I suggested yesterday that the failures in auditing at PWC might be systemic, even though (inevitably) the Financial Reporting Council did not test that hypothesis.
Today I want to go a little further and suggest that the failure in accounting is systemic. My suggestion is that accountancy has been complicit in the valuation of things that simply do not exist.
One of the accusations against PWC was that they had signed off accounts which stated assets to have worth which was simply not in existence. So, an investment was stated to be worth more than £200 million when in fact it was worth, at most, £1. There were other examples. But the issue is not specific to BHS and the companies associated with it. The problem is systemic.
Accountancy is riddled with intangible assets. And arbitrary valuations. I'm not seeking to get too technical here. What I am referring to are four basic categories of assets. Being more specific does not help the argument.
The first such asset is goodwill. This is the excess value paid when acquiring a business over the sum that can be attributed to tangible, physical assets that can be valued in their own right.
The second group of assets are legally constructed property rights. These are things like patents and copyrights that only have value by presuming there is a future income stream.
The third are those supposedly marketable assets that apparently generate an income but for which there is no current market and to which a value is attributed on a ‘mark to market' basis using models that might be as accurate as a forecast that it will snow in the UK today.
And finally are assets created intra-group. These are investments, loans and liabilities created in an intense web of transactions that are in themselves likely to be largely commercially meaningless but which leave a trail of interdependencies that render the accounts that include them largely incomprehensible in themselves, but which are nonetheless declared to be true and fair.
You can argue there are more or fewer such groupings. You can discuss which is more or less esoteric. I have problems with them whichever way you address the issue. The problems are, essentially, twofold.
The first is that these assets may simply not exist. Indeed, in isolation, they do not. So, goodwill is not independent of the underlying entity; intra-group debt is only of worth if the whole group might be, but not even then necessarily, and copyright only has worth as long as the property it relates to is still seen, heard or read. So the fact that someone once paid for these things is proof of nothing more than potential misjudgement at some time in the past. Too often that is now proving to be true. Not always, I stress. But too often. Which suggests that unquestioning acceptance of valuations based on pure history or models is failing accountancy.
And second? The problem is in the income statement. We recognise income from these assets in many cases (intra-group debt often excepted). But when we do we do not apparently think it appropriate to recognise that in most cases we bought that income. In other words, goodwill simply represents a purchased income stream. And an acquired copyright had a cost to buying the future income. And I think it should be mandatory that the cost in question be written off against the income. In fact, it should be written off even when there is no or little income. But accountancy is far too lax on this now, albeit it once was not.
Accounts are riddled, in my opinion, with assets that do not exist because they are at best nothing more than purchased income streams whose cost should have been written off against that revenue. Or the assets are simply manufactured.
I am not suggesting there is never a reason to recognise these assets. There may be, albeit with an over-riding requirement of prudent valuation that is now entirely absent from accounting. But, and this is key, investors need to be vastly more aware of their existence so that they can appraise the risk in an entity. So too do auditors need to do that because, simple souls that they seem to be, they are apparently quite unable to appraise this risk at present even when it hits them in the face.
The need is for a test of resilience. That is, a measure of the durability of the company when all these assets are stripped from consideration. That's a second balance sheet in effect. The directors would, of course, be wholly at liberty to say why they thought this misrepresented the position of the company: I would have no difficulty with that, as long as they were personally liable for their claims. And then the investor can decide. Do they want the accounting hubris, or not? Some fundamental accounting might do no harm.
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The problem, perhaps is in the Going Concern concept. The FRC report on PwC/BHS says this: “The going concern assumption is the assumption that a company will remain in business for the foreseeable future. …. …. The going concern assumption is a fundamental principle in the preparation of financial statements”.
When Luca Pacioli (1447-1517) developed double-entry book-keeping business was typically conceived as a ‘venture’; the venture had a beginning, and a conceived end; there was no assumption of the (permanent) going concern. It seems to me that the modern ‘Going Concern’ concept has simply been bolted on to the idea of discontinuous ventures; and the going concern assumption does not necessarily provide the methods of test that it is a ” fundamental principle in the preparation of financial statements”.
Noticably, the FRC says on Going Concern that “In considering whether a company is a going concern, the key test is whether the company is able to pay its debts as they fall due”. But how does it do this, and what range of contingencies (and what statistical probablities) does it bring into that test. I think this is a far more difficult challenge to meet than is generally acknowledged.
Agreed
So caution is required
As I am suggesting
I do not challenge your argument, and I defer to your far more intimate understanding of the accounting principles and concepts. My question I think neverthless remains; what are the “tests” (specific, consistant, repeatable, disclosable, and presumably statistical) that would meet the requirements for a robust, rigorous and universally applicable ‘Going Concern’ principle?
