What is the point of an audit?

6th Nov '15 by twhasleh

19 comments 8560 reads

I write as a chartered accountant and registered auditor who has lost money on Globo having invested in September this year. I took the view that the fundamentals looked really good - low P/E and PEG ratios, good growth, net cash, stong value and quality ranks, very high Magic Formula Score, reasonable Pitrowski and Altman scores, broker upgrades and rated a strong buy by the 2 brokers.

Why did I ignore the negative posts on this and other forums? Firstly, there usually seem to be equal numbers of bull and bear posts so I took them with a bit of pinch of salt. But the main reason was that the accounts are audited by a reputable firm of auditors - Grant Thornton. As an auditor I know that an audit is not designed to detect fraud, and is only designed to state whether the accounts are materially accurate and present a true and fair view of the state of affairs of ths business. Before making an investment, and with the negative posts in mind, I did download the 31 December 2014 accounts and did check the audit report. The company was given a clean bill of health. It appears to me now that these accounts were materially inaccurate and did not present a true and fair view of the state of affairs of the company and I am somewhat bemused how such an apparently large fraud was missed.

Am I just gullible and naive? Clearly so, but hopefully I have learned a lesson that is something looks too good to be true then it almost certianly is!

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janebolacha

6th Nov '15

What I find most puzzling in the Globo saga is the apparent disappearance of the cash balances which were shown on the balance sheet year after year. I take what you say that the audit is not designed to detect fraud but cash balances are surely the easiest things in the world to verify. The large international firms of auditors must have branch or affiliate offices in just about every country; sending one local staff personally to the banks concerned ought to be all that's needed. I do hope they did not rely solely on copies of bank statements, something which could perhaps be forged or manipulated quite easily. In this particular case, it really does seem to me that the auditors do have serious questions to answer.

Tom Firth

From my audit experience, all evidence for bank balances is obtained directly from the bank itself.

No staff member is sent to visit the bank though. Rather, banks have a department which deals with audit confirmation requests and so on. The audit team will send a request letter to the bank, detailing which accounts and on what date they would like to see balances for.

These balances are then agreed to the physical bank statements at the client's office which are in turn agreed into the relevant nominal ledger accounts/reconciliations.

Exactly as you say it is a very easy process (if slow in waiting for the bank to respond!) and there is no margin for error. Any difference is defined as qualitatively material regardless of the quantitative materiality level set. Really basic stuff so I am keen to hear Grant Thornton's explanation of this too...

cig

Just guessing here, but the previous auditors' resignation RNS included something about disagreement about "component auditors" presumably at the stage of consolidating the audited accounts of private subsidiaries in funny countries. Maybe Grant Thornton was more tolerant here and took them at face value.

Bank balances: I'm not sure I'd trust say Greek banks if the account holder is an oligarchy insider in good terms with oligarchy insiders running them, not necessarily through outright lies, but they can make deals off balance sheet: e.g. you lend me a 50m cash balance for audit week, and I park my 50m yacht at your private port as collateral, we swap back cash and yacht after the audit.

Monty9

I am also a chartered accountant and though I have done no auditing since 1981 I have worked since then in various roles in SME software and financial services businesses. I have also lost money on Globo having held for around 3 years at a cost of about 28p. All credit to Paul Scott who could not be accused on sitting on the fence - he called it spot on, and with considerable confidence. A number of other investors with a vey good record in SME investment have also lost money, for me, as for them, the outcome was not obvious and even now I am really curious to understand exactly how the apparent fraud was pulled off, and for how long it had been going on.

I felt the optimism in the accounts was measurable to a large extent, for e.g. one could adjust the overhead capitalisation vs amortisation of development costs; check the debtors were collected albeit on a longer cycle than many are comfortable with. The one area that did worry me was the "Other current assets" about EUR34M of which was accrued income. Given the income categories that could produce accrued income, very little of the last 6 months and prior period turnover had been invoiced recently. For what it's worth my personal guess is that pretty much all the bogus business will be found lurking in this balance sheet item.

The reason I nevertheless held on was that the net cash balance was slightly increasing despite the rapid increase in (reported) income, which would normally consume cash. I.e. the business was profitable even if less than the accounts showed, and the price was easily justified by even a breakeven P&L. I suppose its possible the interim cash balances were mis-stated but my view was that it would be unlikely as it would only gain 6 months until the formal audit. There are many things on which it is unwise to rely on audit for confirmation but the cash at bank process is pretty robust (I have just read janebolacha and Tom Firth's posts and agree with both). If the cash balance was cooked that will be most interesting to learn about and an salutory lesson for investors. Perhaps the bank balances reported (but not the rest of the accounts) in interim statements should be audited for AIM and listed companies. If the reported cash figures are correct it seems there was a viable and growing business that has been totally destroyed by an over powerful, impatient, over ambitions, CEO, who had little regard for the truth or the faith others had put in him, as much the staff as those that backed him financially.

It is tempting to say I am chasened and will avoid such cases in future but most of my modest success has been derived from buying into situations others are avoiding, so I will continue to take risks and suffer the occasional loss. Remember it is also easy to loose 70% on a pre profit AIM stock without any fraud taking place (I do admit I was mad to buy Tungsten). What I have resolved to do is try much harder to break my own bull case when those around me, whose views I have learned to respect, are calling it the other way.

Ho hum - onwards and upwards, but probably not in a straight line....

Mark Carter

One thing that I think is really valuable is to look at the duds. Ian Smith wrote a good article on Globo: "GLOBO - What the Professional Analysts Missed" (http://www.grindertraderuk.com/blog/globo-what-the-professional-analysts-missed)

Paul Scott also has an eye for frauds, so it's worthwhile reviewing his Small Cap Value Reports.

