Banking Crisis - Treasury Contents


Further memorandum from ACCA

OUR RECOMMENDATIONS TO THE COMMITTEE

  1.  There is a need to separate the activities of retail (ie taking deposits and making loans) from all other forms of banking. We welcome the Government's moves to ring-fence depositor accounts, as this is a key step in the right direction.

  2.  Remuneration design needs to be carefully thought through with a clear eye to inevitable unintended consequences, as far as this is humanly possible. Remuneration design should be linked to cash-flows and clear long term performance measures, rather than short term measures of profit and vaguely defined measures of performance.

  3.  Banks are already heavily regulated, but the regulations appear not to be supervised very effectively. Existing regulation for banking institutions should be more effectively supervised by organisations with clear terms of reference, staffed by people with the right knowledge, skills and experience, suitably empowered to challenge banking practices where appropriate.

  4.  Ethics and professionalism has to be at the heart of repairing the financial services sector. As part of this project professionally qualified accountants and risk managers should be in place and have a stronger voice and profile within the sector. They should be supported by well-qualified, informed and engaged non executive directors who provide an appropriate level of challenge within the sector and give their audit committees real teeth. External auditors should be able to rely on the effectiveness of the organisations' own Audit Committee and internal audit function to a greater extent.

  5.  There is a role for regulators, credit rating agencies, institutional investors and analysts in understanding and better explaining to the wider world what the financial services sector actually does. This has implications for the training of these professionals and the effectiveness of their communications skills.

  6.  The globalisation of business and the current financial crisis are both reasons why one set of international accounting standards is essential. We support principles based International Financial Reporting Standards in our role as an international accounting organisation and oppose any trends towards national protectionism in this area.

  7.  External auditors are party to a wealth of corporate information. It is clear that they should liaise with the regulator of the financial services sector on a more systematic and regular basis than is currently the case.

  8.  The principles outlined in the proposed Operating and Financial Review (OFR) should be reconsidered, and organisations should look at how they can be embedded in their reporting. Within the constraints of commercial confidentiality, the OFR can be a valuable opportunity for the organisation to reflect on its business model, its medium to long term strategy, and to be able to communicate these to its stakeholders.

  9.  It should be noted that in the UK, the vast majority of companies are not subject to statutory audit at all. While the market is doing well and confidence is high, this is fine. However, during a period of economic recession, with companies ceasing to trade and job losses, businesses become more nervous about doing business with each other. This is maybe an area that needs to be considered.

COMMENTS

1.   How much are auditors to blame for the banking crisis—did they ask the right questions, and were they looking at the right things?

  The business review in a set of accounts requires, amongst other things, a board to set out the company's business model and significant risks to the viability of that model. Northern Rock's business model, for example, depended on being able to finance operations through access to wholesale money markets, and its stock rating assumed continuing growth of borrowing and lending. Without this access to markets the company could not have expanded and once this market closed it ceased to be viable. There is a case for further strengthening corporate reporting on the business model and elaborating on the risks, particularly those low likelihood/high impact risks which could jeopardise the model.

  Ultimately, the investment bank business model was unsustainable and based on erroneous assumptions about the future of the economy. The failure that external auditors made was to underrate the importance of their assumptions about the future. Auditing is primarily focused on examining past events. Indeed, the auditor's stated role is not to predict the future but to ensure that companies' financial statements give a true and fair view of the previous 12 months' performance. However, financial statements themselves include assumptions about existing trends which are then often projected uncritically into the future. Examples would be assessments of the outcomes of long term contracts and work in progress; assessments of the useful economic life of key assets; provisions and contingencies; assumptions about future trends in the macro economic environment.

  It is possible that auditors should have been more sceptical when making these projections, however difficult this may seem. The audit role is not static—it should evolve as accounting, organisations and societies evolve.

2.   Conflict of interests: audit work versus non audit work done within the same companies—has the audit community looked at this post Northern Rock and do the Financial Reporting Council (FRC) rules provide adequate protection?

  The potential for a conflict of interest has been well understood by the investor community, accounting and audit firms, professional bodies and regulators for many years. The consensus has been that such a conflict of interests can be managed through self-regulation and does not need to be regulated by statute.

