Examination of Witnesses (Questions 120-139)|
TUESDAY 16 APRIL 2002
120. Professor Sikka, nine out of ten, do you
(Professor Sikka) Possibly.
121. You do?
(Mr Brandt) May I comment? I am astonished!
122. You have been swung by the argument!
(Professor Sikka) Mr Brandt is very eloquent,
so I will have to give you some alternative definition of audit.
Audit, these days, has indeed been promoted since the 19th century
as a risk management technology to enable people to get some informationalways
a question mark about credibilitybut in modern day, one
might argue that it is a system whereby we expect one bunch of
business entrepreneurs, that is accountancy firms, to regulate
another set of business entrepreneurs, that is company directors,
that is how it is really seen, and in both cases, as I indicated
earlier, the performance and success is measured by profits and
fees and clientele rather than doing something broadly speaking
for the public. Indeed, in the Companies Act, auditors are primarily
made responsible to shareholders and not really to the public
at large. Even after BCCI which raised questions about the auditor
obligation to protect depositors, there was no change to say that
the depositors should be appointing the auditors or that the auditors
should owe a duty of care to depositors in any way. So there are
those kind of issues. As regards obligations to directors, in
the evidence that I submitted to you, it shows that there is a
close relationship between directors and auditors. Indeed, a letter
is reproduced from the auditor of a major company where, before
the AGM, the auditor is telling the chairman how he is going to
answer questions at the AGM and which questions he is not going
to answer. It is preposterous that all that would be agreed beforehand.
Also, I think that Mr Brandt is right when he says that the number
of scandals are small but each scandal has a very big impact.
When you look at BCCI, 1.4 million bank depositors are affected.
How many lives? How many jobs? How many people's savings? How
much tax is lost? All these issues arise. We cannot just take
comfort that somehow we are looking at outliers, that these are
just one or two things. Remember, whether we are talking about
BCCI, Equitable Life or anything else, these cases have not been
highlighted by auditors or auditing regulators or regulators like
the DTI. They have somehow hit the street and that is how we are
123. How does your definition vary from Mr Brandt's
and what would your mark out of ten be?
(Professor Sikka) Definition of what,
for an audit?
124. Yes, the definition of the purpose of an
(Professor Sikka) I hesitate to give
marks without a full debate, as it were, but my argument would
be that audit is something which should be designed to protect
a variety of stakeholders, not just shareholders, and it has not
even been effective at that in many cases. We live in a society
where we are told that the principle of equality is overriding,
yet we have laws which say that shareholders or those who provide
finance should have better protection and better rights than those
who invest their human capital or those who invest social capital.
That cannot be right. Either the principle of equality is overriding
and should shape all our laws and social practices or it is not
a good principle.
125. So the current system is a long way away
from your ideal?
(Professor Sikka) It is a long way away
and I feel that we need action at a number of levels. We need
action at regulatory level because we are not easily going to
curb the predatory practices of directors and auditors or analysts
or bankers without strong regulation. Regulation has to be strong.
126. Let me leave it there for one second. Some
of my colleagues will come back onto those issues later on. I
would like to ask another question which is really to Mrs Fearnley.
In your paper to us, you mentioned the effects of personal incentives
and motivation and the impact that that can have on an audit.
What do you have in mind in particular that you are concerned
about in terms of the personal incentives that come into play
that may distort the conduct of an audit?
(Mrs Fearnley) What has very much come
out of our research is that for the individual audit partner dealing
with a client, and there are backup mechanisms which are being
put in place all the time, the principal concern and the principal
fear, especially for an audit partner who may be of a slightly
weak personality because it comes down, at the end of the day,
to the individual and the strength of the individual as well as
the strength of the framework, is the fear of losing the client.
That is the concern because obviously there is a potential loss
of income, maybe loss of status in the firm and that is the fundamental
issue for the individual partner.
127. What you are saying is that some partners
might be worried that if they ask too awkward questions, the client
will say, "They are a bit of a pain, let's get rid of them."
