FRC lets KPMG off the hook for HBOS audit

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Well, at least one of the dark clouds over KPMG’s head has dissipated: the Financial Reporting Council (FRC) has cleared the Big Four firm of any wrongdoing in HBOS’s collapse.

While KPMGs South African troubles continue unabated, the FRC’s closure of its belated 15-month investigation into the HBOS audit will be a welcome relief. The accounting watchdog concluded that a tribunal would not be called as “there was not a realistic prospect that a tribunal would make an adverse finding against KPMG in respect of the matters within the scope of the investigation”.

‘A loose rivet below the waterline’

KPMG’s trouble began with its audit of HBOS’s accounts at the end of 2007. As the bank’s auditor KPMG agreed its designation as a going concern. The HBOS accounts which were published in February of 2008 reflected this fact.

Barely six months later the bank was on the edge of extinction.

KPMG’s critics - chief among them MPs on the Treasury Select Committee - have excoriated the firm for what they see as lacklustre due diligence. The Treasury Select Committee didn’t spare the FRC either, with Andrew Tyrie referring to the watchdog as “a loose rivet below the waterline”.

KPMG, however, has always maintained - and the FRC agrees - that they couldn’t have predicted the financial shock of 2008. As the FRC puts it: “The evidence of market conditions at that time did not show this decision of HBOS or the auditor’s assessment of it to be unreasonable at the time.”

For KPMG, it’s an acquittal - but a rather unceremonious one. The FRC, although it cleared KPMG of wrongdoing, said the firm’s work did “not fall significantly short of the standards reasonably to be expected of the audit”.

That is, the Big Four giant fell short of professional standards - but through incompetence, rather than indifference or intent. Indeed, the entire FRC statement is filled with these sorts of constructions.

Not unreasonable

Most prominent is the accounting watchdog’s contention that KPMG’s assessment was “not unreasonable”. In a letter to the FT Paul Merison, the audit lecturer at the London School of Finance and Business, mocked this as “the equivalent of you asking me if you are attractive, and me replying that you are ‘not ugly’”.

Speaking to AccountingWEB, Merison explained that he believes the issue at hand is deeper than just KPMG. “The underlying problem has been that the auditors check whether last year's accounts are telling the truth. Strictly speaking, auditors are not checking whether the entity is a viable enterprise,” says Merison.

“However, unstrictly speaking, because accounts are produced on a going concern basis, and because companies are required to disclose if there's any significant threat, if you present accounts and say there's no significant threat, you are saying, indirectly, there's no threat to the going concern.”

“Companies don't want to mention something if they don't have to. The auditors don't want to upset their clients, and everytime we have one of these and the auditors didn't spot it, people will start wondering what the point is of bringing in an auditor.”

It's clearly a criticism that the FRC is aware of. The body says it will publish a report in October on the steps it has taken to improve audit and corporate reporting since the financial crisis sparked a wave criticism of the audit profession.

About Francois Badenhorst

I'm AccountingWEB's business editor. Feel free to get in touch with comments, tips, scoops or irreverent banter. 

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28th Sep 2017 11:10

What is the point of an Audit, period? Isn't really that the job of HMRC? Of course the bigger the business the more permutations.
So why are we not surprised when the FRC always get it wrong?

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to johnjenkins
28th Sep 2017 12:42

Presumably you have never done an audit.

The point of an audit is to provide users of accounts with a measure of assurance that they have been put together honestly and accurately.

I am lost by your reference to HMRC. They are among the users of accounts who potentially benefit from the enhanced level of assurance that an audit should provide. But how can HMRC provide assurance to other users, and why is it their job to do so?

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to johngroganjga
28th Sep 2017 12:54

It is very concerning that so many do not seem to understand what an audit is (and what it isn't).

Quite how we fix that...

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to johngroganjga
28th Sep 2017 14:08

Perhaps I didn't word my post correctly.
I was being facetious. I trained as an audit clerk in the early 60's.
I do not think, these days, audits provide the proper level of assurances.
It is the job of HMRC to make sure large concerns pay the Right amount of tax. If we want to get things right let's do it from the top down rather than persecute from the bottom.

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to johnjenkins
28th Sep 2017 14:34

But the issue at hand is not whether a company has paid appropriate tax (and HMRC will no doubt sort that out through their own separate processes).

This is about how (or maybe even whether) companies should have to disclose difficulties they are having, and likewise how auditors should respond if such disclosures are weak or missing entirely.

it is also about whether any outsider can know if directors are lying to them, given that only the executives have all the information.

It is also about whether the audit process as it currently stands is too narrow, or maybe auditors are too unwilling to say what needs saying (backed up by regulators who might also be unwilling to criticise).

I recall a few years back someone reporting that auditors had had a good crisis, or something similar - the audit process (which had not highlighted a single going concern issue at any bank, presumably) had gone as planned. In effect, not our problem the banks went pop, we did our job the way it should have been done.

Which surely implies the audit itself is not doing what shareholders want it to do.

