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The bigger they are …

One could be excused for losing faith in the financial reporting process. You could argue that at the smaller end of the corporate market, among thousands of small, privately owned companies, you would tolerate financial statements that are simply wrong. Apart from unfortunate creditors and employees, no one stands to lose big if a small business collapses after an accounting scandal.

We might even understand why large, fast-growing companies have problems with accounting procedures. Companies that grow fast as a result of acquisitions, or emerge on the crest of a new technology or market, will always struggle to get the accounting systems to keep up.

But surely we would expect the blue chips to have the financial reporting process buttoned down. Sadly, after the Shell oil reserve debacle, capital markets have a right to distrust any numbers that companies produce. If you produce annual reports, finals and interims you may take offence at such a statement, arguing that your published accounts are, in all regards, materially accurate. If you are an auditor you could argue that you produce high-quality audit work which provides assurance to shareholders that the figures are more or less right. If you believe that to be true, then you need a damned good explanation as to why blue chip Shell has just paid out $150m to UK and US stock market regulators as a fine for ‘market abuse’. And that’s just the downpayment. The pain for Shell – or rather for Shell’s shareholders – is just beginning. The company faces ongoing investigations by the US Department of Justice, the Dutch financial regulator, the Euronext stock exchange (which covers Amsterdam, Brussels and Paris), as well as a series of class-action lawsuits in the US. Plus, possible actions against individual Shell directors.

The reason why Shell is in trouble is that it overstated its proved reserves by 23%, or 4.47 billion barrels of oil. The Securities & Exchange Commission also reckons it boosted the standardised measure of future cash flows in its 2002 Form 20-F by a staggering $6.6bn.

Shell overstated its reserves and delayed correcting the overstatement because it wanted to create and maintain the appearance of a strong reserve replacement ratio (RRR). It was able to do this because it lacked effective internal controls over the reserves estimation and reporting process, and its reporting guidelines failed to conform to regulatory requirements.

Of course, the US regulators are talking about more regulation in terms of getting the auditors to do more work on oil reserves – a proposed move which, as you can imagine, US auditors have rejected because they don’t have the resources or skills to do it.

Accountants and auditors have always had to take the work of other technical experts and check that their assumptions are reasonable and consistent. If we take what the US auditors are saying at face value, general auditors may someday argue that business is now so complex they cannot reasonably be called upon to certify that the accounts reflect reality. While the Shell figures might be big, the pattern of behaviour is similar to other scandals: a mixture of poor controls, poor accounting policies and management who encouraged or connived these failures.

According to the FSA, the company approved new, less conservative guidelines for booking reserves in 1997 and then management repeatedly ignored warnings from the company’s internal reserves auditor as a culture of optimism of reserves spread around the organisation.

The Shell scandal is a staggering example of aggressive earnings management (AEM). And one reason AEM flourishes is because the market puts companies under unreasonable pressure to deliver results and senior directors have an incentive to achieve to the point of avarice. While the market may complain about Shell’s action it should understand it is partly responsible for the behaviour by its constant demands for better performance.

If there is any good news to come of this it is that certain regulators – notably the UK’s Auditing Practices Board – has in the past few years been making some noises about the existence and dangers of AEM.

But now Shell has been found to have tucked away a few billion barrels more than it should have one can only speculate who is next. A retailer wrongly counting the number of fags we’re buying? A telecom company forgetting to stop recognising mobile phone customers? Or a bank miscounting its loan book? Of course, it couldn’t happen old chap.

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