Audit and Accountancy - Treasury Contents

Examination of Witnesses (Questions 1-66)



  Q1  Chairman: Good morning. Welcome to Audit and Accountancy. We are very sorry that it ran on but, if you were listening to it, it was an interesting session. Can I start quickly: I have in front of me a selection of the consultation papers, the revised guidance, the working groups and statements that you and other relevant bodies have published following the credit crunch—they number 18 here. What have they achieved? Is this just to obfuscate and to keep the debate going and to make it so technical that we are going to forget about the issue?

Mr Haddrill: Firstly, it is clearly not to obfuscate. I think the starting point was that the audit process had not failed in the crisis but there was room for some improvement, so we needed to be very careful on what we consulted on and in drawing conclusions. A similar conclusion was reached in relation to governance that there was a lot that was right about governance in the UK but in some respects it had not served us well, so again we needed to be careful there. What we have done is, as you see, consulted, at the moment, on the corporate governance code and on the stewardship code, which I think is a very important counterpoise to the governance code because there is no point in having a comply and explain system on governance if there is nobody taking notice of what the explanations are from companies.

  Q2  Chairman: My point, Mr Haddrill, is if you have 18 papers is this process robust enough because there are going to be lots of gaps?

  Mr Haddrill: I think it is robust and it is not just the consultation papers that are going on; you are also seeing the work of the Audit Inspection Unit, which has been going on for several years now, and has been intensified over this period in looking at the audits of banks and the work of the audit firms. So it is underpinned by that whole regulatory system.

  Q3  Chairman: I have in front of me "Helen Brand, CEO of ACA", and now Dr Steve Priddy turns up. Why has she been transformed to you? You are the technical man. Are you here to obfuscate?

  Dr Priddy: I am the Technical Director here.

  Q4  Chairman: Why is she not here?

  Dr Priddy: I do not know. It is her diary.

  Chairman: It is not a good way to treat the Select Committee, okay, so take it back to her, and I will look for a nice letter from her. Thank you.

  Q5  Jim Cousins: Bank auditing both in this country and across the world is dominated by a tiny number of global firms and in this country they have the protection of limited liability. Is that right? Do we not have too few players in the market and are not the players we have too well protected?

  Mr Haddrill: I do not think it is right in the sense that the law introduced the opportunity to negotiate proportionate liability with companies. That is not something that has actually been pursued so far, so they remain quite exposed in terms of liabilities. In terms of the number of firms, we believe strongly in competition and we would like to see more firms there, but in practice that is unlikely to happen. Therefore, the key challenge for us now is to make sure that those big four firms do not become a smaller number of firms, and that is why we pay so much attention to both audit inspection in the UK, to encouraging the improvement of governance of those firms, which we have just done through working with the Institute on a new audit governance code, and through encouraging genuine international regulation of audit because, as you say, they are big global entities.

  Q6  Jim Cousins: How can regulation possibly be effective if regulation is, in a sense, protecting the existence of the big four accountancy firms?

  Mr Haddrill: I would not say regulation is protecting their existence.

  Q7  Jim Cousins: You have just said it is, that you cannot risk a situation where you go down from a big four to a big three.

  Mr Haddrill: I said we wanted to take action in relation to the activities of the big four so that they do not go down to the big three. We are robust in our inspection regime and we would be robust if we found misconduct in pursuing that.

  Q8  Jim Cousins: Is it not the practical reality that there are a number of legal actions now that are underway, most of them in the United States, a lot of them now directed at KPMG because of its activities, in fact some relatively small and non-headline here, American institutions that they audited? Are not those legal actions going to be a far more effective way of regulating, disciplining and improving the quality of auditing than anything you are likely to do?

  Mr Haddrill: I think the liability that the firms hold is actually part of the system, and I would agree with you that if they get things wrong they are maybe taken to court so they will manage themselves in such a way as to try and make sure that they do not get exposed to that. So I do not think that, somehow, as a regulator we are in competition with the courts and the legal system. We are complementary.

  Q9  Jim Cousins: Is it not the situation that the fees the big four accountancy firms are getting from banks are absolutely enormous and that you are limited in what you can do as regulators because you have to protect them? We have a classic cartel.

