What is the point of an audit?

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KPMG is in the news again for the competency of its audit standards over the collapse of Carillion. KPMG has previously been criticised over its audit of HBOS, Co-op and Rolls Royce. Arthur Anderson collapsed after its audit of Enron.

There are clearly issues around auditing standards but let’s be absolutely clear on one thing. It is the responsibility of company directors to ensure the accuracy and relevance of the published financial statements of their companies and to give an informed opinion of the future prospects of the business. For too long directors have hidden behind the role of auditors and sought to gloss over the short comings of their businesses. Directors who exaggerate the strength of their businesses in the Directors Report whilst being in possession of management forecasts which should fully show the future risks the business faces should be the ones that incur the ire of shareholders and not the auditors who will never be fully informed of all aspects of the business. It is entirely the responsibility of the directors to keep informed their shareholders and other stakeholders of the sustainability of the business and what actions they intend to take to maintain the business and its profitability. An audit shows a degree of compliance within the law of the preparation of the company financial statements. It contains an outsiders opinion on the short term sustainability of the business based on the numbers prepared by the Directors and the comments and opinions of those Directors. Beyond that the audit does not claim much else. If shareholders wish to elevate auditors to watch dogs then big changes would be needed.

Firstly, auditors would need to be independent of the company. Currently businesses appoint auditors and pay their fees. Much as Credit Ratings agents were paid by those seeking to get a rating this conflict of interest gives rise to a risk that auditors will err on the side of Directors opinion when it comes to explanations of the accounting data. Would the state take over the cost of company audits? Would companies need to be charged an audit levy to cover the cost? Who would set the price of audit services for each company?

Secondly, auditors would need to be safe from prosecution by companies where an audit opinion is given which damages the audited shareholder value of a company. Since business failure risk can never be 100% certain auditors would be required to give some subjective view of a company’s future potential performance. In nearly all cases this view would be wrong due to circumstances changing with time. An opinion given in January would almost certainly have changed by March if not sooner. Only company Directors and managers can fully be aware of the day to day changes in a Company’s fortunes. Many complete basket cases are rescued by either private or state intervention and it would be impossible for an auditor to comment with any certainty on the likelihood of such a future event or any other crystal ball type occurrence. How for example would an auditor rate the possibility of banks continuing or not continuing to support a business.

Audit opinion would become a major factor in market valuations which could cause big falls in share prices based on unsubstantiated views and those shareholders would be even more irate at the inadequacy of audit opinion then they are now.

It is clear even on just these two factors that it is almost impossible to create a foolproof audit system which captures the potential for business failure within the audit process. It is possible to criticise an audit opinion as being of limited value in evaluating the viability of a business. This criticism is perfectly valid and less emphasis should be paid to audit opinion. Auditors are not watchdogs and cannot be held responsible for not spotting failure any more than racing tipsters can be held responsible for not picking winners.

My view is that shareholders only ever consider the Audit Report when a business fails and largely ignore it up until that point. Shareholders put their faith in the statements of management and Directors when it comes to investment decisions and it is the management and Directors who should take responsibility when businesses fail.

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Politics is about story and narrative not economics

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Many believe that economics and the economy in general lead the political agenda. Economists have developed ever more complex mathematical theories in order to “prove” how society works and benefits from progress. Policy is formed from these economic insights.

But that is not how it works. Political parties have a set narrative and then seek justification for that narrative as a support to the story they want to tell. The story leads and facts and theories are sought to justify the policy narrative.

In the 80’s both Margaret Thatcher and Ronald Reagan had a narrative based around small government and individualism. Little matter that the size of government grew substantially over the period the story that the electorate wanted to believe was the one projected. To support the policy academics such as Hayek, Milton Friedman and the Chicago School of economics were pressed into service to give the narrative some gravitas but their theories followed the dynamic of the storyline offered by the politicians. There were many opposing economic theories to the monetarism of the day which could have supported a counter narrative. In many respect the political narrative came from an intuitive belief held by the chief protagonists. It was a gut view not one supported by hard evidence.

