Tax Research UK

FT.com / UK - FSA on defensive over Lehman failings.

Good to know I got yesterday’s musings on Lehamn right.

As the FT reports:

UK financial regulators said they had no reason to question the so-called “accounting gimmick” used by Lehman Brothers to flatter its results because the investment bank’s UK subsidiary’s reports accurately reflected the transactions.

Why - because they were correctly reportted on balance sheet under UK GAAP here.

But as they also note:

In the UK, the bank was able to get a legal opinion certifying that the transactions qualified as sales . Lawyers not connected to the transactions said the UK’s definition of sale is slightly less restrictive than the relevant law in the US.

The legal opinion made no difference to the Lehman UK subsidiary’s accounts to the FSA because they were made under UK accounting rules, which require both repos and sales to be reported on the balance sheet, the FSA said. But when the UK accounts were consolidated back to the US, under US accounting standards, known as GAAP, the transactions disappeared off Lehman’s balance sheet, the Valukas report said.

“The balance sheet effect referred to in the Lehman report only occurred in the consolidated accounts which were prepared under US GAAP,” Mr Sants [of the FSA] said.

“This is a matter for US financial reporting standards, not . . . for UK supervision,” he said. “This is arbitrage between US accounting rules and UK law.”

This is exactly as I suggsted.

But Hector Sants is wrong because if accounts can be abused in this way of course it is an issue for UK regulators.

So this should be high on the FSA agenda when its continued existence is confirmed after the election.

Richard Murphy Accounting, Auditing, Banking, Regulation

It’s been a hectic couple of days – hence low volume blogging.

That’s been an opportunity missed regarding Ernst & Young (E&Y) and Lehman. It’s also been an opportunity for reflection.

The reality is that there is nothing surprising about what E & Y have done. It seems that a senior partner from an audit form joined a client, devised an off-balance sheet accounting ruse, cleared it with his former colleagues, who then signed it off for audit purposes, and it was used thereafter without further question arising to deliberately misrepresent the true nature of the balance sheet of the entity.

That sounds shocking expect for one thing – this is what happens day in, day out, the whole world over.

This is what securitisation was about.

This is what a lot of offshore is about.

Derivative trading is often intended to achieve such goals – and most finance directors have no clue what they’re doing when engaging in them, and nor do their auditors.

In issues as straightforward as deferred taxation the balance sheet is knowingly and deliberately misstated by companies and auditors with the connivance of auditing and accounting regulators – in this case to overstate a liability that will in most cases never be settled – all to achieve a political objective of conning the world into believing that more tax is being paid than is ever settled..

In the case of fair value accounting myths were created that there were markets in assets for which there was no effective trading.

The E & Y / Lehman case is not an isolated incident. It is indicative of a pandemic of abuse by the accounting profession.

It’s an abuse that starts at the very top. The International Accounting Standards Committee Foundation – the body ultimately responsible for ensuring that accounts showing a true and fair view are prepared says in its constitution that its main objective is

to develop, in the public interest, a single set of high quality, understandable and enforceable global accounting standards that require high quality, transparency and comparable information in financial statements and other financial reporting to help participants in the world’s capital markets and other users make economic decisions;

Note the “and other users” – something that is then blatantly ignored by the International Accounting Standards Board when it says that the main users of financial statements are “present and potential investors, lenders and other creditors in making decisions in their capacity as capital providers”. They then conclude that because investors are providers of risk capital to the entity, financial statements that meet their needs will also meet most of the general financial information needs of other users.

And despite this extraordinary claim, and attention on one small group of users alone, the Big 4 have also engineered that they have almost no liability to providers of capital in the exercise of their duties.

The consequence was always going to be a disaster: it’s a disaster that is unfolding.

Treating that disaster as specific would however compound the error: the problem is systemic. It has to be tackled that way.

