Auditors: EAC Report

Lord Hollick Excerpts

Wednesday 14th March 2012 Grand Committee

[Lord Hollick]

My Lords, I thank the noble Lord, Lord MacGregor, for his excellent chairmanship of our committee and for the very clear review of our report that he has just given. I apologise to the Minister and noble Lords for my early departure from today’s debate to catch a flight to Berlin this evening.

I shall focus my remarks on the committee’s work on how banks were audited before and during the financial crisis and on the impact of IFRS rules on the audit. Banks rely on the confidence of depositors, bond holders and investors to survive. That confidence is founded on the belief that the bank is a going concern. In his report Going Concern and Liquidity Risks, to which the noble Lord, Lord MacGregor, referred, the noble Lord, Lord Sharman, and his colleagues identify two elements to the going-concern test: solvency, which is the ability to meet liabilities in full; and liquidity, which is the ability to liquidate assets at the velocity needed to meet liabilities as they fall due.

If confidence is shaken, the flow of funds to the banks dries up and the fragile business model, which in essence is to borrow short and to lend long, is imperilled and a funding crisis ensues. That is what happened in 2007-08 and, to a considerable degree, the problem persists to this day. Indeed, eurozone banks, in particular, are wary of lending to one another and therefore place their funds with the ECB, which recycles the funds to other banks. That recycling was augmented at the end of 2011 by the ECB’s three-year LTRO—long-term refinancing operation—which is a programme to ease liquidity and introduce quantitative easing into the eurozone. However, that programme does not address solvency. Indeed, it could exacerbate solvency if the banks use the LTRO funds to add to their holdings of risky sovereign debt.

The annual audit, particularly the going-concern test, is crucial to building and maintaining confidence in banks. Without it, banks become uninvestable and unable to fund their day-to-day activities. Our report highlighted several areas of concern. We noted that, in recent years, as the noble Lord, Lord MacGregor, has said, the traditional principles-based approach of auditors has been replaced by a more rules-based approach. “Prudence”, “true and fair view” and “going concern”, all viewed through a sceptical set of spectacles, have given way to a close adherence to rules, which to some observers looks, as the noble Lord, Lord MacGregor, has said, like box-ticking supplanting mature judgment.

For the auditors, this approach makes life a little easier. There is less likelihood of litigation, which of course is a major issue in the United States, whose voice is probably the loudest at the global debate on audit rules, and there is less pressure to use judgment. Yet informed, experienced judgment by a professional sceptic is precisely what is needed. The recognition of losses on loans and other assets held by the banks is just such an issue, where judgment really matters. Instead, IFRS rules are now paramount and IAS 39 requires that provisions against these assets can be made only for incurred, and not expected, losses. This led to a procyclical reporting of bank profits, which Mr Timothy Bush of the Investment Management Association said was in conflict with the Companies Act 2006 requirement to prepare accounts prudently without crediting any unrealised profits. Professor Fearnley saw IAS 39 as far less prudent than its equivalent under UK GAAP because it substituted neutrality for prudence. As a result, the profits of banks were artificially boosted during the period leading up to the banking crisis—including, in some cases, unrealised profits, leading to unjustifiably higher bonuses and dividend payments, a practice colourfully named in the City as “skimming”. That “skimming” led, when the true state of affairs became apparent, to an even larger hole in the balance sheets of our banks, which of course had to be filled with taxpayers’ money.

IFRS rules require assets to be mark to market, which is fine if there is a liquid market, but all too often the assets held by banks—some devilishly complex and frankly beyond the ken of most bank directors—are either not traded or so infrequently traded that a market valuation is meaningless. Quite perversely, such practices could actually lead the banks to write up the value of certain assets, thereby recording unrealised profits which were deemed available for distribution but which turned out to be wholly fictitious when the asset matured or came to be realised.

Before the advent of IAS 39, banks and their auditors were able to apply prudence to loan asset provision and to provide against anticipated but not incurred losses. IAS 39 forbids that. It even has the absurd example in its practice note that a loan to a dead person who died before the accounting date can be provided against, but no such provision can be made if the death occurred after the accounting date. In the world of absurd things, this probably trumps Donald Rumsfeld’s “known unknowns”.

A judgment about the liquidity of the bank is critical to its going-concern status. In retrospect, it is clear that many of our banks were dangerously reliant on short-term money market funds. This risk of illiquidity was not spelt out by the directors or auditors in their report, yet it goes to the heart of the viability of the bank’s business model and its going-concern status, so essential to creditor and depositor confidence. The senior partner of PwC told us:

“It’s not the job of the auditor … to look at the business model of a business”.

This, as we conclude in our report, appears disconcertingly complacent. The noble Lord, Lord Sharman, in his report, says:

“The going concern assessment should focus on the risks the entity takes and faces that are critical to its success or which could cause its business model to fail”.

It is simply not good enough for the auditors to stand aside. It is their job to look at and analyse the business model, and to satisfy themselves that the bank is indeed a going concern. They cannot hide behind the director’s judgment. Indeed, they should recall that when, in 1879, banks were allowed to become limited liability companies, Parliament made it abundantly clear that it intended the auditor to be the last honest man standing, to protect the interests of depositors and investors.

Reliable and transparent bank accounts are essential to rebuilding confidence in our banks. Andy Haldane, the executive director for financial stability at the Bank of England, has called for a different accounting regime, which allows for judgment and prudence to be exercised. His colleague Andrew Bailey, the chief cashier, wrote:

“Current financial statement disclosures … despite being compliant with accounting standards are … not sufficiently granular or transparent … to support users’ understanding”.

The credit rating agencies offer no help. Leaving aside their calamitous record over the past few years, they too have to rely largely on published accounts.

What is the Government’s response to this urgent problem? They agree with the committee’s conclusion that financial institutions should build appropriate capital buffers to provide against downturn. They welcome signs that accounting standards boards are proposing to move to an expected-loss model that provides for a more forward-looking approach to how credit losses are accounted for. Then timidity creeps in. They say:

“Financial reporting however, is designed to convey a true and fair view at a point in time”.

That lets the auditors off the hook on the going-concern test and puts the auditors’ interests ahead of the users’ interests. I would like the Minister to tell us when the Government expect the new forward-looking approach to accounting for credit losses to be introduced. In their response they mention that it would be June 2011. It clearly has not been. As I understand it, there is a three-year backlog among the accounting standards setters, so the earliest that one could expect this would be the middle of this decade, by which time we will probably have another financial crisis.

I ask the Government how they respond to the Sharman report’s call for the going-concern test to be more qualitative and longer-term in outlook rather than, as they say in their response to our report,

“at a point in time”.

Also, what steps do they plan to take to put prudence and judgment back at the heart of accounting, as called for by the Bank of England, which echoes the principles in the Companies Act 2006 setting the requirements for audited accounts to give a true and fair view above all other standards?