The writer is chief investment officer of Muddy Waters Capital
There’s a line in the comedy film Zoolander in which the protagonist, a vacuous and vain model, confesses to having considered volunteering to help underprivileged children.
He then declares that “just thinking about it was the most rewarding experience I’ve ever had”. And it seems the same is true regarding the UK’s failure to actually do anything to reform the audit industry after multiple studies and much hand-wringing over the matter.
Despite scandals at Carillion, Patisserie Valerie, NMC Health, Thomas Cook, Eddie Stobart, Ted Baker and other companies, the UK has dropped audit reform from its next legislative programme. Those scandals show that the audit industry is failing to protect investors and employees from malfeasance. It is therefore not unreasonable to state that the audit industry is effectively little more than a tax on companies in service of a white-collar jobs programme.
The root cause of this dysfunction is that audit firms are not held materially accountable for their failures. Large audit firms have created a legal structure — a legal fiction, really — of independent “member firms” that serve to ringfence liability when something goes wrong. Money and firm personnel move freely through these ringfences, but the auditors have generally been able to convince governments and courts that financial responsibility does not.
The ringfencing of liability is more egregious considering that member firms trade under the (licensed) brands of the large auditors. This arrangement allows auditors to have their cake and eat it too because the member firms are paid for the value of the global brand being stamped on audit reports, but the licensers of that brand bear no liability for misuse of those brands.
The most insidious way that the audit firms abuse public trust in their brands is through consulting services. Consulting services are generally more lucrative than audits.
Frequently, when a company board wants to whitewash accounting, governance and other business problems, they call upon the consulting firms that are branded the same as the audit operations to conduct dubious investigations that miscreant boards then trumpet as an exoneration.
As short sellers, we have seen this play out numerous times. Other investors are often under the mistaken assumption that these reviews are conducted according to the same standards as audits.
When corporate accounts are highly misleading, but stop just short of legally being fraud, investors can be harmed while the auditors were willing participants. In theory, boards work for the shareholders and auditors work for the board.
Often in the real world, though, management effectively controls boards and therefore the auditors. When companies want to mislead investors and the public about the health of their businesses, auditors can be eager partners, issuing unqualified opinions where often the only discomfort visible is in opaquely written notes to the financial statements that even short sellers can struggle to understand.
There are far more examples of this type of enablement by auditors than of outright fraud. One example of auditor-blessed accounting that has played a role in the collapse of several companies, including Carillion and NMC Health, is so-called “reverse factoring”, which is a technique that allows companies to effectively turn bank borrowings into accounts payable, money owed to suppliers. This not only decreases a company’s apparent leverage but also flatters operating and free cash flow.
Another unethical, but apparently legal, accounting manoeuvre I have seen is allowing companies to book gains on asset sales as operating profit, thereby manipulating investors’ perceptions of profitability. Armed with far more expertise and resources in identifying accounting shenanigans than the average investor, my company is able to ferret out the economic reality underlying complex accounting. However, the bar to understanding accounts should not be nearly this high.
My hopes for UK audit reform were modest. The UK could have been a leader on this but I’ve seen the audit industry successfully erode numerous attempts at imposing accountability on it in various jurisdictions, to the point that little, if anything, substantive is done.
So I am shocked, but not surprised, at how the forces of box-ticking have seemingly snatched another victory for the failing status quo from the jaws of defeat. I am therefore left to lament and remind anyone who listens that if we don’t become better stewards of capitalism, capitalism’s future is far from assured.