House of Commons - Treasury - Written Evidence

Banking Crisis - Treasury Contents

Memorandum from Professor Prem Sikka, University of Essex

AUDITORS AND THE FINANCIAL CRISIS

Introduction

This submission argues (see below) that the auditing industry has failed to deliver meaningful audits at banks. Conventional audit model is broken and cannot be repaired. Auditors cannot be independent of the companies they audit. Auditing is also a highly profitable business, but auditors enjoy too many liability shields and lack pressures to deliver good audits. Audit failures are manufactured within accounting firms but regulators pay little attention to the organisational culture that produces the failures. Research shows that a large part of audit work continues to be falsified but the Financial Reporting Council (FRC) has done nothing to check this.

Accounting firms may shelter behind claims of ethics and integrity, but they are involved in money laundering, tax avoidance/evasion and bribery, corruption and violation of laws and rules.[1] Such an industry lacks the necessary social credibility to perform public interest functions.

Banks, as limited liability companies, are created the state and it has the ultimate moral and legal responsibility for their accountability and good conduct. Banks should be audited on a real-time basis directly by the regulators. Thus regulators will have timely information about any impending crisis.

Worthless Audit Reports

An early estimate suggested that despite a raft of accounting standards, banks had around US$5,000 billion of assets and liabilities off balance sheet (Financial Times, 3 June 2008) though this figure is being constantly revised. Some banks have shown assets, especially subprime mortgages, at highly inflated values and derivatives have long been a powerful tool for inflating company profits by hiding losses and hence the risks of company operations. The chief executive of a leading financial advisory business argued that a "big part of the problem is that accounting rules have allowed banks to inflate the value of their assets. Accounting has become a new exercise in creative fiction, with the result that banks are carrying a lot of "sludge" assets clogging up the balance sheet" (Reuters,[2] 30 October 2008).

Table 1 shows that distressed financial enterprises, whether in the UK, or elsewhere, received unqualified audit opinions on their financial statements published immediately prior to the public declaration of financial difficulties. These opinions were provided by one of the Big Four accounting firms—PricewaterhouseCoopers (PwC), Deloitte & Touche (D&T), Ernst & Young (E&Y) and KPMG. These firms claim to have a combined global income of over US$96 billion. They also claim to apply the same standards across their global operations.

Table 1

Company	Country	Year End	Auditor	Date of Audit Report	Audit Opinion	Fees Audit	(millions) Non-Audit
Abbey National	UK	31 December 2007	D&T	4 March 2008	Unqualified	£2.8	£2.1
Alliance & Leicester	UK	31 December 2007	D&T	19 February 2008	Unqualified	£0.8	£0.8
Barclays	UK	31 December 2007	PwC	7 March 2008	Unqualified	£29	£15
Bear Stearns	USA	30 November 2007	D&T	28 January 2008	Unqualified	$23.4	$4.9
Bradford & Bingley	UK	31 December 2007	KPMG	12 February 2008	Unqualified	£0.6	£0.8
Carlyle Capital Corporation	Guernsey	31 December 2007	PwC	27 February 2008	Unqualified	n/a	n/a
Citigroup	USA	31 December 2007	KPMG	22 February 2008	*Unqualified	$81.7	$6.4
Dexia	France/Belgium	31 December 2007	PwC and Mazars & Guérard	28 March 2008	Unqualified	€10.12	€1.48
Fannie Mae	USA	31 December 2007	D&T	26 February 2008	Unqualified	$49.3	—
Fortis	Holland	31 December 2007	KPMG and PwC	6 March 2008	Unqualified	€20	€17
Freddie Mac	USA	31 December 2007	PwC	27 February 2008	*Unqualified	$73.4	—
Glitnir	Iceland	31 December 2007	PwC	31 January 2008	Unqualified	ISK146	ISK218
HBOS	UK	31 December 2007	KPMG	26 February 2008	Unqualified	£9.0	£2.4
Hypo Real Estate	Germany	31 December 2007	KPMG	25 March 2008	Unqualified	€5.4	€5.7
Indymac	USA	31 December 2007	E&Y	28 February 2008	*Unqualified	$5.7	$0.5
ING	Holland	31 December 2007	E&Y	17 March 2008	Unqualified	€68	€7
Kaupthing Bank	Iceland	31 December 2007	KPMG	30 January 2008	Unqualified	ISK421	ISK74
Landsbanki	Iceland	31 December 2007	PwC	28 January 2008	Unqualified	ISK259	ISK46
Lehman Brothers	USA	30 November 2007	E&Y	28 January 2008	Unqualified	$27.8	$3.5
Lloyds TSB	UK	31 December 2007	PwC	21 February 2008	Unqualified	£13.1	£1.5
Northern Rock	UK	31 December 2006	PwC	27 February 2007	Unqualified	£1.3	£0.7
Royal Bank of Scotland	UK	31 December 2007	D&T	27 February 2008	Unqualified	£17	£14.4
TCF Financial Corp	USA	31 December 2007	KPMG	14 February 2008	Unqualified	$0.97	$0.05
Thornburg Mortgage	USA	31 December 2007	KPMG	27 February 2008	Unqualified	$2.1	$0.4
UBS	Switzerland	31 December 2007	E&Y	6 March 2008	Unqualified	CHF61.7	CHF13.4
US Bancorp	USA	31 December 2007	E&Y	20 February 2008	Unqualified	$7.5	$9.6
Wachovia	USA	31 December 2007	KPMG	25 February 2008	Unqualified	$29.2	$4.1
Washington Mutual	USA	31 December 2007	D&T	28 February 2008	Unqualified	$10.7	$4.3