  Mr Haddrill: I do not think that is right. Certainly the fees that they get are large, and our expectation is that those large fees get invested into the business, and it is one of the things we look at in terms of the training of the audit teams and their investment in improving audit quality. That is one thing that we do expect to see. The other thing we expect is that they pursue their work with a high level of ethical standards.

  Q10  Jim Cousins: Excuse me. KPMG got £9 million from auditing HBOS. How much of that went back into improving audit quality?

  Mr Haddrill: I cannot tell you exactly.

  Q11  Jim Cousins: Perhaps you could let us know, because that would be really helpful. Ernst & Young got $27.8 million for auditing Lehman Brothers. Could you find out for us how much of that fee went back into improving audit quality?

  Mr Haddrill: It is not my job to defend the fees of the audit firms.

  Q12  Jim Cousins: You have advanced a justification for the size of the fee in terms of reinvestment in audit quality. I have asked you one or two direct questions that follow from that and it is reasonable to expect an answer.

  Mr Haddrill: No, I am not justifying the size of the fee; I am saying that we, as a regulator, expect audit firms to invest in quality, to invest in the training of their staff and to invest in their ethical systems as well. I am not saying that any particular size of fee is the right size of fee.

  Q13  Jim Cousins: If a regulator says that one of the justifications for the fees is reinvestment in audit quality, it is perfectly legitimate for this Committee to say to you: "Okay, how much of those fees went back into audit quality?"

  Mr Haddrill: No, sorry, I think you are misinterpreting what I said. I am not justifying the level of their fees at all; I am saying that we expect them to invest in those activities.

  Q14  Jim Cousins: How do you carry out that expectation?

  Mr Haddrill: We audit what they do, we inspect what they do, we look at the extent to which they are managing their risks, and we look at the extent to which they are investing in those activities.

  Q15  Jim Cousins: So why can you not tell me how much of the £17 million that Deloitte got for auditing Royal Bank of Scotland went back into improving audit quality?

  Mr Haddrill: Because what we do is look at the firm as a whole and we also look at particular audits, but in terms of the level of investment by the firm as a whole in those activities that would make sense, not the level of investment in relation to a particular audit.

  Q16  Sir Peter Viggers: Following the Enron scandal accountants moved out of consultancies. In the year 2000 something like 300% of audit fees by comparison were consultancy work, in 2009 they were 70%, and now all the accountants are moving back into consultancy. Are you confident that this is a sensible step?

  Mr Haddrill: This is something that we are taking a very close look at. The committee made a recommendation on non-audit service fees and non-audit service work, and the consultation on that has just closed and the FRC will be reaching a conclusion on that over the next two to three months. I must make that clear. As you say, the level of non-audit service fees in relation to audit fees has fallen quite significantly, and we were certainly very pleased to see that. The question is to what extent is it ticking up now, and I do not think we yet know the answer to that, and whether it is going to be a sustained change. If it is going to be sustained, we would be concerned about that because we want to see—and I think investors want to see—that the balance is very much in favour of the fees they earn from audit rather than the fees they earn from other activities.

  Q17  Sir Peter Viggers: You do not know whether they are expanding or not? KPMG have said they plan to treble their consulting revenues to £600 million. PricewaterhouseCoopers are planning to take on a further 300 consultants in the next 12 months. This is a matter of public record. Did you not know that?

  Mr Paterson Brown: I think there is an important issue here with regard to the fragile state of the economy at the present moment. There are a lot of companies turning to, if you like, advisers. Therefore, in a lot of companies the auditors are one source of advice that is close to the company and able to provide support, and I think in the current situation, if you like, where we do not want global economies to go back into recession (or indeed, worse than that) it is important advisory services are there, and I think they will tick up in the short term. I think the issue is that the controls and balances are there to make sure that the balance of these is correct going forward.

  Q18  Sir Peter Viggers: Your organisation, Mr Paterson Brown, had a working group studying this general issue of audit and non-audit. Who sat on that working group?

  Mr Paterson Brown: There were 14 of us. We had a balance of academics, institutional investors and corporates, and the big four were represented as well, but there were 14 of us and they were in the minority.

  Q19  Sir Peter Viggers: Your recommendations were to audit committees. Would it not have been more effective to make recommendations to the auditing firms themselves?

