1. Executive summary
In 1988, Investment broker Barlow Clowes collapsed, owing more than £156 million to more than 18000 investors. It offered the market a fund which purported to invest in low-risk Government gilt-edged stock with high return, but as it turned out, the high returns were down to the fact that investor’ cash had actually been put in very high risk projects, including more than £100 million secretly channeled to fund Peter Barlow’s lavish lifestyle. The scandal was set in an overheated market with relaxed regulations and radical investors arbitraging high profits. The reasons behind the scandal not only lie in the Peter Clowes’s personal greediness and lack of integration, but in the independence and competences of the internal and external auditing function, and the conscientiousness of authoritative institutions (such as DTI). A lack of internal corporate governance also contributed to the tragedy. Although time has passed, the historical scandal reminds us of the importance of the rationality of investors, conforming legal reforms (SOX), enhancement of corporate governance and the competences and integrity of auditors in authoritative industries.
Accounting scandals are political and business frauds which arise from the disclosure of misconduct of directors in the company or governments.Barlow Clowes is a famous accounting scandal in British history which is still being referred to even after many years. This scandal involves misappropriation of the investors’ funds by its director, which makes millions of investors lose their money. This draws our attention to find the reasons behind it. Hence, this report will be divided into four parts. The brief history of Barlow Clowes will be introduced in the first part and three main approaches that Barlow Clowes used to conduct a fraud will be illustrated in the second part. The third part will analyze the reasons for this scandal in aspects of corporate governance, auditing, accounting and environmental contributors. Finally, the implication and reform after Barlow Clowes scandal will be assessed associated with further concerns.
3. Part One: Case overview
Barlow Clowes is the famous accounting scandal in the mid-1980s. Peter Clowes, one of the directors of Gibraltar company Barlow Clowes, operated an off-shore fraudulent investment scheme, by offering the investor higher rate of return in the low-risk government gilt-edged securities. This scheme attracted 18000 small UK investors to invest their money into the company on the recommendation of the dealers. As a result, Peter attracted about £140 million, and he put more than £100 million to fund his lavish lifestyle through a company in Gibraltar. In fact, Peter’s scheme was originally a ‘bond washer’, which transformed high-taxed income into low-taxed capital gains. When the tax rules changed, Clowes began to invest various higher-risk assets to keep the scheme going (Dalton, 2011). However, the crash of stock market in 1987 leaded to the collapse of the value of many fund’s assets (Cowie, 2011). This makes the scheme began to unravel and finally collapsed in 1988. It is said that 16 investors committed suicide as a result of losses incurred over this scandal. In 1989, the Department of Trade and Industry (DTI) agreed to pay £153 million as ex-gratia compensation to 14250 investors who lost money in Barlow Clowes. However, it took more than 20 years for taxpayers to repay this £153 million. In 1992, Peter Clowes was convicted and sentenced to 10 years in prison based on 113 witnesses’ testification against him. The picture below gives a brief history of Barlow Clowes.
4. Part Two: Approaches to financial fraudulence
4.1 Gilt-edged securities
Certain national governments issue bonds named Gilt-edged securities or gilts for shorts. In terms of the simplest form of UK government bond, gilt-edged security is legal essentially and makes up the largest share of UK government in 2008, but it was the cheating tool in Barlow Clowes International Ltd in 1984. Barlow Clowes International Ltd set up a “bond-washing” operation through purchasing and selling gilt-edged Government bonds so that they can create advantages in taxes. The Department of Trade and Industry made things worse: they ignored Barlow’s earlier illegal behavior and even gave the company a selling license in 1985 and
renewed it in 1986 and 1987.
4.2 Ponzi Scheme
Barlow Clowes International Ltd can be regarded as a developed Ponzi Scheme (1919). Through the comparison frame below, the existing of similarities between Barlow Clowes and Ponzi Scheme proves that both of them cheated to the poor by similar investment. However, no one can explain what this investment is and how it works. At the beginning, they gave later investment fund to the earlier investors, so more and more people would believe them and get involved. This is defined as the Pyramid-style investment. But the cheaters actually withdraw the huge sum of money to meet their own consumption. However, there are differences between them. For example, Barlow Clowes obtained more profits with the Government State, the Department of Trade and Industry’s support. This will be analyzed in 5.3.