Notes:

1. Data as per financial statements and statutory filings shown on the respective company's website.

2. "Audit fee" also includes "audit related fees"

3. * Denotes that audit report draws attention to some matters already contained in the notes to financial statements.

Admittedly, the list in Table 1 is incomplete, but it is useful for highlighting a number of issues. Adverse "key financial ratios" are considered to be an indicator of going concern problems. Major institutions had leverage ratios[3] in the range of 11:1 to 83:1. Excessive leverage is just one sign of impending financial problems. For example, a report by the US Securities and Exchange Commission (SEC) noted that Bear Stearns "was highly leveraged, with a gross leverage ratio of approximately 33 to 1 prior to its collapse".[4] One expert informed the US House of Representatives Committee on Oversight and Government Reform that Lehman Brothers, the fourth largest investment bank, "had a leverage of more than 30 to 1. With this leverage, a mere 3.3% drop in the value of assets wipes out the entire value of equity and makes the company insolvent".[5] Yet auditors did not note the consequences of such high ratios.

The UK auditing standards state that the "auditor's procedures necessarily involve a consideration of the entity's ability to continue in operational existence for the foreseeable future. In turn that necessitates consideration of both the current and the possible future circumstances of the business and the environment in which it operates".[6] Auditing standards also require auditors to "perform audit procedures designed to obtain sufficient appropriate audit evidence that all events up to the date of the auditor's report that may require adjustment of, or disclosure in, the financial statements have been identified".[7] How the auditors constructed audits to satisfy themselves that banks were a going concern is open to conjecture, but the financial difficulties of many became publicly evident soon after receiving unqualified audit reports.

The 2006 financial statements of Northern Rock carried an unqualified audit opinion. On 25 July 2007, the bank's interim accounts for six months to 30 June 2007 received a positive report from its reporting accountants. Within days, the bank was under siege and nationalised in early September 2007.[8] Lehman Brothers received an unqualified audit opinion on its annual accounts on 28 January 2008, followed by a clean bill of health on its quarterly accounts on 10 July 2008. By early August it was experiencing severe financial problems and filed for bankruptcy on 14 September 2008. Bear Stearns, America's fifth largest investment bank, received an unqualified audit opinion on 28 January 2008. On 10 March its financial problems hit the headlines and on 14 March, with state support, it was sold to JP Morgan Chase. Carlyle Capital Corporation received an unqualified audit opinion on 27 February 2008. On 9 March, the company was known to be discussing its precarious financial position with its lenders. On 12 March, the company was placed into liquidation. Thornburg Mortgage, America's second-largest independent mortgage provider received an unqualified audit opinion on 27 February 2008. On 7 March, the company received a letter, dated 4 March 2008, from its independent auditor, KPMG LLP, stating that their audit report, dated 27 February 2008, on the company's consolidated financial statements as of 31 December 2007, and 2006, and for the two-year period ended 31 December 2007, which is included in the company's Annual Report on Form 10-K for 2007, should no longer be relied upon.