  Mr Paterson Brown: To the extent that we went through the process I think that, if you like, the issue for us, having done a robust debate which included, I may say, all of the members of the group, was that we had an issue with regard to the difference between perception and reality. The perception out there with regard to certain factions is that, if you like, there is a problem with regard to non-audit services. We believe the reality is that the safeguards are in place and that actually what we need is greater transparency, disclosure of policies and procedures, improved analysis of audit fees and non-audit fees and enhanced corporate governance. To that extent, we think some of this, if you like, comes back to the companies and the audit committees, and we believe that those findings will be supported when the work comes out in a couple of weeks' time.

  Q20  Sir Peter Viggers: Mr Haddrill, your organisation put out a press release in November warning audit firms about providing internal and external audits. Why do you think that audit firms need to be warned about taking on internal and external audit when you do not need to warn them about taking on consultancy work? Is there not a similar risk there?

  Mr Haddrill: The concern is that the audit firm is not taking on work which could compromise their ability to do a proper audit. I would say the issue is whether they are taking on consultancy work which is particularly relevant to the audit and gets them into the position of auditing their own work. That is what we are trying to avoid. We have made clear in our ethical standards that is something that auditors need to avoid and need to think very carefully about, and in the inspection work that is something we pay a lot of attention to.

  Q21  Sir Peter Viggers: It seems that the profession is accepting the need for greater transparency, so can I ask each of you whether you would support greater transparency of auditor remuneration in the company's annual report, showing more details of the non-audit services provided to the company, and more disclosures from auditors themselves giving information as to their various undertakings. Would you support greater transparency?

  Mr Hodgkinson: Yes, and I think, going back to your figures of 300% to something like 70%, that applied to individual companies, the ratio between the non-audit fees and audit fees. What has happened is there has been a real transformation in practice which has not been communicated appropriately. We have had a lot of reform and change in substance, but actually—and it was evidenced by the reaction of this Committee and others—the perception has not changed. It is important that there be transparency. There are absurdities in the present disclosure, like most people would regard work on an interim set of accounts by auditors as audit work but it gets classified as non-audit work. There is a host of anomalies which mean that, quite rightly, people look at what has been disclosed and say, "Has a lot changed?" If I could just make a comment about what you said earlier about the growth in the firms. There is no plan that I know of for firms to increase, as a matter of policy or strategy, the ratio of non-audit fees to audit fees. We are talking about the total business and we will be talking about business done for non-audit clients. That is just to clarify the comparison made between the press announcements and the issue of non-audit fees on audits.

  Q22  Sir Peter Viggers: Disclosure, Dr Priddy?

  Dr Priddy: Yes, I totally agree with Robert.

  Mr Haddrill: Yes, I think disclosure is very important. Just to pick up a point that was made before, it is both disclosure by the auditor and disclosure by the audit committee of what its policy is. I think the two have to go together.

  Mr Paterson Brown: It goes to the very core of the working group report.

  Q23  John Thurso: Can we go on to the question of fair value mark-to-market accounting and pro-cyclicality? Perhaps we will start with you, Mr Hodgkinson. Do you think that fair value accounting will always result in an element of pro-cyclicality? Is it inevitable?

  Mr Hodgkinson: This question of pro-cyclicality, as you know, has been subject to a lot of attention, and it is fair to say that the professional standard-setters before this crisis probably had not given it enough attention. There is a very good speech, which I am sure you are aware of, that Lord Turner gave at the ICAEW a couple of weeks ago setting out a very clear analysis of how the model that was used for providing against loans and the model that was used for marking certain instruments to market could contribute to pro-cyclicality. That is a good analysis. I think what we need to look at, though, and be careful about in our research, is whether that actually happened in practice, because there are within individual entities ways that some of them do not respond to fair mark-to-market accounting in ways which lead them to get over-exuberant, but there are controls that are in place as to how regulatory capital is calculated and controls in UK company law as to how dividends are based on accounts. There are safeguards in there. Yes, there is a tendency towards pro-cyclicality, but I think we should be looking at the safeguards and the alternatives to mitigate those effects rather than say that mark-to-market accounting is a bad thing. As Lord Turner acknowledged in his speech. There are reasons why it is very good.

  Q24  John Thurso: It has the opposite ill-effects of historical cost, basically.

  Mr Hodgkinson: Yes.

  Q25  John Thurso: In one it lets management get away with being too optimistic, the other lets the market get away with being too optimistic.

