Internal audit, going concern, Jessops and the sweep of history

Posted on June 17, 2013

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flickr Cairo pyramids

An earlier version of this article appears on the ACCA e-newsletter here.

With multiple UK high-street retailers failing since Christmas 2012, it is reasonable to ask ‘where were the internal auditors?’ and ‘where was these firms’ management of risk’?  The rash of failures in a single sector raises inevitable questions about the focus of risk management and internal audit – about ‘best practice’ – in that sector.  Can these disciplines contribute to firms’ strategic debate?  If so, how?  If not, what is their real potential value?  For the answers, we must look further afield and farther in to history than most commentators presume.  For techniques, help – at least in the regulatory sense – may be closer at hand than most presuppose.

Just over a month after I was born, a young scientist with a PhD in physical chemistry from Caltech looked ten years in to the future of integrated electronics and forecast that current patterns of increase in the complexity of integrated circuitry would be maintained.  The cost reduction in circuitry, he noted,

“has increased at a rate of roughly a factor of two per year. Certainly over the short term this rate can be expected to continue, if not to increase. Over the longer term, the rate of increase is a bit more uncertain, although there is no reason to believe it will not remain nearly constant for at least 10 years.”

Gordon Moore was, at the time, head of R&D for Fairchild Camera and Instrument Corporation, a company which had begun its life in 1927 as an aircraft manufacturer. Through a complicated series of mergers and acquisitions, the company of which Moore was an executive is now owned by BAE Systems.

Moore, himself, had moved on. In 1968, he founded a company that would later be Intel Corporation. It was not his first, nor was it his only, prescient action. Remarkably, the estimate he provided of growth in circuit integration in 1965, now known universally as Moore’s Law, still holds largely true almost fifty years later; in that time, processing power has increased in the region of 15 million times.  In 2011, theoretical physicist Michio Kaku noted “your cell phone today has more computing power than NASA when they put two men on the moon.”  That cellphone from 2011, incidentally, is already obsolete.

The year that Moore wrote his prophetic article in the journal Electronics, a young New Yorker and journalist wrote an article for the arts magazine Horizon titled “The future as a way of life.” The author extended the ideas in the article in to a book published in 1970 that sold 6 million copies under the far catchier title of Future Shock.

In 1980, as a teenager, I read two books that would prove influential on my understanding of the world.  The first, Joseph Heller’s satiric masterpiece, Catch-22, shaped my views on the absurdity of war and the nature of bureaucracy; views that persist to this day.  The other, fresh off the bookstands, was Alvin Toffler’s second book, The Third Wave. In that book, Toffler traced the development of systems of production and distribution from man’s earliest settlements and agricultural production in the Neolithic era around 12,000 years ago – the agrarian revolution; ‘the first wave’.  Life and production systems remained largely unchanged until the confluence of a series of events in Europe beginning in the fifteenth century.  Strasbourg, which has changed hands many times as wars raged back on forth over Europe and is now the official seat of the European Parliament, was at the centre of those events.

The old Roman fortified town of Strasbourg had played a role as a major commercial centre during the period of the Holy Roman Empire but, following a revolution in 1332, was a free republic which it remained until 1681 when it was seized by Louis XIV, le Roi Soleil.  In the 1440s, Strasbourg’s cathedral’s new north tower was completed.  It would later become the tallest building in the world following a fire in the cathedral in Straslund on Germany’s Baltic Coast in 1647.  Straslund held the record following the collapse of the spire at Lincoln Cathedral and the destruction by lightning of the spire of Old St Paul’s Cathedral in London. Old St Paul’s, consecrated in 1240, was the world’s tallest building, overtaking the pyramid of Giza which had held the record for almost 3,700 years.  Lincoln Cathedral held the record for almost 250 years until the collapse of its spire; a taller building was not constructed until Ulm Minster in 1890.  A mere 11 years later, Ulm Minster was surpassed by the Philadelphia City Hall, the first secular building to hold the record.

Just as the Strasbourg Cathedral tower was being completed in 1439, a German blacksmith, Johannes Gutenberg, developed the mechanical, moveable-type printing press. In a little over 20 years, this technology and the ensuing communication revolution swept Europe, eliminating an industry in the process and transforming the role and focus of monastic life and the power of the monastic orders.  Gutenberg’s innovation radically reduced the price of books and increased both the pace and speed, as well as the accuracy, of the spread of knowledge, hiking literacy rates and setting the scene for the Renaissance and the Enlightenment that were to follow.

