Memorandum from PricewaterhouseCoopers
This Memorandum responds to the Committee's
requests at the evidence session on 4 December.
1. A detailed commentary of the nature of
information sought, and the work carried out, by PwC in relation
to Northern Rock's 2006 Annual Report and the "Going Concern
review" in February 2007 [Q1316]
1.1 Q1316 reads "Can you provide us
with a summary of how you worked with Northern Rock on the assumptions
of impairment that they produced?" This arose in the context
of a series of questions about the bank's loan book as at 31 December
2006. We assume therefore that the question is directed towards
our work in relation to impairment, and we have answered on that
basis. If we have misunderstood, and the query is directed at
the audit process as a whole (which would of course involve a
much fuller response), please let us know.
2006 Annual Report
1.2 Northern Rock prepared its financial
statements in accordance with EU endorsed International Financial
Reporting Standards ("IFRS"). These standards are a
complex mix of prescription and application of subjective judgment
in the area of accounting for loan loss impairments.
1.3 It may be helpful first to set out the
accounting policy in the 2006 Annual Report as it details the
steps the company has to follow in preparing this aspect of the
financial statements:
The Group assesses its financial assets or groups
of financial assets for objective evidence of impairment at each
balance sheet date. An impairment loss is recognised if, and only
if, there is a loss event (or events) that has occurred after
initial recognition and before the balance sheet date and has
a reliably measurable impact on the estimated future cash flows
of the financial assets or groups of financial assets.
i) Assets held at amortised cost
The Group first assesses whether objective
evidence of impairment exists individually for financial assets
that are individually significant, and individually or collectively
for financial assets that are not individually significant. Objective
evidence that a financial asset is impaired includes observable
data that comes to the attention of the Group about the following
loss events:
a) significant financial difficulty
of the issuer or obligor;
b) a breach of contract, such as
a default or delinquency in interest or principal repayments;
c) the lender, for economic or
legal reasons relating to the borrower's financial difficulty,
granting to the borrower a concession that the lender would not
otherwise consider;
d) it becomes probable that the
borrower will enter bankruptcy or other financial reorganisation;
e) the disappearance of an active
market for that financial asset because of financial difficulties;
or
f) observable data indicating that
there is a measurable decrease in the estimated future cash flows
from a portfolio of assets since the initial recognition of those
assets, although the decrease cannot yet be identified with the
individual financial assets in the portfolio, including:
i adverse changes in the
payment status of borrowers in the portfolio;
ii national or local economic
conditions that correlate with defaults on the assets in the portfolio.
If the Group determines that no objective
evidence of impairment exists for an individually assessed financial
asset, whether significant or not, it includes the asset in a
group of financial assets with similar credit risk characteristics
and collectively assesses them for impairment. Assets that are
individually assessed and for which an impairment loss is or continues
to be recognised are not included in a collective assessment of
impairment.
If there is objective evidence that an impairment
loss on loans and receivables has been incurred, the amount of
the loss is measured as the difference between the asset's carrying
amount and the present value of the estimated future cash flows
(excluding future credit losses that have not been incurred) discounted
at the financial asset's original effective interest rate. The
carrying amount of the asset is reduced through the use of an
impairment allowance . . ."
1.4 It therefore follows that the directors
first need to make an assessment as to whether there is objective
evidence of impairment firstly at an individual level and secondly
at a collective level. If there is evidence of impairment at either
level an impairment provision is created being the difference
between the then carrying value and the net present value of anticipated
future cash flows. Although objective measures of the existence
of impairment are to be applied there is inherently a range of
reasonable latitude in the choice and use of such measures. There
is a further element of subjectivity in the assessment of the
range of expected future cash flows. Consequently, it follows
that there is no single correct answer for the level of impairment
provisions rather a range of acceptable values.