  Mr Hodgkinson: There is also an issue that if you allow people to hold assets at way below their market price then you give them discretion to manage their earnings, because all they need to do is release a flow of under-valued assets and managed earnings, which isn't what investors would want.

  Q26  John Thurso: So we know the danger but, on balance, we think it is the least of the two. The FSA proposed that, basically, we go to two lines for loan loss provision, so you have the one which is historical, which says that is what has happened, and the other which is an estimate and basically tries to aim off on the market's optimism, as it were. Do you think this will be (a) more informative for investors and (b) help mitigate the risk?

  Mr Hodgkinson: It is a suggestion which has been around for some time. We are quite sceptical about it because we think that presenting two numbers risks confusing people and, heaven knows, we are concerned enough about the complexity of financial reporting without having the complexity that that introduces. I think the approach which the IASB has been taking, which is trying to find a way in the published accounts that are useful to investors, of introducing an economic approach to provisioning, rather than the "incurred loss" approach, is trying to tread a middle path. It is always possible for regulators to have their own overrides and rules which modify the reported numbers, so it would be really hard trying to find a single number in the accounts, otherwise people will just say: "Which one are we supposed to look at?"

  Q27  John Thurso: Anybody else?

  Mr Haddrill: We have to watch within the incurred loss approach that we do not ask it to do more than it is capable of doing, because the incurred loss can still only be recognised at a particular time by banks as their market changes, so we could still have volatility even with an incurred loss approach. The point Robert makes very well is that there is only so much accounting can do here, and there is much that regulators may well have to do on top of the accounting provisions in terms of asking the banks to reserve against losses that are arising. We should certainly not devise accounting rules that apply to the whole of the economy just to sort out the problems of the banks. If the regulators are asking for more capital to be put aside because they perceive particular risks applying to banking or particular banks, the disclosure issue is, how does that get fed through into the accounts? We need to see disclosure of the consequences of the regulator's decisions.

  Q28  John Thurso: At the heart of this is the whole thing Warren Buffett always used to come up with, which is that in the short-term the market is a voting machine but in the long-term it is a weighing machine. What we are seeing is that the pure voting has got very little relevance to actual underlying value; it is whatever people are prepared to pay in the market, and if it goes across a year and everybody gets a big bonus they pump that back in, whereas what we need is the weighing machine approach somehow to be reflected. Can accounts ever do that or is that always going to be a matter of judgment for investors?

  Mr Haddrill: I think accounts are always, to some extent, going to be a record of what happened the year before, but there is also the report at the front end, the directors' statements, and what you are getting with more fair value is that there is more judgment in the accounts and more reliance upon understanding of the business strategy in order to interpret the members. There needs to be more understanding of the business strategy. We therefore feel that the quality of the front end of the report and accounts is very important and maybe the auditors should have a bigger role in ensuring what the management is saying about where it is going than they have done so far.

  Mr Hodgkinson: Could I add another perspective on this? Stephen is quite right to say that the context in which you report the accounting numbers is important, but I think it is also important to recognise that the accounting profession as a whole has a range of users of information; they need to be given information which is fit for purpose. We have tended to have a debate over the past year about there being only one set of numbers, and there is a fight for who kind of controls the steering wheel: is it for investors or is it for regulators? I think it is more constructive to say that you have, as far as possible, a core set of numbers and then you make it very clear to those involved in remuneration decisions or distribution decisions or regulatory decisions the limitations of the information for their purpose. I think we need to get away from this idea that if there is more than one number then somehow we have let people down or it is duplicitous—actually, people have different purposes—and I think acknowledging those differences, rather than just saying: "The numbers are for the investors, everyone else forget about it", is not helpful.

  Q29  John Thurso: We are tight for time, so can we go on to the next issue? Stephen Haddrill, perhaps I can ask this of you: have you had any feedback on your revised guidance on the going concern issue?

  Mr Haddrill: The feedback has been positive and seems to be being adopted effectively, so we feel that is satisfactory.

  Q30  John Thurso: Can I, just for the form, ask the rest of you if you have any feedback to give me?

  Mr Hodgkinson: I think that everyone concerned thinks it has been a big success, and I think it is a big success in an important way because it shows that the accounting firms, the accounting profession and the regulator all realise that they were potentially brewing a systemic problem here because individuals reporting on individual banks and individual entities could have created a systemic problem because of the going concern regime. I think identifying that everybody needed to understand what the reporting meant and also realise the importance of banks helping businesses clarify their facilities and everyone helping people to think through their business plans helped to avoid a systemic problem. It is easy to focus on systemic problems that have happened, but we have not had a systemic problem of mass qualification of accounts or modifications leading to a collapse in confidence.