New Century Financial Corporation, America's second largest subprime mortgage lender, announced its financial problems in February 2007. It was delisted in March 2007. On 24 May 2007, it announced that its 2005 financial statement should not be relied upon and an insolvency examiner was appointed. Yet auditors remained oblivious to any sectoral problems. After the collapse of Northern Rock, auditors should have become aware that banks were facing acute financial problems, but they continued to issue unqualified audit reports.

AUDITORS CANNOT BE INDEPENDENT OF THEIR PAYMASTERS

Auditing firms are commercial enterprises and cannot afford to alienate their paymasters. The basic auditing model requires one set of business entrepreneurs (auditing firms) to regulate another (company directors). Neither party owes a "duty of care" to any individual shareholder, creditor, employee, bank depositor or borrower. Their success is measured by profits rather than anything they might do for society, regulators or the state.

There has been no state sponsored investigation into the current banking and auditing failures. The Bank of Credit and Commerce International (BCCI) was considered to be one of the biggest banking frauds of the twentieth century. In 1992, a US Senate report[9] stated that "BCCI's British auditors, Abu Dhabi owners, and British regulators, had now become BCCI's partners, not in crime, but in cover up" (p 276). Yet this did not persuade any UK government department to investigate the episode. Eventually, in 2006, some 15 years after the events, without considering any of the findings of the US Senate, a disciplinary panel of the UK accountancy profession fined Price Watehrouse (now part of PricewaterhouseCoopers) £150,000. At that time the firm had UK income of around £2 billion. Did the UK learn anything from past failures?

Table 1 also shows that auditors received considerable income from their audit clients, which may be significant for regional offices managing the audit. The fee dependency and related advancement of career creates conflict of interests. The insolvency examiner of New Century Financial Corporation, America's second largest subprime mortgage lender, stated that "KPMG bears responsibility, at a minimum, for suggesting accounting changes in the second and third quarters of 2006 that were inconsistent with GAAP and for failing to detect the material understatements... The KPMG team acquiesced in New Century's departures from prescribed accounting methodologies and often resisted or ignored valid recommendations from specialists within KPMG. At times, the engagement team acted more as advocates for New Century, even when practices were questioned by KPMG specialists who had greater knowledge of relevant accounting guidelines and industry practice. When one KPMG specialist persisted in objecting to a particular accounting practice on the eve of the Company's 2005 Form 10-K filing—an objection that was well founded and later led to a change in the Company's practice—the lead KPMG engagement partner told him in an email: "I am very disappointed we are still discussing this. As far as I am concerned we are done. The client thinks we are done. All we are going to do is piss everybody off".[10]

Table 1 shows that in most cases, auditors provided non-auditing services and this inevitably raises the age-old question about auditor independence. The issues were again flagged by the US Senate Committee's report on the collapse of Enron[11] and revisited by the UK House of Commons Treasury Committee report on Northern Rock. The Committee stated that "there appears to be a particular conflict of interest between the statutory role of the auditor, and the other work it may undertake for a financial institution" (p. 115). The immediate response from the Auditing Practices Board (APB), UK's auditing standard setter, was that "After Enron we consulted on this question of auditor conflicts of interest and there was no appetite for a blanket ban on non-audit services" (Accountancy Age, 7 February 2008). The APB is dominated by the auditing industry and is no position to set independent or effective auditing standards.

The public encounters auditors in many other walks of life eg passport checks at airports, HMRC inspectors, health and safety officers, etc. In none of these cases the auditee selects, appoints or remunerates the auditors. Yet that is a common practice in the case of company audits.

ARE AUDITS WORTH ANYTHING?

Traditionalists have often claimed that external audit adds credibility to financial statements. Such claims may be based upon the view that auditors have "inside" knowledge and are thus able to curb management enthusiasm and impart superior information. The difficulty with such a hypothesis is that the current financial crisis shows that markets and significant others were not comforted by unqualified audit opinions. Evidently, markets and significant others attached little value to audit reports. Perhaps, they know that auditors are too close to their clients and thus largely discounted their opinions.