The key issues are, I suggest, in no particular order:

1. Why we gave up control of accounting disclosure to the accounting profession

2. Why we gave up control of auditing regulation to the auditing profession

3. Why we allowed the definition of an audit to be limited to confirmation of compliance with an accounting framework and abandoned the true and fair override

4. Why we allowed the users of financial statements to be considered the providers of capital alone

5. Why we don’t demand financial statements that meet the needs of other major user groups including:

   a. Employees

   b. Suppliers

   c. Customers

   d. Regulators

   e. Tax authorities

   f. Civil society groups

   g. People at large

6. Why we limited auditor liability so much

7. Why we allowed the concept of limited liability to be porous when it comes to failure and yet so restrictive when it comes to sharing information and reward

8. Why we allow limited liability within limited liability i.e. subsidiaries have limited liability distinct from parent companies

9. Why we consider group accounts the only useful perspective on corporate activity

10. Why we allow off balance sheet accounting

11. Why we still allow auditors to undertake other commercial activities

12. Why we don’t increase company registration fees to ensure auditors can always be fairly remunerated from a communally managed purse

13. Why we allow companies to not file accounts on public record

14. Why we accept a lack of transparency on group structures

15. Why we don’t demand full accounts on public record from all entities created under law wherever they are in the world, whether they be companies, partnerships, all variations on these, trusts, charities, foundations and other such entities. Such information to include full information on ownership, entitlement to assets, establishment, constitutions, management and accounts.

16. Why we allow companies to be struck off public registers without questions being asked and substantial fees being paid in lieu of accounts.

17. Why fit and proper tests aren’t conducted for all persons incorporating and owning companies.

Of course the list goes on, and on. So it should.

Now is the time for the most fundamental review of what the limited liability entity is, why we allow it, what its rights and obligations are and how we regulate it.

Surely this time we appreciate the need to do this?

Don’t we?

Richard Murphy Auditing, Big 4

re: The Auditors » Blog Archive » Liberté, Egalité, Fraternité: Big Lehman Brothers Troubles For Ernst & Young.

Francine McKenna’s take on Lehman and E & Y

A must read.

Richard Murphy Auditing, Banking, Ernst & Young

FT.com / Companies / Financial Services - Lehman report casts auditors in poor light.

As the FT notes:

Claims about Ernst & Young’s part in the collapse of Lehman Brothers look set to open a wider debate on what has until now been one of the least dissected aspects of the financial crisis – the role played by auditors.

Anton Valukas’s report on the biggest bankruptcy in US history has sent shockwaves through the accounting fraternity in its heavy criticism of Lehman’s auditor E&Y, one of the Big Four firms.

It goes on to say:

The claims against E&Y, although exceptional, give grist to a growing lobby questioning the purpose of auditors in providing investors with a true picture of the financial health of a company.

This is where I part company with the report. What’s exceptional about E & Y’s performance. They:

- alloweed window dressing

- put fornm over substance

- ignore the true and fair over-ride

- box ticked to confirm compliance with an accounting framework they helped create and which is itself misleading

That’s what auditors do. There’s nothing exceptional about this. The only odd thing is no one has appreciated it - bar the likes of Prem Sikka, Dennis Howlett, Francine McKenna and me.

This is not chance. This has been the collective turning of a blind eye.

Of course that could carry on. But society will pay the price.

Richard Murphy Accountancy, Auditing, Big 4

There’s much discussion today about whether the alleged professional negligence by Ernst & Young with regard to the audit of Lehman Brothers – where it appears they turned a blind eye to the rigging of the balance sheet – might be their Enron and lead to the demise of the firm.

I’m on record as saying I think the end of at least one of the Big 4 is nigh – and with it the whole audit market.

But let’s be clear – Ernst & Youngs’ defence – that their audit complied with US GAAP (Generally Accepted Accounting Principles - pronounced ’gap’) may be true. But that’s not the point. The point is US GAAP is crap and the Big 4 engineered that their audits do not need to report either truth  or fairness.