  Q31  John Thurso: The core point, really, is what we are seeking is to get away from that cosy relationship where the chairman of the audit committee and the senior partner of the audit sit down together and—if not manage—make sure that everything is all right, to something where the auditor really feels quite free and has a clear responsibility to say and enter things in different degrees of tone without it bringing the whole edifice collapsing down.

  Mr Paterson Brown: To the extent that I am currently a finance director and was previously a finance director in the City of London, with regard to a listed 250 company, the cosy relationship between the audit partner and the chairman, I think, is a perception rather than reality.

  Q32  John Thurso: I have sat on a number of audit committees and watched it happen.

  Mr Paterson Brown: It does not happen in the areas I have been involved in. What I would say is that by flagging the issue at an early stage and by getting everyone focused on it, if you like, there were more than actions taken with regards to discussions; a lot of money was raised by companies in the marketplace with regards to rights issues, there was a lot of discussion with regard to banks, with regard to banking, a lot of action was taken with regard to the going concern, and I think by getting issues out on the table early and getting people sensibly discussing them we, if you like, headed off a lot of problems that may have emerged and, thankfully, did not.

  Q33  Chairman: Stephen Haddrill, you talked about the Audit Inspection Unit as a way of keeping tabs on the auditor. Is that correct?

  Mr Haddrill: That is their role.

  Q34  Chairman: In its 2007 report on PwC the Audit Inspection Unit found that PwC audit staff were selling non-audit services to audit clients. As you know, that is not allowed. A year later they were still doing it. So do audit firms have any regard for the AIU's findings?

  Mr Haddrill: We believe that they do. Being only two months into the job I am a bit reluctant to comment on two years ago.

  Q35  Chairman: But the case I have put to you—

  Mr Haddrill: I understand that. We pursue the questions that are raised in each inspection report the following year to make sure that there is follow-up and that we are satisfied with that and that we continue to do that.

  Q36  Chairman: It did not happen in this case.

  Mr Hodgkinson: It did happen in the sense that we have continued to pursue it.

  Q37  Chairman: They are still doing it. What is the use of the AIU if they are still doing it?

  Mr Haddrill: Because we have highlighted it; we have raised it.

  Q38  Chairman: There is no use highlighting it if there is no behavioural change.

  Mr Haddrill: I think there has been behavioural change in this case. I will ask the firm to respond to that, but what we have put in the public domain is an anxiety and I think that is of considerable interest.

  Q39  Chairman: Do you have any sanctions?

  Mr Haddrill: We have sanctions if there is misconduct, and I think one of the things that we are increasingly concerned about is that we have got a sort of nuclear sanction in relation to the firm but we do not have an intermediate set of proportionate sanctions.

  Q40  Chairman: You said earlier, and I just make the point, that there is a difference between perception and practice. The perception is that this is going on, but in this case the practice is that it is going on as well. If the AIU does not have decent sanctions to do anything about it, it just seems as if things will be business as usual.

  Mr Haddrill: I think I am agreeing with you that there should be a more flexible set of sanctions rather than removing an auditor's licence to practice.

  Q41  Nick Ainger: Mr Hodgkinson, in our report on the banking crisis and corporate governance, you came forward with five suggestions about strengthening the links between auditors and the FSA. We have seen the written response from the FSA. How is it actually working out in practice?

  Mr Hodgkinson: First of all, thank you for referencing those suggestions. I think that we need to disaggregate them a little bit because there are different powers the FSA has unilaterally to change things, because some are in company law and some are about international agreements. Just to give some examples of things changing, I think it is worth saying that the FSA now supports supervisors with an accounting review team, and that there is an expectation that there are annual meetings, at least, on institutions, and they have doubled or tripled the use of section 166 reports, and that is quite a change in practice. These things take time, but I think they are indicating a change in the right direction. Also, we established towards the end of last year an Audit of Banks working party, which we expect to report in April this year, which will have had the input we said was necessary when we made our submission to the committee of a wider group of stakeholders as to whether this potential expansion of the role was seen as being helpful That is something which is ongoing.

