Examination of Witnesses (Questions 140-153)|
TUESDAY 16 APRIL 2002
140. Are there British examples of audit firms
and senior audit partners suffering?
(Mr Brandt) Yes. Atlantic Computers.
The auditors were Spicer & Pegler. After that Spicers was
taken over and disappeared. Spicers was a highly respected firm
which all the big eight at that time would have been delighted
to take over, but they were not available until they slipped up.
Barlow Clowes is another one. That was Spicers as well. So, yes,
they do suffer. You do not necessarily get it in the press saying
that these people are suffering, but the evidence is there.
141. Mrs Fearnley, you said your research "indicates
that audit firms of all sizes believe that the standard of their
audit work has improved".
They would say that, would they not?
(Mrs Fearnley) The way we frame our research
is that we do it in a very objective way.
142. I am sorry to interrupt, but that is not
an objective sentence; you are not saying that the standard has
improved, you are simply telling us that audit firms believe the
standard has improved. That is not objective.
(Mrs Fearnley) It is very difficult,
unless we are a monitoring unit actually looking at audit files,
to say from a research perspective that auditing has improved.
Company directors have said, auditors have saidand journalists
have said this toothat they believe that the integrity
of the financial reporting system and auditor independence has
improved. This is on the basis of objective surveys. I have no
reason to believe that people responding to surveys would say
things that were false. Certainly, from talking to audit firms
and so on and from the way they have described the changes that
have come in since 1991, this has indicated that they believe
that the regulatory process that came in has tightened things
up quite a bit. I have no reason to believe that that is not the
case. That is a good thing, it is obviously not a bad thing; it
is a good thing if it has improved.
143. If it is true it is certainly a good thing.
This is obviously an important study of yours in the ten years
since audit regulation was introduced, I am just puzzled that
it seems to comprise, as you say, of talking to firms and talking
to journalists. How is that an objective measure of whether auditing
has actually improved or not?
(Mrs Fearnley) It is not just talking
to people, it is sending them surveys and asking them in a very
objective way. If they did not believe it had improved they would
not say so. If the auditors did not believe that this costly regulatory
process that they are now engaged in was actually doing any good
they would soon say so, because they are bearing the cost of it.
If they thought it was useless they would be round at the DTI
tomorrow saying "We are going through all these motions and
it is not actually achieving any benefit for anybody". So
I have no reason to believe there is a problem there, and I think,
overall, it is a benefit if there is a general belief that things
have got better. As I say, when you have got a booming economy
you cannot assume that the lack of major problems or the limitation
of major problems is purely as a result of that, but we have not
had a lot go wrong since the changes in 1991. It is a combination
of the changes, it is not just one change that seems to have made
144. Let me ask Professor Sikka. Do you think
it is likely that audit firms would say that the standard of their
work had declined?
(Professor Sikka) Extremely unlikely,
as that could certainly make some clients disappear and have all
sorts of implications for insurance as well. So the question then
comes in terms of the evidence. Sure, the regulators, who are
accountancy-trade associations primarily, would say that the regulation
has improved, but they do not provide any public evidence to back
that up. They are primarily concerned during their monitoring
visits to check compliance with auditing standards. The Auditing
Practices Board meets behind closed doors and its inside documentsagenda
and minutesare available to partners in accountancy firms
but not to the public, the public has little input in preparing
these standards. We have to remember, though we have a different
going concern that is standard now, the earlier one encouraged
auditors to be passive; they actually made a great scene of it,
that it will not require auditors to do more than half-an-hour
of extra workthat was the phrase quoted. They also check
compliance with ethical rules, but the public has no opportunity
whatsoever to see whether auditors have got a client who is generating
5 per cent, 10 per cent or 15 per cent of income; the public has
no information about conflicts of interest, so the ethical guidelines
are not worth the paper they are written on. If I can give you
an example which is again cited in the evidence already provided
to the Committee, Coopers & Lybrand (who are now part of PricewaterhouseCoopers)
accepted a Polly Peck receivership which utterly violated the
ethical guidelines at that time. After two years of campaigning
by some Partners they were fined £1,000, which at that time
was the maximum possible. It is estimated that the Polly Peck
receivership has generated £40 million.
145. I just want to come back to the point referred
to that the individual partner, really, is the key element to
determining the reality of auditor independence. How can we even
be sure of this when the fee for that partner may be very large
indeed and might be the only job for which the partner has overall
responsibility; it might be the main fee income for that particular
regional office of the firm? How can we be sure of auditor independence?