(Mrs Fearnley) Yes, that is the ultimate
concern and that is the ultimate problem for the audit firm as
well because they do not want to find themselves in a situation
where an individual partner gives into a client and the firm itself
is not aware that this has happened. So, one cannot just look
at what the firm's overall policy is, one has to look at the way
the firm manages its individual partners and the way the firm's
internal backup procedures and support procedures are such that
they put the right partners in with the right clients. If you
have an aggressive, difficult and awkward client, in reality you
probably need to put an aggressive, difficult and awkward partner
in there to stand up to them or someone who is a very tough negotiator,
and a lot of it does come down to the way the firms choose their
audit partners and the way they match their audit partners to
the nature of the clients that they have.
128. Is this an individual problem for particular
audit companies and businesses or is it something that changes
in the regulatory environments are playing a role in addressing
and, if there could be a change in the regulatory environment,
would that be to strengthen the determination of the audit companies
or would it create some type of different environment of accountability
within the companies so that there was a stronger incentive to
take a very close scrutinising role?
(Mrs Fearnley) One of the difficult things
is that it is very difficult to regulate this kind of activity
within a firm. The Auditing Practices Board has recently brought
out requirements for a totally independent partner who has no
connection with that client to review the audit. I think that
kind of a structure will go a long way to catching the partner
who is weak and rolls over and allows the client to do something
that they should not do. To an extent, the framework can help
but, at the end of the day, you are looking at the behaviour of
individuals and auditors are people the same as directors are
people and they either interact and the thing works or it does
not. If one looks at some of the cases where things have gone
wrong, you will find that the chairman or the chief executive
of the company has been an aggressive bully and that the audit
partner has not been tough enough to actually stand up to them.
129. Is that something that firms can address
at all? You might have within a firm two different interests in
the way in which the audit is carried out.
(Mrs Fearnley) Indeed.
130. You might have a business manager or chief
executive who wants everything to be brushed away, but you might
have a finance director or somebody else in the audit responsibility
who might have a very strong incentive in making sure that the
firm is audited very thoroughly.
(Mrs Fearnley) We have found from our
research cases where the finance director of the company has taken
the auditor's side in trying to push the company to move in the
right direction. We have found other cases where the audit committee
has taken the side of the directors against the auditor. It is
very difficult to regulate for the way all these sort of people
behave in relation to each other. If we could find a way of making
sure that everybody behaved themselves, that would be great. When
you dig deep into the dark side of human behaviour, it is very
difficult to regulate it completely.
131. Just following up on a couple of earlier
questions, Professor Beattie, you suggested that auditing firms
have a commercial interest in appearing to be tough in the sense
that, if they are seen to be weak, it will damage their long-term
prospects because people lose confidence in them. Do you actually
think that companies have a business place for engaging tough
auditors? Might it not actually be the case that companies would
tend to prefer auditors who were less tough or do you think they
would really lose out in the financial markets by doing so?
(Professor Beattie) I think the reality
is that some companies see a benefit to them of engaging and being
seen to engage tough auditors. They want to be seen as open and
transparent and they see commercial benefits in being seen in
that way. Other companies have a quite different set of circumstances
and wish to be less open and less transparent and would seek out
a different type of auditor. So there is a range of behaviour.
132. Would there not be a correlation between
the companies who we would be most worried about tending to choose
the auditors who would be least strict rather as if schools could
choose which OFSTED to go to from a range of a very fierce OFSTED
to a rather mild one?
(Professor Beattie) Before the audit
firms would accept an engagement, they have certain procedures
that they would go through in determining whether they wish to
take on a client and I have no evidence as to whether that varies
or not from audit firm to audit firm. I am not sufficiently involved
with the audit firms to know that.
133. I am sure that I did not express the question
very well. What I mean is if, as you suggest and I am sure it
is true, there is a range and there is known to be a range of
audit firms from the very tough to perhaps not quite so tough,
companies which are manoeuvring on the borders of acceptable practice
will tend to choose the less tough one, will they not?
