Audit and Accountancy - Treasury Contents


Supplementary written evidence submitted by the Institute of Chartered Accountants in England and Wales

  In May 2009 the Treasury Select Committee put a number of challenges and recommendations to the accounting profession as part of its ongoing enquiry into the banking crisis.[3] In addition the FRC are ascertaining facts around the publication of the Valukas report on Lehman.

  During my oral evidence to the Committee on 9 February 2010 I undertook to come back to you on a number of specific areas:

    — dialogue between auditors and the FSA on systemic risk issues;

    — the work of the Audit Quality Forum; and

    — how insolvency practitioners manage conflicts of interest.

  Appendix 1 addresses the first two points as well as progress made against other areas the Committee asked us to consider in its Ninth Report. Appendix 2 sets out a short explanation of the conditions under which insolvency practitioners are licensed.

  Progress is being made on a number of important fronts:

    — the Walker recommendations provide a clear governance framework for major financial institutions;

    — there is increased dialogue between auditors and the FSA on systemic risk issues;

    — detailed recommendations for improved disclosure, transparency and governance around non-audit fees have been published by ICAS;

    — independent research undertaken for the ICAEW Foundation has identified important areas for improved application of the Combined Code by listed entities;

    — on the back of extensive input from the profession updated guidance for preparers and auditors on going concern was issued by the Financial Reporting Council;

    — ICAEW is assisting audit firms implement the new clarified International Standards on Auditing; and

    — a governance code has been introduced for auditors of listed entities.

  Everyone in the financial reporting chain has an important role to play as we move towards economic recovery and a return to business confidence. ICAEW is committed to playing a full part in this process.

APPENDIX 1

PROGRESS ON RECOMMENDATIONS FROM THE NINTH TSC REPORT 2009

Paragraphs 35-43 of the Ninth TSC Report of May 2009 raised a number of specific issues for the auditing profession. The progress we have made on each of these issues is set out below:

  35.  We have received very little evidence that auditors failed to fulfil their duties as currently stipulated. The fact that some banks failed soon after receiving unqualified audits does not necessarily mean that these audits were deficient. But the fact that the audit process failed to highlight developing problems in the banking sector does cause us to question exactly how useful audit currently is. We are perturbed that the process results in "tunnel vision", where the big picture that shareholders want to see is lost in a sea of detail and regulatory disclosures.

  The audit profession has been reflecting hard on what steps can be taken to help mitigate future systemic failure of the kind that has characterised the banking crisis. This is more than a question about audit quality and the financial statements of individual financial institutions. In December 2009 the Audit Inspection Unit of the Financial Reporting Council reported "the overall quality of major public company audit work to be fundamentally sound"[4] and that "firms generally continue to take appropriate action|to respond to increasing turmoil in financial markets and the onset of the economic downturn." It is also a question about whether auditors can do more to help identify potential systemic risk areas—something the current reporting model was not designed to pinpoint. Since the Committee published its Ninth Report, the Audit Quality Forum (www.icaew.com/aqf) has brought together auditors, investors, corporates, regulators and wider market participants specifically to debate the potential role of auditors in helping to identify systemic risk. The output of that debate has been fed through to regulators and policy makers in order to help inform public policy development. ICAEW is also consulting on Audit of banks: lessons from the crisis which will examine how the role of bank auditors could change, for example around information exchange between audit firms and the FSA. We aim to publish our recommendations in April.

  36.  We are not convinced that auditors are particularly well placed to provide additional assurance regarding the risk management practices of financial institutions. Bearing in mind the view of the Chief Executive of the Financial Reporting Council, that auditors were not competent to perform such a role, it would be perverse to come to any other conclusion. A better way to ensure that banks manage their risks would be to concentrate on the banks' own internal risk management functions, complemented by more invasive regulation of risk by the FSA.

  It is clear that a number of major financial institutions failed to identify and manage effectively the possibility of systemic risk in the run-up to the economic crisis. The Walker recommendations, published in November 2009 are designed to address this problem. Last year the ICAEW Foundation commissioned independent research on the governance regime across the wider listed company sector. The research, which was published in September, concluded that while the current governance framework is fit for purpose, listed entities need to be more rigorous in their adherence to the Combined Code. We are now working with the FRC on its current review of the Turnbull guidance on risk management and internal control to embed changes proposed by Walker and the FRC. While the Committee is correct that the banks themselves and their regulators are best placed to ensure effective risk management, the assistance that auditors can provide is being explored as part of our work on Audit of banks: lessons from the crisis referenced above.

