Panel on Tax, Audit and Accounting

Written evidence submitted by Professor Prem Sikka, Centre for Global Accountability, Essex Business School, University of Essex (SH 023)


This submission is a response to the request by the Parliamentary Commission on Banking Standards ( PCBS) for evidence on matters relating to tax, audit and accounting.

The banking crash is not only a crisis for the financial sector, but also for the social and political institutions charged for securing accountabilities. These also include accounting and auditing, which supposedly enable external parties to make some sense of the risks.

A brief overview of the submission is as follows:

· This submission argues that the auditing industry has failed in its duty to give an honest and truthful opinion on the accounts published by banks. It argues that private sector audit firms should not continue to audit banks. That function should be performed by a state designated regulator.

· It notes the involvement of accounting firms in anti-social practices and their tendency of non-cooperation with regulators investigating banking frauds.

· It urges the banking regulator to set accounting and auditing standards for banks, all subject to a parliamentary scrutiny.

· This submission argues that the public has the right to know of any arrangements between banks, auditors and regulators and thus opposes the wall of secrecy that is erected around dialogue.

· It calls for withdrawal of tax relief on interest payments by banks on their borrowing as that amounts to a public subsidy and encourages excessive leverage.

· It calls for executive remuneration to be linked to a wider measure of performance, which takes account of investment, job creation, providing finance to emerging businesses, staff training, staff retention, staff welfare, maintaining branch networks, customer satisfaction and freedom from regulatory action.

· It calls for bank employees, depositors and borrowers to vote on executive remuneration.

· It calls for publication of the tax returns of banks and greater public information about their operations. For example, by embracing Country-by-Country reporting which would require banks to show assets, liabilities, profits, losses, taxes, employees for each country of their operation.

1. How, if at all, does the tax system encourage leverage in banks? What is the effect of having tax relief for debt interest but not for dividends on equity? What effect does this have on the stability of the banking system?

1.1. Tax relief on corporate borrowings is a key factor in leverage. Well known theories of capital structures in the corporate finance literature have shown that tax relief reduces the weighted average cost of capital. Consequently, equity holders enjoy a higher rate of return, but it takes no account of the social consequences or any implications for the stability and integrity of the financial system. The pursuit of higher rates of return for shareholders has persuaded banks to take on excessive leverage. This makes them vulnerable. Just before its demise Lehman Brothers had a leverage ratio of just over 30. This means that a negative change of just over 3% in underlying assets would have wiped out its entire equity. Similarly, Bear Stearns had a gross leverage ratio of 33 and it was not able to withstand the shocks either. Higher leverage reduces a bank’s ability to absorb shocks, deal with bad debts, toxic assets and maintain its capital.

1.2. How returns are packaged in the form of dividends to equity holders or as interest payments to debt holders does not make any difference to the underlying systemic risks. Dividend and interest payment are simple division of operating profits. They are not a business expense and neither should qualify for any tax relief.

1.3. The interest paid on corporate borrowings should not qualify for tax relief. This already applies to individuals and should also apply to companies. The tax relief on interest payment effectively gives a public subsidy to banks and other corporations. It increases the return on equity, often a variable in executive remuneration. Safety and integrity of the financial system should take precedence over bank profits.

1.4. Banks should build their capital through control of executive remuneration, bonuses and dividends. Whether equity of debt is used to finance assets should be governed by commercial considerations rather than tax subsidies on the payment of interest.

2. What are your views on alternative systems to level the playing field?

2.1. Alternative structures for banks can reduce pressures for ever rising profits and financial and tax arbitrage. For example, retail banks could be owned by employees, they could become co-operatives and some can return to a mutual structure. This would reduce incessant market pressures for higher returns and lets employees, customers and depositors be the judges of bank performance. Market pressures for short-term profits are also a key driver for tax avoidance. Past experience suggests that mutuals were less prone to higher leverage and tax avoidance.

2.2. The proposals for a Common Corporate Tax Base (CCTB) proposed by the European Union have a capacity to reduce organised tax avoidance. This has much in common with formulary apportionment system operated in the US and chec ks some of the avoidance schemes, especially when corporations are resident in low tax states (e.g. Delaware) but the economic activity is in a different place (e.g. California). Such a system can be tested on banks.