(Professor Beattie) I am not sure that
I would say that audit firms range in whether they are tough or
not tough. I think companies vary in what they might seek in their
auditor. I just do not know; I have seen no evidence that the
audit firms vary in their own behaviour.
134. Would you agree with that, Mrs Fearnley?
(Mrs Fearnley) I think the individual
partners in the firms can vary in their own behaviour, very much.
(Professor Beattie) That can vary, yes.
(Mrs Fearnley) But I think it is very difficult to
express the view that firm X is tougher than firm Y because I
think that is a very difficult issue to get behind, and partner
X can be tougher than partner Y and it comes back to this issue
of matching the firms with the partners. If a firm consistently
falls below standard in what they do, the oversight mechanisms
from the inspection of work are likely to pick that up. An individual
case can go wrong but I would be very surprised if there were
systematic sloppiness in the firm and that was not actually picked
up and dealt with.
(Mr Brandt) I cannot speak from our research on this
matter but I can speak from my experience when I was a partner.
I think that the size of the listed company and the spread of
its ownership can have a great effect on whether they are treating
their accounts and their audits as being important or not. Once
you get away from the FTSE 500 up into the non-FTSE 1500 or something
like that, you have companies which are listed public companies
which are run as private businesses and you will get the aggressive
chairman, and we have come across that in our book, who is not
going to be told by an auditor what he is going to do and, as
he controls the company, he will search out somebody who is more
amenable. I do not think it is possible to say that is not true.
How you regulate that, goodness, I do not know. Just like, how
do you regulate how a firm chooses which partner for which job?
You have got to leave that to them. If they get it wrong they
suffer for it. I do not think it is a matter for regulation.
135. I should declare an interest here, I am
the secretary of a very, very small family firm. Can I ask, just
to complete my questions on this, one follow-up to what Mrs Fearnley
and Mr Brandt said earlier. You argued that on the whole the situation
is, without being complacent, in reasonably good shape but there
are these glaring exceptions. Is it not much more likely that
there is a continuing spectrum, as in almost all areas of human
endeavour, between the glaring, horror cases which get all over
the newspapers, to the cases which are not so dissatisfactory
and that usually get more or less sorted out, to the cases where
everything is fine? Mrs Fearnley, in particular, you said the
cases we know about that go wrong are the cases which have particularly
complex areas. Is it perhaps the case that the more complex the
company the less effective the audit is in ensuring that everything
is satisfactory because of time pressures and practical difficulties,
and perhaps we ought to be taking up Professor Sikka's proposals
to allow the Inland Revenue to make an audit if they feel that
there is a potential case to answer?
(Mrs Fearnley) If you look at a case
like Enron, for exampleand this is based on evidence that
I have read which has been written by US academics, because nothing
has been proven in the courts yetthere does appear to be
prime facie evidence of serious dishonesty in some aspects
of that company. The very nature of dishonest accounting is that
it tends to be very obscure and very complex, because if it was
simple somebody would notice. One of the issues about these complex
cases is that it gets buried in a mountain of different activities
in different companies and it shoots around the houses, so that
it is very difficult for anybody to follow that up. Where you
get these kind of complex situations you have got to have very,
very highly skilled auditors going in and looking at them because
if you put in someone who was not a highly skilled auditor they
would not have any chance at all of actually being able to trace
and pick up some of these issues. I was trying to read what had
happened in Enron and I think if I was really going to try and
understand it it would take me a very long time to trace what
they actually did and how they actually managed it. I think there
are great dangers in saying other bodies can go in and look at
it without that very high level of skill, because they could be
completely snowballed by some very clever people who were setting
these things up for their own devices. I think that is quite a
dangerous route to go down, but that does not excuse the situation
that if an audit firm recognises that a client has got very, very
complex dealingsand I have to say these financial instruments
scare me stiff because they are so difficult to follow and understand
136. We want to move on. The Powell Report on
Enron makes quite a good read as to where the culpability was.
Professor Sikka, before we move on to the next question.