The issuing of audit reports is subject to organizational and regulatory politics. Auditors may be reluctant to qualify bank accounts for fear of losing a substantial client, creating panic or jeopardising their liability position. During previous banking failures US legislators argued that auditor silence "caused substantial injury to innocent depositors and customers".[12] The Financial Services and Markets Act 2000 formalises exchange of information between auditors and regulators. It requires auditors to inform the regulators if during the course of their audit they become aware of anything that materially affects the regulator's functions of consumer protection and maintenance of market confidence. Within this context, auditors are obliged to inform regulators of their intention to issue a qualified audit report. Whether auditors did so or were dissuaded from issuing qualified opinions is not known. The politics of audit opinion beg questions about the value of an audit.

The organisational culture is a key ingredient in the manufacture of audits. Some glimpses of firm culture have been noted. For example, DTI inspectors noted that auditors at the business empire of late Robert Maxwell "consistently agreed accounting treatments of transactions that served the interest of RM (Robert Maxwell) and not those of the trustees or the beneficiaries of the pension scheme, provided it could be justified by an interpretation of the letter of the relevant standards or regulations".[13] The audit firm's strategy was summed up by a senior partner who told staff that "The first requirement is to continue to be at the beck and call of RM [Robert Maxwell], his sons and staff, appear when wanted and provide whatever is required".[14]

Scholarly research[15] also shows that a large number of audit staff either use irregular practices or falsify audit work, ie claim that audit work is done when in fact it has not been done. I have submitted research to the FRC, but it has not informed any of its utterances.

In a market economy, pressures are exerted upon producers to improve the quality of their goods and services. The comparative pressures on auditors are weak. In the UK, auditors can trade as limited liability companies and limited liability partnerships. In addition, following the 1990 House of Lords' Caparo judgement,[16] which is now part of the Companies Act, auditors generally owe a "duty of care" to the company only and not to any individual shareholder, creditor or other stakeholder. A HM Treasury paper[17] acknowledges that individual stakeholders cannot successfully sue auditors even when they can show that "the auditors had been negligent". Auditors also enjoy the benefit of the principle of "contributory negligence". This principle was applied in the litigation after the collapse of Barings. In this case, the liquidator KPMG sued auditors initially for £1 billion, subsequently revised to £200 million. The court ruled that Deloitte & Touche was negligent in its audit work. However, auditors only had to pay £1.5 million because the bank, its directors and poor internal controls contributed to the frauds and collapse of the bank. The case emphasised that despite admitting negligence auditors face little liability.

Liability concessions to auditing firms have continued unabated. In the words of Joseph Stiglitz, former senior Vice-President of the World Bank, "there are plenty of carrots encouraging accounting firms to look the other way... there had been one big stick discouraging them. If things went awry, they could be sued... In 1995, (US) Congress.. provided substantial [liability] protection for the auditors. But we may have gone too far: insulated from suits, the accountants are now willing to take more "gambles".[18] Despite Enron and WorldCom, the Companies Act 2006 gave the US style "proportionate liability" to UK auditors. The dilution of liability has reduced incentives to produce good audits.

KNOWLEDGE FAILURES

For over a century auditors have utilised methods of an industrial age in which tangible things could be examined, counted and measured and their values could be checked from invoices and vouchers. Such a world has been eclipsed by complex financial instruments (eg derivatives) whose value depends on uncertain future events and can be anything from zero to several million dollars/pounds. Derivatives were central to the collapse of Barings, Enron and Parmalat. The US government's 1998 bailout of Long Term Capital Management (LTCM) showed that even the Nobel Prize winners in economics had difficulties in valuing derivatives. It is doubtful that auditor knowledge surpasses that of Nobel Prize winners. They seem to go along with the "mark-to-model" accounting practices of banks.

Auditors may argue that the financial crisis unfolded suddenly and they were thus ill-prepared to make judgments about the likely financial distress. The difficulty with such an argument is that finance capitalism and expansion of credit has been in ascendancy and played a leading role in the banking crises in Latin America, South-East Asia, Sweden, Norway and Japan. The US experienced a Savings and Loan crisis in the early 1990s. Fannie Mae has a history of accounting and auditing problems. In 1991, the Bank of Credit and Commerce International was closed. The mid-1990s, collapse of Barings attracted considerable international attention. Previous episodes have highlighted issues about earnings management, income shifting, excessive leverage, complex financial instruments and failures of conventional auditing technologies. Auditors have paid little attention to changes in capitalism and emerging issues. Professional accounting education prioritises technical and rote learning and neglects reflections upon the social aspects of accounting and auditing.