3. Do banks’ attitudes to tax planning affect banking standards and culture, and does this have any effect on the wider economy?

3.1. Tax planning has become a euphemism for tax avoidance and even tax evasion. In an environment of unrestrained entrepreneurial capitalism, banks and major companies are willing to bend the rules to make profits at almost any cost. They have constructed elaborate organisational structures to achieve the outcomes. The shame is no longer in being caught or even paying the fines as fines have become just another part of the business cost and are in any case passed on to the innocent consumer. There are virtually no penalties on directors or designers of the tax avoidance schemes.

3.2. Banks avoid not only taxes on their own profits through complex corporate structures, joint ventures and special purpose entities, but also work with other financial intermediaries (e.g. accountants) to enable other entities and rich individuals to avoid taxes. A key motive is profits and people are often incentivised to sell tax services to generate revenues. The avoidance of taxes inevitably shifts the tax burdens and successive governments have shifted taxes to labour, consumption and savings. Ordinary people and responsible businesses are either forced to pay higher taxes or forego public goods.

3.3. There is little public information about the internal culture of banks though they have elaborate offshore structures. For example, Barclays has more Cayman Islands subsidiaries than any other FTSE 100 company. In 2009, The Guardian newspaper received and published a sheaf of internal memos from Barclay's structured finance department. These documents allegedly provided insights into Barclays’ tax avoidance "knowhow" and "global expertise gained over several years" [1] . However, the bank obtained a court injunction and the documents were withdrawn from the newspaper’s website. It is hoped that the Commission would now ask to see those documents, and others, to enable it to make assessment of the internal culture of banks.

3.4. A glimpse of the internal culture at Barclays is provided by the action taken by HM Treasury in halting the bank’s tax avoidance schemes. These were described by the Treasury [2] as "highly abusive" and "designed to work around legislation that has been introduced in the past to block similar attempts at tax avoidance". HM Treasury explained that the first scheme seeks to ensure that the commercial profit arising to the bank from a buyback of its own debt is not subject to corporation tax. In a bold step not previously taken by this Government, legislation is being introduced today that will not only prevent the scheme’s use in the future, but will also act retrospectively to block its recent use by the bank that has disclosed the scheme and by any other company that has engaged in a similar scheme in the same period. The second scheme involves Authorised Investment Funds (AIFs) and aims to convert non-taxable income into an amount carrying a repayable tax credit in an attempt to secure ‘repayment’ from the Exchequer of tax that has not been paid".

3.5. The above shows that tax avoidance schemes cannot be designed without the appropriate organisational structure, culture, approval at the highest level and a supportive reward system. Profits through tax avoidance schemes are hard to maintain as the loopholes may be closed by the government, but that does not deter banks. Their annual accounts remain silent on the quality of profits, especially as gains from tax avoidance are not sustainable and can also result in prolonged investigations, litigation and fines, as evidenced by fines in relation to LIBOR manipulations.

3.6. The US Senate Permanent Subcommittee on Investigations has held hearings on some of the bank facilities offered through offshore entities [3] and exposed an organised culture of deceit and fraud that enabled wealthy US citizens to avoid/evade around $100 billion in taxes. The Senate report was particularly scathing about the role of UBS.

3.7. Another report from the same US Senate Committee examined tax avoidance/evasion on dividend payments [4] . This was facilitated by banks, including those operating in the UK. The Committee noted avoidance was facilitated through the use of "a variety of complex financial instruments, primarily involving equity swaps and stock loans, these U.S. financial institutions structured transactions to enable their non-U.S. clients to enjoy all of the economic benefits of owning shares of U.S. stock, including receiving dividends, without paying the tax applicable to those dividends. These structured transactions increased the amount of dividend returns obtained by some of their non-U.S. clients by 30% or more ... evidence also showed that use of abusive dividend tax transactions is widespread throughout the offshore hedge fund industry. Offshore hedge funds actively sought these abusive transactions, negotiated the terms of the arrangements with the financial institutions, and at times played one financial institution against another to elicit the largest possible tax reduction". The report also pointed to the role of accounting firms and other financial intermediaries.

