Member Article

It was the age of wisdom, it was the age of incredulity.

Blazing yellow sun. Lapping blue waves. Tanned beach bods and a palm tree’s silhouette swaying against an orange sky. Once ubiquitous, the California Fitness logo that hints at its fabulous lifestyle offering has vanished from Singapore. In its heyday “Cali”, as its legions of fans called it, was not merely a gym, it was a status symbol. And as its popularity grew, many signed up for long-term memberships despite the hefty upfront payments.

In July 2016, the Zumba music abruptly stopped. Lycra-clad gym warriors found the doors to their dojo padlocked and a thunderstruck public heard that JV Fitness, which owned the outlets, had run out of cash. Tens of thousands of members were reportedly more than S$20 million out of pocket. In a scathing report released last month, JV Fitness’s liquidators fingered the management and auditors for allowing gym members to fund the business for three years even though it continued to bleed red ink.

Accounting firms face Hard Times

The past decade certainly has not been an easy one for accounting firms. Witness the high-profile corporate failure of Brazilian state-owned oil company, Petrobras, where a US$50 million (S$68 million) class-action settlement with its auditors is being finalised. Also, Japanese conglomerate Toshiba’s US$1.2 billion inflated-profits accounting scandal, which saw its auditors fined ¥2.1 billion (S$26 million) and blocked from taking on new contracts for three months. In Britain, the auditors of department store BHS – once a constituent of theFTSE 100 Index – were docked £6.5 million (S$11.5 million) for misconduct.

Back home, the much-publicised failures of businesses from California Fitness to Noble Group and Hyflux have similarly drawn auditors flak from shareholders and the public seeking someone to blame, an obvious target particularly when the financial statements did not red flag the financial risks.

This reaction is understandable, even if not always justified. While professionals, with their specialist expertise, should be held to a high standard, they cannot be responsible each time a company goes under. Not every corporate failure is an audit fail; businesses falter for a variety of reasons.

And in evaluating auditors’ work, it is unfair to apply 20/20 hindsight. In the case of Hyflux, for example, how much did the steep drop in electricity prices – a factor totally out of its control – contribute to the water treatment company’s financial troubles?

Additionally, not every corporate failure is the result of the audit firm’s wrongdoing or misfeasance. Some may be the work of rogue audit partners.

Take the case of the Guptas in South Africa. The family had emigrated from India and built a computer equipment, media and mining business empire. In 2013, Vega Gupta, the niece of the Gupta brothers, decided to get married. In typical lavish fashion, no expense was spared: 130 chefs were flown in from the subcontinent; VIP guests were assigned personal servants. The nuptials cost an estimated R30 million (S$2.9 million) – which would have been nobody’s business had the family not allegedly tried to hive off hotel expenses of R6.9 million as an “unspecified tax deductible” related to a dairy farm development project in Vrede, South Africa.

The Gupta-owned companies’ auditors was a Big Four firm, but investigations have discovered that it was the audit partner – an attendee at the extravagant celebrations – who had cleared the wedding expenses’ accounting treatment against the advice of his colleague. He has since been struck off for dishonesty and negligence.

But clearly, with more corporate scandals hitting headlines, auditors are soft targets facing an increasing bombardment of blame.

Bleak House for bean counters

Business models are evolving with accelerated complexity. This creates challenges in, for example, valuing intangible assets such as intellectual property rights (growing in significance in an age where the Internet and technology are the economy’s key drivers) and novel financial instruments.

That granddaddy of corporate failures, Enron, highlighted mark-to-market (MTM) accounting’s inherent risks, where present-day profits could be inflated by booking them at the contract’s signing, rather than the more traditional spreading out of revenue recognition over the contract’s life.

More recently, the Muddy Waters-Olam saga shone the spotlight on issues with valuing biological assets. Modern international accounting standards such as IAS 41 require such assets to be measured at “fair value” – another name for MTM – less costs to sell. Determining this “fair value” in turn requires the business to estimate how much the crop or animal is worth before it has been harvested or slaughtered. If the asset’s market price climbs, the business books an unrealised fair value gain. It may be counterintuitive to the lay person – although it is common practice – that such unrealised profits are added to profits that have materialised when determining the current “net profits” of the company.

According to Muddy Waters’ 2012 report, the booking of biological asset gains “encourages companies to spend money on asset purchases, with the possible result being – as in Enron Corp’s case – the asset quality becomes less important than the potential to recognise accounting gains”. The report goes on to say that “biological gains for each period are determined via an internal model that has numerous inputs that are not made public – as a result, it could be susceptible to manipulation by [the] management”. The role that auditors play in such scenarios include ensuring that management’s view on its continuing ability to sell perishables at a certain value remains well founded.

In Noble’s case, it was the trader’s fair value gains from commodities contracts that were questioned by Iceberg Research. Similar to Enron’s energy contacts, the accounting required assumptions to be made about their future performance, which leaves room for subjective judgment (or, depending on one’s perspective, creative manoeuvring). Investigations into Noble’s troubled financials, and specifically into the audit work’s appropriateness, continue. In particular, the Singapore regulators have noted that the current investigation is being undertaken “notwithstanding the clean audit opinions issued by [Noble’s] statutory auditors for financial years ended 31 December 2014, 2015 and 2016”, an indication of a key focus area of the review.

Obviously a tick-the-box approach to the audit process must be rejected, another weakness that the Enron debacle revealed. Commentators have suggested that had the US adopted the “truth and fairness” touchstone used by UK auditors, which “would allow auditors to use their judgment to override the prescriptive box-ticking rules of auditing”, Enron’s collapse might have been prevented as “it does not appear that any accounting rules were actually breached”.

Great Expectations

The million (sometimes, billion) dollar question is this: what exactly is the role of the 21st century auditor?

Traditionally the auditor’s job has been to opine on whether the company’s accounts are represented fairly in all material respects, in accordance with the financial reporting framework. But relying on judgment calls made in previous audits or on “market practice” will no longer suffice. Modern financial standards require auditors to exercise heightened professional judgement, and to this party they must bring a healthy dose of professional scepticism, challenging management’s valuations where appropriate.

But the public baying for blood whenever a corporate fails seems to be widening the goal posts even further. We now expect auditors to challenge valuations, interrogate assumptions and second-guess forecasts: in other words, underwrite the accuracy of the financial statements. Their role is morphing from financial sentry to forensic investigator; a move that will escalate professional costs.

Fairly or not, in a universe of increasing business complexity, there is an expectation that the auditor play financial guardian. For the befuddled investor staring at financial statements is – to bastardise Charles Dickens’ words – to have everything before us, and nothing before us.