Auditors: EAC Report

Lord Hodgson of Astley Abbotts Excerpts

Wednesday 14th March 2012 Grand Committee

[Lord Hodgson of Astley Abbotts]

My Lords, I was not a member of my noble friend’s committee, but I add my congratulations to him and his fellow committee members on a really interesting—indeed, fascinating—report that raises many important issues, both within and without the banking system. I have a number of relevant interests declared on the register of your Lordships’ House, but I draw the committee’s specific attention to the fact that I am the senior independent director—the SID, as it is known in the trade—of one of the FTSE 250 companies. I am a member of its audit committee and chair of its remuneration committee.

I will focus my remarks not on the banking issues, which have been ably and decisively covered by my noble friends Lord Stewartby and Lord Lawson. I will focus my remarks on the first two issues that the committee looked at: the dominance of the big four and its effect on competition and choice and whether the traditional audit still meets today’s needs.

The committee hit the nail on the head when it mentioned in paragraphs 18.vi and 18.vii,

“the perception that big is best”,

and,

“the reputational assurance of using Big Four auditors”.

These things are at the heart of the difficulty that we face. I do not wish to press the noble Lord, Lord Currie of Marylebone, but I think it unlikely that my co-directors would be prepared to take on a firm outside the big four, even if it were demonstrably cheaper and probably even if the service was the same. We are reaching the tipping point, but we are not there yet. There is more to be done along the lines that I shall refer to in a minute and which he was hinting at in his remarks. The noble Lord, Lord Shipley, asked how we deal with conflicts of interest. Well, we have a fairly clear way of doing that, in the sense that we make sure that we measure the amount of non-audit work that we are giving to the firm, we measure the amount that we give to the firm in relation to the total in the office—in other words, how big we are in relation to that particular firm’s regional office—and we disclose in the annual report. Where we have areas where conflicts of interest are clearly irreconcilable, such as international law, we use another firm. We go outside for things where we cannot satisfy ourselves that we can have a proper divide-and-rule situation.

I was not at all surprised that the committee reached the conclusion that the Financial Reporting Council’s market participants group had not really achieved very much. The suggestion in paragraph 49 that the way in which to encourage more participation by firms outside the big four is by involving institutional shareholders is, I fear, doomed, as my noble friend Lord MacGregor said in his opening remarks. I am not hopeful because it is pretty difficult to get institutions or shareholders to engage at any level. It is very depressing, with a few honourable exceptions. Apathy and worse is the only description of their interest.

Why is that? In the company I am talking about, three of our top 10 shareholders are tracker funds, so they have no particular interest in what we are doing. In fact, they would rather not see us as it might bias them in a sense. They want us to follow the index exactly or they do not want to see us at all. For others, best governance practice suggests that the SID—senior independent director—should meet the major institutional shareholders once a year. Trying to get a meeting is extremely difficult. Most of the time they say that they are perfectly happy and do not want to meet you. Meetings are cancelled at the last moment. You turn up and find that the man with whom you had a relationship is too busy and you end up with a junior person who may have been in the investment business for only two or three years. There is nothing wrong with that; I am not trying to sound pompous and say that I will not talk to him. The nature of the relationship that you have with your institutional shareholders is transitory in that sense. We are talking here about the operations of a company itself, not the appointment of auditors, which by its nature is of another degree of importance.

A counsel of despair surrounds one, but things can be done. First, I share the committee’s conclusion that examination by the Competition Commission is a worthwhile exercise, so that we get examination in detail of the warp and weft of this difficult issue. As to the advantage of a big bang conclusion with the recommended break-up of one or more of the big four, I am more doubtful about that. I am far from convinced. To use the famous phrase, “You don’t strengthen the weak by weakening the strong”. The halo effect will continue and may well survive and you may have damaged the firm’s international reach in the mean time.

Clearly the Government have the reach and the scale to offset some of this halo effect, so I very much support the committee’s proposal about work previously undertaken by the Audit Commission being a possible way to build a new firm. The Government should go further than the committee suggests. There are a number of areas where the Government could help to create a situation where the smaller firms reach a tipping point. For example, within the Financial Services Authority— I know that it is unfashionable to say anything good about the FSA—a Section 166 report, or expert person’s report, is increasingly being used. There is a tendency to go for the big four firms there, but reports could easily be carried out by other firms. These and other reports carried out by the FSA, and no doubt by other government bodies that I do not know about, could usefully suggest that a wider range of firms should get involved with this. There are things such as encouraging banks and private equity houses to use firms outside the big four for due diligence purposes, and there are the trade bodies—the Investment Management Association and the British Insurance Association—that could also lend their weight to ensure that over time this situation could be improved. There is no silver bullet, but with a concentrated effort from within the profession, in whose interests this sort of development must be, something will be achieved.

In my remaining remarks, I will deal with whether the traditional statutory audit still meets today’s needs. Clearly many people feel that it does not. Many people feel that it lacks focus and priorities and emphasises process at the expense of judgment. At our annual general meeting, one of our more experienced private investors said that reading the annual report was like having a bucket of warm blancmange poured over your head. Perhaps I can illustrate that in a very simple way. The company of which I am the senior independent director is a simple company. We are entirely in the UK; we have no overseas operations. Our final salary pension scheme is closed. The only complication in our business is that we have some hedging and some derivatives for our longer-term borrowings. In 1995, our annual report was 25 pages long; in 2000, it was 41 pages; in 2005, it was 76 pages; in 2010, it was 104 pages; and it will be a bigger number in 2011. I cannot see that this—

--- Later in debate ---

[The Deputy Chairman of Committees (Lord Geddes)]

It is now 5.35 pm. The noble Lord, Lord Hodgson of Astley Abbotts, who was so abruptly cut off in mid-flow, may resume his speech.

[Lord Hodgson of Astley Abbotts]

I was winding up, talking about the value of the traditional statutory audit and whether it now needs some serious revision. I said that my company is a simple company, with market capitalisation of £660 million, all in the UK, no foreign exchange, none of those complications, no open final salary pension scheme and, apart from some hedging for our long-term debt, not a great deal of complexity. I pointed out that in 15 years our annual report has gone from 35 pages to 104 pages. I questioned whether that is a useful exercise and how many people read it. In the Companies Act 2006, we thought we were being extremely clever in introducing the e-mail opportunity for companies. In a strange way, that has taken the pressure off auditors to think about the thing because they can e-mail people. Many fewer copies of the report can be printed. Increasingly the default option is to send it by e-mail anyway, so some of the self-restraint has been removed.

I think the auditing profession needs to follow this report with some serious intellectual heavy lifting to provide a greater degree of focus going forward. I turn to another context: the City at the moment. Noble Lords will have received papers from banks recommending shares. On the back page there is half a page of tiny type containing disclaimers. An investment bank put halfway down that, “If you have read this far, call this number and we will send you a bottle of champagne”. In three months, it never had a call. That is how much all this stuff is being read. It has become boiler plate. Similarly, too much of annual reports has become box-ticking and verbiage read by almost nobody. I think the profession could do a really valuable service by introducing a degree of rigour and focus. I hope that above the desk of each of the members of that working party, there will be a banner reading: “Less is More”.