  However, there is widespread concern about the dominance of the listed company audit market by the larger audit firms, and the UK FRC has made proposals for reform—which ACCA supports. Currently though it should be acknowledged that there appears to be little appetite for change in the UK's audit market, particularly from the shareholder community.

3.   Does the auditor have a duty of care to stakeholders such as lenders, suppliers, customers and the general public as well as shareholders etc?

  In the UK, statutory and case law favour a narrow interpretation of an auditor's duty of care. Their responsibility is purely to the owners/shareholders of the company. Any extensions in the auditor's duty of care as presently understood would have to be based on an extension of the core purpose of the audit, which is, currently, solely to provide shareholders with an opinion on the truth and fairness of the annual accounts.

  In the light of current and future developments in financial and non-financial reporting, we would be supportive of an evolution of the overall function of the external auditor but consider that such an evolution would need to be accompanied or preceded by an acceptable, fair and proportionate application of the limitation of liability issue.

  Statutory audit reporting should be conducted in accordance with audit standards, and financial statements be prepared in accordance with financial reporting standards. There is always a wider public interest question: should financial statements and the audit reports on them avoid reporting concerns about major public interest entities in case there is a knock-on impact on the economy causing is a loss of confidence in the market? As implied above, the imposition of accounting and auditing standards may restrict professional judgement.

  In our view, financial statements and audit reports should fairly reflect the position of the organisation but we need to make sure that our reporting and auditing framework does not inadvertently contribute to pro-cyclicality or a volatility in asset prices that does not reflect underlying economic fundamentals. Market prices reflect perceptions about the future which in turn are influenced by psychological emotions such as exuberance and fear. The Present emphasis of financial statements on current market values, arguably at the expense of prudence, would seem to contribute to pro-cyclicality by presenting a rosy picture of assets, which do not necessarily need to be liquidated, when sentiment is exuberant, and a dismal picture when fearful.

4.   Should auditors be doing more in fostering financial stability?

  Auditors have a corporate responsibility, ie the responsibility to report to the shareholders of organisations that they audit. This contributes in aggregate to fostering confidence in the corporate sector. As the law stands, auditors have no wider legal duty to foster general or national financial stability, and the definition of their role would have to be considerably altered to make this one of their responsibilities.

5.   How useful are financial statements, why are they so long, can anything be done to streamline them?

  Financial statements, which give an overall view of an organisation, are lengthy because of the complexity of transactions, and the evolution of disclosure requirements for competing stakeholders. It should be noted that they are only one source of information about an organisation's performance. There are other sources of information available, for example investor packs, analyst notes and the organisation's own website, all of which are relied on by investors and other interested parties.

  There is an acknowledgment within the accounting profession of the necessity to streamline financial statements, in order to make them more accessible and understandable. Possible suggested solutions include:

    —  The inclusion of an Executive Summary—style document at the front of the financial statements would be a good first step.

    —  XBRL (eXtensible Business Reporting Language) also offers a technological means of tagging keywords and data-mining to find relevant information quickly—this direction is under active investigation by HMRC.

    —  Other ICT developments may include "embedding" detail in financial statements to keep them shorter.

    —  Account preparers should also be encouraged to use plain English!

6.   Auditors operate in a litigious environment. This gives them a more defensive approach and prevents them from disclosing important information.

  This defensive stance could be mitigated through a fair, sensible and proportionate approach to the limitation of auditor-liability issue—as referred to above.

7.   How significant an issue is going concern—what can be done to mitigate the related panic. What is the audit community doing to reduce panic and explain?

  Going concern is an important issue. In the coming year, we will see some sets of accounts highlighting going concern issues and/or auditors drawing attention to them. Primary responsibility for the assessment of going concern rests with the Board of Directors, and good practice varies hugely in this area. The role of the auditor is to form an opinion on the truth and fairness of those accounts which will include the Board's assessment. The real problem with going concern is that organisations do not neatly stop becoming going concerns in line with balance sheet dates or the dates accounts are signed. On the contrary, they can get into trouble very rapidly—this highlights the arbitrariness of the financial year end. It is important to remember that the going concern assessment, and the auditor's report on that assessment, are conducted at a specific point in time, and cannot constitute a cast iron guarantee that the organization will be around for the foreseeable future.

