Lords call for OFT audit probe

A House of Lords committee this morning called for the Office of Fair Trading to investigate concentration within the audit market. But is anyone listening?

After listening to months of evidence - including a live appearance by the UK senior partners of the Big Four firms - the House of Lords economic affairs committee published a report concluding that further investigation was needed.

Committee chairman, Lord MacGregor of Pulham Market, commented, “Our inquiry has revealed widespread concerns about  the Big Four’s dominance and the risk that they could become the Big Three. Our report makes several recommendations to reduce this dominance but we feel that this market concentration is of such significance that a thorough review of the issues by the Office of Fair Trading and possibly the Competition Commission is now overdue.”

The impact of the global banking collapse and the complete silence of the Big Four accountancy firms about the banks’ liquidity and risk strategies beforehand was one of the driving forces behind the Lords committee hearings.

In their report, published today at 11.15am, the Lords found evidence of “serious failures of communications” that contributed to the financial crisis. The lack of any meetings between bank auditors and the FSA was a “dereliction of duty” by both auditors and regulators, the report concluded. To avoid similar crises in future, the committee recommended a new framework for banking supervision backed by legislation to enforce dialogue between bank auditors and supervisors.

While the Big Four audit firms have a global reach that goes beyond the scope of any national competition authority, the report added that it made sense for the UK to take a lead on the issue because of the accountancy firms’ links to the City of London.

Audit quality within the concentrated marketplace also came under scrutiny, with the report suggesting the need for prudence to be reasserted as the guiding principle of audit.

The Lords lent some support to the view presented in evidence that IFRS allowed banks to prepare financial statements to a lower standard than UK GAAP, particularly in “mark to market” valuations, where they made provision only for incurred and not expected losses. The effect was to overstate profts, leading to excessive distributions and bonuses that would not have occurred under UK GAAP.

Mr Timothy Bush, the Investment Management Association representative on the ASB’s Urgent Issues Task Force told the Lords the UK crash was “a crisis largely caused by accounting”.

Ernst & Young and KPMG, however, argued that the standards governing banks’ loan loss provisions and fair value provisions were not significantly different under UK GAAP and IFRS. Both systems are based on the “incurred loss model”, so that impairment provisons would be based on the prevailing conditions at a given time (the balance sheet date).

Continued...

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John Stokdyk's picture

Press conference transcript

John Stokdyk | | Permalink

I went along to the Houses of Parliament this morning, along with representatives from Accountancy Age, Accountancy & Business, International Accountancy Bulletin, The Daily Telegraph, The Guardian and The Daily Mail, to a press conference with four of the report’s authors.

I would agree with Lord McGregor’s  assertion that there was a lot of valuable evidence in the report and that it is well worth reading, but put a question to him first raised by an AccountingWEB member during the committee’s hearing with the Big Four’s UK senior partners in November: why had it taken so long to complete any kind of enquiry, and does it represent an adequate response to the scale of the financial crisis?

Lord McGregor answered: “We think the things that should be done are what we recommended.” From the way the hearings proceeded on Lord Lawson’s proposal to require dialogue between bank auditors and the Bank of England, he added, “We are now pushing at an open door… and would hope that could be followed up.”

He continued: “The OFT investigation we hope will be pursued, but will take time to complete. They have resources we didn’t and ability to do it more in depth.”

McGregor characterised many of the recommendations as “prods” that he hoped other government bodies would pick up.

Lawson weighed on the subject of the relationship with auditors and the supervisors of banks: “It’s an area which I have been very involved with for many years. One of reasons why nothing has happened is that there is this transfer of authority, with [regulatory responsibility] moving back from the FSA to the Bank of England. So this is not merely complicated - it is without doubt a glaring failure - but also it means that the everything in this area has to be agreed informally between the Bank and FSA, which is slowing things down a bit.”

The letter from the Bank of England chief cashier Andrew Bailey (appendix 4 of the report) is “a very important step forward… well worth reading”, he added, hinting that both the bank and the Lords themselves took a critical view of the FSA’s effectiveness as a supervisory regulator.

Lord Lipsey joined in: “The regulatory system has changed a lot, but the role of auditors has not changed. One thing that came out was Lord Myners’ evidence (detailed in Chapter 6, paragraphs 138-150). It was clear the auditors’ defence was full of holes - he was extremely critical o auditors. We didn’t find the Big Four frightfully impressive in their dealing with this. The argument has moved on and this report is part of that.”

Lawson: "An implicit defence of the Big Four was that it is very difficult to qualify the accounts of banks because of the consequences. We accept this: that makes it more important that they have more regular contact with the regulator to make up for that."