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to Charlie's Mate
28th Sep 2017 16:24

If an important issue has not been disclosed it makes one suspicious as to what else has not been done properly which could influence the tax position.
This is not an isolated case is it? Quite honestly it makes me wonder if Audits carry the same weight as they used to. Although I have to laugh when lenders ask for audited accounts for a business with a turnover of £50k.

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28th Sep 2017 12:51

With audit reports now enhanced, one would hope that the auditor's view on going concern status would now be clear (in reference to my FT letter quoted above). However, in the same circumstances, even with the audit report changes, I imagine the directors would have disclosed no going concern issues and the auditors would not have raised this omission as a problem.

Nobody wants to mention the threat of a problem, because disclosing it magnifies the chance of the threat becoming a reality of course.

But the simple truth is that by February 2008 when this audit was signed off, the Fed and ECB were pumping billions into the banking sector to shore things up, numerous articles were stating concern over how bad things actually were, some banks had already imploded and the UK government was creating a new emergency law to allow them to step in and save the markets in a crisis.

If that does not suggest a significant threat existed (to every bank), I am not sure what does. How it avoided disclosure in the Accounts (and audit report) is beyond me.

One year later HBOS disclosed (finally) the threat caused by the state of the markets. It had just been taken over by Lloyds. The disclosure is pretty general and mentions no specific HBOS threat. Much of what that disclosure said had also been the case 12 months earlier, and whilst the situation had of course worsened over that 12 month period, in my humble opinion the 2008 disclosures were also suited to the 2007 Accounts.

But even in 2008, KPMG's audit report did not refer to the Note disclosing the threats, which in my opinion it should have done.

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By MDK45
to Charlie's Mate
30th Sep 2017 14:57

Exactly what I think. I was trying to recall the chronological sequence of events and wondered why going concern wasn't emphasised as the world crashed around them.

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By MDK45
to Charlie's Mate
30th Sep 2017 14:57

Exactly what I think. I was trying to recall the chronological sequence of events and wondered why going concern wasn't emphasised as the world crashed around them.

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By ShayaG
28th Sep 2017 17:45

There is no point to an audit. Money cannot buy independence. Hence the forensic accountancy profession for those who do need financial reporting rigorously tested.

The financial incentives are stacked in favour of those who can, like the three wise men, collate an audit file and find no evil. There is always "wriggle room" or, as auditors like to call it "professional judgement." Hence, matters as basic as a quantification of "material" are missing from audit standards.

You cannot expect an auditor to rigorously challenge those whose fees puts food on the table for the family and pays the mortgage. The 19th century model of audit does not work.

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to ShayaG
01st Oct 2017 12:42

I think you are overly cynical, but I accept the logic of your central point that auditors cannot be wholly independent of those who pay their fees. What would be your solution? Abolish the audit requirement entirely as the whole endeavour is inherently pointless? Or nationalise the auditing profession and make them all civil servants remunerated from public funds?

I am at a loss about your reference to the forensic accountancy profession!

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to johngroganjga
02nd Oct 2017 12:06

The big question has to be this - when a company fails to disclose it might have serious issues, and the auditors do not say a word, to what extent is this directors hiding info from the auditors, or the auditors not wanting to upset a big fee client, or the auditors not understanding the client well enough, or the auditors simply following the path of least resistance (i.e. doing nothing)?

It will vary a bit no doubt, but I am not convinced this is as much about the money as people may think.

What should have happened in 2008 (and surely did happen) is an experienced KPMG partner sat in a meeting with the KPMG audit committee - a meeting of equals one would hope - and the ongoing banking crisis was discussed. The HBOS audit committee cannot have denied a crisis but presumably said that they felt the bank was safer than others might be, and were satisfied no disclosure was required in the financial statements.

My concern here is that it is very possible that neither the auditors or the audit committee understood enough about the interaction between every player in the banking industry (meaning every single bank on the planet was at risk) and as such were in no position to realise the true scale of the problem. In fact, given how far above the coalface most executive directors sit, I would not be surprised if most of them were not totally clued up as well.

It is now the case that directors of banks have to be vetted before they can be appointed. Let's hope that vetting process is thorough.

As for audit, I certainly believe it has a critical role to play, but equally am concerned that if auditors are not brave enough to not just ask the difficult questions, but disclose when the answers are not good enough, audit could be in trouble.

Change or die (rightly or wrongly).

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to Charlie's Mate
02nd Oct 2017 13:10

Makes you question what good any of them (the bank and KPMG) are then really doesn't it? So the audit committee of a bank, and the senior partners of the largest auditors in the world, sat around a table and were oblivious to what state the market was in and what risks there may be? Despite banks having a credit and risk committee specifically dealing with things like this, and KMPG getting paid millions for advising banks day in day out. Seemingly oblivious to the fact that lenders were giving 125% self-certification mortgages to people who couldn't afford it, and what may happen if property prices fell, or the liquidity ran out. Really? Well no, not oblivious, infact fully aware of the exact situation but the bank didn't want to have a qualified audit report, and KPMG didn't want to qualify it and lose the fees, unfortunately for them they didn't get away with it this time.