ANTI-SOCIAL ACCOUNTING FIRMS

In an ideal world accounting firms would compete to advance standards and quality of work, but they are involved in a race-to-the-bottom. They are unfit to deliver worthwhile audits.

In the year 2000, Consob, the Italian Competition Authority fined Arthur Andersen, Coopers & Lybrand [now part of PricewaterhouseCoopers], Deloitte & Touche, KPMG, Price Waterhouse [now part of PricewaterhouseCoopers], Reconta Ernst & Young, the then Big-Six accounting firms, for operating a cartel.[19] The firms had agreement to restrict competition and carved out the auditing market. In November 2005, France introduced legislation restricting the ability of auditing firms to sell non-auditing services to audit clients. It imposed a ban on offering an audit if the client has received other services from the audit firm in the previous two years. The Big Four firms and Grant Thornton formed an alliance to contest the law (Accountancy Age, 20 September 2007). Previously, Ernst & Young and PricewaterhouseCoopers combined forces to pressurise the UK government to secure liability concessions in the shape of limited liability partnerships. As the UK government eventually capitulated an Ernst & Young senior partner boasted, "It was the work that Ernst & Young and Price Waterhouse undertook with the Jersey government | that concentrated the mind of UK ministers on the structure of professional partnerships. The idea that two of the biggest accountancy firms plus, conceivably, legal, architectural and engineering and other partnerships, might take flight and register offshore looked like a real threat. I have no doubt whatsoever that ourselves and Price Waterhouse drove it onto the government's agenda because of the Jersey[20] idea" (Accountancy Age, 29 March 2001).

Following a US Senate investigation into the sale of tax avoidance/evasion schemes, KPMG admitted "criminal wrongdoing"[21] and paid a fine of $456 million. The Senate report[22] stated that "KPMG tax professionals were directed to contact existing clients about the product, including KPMG's own audit clients | By engaging in this marketing tactic, KPMG not only took advantage of its auditor-client relationship, but also created a conflict of interest in those cases where it successfully sold a tax product to an audit client." (pages 4, 9, 15-16)

A UK Tax Tribunal found that KPMG cold-called on clients to sell a scheme that would boost corporate earnings by avoiding sales tax (or Value Added Tax (VAT)). The scheme involving use of offshore tax havens and complex corporate structures was declared unlawful by the Tribunal and subsequently the European Court of Justice described it as "unacceptable" (The Observer, 27 March 2005).

The role of Deloitte & Touche in crafting tax avoidance schemes for Enron is under scrutiny.[23] A US Senate report[24] stated that "PricewaterhouseCoopers sold generic tax products to multiple clients, despite evidence that some.. were potentially abusive or illegal". The same Senate report also concluded that Ernst & Young (E&Y) sold "abusive or illegal tax shelters". The US Justice Department charged "four current and former partners of Big-Four accounting firm Ernst & Young ("E&Y") with tax fraud conspiracy and related crimes arising out of tax shelters promoted by E&Y" (US Justice Department press release, 30 May 2007).

Ernst & Young marketed a scheme to enable retailers to boost earnings by avoiding VAT and levying a credit handling fee on credit card sales. The scheme was declared unlawful by a Tax Tribunal and a UK Treasury spokesperson described it as "one of the most blatantly abusive avoidance scams of recent years" (The Guardian, 19 July 2005).

In August 2007, the US Justice Department[25] announced that "IBM Corporation and PricewaterhouseCoopers have both agreed to pay the United States more than $5.2 million to settle allegations that the companies solicited and provided improper payments and other things of value on technology contracts with government agencies... PWC will pay $2,316,662".

In July 2005, the US Department of Justice announced that PricewaterhouseCoopers paid the government $41.9 million to "resolve allegations that it defrauded numerous federal government agencies over a 13-year period.[26]

In January 2006, the US government announced that Ernst & Young and KPMG settled lawsuits "concerning false claims allegedly submitted to various agencies of the United States in connection with travel reimbursement. ...E&Y has agreed to pay $4,471,980 and KPMG has agreed to pay $2,770,000" (Department of Justice press release, 3 January 2006).