Some 260 years later, a young English gentleman and later a lawyer, Jethro Tull, patented the seed drill in 1703.  It was rapidly and enthusiastically adopted throughout England, along with other of Tull’s pioneering technologies and improved land management, improving agricultural productivity by an estimated 50% in just over 100 years. The capital accumulation this supported financed the coming industrial revolution, the second of Toffler’s major productive revolutions, his ‘second wave’.

Improving the production of cotton in mills, improved canal-based transportation and greater navigation systems in international waters all played their part in the industrial revolution, but the crowning achievement was the steam engine, developed in the 1770s by a English engineer, James Watt, who improved on an earlier design, also of English origin.  The change to production systems, labour and consumption patterns changed life almost as radically as had the agrarian revolution – the first wave – before it.  The economic, technological and social changes ushered in by the industrial era changed irrevocably the patterns of earlier, agricultural life leading to massive urbanization and accelerating the shift in power between the land-owing aristocracy and merchants and mill owners.

Despite the upheaval of two world wars in what was certainly man’s bloodiest century to date, the productive and social patterns of the industrial era continued largely unchallenged until the 1960s, albeit with enormous increases in productivity through improved mechanization, organisation and knowledge and greatly-improved levels of sanitation, education and general welfare.

Then along came Gordon Moore.  And Toffler’s third revolution, the ‘third wave’; the information era; the digital era.

While we all live with more gadgets in our lives, the massive social and economic changes this ‘wave’ will induce are just beginning.  Living through such a period of change, it is easy to forget, day to day, that we are living through a fundamental shift in the nature of production and consumption and that the changes that digitized technology imposes will reach every facet of our lives and relationships – think online dating.  Just as Toffler predicted.

But that does not necessarily make the change any easier nor any easier to understand or accept.  Just ask the directors and the 2,000 employees of Jessops, or the directors and 8,500 employees of HMV or Blockbuster in the UK, each of which failed in early 2013. Indeed, since 2008, in the UK retail sectors, some 230+ firms have failed with the loss or threat of loss of over 200,000 jobs. In a sector that employs 3.1 million Britons, that represents around 6.5% of the 2008 retail workforce.

Analyses of the cause of these problems are as uniform as they are familiar:

  • —The global financial crisis and accompanying fiscal austerity have markedly reduced household purchases of non-essential items
  • —Discretionary spending is now growing most quickly in the over-65 age cohort with greatest negative financial impact of the crisis in the previously-rapidly-growing youth market
  • Home-related sectors have been hammered, with the loss of £900 million in revenue per year in the UK
  • Food and grocery businesses are experiencing growth at the expense of restaurants and bars
  • Online shopping is reducing the need for high-street presence and changing the economics of retail floor space ; retailers are having to respond to shoppers’ ‘scan-and-dash’ impulse to identify a product in-store but purchase online.

But the digital revolution is also altering the technology underlying our gadgets.  Retailers in these markets have suffered a double-whammy. My teenage daughter is music-mad but has never bought a CD; the expensive SLR camera I bought my wife in the 1990s is completely obsolete, replaced by the phone she carries with her everywhere; we hire movies online from a subscription service without leaving the sofa. Product strategies that have failed to adapt to these technological changes and changes in consumer preferences and ubiquitous media will fail, as have those of Jessops, HMV and Blockbuster.

Some mourn these losses.  HMV’s flagship Regent St store’s classical musical department brought me hours of pleasure and led me to discover the transcendence of Bach’s cantatas.  But, increasingly. I bought the CDs online, as I now buy the MP3 files.

All these stores and the firms that operated them had internal auditors.  Those internal auditors stopped fraud; they ensured inventories were accurate, they reconciled stock movement to cash, they checked executives’ expenses.  The better ones recommended improvements to sourcing arrangements and ensured market feedback was captured early in campaigns for fine-tuning.  But they did not challenge directors who were hoping, like Canute commanding the sea at Old Bosham, to turn back the tide of technological change rather than seek to adapt to it and alter their business models.  Or if they did, the directors didn’t listen.  Or if they did listen, they didn’t act.

Recently, at an ACCA forum in London, a panel of leading governance and audit experts debated the role of auditors in strategy.  I agreed with my former colleague, Jonathan Hayward, that directors simply do not want to hear these messages from internal auditors.  My company directors certainly did not want to hear such messages from me when I was an audit director (yes, in a technology-based company) in the 1990s.