More recently Donald Trump gained success based on a narrative reasserting former national greatness and the resurrection of rust belt industries aimed at reinvigorating working class fortunes. The story is enhanced by a form a scapegoating of foreigners as being the source for the decline in working class fortunes whether that is Mexican immigration or a story of Chinese manipulation of world trade to the detriment of the US. There is no factual basis for these assertions but that does not matter. What matters is that the narrative is believable to those to whom it is aimed at. Trump has not sort to justify his position with any intellectual rigour or economic theory. His Presidency relies solely on his story narrative.

In the UK too we have Brexit. The leave campaign told a narrative that appealed to a large portion of the electorate. This narrative was one, like Trump’s, based on a story of former greatness now lost due to the unwelcome embrace of foreign powers taking away the sovereignty of the nation. As humans we are more susceptible to a story narrative than something based around numbers. The remain campaign lead with dry numbers and economic data in an attempt to show that economically leaving would be a mistake. But this was a mistake. We are a species of story tellers not mathematicians. There can be little doubt that on balance leaving will be economically detrimental but for voters that didn’t matter. What mattered was the affirmation of national pride and the promotion of a golden future free from foreign interference. The fact that the world does not work in this way did not matter. The narrative of the story was something the voter wanted to believe in irrespective of any counter narrative based on purported facts or economic numbers. The leave campaign found it easy to bat away these facts as “project fear” a narrative easily understood by voters who supported the central story of lost national power and lost cultural identity caused by immigration.

The way forward for politicians is clear. Have a strong spoken narrative for your policies otherwise voters will not connect with the message however strong the academic evidence backing it up.

For economics too the need to project a strong narrative outweighs the cleverness of the mathematical proposition. Only when economists grasp the fact that their discipline is only useful if people understand the story will it become truly relevant to our society.

Why the referendum on Europe has fundamentally damaged British democracy

 

There is much debate about a second referendum on whether Britain should leave Europe. Those on the leave side consider such an event to be tantamount to treason and unconstitutional. The argument is that the people have spoken and their view is that Britain should leave. Any attempt to amend that is unlawful and unconstitutional. It is arguable that referendums themselves are unconstitutional in that they bypass the sovereignty of Parliament. Curiously that sovereignty is one of the rights the leave camp are claiming to recover from Europe.

Many resist the potential for a second referendum principally because they fear the result could be reversed. This view that a second referendum could produce a different result stems from fear. If, as many claim, the British public are steadfast in their desire to leave Europe there should be no fear in holding a second vote. The people would simply re-affirm their original choice or even strengthen their vote given the strength of conviction the leave politicians insist is the preference of the Country.

The reality is that the fear of the leave politicians is genuine. They realise, but are unwilling to say, that the likely result of a second referendum is that there could be a majority which would vote to stay within Europe. The narrowness of the first vote and the absence of over a third of the potential voters puts a narrow win to remain highly likely. In such an event would the leavers consider that result to be a representation of the ‘will of the people’ or the theft of their legitimately expressed view exercised in the first referendum. Many would say that it is a typical move by politicians where the result doesn’t correspond to what they want to keep having a vote until they get the result they want.

The view of leavers is that the first result represents the ‘will of the people’ as expressed by a democratically held vote and that choice as expressed in that vote should be respected. The problem arises in that a second referendum vote would be no less a reflection of the democratically held views of the electorate. Any number of referendums have the same legitimacy as every other referendum and so it is a fallacy to hold up a single vote as being the sole will of the electorate. That is why historically referendums have not been resorted to in British politics. Prior to 1975 there had never been a UK wide referendum. Since 1975 their have been a number of other referendums but only two other UK wide votes, one on the voting system itself and of course one on membership of the European Union. The conclusiveness of the vote in the other two votes has been more decisive but this is tempered by lower turnout in both those votes suggesting the EU vote was of greater concern to a higher number of voters this time around.