As the rules of the IAASB (International Auditing and Assurance Standards Board), which sets auditing standards  says, an audit is:

The purpose of an audit is to enhance the degree of confidence of intended users in the financial statements. This is achieved by the expression of an opinion by the auditor on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework. In the case of most general purpose frameworks, that opinion is on whether the financial statements are presented fairly, in all material respects, or give a true and fair view in accordance with the framework. An audit conducted in accordance with ISAs and relevant ethical requirements enables the auditor to form that opinion.

The wording is not a chance: the emphasis is on compliance with the financial reporting framework first; the consequence of being true and fair is assumed to follow, but is consequential, not the goal.

So, E & Y influence the International Accounting Standards Board that sets the framework.

And they influence the IAASB which limits the scope of the audit to the point it’s useless.

And although financial statements are meant to be produced for the benefit of the providers of capital to a business (in itself far too narrow a requirement) the auditors in the UK (by reason of the Caparo decision) and in the US under Delaware law basically can’t be sued by those providers of capital.

In other words the auditors charge a lot for doing a job badly for which they know they have almost no liability. It’s not surprising they don’t really care.

It’s not E & Y who have erred here – it’s all those who let this situation develop that have erred. The accounting structures we use are rotten to the core and so is auditing. Unless both are reformed we are heading for collapse after collapse after collapse as the prevailing mood of society to promote expedient short term greed will destroy entity after entity without any check or balance in place to stop it happening.

This can be tackled.

It needs to be tackled.

Without the political will to tackle it just watch society collapse like a pack of dominos as big business begins to fail all round us.

And I think I’m underselling the melodrama in saying that.

Richard Murphy Accounting, Auditing, Big 4, Ernst & Young, Ethics, IASB

FT.com / Companies / Banks - Lehman report blames top executives.

A one-year probe into the collapse of Lehman Brothers found “credible evidence” that top executives, including the former chief Dick Fuld, approved misleading financial statements and used an “accounting gimmick” to flatter results.

The long-awaited report by the court-appointed examiner Anton Valukas also said that there was enough evidence to claim that Ernst & Young, Lehman’s auditors, failed to “question and challenge improper or inadequate disclosures” in the firm’s results.

Now why aren’t I surprised?

Did anyone really think people did not know what they were doing? And that they turned a blind eye whilst their own coffers over-flowed.

This was grand corruption.

It wasn’t just in Lehman either.

Let’s say it.

And let’s say that restoring the system will perpetuate that corruption. Because it will.

Richard Murphy Auditing, Banking, Corruption

My latest Forbes column is out. Entitled ‘Precious Little Prudence’ it asks ‘When is a debt a bad thing–do accountants really even know?’

As I conclude:

[L]et’s never forget that both the IASB and IAASB are dominated and even significantly financed by the Big 4 firms of accountants and auditors - PricewaterhouseCoopers, Deloitte, KPMG and Ernst & Young.

According to popular myth these firms have had a ‘good recession’ – little blame attaching to them for what has happened. But that’s just a myth, because the truth is they carry a great deal of responsibility for what has gone wrong – and should bear the consequences.

Which is something I firmly believe.

Richard Murphy Accounting, Auditing, Big 4

FT.com / Lex / Finance & governance - Auditors.

The Lex column of the FT notes:

Welcome to the real world. UK audit firms will finally have to behave in the same way as the public companies they monitor when independent non-executives join their boards this year.

Auditors are already fighting back according to Lex:

Auditors’ criticisms are readily apparent. The independents won’t be involved in day-to-day business, are unlikely to know the details of individual audits, and so may not be able to prevent another Andersen, post-Enron collapse. Issues which usually occupy the time of independents, such as mergers and acquisitions and remuneration, are also rarely problematic inside a partnership such as Deloitte, KPMG or Ernst & Young. So it may be easier to see them as schmoozers whose job is simply to represent the firm at dinner parties.

And yes, that is exactly how I see them. Appointing a few friendly chaps - almopst certainty from the alumni of the firm to be non-execs is going to change absoluely nothing at all.