(Professor Sikka) Just to respond to
some of the issues raised by your questions and the responses.
First of all, UK companies, as in the US, engage in what is commonly
known as opinion-shopping; they shop around for auditors and tenders
are invited. When you look at Prudential there was no problem,
the auditor was continuing, then a former partner from one of
the major accountancy firms became the finance director and, lo
and behold, the current auditors were pushed out and the auditors
came from the very firm where he came from, and sometime later
the non-auditing fees shot up as well. So opinion-shopping is
common. There have been allegations that lowballing is rife, that
is that the auditors use auditing as a loss-leader with a view
to getting in and then selling non-auditing services. The Institute
of Chartered Accountants commissioned a working party and the
working party said to accountancy firms "Send us evidence".
Obviously, they were not going to send in evidence that any one
of them engaged in this and eventually the working party said
"We did not find any evidence". There is some anecdotal
evidence, I indicated toPrudential, for example. Many clients
of auditing firms have danger written all over them. Maxwell was
a good example which never, ever attracted a qualified audit opinion.
BCCI pleaded guilty to money laundering in the US in 1990, no
auditor qualified the accounts and no auditor resigned. In the
evidence I submitted to you, two episodes are mentioned where
the auditors resigned and walked away quietly, saying there are
no problems, yet in one case the Serious Fraud Office is investigating
the company. That is in the newspapers, yet auditors walked away
saying "There is no major problem with this client".
As regards audit work being done by skilled personnel, I am sure
there are many skilled people, but the DTI Inspectors report in
1991 on Rotaprint said that the firm's audit team was composed
of relatively inexperienced trainees, led on a day-to-day basis
by an unqualified senior. Similar issues have been repeated in
the DTI Inspectors' report on other cases as well. As regards
regulation, there is a real problem here in relation to auditing
firms. We do not have any state guaranteed markets for mathematicians,
engineers and scientists, but the market for auditing is guaranteed
for accountants. However, the public knows very little about the
relationship between the auditing firm and the company. For example,
we do not have sight of the audit tender or the audit contract;
we do not get to see the composition of the audit team, what kind
of time is spent, or whether there are any issues about conflicts
of interests? All these things are glossed over. If any of this
information was available this would enable people to call auditors
and companies to account, but it is amazing that despite being
some of the world's biggest organisationscertainly the
UK's biggest business organisationsthere is no public accountability
requirement for major accountancy firms.
137. Coming back to Mrs Fearnley's comment a
moment ago, there are many defences of auditing but the idea that
it is all too complicated is surely not one. At Enron one of the
biggest issues, clearly, was special purpose vehicles. You are
not really telling this Committee that auditors cannot get to
grips with these things?
(Mrs Fearnley) I never suggested that
was a defence for auditors, what I was actually saying was that
if you have companies that are extremely complex the auditors
have got to make sure that the people that are in there doing
the audit have got the background and experience to deal with
these things. One cannot move from auditing a major bank one day
to auditing a major oil company the next day without a lot of
knowledge and experience to take with you, because those are the
points where somebody could miss some major issue that is sitting
around in there. I think I may have communicated the wrong point
on that. I think there is a culpability in an audit firm if they
do not put the right people in to deal with a big and difficult
and complex job, because then the risks do arise that something
of great significance could be missed. I am sorry if I misled
you on that.
138. You are not suggesting that in the UK the
profession has not got the skills to tackle the issues involving
special purpose vehicles?
(Mrs Fearnley) I am not suggesting that.
What I am saying is that they are not easy things to deal with,
and that people dealing with them have got to be sure they do
139. Mr Brandt, you said a few moments ago that
if there was failure audit firms suffer. How?
(Mr Brandt) You have only got to look
at what has happened to Andersens. That has suffered; it has broken
up. It is a world-wide firm employing 85,000 people and by about
next week or so it will have gone into various little bits. That
is in a period of about six months. That is suffering, I think.
I am not suggesting the same thing would happen here, but scaled
down you would lose your reputation if you did not get it right.