The test is always cash flow
And the obligation is to disclose uncertainties if they exist
No cash flow is right, of course. But my own experience (and I have some form here) is that models can be built that can be based upon testable assumptions
I have to say that most accountants I know seem utterly incapable of doing this i.e. programming a model to say what happens if debtor days extend by 10, for example
Or what happens if that project does not come on stream?
It’s not that hard to build conditionality in, but I don’t see it
I did that from the time
Another typo – oh, bother!: “consistent”.
We can deal with them 🙂
I know exactly what you mean about cash flow from my own experience. I would have thought modelling, combined in some form with Bayesian statistics could provide the appropriate platform.
It seems to me the importance of cash flow has always been understated because of the emphasis on the income statement; which in turn only has the form it has to meet the requirements of the Going Concern principle.
Agreed
PWC did not even consider going concern, apparently
“Accounts are riddled, in my opinion, with assets that do not exist because they are at best nothing more than purchased income streams whose cost should have been written off against that revenue. ”
Isn’t that what depreciation achieves?
Purchased Goodwill is written off.
So is IP
So are copyrights
Didn’t you write off such assets way back when you did accounts? How on earth did you treat them if you didn’t? Or did you never come across such assets?
Nothing now requires that goodwill be written off
Richard,
Surely an experienced accountant such as yourself should know the difference between mark-to-market and mark-to-model?
TJ
You appear not to know what an intangible asset is
Goodwill is not intangible.
Goodwill is simply the difference between two known tangible figures, the value of assets and the value paid for the business.
Further, companies depreciate intangible assets over their useful lifetime, don’t they?
It is called an intangible asset for a reason
And no, they don’t
Richard:
Is the amount a company has been bought for a tangible or intangible amount?
– It would be hard to argue that it is not tangible, it is a fixed, known amount.
Is the value of a company’s tangible assets a tangible amount?
– By definition it is.
Is the result of subtracting one tangible amount from another tangible amount, something tangible or intangible? I think we both know the answer to that.
And we are discussing intangibles
And they do not exist, by definition
They had a worth
And we know that may not be the worth now
All I am saying is accounts need to make clear what does and does not exist
It’s really not hard, is it?
You are of course quite wrong to say that intangibles do not exist.
A copyright exists. A patent exists.
Try breaking one if you think they don’t exist.
Love between two adults in a relationship is an intangible. Are you saying love does not exist? Perhaps in your own life that is true but many would argue against you.
Show me goodwill
It’s intangible for a reason
As is copyright: it’s a wholly artificial legal construct
Be interesting to see if investment analysts start making Brexit adjustments as we move ever closer to a hard Brexit, and write off intangibles linked to EU trade when valuing a company?
I wonder if Rees-Mogg and the rest of the Brexit crew are already divesting themselves, just in case…
As far as writing off goodwill is concerned:
https://www.frc.org.uk/accountants/accounting-and-reporting-policy/uk-accounting-standards/standards-in-issue/frs-10-goodwill-and-intangible-assets
“The standard requires purchased goodwill and certain intangible assets to be capitalised and, in most circumstances, to be amortised systematically through the profit and loss account (usually over 20 years or less)”
Which rules are you working to?
Note that ‘most’
It’s key
And the let out that means far too much is not
Perhaps you could supply some specific examples of companies which are not writing down Goodwill and other intangibles. If you say “far too much is not” it should be easy for you to find some examples.
But I don’t think you can.
Every accountant and tax advisor knows that the tax treatment of intangibles was overhauled in 2002 and tax deductions are tied to accountancy treatment. If as you say companies are not writing off intangibles then they are giving up tax deductions.
So is your argument that tax avoiding companies are not claiming tax deductions they are entitled to?
If that is so I would have thought you would be happy. But of course it isn’t so and you are wrong. Companies write off intangibles against income.
The rules are currently in CTA 2009. You should take a look.
I am wholly aware of the rules
I am also amused that you think the world is wholly governed by UK tax rules
And might I suggest you look at Carilion?
[…] By Richard Murphy, a chartered accountant and a political economist. He has been described by the Guardian newspaper as an “anti-poverty campaigner and tax expert”. He is Professor of Practice in International Political Economy at City University, London and Director of Tax Research UK. He is a non-executive director of Cambridge Econometrics. He is a member of the Progressive Economy Forum. Originally published at Tax Research UK […]
Thank you Richard most illuminating what has been slipped into the standards when backs were turned.