4.3 Misappropriation of investment funds
In the mid-1980s, Guy Cramer, Peter Clowes’s former assistant, opened a listed company called James Ferguson Holding Plc (JFH) abroad. In fact, this oversea company was an associate of Peter Clowes and was funded with the money from the public who thought they were subscribing to a scheme of investment in gilt-edged securities. In 1986, Guy Cramer instructed a company offering off-shore financial services called International Trust Corporation Ltd (ITC) to form and administer a number of off-shore companies. Between May 1986 and February 1987 ITC dealt with many payments from Barlow Clowes to off-shore companies which they administered on behalf of Guy Cramer. These payment transactions were actually misappropriation of Barlow Clowes investors’ funds. Moreover, Peter Henwood and Andrew Sebastian, two directors of JFH, dishonestly assisted in the misappropriation of three or four sums, helping Peter Clowes transfer the investment fund for personal use. The timeline below shows the detailed misappropriations assisted by Peter Henwood and Andrew Sebastian in 1987.
5. Part Three： Reasons behind the scandal
5.1 Accounting—accounting manipulation
The Barlow Clowes scandal involved accounting manipulation. It can be defined
as using aggressive or fraudulent applications of accounting principles. (Johnson et al 2012) In this case, David Mitchell, a former chartered accountancy, helped Clowes steal client funds and move it to Switzerland. (Walsh 2001) Peter Clowes attracted 140m pounds and misused most of the funds into his personal use. Meanwhile, the director Mr. Naylor engaged in a systematic approach such as insider trading to manipulate profit figures to mislead and appeal to investors. Initially the accounting manipulation was about personal gain of Peter Clowes. Later, to cover the losses of high risk projects and worse financial condition, accounting figures were further manipulated under the public pressure of investment return. It was believed most of the losses caused by Clowes groups were due to the insider fund stealing.
5.2 Corporate governance
Corporate governance is one of the vital factors in the operation of an organization. It not only enhances operational efficiency and builds market confidence, but good corporate governance also makes the board of directors and managers strive for optimal results while rigorously monitoring periodic performance (OECD, 2004).The primary persons involved in the scandal are shown in the chart:
5.2.1 BoDs and Executives
Although board of directors are perceived to take a crucial role in overseeing the activities of the company and aligning long-term interests of shareholders and managements, the role can be easily distorted (GE 2002 annual report)8. Jensen (1993)7, after conducting several researches about corporate governance, argues that only a few boards have conscientiously performed their job of nomination of CEOs and allocation of remunerations, leading to loose internal control in corporations. In addition, even if the boards take an active part in the firm’s internal control through nominating CEOs and managers, regulating the corporate behavior, remunerating and firing the managers etc., Boyd (1996)5 asserts that there are still some methods to distort the balance. According to the agency theory, it is of high probability that Peter Clowes and Peter Naylor in Barlow Clowes Ins. abuse the corporate governance in a way that achieves their own interest
instead of that of the shareholders’. Based on Boyd’s investigation into the case, it might be inferred that Peter Clowes and Peter Naylor had monopolized the information flow, influenced the board’s nomination of directors and auditors, leading to the alliance of the directors and CEOs and the violation against independent auditing.
5.2.2 Governance system
An insider-dominated corporate system can be resulted due to the minority power in the shell corporate (). This is because of the fact that the Barlow Clowes Ins. was dominantly controlled by Peter Clowes and Peter Naylor, which has resulted in a lack of transparency manifested by insufficient disclosure of management activities and financial information. Through these loopholes, the money-laundering scheme was able to be implemented. Moreover, the executives in Barlow Clowes Ltd. appeared to have abused their power in corporate governance as the separation of ownership and control was not distinctively noted (Solomon, 2007).
5.2.3 Audit committee
Crippled functioning of Audit Committee is another factor contributing to inefficient corporate governance. Cohen et al (2000)6 states that the audit committee, together with the board of directors, plays the role of performance monitoring of the firm. Nevertheless, Audit Committee was not prevalently established until the publication of Cadbury Report in 1992. Though most public companies had already set up this department at that time, there is no evidence that Audit Committee had existed in Barlow Clowes Ltd. Edward John Godfrey was the internal audit controller of the firm, but was obviously under qualified (explained in the auditing part below). However, conclusions can be made that in Barlow Clowes Ltd. either Audit Committee’s function was crippled or there was no Audit Committee to fulfill the role of supervision and assurance of independent internal audit.