  37.  The FSA's piecemeal approach to garnering auditor knowledge about individual banks indicates to us a wasted opportunity to improve the effectiveness of bank supervision. In future, the FSA should make far more use of audit knowledge, on a confidential basis. We are grateful for the response by the ICAEW in bringing together audit firms and drawing up some suggestions to strengthen links between the FSA and auditors. We recommend that the FSA should respond to each of the five suggestions made by the ICAEW.

  This area forms an important part of our consultation on the Audit of banks: lessons from the crisis referenced above. We will report in detail to the Committee in April.

  38.  We remain concerned about the issue of auditor independence. Although independence is just one of several determinants of audit quality, we believe that, as economic agents, audit firms will face strong incentives to temper critical opinions of accounts prepared by executive boards, if there is a perceived risk that non-audit work could be jeopardised. Representatives of the investor community told us of their scepticism that audit independence could be maintained under such circumstances. This problem is exacerbated by the concentration of audit work in so few major firms. We strongly believe that investor confidence, and trust in audit would be enhanced by a prohibition on audit firms conducting non-audit work for the same company, and recommend that the Financial Reporting Council consult on this proposal at the earliest opportunity.

  It is clear that non-audit service provision remains a source of concern to the Committee. Responses to the recent Auditing Practices Board consultation in this area suggest that, while there remain some perception issues around non-audit services, neither companies nor the majority of investors believe that such services adversely affect audit quality. What is also clear is that auditors, corporates and regulators need to do more to explain the current regime to investors and other stakeholders. Recent work in this area published by ICAS makes an important contribution in this regard. A great deal has been achieved since the collapse of Enron and the banking crisis has been the first major test of the ethical standards on auditor independence that were put in place at that time. The evidence we have seen to date indicates that this new regime—which defines threats and related safeguards, appropriate prohibitions and audit committee review—is working. In our view enhanced disclosure of audit committee process and the reasons for auditors performing non-audit services, not prohibition, is what is needed and we look forward to working with regulators and standard setters to make this happen.

  39.  The Financial Reporting Council should build on steps it has already taken to ensure that users of accounts are sufficiently well informed about going concern considerations that the issuance of modified audit opinions does not result in undue panic. With a view to the longer term, we believe there is a case for the FRC to consider the introduction of a graduated ladder of concern, along the lines suggested by Professor Power. We would welcome a system whereby the auditor could transparently express an opinion on a bank's future, without triggering emergency action by the FSA.

  The regime that has been established in this area by the FRC in response to the credit crunch now deals effectively with this issue and provides for the graduated ladder of concern recommended by Professor Power. The real risk over the last 24 months was that investors would take fright at the increased occurrence of modified audit reports. The proactive steps the profession took during this period to explain what these modifications meant in practice helped prevent a wider systemic problem arising. The issue has not gone away. Research undertaken by Deloitte states that the level of audit reports modified for going concern issues for listed corporates rose to 8% during the recession demonstrating that UK preparers and auditors have been taking a robust stance on going concern. Wider awareness of the issues however, has helped maintain economic confidence.

  40.  We believe that the complexity and length of financial reports represent a missed opportunity to improve the understanding that users of accounts possess of the financial health of firms and recommend that the FSA consult on ways in which financial reporting can be improved to provide information in a more accessible way. At the moment, financial reports can be used for finding specific bits of information, so are useful for reference, but they do not tell the reader much of a story. We would like them to read less like dictionaries and more like histories. A useful approach would be to insist on all listed firms setting out their business model in a short business review, in clear jargon-free English, to detail how the firm has made (or lost) its money and what the main future risks are judged to be.

  As the Committee rightly identifies, one of the key lessons from the economic crisis is that financial reports need to provide a stronger more useful narrative. On 5 March the FRC finished consulting on a revised UK corporate governance code. The draft proposals include a requirement that listed companies explain their business model and overall financial strategy in clear and concise terms that provide such a narrative. Once the outputs from this consultation have been incorporated into the Listing Rules the challenge for the profession will be to ensure that the resulting reports avoid anodyne boiler plating in favour of something that meets the aspirations of the Committee. We are aware that BIS is also looking at improvements to narrative reporting.

  41.  Fair value accounting has led to banks publishing some very dispiriting financial results, but this is because the news itself has been bad, not the way in which it has been presented. The uncomfortable truth for banks is that market participants had over-inflated asset prices which have subsequently corrected dramatically. Fair value accounting has actually exposed this correction, and done so more quickly than an alternative method would have done. Important features of accounting frameworks are that they encourage transparency and consistency across firms and asset classes. But it is a bridge too far to expect them to also lead to intelligent decision-making. We do not consider fair value accounting to be a suitable scapegoat for the hubris, poor risk controls and bad decisions of the banking sector.

  Over the course of the past 18 months the ICAEW has been a consistent and vocal advocate of the issues identified by the Committee. We will continue to make the case.