3.8. In an ideal world, the US revelations should have promoted the UK government and parliamentary committees to investigate the UK-based banks, but there have been no inquiries.

4. Do you have any views on the role and purpose of structured capital markets teams in banks? Does the volume and type of structured tax transactions have any effect on bank stability, and did this play a part in the banking crisis?

No views are offered on this question.

5. What are your views on the effectiveness of the Code of Practice on Taxation for banks? Would the Code benefit from having sanctions and if so what should these be?

5.1. The Code was introduced as a result of Government concerns about banks engaging in tax avoidance, and undertaking transactions that they contend are within the letter of the law, but which are contrary to the spirit of the law. The consultation document explained how the Code would encourage all banks and organisations providing banking services operating in the UK to adopt best practice in relation to their tax affairs and to comply with the spirit, and not just the letter, of the law. In November 2010, the government announced that UK’s top fifteen banks have adopted the code.

5.2. The Code has been a failure. There has been no enforcement. Despite public revelations no banks has been punished and the government failed to devise any specific means of monitoring and public accountability. Taxpayers were not given any rights to check compliance or enforce the Code either. Banks have been serial offenders on tax matters. Here are a few examples:

· According to the US Senate Permanent Subcommittee on Investigations [5] , major banks, including Deutsche Bank, HVB, UBS, and NatWest collaborated with KPMG and provided orchestrated loans for millions of dollars to enable the firm to design, market and implement tax avoidance. KPMG was fined $456 million after admitting "criminal wrongdoing [6] ".

· Barclays Bank was told by the UK Treasury to pay £500m avoided tax. The government had to introduce retrospective legislation to deal with its schemes [7] .

· HSBC is under investigation by HMRC for possibly facilitating tax evasion though its Jersey operations [8] .

· With advice from Deloitte & Touche, RBS is accused of avoiding £500 million of taxes through complex avoidance schemes [9] .

· Royal Bank of Scotland has been drawn into a criminal tax fraud investigation of its investment banking arm and involvement in tax avoidance [10] .

· Royal Bank of Scotland (RBS) and Goldman Sachs were direct participants in an Ernst & Young marketed scheme to enable Prudential Plc to avoid taxes [11] .

· UBS has paid a fine of $780 million for facilitating tax evasion in the US [12] .

· Deutsche Bank [13] used an avoidance scheme designed by Deloitte to enable its staff to avoid income tax and National Insurance Contributions (NIC) on bonuses.

· Citigroup and Bank of America, with a combined $8 billion of pretax earnings in 2009 and 2010, each paid zero US corporate taxes two years in a row [14]

5.3. It is hard find many bank s that have honoured the spirit of the Code. The following sanctions and reforms would be helpful.

· Banks indulging in tax avoidance should lose their deposit-taking licence. This licence is part of a social contract that enables banks to operate. In return, society has the right to expect ethical conduct. Those failing to fulfil their part of the s ocial contract should lose the privileges .

· All bank tax returns and related documents should be publicly available so that citizens can monitor the tax behaviour of banks and also alert HMRC of possible tax avoidance schemes.

· Banks engaged in tax avoidance should not be given any publicly funded contracts.

· Fines for tax avoidance should be levied not only on banks but also from thei r directors and promoters of the avoidance schemes.

· The financial statements published by banks should state the profits made from tax avoidance.

6. How effective has the Senior Accounting Officer legislation been with particular regard to banking standards and culture?

6.1. The Senior Accounting Office (SAO) legislation was introduced in 2009 and requires large companies to appoint an SAO to strengthen its internal controls in relation to tax accounting matters.

6.2. In view of the newspaper headlines about organised tax avoidance (for example, relating to Barclays Bank) the success of this legislation must be doubted. The difficulty is that banks are under constant pressure to report higher short-term profits. Stock markets exert pressures for higher profits. The typical tenure of a CEO of FTSE250 companies is about four years and shrinking. In that period they need to build their CV and maximise personal financial rewards. Tax avoidance has been a comparatively easy way for them to increase profits and also appease stock markets. Increased monitoring by HMRC may have identified errors and possibly dissuaded some from indulgence in tax avoidance schemes, but has not curbed avoidance. A recent report by the National Audit Office stated that HMRC were examining 41,000 tax avoidance schemes.