Appendix 3 of the report includes all of the recommendations made during evidence to deal with the Big Four audit oligarchy, and the ones that the committee backed most enthusiastically were:

  • Enhancing the role of risk committees in major institutions - preferably to be independent of audit committees. This would also give second tier firms a chance to enter the large company audit market.
  • Mandatory retendering of audit work every five years (although Lord Myners told the committee that investors were apathetic about this - “reappointment of the auditors is the one thing that tends to go through on the nod at AGMs,” noted Lord McGregor.
  • Taking up the “living wills” recommendation to set out contingencies if the Big Four became three. When asked how they would operate, Lord Lawson said that similar plans were already being drawn up within banks.
  • The government should use the opportunity to make sure that when the Audit Commission ended, its experts wouldn’t all just be circulated to the Big Four.

“All of these seemed to us to be good recommendations. But as FRC found they do not amount to really major attempts to deal with oligarchy,” said Lord McGregor. “That’s why we recommend the OFT/Competition Commission’s involvement.”

Looking back at the committee’s hearing with the Big Four partners, Lord McGregor said it “wasn’t their finest hour” and that it encouraged the committee to look more deeply into two resulting issues: communication with banking regulators and whether or not audit standards were slipping because of IFRS.

Auditors and the banking crisis: Dialogue with regulator
The breakdown of dialogue between auditors and banking regulators was a pet subject of Lord Lawson’s and a separate chapter was given over to this area. In written evidence from the Bank of England (para 162) it became clear that the working relationship between external auditors and regulators had broken down.

Following the 1987 Johnson Matthey bank collapse, when he was Chancellor of the Exchequer, Lord Lawson came to conclusion there should be mandatory requirements for auditors and the regulator (Bank of England) to share their concerns. That lack of consultation was a major contributory factor to banking collapse in 2007-08, which is why the committee took up that suggestion again, said Lord McGregor.

Lawson explained that when responsibility for bank supervision was transferred from the Bank of England to the FSA in 1997, it was “clearly not thought through”. He added that the FSA’s post-mortem on Northern Rock illustrated that the arrangement was dysfunctional. The then Chance of the Exchequer [Gordon Brown - Lawson may have been miffed at the auditors, but he still wasn’t above scoring the odd political point] may not have realised there are two forms of regulation: prudential regulation and conduct of business regulation. They are quire separate and requires separate people and separate career structures. Probably was happened was that consumer protection and misselling had quite a high profile. They tended to dominate the FSA and the other form of regulation was lost.

“I recommended maybe the prudent regulator should be with a totally separate agency. As it is now in Canada and Eurozone… It really was a structural error. Read my memoirs - I’m quite content for it to go back to the Bank of England.”

Lord McGregor added that conversations with institutional investors had no problems if confidential discussions took place between auditors and the Bank of England

Stop the International Financial Reporting Standards bandwagon
This was the point at which the Lords admitted they were straying into difficult technical waters, but evidence from the likes of BDO, Timothy Bush of the Investment Management Association and professor Stella Fearnley convinced them that the introduction of IFRS “led to encouragement of box ticking and has reduced the scope for auditors to use judgment to exercise true and fair view”, as Lord McGregor put it.

“It’s clear that the box-ticking approach and the failure to apply judgment, prudence, and going concern meant that assurance received was extremely narrow and fell short of what users could expect of accountants,” he added.

Lord Lipsey quoted paragraph 198 of the report: “It may be that the Big Four carried out their responsibilities in a strictly legal sense, but in the wider sense they did not do so.”

Lord Lawson added: “We did find that there was complacency on the part of auditors.”

Chapter 5 of the report concludes that IFRS is more “rules-based” than UK GAAP and “an inferior system which offers less assurance”, particularly in specific defects such as its inability to account for expected losses, making the IFRS weaknesses especially serious in relation to bank audits.”

As a result, the committee “recommend that the government and regulators should not extend application of IFRS beyond the larger, listed companies where it is already mandatory. Continued use of UK GAAP should be permitted elsewhere, so that the basis of a functioning, alternative system remains in place in case IFRS do not meet their aims.” (para 132).

In effect, the committee called for the suspension of the FRSME project and for the transition to IFRS to be abandoned for mid-size companies.

Lord McGregor added afterwards: “We didn’t feel able to come to a conclusion, but I hope we’re prodding in the same direction as others... We’re giving a push to others to take steps and I hope this prod to the IASB will be very helpful.”

Lord McGregor was at pains to emphasise that the committee gave its full backing to the audit process. “We are not trying to undermine the importance of audit or the credibility of auditors. The first thing the report emphasises is that there are some defects and a lack of clarity. The IFRS recommendation is [a response] to that.”

We will definitely be hearing a lot more about this element of the report in the next few days.

robertlovell's picture

More reactions

robertlovell | | Permalink

FRC

Stephen Haddrill, chief executive of the Financial Reporting Council, said: “This is a serious and comprehensive report to which we will give full weight in considering how to strengthen the value of audit to the capital markets.