Referendums are good at obtaining voter opinion on simple binary questions. What they are very bad at is answering complex questions especially where information regarding the consequences of those questions are either scarce, distorted or hard to predict. Political votes are seldom clear black or white choices. It is only now after the decision to leave the EU that a proper discussion is being held as to what the consequences will be. This debate highlights the foolhardiness of making complex decisions based on a simple binary yes/no vote where emotion takes a prominent position fanned by exaggerated and partisan opinions lacking a proper factual analysis both in the press and from politicians. The Cameron government clearly grossly miscalculated voter attitudes to Europe in a vain attempt to squash internal Conservative Party discontent and to shore up his own personal position within the party. Mrs May made a similar miscalculation in her decision to call a General Election again over European issues.

The referendum on Europe has done irreparable damage to the UK constitution. Cabinet collective responsibility is undermined when it is clear that so many within cabinet disagree fundamentally with decisions being taken on Brexit for whichever side. Cabinet Ministers brief in the press their personally held views against the Government held position. This is clearly counter to the principle of collective responsibility.

Parliamentary sovereignty has been undermined when David Cameron gave a cast iron guarantee of a referendum and then creating a virtual fait acomplis that the vote would be binding on Parliament even though the majority of parliamentarians disagreed with the vote against leaving the EU. At the time it is arguable if the UK public held strong views on the issue at all and that the referendum was actually forced on Cameron by discontent within his own party and a section of the press with an ongoing rabid dislike of Europe coupled with an erosion at the extreme edges of the Conservative vote resulting in a shift towards more extreme views held by UKIP. At no point was UKIP ever a serious political movement only ever having 1 seat at Westminster and for the Conservative Party to use the political expedient of the referendum to shore up its own flagging vote is a dishonest use of the parliamentary system which effectively took the decision making process away from parliament.

Discontent with Europe will not be removed once the UK leaves the EU. It will only take one rejection of UK goods due to non-compliance of EU standards or an increase in water or energy prices instigated by a European owned water or energy company to stimulate the headlines in the tabloid press about the iniquity of perfidious europeans. The only difference now will be that the UK will have no say in European issues beyond that of a lobbyist. Our political parties will be riven by discontent caused by the polarisation of views over Europe for years to come unless, as the leavers proclaim, the UK will sail off into the sunny uplands of economic prosperity now that the country is released from the constraints of European bureaucracy and the crippling costs of supporting French agriculture. There is little to believe that this will happen beyond the wishful thinking of a few rich businessmen who see the opportunities for themselves. The economic boom wasn’t there in the 1970’s when we begged to join the EU and there isn’t any reason to believe the UK is in a stronger world position now.

The Art of the deal – A way forward for Brexit

 

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Brexit negotiations continue to stumble along in an inconclusive and chaotic manner. The European Commission refuses to countenance opening up trade talks until the UK agrees how much it will pay to leave the club. The UK negotiators seem incapable of coming up with a figure and to a certain extent that is understandable because the price paid to leave will effect the concessions both are willing to concede on any subsequent trade agreement. It is also understandable that the EU does not want to lose out on funding it had expected to receive to cover planned projects. Germany in particular would want this resolved as in all likelihood it would be Germany that would shoulder the lions share of this extra cost.

So here is the dilemma. The UK electorate expects a substantial saving on contributions to the EU and it expects them immediately. The EU in contrast expects to maintain the UK contribution. These two positions are not reconcilable.

The Government negotiators tell us that in any negotiation you never show your hand otherwise you are simply giving away your position to the other side and so the negotiations become mired in stalemate. This is madness. In any negotiation there is always a position which can be stated around which negotiations can take place. It is a fallacy to imply that talks can only revolve around secrecy and guess work. The UK Government does not have to comply with the notion that nothing can be said about trade until the divorce bill has been settled. That is the EU position. The UK can make a positive step and set out what it wants from Brexit and what in principle it is willing to pay for it. That is how negotiations work. One side sets an agenda and talks move toward consensus. It also allows Parliament to comment on the position being taken by the UK Government which seems only right given that any deal will impact all future governments.

Here is one possible set of broad principles around which negotiations could take place.