  42.  We consider that fair value accounting has featured an element of pro-cyclicality through its inter-linkage with the Basel capital requirements. This is not a fault of the accounting standards, but rather a result of published accounts being used too crudely in the calculation of regulatory capital requirements. The primary audience of accounts are the shareholders, who have a desire to see the true worth of their firm. The FSA, as the banks' supervisor, is a secondary user of the accounts, and has a legitimate interest in ensuring that firms are run prudently. This is not the same objective as that of the shareholder, so the regulator need not rely, and certainly should not rely exclusively, on the published accounts in calculating capital requirements. We will consider ways in which the FSA might introduce such an element of prudence in the capital regime in our forthcoming report on public regulation.

  Accounting standard setters need to better understand what prudential regulators are trying to achieve. Prudential regulators need to better understand how accounting standard setters are striving to meet the needs of investors. We note that the dialogue between the International Accounting Standards Board (IASB) and the regulatory community has improved over recent months and it was evident from a speech that the Chairman of the FSA delivered at ICAEW in January 2010 that the IASB is listening more carefully to its wider stakeholders. ICAEW will be considering how separate, tailored financial reports can meet the needs of users other than investors including regulators.

  43.  The existence of the European Commission's carve-out power seriously undermines the ability of the International Accounting Standards Board to project itself as a truly global setter of accounting standards, and indeed threatens the integrity of published accounts. Both are profoundly regrettable. Any threatened carve-out effectively presents the IASB with an invidious choice between losing the IASB's coverage of the European Union on the one hand, or acceding to the Commission's demands at the expense of a loss of credibility in other nations on the other. We are concerned that the IASB has already become tarnished by the accusation that it gave in too easily to the Commission's demands over fair value accounting, and by its suspension of its usual consultation process. We recommend that the Treasury consider the impact of the Commission's carve-out power on the prospects for the IASB's reputation and continuing work in establishing a global set of accounting standards.

  If we are to avoid the possibility of a European carve-out being exercised it is essential that the IASB engage effectively with EU stakeholders particularly during the current period of political transition in Brussels. On 14 January 2010 ICAEW wrote a detailed letter to the Committee on the progress that has been made in this area since the beginning of 2009.

APPENDIX 2

INSOLVENCY-RELATED ISSUES

  Insolvency has risen up the political agenda in recent months with the fallout from the economic crisis. There has also been understandable concern over the issue of pre-packs. We believe that the current regulatory regime for insolvency practitioners is broadly fit for purpose but that this sector needs to be more transparent about the ways in which it is held to account. The following explanation is intended to meet Committee concerns in this area.

ADVISING A COMPANY IN FINANCIAL DIFFICULTY

  In circumstances where a company is no longer able to pay its debts, the directors of that company are required to consider the interests of creditors over shareholders. In these circumstances, the directors should seek professional advice from a specialised Insolvency Practitioner (IP). Where this may result in insolvency proceedings, ICAEW, in conjunction with other insolvency regulators, has produced the Ethical Code for Insolvency Practitioners[5] (The Code) based on the Code of Ethics for Professional Accountants produced by the International Ethics Standards Board for Accountants (IESBA). This requires IPs to undertake ethical checks and impose safeguards in relation to any potential conflicts that could arise from advising the company concerned.

CONFLICTS OF INTEREST

  The Ethical Code became effective from 1 January 2009, and applies to all IPs irrespective of their authorising body. The Code sets out five fundamental principles—integrity, objectivity, professional competence and due care, confidentiality and professional behaviour—with which the IP must always comply, and requires IPs to consider whether actions or relationships might constitute threats to those principles and, where these threats are significant, requires safeguards to be implemented.

  When considering potential conflicts of interest, the most relevant principle in the Code is objectivity: "An Insolvency Practitioner should not allow bias, conflict of interest or undue influence of others to override professional or business judgements."

  The Code includes examples of specific situations, for example, a practitioner should not accept an insolvency appointment where he or his firm have carried out audit-related work for the company within the previous three years. Where audit-related work has been carried out more than three years previously, a threat to compliance with the fundamental principles may still arise, but it is for the practitioner to consider whether such a threat can be eliminated or reduced to an acceptable level.

  It is important to note that the Code applies to all professional work relating to an insolvency appointment and to any work that may lead to such an appointment.

SANCTIONS

  Failures to comply with the Code, as well as breaches of any other legislative or regulatory requirements, can result in fines and restrictions on the appointments that can be taken. Where appropriate, the IP's licence can also be withdrawn. Ultimately, the IP can be referred to the disciplinary board of a Recognised Professional Body and their membership can be removed. Such breaches and failures can be identified either through the authorising bodies' monitoring visits to the IPs that they regulate, or as a result of a complaint made to the authorising body.

