The Co-op Bank’s bondholders got some good news last week, when they voted overwhelmingly to restructure the company’s debt.
But the episode leaves a sour taste. The recriminations will go on for quite some time. And yesterday, it was the turn of the Co-op’s financial auditor, KPMG, to take the stand.
The auditor was hauled up in front of the Treasury Select Committee to give evidence about its part in the bank’s downfall. In many ways, what came out of the hearing was something most investors already knew. That is the astonishingly cosy relationship between the auditor and its client.
I say client, but that’s a bit of a misnomer. The clients are really all those people who have put money into the business and expect to receive accurate and trustworthy financial reports.
And it’s this rather odd situation – where the felon employs his own policeman – that I want to look at today. You should be aware of what an auditor will and will not do for you.
Some guesswork and assumptions
For shareholders and bondholders, accurate accounts are absolutely imperative. Though the profession has plenty of regulation, codes and rules, at the end of the day, accounts are a very subjective thing. I mean, the whole value of the balance sheet really comes down to some assumptions about the future value of the company’s assets.
Take pawnbroker Albemarle and Bond – a company I mentioned earlier in the week. This is a company that’s clearly in trouble, where the shares have collapsed from £4 to less than 20p. And yet this business is deemed to have £1.74 in assets on the balance sheet.
In theory, that means you should be able to wind up the business and return the book value (less admin costs) to shareholders.
Evidently the value of these assets is not cast in stone. In this case, there’s a lot of goodwill on the balance sheet – I strongly suggest this will be written down. We know that they’re smelting much of their gold holdings too – so probably they won’t realise quite what they had anticipated on this stock!
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Provisions for future liabilities – again, these are totally subjective. In the case of Co-op Bank, how much might they lose as the loan book sours? (We’ll see in a second.)
The whole point of the auditor is to ensure that the reported figures are true and fair, that all the directors’ assumptions are built on a solid footing. In essence, to ensure that shareholders get a reasonable idea about the business’s standing.
You will remember that the Co-op Bank’s problems came to light after Moody’s downgraded its bonds early in the summer. Moody’s suggested that Co-op’s loan book wasn’t as clean as it had reported, and they saw significant losses down the line.
Moreover, insufficient provisions were in place – meaning there wouldn’t be enough capital on the balance sheet to keep the regulators happy. And to top it all, Moody’s suggested the bank wouldn’t earn enough profit to generate the extra capital required.
Now, here’s the point. If Moody’s saw this coming, then why on earth didn’t the auditor?
An inadvertent slip
During yesterday’s grilling, Andrew Walker of KPMG inadvertently gave the game away. In his defence, he said that he had insisted the Co-op rewrite some of the statements that were to be published in the 2012 accounts.
Mr Walker wasn’t happy about how blasé management appeared to be in reassuring investors about the robust capital health of the business.
You’re damned right about that Mr Walker! These guys were completely nuts. I have previously suggested that the statements made by the Co-op Group and the Co-op Bank’s board were totally misleading. In my opinion, former directors should be sued for misrepresentation.
But it is not the job of the auditor to help the board from tying their own noose. You see, when you read a set of accounts, all that pre-amble (you know, the letter from the chairman, the chief exec’s review, etc) should be taken with a pinch of salt. I always look at it as the board’s sales pitch to investors (that said, directors have to be honest).
But it’s just that it’s not the auditor’s job to edit this part of the accounts.
What I expect the auditor to do is to make damn sure the actual accounting figures are true and fair. I expect the auditor to look at the directors’ assumptions and valuations and if he’s not happy, he must ‘qualify’ the accounts. That is, he must write in his letter to the board (which is published in the accounts) why he’s not happy. Or if things really get bad, he should resign.
What he mustn’t do is help the board generate a set of accounts that gets away with the bare minimum standard. He’s there to police the felon, not help him.
In reality, auditors rarely use the powers they have. Why? Well, for starters, an auditor is unlikely to pick up a lot of new work if he’s seen as a bit of a stickler.
But also, I do concede that there has to be an element of goodwill and co-operation between the auditor and the company itself. These guys have to work together if they are to succeed. But none of this excuses lax auditing.
I expect accounts to always be true and fair. I want assumptions to be prudent and conservative. If not, I want the auditor to tell me so. I attend AGMs to eyeball directors – I want to see if I trust them. But I also expect the auditor to do his bit.
As investors, what on earth are we paying these bozos for, if not to protect us from scandals like the Co-op (and countless others). Auditors should be there to help foresee problems early so that things can be put right. If not, they should be pursued in a case of negligence. Hmm… fat chance!
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