Examination of Witnesses (Questions 1280
TUESDAY 4 DECEMBER 2007
Q1280 Chairman: In the independent
auditor's report on Northern Rock's 2006 accounts you state that
"you are not required to consider whether the Board's statements
on internal control cover all risks and controls". Given
what has happened to Northern Rock, do you think this is a possible
area of reform of auditing standards?
Mr Sexton: That statement is derived
specifically from the combined code which requires us to look
at controls over financial information, not the operational risks.
I suspect that it would be a matter therefore for those responsible
for the combined codes and others to consider that issue. At the
moment we are explicitly not required to look at those aspects.
Q1281 Mr Fallon: You are required
to look at the operating and business review, are you not?
Mr Sexton: It is correct that
we have a duty to consider the operating and business review to
ensure that it is not inconsistent with information presented
on which we express an opinion in the financial statements.
Q1282 Mr Fallon: But the operating
and business review of Northern Rock had three or four paragraphs
on liquidity risks, so you reviewed those paragraphs presumably?
Mr Sexton: They would have been
reviewed by the audit team as part of its duty.
Q1283 Mr Fallon: Why is there nothing
in the 2006 report or interim report pointing out the risk of
Mr Sexton: The audit opinion in
both the annual report and interim review covers the financial
statements. The financial statements set out in very detailed
note disclosure, as required under IFRS, information on the liquidity
profile of Northern Rock.
Q1284 Mr Fallon: Were you content
with the liquidity risk?
Mr Sexton: Our opinion explicitly
covers the disclosures required under international financial
reporting standards in connection with the historical information.
Q1285 Mr Fallon: That does not answer
my question. Were you content with the liquidity risk that Northern
Rock was running?
Mr Sexton: Our job is to look
at the presented historical information and whether it represents
fairly the actions of management and the board in managing the
assets and liabilities of Northern Rock in this case. That is
what is presented in the notes to the account on which we have
expressed an opinion.
Q1286 Mr Fallon: Northern Rock told
us that at 30 June, 73% of its total liabilities were in wholesale
funds. Excluding the main banks, no other mortgage lender comes
anywhere near that. The nearest would be Alliance & Leicester
at 55% or Bradford at 53%. Were you aware of the extent to which
there was such a liability?
Mr Sexton: I should say that I
am not directly involved in the audit of Northern Rock. I oversee
that audit and I have therefore regular contact with all of our
audit partners, so the answers I give are in that context. The
information presented by Northern Rock clearly set out its portfolio
of mortgages. Yes, it is different from others. The accounting
standard on which we base our opinion requires that information
to be disclosed.
Q1287 Mr Fallon: Did it not occur
to you that this was something of an extreme business model, as
the FSA chairman described it?
Mr Sexton: The information required
to be audited was thoroughly audited and presented in the financial
statements for all to see.
Q1288 Mr Fallon: Why did you approve
the peculiar trust status given to Granite Finance whereby 70%
of Northern Rock's mortgages were placed off-balance sheet in
a separate vehicles?
Mr Hitchins: First, I should make
one correction. They are not placed off-balance sheet. You will
see that all of those mortgages and the related Granite funding
are disclosed in the annual report on Northern Rock's balance
sheet. Securitisation is a normal structure in the market whereby
notes are issued to note-holders who have recourse only to the
pool of mortgages that backs those notes. They are placed into
a special purpose vehicle which effectively ring-fences the pool
of mortgages for the benefit of the note-holders. They are not
taken off balance sheet because accounting standards still require
that vehicle to be consolidated as if it was a subsidiary of Northern
Rock. Overarching that is the Granite master trust that owns those
vehicles and that is itself also part of the special purpose vehicle
structure. That has nothing in it other than a small amount of
income to cover its expenses. At the end of a securitisation structure
it is normal to have a small amount of residual profit left in
the vehicle company and typically that money is given to charity
effectively in the form of a legacy.
Q1289 Mr Fallon: Are you aware that
a charity had been nominated without its knowledge to be the beneficiary?
Mr Hitchins: We were not aware
that the charity did not know, but in securitisation it is quite
normal for the residue to be given to charities. In some cases
it is just left as a charitable trust with the charity to be decided
at the time the money is available; in other cases it is specified
just as a testator in his will directs that an amount of money
is to be given to a charity. There is no requirement to notify
Q1290 Mr Fallon: Do you not think
it is somewhat improper not to notify the charity?
