in Luxembourg.”
The executive was also repeatedly asked to explain the commercial rationale behind Shire establishing companies in Luxembourg and his answers included: “The commercial purpose is to allow us to have a treasury operation in Luxembourg which finances our activities”; and “the commercial purpose is for us to reinvest our cash appropriately and efficiently.”
When asked what Shire could do more efficiently in Luxembourg, Carruthers said: “It is not necessarily a question of comparative efficiency, we could have this lending in and lending out in all sorts of other jurisdictions. It’s just a good location.”
Well-known buyout firms such as Blackstone and Carlyle also appeared in the leaked documents, and Luxembourg investment vehicles are commonplace in such investment firms. A 2008 joint venture between private equity group Apax Partners and Guardian Media Group, which owns the Guardian, used a Luxembourg structure after it invested in the magazine and events group Emap, now called Top Right.
When the leaked documents were published, a GMG spokesman said: “We partnered with a private equity company which regularly used such structures. A Luxembourg entity was used because Apax already had that structure in place. The fact that the parent company is a Luxembourg company does not give rise to any UK corporation tax savings for GMG.”
Last year, PwC made revenues of £2.81bn, of which £714m came from its tax advisory practice. PwC Luxembourg had turnover of €276m for the year to June 2013, up more than 12% on the previous 12 months. Tax advice accounted for 29% of revenues, up from 24% two years ago. The Luxembourg partnership employs about 2,300 staff – equivalent to one in every 240 people resident in the small country. New offices for the fast-growing practice were officially opened last week at a ceremony attended by the duchy’s prime minister, Xavier Bettel.
Friday 21 June 2013
Our banks are not merely out of control. They're beyond control
Jailing reckless bankers is a dangerously incomplete solution. The market is bust. Institutions that are too big to fail are too big to exist
'The banking system is highly dysfunctional, deeply entrenched, and enormously abusive, both to its own workers and the society it operates in.' Photograph: Adrian Dennis/AFP/Getty
Seeing the British establishment struggle with the financial sector is like watching an alcoholic who still resists the idea that something drastic needs to happen for him to turn his life around. Until 2008 there was denial over what finance had become. When a series of bank failures made this impossible, there was widespread anger, leading to the public humiliation of symbolic figures. But the scandals kept coming, and so we entered stage three – what therapists call "bargaining". A broad section of the political class now recognises the need for change but remains unable to see the necessity of a fundamental overhaul. Instead it offers fixes and patches, from tiny increases in leverage ratios tobonus clawbacks and "electrified ring fences".
Today's report by the parliamentary commission on banking standards (to which I gave evidence) is a perfect example of this tendency to fight the symptoms while keeping the dysfunctional system itself intact. The commission, set up after last year's Libor scandal, identifies all the structural problems and nails the fundamental flaw in finance today: "Too many bankers, especially at the most senior levels, have operated in an environment with insufficient personal responsibility." Indeed, as they like to say in the City, running a mega-bank these days is like "Catholicism without a hell", or "playing russian roulette with someone else's head".
In response, the commission proposes jailing reckless bankers. Restoring the link between risk, reward and responsibility is a crucial step towards a robust and stable financial sector. But the report's focus on individual responsibility is also dangerously incomplete because it implies that the sector is merely out of control. This plays into the narrative that things can be fixed by tweaking rules and realigning incentives; in other words, by bargaining.
In reality the financial sector is not out of control. It's beyond control. During the past two years I have interviewed almost 200 people working in finance in London: "front office" bankers with telephone-number bonuses as well as those in "risk and compliance" who are meant to stop them being reckless. I have also spoken to many internal and external accountants, lawyers and consultants.
The picture emerging from those interviews is of big banks not as coherent units run by top bankers who know what they are doing. Instead these banks seem, in the words of Manchester University anthropologist Karel Williams, "loose federations of money-making franchises". One risk analyst talked about her bank as "a nation engaged in perpetual civil war", while a trader said, "You have to understand, it's us against the bank."
I could give 50 similar quotes. Taken together, they leave but one conclusion: employees at the big banks themselves do not believe their top people know what's going on; the big banks have simply become too complex and too big to manage. If this is true, the solution is not so much to jail the top bankers when something goes wrong, it is to break up the banks into manageable parts. But the British establishment still seems incapable of accepting the notion that a bank that is too big to fail or manage is a also bank that is too big to exist.
The same seems to apply to the need to restore market forces in the financial sector: the second source of structural dysfunctionality. Imagine a restaurant had served up product as toxic as that which big banks, credit rating agencies and accountancy firms were churning out until 2008. You would expect that restaurant to have closed. You would also expect new restaurants to have opened up in the area. This is how a free market should work: competition drives out bad practices.
But where are the new credit-rating agencies, accountancy firms or big banks? Even worse, not only are there just four major accountancy firms, they are also financially dependent on the very banks they are supposed to audit critically. It's the same with thethree credit-rating agencies dominating the market.
And it gets worse. Imagine that a restaurant in your neighbourhood made the kind of money paid to top employees in banking, credit-rating and accountancy firms. You'd expect people rushing to open more restaurants, and with that increased competition you'd expect wages to come down. Again, this is how competition works. There are thousands and thousands of young graduates aching to get into investment banking, so no shortage of prospective chefs. So where are the new players in high finance?