The Barlow Clowes affair lasted from 1984 to 1988. Despite of the governance failure inside the company, a considerable number of members of the accountancy profession and firms were implicated in the scandal (source:
‘frb’ website). Authorities such as the Department of Trade and Industry (DTI), the Investigation Appeal Committee from Joint Disciplinary Scheme (JDS) and the Committee of Inquiry have presented their opinions or decisions. Based on their findings, this section will specifically discuss the problems with the internal audit performed by Mr. Edward John Godfrey and the external audit served by Spicer & Oppenheim and Touche Ross. 5.3.1 Internal Audit – Edward John Godfrey
Barlow Clowes had no audit committee in its short history. The job of inside monitoring and controlling was taken by Mr. Godfrey. From 1 January 1987 to June 1988, he was employed as the financial and administration controller and later as the compliance officer designate of the Company (source: ‘frb’ website). Therefore, he seemed to be the closest employee the Company had to the internal auditor whose responsibility is to assist corporate governance (Boynton et al, 2001). However, in the No. 29 Report of the Committee of Inquiry, his service was assessed to fell below standards and Mr. Godfrey was ordered to pay £5,000 as costs (source: ‘frb’ website).
The internal audit failure was most likely to be a result of the lack of independence. Beasley et al (2009) and Voeller (2013) pointed out that internal auditors should be independent to management as well as accountant, which was an essential factor to make sure the auditing quality. As Gary & Manson (2008) mentioned, “independence” can be defined as “unbiased and not be affected by vested interest”. This is achieved by restricting abuse of power of management and authorizes auditing committee to report misbehavior such as accounting manipulation and misusage of corporate assets. But in the case of Clowes group, head of accountancy and insider auditors seemed to be the same person. The structure might lead to insufficiency in the review of either accountancy work or inside auditing work. And it is proved that Mr. Godfrey failed to report the misbehavior of management with accounting manipulation either due to vested interest or fear of losing job.
5.3.2 External Audit – Spicer & Oppenheim
Spicers provided a range of services to a number of Barlow Clowes entities between 1985 and 1987 and were auditors of the partnership company from
November 1985 (source: ‘frb’ website). It was also the firm which gave assurance to the DTI in 1985 before it finally granted the license to Barlow Clowes (Barry Riley, 1991). In No. 13 Report of the Committee of Inquiry, Spicers fell below standards on the audit of the client accounts and was censured to pay £350,000 (later deducted to £300,000 in the Appeal Committee’s report) (source: ‘frb’ website). Despite complaining on the audit of the client accounts, the Appeal Committee also pointed out more specific faults in the audit process. Most notable problem was the failure of Spicers to appoint a review partner(source: ‘frb’ website).
In the model of audit risk, which specified as ‘Audit Risk = Inherent Risk * Control Risk * Detection Risk’, detection risk stands for the risk that the auditor will fail to detect a material misstatement (William F. Messier, Jr. et al, 2006). Unlike the other two components of audit risk, detection risk is the only one that can be controlled by designing effective audit procedures (William F. Messier, Jr. et al, 2006). However, the detection is very likely to be misstated due to the limitation of audit sampling or other causes such as auditor deficiency (Charlie Cullinan, 2003). In the case of Barlow Clowes, the audit work performed by Spicers was obviously at ‘high risk’ and the lack of review partner directly led to the audit failure. According to the Appeal Committee, the fraud could be detected or prevented much earlier if the review partner would have been appointed (source: ‘frb’ website).
5.3.3 External Audit – Touche Ross
Another auditor of Barlow Clowes was Mr. John Connolly from Touche Ross who appeared to be the most discussing part in the audit failure. Receiving a high salary of £2.9 million (Jim Cousins et al, 2004), he used to be in charge of Touche Ross (former part of Deloitte & Touche) in northern region and later even became the senior partner in Deloitte (John Willcock, 1995). In the case, JDS criticized him for the serious and material omissions in the information contained in the Touche long form reports and even in the circular sent to shareholders of another company called James Ferguson in a reverse takeover (Moher, 2004). On the other hand, DTI helped in defense of John and mentioned the possibility that Mr. Connolly was ‘misled by Peter
Clowes and his associates’ and was ‘a victim in many ways’ (John Willcock, 1995). And the Touche Ross Company also described their partner, Mr. Connolly, as ‘scapegoat’ (John Willcock, 1995).