Mr Sexton: Neither of us was involved
in the detail of that review. As auditors we were interested in
whether the structure was properly consolidated into the balance
sheet of Northern Rock and the assets and liabilities of those
structures were properly reflected in the liquidity analysis.
The status of the trust from a legal perspective is not a matter
that is relevant to the presentation of those assets and liabilities
properly in the financial statements.
Q1291 Mr Fallon: Did PricewaterhouseCoopers
advise on the two securitisations in the current year?
Mr Sexton: We did not advise on
the securitisations. The work of PricewaterhouseCoopers has been
to provide comfort letters on historical information included
in the prospectus offerings, as is normal for any such offering
in the United Kingdom market and around the world.
Q1292 Mr Fallon: Therefore, you were
Mr Sexton: We provided comfort
letters as auditors and reporting accountants on information in
a prospectus, in the same way that as auditors we provide short
form reports on IPOs.
Q1293 Mr Fallon: Last year you charged
Northern Rock an audit fee of £500,000 in addition to non-audit
fees of over £1.3 million. Do you think that ratio is appropriate?
Mr Sexton: I think we have to
be very careful about understanding the disclosure in the statutory
accounts of our fees to Northern Rock because the manner in which
we disclose them in buckets is mandated. The numbers you quote
include: work as statutory auditor, the first number, for Northern
Rock group; work as the statutory auditor of the subsidiaries
which has to be disclosed separately; work as the statutory auditor
in connection with the regulatory responsibilities that my colleague
mentioned; and work that we provide as auditors in an audit-related
sense on the offering circulars for securitisation, that is, comfort
letters on the financial information in those circulars. That
is normal practice and is required by the banks.
Q1294 Mr Fallon: The problem is that
you were earning in fees three times as much from consultancy
advice which further securitised Northern Rock's borrowing as
you were getting for checking whether or not that securitisation
was placing the organisation at risk. There was a conflict, was
Mr Sexton: With respect, I do
not believe that it was three times our audit fees as statutory
auditors. I believe the number is £1,100,000 if you include
the three relevant disclosures, and the other fees are in the
nature of audit-related activity providing audit and comfort letters
on offer circulars which amount to £700,000.
Q1295 Mr Fallon: The non-audit fees
are listed at £1.3 million.
Mr Sexton: As I have explained,
the non-audit fees are a categorisation under UK law which includes
the statutory audit responsibilities around subsidiaries and regulatory
reporting in the case of a bank.
Q1296 Mr Fallon: Do you see nothing
wrong in the same firm doing the audit and checking whether the
bank is liquid and at the same time charging consultancy fees
for arranging securitisation that increases the risk of illiquidity?
Mr Sexton: We did not charge fees
for consulting on the creation of further securitisation. Our
fees were in connection with very specific comfort letters in
relation to historical financial information that appears in those
documents. Our audit covers the historical financial information
in the annual report.
Q1297 Mr Fallon: Altogether last
year you took fees of £1.8 million and probably £1 million
or so already this year. The taxpayer has now had to lend Northern
Rock £19 billion. Do you not think you should repay your
fees to the taxpayer?
Mr Sexton: All I can say is that
fees were charged in connection with the work we performed and
the annual report and accounts and the presentation of the historical
information therein and subsequently in providing comfort in connection
with securitisation offerings and in relation to specific financial
Q1298 Mr Fallon: You have audited
and provided comfort to the biggest banking disaster for 150 years.
Mr Sexton: We have provided audit
services in connection with auditing standards and guidance from
the UK Auditing Standards Board and the International Auditing
Standards Board and performed the duties required of statutory
Q1299 Mr Todd: Have subsequent events
caused you to revisit your audit practice in this particular bank;
in other words, do you think there is something to be learnt from
your contribution to this disaster?
Mr Sexton: Perhaps I may answer
that on a general basis and then ask my colleague to pick it up
specifically in relation to the banking sector. The auditor is
always cognisant of market developments in order to understand
all of the information available to it to give those opinions
that it does give on that historical financial information. We
are reviewing and thinking about the market information now available
to us and how that might influence the level of audit evidence
we might require and the nature of our procedures in today's circumstances.
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