Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 140-153)



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"[24]. 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 said—and journalists have said this too—that 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 things different.

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 documents—agenda and minutes—are 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 work—that 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 individual—it is the same with a director—decides 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.

Mr Ruffley

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 absolutely essential.

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 partners rotate.

Mr Plaskitt

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.[25]

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 be safe.

  (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 fees.


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 team—it moves into the next firm—and 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

25   See Ev 73. Back

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