  Q42  Nick Ainger: The annual meeting which takes place between the auditors and the FSA, where is that in relation to the audit itself? How close is it? Is it immediately before, is it immediately after or is it during? When does it happen?

  Mr Hodgkinson: I think it is fair to say that I am not a bank auditor and privy to those, so it is difficult for me to comment on that.

  Q43  Nick Ainger: Does anybody else know when these meetings take place? Perhaps you can let us know on that because, obviously, the concern would be that maybe if something is shown up and the meeting does not take place for six months, nine months or whatever, then the FSA is not made aware of this.

  Mr Hodgkinson: I am sorry; I think there is a well-established regulatory framework so that where there are things which need to be brought to the attention of the regulator then there are professional obligations to do that. It is also important to say that auditing these businesses is a round-the-year activity, not only in relation to quarterly statements from the US but half-year announcements, and the fact that you cannot complete the audit in a few weeks after the year-end. I think we can give an assurance, even without having detailed knowledge of the timing, that those sorts of concerns that you raise should not worry the Committee too much.

  Q44  Nick Ainger: Can I ask the rest of the panel then have you seen a change in the relationship between auditors and the FSA since our report?

  Mr Haddrill: I think what we have seen is the FSA paying more attention to the auditors' knowledge of what they are saying and to that information set alongside the direct supervisory reports that the FSA gets itself.

  Q45  Nick Ainger: So there has been an improvement in those relationships?

  Mr Haddrill: I think the FSA is certainly paying more attention to that.

  Q46  Nick Ainger: If another bank were to fail or get into serious difficulty, would it be absolutely clear now who was responsible for telling whom about what the problems were? That was part of the problem with Northern Rock.

  Mr Hodgkinson: It is quite a rich question which makes some assumptions about what happened in Northern Rock. What is important is to recognise that there is a greater acknowledgement of how two different functions, one a regulatory function and one an audit function, which are distinct but are both based on having an understanding of risk, can benefit from dialogue. I think if we look at the collapses that we saw, I do not think it was a conclusion of the committee that they were caused by the auditors, nor was it a crucial fact in those failures that there was not communication between auditors and the FSA. I think what we were trying to do was talk about, in our suggestions, ways in which there could be extra safeguards and greater confidence so that when people asked, "What liaison is there between FSA and auditors and how do they mutually benefit each other?" there was a better answer. I think there will be a better answer in future.

  Mr Paterson Brown: I think it is not just the FSA and the auditors; it is the FSA, the companies and everything else. Working currently in a regulated business, the level of communication is hugely different now with the FSA from what it was 18 months, two years ago.

  Q47  Chairman: We asked a question about the big four going to the big three, but what steps have been taken to increase competition?

  Mr Haddrill: There was the market report that was produced between the FRC and the Department some three years ago. There were 15 recommendations there, they have been implemented and we will be reporting on their effectiveness in the coming year.

  Q48  Chairman: So four years later you are reporting on their effectiveness. The APB ethical standard four prohibits a firm from accepting a client if the fees are more than 10% of the audit firm total annual fees. Does this unhelpfully restrict competition in the accounting world?

  Mr Haddrill: I do not think it restricts competition. I think if there is one area where we would certainly like to see competition grow it is in relation to the smaller end of the listed market. If you look at the AIM market you see auditors abounding other than just the big four. If you look at the 350 around the FTSE you do not see that. Actually, I think there is not just a challenge to regulators to encourage companies there to look outside the big four, I also think there is a challenge to investors to encourage it as well.

  Mr Hodgkinson: Could I just make an observation: the point you make is a good one which shows that there are conflicting regulatory objectives and public policy objectives because the reason that 10% rule is there is for independence, and the appearance of independence. Yes, you are right that if an audit firm which does not have a very major client is looking to enter that market you could create problems, so there are conflicting public policy objectives.

  Q49  Chairman: Can we take it that you disagree with the Governor of the Bank of England then when he says that to rely on Chinese walls is a triumph of hope over experience?

  Mr Haddrill: He said that in this context?

  Q50  Chairman: The institutions. What about you, Dr Priddy? We have not got you here for nothing!