6.3. A major problem is that successive governments have opted for softer options rather than investigation, enforcement and punishment.

7. Do we need a special tax regime for banks? If so, what would this look like and what would be priorities for change? Should tax continue to follow accounting with respect to banks? Should the tax system actively seek to influence banking standards and culture?

7.1. Banks do not need a special tax regime. Their compliance with the rules should be enforced. Their abuses should be investigated. Details of any tax avoidance schemes filed with the DOTAS regime should be publicly available. Details of any tax avoidance scheme developed and marketed should be publicly available. Where the tax tribunals and courts rule against a tax avoidance scheme in which a bank has participated then a fine equivalent to ten times the amount of tax involved should be levied on the bank. Its directors should be required to provide a written explanation of why they entered into such a scheme and the steps they have taken to ensure that such behaviour is not repeated.

7.2. The divergence between accounting and tax rules is a source of problems. The tax system is created by democratic consent. It is enforceable and violation can lead to criminal penalties. The accounting standards are created by private interest organisation, lacking in democratic mandate. Their violations are not enforced by any government department and rarely carry any criminal penalties. In principle, the Financial Reporting Review Panel (FRRP) can force companies to correct defective accounts, but has always missed the bigger picture. Despite publishing dubious accounts no bank has ever been required to correct its accounts.

7.3. Accounting and taxation rules should be aligned. This reduces the learning costs and enhances compliance and enforcement. This would enhance public accountability in that a Minister and Parliamentary Committee would design and refine the rules. The abuses would be punishable by law. Even if Parliament delegates some such powers to another agency, Ministers can be called to account. Currently, no Minister has assumed responsibility for defective accounting rules.

7.4. The culture f banks can be changed through greater public availability of information. For example, Country-by-Country reporting can shed light on the shifting of profits and thus enable the public to ask pertinent questions.

8. Are banks exploiting regulatory and information arbitrage between FSA, HMRC and auditors? If so, what is needed to address this?

8.1. For the reason explained below, we do not have confidence in auditors. They are required to state whether the accounts show a ‘true and fair’ view. This requirement overrides compliance with the Companies Acts and IFRSs. This means that any material information which is appropriate for understanding the financial statements should be published. The amounts of tax avoidance are material (for example, the £00 million avoidance scheme operated by Barclays) and have a significant bearing on the quality of profits, likelihood of litigation, public opprobrium and business reputation. Yet, it is hard to think of even one example, where the bank involved has published any information about tax avoidance, or where the absence of this vital information has resulted in the issuance of a qualified audit opinion. Auditors are aligned with the banks and do have failed to provide an effective check on their excesses.

8.2. FSA has clearly failed to effectively regulate banks. The revolving doors have not helped as bank executives have been parachuted into senior regulatory position. Psychologically their sympathies have been with the banking industry though after the banking crash many have been busy reinventing themselves. Banks have lunch-table and other meetings with regulators and there is virtually no public information about discussions or any deals.

8.3. HMRC is poorly equipped to deal with tax avoidance. Low pay and morale means that many able people leave and are captured by the tax avoidance industry. This inevitably creates opportunities for banks and other tax avoiders. HMRC will probably never be able to match the resources commanded by banks and other large corporations. Therefore, more attention needs to be paid to redesigning the tax system, enforcement and public availability of information

9. Should there be a ‘safe environment’ in which the tax authority, regulator and auditors can share confidential information and concerns, possibly on varying levels of seniority?

9.1. There are problems with the notion of ‘safe environment’ as it seems to elevate secrecy over public accountability. Greater emphasis should be placed on the public’s right to know about banking practices, abuses, regulatory action and any tax deals. The danger is that behind closed doors some elites will discuss matters of public interest and make mutual concessions without any public accountability. Such arrangements thwart public debate and the development of effective legislation.