“The Committee has urged the UK to take a lead in the debate about the future of audit. As the home market for some of the world’s largest audit firms, we agree that the UK has a special responsibility to lead this debate to secure the vibrant, internationally competitive market for audit services that investors wish to see and which the public interest demands. We look to the profession, investors and companies to play a full and constructive part in this work.

“We are particularly pleased that several of the Committee’s recommendations are similar to proposals made by the FRC in its Effective Company Stewardship paper, in particular its emphasis on an increased role for audit committees. We will take the Committee’s views fully into account in considering the responses to this consultation”.

CIIA

Dr Ian Peters, chief executive, of the Chartered Institute of Internal Auditors, said: “Allowing external auditors to do internal audit work for their audit clients creates a number of potential conflicts of interest that threaten the quality of the audit – not least being dependent on the audit firm to identify problems with its own work.”

“However, we feel the Committee should have gone much further in exploring how future financial scandals might be averted by strengthening the role of the internal audit function.”

“External auditing takes place on an annual basis, it looks at historic numbers and is narrow in its role. In contrast a properly working internal audit function is forward looking, continuous and broad in its remit.”

“Internal audit provides a distinct perspective on what is happening within a company, and strengthening internal audit functions is crucial to addressing the limitations of the external audit in identifying risk management and governance issues.”

ICAEW

Michael Izza, chief executive of ICAEW, said: “The House of Lords Economic Affairs committee has raised some important issues in its report about the role of audit. We do not accept that auditors contributed to the severity of the financial crisis. They did the job that they were expected to do – provide an audit opinion on banks’ financial statements. However, as a profession, we recognise that the audit model has to evolve to continue to meet the needs of the market and society.

ACCA

Helen Brand, ACCA’s chief executive, said: “We are most worried by the Lords’ conclusion that the introduction of IFRS has led directly to a reduction in audit quality. ACCA does not believe this to be the case.
“The Lords have quoted many eminent participants in the inquiry process who have disagreed with the Lords’ assertion. ACCA does not believe the banking crisis was predominantly caused by accounting issues and we are not convinced that IFRS provides less scope for auditors to exercise prudent judgement, as is alleged.

“IFRS includes an overriding requirement that the financial statements should present fairly the position and performance of a company. An audit has always been, and continues to be, more than a report on compliance with a set of accounting standards. The Lords have overemphasised the differences between UK GAAP and IFRS in this respect.”

Helen Brand continues: “It is important to note that the specific IFRS weakness identified by the Lords – around expected rather than incurred loan losses – is already being remedied. The recommendation that UK GAAP should be continued ignores the fact that the key accounting standards in UK GAAP – on financial instruments – are virtually identical to existing IFRS. Any shortcomings of the accounts and audits of banks should not be either a reason to deny global standards to other companies or a justification of continuing to impose on other UK businesses the extra costs of maintaining both systems.

“The criticisms made of IFRS are not helpful given that most countries have now committed themselves to adopting IFRS as the preferred reporting framework for listed companies, and the US is preparing to make its own decision as to the status of IFRS later this year.”

Regarding the Lords’ conclusions on non-audit services, Helen Brand says: “We disagree with the report’s conclusions. While we accept that there is a strong case for auditors to be excluded from internal audit work, we do not feel that tax advisory work should be included in any ban, and certainly not for smaller entities. Most companies will feel aggrieved at the prospect of having to take on another firm of advisors to do tax work, something that seems costly and unnecessary.”

Concluding, Helen Brand says: “Lastly, the report calls for a reduction in the audit requirement for smaller companies in order to ‘lower regulatory costs’. The Department of Business, Innovation, and Skills (BIS) has also recently suggested this, but both the Lords and BIS have failed to recognise that there would be a downside to removing external checks on small companies’ finances. Audit must not be so lazily confused with red tape.”
 

DMGbus's picture

Big 4 discredited? Too close to management? Selling their sign

DMGbus | | Permalink

I'm sure I saw a report last year that a "whistleblower" brought their concerns about wreckless lending to the the attention of their employer's auditors - and what happened?

The auditors rubbished the whistleblower's concerns.  The auditors sided with bank management in effect.   The bank was later one of those to almost go bust.

So, in effect the "Big 4" audit firm were working for management and not for the shareholders - they were in effect doing no more than doing robotic audit procedures to "tick the boxes" and "Selling their signature" to help management.

As it happens I seem to recall the same Big 4 firm justify the sell-off of a publicly owned business to its management many years ago at an undervalue and discount other higher offers as the local politicians really wanted to sell to management rather than to a third party.   Another example of "signature selling" I wonder?

Its about time that if a firm wish to audit a PLC then they should provide little or no other services to that PLC.   Also, lets see REAL rotation of auditors.  Only having a big FOUR is an issue, maybe we need a big TEN?