thenextwave

“Bad apples” and rotten audits

Posted in business, ethics, organisational by thenextwavefutures on 22 October, 2014

39596355Tesco is due to announce the result of its investigation into its accounting scandal along with its half-yearly results on Thursday, and the Telegraph got first wind of Tesco’s report into its accounting “irregularities” a few days ahead of publication. The ever-diligent Ian Fraser was quick off the mark on Twitter:

And when I retweeted this, Jamie Saunders, who runs futuresedge in his spare time (“this isn’t my job, it’s a hobby”, as Clara said recently on Dr. Who), sent me an interesting question as to whether this was actually about an absence of checks and balances. But actually, it’s worse than that.

Bad apples

Organisations tend to like the “bad apple” model of wrongdoing, for the obvious reason. It means they can blame a group of individuals rather than have to address systemic faults. Police corruption is always blamed first on a handful of rotten coppers. And so – for quite a long time – were the phone hackings by the News of the World. So it comes as no surprise that someone has leaked to the Telegraph the conclusion of the Tesco inquiry:

The investigation … is understood to have uncovered evidence that a “small group” of people within Britain’s biggest retailer deliberately misled its auditors and accountants to flatter its financial results.

In other words: it was some bad apples.

A premium crop

We won’t know until Tesco releases more details (or even the full report?) who was responsible for manipulating the company’s commercial income arrangements. The quick points here is that if the suspensions are a reliable guide to the identity of the apples (and they may not be), [a] there seems to have been quite a lot of them, since eight people have been suspended, and [b], it was a pretty premium crop, since five of them were senior executives. In such circumstances, the line between a group of individuals rigging the system and a systemic corporate failure becomes vanishingly thin.

But there’s a wider point – an important systemic point – that gets lost, perhaps deliberately, in this version of the story.

This is about the nature and purpose of auditing. An audit is not a private arrangement between the client and their accountants. It is effectively a public good, a public assurance (to shareholders, yes, but also to suppliers or business partners or the general public) that the company is soundly run.

And a bit more: that the modern audit was introduced in the UK partly in response to the “railways mania” of the 1840s, and partly as a quid pro quo for the significant commercial benefits that companies got from the legal creation of the joint stock company in the mid-19th century under successive Companies Acts.

Audit and the public interest

It’s worth going back into the history a little to expand on this point. As Jane Gleeson-White writes in her excellent history of accounting,

“Under the [1844 Companies] Act, companies had to be publicly registered, present a ‘full and fair’ balance sheet at the annual shareholders’ meeting, pay dividends out of profits, maintain capital, and ensure their accounts were audited by people other than the company directors.”

To repeat the point: fair and trustable accounts are a protection for the public against the potential crimes or misdemeanours of company directors. And they are one of the prices that businesses pay for the very significant benefit of limited liability (which limits risk). Although the accountants are paid by the business, in carrying out the audit they are representing the public interest. Of course, it’s not surprising that the auditing company doing the Tesco investigation (Deloittes) would overlook this. On the most generous interpretation, fish don’t notice the water they swim in.

“A risk of manipulation”

So, back to Tesco. What we learned from the story given to the Telegraph on Sunday was this:

Sources within Tesco have confirmed there was concern among the company’s finance team and auditors for some time over its commercial income, because it was remaining flat while sales were falling.

PwC, Tesco’s auditors, took a detailed look at the retailer’s commercial income earlier this year and warned there was a “risk of manipulation”.

In other words, they noticed an anomaly. And what did they do? They warned their client. But—and this is quite an important “but”—they went ahead and signed off the accounts anyway:

On the basis of the information available, Tesco’s accounts were given a clean bill of health. as a fair record of the business.

On the basis of the information available. In other words, they had strong suspicions that something was wrong, but they chose not to act on it.

A big call

We can guess why. An auditor that declines to sign off the accounts of a business, especially a publicly quoted business, is making a big statement. The share price will fall, there will be intense scrutiny, the Chief Executive will find themselves under pressure. Whatever the public good, they are putting at risk future audit income and the related services and consulting fees. It’s not just a big statement; it’s a big call. And it’s not a call that audit partners are incentivised to make.

A thought experiment

So, by way of a thought experiment, let’s imagine that another group of professionals is auditing a service provided by a commercial company. Let’s say they’re local authority inspectors tasked with ensuring the quality of care for elderly people in a nursing home.

As they’re doing their inspection – their audit – they become concerned that something is amiss. Staff hint at it. The inspectors think the owners might be cutting corners, but they can’t quite nail the thing down, so they raise their concerns privately but don’t mention them in their inspection report.

A few months later some patients die, because of the care issue the inspectors had identified and raised privately, but not recorded in their report.

So: do we think that we’d be happy with being told that the deaths were the result of a few bad apples at the nursing home? I don’t think so. In fact, I think the inspectors would be regarded as negligent – and would quite likely be vilified on the front page of the Daily Mail. Or the Daily Telegraph.

Professionals and managers

A few years ago I co-wrote a paper on the future of the building professions. One of the issues we explored in that paper was the gap between perceptions of the world of “professionals”, who typically had a view of the world that was at least partly inflected by a notion of the wider good, and “managers”, whose view was more directly inflected by the needs of their organisation. (Of course, I know that this is a simplification, and that more progressive managers know that success requires them to behave more like professionals and take a wider view of their context and outcomes.)

“Managers” are more driven by internal incentives such as targets and budgets; under pressure, “professionals” trim their behaviour, or get into conflicts about outcomes. Auditors have the trappings of professionals (certification, examinations, licences to practice, and so on) but when the chips are down they behave like organisational managers. The diagram looked like this:

Screenshot 2014-10-21 21.05.04Source: The Henley Centre

And, of course, the reason we have whistle-blowing legislation, weak though it is, is so that employees are protected if they raise concerns about fraud or public safety. The fact that it took a whistleblower from inside the Tesco finance team to break the news of the company’s misleading accounts tells you everything you need to know about the systemic failure of Britain’s 21st century auditors; corporate creatures dressed up as professionals.

The image at the top of the post is of “Corporate Gangsters” by the London street artist T.WAT. It is used with thanks courtesy of the online shop Rat-King.

 

One Response

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  1. i.christie@surrey.ac.uk said, on 22 October, 2014 at 12:11 pm

    Spot-on. Have cited you in my upcoming lecture on corporate responsibility for the MSc students….

    Who audits the auditors…?

    Another issue for TNW blog: how it’s become normal for banks in USA and EU to pay huge and arbitrary fines in lieu of any due legal process (much less any convictions of executives) concerning cartel practices.

    best i Ian Christie i.christie@surrey.ac.uk

    Fellow, Centre for Environmental Strategy & Sustainable Lifestyles Research Group University of Surrey

    Home tel. +44(0) 208 540 9862 Work tel. : +44 (0)1483 689612

    [cid:25A95AB1-3A10-4F4A-AC68-27959D80390C@surrey.ac.uk]


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