  Reports on listed companies are available every six months—we should consider whether auditors could be given more responsibility at the six-month stage. External auditors should also engage more effectively with the internal audit function, which may bring issues of going concern to light more quickly.

  As the audit role evolves, we need to look not just at cash flow and going concern but also at the business model and how well it serves the organisation in the medium to longer-term.

  ACCA, along with the FRC and the International Federation of Accountants (IFAC), is communicating these issues to audit and accounting members and is working to communicate them directly to wider stakeholders.

10.   Should/can we view audit as part of an early warning system for problems in the financial system?

  Internal audit could make more of a contribution toward such an early-warning system than external audit. Nevertheless, this is still only a limited contribution since the many of the implied predictions in financial statements are largely an extrapolation of past and current trends. Clearly this is inadequate data to rely on in a period of rapid economic change.

  There is a necessity for auditors to engage more with the forward-planning of companies as we have repeatedly stated in this evidence.

  Also, if we had an Operating and Financial Review (OFR) which presented a balanced and understandable assessment of a company's position and prospects this could let us better examine any early warning signs that do exist and which could seriously impact on the organisation's viability.

11.   What is the role of audit and how relevant is it in a stressed, fast-moving world?

  One issue which needs to be revisited is the "expectation gap" between what the public and users of financial statements believe is the role of an auditor, and what the audit profession understand to be their role. The general public, for example, believe that the role of an auditor is to detect fraud and error in financial statements. However, as famously stated in Re Kingston Cotton Mills in 1896, by LJ Lopes of the Appeal Court: the auditor is "a watchdog but not a bloodhound".

  Audit instils discipline, financial rigour, better corporate governance and can deter fraud. Audit is part of the operating fabric of the economy, and the success of capital markets is dependant on there being a competitive and stable audit market. However, there is much evidence showing that the public and other users of financial statements do not understand what the role of audit is. How to resolve this issue has been the subject of much debate. Possible ways forward include:

    —  Broadening the role and responsibility of auditors in the areas of fraud detection.

    —  Further strengthening the independence of auditors and improving financial disclosure.

    —  Provision of auditing education—better educating the public and users of financial statements on the limitations of an audit.

12.   The unaudited society

  One area which seemed to be working well before the crisis was the exempting of smaller companies from the need to be audited. Indeed, most UK businesses are no longer audited—and while the market is doing well and confidence is high, this is fine. However, during a period of economic recession, with companies ceasing to trade and job losses, businesses become more nervous about doing business with each other.

  The UK companies that are audited include the FTSE 100 and 250 companies, the other main market companies (c.2, 000) and the AIM companies (c.2, 000), Large private companies (c.12, 500), and midsized companies (c.25,000). This comes to a total of c.42, 000 companies. The number of companies in the UK that come below the statutory audit threshold is 1,300,000. That is to say that in the UK, the vast majority of companies are not subject to statutory audit.

  It should be a cause for concern that accounting information is disappearing from the public domain. It means that fraud, money-laundering, bribery and corruption, which all increase during an economic recession, stand a greater chance of going undetected.

13.   Corporate governance issues

  ACCA's policy paper Climbing Out of the Credit Crunch, examines five key areas: corporate governance, remuneration and incentives, risk identification and management, accounting and financial reporting and regulation—and recommends that accepted practices in all these areas need to change to avoid future failures.

  The fundamental responsibilities of a corporate board—to provide strategic oversight and direction, to ensure a strong control environment and to challenge the executive—appear to have been inadequately discharged. Remuneration and incentive packages have encouraged short term thinking. We need to ask what inhibited banks' boards from asking the right questions and understanding the risks that were being run by their managements.

  If banks' existing incentive and career structures meant enormous rewards for failure, then this needs to change. Firstly, we have to question whether the relative share of banks' income paid as remuneration compared with dividends has been in the best interest of long-term shareholders. Secondly, risk management and remuneration/incentive systems must be linked. Executive bonus payments should be deferred until there is incontrovertible evidence that profits have been realised, cash received and accounting transactions cannot be reversed.

  Increased transparency of regulation is also important. Most large banks now combine both retail and investment banking activities, and the regulatory goal should be for separation of retail from investment banking to protect retail customers from wholesale risk, or at least to alert them to the risks if they opt to deposit funds in banks combining the two.

February 2009





 
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