1.5 The nature of critical estimates in
the process were set out in the Northern Rock 2006 Annual Report
as follows:
"Impairment losses on loans and advances
Individual impairment losses on loans and advances
are calculated based on an individual valuation of the underlying
asset. Collective impairment losses on loans and advances are
calculated using a statistical model. The key assumptions used
in the model are the probability of any account going into default
in the next 12 months, the loss incurred in the event of possession
or write off, the roll rates of borrowers moving from lower levels
of arrears to serious arrears and possession or write off, and
the time period from the date of the event causing the loss to
the date of realisation of the property or write off. The probability
of accounts going into default is based on application and behavioural
scorecards, which are regularly recalibrated to take account of
current circumstances. These key assumptions are based on observed
data from historical patterns from lending over previous years
and are updated regularly based on new data as it becomes available.
In addition, management considers how appropriate past trends
and patterns might be in the current economic situation and makes
any adjustments that it believes to be necessary to reflect current
conditions. The accuracy of the impairment calculation would therefore
be affected by unexpected changes to the economic situation, inaccuracies
within the models used compared to actual outcomes and assumptions
which differ from actual outcomes. To the extent that the loss
given default differs by +/- 10%, the impairment allowance would
be an estimated £9.4 million higher (2005 £12.1 million)
or £10.1 million lower (2005 £12.0 million) respectively."
1.6 The role of the directors, therefore,
is to adopt appropriate objective measures of impairment, apply
those to the loan book as a whole and then carry out estimations
of future cash flows for those loans which may be impaired. In
both parts of this process they are applying banking judgements.
This is especially so in the case of the expected future cash
flows as these will depend upon the manner in which the bankers
intend to manage the problem loan. As is clear from the description
of the critical estimates above there a number of key parameters
that are included in the statistical model referred to above.
The directors are responsible for determining the input assumptions
to be used in the model described above.
1.7 The role of the auditors is to make
an assessment as to whether the directors have acted reasonably
and diligently in their application of the requirements of the
IFRS (referred to above) such that the resultant provision for
impairment is likely to be within the permissible range arising
from proper application of the Standard. Consequently, as auditors
we look at the assumptions used by the directors in the model
above and assess whether they fall within a reasonable range.
1.8 To set the context as to how we obtain
audit evidence to assess whether the assumptions are reasonable
it is worthwhile explaining the nature of audit evidence as taken
from Auditing Standards which govern the conduct of audits in
this country. This may assist the Committee in understanding the
nature of an auditor's evidence gathering activities:
"In forming the audit opinion the auditor
does not examine all the information available because conclusions
ordinarily can be reached by using sampling approaches and other
means of selecting items for testing. Also, the auditor ordinarily
finds it necessary to rely on audit evidence that is persuasive
rather than conclusive; however, to obtain reasonable assurance,
the auditor is not satisfied with audit evidence that is less
than persuasive. The auditor uses professional judgment and exercises
professional skepticism [sic] in evaluating the quantity and quality
of audit evidence, and thus its sufficiency and appropriateness,
to support the audit opinion" [ISA (UK & Ireland) 500
para 14—footnote omitted]
1.9 By way of an overview, the audit process
adopted for Northern Rock for the 2006 year end in this regard
is set out below. It is not practical in a document of this nature
to describe every test or procedure adopted or the individual
outcomes of those processes.
10(a) We considered the statistical models
used by the bank. The models hold data on balances, arrears and
security values provided from the company's systems. They also
use external credit reference agency data to provide benchmark
information on current credit scores. The model is derived from
the Basle II capital adequacy model which obtained specific approval
from the FSA for capital adequacy purposes. We also examined the
workings of the model at the time of introduction of IFRS for
the 2005 year end.
(b) In considering the statistical models
used by the directors for this purpose, we also considered the
internal review processes adopted by the company to control and
monitor the inputs and outputs from the models.
(c) We reviewed the input data for key parameters
in the modelling including the results of examining historical
data to support the parameters. In so doing we satisfied ourselves
that the company had carefully considered the modelling parameters.
Having satisfied ourselves by testing and review that the bank's
systems were a reliable foundation for the production of information,
we examined reconciliations of data feeds from the company's systems
into the modelling processes. We then compared the outputs from
the models with the impairment provisions actually booked.
(d) In addition to the formulaic output from
the above models the bank also has a comprehensive and structured
system for reviewing the quality of its loan book. Regular reports
were produced to the bank's asset and liability committee ("ALCO").