But there is a light at the end of the tunnel and it has an unexpected source: the apparently arcane and technical accounting issue of ‘going concern’.  Former KPMG chairman, Colin Sharman (now Lord Sharman of Redlynch) has recently chaired a committee on behalf of the UK corporate regulator, the Financial Reporting Council, to investigate the going concern requirement.  In June 2012, the Sharman Inquiry . . .

concluded that the primary purpose [of the going-concern review] is not to inform outsiders of distress through such accounting disclosures. It is not to try and ensure that the first person to read the accounts on a Bloomberg screen gets to sell their shares, while others are left standing. Rather, it should be about the economic and financial viability of the entity. It should be to demonstrate that the directors’ stewardship of the going concern status of the entity has been effective.

As Sharman noted in his letter of transmissal to the FRC,

the aim of the directors’ assessment and reporting of going concern risks is not primarily to inform outsiders of distress. Rather, it is to ensure that the company is managed to avoid such distress, while still taking well-judged risks.

The very first paragraph of the report says it all.  The ‘going concern’ report

should not inhibit sensible risk taking that is critical to the growth and maintenance of economic activity. It cannot therefore eliminate the risk that economic or financial distress will arise or the possibility of failure. It should aim to support better risk decision-taking; ensure that investors and other stakeholders are wellprotected and informed about those risks; and sustain an environment in which directors recognise, acknowledge and respond to economic and financial distress sooner rather than later.

In particular, the Sharman Review referred to

  • establishing a common understanding of purpose, thresholds and what constitutes a going concern
  • integrating the going concern assessment with business planning and risk management

In effect, these represent the expectation that the firm will (i) establish and communicate a clear understanding of its risk tolerance and appetite over a medium-term horizon and (ii) build that understanding in to its systems for financial control.  Pure common sense.  Or it should be.  The shrieks of protest have scarcely died down in the intervening year.  The prospects for implementation of the Sharman vision by the FRC remain mixed.

If it is implemented properly (something at which UK regulators have, at best, a mixed record), the role of internal auditors will, finally, clearly and unequivocally, reach in to strategy – albeit via uncertainty, its analysis and its impact on the business plan and corporate strategy.

Just some of the activities internal auditors will need to add to their job descriptions – or audit workplans – will include:

  • validating the realism and scope of review of the going-concern assessment and the stochastic analysis on which it is based
  • monitoring obsolescence of product and productive technologies
  • ensuring horizon-scanning and marketing are picking up changes in technology and impact on production and consumption
  • avoiding concentration of income streams in specific technologies and market or user groups
  • hedging bets – assessing the real value of options to develop technologies, applications or markets

Sometimes, shifting technologies will mean that firms will succumb to the gale of creative destruction; capital will be redeployed more productively; firms will fail.  But, if detected and understood by directors early enough, shifting technologies and their impact – however far-reaching – on patterns of sourcing, production, distribution and consumption can be anticipated and firms can reposition, sometimes gaining early mover advantages in the process.

Just like the Fairchild experience in 1920s, this may involve a change of direction – in that case to the newly-emerging aviation industry – and an adaption of the use of the firm’s core competencies.  New competencies may be needed.  That’s the inventive genius of capitalism.  There is time to reflect on these changes and make the (sometimes hard) decisions needed.  But the pace of change is accelerating and, even with Toffler’s sage counsel in our minds, we do not know where it will end or what will emerge from the ‘third wave’.  Awareness and alertness are invaluable companions on the journey.

I had lunch in the food court of the Petronas Towers on Jalan Ampang in Kuala Lumpur the day they opened to the public in 1997.  My Malaysian colleagues were justifiably proud that their city had the world’s tallest building (by 3m), a record the Sear’s Tower in Chicago had held since 1973.  A mere seven years later, that record would pass to the Taipei Financial Center.  In 2010, Burj Khalifa in Dubai would smash the record by a phenomenal 320m.

The pyramids at Giza held the record for 3700 years, Lincoln Cathedral 250 years and the Petronas Towers seven years.  Change is ubiquitous, unavoidable and accelerating.  Internal auditors need to understand how that change, and the uncertainty that goes with it, impacts business models and business activities.  And they – you – need to tell someone.  And they need to listen.  Not much to ask, is it?  In the UK, the FRC implementing fully the recommendations of the Sharman Inquiry would certainly help.

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