Given his high position in Touche and qualification of audit and certification he held, it is less likely to judge him as incompetence. Therefore it is suspicious that he would easily misled by Clowes and overlook such obvious materialistic mistakes. Without other direct evidences, the lack of independence and the client-based culture seemed to be plausible explanations to the failure of external auditing.
Firstly, there is no sufficient evidence to deny the personal relationship between senior management and Mr. Connolly. When an auditing assistant in Touche was interviewed, the young man claimed that a few employees in Touche initially realized the mistakes in financial report (Need Citation). But Mr. Connolly overruled the concerns and refused to disclosure. Although the court did not charge this officially, we cannot rule out the possibility that Mr. Connolly deliberately ignored the problems in auditing. Client-based culture is a compromised speculation of “lack of independence”. Even there was no personal relationship between management and Mr. Connolly, the concerns of losing huge revenue in auditing and non-auditing services from Clowes can make Connolly betray the professional ethics. There is usually a sense of loyalty between an auditor and a manager being audited (Peter Moizer, 1997). For example, Hilzenrath (2001) criticized another ‘Big Four’ Anderson in Enron case that, although the ultimate customers of auditors are public investors, auditors are likely to compromise to the managers who hire and pay them. 5.4 Department of Trade and Industry
In the Barlow Clowes International Ltd scandal, Department of Trade and Industry (DTI) plays a vital role through providing facilitation to the company. In 1989, The Parliamentary Commissioner for Administration published an investigation report which accused the DTI of duty dereliction in Barlow Clowes scandal. Firstly, the DTI made early licensing errors because there was no mechanism of earlier rules to monitor a license holder’s conduct in business. They not only ignored the truth that Barlow
Clowes is unauthorized to sell gilt-edged securities from 1975 to 1984, but did they give a license to the company in 1985 without reasonable inspection. Additionally in the period from 1985 to the bankruptcy, Barlow Clowes had a separate partner named “Jersey Partnership” facing the DTI. The DTI only gave the authorization to Barlow Clowes, but both of Barlow and Jersey were earning investments with this license. They claimed that investors’ money are payable to “Barlow Clowes and Partners Client”. The DTI even renewed this license in both 1986 and 1987.
It is accepted that the DTI breached its duty of supervision in Barlow Clowes affairs, but both of two previous secretaries of state for the DTI, Lord Young and Nicholas Ridley, denied their liability to the investors. Barrowclough published an exhaustive report describing the DTI’s maladministration from five aspects, but his investigation was rejected by Nicholas (1989). Finally, the DTI just accepted to repay ₤150 million to investors without crime confession. The Department of Trade and Industry, as a related Government state indeed provided an approach of cheating to Barlow Clowes International Ltd somehow due to the vague verification of authorization in the company.
5.5 Environmental contributor
5.5.1 Economic conditions and financial markets
In 1970s, UK was confronted with economic competitions under the big background of globalization. Based on the research of fraud cases by Punch (1996), London, in order to maintain its competitive position as a financial Centre against New York and Tokyo, was forced to go through deregulation and a relaxation of restrictions on channeling financial transactions. “Deregulation” was said to have sponsored resurgence in the British economy. Morrison (2001) also states that 1980s’ UK experienced the mode of the Anglo-Saxon economy which was characterized as low in the levels of regulation and taxation, overall ease of doing businesses and low barriers to free trade. During the times, ambitious bankers take on more risks due to over-confidence in the professionalism and competence of London’s financial institutions, which has contributed to a possible bubble economy (Franklin, 1990).
As a result of the relaxed credit standards and relaxed investment criteria of investors, the financial market was of high inflation and volatile. Therefore, treasury bonds backed by government creditability were perceived a much safer investment than the shares of firms which may go bust with the firm’s crash (Pettinger, 2009). To take advantage of this, Barlow Clowes alleged to have investment in the UK gilts which promised a high return while maintaining security-reputed, successfully deceiving ignorant investors.
