How the Co-op got away with it

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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6 Responses

  1. 04/12/2013, Chris Goodwin wrote

    Dear Bengt,

    the entire problem could be solved if the Auditor reported directly to the shareholders; was required to answer any supplementary questions by them, and not, as now, get their appointment from and report to the management. Then sharp auditors would be sought out by the shareholders, and be protected from iffy managers. Also, they should be appointed for, say, five years Maximum, and then be switched out.

    All that’s needed is a change to the Companies Act: i.e. intelligent, timely action by politicians: now, why do I bother to hope for that ?

    • 04/12/2013, Headhunter wrote

      The auditors are elected by the shareholders (but not the bondholders) at the AGM, so they do report to them and what is needed is more shareholder vigilance. Bengt is being wise after the event. As he says, if Moodys could see the problem why could KPMG not? (Probably because they are all graduates of Common Purpose.) But the same could be said of Bengt – why could he not see what Moodys saw? A Yield of over 16% is not to be sniffed at in these times of negative real returns, but we did not know about the “Reverend” Paul Flowers, the crystal Methodist hypocrite, back then. As always, if it looks too good to be true, it probably is. Recommending a pawnbroker is a laugh. The share price reflects the state of the business. Bookmakers never go broke, so a pawnbroker in that kind of shape has to be exceptionally stupid.

  2. 04/12/2013, Texas Pete wrote

    KPMG also happen to be the same auditors who signed off HBOS’ questionable accounts. I see a couple of problems with auditors, the first being they are selected by the directors of the companies they are auditing as Bengt points out (shareholder “approval” is nothing other than a rubber stamp), which surely creates a conflict of interest especially if the audit firm is trying to cross sell other services. The second is that the audit teams of the big 4 rely heavily on their trainees, who having little experience and almost no understanding of the businesses they are auditing are to put it bluntly very easy to fob-off with half-baked answers. Lastly all auditors are really looking to do is be able to put a tick against the firm’s books and there is little incentive for them to dig deeper once they have a half-reasonable answer. These could be addressed by a requirement to use an alternative auditor periodically, e.g. once every five years – the alternate auditor is likely to be less conflicted since they will not have a long term relationship to maintain, and an occasional review by a fresh pair of eyes might increase the liklihood of discrepancies being discovered as part of the audit process.

  3. 05/12/2013, Russell Bruce wrote

    It is quite clear that KMPG were remiss in the due diligence to ensure the assets were correctly valued. They have enough experience with other businesses and banks to have probed harder. Just changing the auditor every 5 years is not enough that is too long for things to get buried. Like the public sector, financial companies should have 2 sets of auditors with the external auditors appointed by the PRA. It was Lloyds who uncovered the mess. As they had been through it they knew what they were looking at. KMPG rakes in substantial fees. We are now fining banks for misconduct/mis-selling. Signing off accounts in too cosy a relationship should not be risk free and the fines substantial. Auditors need to be more focussed on the risks that may come back to haunt them. Investors were misled without a doubt. As for the shareholders, in this situation, they were the directors of the Co-op Group who thought all was fine

    Given the experience of the Co-op bank and HBOS it is clear that they had members on their boards who should never have been appointed.

  4. 05/12/2013, Rodrigo Cordova wrote

    Auditors at the end of the day, depend on the Board of Directors and CEO to get the contract. Shareholders typically just confirm Directors’ suggestion. Thus, auditors serve the interest of Directors. If auditors are questioning senior management, then they are replaced. Auditors know that.
    This system to appoint auditors is not working we see scandals over and over in different jurisdictions.
    It is time to change.
    Companies going public (in debt or equity) should be subject to different rules to protect the public.
    I think auditors should be appointed by the securities authority using a system considering a variety of factors such as: price, previous relation with the company (rotation is good), market share (avoiding concentration), etc.
    Auditors will have to compete for clients, if they don’t do the job, they would be excluded from the list. The system would also open space to new auditors as networking with Directors and marketing will not be relevant.

  5. 05/12/2013, Natalie wrote

    For the last 25 years I have never voted for the reappointment of auditors. Not since I shared a house with a trainee auditor who came home from the Mirror Group audit frustrated that when he found money disappearing into Maxwell’s private accounts. He challenged Maxwell who told him it was none of his business. He reported it to the most senior auditor on the audit who told him to ignore it and not rock the boat as they needed the business next year.

    Rotten to the core.

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