As would be expected when dealing with about 800,000 loan accounts
much of the detail in these comprehensive reports is stratified
having regard to the nature of the underlying loan book.
(e) We considered the procedures used by
the bank to produce the ALCO reports from the underlying systems.
We concluded that the ALCO reports were a reliable source for
considering, inter alia, impairment provisions. We reviewed the
analyses, results and trends shown by these comprehensive reports
with the bank's management and directors at a number of levels.
We asked questions on those areas where we wished to better understand
the data. In particular, we had regard to the levels of arrears
reported by the systems and placed that in the context of the
results of industry wide analysis in particular that obtained
by the bank from the Council of Mortgage Lenders. This showed
that the level of arrears experienced by the bank was better than
the industry average.
(f) We were also aware of the history of
the bank's past assessment of bad and doubtful debt provisions.
We considered the economic position generally. We considered the
reasoning and development of the methodology as a whole and considered
the consistency of the methodology with prior periods.
1.10 Having considered the above matters,
and having received satisfactory answers to questions posed, we
concluded that the procedures the directors had put in place were
indeed likely to produce a provision for bad and doubtful debts
within an appropriate range and in compliance with IFRS.
Going concern
1.11 The second part of your request for
information deals with "the `Going Concern' review in February
2007". There was no separate assignment to conduct such a
review. The financial statements are prepared on a going concern
basis. Auditing standards, specifically ISA (UK & Ireland)
570 and APB Practice Note 19, require an auditor to consider whether
the going concern basis is appropriate. In the first instance,
the directors are responsible for making the assessment that the
bank is a going concern. That is normally taken to mean that an
entity is ordinarily viewed as continuing in business for the
"foreseeable future" with neither the intention nor
the necessity of liquidation, ceasing trading or seeking protection
from creditors pursuant to laws or regulations. The "foreseeable
future" is usually taken as meaning the next 12 months. As
ISA570 observes at para 6 "When there is a history of profitable
operations and a ready access to financial resources, management
may make its assessment without detailed analysis." The bank
fell into this category. It had traded profitably and it had a
track record of ready access to funds at low spreads over LIBOR
indicating a willingness by lending institutions to provide finance.
In February 2007 there were no indications in the financial markets
that the then extant circumstances were to change dramatically.
As the relevant auditing standard observes "Any judgment
about the future is based on information available at the time
at which the judgment is made. Subsequent events can contradict
a judgment which was reasonable at the time it was made."
[ISA570 para 7] Obviously the future is by its nature uncertain,
and the relevant auditing standard therefore requires the auditor
to consider whether there is a "material uncertainty"
that "may cast significant doubt" that the company may
not be a going concern.
1.12 In addition to the positive trading
and financial characteristics mentioned in the preceding paragraph
we looked at the post year end trading results, the most recent
ALCO reports being those for January 2007 for the year and studied
the bank's operating plans. We also studied external information
about forecasts for the UK domestic mortgage markets. None of
these exhibited any features other than to indicate a substantial
profit for the bank with every rational expectation that there
would be no significant financing difficulties. Certainly, nothing
that fell into the category of a "material uncertainty"
as explained in the auditing standard. Consequently, we concluded
that in our opinion there were no matters about the going concern
basis of accounting that were required to be reported to shareholders.
2. A detailed breakdown of the "non-audit
services" performed by PwC for Northern Rock, amounting to
a value of £1.3 million as reported in the 2006 Annual Report
[Qq 1293-8]
2.1 The total fees received by PwC as reported
in the 2006 financial statements was £1.8 million. It is
not correct to describe the sum of £1.3 million as being
for "non-audit services". A sum of £0.5 million
was received for the audit of the parent company. The £1.3
million is then analysed in the financial statements as follows.