1. The UK agrees to the free movement of goods and services on a tariff free basis from the EU. (This seems reasonable in that there seems to be no disagreement that foregoing this is detrimental to both the EU and the UK)

2. The UK agrees to the free movement of Irish nationals between Ireland and Northern Ireland and the rest of the UK. (This seems feasible to allow Irish EU passport holders to enter the UK as present and should be easy to implement. Many countries allow entry without visa requirements. This measure and 1 above would remove the Irish border issue.)

3. Other EU nationals will be subject to UK immigration laws and regulations. (These laws and requirements would need to be fleshed out but this measure is necessary as immigration was probably the main issue in the referendum along with the source of lawmaking.)

4. EU nationals currently legitimately resident in the UK will be granted permanent rights to remain and be treated in the same way as UK nationals either by dual nationality status or visa rights, to be determined.

5. The UK agrees to maintain compliance of EU safety standards on goods including any regulations applying to food safety. The UK could not therefore export non compliant food stuffs to Europe although it would be free to import them should the UK choose. (This would need to happen in order that free movement of goods and services could continue. It also seems rather pointless to have different standards for the UK and Europe.)

6. The UK will incorporate EU law into UK law where it is considered appropriate and of sound value. The UK as a sovereign nation shall not be obliged to adopt EU laws. (This would allow for legal harmonisation where possible but would still grant sovereign rights to the UK with the ability not to implement EU law if after appropriate scrutiny the UK decided it was not appropriate.)

7. The UK will pay a contribution towards the EU budget to cover its share of costs relating to Europe wide initiatives on policing, counter terrorism, safety standards and other mutually beneficial policies. This would be open to negotiation but could be in the region of £4bn to £6bn annually. The UK will not pay a penalty fee to exit but will agree to the annual payment. (It would be fair for the UK to continue making some contribution to the EU budget to cover mutually beneficial joint policies and access to the market place.)

In return for the above the UK would want the following;

1. The free movement of goods and services from the UK to the EU bloc on a tariff free basis.

2. The free movement of UK citizens to and within the European Union. (Some will argue that if the UK doesn’t grant reciprocal rights why should the EU grant this. Since the EU advocates that free movement is beneficial to the EU it should acknowledge that this benefit still exists and the EU would be foolish to punish itself. It is UK that is losing out in its mind.)

3. The UK would be free to negotiate with non-EU countries the basis of its relations with them especially with regard to trade.

4. UK courts and Parliament will be the sole arbiter of UK law, although consideration will be given to the implementation of EU law where appropriate.

5 The UK will be granted a transition period to allow for the smooth transition to new arrangements.

No doubt there will be many arguments against the above but it does set out a position around which negotiations can take place and to allow for UK Parliamentary discussion of the primary aims of the UK in its negotiating stance with Europe. What shouldn’t be allowed to continue is the mist of uncertainty over what the UK position is. There can be no negotiation unless one or other of the parties sets out terms around which the negotiations can be held. Too much time has already been wasted in secrecy in the mistaken belief that only by withholding information from the respective electorates will solutions be found. That is a recipe for disaster.

Move C 4 – Be sure, be very sure

 

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It is a laudable ambition for government to seek to increase the employment and economic prosperity of the nation outside of London and the South East but is it a good idea to initiate policies that will not increase the overall GDP of the country to the detriment of London?

There is nothing which ties television broadcasting or television production to any geographic location but unless moving Channel 4 provides a boost to either industry as a whole then should the move be contemplated?

The current consultation regarding a relocation of Channel 4 would appear to be falling into the idea of relocating some staff and at the same time increasing the proportion of production spend away from London and towards the regions.

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There is no suggestion that new money will be used for these purposes but simply a reallocation in percentage terms of the existing Channel 4 resources. Both of the proposal to relocate staff and to reallocate funds to non London Indies will have a negative impact on those individuals having to relocate or having to change jobs because they are unable or unwilling to relocate and on those London based production companies who are currently in receipt of the Channel 4 commissioning spend which will be reallocated to the regions.