However, the burst of bubble is inevitable as the momentum eventually halted, as was proved when the UK stock market collapsed in 1987 crash. In order to keep the company healthy-looking, Barlow Clowes abandoned the original “bond washer” scheme and embarked on a complex investment strategy. As the investment went bad in the crisis, the shell company was forced to announce bankruptcy, revealing large uncovered liabilities. 5.5.2 Behavioral finance
Behavioral finance attempts to understand and explain investor’s psychological decision process theoretically (Fromlet, 2001). The theory explains why the investors should not rationally evaluate their investments in Barlow Clowes. Firstly, investors show “herd instinct” that is to follow the crowd without their own judgments (Johnsson et al, 2002). This is because the investors are mostly retired pension holders who lack the ability to evaluate their own investments, and they could rely too easily on the creditability of the authoritative institutes such as the Department of Trade and Industry. Another key behavioral factor to understand market anomalies is overconfidence. In the case of Barlow Clowes, MrClowes tended to exaggerate his talents and underestimate the likelihood of negative outcomes of his investment. March and Shapira (1987) discovered in their research that investors overestimate the probability of success are subject to greater optimism risks when they think of themselves as experts. Thirdly, people are “myopic” which means to ignore information they consider inconvenient, leading to confirmation bias. This is practiced by the department of Trade and Industry, which made quick decisions and approved license to Barlow Clowes in the first place without thorough investigation,
given the available information and criticism (Shiller, 2000).
5.5.3 Regulations and acts
Another reason for the triggering of frauds during late 1980s was the relatively light approach of the Financial Service Act 1986. The Act was passed to regulate financial services industry but more emphasis was placed on self-regulation rather than governmental regulation. According to the historical literature, the Thatcher government was impatient with the proceeding of act drafted by Professor Laurence Gower who tended towards a tighter and more top-heavy regime, and the government pushed a second bill with lighter regulations. The act turned out to be loose in control as it was hit hard by the major financial scandal of Barlow Clowes in 1988. In 2000, Financial Services and Markets Act superseded the 1986s’ act with stricter and heavier provisions.
6. Part Four: Implication and reform
6.1 Remind of the scandal
The chart below illustrates the process of the Barlow Clowes scandal from mean five aspects. Firstly, corporate governance in Barlow Clowes International Ltd is bad, especially the firm’s internal control. If this can be improved, the scandal may not happen.Next, the most significant point is auditing problem, which has both internal drawbacks and external cheatings.The scandal could be noticed if there was an effective internal auditing committee or an independent auditing controller. Additionally, the external auditing work via two accounting firms was finished with very low-quality.Thirdly, Barlow’s targeting consumers are theretired persons with low understanding of finance, investment, or legislation.It is possible that if the company’s targets are young and educational people, they might fail.As mentioned above, the DTI misconducted in the Barlow Clowes affair, and helped themfour times in total.Besides, in 1980s, the whole environment and imperfect regulations or acts accelerated this scandal more or less.This chart will provide a simple remind of the case, and highlight the important approaches, reasons, and several possible reforming orientations.
6.2 Accounting reform
The current reform includes conceptual framework approach. “Statement of Principles for Financial Reporting” was implemented by ASB UK 1999. (SPFR 1999) Similarly, IASB, the international version was also published to deal with the international companies like Barlow Clowes. (IASB 2001) The financial standards limit accounting manipulation by posing a restriction on the accounting policies and choices such as depreciation and impairment charge. Moreover, accounting fraud is under the detection of auditors and their monitoring regulator FRC, a UK version of SEC in the US. SOX 2002 increased the budget of regulator SEC and the penalty of committing accounting fraudulent. (FRC; SOX 2002) Furthermore, modern companies employ internal governance mechanism such as audit committee, which is no longer subject to the authority of management. This reduced abuse power of management in financial figures and internal stealing. Additionally, to be listed in stock market, the financial statement will be under strict trial of analysts of credit rating agencies. Therefore investors can be protected from companies with poor financial condition.
However, not all the fraud is on the financial statement. For instance, in this case, managers intentionally put company funds into high risky funds to gain a short time return. (citation) And CEOs tend to pursue a short term strategy to hit a sales target for remuneration. More importantly, the pressure of internal return still exist, thus the motivation of manipulation does not decline. It is relatively easy for management to management earnings to hit a certain target in rule-based policies. In addition, the borderbetween lawful manipulation and illegal ones should be clarified. (Johnson 2012) Otherwise the restriction of accounting manipulation is always “empty talk”.