  Mr Haddrill: I think that one of the things that we are consulting on in relation to this whole question of non-audit services, and which we will reach a conclusion on, is whether there is sufficient clarity in the ethical standards about what non-audit work can be accepted and whether there are tight enough lines around the quantum of fees from one set of activity versus another. To that extent I would agree with the Governor that there is always a question to be looked at as to whether you actually need harder black letter rules.

  Mr Hodgkinson: I think the experience of firms—and it is supported by the inspection regime—is actually the accounting firms do have a good record in relation to Chinese walls, and the system, again, has other objectives, because in terms of making available to corporates a variety of services in a market which is to the proportionate degree regulated and director choices are limited, if you are going to do that in as limited a way as possible that supports economic prosperity then you have got to have some trust in safeguards. It would be very easy to have no trust in any safeguards but just constrain economic activity in a way which would not be helpful; it is a balance.

  Q51  Chairman: You deal with ethical issues as well, Dr Priddy, do you not?

  Dr Priddy: Yes.

  Q52  Chairman: Chinese walls and the Governor?

  Dr Priddy: I think the point that I would make is that at the heart of this is a commercial decision between the audit firm, the board of directors and shareholders, and all those key players have something to play in that commercial decision. I think when you look at the way services are procured, audit committees will look very carefully at the best person to provide the services, and my experience is that Chinese walls do work very well.

  Q53  Chairman: There have been recent instances where a firm has been advised to go into administration and those advisers have overseen the administration and made large amounts of money. As the Chairman of Woolworths said, is this not a clear case of a conflict of interest?

  Mr Paterson Brown: I think in business life one comes across conflicts of interest all the time. One needs to clear them and one needs to make sure the appropriate safeguards are in place, and one moves on. To think that you can go through your business life without coming across a conflict of interest is impossible at a senior level; what you need to make sure is—

  Q54  Chairman: Hold on, hold on. If you are going to advise an entity to go into administration and then you are going to oversee that administration, maybe your initial advice could be a little bit wonky. If there is a conflict of interest there why do you not separate it? Those giving the advice and those undertaking it at a later date, surely that is a real clear conflict of interest there. It is not good enough just to say: "There are conflicts of interest in life every day; let's forget them; let's get on with business".

  Mr Paterson Brown: No, the comment was that the advice with regard to going into administration can be given with the safeguards in place. Having gone into administration that work can be done, if you like, having exercised the safeguards with regard to the original decision. I do not see that the two need to be completely linked.

  Q55  Jim Cousins: Following the Chairman's issue there, is this whole area of abusive pre-pack insolvencies and the relationship with advice from auditors that goes into this something you are looking at?

  Mr Haddrill: It is not something I have looked at in my current job; I certainly looked at it in my previous one, at the ABI, where we were concerned about whether a pre-pack was, effectively, in the interests of the owners of the business.

  Q56  Jim Cousins: Pre-packs are an absolute outrage and they are spreading like wildfire. Clearly, people are being advised to set them up.

  Mr Haddrill: I think pre-packs are (I do not know whether I would use the word "outrage", but let's use it) an outrage where they are set up for a purpose which is not in the interests of the people who have a relationship with a company as investors and so on. If, however, it can be set up in a way where there is proper disclosure, the business remains in being as a result, and people remain in employment, and everybody understands what is going on, then I think it is potentially a good thing.

  Q57  Mr Love: Insolvency practitioners have always argued that if you look at the evidence pre-packs are good for the creditors, especially the smaller creditors. Is there any validity to that argument?

  Mr Haddrill: You are taking me into territory where I think it is probably best that I do not answer from an FRC perspective because that is not part of our responsibility now. I was looking at it in relation to having experience in the insurance industry before, in a previous job.

  Mr Hodgkinson: If it would help—and it is not something on which I am deeply knowledgeable—to provide the Committee with further information we would be happy to do that.

  Q58  Chairman: There does just seem to be a little degree of complacency here.

  Mr Hodgkinson: It is probably just a degree of unfamiliarity with the territory.

  Q59  Chairman: We have been told that there has been a real transformation in practice. Can each of you set out one of the most significant things achieved since the credit crunch? Why do we not start with Dr Priddy, then he can get full marks for being here today.

  Dr Priddy: Thank you very much. I think one of the things that has come through for me as being a really good advance is the role of the audit committee and the duties of the audit committee within the new corporate governance codes that have come through. I think this is a really good, positive step forward, it does highlight much more clearly the role of the audit committee, and I think that is very good. I think, also, the guidance that has come through on going concern is very important, and that has also been a great progress as a result of this crisis. Those are two things I would flag.