9.2. It is salutary to look at a couple of examples of chaps talking to other chaps culture that is so corrosive and deeply embedded in the UK regulatory circles.

9.3. Former Nigerian dictator General Sani Abacha laundered his loot through 42 bank accounts in the UK [15] . Yet unlike the Swiss authorities, neither the FSA nor the Treasury has publicly named any of these banks. Thus the public is not in a position to ask questions about the integrity of banks and regulatory system. The political protection encourages banks to be even more reckless and may have encouraged the involvement of Standard Chartered Bank and HSBC in money laundering. It is noticeable that the recent exposure of LIBOR abuses by Barclays and the involvement of UK banks in money laundering primarily came from the US rather than the UK regulators.

9.4. The so-called "safe environment" works against the public interest. It makes regulators too comfortable and even parliamentary committees are kept in the dark. A brief overview of the closure of Bank of Credit and Commerce International would be a good reminder.

9.4.1 In July 1991, Bank of Credit and Commerce International (BCCI) was closed by the Bank of England (BoE). It was the biggest banking fraud of the twentieth century. For many years before its closure, BCCI engaged in fraudulent activities, but the BoE did nothing. By the early 1980s, there was some unease at the Bank of England about BCCI’s operations. In 1982, an internal Bank of England memo described BCCI as "on its way to becoming the financial equivalent of the Titanic [16] ", in a supposedly safe environment the BoE did little. According to New York District Attorney Robert Morgenthau [17] , who mounted a number of criminal prosecutions, BCCI operated corruptly for 19 years prior to its closure. It systematically falsified its records, laundered the money of drug traffickers and other criminals. It paid kickbacks and bribes to public officials. BCCI had links with senior government officials in many countries. It handled money transfers for dictators, such as Saddam Hussein, Manuel Noriega, Hussain Mohammad Ershad and Samuel Doe. It provided accounts for the Medellin Cartel and Abu Nidal.

9.4.2 A US Senate Committee investigated the BCCI frauds [18] and was highly critical of the Bank of England, then the statutory regulator of UK banks, and again being reincarnated in that capacity. The report stated that "In April, 1990, the Bank of England reached an agreement with BCCI, Abu Dhabi, and Price Waterhouse to keep BCCI from collapsing. Under the agreement, Abu Dhabi agreed to guarantee BCCI's losses and Price Waterhouse agreed to certify BCCI's books. As a consequence, innocent depositors and creditors who did business with BCCI following that date were deceived into believing that BCCI's financial problems. From April, 1990, the Bank of England relied on British bank secrecy and confidentiality laws to reduce the risk of BCCI's collapse if word of its improprieties leaked out. As a consequence, innocent depositors and creditors who did business with BCCI following that date were denied vital information, in the possession of the regulators, auditors, officers, and shareholders of BCCI, that could have protected them against their losses.

9.4.3 On page 276 of its report the US Senate Committee stated that Bank of England was engaged in a "cover-up" "By agreement, Price Waterhouse, Abu Dhabi, BCCI, and the Bank of England had in effect agreed upon a plan in which they would each keep the true state of affairs at BCCI secret in return for cooperation with one another in trying to restructure the bank to avoid a catastrophic multi-billion dollar collapse. Thus to some extent, from April 1990 forward, BCCI's British auditors, Abu Dhabi owners, and British regulators, had now become BCCI's partners, not in crime, but in coverup. The goal was not to ignore BCCI's wrongdoing, but to prevent disclosure of the wrongdoing from closing the bank. Rather than permitting ordinary depositors to find out for themselves the true state of BCCI's finances, the Bank of England, Price Waterhouse, Abu Dhabi and BCCI had together colluded to deprive the public of the information necessary for them to reach any reasonable judgment on the matter, because the alternative would have been BCCI's collapse".