The suggestion by PACT, to the detriment of PACT’S London membership, that Channel 4 should spend 50% of its commissioning budget outside of London would mean a further £51 million being allocated to the regions based on current figures. Such a sum would have a significant impact on the London based producers this funding would be switched away from. Many of these producers are small and rely heavily on Channel 4 commissioning. Would there be safeguards to protect the funding of smaller London based independent producers? There are no guarantees. Is there any justification in seriously effecting producers, their employees and their freelance contractors simply on the basis of a political decision?

There is also a danger that this policy would produce false regionality. There are numerous instances currently of London based producers making “regional productions” and complying with two of the three current requirements to qualify for a regional production. Whilst satisfying the rules is this really within the spirit intended? Perhaps a better solution for Channel 4 would be to ensure that all its current regional funding was properly allocated to bona fide regional companies. If the same were also the case for other broadcasters then the total injection of funds into the regions would be substantial and make any other changes unnecessary.

I would question whether it is fair, within an industry that has thrived organically and grown in a strategic location naturally, that changes should be implemented in an arbitrary and politically motivated manner to the detriment of those individuals who are having their livelihoods effected. Politically it seems odd that a Conservative lead government should seek to interfere in the workings of the market for television when such moves would be anathema in any other market. Reallocating resources to the regions would not in itself provide a boost to the industry as a whole but simply a redistribution from one area to another. Neither is there any guarantee that Channel 4’s output would be more “regional” or representative of the diverse regions of Britain. Has anyone noticed any difference in regional culture relating to BBC output produced in Salford? I would say it is the same as it always was.

Viewers are largely ambivalent about the regionality of the programmes they watch preferring to base their choices on a quality threshold rather than where the show is produced or broadcast. Attempts at setting up regional city franchises following the lead of Jeremy Hunt have failed. ITV which was established as a grouping of regionally based franchises has consolidated into a London based company despite the initial push towards consolidation being undertaken by Granada a well established North West based broadcaster and producer.

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Neither television production nor broadcasting is akin to opening a shop in the high street where locals will go to buy their television needs. Neither is television like other entertainment forms in which nascent practitioners can practise their skills locally. Actors, musicians, visual artists and even chefs can all develop their skills in a local market place. This allows a local market to develop in theatre, music and gallery spaces. The same is not true for television. Having local workers does not produce a local industry.

Television has increasingly become global both in output and in who owns it. Viewers enjoy Scandinavian drama, US reality shows and global news networks as well as home grown fare. British originated television needs to compete in that global marketplace both at home and abroad. Large international broadcasting companies will pay big money to get hold of the best programming, featuring the most expensive talent both in front and behind the camera. Removing Channel 4 from London will not give it any competitive advantage over London based rivals and will in all probability mean that Channel 4 will need to invest heavily to create a regionally based broadcaster of similar size to its rivals, money it does not have and will not be given.

The other strand of the strategy is to force Channel 4 to spend more of its production budget outside of the M25 in order to boost regional production. Where should these funds be allocated? It could be made available to all regional producers but such a broad brush strategy will do little to boost any particular region and the thinness of the spread would benefit no one in the end. That leaves investing the funds in one or perhaps two areas in attempt to create a regional super producer. The investment would allow a single company to invest in training and development given that it could be given a more secure income. A longer term commitment would need to be given until such time as the company was a size that would allow it to compete with the largest of the UK’s current producers. Such a strategy could work but would no doubt incur the ire of those regional producers not favoured by an injection of funds. It would also require a long term commitment to a single company something which any future government could easily reverse.

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Moving Channel 4 will not significantly change the broadcasting or production landscape of the UK. Neither will it dramatically boost regional economies or employment. Uprooting 850 or in all probability fewer jobs from London to somewhere will have an effect on the chosen region but it will be only one region and may only be temporary. To make a political decision which adversely affects the lives of individuals it is important to be sure, absolutely sure that the decision will in the long run have beneficial effects for the totality of the industry. I don’t believe that surety is there. To move a broadcasting business away from its London hub needs proper consideration. Other broadcasters are not going to move. ITV, BBC, Sky, Discovery and Liberty Global will remain in their London bases leaving Channel 4 potentially isolated.