|
| Fees payable to Company auditor and its associates for other services
| £m |
|
| — The audit of Company's subsidiaries pursuant to legislation
| 0.3 |
| — Other services pursuant to legislation
| 0.3 |
| — Other assurance services
| 0.7 |
|
2.2 Accordingly, an additional £0.3 million was
specifically for audit services pursuant to legislation. The second
£0.3 million arises from fees in reporting as auditors to
the shareholders of the bank or pursuant to professional standards
or legislation. The total audit related fees are therefore £1.1
million. The final £0.7 million is largely comprised of fees
relating to assurance services in connection with the bank's actions
in raising finance. The fees are analysed in greater detail as
follows:
|
| The audit of Company's subsidiaries pursuant to legislation
| £ |
|
| Statutory audits of 5 head office companies
| 34,700 |
| Statutory Audit of Special Purpose Companies or partnership
| |
| Granite Mortgage Holdings Limited | 6,000
|
| Granite Mortgages 00-2 plc | 14,750
|
| Granite Finance Trustees | 6,000
|
| Granite Finance Holdings Limited | 6,000
|
| Granite Finance Funding Limited | 16,000
|
| Granite Mortgages 01-1 plc | 16,000
|
| Granite Mortgages 02-2 plc | 16,000
|
| Granite Mortgages 03-1 plc | 16,000
|
| Granite Mortgages 03-2 plc | 16,000
|
| Granite Mortgages 03-3 plc | 16,000
|
| Granite Mortgages 04-1 plc | 16,000
|
| Granite Mortgages 04-2 plc | 16,000
|
| Granite Mortgages 04-3 plc | 16,000
|
| Granite Master Issuer plc | 29,500
|
| Granite Finance Funding 2 Limited | 16,000
|
| Dolerite Mortgages Trustees Limited | 6,000
|
| Dolerite Funding No.1 plc | 14,500
|
| Dolerite Mortgage No.2 plc | 14,500
|
| Dolerite Mortgage Trustees No.2 Limited |
6,000 |
| Covered Bonds LLP | 27,700
|
| Total | 325,650
|
|
|
| Other services pursuant to legislation
| £ |
|
| Interim Review opinion on the results to 30 June 2006 pursuant to APB Bulletin 1999-2004
| 79,000 |
| Opinion to the board on financial statements pursuant to regulation AB
| 190,000 |
| Total | 269,000
|
|
|
| Other assurance services | £
|
|
| Report to, inter alia, the company, the investment bank lead managers (so called "comfort letters") in respect of four securitisation issues and two pool audits of receivables pursuant to the Granite securitisation programme
| 400,000 |
| Report to, inter alia, the company, the investment bank lead managers (so called "comfort letters") in respect of two covered bond issues, two pool audits of receivables and an annual prospectus update pursuant to the bank's covered bond programme
| 110,000 |
| Report to, inter alia, the company, the investment bank lead managers (so called "comfort letters") in respect of a securitisation issue and a pool audit of receivables pursuant to the Whinstone securitisation programme
| 90,000 |
| Report to the bank and the investment bank lead managers (so called "comfort letters") in respect of the offering circular for Medium Term Note programme
| 100,000 |
| Total | 700,000
|
|
2.3 In preparing the answer to this question we have
observed that Mr Hitchins inadvertently provided incorrect information
at Q1341 when he said that £300,000 of fees was in respect
of reporting on regulatory returns to the FSA. The above analysis
shows the actual position.
3. An account of any non routine activity on the part of
PwC with regards to Northern Rock since August 2007 [Q 1377]
3.1 In view of the significant changes in the business
and exceptional circumstances facing the company since August
2007 personnel from this firm have advised the bank's management
in the following areas outside the normal audit relationship:
(a) an oral report to board on 13 September following
limited review of company projections to end 2008;
(b) reviewed, commented upon and advised in respect of
the company's short term cash forecasts and its alternative longer
term business plan scenarios;
(c) the production of a report for the purposes of potential
sale of the company, including assisting the company with the
creation of a financial forecasting model separate from the company's
accounting records with inputs to the model determined by the
company; and
(d) the production of a report on potential acquirers
of the company.
4. An account of any three-way discussions you have been
involved in with Northern Rock and the FSA [Q1340]
4.1 This question is posed in the context of the programme
of tripartite meetings the FSA has with banks and their auditors.
In respect of the financial year ended 31 December 2006 we did
not have any tripartite or bipartite meetings with the FSA and
the company. As Mr Hitchins observed in response to Q1338 such
meetings do not happen every year, but only at the request of
the FSA.