Keep dissecting, and you'll get there.

The partners involved must have been more tolerant! Not exactly ticking the professional scepticism box there though...

I'm not sure I'd trust the Greek banks either but I can't see evidence in the accounts (after a quick glance) of where the cash was held. If a large cash balance was transferred before audit week as you say though, that should have been picked up as part of testing for 'large and unusual' transactions. Again, this should be easy to do as the bank statements (which are supposed to be scanned manually in addition to electronic nominal ledger data being reviewed) would then show a large 50m balance come in and the obvious question should then be, what's this for?

Another way this could have happened is through manipulation of the bank reconciliation. The numbers shown in the accounts are, after all, the nominal ledger balances in the accounting system, not the cash actually in the bank on that date.

This is done in order to represent the true financial position at year end. For example, if the company pays an amount by cheque the day before year end, this won't show in the bank account but the money no longer belongs to the company so we should deduct it from the bank balance shown.

The reverse could be the case here. A false reconciling item of cash due to Globo could artificially inflate the bank balance at year end. Again though, this should be easy to pick up on as the bank rec should be reviewed in full and any money due should then be agreed to invoice as well as checking the bank statements in the months following year end to confirm the cash came in.

We know that Globo have inflated debtors that never turn into cash...could they have been keeping some large debtors on the bank reconciliation too in order to artificially inflate reported cash balances?

Flackwell

Surely the other area to focus on is the concentration of sales to a limited number of customers (given the accusation a material proportion were routed to 'sister' companies etc)

And whilst the auditors imo have an irrefutable responsibility here, what on earth were the other directors paid for ?

dmjram

There is a very simple test which the auditors failed (again!) - why would a company claiming to have many, many millions in the bank be attempting to raise cash via a junk bond issue at a very high interest rate? Are they incompetent or fraudsters are the only two possible explanations.

From memory, this was also the case with Parmalat. Who were also audited by GT I think.

The Parmalat fraud for those interested - a similar tale to Globo. Claimed to have $3.95bn of cash at the same time as trying to sell bonds for $300m. They were caught out after the auditor changed from GT to Deloitte who became suspicious.

http://www.ukessays.co.uk/essays/accounting/parmalat-accounting-scandal.php

The grindertrader blog sets out a very interesting approach to avoiding, or at least being aware of, high risk situations. Thanks for the link.

GT (Grant Thornton). That name keeps cropping up. It seems to be overdue for some well-earned reputational damage.

GrindertraderUK

Thanks Mark for the kind mention :)

Paul Scott

7th Nov '15

Well I failed my Chartered Accountancy final exams, because I preferred to spend my time in the early 1990s in nightclubs, boozing, taking E's, and disco dancing!

Yet I seem to be one of the few people who can spot frauds about 2-3 years in advance!

So I must have picked up the good bits during my accountancy course, and passed out during the bits that made everyone else useless slaves to the bent system!?

Cheese! PP.

mpat89

8th Nov '15

I spy that someone posting here works for GT! Spill the beans on what went wrong..?!

In all seriousness, the international networks, i.e. GT.gr are not the same as the UK firms. GT maybe a reputable firm in the UK(?), but not at all the same firm as GT.gr, so the reputation and reliability of their audits would need to be assessed separately. (Unarguably the firms are associated)

Given the previous auditors' resignation, it seems likely that GT.gr were willing to do less work on the components (subsidiaries), maybe to have a "prestigious" listed company on their list of clients.

It's likely the components were able to use sufficiently small firms (i.e. partners who allowed financial gain to effect their integrity) to sign off on reporting packs with falsified or questionable asset balances, including cash. So it's entirely possible GT.gr weren't even fully aware, although it's still impossible to argue as they would have naturally exercised skepticism.

AlanJenkins2

I have lost money on a number of Chinese companies that had been reversed into US companies and traded on the US markets.A large proportion of them were proven to be frauds.I did make money on one of them - Xinyuan Real Estate - which had a really good firm of auditors and was [and still is] traded on the NYSE. However,its shares have fallen substantially since I sold them.
My point here is that buying shares which look too cheap to be true because there is some sort of question mark over them invariably tends to be a losing proposition - no matter how good their auditors are.I would except from that category only cases where you actually know what the trouble is [for example,when BP were likely to be fined].

roque22x

9th Nov '15

The bottom line as i see it is that we rely a lot on the expertise of auditors to check accounts. Are they not supposed to be the check mechanism for authenticity and reliability of accounts. If this is failing on such a massive level then in these cases an independent examining body should check that accounts were audited correctly and recommendations where failures were found so that these failures can be minimised. If auditors cannot spot anomalies then what is the point of an audit? Will measures been put into place to avoid similar cases or do we just accept the imperfection of the system? I am not saying that the auditors necessarily did a bad job as we do not know the facts and the system may have failed.My view is that each such case presents an opportunity to review procedures and requirements.

Mark Halliwell

10th Nov '15

One of the issues in terms of the cash may be that the Administrators (as I understand to date) are just appointed over the PLC.

The PLC looks as though it has lent money to its subsidiary foreign companies and so the cash sits in the subsidiaries' accounts and not in the PLC - see the Company (as opposed to Consolidated) balance sheet of the PLC at December 2014 which reveals cEuro7m in cash and cEuro129m receivables

Barclays took a charge in June 2015 over what appear to be the accounts of the PLC and Globo Mobile SA with UBS in London to secure Euro 65m of lending in 2013 - one assumes they (Barclays) must know where the cash is??

It begs the question why the PLC (Administrators) can't demand repayment and exercise security over the group............

Elaine Medina

21st Nov '19

This comment is under review

I agree

What is the point of an audit?

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Twhasleh

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