Is there a realistic case for moving Channel 4? I think not.

The Three Accounting Essentials for the Profitable Financial Management of any Business

 

There are only three things any successful business needs to focus on from an accounting perspective everything else is hot air and window dressing.

Number 1 – CASH

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By far the most important element is cash. Every business owner and manager must pay attention to and acquire knowledge of the business cash position at any given time and make reasonable predictions of future positions. Cash is the blood of the business coursing around the body and keeping it alive and well. With a little thought and a spreadsheet it is possible to estimate cash income and outgoings on a weekly, monthly and annual basis. Continual monitoring of the cash position will allow any business to maintain a cash buffer against unknown shocks and allow investment and business planning decisions to be made. Long term positive cash accumulation on its own will ensure profitability and being aware of potential problems early means corrective decisions can be made in time. Every element of the business can be reduced down to cash including financing of investments and other capital items, dividend payments to shareholders and tax payments. Cash encompasses all aspects of the business so a sound understanding of where it comes from and what it is being used for is essential.

Number 2 – MARGIN

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The second thing to focus on is Gross Profit Margin. This is simply the difference between what it costs to produce the product or service and the price it is sold for net of Vat elements. The easiest way to track this is as a percentage. Take the total margin and divide by the total sales to give a Gross Profit Margin percentage. The higher this is the better. Monitoring the margin will show improvements or falls in the profitability of the products produced by the business, allow pricing decisions to be made and make decisions regarding the costs of production. If the margin is too low it will show that it is uneconomic to be in that market and the business can decide to cut costs, increase price or exit the market all together.

Number 3 – OVERHEADS

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The third and final essential element are overheads. These are all the other pre-tax costs deducted from the total margin to give a profit number. Every pound (or dollar, yen, euro etc) saved on overheads drops straight to the bottom line. That is why cutting these costs is so beloved by businesses acquiring other businesses. Reducing overheads is the quickest and in most respects the simplest way to increase profits. Overheads have a habit of creeping up over time slowly eroding the profitability of the business unless they are routinely monitored. Cutting out non essential costs is a sure route to profitability.

Of course there is more to running a business than finance and accounting so focus on these essentials and you will have more time to deal with manufacturing, sales, marketing and finding the right people to make your business fly instead of fretting over complex KPI’s.

The World Is Messy

 The world is an inherently messy place. President Trump’s attempt to take on the mantle of organiser is doomed to failure because it is an impossible task. Unless he takes on board the knowledge that he will not be able to fulfil the role of America’s,let alone the world’s CEO then his term in office will prove to be personally frustrating for him and a political failure.
The fact that the world is messy was something Barrack Obama well understood and that the best he could hope to achieve were small steps in social improvement. He realised that to strive to improve the world for Americans was laudable but that in all probability the majority of these attempts would fail.  This was one of his great strengths as it was for that other great black leader Nelson Mandela. That small steps were progress to greater ones.
Societal changes shift forward and back in small increments ordinarily. Granted there have been cataclysmic events in the past. World wars and revolutions throughout the globe and through history have altered political regimes, when personal ambition of political leaders have galvanised a mass response from a disaffected populous. But it is arguable that any of these convulsions have brought about the beneficial changes sought beyond what would have arisen from the simple passage of time. Many it might be said have held back progress due to the wanton destruction of people and the ideas they could have produced.
In the UK too our political and economic future will be messy. We will continue to be part of the European Union and it will continue to impact on our lives even when we as a nation are no longer formal members. Those that believe that hard,soft or even slightly squishy Brexit will bring about a clean and decisive end to our interaction with Europe will be disappointed. The playing conditions might change slightly but the game will continue. The balance of probability is that the frustrating nil nil draw of the first half will be repeated in the second.
None of this is to say we shouldn’t try to improve our world. Far from it. It is important that ideas are experimented with and built upon, discarding those that fail and improving those that work.
Just do not fall into the trap that their is a quick and easy fix. That there is a grand gesture that will transform reality in an instant.
This is true whether it is Brexit, Scottish Independence or a wall at the back of your garden.