Select Committee on Treasury Written Evidence

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:

    "Impairment losses

    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

—  The audit of Company's subsidiaries pursuant to legislation
—  Other services pursuant to legislation
—  Other assurance services

  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
Statutory Audit of Special Purpose Companies or partnership
Granite Mortgage Holdings Limited
Granite Mortgages 00-2 plc
Granite Finance Trustees
Granite Finance Holdings Limited
Granite Finance Funding Limited
Granite Mortgages 01-1 plc
Granite Mortgages 02-2 plc
Granite Mortgages 03-1 plc
Granite Mortgages 03-2 plc
Granite Mortgages 03-3 plc
Granite Mortgages 04-1 plc
Granite Mortgages 04-2 plc
Granite Mortgages 04-3 plc
Granite Master Issuer plc
Granite Finance Funding 2 Limited
Dolerite Mortgages Trustees Limited
Dolerite Funding No.1 plc
Dolerite Mortgage No.2 plc
Dolerite Mortgage Trustees No.2 Limited
Covered Bonds LLP

Other services pursuant to legislation

Interim Review opinion on the results to 30 June 2006 pursuant to APB Bulletin 1999-2004
Opinion to the board on financial statements pursuant to regulation AB

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
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
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
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

  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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