Companies fail for many reasons but never because the accounting was overly aggressive. Dodgy bookkeeping is a symptom, not a cause; the real problems are always operational.
Looking back at my experience of watching accounting scandals unfold, there are usually three common factors. The first is that the CEO is often an overconfident bully (see my previous AB article ‘Pay, power and toxic management’). He (and it is almost always a man) has managed to simultaneously bludgeon internal dissent and bamboozle investors. Greed is often more powerful than fear, and too many investors turn a blind eye when the returns appear spectacular.
The second common factor is the uselessness of the audit committee. I can think of almost no examples where the committee has uncovered and acted on fraudulent accounting. I can think of many examples where it should have been obvious to any competent committee that all was not well. The members have access to inside information and the option to question the auditors without the presence of executive management. Some may even encourage warnings from whistleblowers.
Accounting firms are an easy target for unhappy investors
I am genuinely mystified why audit committees consistently fail to perform this crucial function. I suspect that the reasons are behavioural – ‘don’t rock the boat’ – rather than outright incompetence but I will never know, as no post-collapse review ever seems to ask this vital question.
Misguided attack
The third common factor is that everyone then blames the auditor. I think this is fundamentally wrong-headed, for several reasons. First, auditors are not there to look for fraud; they are entitled to assume that management is honest, unless they find evidence to the contrary. Second, it takes the blame away from the real culprits: executive and non-executive management.
Accounting firms are an easy target for unhappy investors. There is no need to prove criminal activity in a civil lawsuit, and the profession is subject to robust and punitive oversight. Accounting firms have deep pockets and can usually afford to pay large settlements.
Wrong target
As an analyst, my greatest fear was inadvertently publishing inside information. The dividing line between public and non-public information is not always clear and the penalties for transgression can be severe. I saw instances of analysts being punished for this crime, but I never once saw the company source – often the CFO – being sanctioned. This is perverse, as it seems obvious to me that the most effective response is to go after the person who disclosed the information in the first place.
I think the same argument can be made for accounting failures. The auditor may well have been at fault, but the problem was created by management. And any audit committee that has failed to spot the problem has, in my opinion, automatically failed in its statutory duty.
Tougher penalties are required for the people who are really responsible: the directors
Much has been written about the government’s decision to axe audit reform (not least in AB), often focusing on the auditor’s role. There are already many examples of auditors paying a high price, professionally and financially, for inadequate audits. I am not convinced that tougher regulation is needed. I am, however, convinced that tougher penalties are required for the people who are really responsible: the directors. My biggest disappointment is the withdrawal of tougher penalties for directors who fail to exercise sufficient oversight.
Banning an individual from being a director is a powerful tool. Many non-executives serve on multiple boards and I suspect that the motivation is as much status as money.
Life is all about choices and incentives. People choose to do things because they expect a positive outcome and vice versa. Being a director of a firm that commits accounting fraud should result in permanent career damage. Everything else is window-dressing.
