Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 120-139)



120.  Professor Sikka, nine out of ten, do you agree?

  (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 information—always a question mark about credibility—but 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 aware.

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 audit.

  (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.

Dr Palmer

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 example—and this is based on evidence that I have read which has been written by US academics, because nothing has been proven in the courts yet—there 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 dealings—and 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 to—Prudential, 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 organisations—certainly the UK's biggest business organisations—there is no public accountability requirement for major accountancy firms.

Mr Fallon

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 understand them.

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.

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