Further memorandum from ACCA
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
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.
1. How much are auditors to blame for the
banking crisisdid 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
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 staticit should evolve
as accounting, organisations and societies evolve.
2. Conflict of interests: audit work versus
non audit work done within the same companieshas 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
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 reformwhich
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
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 Summarystyle
document at the front of the financial statements would be a good
XBRL (eXtensible Business Reporting
Language) also offers a technological means of tagging keywords
and data-mining to find relevant information quicklythis
direction is under active investigation by HMRC.
Other ICT developments may include
"embedding" detail in financial statements to keep them
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 issueas referred to above.
7. How significant an issue is going concernwhat
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 rapidlythis 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 monthswe 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
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 educationbetter
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 auditedand
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
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 regulationand recommends that
accepted practices in all these areas need to change to avoid
The fundamental responsibilities of a corporate
boardto provide strategic oversight and direction, to ensure
a strong control environment and to challenge the executiveappear
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.