6.3 Corporate governance
6.3.1 The CG reform: NEDs
The combination of Cadbury Report, Greenbury Report and Hampel Report attempted to facilitate the relationship between chairman and CEO, defined the non-executive directors to enhance the firm’s internal control. The concept of Independent director (non-executive director) was denoted by
Cadbury Report. Non-executive directors are required to keep independent of directors but have the same duties like executive directors. Ezzamel et al (2005?)2 proposed that it is contradictory and explained that this is because NEDs plays a major role in assuring the disclosure of information’s quality as well as reliability. Nevertheless, even though efforts were made to enhance the status of the board, the scandals still exist. As board is ineffective, or the NEDs are not really independent of the management, or the NEDs do not fulfill their responsibility well, the scandal might still occur because of the greed and hubris of managers.
The establishment of Sarbanes-Oxley Act (SOX) is for the situation of poor governance, the deficiency of internal control etc. It links the responsibility of executives with corporate accounting, and the internal audit system is rebuilt (Bergen, 2005)3. Initially, the Public Company Accounting Oversight Board (PCAOB)4 was set up by SOX and it provides independent audit services to assure the interest of investors. Secondly, the SOX 404 states the requirement of annual report to assess the internal control; and it emphasizes and lists the responsibilities of management. Moreover, SOX 404 indicates that COSO model need to be used as the standard of assessing the internal control. On the one hand, COSO provides firms the guidance of risk assessment, risk response, control activities, etc. On the other hand, it realizes the importance of the board in internal control system: internal control is affected by the integration of the board, the management and other staffs for the purpose of assuring the realization of corporate objectives (McNally, 2013)6. However, COSO has its inherent limitation: the guidance of COSO provides is so general that it is not detailed enough to guide the risk management. In other words, COSO is too theoretical to apply technically (COSO)7.
6.3.3 Audit Committee
Levitt (1998)5 claimed that the power of audit committee should be strengthened to enhance the corporate governance. Audit committee has the responsibility to review the effectiveness of corporate’s internal control and report it to the board. Although the audit committee was not required to
adhere to corporate until the Cadbury Report issued in 1992, there were still quite a number of firms establish audit committee.
6.4 Auditing improvement—SOX, ESA
After the scandal of Enron and WorldCom, Sarbanes-Oxley Act 0f 2002 was signed into law to prevent similar scandals. (Sarbanes-Oxley: an overview 2002) Later in 2005, UK had its own version named APB Ethical Standards for Auditors. (Gary, I and Manson S 2008) In order to stress independence of auditing work, ESA strictly limits auditing firms to provide none-audit services such as human resource consultancy in order to eliminate “conflicts of interest to investors”. (APB Ethical Standards section5) Similarly, SOX in principle limit such services, unless they are proved by the board of directors and the cost accounts less than 5% of total auditing cost. (SOX 2002 section 2) This means auditing firms are less likely to lower their standards concerning the lost revenue. (Adeyemi, S. and Olowookere, J. 2012; Cullinan, 2003) Furthermore, ESA also requires the audit fees to be predetermined by time, experience and effort. (APB section 4) Therefore management cannot alter the fees to manipulate auditors.
But the SOX did not properly solve the problem of independence problem in internal auditing. SOX required each annual report of an issuer to contain an “internal control report” (Section 404 of SOX 2002; AICPA 2005) It is costly and difficult to implement especially for small firms. (Bergen 2005) Thus the effect on this term is compromised.
6.4.2 Audit quality
Current reform increased audit quality by the following means.
APB stresses the principle of “integrity”, which refers to not only intellectual competence, but also honesty, courage, fairness and confidentiality. (APB ESA section 1) Similarly, SOX redefined the accountability to public interest and posed legal burden on CEOs and CFOs by requiring their personal sign on financial report. (Lee, T &Azham, M 2008) Their personal obligation of any financial error largely encourages
proficiency of accountancy and internal auditors. This is enhanced by increase the budget of SEC, the organization monitoring quality of financial statement.