(Mrs Fearnley) You can never be entirely
sure of auditor independence. What one has to do is to look at
the structures within the firm and look at the regulatory oversight
to make sure that the mechanisms are in place as much as can be
in place to make sure that the independence is protected as much
as possible. If an individualit is the same with a directordecides
to engage in dysfunctional behaviour we want the best possible
mechanisms in place to be able to identify and uncover that. That
is, really, as far as anyone can go. I think that the mechanisms
are reasonably strong. You do have this tension between the partner
wishing to make money, the firm wishing to make money and the
firm being in the position and knowing full well that if they
re faced with a major scandal their reputation is going to be
shot to pieces. I think these are the tensions that the firms
and the regulators have to manage within those organisations.
If you talk to the top management of an audit firm they would
say "We do not want any scandals" and it makes perfect
sense that they do not want any scandals because they are disastrously
damaging to the reputation and internally massively costly because
the fines that the firms get do not reflect the costs that they
incur in defending themselves against the issues.
Chairman: We have ten minutes left in
which to sum-up and a number of my colleagues want to come in
and put questions. If you could be brief with your answers we
would be very grateful.
146. Can I ask Mrs Fearnley, should partner rotation
be put on a statutory footing? Should that be every three years
or every five years? Maybe you could also say something about
the international experience of putting audit partner rotation
on a statutory basis.
(Mrs Fearnley) In the UK at the moment
there is a requirement for partner rotation every seven years.
That seems to work reasonably well. The partner within the same
firm rotating every seven years. So there is a shift of person
and a shift of emphasis there. I have no time for the idea of
a whole audit firm switching after time because that is massively
costly and there is not enough evidence to suggest that it would
do a great deal of good. Partner rotation, however, I think is
147. Seven years. There is a debate about shortening
that period and putting it on a statutory basis. What is your
assessment of that proposal?
(Mrs Fearnley) At the moment it is sitting
in the Auditing Standards. If there is a view that it needs to
be a shorter period then that can be open to debate, but making
it a statutory issue I do not think would make the slightest difference
because it is done anyway, it is in the Auditing Standards that
148. Mrs Fearnley, I do not know whether you
came hoping to reassure us this morning, but I have been listening
carefully to what you have said and I think you are painting a
very worrying picture of the state of the industry. If I can just
quote back to you three things you said during the course of evidence
this morning, firstly you said that there certainly could be market
failure; on another occasion you said that a lot in the end depends
on individual characters, and you have just said that we cannot
be sure of auditor independence. That all paints a pretty worrying
portrait of this industry. If you believe all of those things,
is there anything you can suggest that should be done to try and
deal with those pretty serious structural problems?
(Mrs Fearnley) I am sorry, could you
give me the second one again? I picked up the market failure point.
149. A lot depends on individual characters.
You said that when we were talking about, in a sense, the whole
subject about companies effectively choosing their own auditors.
That is what it seems to boil down to. We cannot rely on a system
that has got those characteristics, can we? It is not going to
(Mrs Fearnley) Any regulatory system
could suffer from market failure at any particular time. Nobody
thought, for example, that the system in the US was going to have
the problems that it had. We cannot be complacent. I think you
have pulled out comments that I have made in certain contexts
and, obviously, looked at that and said you think that is worrying,
but we cannot be complacent. I think the issues of looking at
the whole issue of accounting and so on, at any time if we have
got a company that collapsed, for whatever reason, then people
would get worried about it and would start to look and say "What
is the framework that has actually led to this collapse?"
One of the things that worries us greatly, and I think Professor
Sikka has said this as well, is financial instruments and the
way these are being pushed around. This is a concern, I think,
for everybody. When we are talking about auditors and individual
characters, it is not simply the individual character, what we
have said from our research is that a lot depends on the character
of the individual auditor, but that does not mean that that individual
partner is simply operating in isolation to the framework. You
can never guarantee human behaviour in auditor independence; you
can never guarantee human behaviour in any aspect of life.
150. I would love to follow that up but we are
running out of time. Can I just put one further finding to you,
which gives me cause for concern, and ask you to react to it,
and that is the survey carried out by Accountancy magazine
of the FTSE 350 companies, which found that only 30 per cent of
auditor fees comes from the audit work and 70 per cent comes from
non-audit work. Does that not seriously compromise the independence
of the audit work? A company is not going to put its audit contract
at risk if it is going to lose 70 per cent of its revenue. Surely,
that is not a satisfactory state of affairs?