The involvement of major accountancy firms in bribery and fraud is highlighted by the New York District Attorney Robert Morgenthau's testimony[27] to the US Senate Subcommittee on Permanent Investigations on 16 July 2001 (also see New York Times, 4 May 1995).

In a money laundering case,[28] a UK High Court judgement stated that "Mr Jackson and Mr Griffin are professional men. They obviously knew they were laundering money.... It must have been obvious to them that their clients could not afford their activities to see the light of the day. Secrecy is the badge of fraud. They must have realised at least that their clients might be involved in a fraud on the plaintiffs". Jackson & Co. were introduced to the High Holborn branch of Lloyds Bank Plc. in March 1983 by a Mr Humphrey, a partner in the well known firm of Thornton Baker [now part of Grant Thornton]. They probably took over an established arrangement. Thenceforth they provided the payee companies| In each case Mr Jackson and Mr Griffin were the directors and the authorised signatories on the company's account at Lloyds Bank. In the case of the first few companies Mr Humphrey was also a director and authorised signatory". To this day, no action has been taken against the firm or its partners.

In January 1999, following a $2.5 million fine on PricewaterhouseCoopers for violating audit independence rules, primarily relating to ownership of securities in client companies, (SEC press release, 14 January 1999), the US Securities and Exchange Commission (SEC) commissioned a study into the firm's compliance practices. The report[29] disclosed that "a substantial number of PwC professionals, particularly partners, had violations of the independence rules, and that many had multiple violations". The study said that over 8,000 violations of the rules, in a one month period, were found and the firm agreed to revise its compliance procedures. In 2002, PricewaterhouseCoopers were fined $5 million for violating auditor independence rules and entering "into impermissible contingent fee arrangements with 14 public audit clients..." (SEC press release, 17 July 2002).

Following previous US regulatory actions, in 1995, Ernst & Young gave undertakings to comply with the auditor independence rules. The SEC learnt that for the period 1994 to 2000, contrary to the rules on auditor independence, Ernst & Young (EY) entered into a business relationship with software giant PeopleSoft, one of its audit clients. This time the SEC prosecuted.[30] Ernst & Young were fined $1.7 million, banned for six months from securing new audit clients and also put on probation for the next two years. Ernst & Young were again censured in March 2007 for violation of auditor independence rules and fined $1.7 million. In 2003, a [former] Ernst & Young partner was arrested on criminal charges for allegedly altering and destroying audit working papers and obstructing investigations relating to NextCard (SEC press release, 25 September 2003). He became the first case to be tried under the Sarbanes-Oxley Act 2002. He admitted that "he knowingly altered, destroyed and falsified records with the intent to impede and obstruct an investigation by the Securities and Exchange Commission (SEC)... by not informing the SEC of these alterations and deletions that he knowingly concealed and covered up an original version of the documents with the intent to impede, obstruct, and influence an investigation of the SEC (US Department of Justice press release, 27 January 2005). The Ernst & Young partner was sentenced to a year in federal prison, a fine of $5,000 and two years of supervised release. In August 2008, the firm was again fined $2.9 million for further violations of auditor independence rules.[31]

KPMG was admonished by the US authorities for violating auditor independence rules by holding investments in a client company (SEC press release, 14 January 2002).

In 2005, Deloitte & Touche were fined $50 million to settle charges stemming from its audit of Adelphia Communications Corporation. The SEC stated that "Deloitte engaged in improper professional conduct and caused Adelphia's violations of the recordkeeping provisions of the securities laws because it failed to detect a massive fraud... Deloitte failed to design an audit appropriately tailored to address audit risk areas that Deloitte had explicitly identified" (SEC press release, 26 April 2005). After settlement with the SEC, Deloitte issued a press statement stating that "the client and certain of its senior executives and others deliberately misled Deloitte & Touche". The SEC objected to this characterisation and forced the firm to revise its press release which ommitted the above sentence. In 2007, a Deloitte partner responsible for the Adelphia audit was banned for life from conducting audits.