But increase legal obligation and institution budget does not directly ensure the audit quality. Quality of financial report depends directly on auditors. Performance appraisal of them across the auditing industry is needed. (citation needed) The test should include both competence and ethics. Competence can be signaled as result of a uniform and regular test while ethics trial needs further measurable definition. Consequently, auditors who fall below standard like Mr. Connolly can be weeded out in the auditing field before any large scandals take place.
The competence and ethics test is meaningful because auditors are supposed to deal with clients with various risk levels, then identify material errors, rather than conventional business models selecting only bona fide clients. The current reform of risk-based business models has it limitation. Need citation 求现在审计行业业内对审计员的要求。
6.4.3 Adjust to small firms—take a broader view
SOX 2002 was signed focusing on large public corporations such as Enron and WorldCom due to the shocking scandal of these two companies. But many provisions in SOX are not suitable to small companies and private companies such as section 404, which is discussed above. CEOs have to divert energy from strategic decision into audit meetings. Meanwhile, corporation funds spent in internal auditing may not result in a measureable return. (Bergen 2005) Although this can be a sunk cost to generate future efficiency, not all the firms afford this. The high cost may push many public companies to delist from market, which make the regulation less meaningful. Fortunately, APB was revised and adjusted to small and private companies to gain a broader view of auditing control. (APB ethical standard 2010) The provisions involving effort and scale of auditing work in small companies can be altered to save cost and. (example) This causes a more general solution of auditing failures. http://www.frc.org.uk/Our-Work/Publications/APB/ES-Provisions-Available-for-S
6.4.4 Limitations of auditing improvement
Although there are constant development of regulations and academics, the scandals do not stop. Madoff is another “Ponds fraudulent”. Sequential cases involving “big four” have not cured yet. It’s a “cat and mice” game between regulators and firms. Firstly, this is because each audit failure is particular and each solution is general. (Zhou Jiaqi source) That is, the failure is due to specification of firms but solutions can only be uniform. Secondly, only perceived auditing failure can catch public attention until the situation is difficult to rescue. Auditors are supposed to be cautious in each piece of work they do before the problem grow larger. Thirdly, updated auditing regulation is less meaningful in absence of development of regulators. In Barlow’s case, regulators, TDI shoulders a proportion of responsibility in the failure. Yet it is not charged against any order. Fourthly, audit reform should be in compliance with developments in corporate governance. Efficient corporate governance can reduce the cost and effort of auditing work. (Cohen, J et al 2002) Finally, due to the basic auditing process, the auditors select only a proportion of transactions of firms as samples. Thus errors may not be discovered, which means only reasonable assurance of financial statements is ensured. (Gary I & Mason S 2008) Thus, further reforms in auditing should be emerged.
6.5 Public lessons
Although nowadays few people will remember the Barlow Clowes scandal, the case still offers lessons for the public investors today (The Telegraph, 2011). Firstly, it usually isn’t reliable when something has very high rate of return but with very low risk. In this scandal, Barlow Clowes offered a low-risk government gilt-edged stock but promised a high yield. Secondly, it is advisable for the public to avoid some obfuscation and complex investments. Thirdly, do not merely rely on the fact that the regulators have approved a business a safe one to make the investment decision. Barlow Clowes’ business was authorized by the Department of Trade and Industry, but the DTI inspectors failed to disclose the scandal immediately. Fourthly, beware the compensation scheme will not cover the offshore investments. When
the scandal was exposed, most of the money had been already transferred to Gibraltar which offered no safety to the public investors.
The case of Barlow Clowes was simply a developed version of Ponzi scheme by its nature while its complexity and adverse impacts were great shocks to the public and serious challenges to the regulatory system. Despite the environmental contributors at that time, the poor corporate governance and audit quality also created opportunities for the company to commit and conceal the fraud. This notorious case has become the hardest lesson for all the members involved, including the investors, the accounting professions and the regulators until now. Although a part of quantitative primary data was not available, we have attempted to combine findings of investigation departments with theoretical comments from scholars, and therefore concluded several primary issues within the case from the perspective of corporate governance, auditing and other relevant factors. Accordingly, the reform will need joint efforts of the management, auditing firms and regulatory authority. It may be a fantasy to solve all the problems with governance and auditing once. But hopefully, with more systematic rules and standards being updated to meet the modern needs, the function of management and monitoring could be approaching standardized.
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