ADMINISTRATION

  The administration procedure was brought in to promote company rescue and, where it is considered the best way to serve the creditors, it will be recommended by IPs or other professional advisers. The purpose of administration[6] is to rescue the company as a going concern or to achieve better results for the creditors as a whole than would be likely if the company were wound up without administration. The proposed administrator may be selected by the directors but secured creditors must consent to the appointment. Mechanisms are also available for creditors to challenge the appointment. However, in many cases, creditors accept the IP put forward by the directors if the IP has been advising the company, as it helps the administration and is more cost-effective if the administrator has a knowledge and understanding of the business.

PRE-PACKAGED ADMINISTRATIONS

  The interests of creditors are often best served where the business is sold as a going concern. In many instances, the adverse publicity associated with entering into administration will harm the goodwill of the business to such an extent that it precludes sale as going concern, and so the practice of "pre-pack" has developed. Pre-packs are not a new phenomenon and are not exclusive to administration. The Insolvency Service[7] has stated that it considers that pre-packs are a valuable tool for insolvency practitioners, and that a pre-pack can be the best way for an administrator to proceed.

  It is in the nature of a pre-packaged sale in an administration that unsecured creditors are not given the opportunity to consider the sale of the business or assets before it takes place. It is important, therefore, that they are provided with a detailed explanation and justification of why a pre-packaged sale was undertaken, so that they can be satisfied that the administrator has acted with due regard for their interests.

  To respond to this need, the authorising bodies issued Statement of Insolvency Practice 16—pre packaged sales in administrations[8] (SIP 16) in January 2009. The primary purpose of SIP 16 is to ensure that creditors are provided with the detailed and comprehensive explanation and justification of why a pre-packaged sale was undertaken. The SIP also requires practitioners to make clear disclosure about the nature and extent of their role and their relationship with the directors in the pre-appointment period.

  The then Business and Enterprise Committee, in its April 2009 report on The Insolvency Service, stated that prompt, robust and effective action is needed to ensure that pre-pack administrations are transparent and free from abuse. The Committee subsequently welcomed the introduction of SIP 16 and The Insolvency Service's commitment to monitor its implementation.

  R3, which represents IPs, conducted a survey in April 2009,9 which indicated that the top four reasons for undertaking a pre-pack were:

    — the sale needed to be fast;

    — it was the best chance of saving the jobs of the workforce;

    — it was the only alternative to liquidation; and

    — the pre-pack would achieve a better return to creditors.

  In 89 pre-pack case studies identified in the report, 5,478 jobs were at risk, but the pre-pack meant that 4,846 jobs (88%) were saved. It is also worth noting that pre-packs do not necessarily mean that the previous owner remains in charge—the survey responses noted that the business owner remained in charge in 59% of cases.

  It is now a little over a year since SIP 16, came into force. Given that pre-packs remain high profile and elicit strong views both within and outside the insolvency profession, the authorising bodies will shortly be reviewing SIP16 to see whether it is achieving its purpose, and such review will seek the views of creditor groups and others affected by the insolvency process.

  While pre-packs have attracted much media attention, it is important to remember that they represent a relatively low proportion of corporate insolvencies. In 2009, administrations represented only 16% of all corporate failures, of which the Insolvency Service estimated that around 25% were pre-packs. This means that only around 4% of all corporate failures in 2009 resulted in pre-packaged administrations.

ADMINISTRATION FEES

  The complexity, size and risk of an administration are reflected in the fees charged by IPs. In most insolvency proceedings, the creditors collectively determine the bases of the IP's remuneration. Also, new insolvency rules10 will come into effect from April 2010, which aim to make it easier for creditors to challenge IP fees that they think are excessive. The OFT launched a market study into corporate insolvency on 12 November 2009, which is also examining IP fees.



9  Available from www.bpf.org.uk/pdf/21405/R3 pre-pack survey May 2009.pdf

10  New Insolvency Rules and revised SIP 9 Remuneration of insolvency office holders will be introduced in April 2010.










3   Banking Crisis: reforming corporate governance and pay in the City-Ninth Report of Session 2008-09-12 May 2009 (the Ninth Report). Back

4   Audit Inspection Unit 2008-09-Audit Quality Inspections, An Overview-7 December 2009. Back

5   Available from www.icaew.com/insolvency Back

6   Insolvency Act 1896, Schedule B1. Back

7   Report on the first six months operation of SIP 16 http://www.insolvency.gov.uk/insolvencyprofessionandlegislation/policychange/sip16-final.pdf Back

8   Available from www.icaew.com/insolvency Back


 
previous page contents

House of Commons home page Parliament home page House of Lords home page search page enquiries index

© Parliamentary copyright 2010
Prepared 6 April 2010