Auditors: EAC Report

Lord Northbrook Excerpts

Wednesday 14th March 2012 Grand Committee

[Lord Northbrook]

My Lords, we are all grateful to the noble Lord, Lord MacGregor, and his committee for a thorough, detailed and important report. Like him, I am very sorry for the delay of nearly a year before we have come to discuss it.

As other speakers have said, the report covers four major issues: the dominance of the big four accountancy firms; whether the traditional audit still meets today’s needs; the effect on audit of the adoption of international reporting requirements; and how banks were audited before and during the banking crisis and what changes there should be. Having carefully read the report, I find that the second and third issues are well covered but, though very reluctant to disagree with such an eminent team on the committee, I find the conclusions on the first and fourth issues slightly unsatisfactory. I will go on to cover each issue in more detail.

There is no doubt about the dominance of the big four accountancy firms in auditing large quoted companies. As the noble Lord, Lord MacGregor, has already said, in 2010 the big four audited 99 out of the FTSE 100 leading firms, and around 240 of the next biggest FTSE 250 firms. They also had about 80 per cent of the FTSE smaller capitalisation firm audits.

I first make one comment based on my experience as an investment manager. I always had a comfort factor in seeing the name of a big four auditor, particularly when looking at a small and growing company's accounts. Several companies with smaller-sized auditors came to grief through, as it subsequently proved, being allowed to adopt overoptimistic accounting policies, which I am sure would not have been tolerated by the big four auditors. I am not sure that that is fully appreciated by the committee’s report.

The report also states that the chairman of the Hundred Group of finance directors of FTSE 100 companies said they were, in general, content with the service provided and the competition they noticed in the market today. I know it may be heresy to say so, but I do not know what is going to be usefully achieved by a Competition Commission investigation, even though the noble Lord, Lord Currie, has made an interesting argument for the merits of BDO and Grant Thornton, and I know it is supported by the Economic Affairs Committee and the noble Baroness, Lady Hogg, of the Financial Reporting Council.

What will it conclude? Are major companies going to be forced to change auditors? I cannot see the advantage of mandatory joint audits either, and nor can the Government in their response to the committee’s report. I also cannot really agree with the idea of compulsory tender for audits every five years. The reply from the Government—and that of the noble Baroness, Lady Hogg—suggesting a more flexible approach is better. I agree with paragraph 53, which refers to the noble Baroness’s view that,

“the expected abolition of the Audit Commission would provide an opportunity to increase competition and choice in the audit market if it formed the basis of a substantial new competitor to the Big Four”.

Paragraph 60 of the report also raises an important question about whether the limited liability partnership status of the medium and smaller-sized audit companies will be sufficient to protect them from unlimited liability. According to the noble Baroness, Lady Hogg, the situation is not entirely clear on this matter.

The third issue is the major impact of international financial reporting standards. Although I am far from being an expert on these matters, I note—as have many other speakers—with interest the sentence in paragraph 113 that states:

“In short, a box-ticking approach is replacing the exercise of professional judgment which allowed the auditor’s view of what was true and fair to override form”.

The report then moves on to the application of IFRS standards to UK banks. The letter by the noble Lord, Lord Flight, in Appendix 7 of the report is very interesting on this subject. He makes three interesting, if rather technical, points: first, that the accounting treatment of the granting of options to be booked through the profit and loss account both obscures the real trading position of the business and fails to advise shareholders of actual or potential dilution. It is significant that Adam Applegarth, then CEO of Northern Rock, told the Daily Telegraph in 2005 that moving to IFRS had introduced more volatility and led to “faintly insane” profits growth.

Secondly, as the noble Lord, Lord Hollick, discussed earlier, the IFRS mark-to-market standards served to overstate capital resources in buoyant times; subsequently they served to understate them in difficult times. Thirdly, he considered that the requirement to discount pension fund liabilities at a rate of interest measured by prime bond yields overstates effective liabilities and has been a major contributor to the demise of final salary pension schemes.

The committee overall concludes that IFRS standards are not fit for purpose. However, in their response, the Government disagree and do not accept that they have led to this loss of prudence. The results of the panel convened by the FRC and chaired by the noble Lord, Lord Sharman, which were published in November, identified lessons on going-concern and liquidity risk for companies and auditors. Again, as the noble Lord, Lord Hollick, reiterated earlier, the key sentence of its preliminary report, as far as I am concerned, is:

“Require the going concern assessment process to focus on solvency risks”—

to the entity’s business—

“as well as liquidity risk”.

The final major issue of the report is how banks were audited before and during the financial crisis and what changes there should be, including to auditors’ relationships with financial regulators. I think overall the committee is unfair in criticising the auditors so strongly in paragraph 142. I support the comments of the heads of KPMG, Deloitte and PwC: the role of auditors, in my view, is to count the score at the end of an accounting period. They are not trying to forecast next year’s profits. It is not the job of the auditor to look at the business model of a business; that is the job of management. Surely the job of monitoring the day-to-day activities of the banks should be for the regulators. Auditors look at the company at a set time, not throughout the year, as regulators should be doing. Otherwise, what can be the limits of the auditor’s responsibilities?

For instance, the FSA, in its report on Northern Rock, tells us that its insurance team was in charge of regulating the company. No wonder it totally failed to understand the dangers of the company’s business model. How could auditors influence the disastrous tie-up between HBOS and Lloyds TSB which was personally engineered by the Prime Minister? How could they have influenced the RBS takeover of ABN AMRO which Barclays was also interested in? It was a management decision and seemed justifiable at the time. Let us remember that neither the regulators nor the rating agencies foresaw the major problems which began in the USA with the abandonment of the Glass-Steagall Act and the US Government’s decision to allow cheap loans to NINJAs—those with no income, job or assets.

Finally, I would just like to requote paragraph 151 of the Economic Affairs Committee report which states that,

“very few in senior management positions in the major banks had more than a ‘cloudy’ grasp themselves of the mathematical models used to value the banks’ complex financial instruments”.

From my knowledge, I fear that that is true. Universities, such as Reading, offer highly detailed courses in financial instruments. This is a relatively recent development, so I am not surprised that senior management is not up to date. Surely they should do courses as well. Auditors should also go on courses to familiarise themselves more with these products. Overall I welcome this most interesting report despite my disagreement with parts of it. It has been an excellent undertaking, but the important dialogue in my view is not between auditors and regulators; it should be between regulators and companies.