  Mr Haddrill: I would mention two things. I think within governance the much clearer focus on risk, the rise of the risk committee within the businesses and the appointment of people to make sure that boards really understand risk. Also, I think, from our perspective in relation to audit on an international level, the growing liaison between auditor regulators on an international basis.

  Mr Paterson Brown: Obviously I came in to chair this working group and, therefore, have not been involved as far back as other people. I think what I would say is that, if you like, post-2002 we have seen a change in the world with regard to governance and with regard to regulation, et cetera, and I think we need to keep moving down the transparency, disclosure and governance route. I do not think we have ended the journey.

  Mr Hodgkinson: I am a little bit hampered being the last but, maybe, rather than talking about specifics, the important thing is that this, as the Committee summarised, was not primarily an audit crisis, but the challenges, for example, that you laid down in your nine recommendations have caused us a lot of reflection: the value of audit; risk management responsibilities; liaison with regulators and auditors, and going concern. These are important issues which I think we have been forced to reflect on; in particular the question that Mr Thurso raised about thinking about pro-cyclicality and the impact on the accounting profession not just on a micro level relating to individual entities but thinking about the consequences. I think that consciousness is something that will lead us to do a lot of work over the next few years.

  Q60  Mr Love: The word "rotation" has not come up as yet. I wondered whether you felt (I am asking you collectively) that rotation has a larger role to play than it currently has done up to the present time.

  Mr Haddrill: Certainly the decision has been taken not to relax on rotation and there was pressure—

  Q61  Mr Love: Should we strengthen it?

  Mr Haddrill: I do not think we need to strengthen it because we looked at both sides of it when we reviewed it, but I certainly think that one of the things that has come out of the work over the last couple of years is we should not be relaxing it.

  Q62  Mr Love: Does anybody have a different view?

  Mr Hodgkinson: Are we talking about rotation of auditors?

  Q63  Mr Love: Yes, rotation of auditors.

  Mr Hodgkinson: I think that as an issue for regulatory change it is not considered a live one. What I would emphasise is that rather than looking at these ways of constraining activity to build confidence we have to have the audit firms and the profession building their own confidence. We have not mentioned the publication by FRC and the ICAEW two weeks ago of an audit firm governance code. It is all about the profession taking its own responsibility to build confidence rather than waiting for another regulatory constraint or limitation. I think it will be seen more actively ...

  Q64  Chairman: At the beginning I said you had 18 working papers. I would like to see some coherence in that and that it is not just 18 disparate pieces of work. If I take you back to the genesis of our concerns it was where we saw that within days of getting a clean bill of health from the auditors many banks simply collapsed. We said the fact that the audit process failed to highlight developing problems in the banking sector did cause us to question exactly how useful audit currently is, and I think that is still a live question for us. I think there is a problem in terms of perception and reality, and you have quite a bit of work to do there. I would hope that the successor Committee to this in the next Parliament looks at this and we keep engaging on that so that we do have more clarity and transparency in the process and have a real understanding of exactly what an audit is about and how we ensure that we have real time information that is shared so that if the business models are skewed or wonky something can be done about it.

  Dr Priddy: Can I just say something from an international perspective, because Stephen did refer to that? We have been doing some round tables across different territories and I was in the Ukraine the week before last. Around the table we had people from the World Bank, people from the audit profession, people from the regulators and people from business. One of the points that was made very clearly there is that the way the UK works in terms of its audit framework, in terms of Companies House and having transparency of accounts, and so on, is something that other countries in the world look to with great envy.

  Q65  Chairman: Maybe with regard to the Ukraine the UK does do it better—I do not doubt that—but I think we need our own standards and the standards need to be raised, Dr Priddy. We want, as a Committee, to engage with you in that exercise.

  Mr Hodgkinson: Can I also say that we did not have time to talk about the activities of the Audit Quality Forum, which was set up five years ago to raise these issues amongst all the stakeholders in audit. Although we have not got time to go through the work that has been done since last year on this, there are important initiatives which I think respond to your challenge, and, again, we would be quite happy to update you.

  Q66  Chairman: It is still a work in progress.

  Mr Hodgkinson: Work in progress.

  Chairman: Thank you very much.

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