Lex thinks it will.

Dream on, I say.

Richard Murphy Auditing

FT.com / Companies / Banks - Central bankers demand new rules.

The FT notes:

Top central bankers and regulators underlined their differences with accounting rule-makers on Monday over the way banks account for bad loans, highlighting the politicisation of the standard-setting process.

The central bank governors and heads of supervision of the world’s largest economies, who oversee the Basel Committee on Banking Supervision, said it was “essential” that accounting rule-makers and their supervisors develop a “truly robust” approach on banks’ provision for bad loans.

This was becasue:

The oversight body’s proposals would, crucially, lead to more smoothing-out of bank profits through the financial cycle than the IASB proposals would allow.

This, I stress is not a minor difference. This is the two bodies being fundamentally at odds with each other and with the IASB being absolutely in the wrong.

The IASB promotes the mark to market model. This is the absolute reverse of what accounting used to be when it came to bad debts. Accountants always used to anticipate losses on debts and make provision for them. This was prudent.

But come mark to market and securitised loans so long as there was a market for the security no provision for loss was allowed EVEN IF the underlying assets were obviously not performing: the market ruled value and prudence could not overtake. So there was no provisioning. Imprudence ruled. Losses could only be recognised when they had occurred with regard to the vast majority of bank debt.

So, of course, IFRS accounts allowed bank profit to sky rocket as loss provisions fell.

And then the world fell apart because bankers believed they could lend and never make a loss.

That is completely and utterly the fault of the International Accounting Standards Board.

No wonder Basel disagrees with them.

And Basel has to win this one. And all accountants should support Basel because prudent may be boring but it’s what good accountancy is about.

PS And you can’t blame the auditors - the Big 4 ensured the rules of auditing were changed so they no longer had to be prudent either - because they no longer had to say accounts were true and fair - they just had to say they were true and fair within IFRS - which meant that even if IFRS were nonsense they had no duty to apply what used to be called the ‘true and fair over-ride’ because that no longer existed.

Blame the IASB by all means. But let’s never forget that the IASB is the mere agent of PricewaterhouseCoopers, Deloitte, KPMG and Ernst & Young. And they are really to blame.

Richard Murphy Accountancy, Accounting, Auditing, Banking

Debtonation » Blog Archive » A new Icelandic ‘drop the debt’ campaign? .

My Green New Deal colleague, Ann Pettifor blogs regularly. She’s written in the last day or so about the debt crisis in Iceland. Ann has, of course, considerable credibility on this issue, having run Jubillee 2000 and having foretold the current world debt crisis.

She says:

About one quarter of Iceland’s voters - 56,000 people - recently signed a petition which urges President Olaf Ragnar Grimsson to ‘drop the debt’ owed to the British and Dutch governments.  This petition reflects the view of 70% of Icelanders, according to a poll taken in August.

This debt - which amounts to 12,000 Euros per Icelandic citizen - is the result of reckless lending by an unregulated, private bank - and reckless, unregulated borrowing by British and Dutch depositors that earned very high rates of interest on their risky deposits. For political reasons, these depositors were bailed out by the British and Dutch governments - at a cost of about 50 Euros per citizen.

A country with a population the size of the city of Leicester - 317,000 - is now asked to bear the full burden of losses incurred by a private bank, and by private citizens in two countries with a joint population of 76 million.

The Icelanders are right in their instincts that have given rise to their opposition: this debt is unpayable. More than that, it is not their fault. It was undoubtedly an Icelandic bank that failed. But the system in which it worked was not Icelandic. And the people of Iceland were not responsible for its failure. It is pointless to now ask them to pay.

There is, however, very good reason why they should expect the auditors of that bank to pay. They had responsibility for making sure it could pay. They had to assess that it was a going concern and failed to do so. For that they do have liability, and they should bear the cost.

But the people of Iceland should not.

It’s a simple choice: failed auditors or innocent people? Which would you choose?

Richard Murphy Accountancy, Auditing, Banking