Auditors: EAC Report

Baroness Hogg Excerpts

Wednesday 14th March 2012 Grand Committee

[Baroness Hogg]

My Lords, I, too, should like warmly to congratulate the noble Lord, Lord MacGregor, and his committee. First, however, I must declare my interests—which are in the register—principally, today, as chairman of the Financial Reporting Council.

The report was, as one would expect from this distinguished committee, rigorous in its analysis, but equally important, and much more unusual, have been the results. As a former member of this committee, I cannot think of another inquiry conducted by it in recent years that has had such a powerful effect. I am sure that the Minister will provide an excellent summary of the actions taken by government and regulators following this report, so I shall concentrate on those taken by the FRC.

As many noble Lords have said in this debate, these issues go to the heart of the effective functioning of capital markets. The FRC’s mission is to,

“promote high-quality corporate governance and reporting to foster investment”.

This reflects our recognition that the willingness of investors to provide risk capital—a vital link in the chain of economic growth—depends on their confidence in how companies are run and how their accounts are prepared and audited. So, after the financial crisis, this report was timely and influential.

I would diffidently say to the noble Lord, Lord MacGregor, that the committee did not have to tell us at the FRC that the efforts we were making within our remit to reduce concentration in the market had made very little difference. We have been shouting that loudly, hoping someone would take notice. We are delighted that the committee did and that the alarm it sounded penetrated more ears and led to the Office of Fair Trading asking the Competition Commission to take another look. This is a very important step which we hope will also lead to thinking, at national and international level, about what the government response would be if there were to be another crisis and a threat that the big four would come down to three.

We are also very pleased that a new point of alarm on domestic concentration that we raised with the committee has been taken up by it and then picked up by the Government. Like the noble Lord, Lord Hodgson, we welcome the action that the Government have taken to ensure that work flowing from the abolition of the Audit Commission is well spread among firms of a certain size and not concentrated among the big four.

The European Commission is right to see concentration as an international issue. However, the reason why we want a competitive audit market is to safeguard audit quality, not to endanger it. We have therefore made clear that we are opposed to certain EC proposals, such as the break-up of the audit firms, which we think would damage quality.

Equally, we want to encourage competition in order to empower choice of auditors, not simply to disrupt it. We believe that clearer guidance on non-audit services will both deal with conflicts of interest and stimulate market development. We will also shortly be publishing proposals that do not enforce a merry-go-round of compulsory auditor rotation but request companies to retender their audits after eight to 10 years. This should be introduced on a “comply or explain” basis and with transition arrangements to prevent market turmoil. We must not disempower the audit committee from choosing the best firm for the job.

Whatever improvements are needed, we must not shoot ourselves in the foot. Despite all its strictures, the committee noted much evidence to support the view that British auditing is among the strongest in Europe and indeed is arguably the world leader. Moreover, our approach to corporate governance, of which audit is a key component, has helped give us the deepest capital market in Europe. We must continue to strive for improvement. The audit inspection unit continues to highlight weaknesses—as the profession will tell you, sometimes through gritted teeth. However, in considering EU reforms, we must avoid a surfeit of prescription designed to raise standards elsewhere. Rules that are too detailed damage the willingness to exercise judgment; and judgment is what we most need in times of crisis, as the committee has rightly said.

Many of the key recommendations of this report chime with the proposals that we at the FRC have set out in our paper on effective company stewardship. I hope that all Members of the Committee have had the opportunity to read this report. I would be happy to send copies to those who would like it. They may have noted particularly the points on auditor scepticism in this report.

We are very mindful of the questions that members of the committee raised about the role of accounting standard-setters, preparers of accounts and auditors in the financial crisis. Put simply, the challenges were: did they do their job; if they did not, what is being done about them; and if they did, what does that say about the value of accounting, reporting and auditing?

The most far-sighted members of the accounting profession do not seek to answer these challenges simply by reminding us of the limitations of accounting and audit or by asserting that these are mysteries others cannot challenge. They are willing to engage in a more ambitious debate on how the value of audit can be enhanced and how accounting standards can be improved. The committee has challenged the monopoly of wisdom of the technical standard-setters. Our reforms at the FRC are designed to help us engage with the wider debate. Many of the weaknesses in IAS 39 that have been referred to have been addressed, in fairness to the technicians, but we are still concerned about the speed of implementation. Brussels seems to take the view that all changes should be saved up to do together. We believe this to be unnecessary delay.

Meanwhile, as the Minister will no doubt confirm, at the FRC we have taken the lead on a key issue by asking the noble Lord, Lord Sharman, to head an inquiry into the role and value of going-concern statements. His draft report has been published and we expect the final report shortly.

For this report raised a deeper challenge for the FRC. The committee criticised our structure, finding it confusing and overcomplicated. Indeed, we have at present some seven operating bodies to fulfil one objective. The result is that too much of our work is done in silos, and there are overlaps and underlaps between them. This is no criticism of the excellent people involved. Some of these barriers are statutory, others derived from the way in which the FRC was cobbled together. However, the committee was right to call for change, and we are glad that the Government have responded.

We need to share knowledge across the organisation in order to operate more effectively, both in our conduct role in the UK and in the international debate on codes and standards. Our international task has become a much more complex exercise, requiring us to mobilise all the expertise in different operating bodies for maximum effect, and for cross-silo challenge within the organisation.

We also need to ensure that the work of the audit inspection unit is useful to chairmen of audit committees and maximise the combined value of the work of the audit inspection unit and the financial reporting review panel. We also need to clarify the dividing lines between ourselves and the professions so that we can truly claim to be an independent regulator. Clarifying that status will also help us to work more effectively with other regulators. The noble Lord, Lord Lawson, rightly highlighted the breakdown in the arrangements that he put in place to ensure the Bank of England's assessment of macroprudential risk was informed by what the major audit firms were seeing. He also used this inquiry to probe at the gaps and overlaps between regulators.

Legislation is not for us, but with these challenges in mind we have with the Bank's help put in place a forum for information flow and discussion of risks and appropriate responses between ourselves at the FRC, the Prudential Regulation Authority, the Financial Conduct Authority and the Financial Policy Committee. The reform proposals that we put forward jointly with government would streamline our work on codes and standards on the one hand, and conduct—review, inspection and disciplinary action—on the other.

I welcome the prompt that the committee's report gave to fresh thinking about this in government and at the FRC. We have had a lively consultation on our proposals and done our best to respond to the points made without compromising our independence or losing the opportunity to match our organisation to today's challenges. I hope that we will receive a statement from the department on this soon, and look forward to hearing what the Minister has to say. I hope that the resulting reforms will lead the committee to conclude that we have responded to its challenge.