As a sole practitioner I would get crucified by my regulator for signing off an audit report on even a small job with that level of incompetence, even though virtually no-one actually relies on that audit. There's clearly 2 very different sets of regulations and standards for auditors.

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By ShayaG
to johngroganjga
02nd Oct 2017 15:10

Hi John,

I have a series of proposals, all informed by the fact that we clearly do not have a properly functional independent auditing system and in fact never have had such a system for the past century - yet nevertheless capitalism has lurched onwards (from crisis to crisis...).

1) Remove all reference to "audit" or "independent" and rename "accountant's report". Close the expectations gap by removing any expectations that the accountant's report offers any assurance at all. The only obligations accountants have are to the directors and professional / ethical obligations.
2) Reporting accountants to have presumed responsibility for financial statements as shadow directors of their clients.
3) The inclusion in listed accounts of audit evidence as specified by regulations. if confidentiality is important to you, don't take investment from the public.
4) Quantification of "material".

I don't mean to tar every auditor with the same brush. There are some wonderful courageous people out there.

My refernce to forensic accountants was to a profession which does what people think auditors do - rigorously interrogate and challenge dodgy financial reporting.

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to ShayaG
02nd Oct 2017 16:28

Accountants report.
These Accounts have been produced from the records and explanations supplied to us and give a true and fair view.
Meaningless and absolving.

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By ShayaG
to johnjenkins
02nd Oct 2017 17:19

Precisely. Because, let's face it, it is. Like the audit report with the Bannerman paragraph but without the potentially dangerous pretense of impartiality.

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to johnjenkins
03rd Oct 2017 09:30

That's a made up report that bears no resemblance to what any accountant would ever issue. You have just made it up so that you can criticise it.

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to johngroganjga
03rd Oct 2017 11:26

So post an Accountants report that isn't meaningless and absolving.
I'll give you a start. We have carried out an audit (checked 3 months, found nothing material so assumed the rest of the year is ok as the bank balances) and the above Accounts form a true and fair view of the business at (year end).
I've seen so many different formats which all bear a similar resemblance.

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to johnjenkins
03rd Oct 2017 12:28

On the one hand:

"We have prepared the accounts from the information and explanations given to us. We have not carried out an audit".

On the other hand:

"We have carried out an audit in accordance with auditing standards. In our opinion the accounts give a true and fair view and comply ... etc"

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to johngroganjga
03rd Oct 2017 13:35

Thanks for proving my point.

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By ShayaG
to johnjenkins
03rd Oct 2017 15:19

How about "We have compiled these accounts in accordance with our professional obligations, but express no opinion or assurance as to their veracity to third parties."

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to ShayaG
03rd Oct 2017 15:42

You could use that as a reference as well.

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to ShayaG
03rd Oct 2017 15:51

That's in effect what a standard accountant's report says, and always has said. It's not something new.

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By ShayaG
to johngroganjga
16th Oct 2017 18:47

What is new is that I would ban use of the word "audit" in connection with standardised year after year reports on accounts.

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to johnjenkins
03rd Oct 2017 15:55

Your point was about a made up report where accountants had not done an audit but nevertheless gave a true and fair opinion.

My examples were stylised extracts to show how actual reports make the distinction clear. How that proves your point that accountants habitually fail to make the distinction in their reports is beyond me.

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to johngroganjga
04th Oct 2017 09:33

You've either missed the point or I'm not making myself clear.
The wording is not in question it's what the wording means is the crux.
I think this case actually proves what I am saying.

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03rd Oct 2017 09:00

It is my view that "trust" (not just in Accountancy) has gone out of the window. You've only got to look at the Tory and labour party to see what I mean.

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03rd Oct 2017 15:43

I am not convinced the wording of the opinion is the issue.

It could perhaps be worded more simply and build in materiality (in our opinion profit is correct +/- $5m, or similar), but the bigger issue is that it is not in the directors' or auditors' interests to disclose bad news, meaning there is a fairly strong chance it will not get disclosed.

There may be no magic solution to this. More detailed investigations (e.g. legal) typically take years (and cost a fortune) meaning by the time we find out the truth it is largely irrelevant (other than to belatedly prosecute those who are guilty).

There is no doubt that HBOS directors and KPMG knew a banking crisis was occurring. It was too far down the line for it to be ignored. The question is whether HBOS directors understood how much trouble they were in, whether this was something that could be tested by auditors (or whether it was more gut feel), and whether the auditors knew they could have turned over more rocks but decided they did not want to see what was underneath.

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By ShayaG
to Charlie's Mate
16th Oct 2017 18:45

I am convinced the wording is part of the issue. The very word "audit" is a misleading description of what an audit actually is in reality. I'd like to take a poll of professional accountants to see if they place any more trust in audited versus unaudited accounts. I don't.

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05th Oct 2017 08:51

Perhaps if it were the shareholders who had to submit the Accounts instead of the directors things might be different (I know that's impossible for the larger companies with many shareholders). For the shareholders to rely on an audit, auditors have to be trusted. This case does nothing to enhance that trust.
However I do take the point that an auditor could bring a company down with lost jobs resulting.

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