4.2 More information concerning other meetings with the
FSA is provided in the response to your next question below.
5.An account of the nature timing and extent of any other involvement
with HM Treasury, the Financial Services Authority or the Bank
of England in relation to Northern Rock in 2007, including assisting
with the valuation of Northern Rock's assets and liabilities in
September [Q1318]
5.1 We answer this question in the context of Q1318 which
is in effect a request for a written response to Q1317 which reads:
"Mr Todd: The other aspect I am interested in is your
role of the September process in trying to sort out the valuation
of Northern Rock and its assets and liabilities at that particular
time when, very understandably, public authorities were wondering
quite what they were getting themselves into. You said you were
not too sure what happened then."
5.2 We did not issue any report on the valuation of the
bank's assets or liabilities in September 2007. Various projections
were provided by the company to us in September 2007. We reviewed
those projections in a very short timeframe and discussed them
with the company. We provided an oral report on our observations
to the board on 13 September but did not issue any written report
on the projections. We understand those projections, or subsequent
variations thereof, were provided by the company to the Bank of
England.
5.3 We have not formally reported to the Bank of England,
FSA or HM Treasury on any historical or prospective financial
information in 2007. The only report we have issued on 2007 financial
information of the bank is the normal limited review report dated
25 July 2007 on the interim results to 30 June 2007 pursuant to
APB Bulletin 1999-2004. We have attended a number of meetings
with one or more of the Bank of England, FSA or HM Treasury since
August this year. In all cases we were invited to attend by the
company either in our advisory capacity pursuant to one of the
engagements above or as auditors of the company.
5.4 In addition, we spoke on a bilateral basis with the
FSA on 11 September 2007 about the need to report to the FSA pursuant
to the Financial Services and Markets Act 2000 (Communications
by Auditors) Regulations 2001. We reported in writing the same
day to the effect that during the normal course of our audit planning
activities for our audit of the financial statements of the bank
for the year ending 31 December 2007, we had become aware of certain
limited information regarding the Group's financial position which
we considered may be relevant to the FSA as the supervisor of
the bank.
5.5 This limited information had been supplied verbally
by Mr D A Jones, Group Finance Director, Northern Rock plc, in
the period 7-10 September 2007 and had not been subject to audit
or verification. As a result of this information, we had reasonable
grounds to believe that the Company may cease to be a going concern
given the current significant pressure on the Group's liquidity
due to its inability to undertake its normal funding programme.
We were aware that a potential solution involving the Bank of
England had been proposed but had no knowledge of the terms or
conditions of that solution or its impact on the Group's going
concern. We understood that Mr Jones had been in regular contact
with the FSA about this matter.
5.6 Members of the audit team attended a bi-partite meeting
with the FSA on 20 September to discuss our letter of 11 September
2007. We explained the events which had caused us to have to write
the letter. The following additional matters were discussed at
that meeting in particular:
(a) We explained to the FSA the nature of the additional
work we were undertaking for the company and the very limited
nature of our review of the projections covered by our oral report
to the board on 13 September.
(b) We were asked to provide our present impressions of
the company activity together with Board and management actions.
The FSA enquired as to our views on the "going concern"
question. We indicated that we were unable to express a view as
the work required had not been undertaken.
(c) The circumstances surrounding the trading statement
on 14 September were discussed The FSA sought our views on our
current impressions of the bank, how robust the bank's processes
were, the capabilities of those dealing with the securitization
programme, the valuation of Treasury assets, the quality of the
asset base, the adequacy of the internal audit function including
any previously reported control issues and how the company was
responding to FSA requests for information.
(d) We were requested, in the context of our duties as
auditors, to advise the FSA if our views changed.
6. A statement as to whether PwC raised the issue of the
dangers of expansion, using the money markets, with the Audit
or Risk Committee of Northern Rock and, if so, what the nature
of that warning was [Q 1377]
6.1 We did not attend meetings of the risk committee
or report to them.
6.2 To the best of our knowledge and belief the issue
was not raised with the Audit Committee. Nor would we have expected
it to be raised. We meet with the Audit Committee to discuss matters
arising from our audit of the historical financial information
rather than matters of company strategy.
January 2008
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