In September 2005, Japanese regulators arrested four partners of ChuoAoyama PricewaterhouseCoopers for allegedly helping executives at Kenebo, an audit client, to falsify company accounts. (Financial Times, 14 September 2005). Subsequently, the regulator stated that "ChuoAoyama PricewaterhouseCoopers admitted the facts charged in the Kanebo accounting fraud scandal" and that the four "willfully certified Kanebo's falsified annual reports for the five periods, ending March 1999, March 2000, March 2001, March 2002 and March 2003, as not containing such falsities". The firm's licence to conduct company audits was suspended for a two month period covering July-August 2006. Subsequently, despite a name change, a number of major clients deserted and in August 2007 the firm was disbanded.

The above malaise affects small and medium size firms too. Consider the case of Versailles Group, whose founder was convicted of fraud. A 2004 report of a disciplinary committee of the profession[32] noted that "In 1996, Mr Clough [company's finance director] arranged for publication of the Versailles accounts, and their circulation to shareholders, before [emphasised in the original] the audit was completed. The published accounts contained a false audit certificate. When this was discovered, Nunn Hayward signed an audit certificate on unchanged accounts after little further work, and these were re-circulated to shareholders. In the face of this obvious dishonesty, Nunn Hayward acquiesced in a circular to shareholders describing what had happened as "an oversight". The reality was that Versailles was too important a client for Nunn Hayward to risk losing: when resignation as auditors was mentioned by Nunn Hayward's solicitors, Mr Dales [partner in-charge of audit] responded that this was "a big fee account" and his firm did not want to resign...". The report goes on to add that one member of the audit team, raised concerns which included "a lack of access to Versailles's accounting records; Versailles's reluctance to produce fundamental accounting information; its complex accounting system and the amount of control which Mr Cushnie [company chairman] was able to exert over it; and the lack of information about Traders in the British Virgin Islands. She wrote two memoranda, the first to Mr Ian Nunn, the senior partner, and Mr Dales, and the second to all the Nunn Hayward partners, detailing her concerns. These were ignored, and she was shortly moved off the audit. | Nunn Hayward and Mr Dales... signed false "comfort letters" required by the banks which had lent money to Versailles. ...There is evidence that several comfort letters were simply faxed to Nunn Hayward by Versailles's accountant with the request: "...please type the enclosed letters on your letter head... and fax them across to Fred [Clough] asap and post hard copy to him direct.".

The above is a small snippet of evidence that suggests that major accounting firms are unfit to act as public watchdogs.

REFORMS

The present auditing model is broken and cannot be repaired. Audits of banks are supposedly conducted to protect depositors and borrowers, and possibly act as eyes and ears of regulators. Yet auditors do not owe a "duty of care" to these stakeholders. Auditors are not appointed by any of these constituencies either. Present auditors are not independent of the companies they audit. They lack pressures to deliver good audits.

The flaws persuaded the previous Conservative administration to create the Audit Commission, an independent statutory body, for appointment and remuneration of auditors for public bodies. The auditors are generally prohibited from selling consultancy services to audit clients. It is also recognised that the private sector auditors, with their fee dependency on clients, are not in a position to conduct effective audits. For these reasons, the draft legislation that created the US Securities and Exchange Commission (SEC) in the 1930s proposed that the Commission should be the auditor for public companies.[33] However, under the weight of corporate lobbying the proposal was abandoned.

The present current financial crisis is an opportunity to build alternative institutional arrangements for auditing. Banks and financial enterprises should be audited directly by the Bank of England (BoE), the Financial Services Authority (FSA), or other designated statutory authorities. They should have specialist teams of auditors. Such auditors will act as eyes and ears of regulators and also help to build an institutional memory of past problems and emerging issues. Currently auditors hide behind claims of "duty of confidentiality" to clients. Such complications will be eliminated by reforms suggested here.

Audits should be conducted on a real-time basis. Ex-post audits are of little use at banks, especially as banks engage in real time transfers of money. Auditors need to be continuously present at banks to monitor significant transactions and enforce capital adequacy, solvency and other regulations.

Auditors of banks should owe a "duty of care" to all stakeholders, including savers and borrowers.

The Treasury Select Committee should periodically consider effectiveness of the arrangements for bank audits.

The NAO should examine the effectiveness and efficiency of bank auditors.

The auditors shall act exclusively as auditors and that means that they would not act as consultants and advisers to banks or their executives.

January 2009