(Mrs Fearnley) I do not know the survey
that you looked at, but the issue that we have found when we have
151. You think it is wrong?
(Mrs Fearnley) I am not suggesting it
is wrong, I am simply not familiar with that particular piece
of work. We have found that the concern for the audit firm is
losing the client, not the mix of fee. There may be evidence in
other areas but we have not found evidence that that is a big
issue within the firm. There is a big perception out in the marketplace
that it is a big problem but from our research we have not found
evidence of it being a problem. One has to look at the perceptions
of what it is and what actually happened. We have found that that
has not influenced the partners that we have looked at, it is
the fear of losing the client overall rather than the mix of the
152. Could I ask you all to sum-up and leave
us with what your thoughts are on that. I think the accountants
have sent their newspaper to MPS which contained ten points that
could be changed, which seemed to us quite sensible. I will start
with Professor Sikka.
(Professor Sikka) I think it would be
useful, perhaps, for me, from a different viewpoint, to say there
is a danger that we can end up individualising corporate failures,
audit failures, and arguing that it is one or two bad apples.
These bad apples come from an orchard, what kind of orchard is
it? In other words, attention has to be paid to the culture of
accountancy firms where partners are getting a salary, bonuses,
promotion and all sorts of incentives linked to maximisation of
fees. No way are they going to let a client go. Nobody let Maxwell
go or BCCI go. When you look at episodes like Levitt, Maxwell,
Polly Peck and many others, in each case auditors have been there
for a long, long, long time. So there is a very strong case for
rotation of auditors. France does it every seven years, and even
the Audit Commission, if an audit firm wants to stay there beyond
five years, has to look into it. So there is a strong case for
rotation of auditors; rotation of partners does not give you a
fresh broom. Mrs Fearnley raised questions about costs, which
I think is very one-sided. There is also a cost associated with
not doing something. Just ask the BCCI and Maxwell pensioners
what was the cost associated with not introducing certain changes.
I feel that these costs are well worth incurring in order to protect
stakeholders. In the submission I made I sketched out what I feel
are the alternatives, at least in relation to the auditing, and
it is really farcical to have 23 regulators. A multiplicity of
regulators was considered to be the prime failure in the financial
services sector leading to pensions mis-selling, and we have got
exactly the same here. Regulators do not owe a duty of care to
anyone relying on their decisions; auditors do not owe a duty
of care to individuals relying upon them. The whole area is ripe
for reform, and I have sketched some of the reforms out.
(Professor Beattie) I think my main message would
be not to look for a single solution to some of the concerns that
are around at the moment. We should be addressing and are addressing
issues in the field of financial reporting; reforms are taking
place there on a continual basis. Within the accountancy profession,
in terms of audit regulation, changes are happening. We need to
be looking at corporate governance as well. I would refer to some
of the points we made in our submission and in the last chapter
of the book that we also submitted for ideas.
(Mrs Fearnley) I have said this before but there is
no evidence of problems in the market in the UK at the moment,
but that does not mean that some time in the future we could not
have these problems. What I would see as the great value of this
Committee is as a diagnostic of where problems could emerge in
the future, and I think this is really a vital role. I would hope
that the issues that we have brought out today can be looked at
in a reasonable and sensible way. I am less concerned about the
structure of regulation than I am about its effectiveness, and
I think this is what we really want to go for. We have got a system
that seems to be working reasonably well at the moment, but that
does not mean that we just fold our arms and say "We do not
have to worry ". We always have to worry about these things.
(Mr Brandt) Without wishing to go over what other
people have said, my feeling is do not, please, have a knee-jerk
reaction and rush into activity as a substitute for action. There
is a great danger of feeling we have to do something, which may,
in fact, make things worse than they are. Rotation of auditor
firms is one of the points. It happens in Italy, and what happens
is that the job rotates and so does the auditing teamit
moves into the next firmand it is sorted out among them
in the way in which the Mafia has made plausible, and it happens
in the Italian profession. So "be very careful" is my
feeling on this.
153. You ask us to be careful and your last comments
are to do with the Mafia!
(Mr Brandt) I particularly like to be
careful with the Mafia.
Chairman: Okay. That was fascinating
exposure this morning for us. The range, you can see, is from
being told "Do nothing" to "have a revolution".
We will, I think, Professor Sikka, bring, as Lord Justice Wolfe
said, our inquiring, collective mind to this. There is a long
way to go yet in the Inquiry and you have helped enormously this
morning. Can I thank you for your attendance.
24 See Ev 55. Back
See Ev 73. Back