The reality is that global high finance is de facto a set of interlocking cartels that divide the market among themselves and use their advantages to keep out competitors. Cartels can extract huge premiums over what would be normal profits in a functioning market, and part of those profits go to keeping the cartel intact: huge PR efforts, a permanent recruiting circus drawing in top academic talent; clever sponsoring of, say, an ambitious politician's cycling scheme; vast lobbying efforts behind the scenes; and highly lucrative second careers for ex-politicians. There is also plenty of money to offer talented regulators three or four times their salary.
Capitalists have an expression for this, and it's "market failure". Here is the source of so many of the perversities in modern finance, and the solution is not only to denounce those who can't resist its temptations, it's to take away those temptations. That probably means smaller banks, smaller and independent accountancy firms and credit-rating agencies, simpler financial products, and much higher capital requirements.
Before studying bankers I spent many years researching Islam and Muslims. I set out with images in my mind of angry bearded men burning American flags, but as the years went by I became more and more optimistic: beyond the frightening rhetoric and sensationalist television footage, ordinary Muslim people go about their day like all other human beings. The problem of radical Islam is smaller and more containable than Islamophobes believe.
With bankers I have experienced an opposite trajectory. I started with the reassuring images in my mind of well-dressed bankers and their lobbyists; surely at some basic level these people knew what they were doing? But after two years I feel myself becoming deeply pessimistic and genuinely terrified. This system is highly dysfunctional, deeply entrenched, and enormously abusive, both to its own workers and the society it operates in. The problem really is exactly as bad as the "banker bashers" believe.
Friday 15 February 2013
Big UK tax avoiders will easily get round new government policy
These new proposals to beat tax avoidance won't work, as they expect opaque corporations to come clean
'Starbucks, Google, Amazon, Microsoft and others can continue to route transactions through offshore subsidiaries and suck out profits through loans, royalties and management fee programmes and thus reduce their taxable profits in the UK.' Photograph: Kerim Okten/EPA
The UK government has finally responded to public anger about organised tax avoidance. The key policy is that from April 2013, potential suppliers to central government for contracts of £2m or more will have to declare whether they indulged in tax avoidance. Those with a history of indulgence in aggressive tax avoidance schemes during the previous 10 years, as evidenced by negative tax tribunal decisions and court cases, could be barred from contracts. Their existing contracts could also be terminated. The policy is high on gimmicks and empty gestures, and short on substance.
The proposed policy only applies to bidders for central government contracts. Thus tax avoiders can continue to make profits from local government, government agencies and other government-funded organisations – including universities, hospitals, schools and public bodies. Banks, railway companies, gas, electricity, water, steel, biotechnology, motor vehicle and arms companies receive taxpayer-funded loans, guarantees and subsidies, but their addiction to tax avoidance will not be touched by the proposed policy.
The policy will apply to one bidder, or a company, at a time and not to all members of a group of companies even though they will share the profits. Thus, one subsidiary in a group can secure a government contract by claiming to be clean, while other affiliates and subsidiaries can continue to rob the public purse through tax avoidance. There is nothing to prevent a company from forming another subsidiary for the sole purpose of bidding for a contract while continuing with nefarious practices elsewhere.
Starbucks, Google, Amazon, Microsoft and others can continue to route transactions through offshore subsidiaries and suck out profits through loans, royalties and management fee programmes and thus reduce their taxable profits in the UK. Such strategies are not covered by the government policy and these companies can continue to receive taxpayer-funded contracts.
The policy will not apply to the tax avoidance industry, consisting of accountants, lawyers and finance experts devising new dodges. Earlier this week, a US court declared that an avoidance scheme jointly developed and marketed by UK-based Barclays Bank and accountancy firm KPMG was unlawful. The scheme, codenamed Stars – or Structured Trust Advantaged Repackaged Securities – enabled its participants to manufacture artificial tax credits on loans. This scheme was sold to the US-based Bank of New York Mellon (BNYM). The US tax authorities launched a test case and a court rejected BNYM's claim for tax credits of $900m. The presiding judge said that that avoidance scheme "was an elaborate series of pre-arranged steps designed as a subterfuge for generating, monetising and transferring the value of foreign tax credits among the Stars participants" (page 25). It "lacked economic substance" (page 53) and was a "sham" transaction (page 54). Whether equivalent schemes have been used by UK corporations is not yet known.
The above case highlights a number of issues. The UK-based organisations causing havoc in the US, Africa, Asia and elsewhere will not be restrained. They can still secure taxpayer-funded contracts in the UK. Now suppose that the Bank of New York Mellon scheme was applied by Barclays Bank to its own affairs and declared to be unlawful by a UK court. If so, possibly Barclays may be deterred from bidding for a central government contract, but there will be no penalties for KPMG as accountancy firms are not covered by the proposed rules.
The recent inquiry by the public accounts committee into the operations of PricewaterhouseCoopers, Deloitte, KPMG and Ernst & Young noted that the firms are the centre of a global tax avoidance industry. Even though a US court has declared one of these schemes to be unlawful, the UK government does not investigate them, close them, or recover legal costs of fighting the schemes devised by them. No accountancy firm has ever been disciplined by any professional accountancy body for peddling avoidance schemes, even when they have been shown to be unlawful. The firms continue to act as advisers to government departments, make profits from taxpayers through private finance initiative, information technology and consultancy contracts. There is clearly no business like accountancy business.
The proposed government policy will not work. It expects corporations who can construct opaque corporate structures and sham transactions to come clean. That will not happen. In addition, a government loth to invest in public regulation will not have the sufficient manpower to police any self-certifications by big business.
An effective policy should prevent tax avoiders and their advisers from making any profit from taxpayers. It should apply to all the players in the tax avoidance industry, regardless of whether their schemes are peddled at home or abroad.
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