9.4.4 The BoE decision to close BCCI was based on a report that it commissioned from Price Waterhouse in March 1991. This report was prepared under Section 41 of the Banking Act 1987 and codenamed "The Sandstorm Report". The cost was borne by the UK taxpayer. The report was never finalised but an interim draft was submitted to the Bank of England on 24 June 1991 and few days later BCCI was closed. In the UK, the "Sandstorm Report" was considered to be a secret report, but a censored version eventually reached the US Senate Committee investigating BCCI’s operations. Later on, the Committee noted that "shortly before the conclusion of the preparation of this report in late August 1992, the Subcommittee obtained an uncensored version of the report from a former BCCI official, which revealed criminality on an even wider scale than that set forth in the censured version".

9.4.5 BCCI closure has been the subject of a number of reports by various UK parliamentary committees [19] . However, unlike the US Senate hearings none are thought to have had access to the full or even censored version(s) of the Sandstorm Report for their deliberations.

9.4.6 The UK government did not release the Sandstorm Report, even though a censored version was given to the US Federal Reserve and passed on the US Senate Committee. This censored version, which later turned out to be about 99% of the Sandstorm Report was placed in the US Congress Library. The same version has remained a state secret in the UK. The BoE had carefully removed the names of wrongdoers, possibly to protect politicians, wealthy elites and the UK arms trade with Middle East countries. There was little regard for the interests of the UK citizens.

9.4.7 Faced with public pressure to know more the then Prime Minister John Major informed the House of Commons that Lord Justice Bingham will prepare a report not on the banking frauds, or how they continued, but solely on the supervisory role of the Bank of England. Lord Justice Bingham was not allowed to interview any official of BCCI, but the Prime Minister stated that he "will have access to all relevant papers, officials and Ministers. Nothing and no one will be held back. I assure the House that any relevant matter of any sort will be made available to Lord Justice Bingham. The conclusion of the inquiry will be made public … I shall publish the results of the inquiry as soon as Lord Justice Bingham presents them to me [20] ". However, the complete document was never published. The appendices containing extracts from the Sandstorm Report were excised from the Bingham Report [21] , and some 21 years later still remain unpublished.

9.4.8 In 2005, following the enactment of the Freedom of Information (FOI) legislation, the Treasury was asked to release the Sandstorm Report. It refused. The refusal was taken up with the Information Commissioners. He eventually sided with the Treasury. In July 2011, after some five and half years of protracted legal battle, the Treasury was ordered by three judges to release most of the missing information [22] . It is worth bearing in mind that the Treasury was preventing the release of information which was over twenty years old and most of it was sitting in the US Congress Library.

9.4.9 The release of the missing information showed that the Treasury and the BoE had covered up the names of many wrongdoers, which included members of the Royal family of Abu Dhabi, wealthy elites, politicians and other well connected individuals. The Sandstorm Report also raised questions about the role of auditors. Arguably, its concealment stifled public debate and also did not enable parliament to design good banking laws.

9.4.10 Despite losing the court case, the Treasury has failed to make the Sandstorm Report publicly available. Its duty under the FOI is fulfilled by providing a copy to the litigant. It is content to keep the public in the dark [23] .

There is little evidence to suggest that the UK regulatory culture has changed and we are suspicious of any "safe environment" which can become a licence to keep the public in the dark.

10. What was the role of accounting standards and reliance on fair value principles in the banking crisis? What does a ‘true and fair view’ really represent to the market?

10.1. One of the most disturbing things in the current crisis has been the position taken up by accounting standard setters, accounting firms and the accounting industry generally. Their mantra is that accounting rules have had no impact on the crisis. This bizarre argument does not explain why if accounting is so insignificant do companies and accounting firms spend time lot of producing financial statements or dominate the production of accounting standards through the IASB and other standard setters. If it is so insignificant why does accounting matter to business operations? How can any accounting rule be produced if it is not written with some outcomes in mind?

10.2. The accounting industry has reached a conclusion that it is not accountable for the consequences of the rules produced by it. But somehow banking and other regulators are the ones accountable for what accountants are supposed to do, or have done. If so, there is no justification for having any accounting standard setting structure. Market failure, according to the IASB, FRC and others, is apparently not accounting’s fault; instead, regulators failed, which is a particularly disingenuous claim coming from an intellectual tradition of rather dogmatic insistence that the less regulation is somehow better for everyone, or that accounting rules designed by insiders (accounting firms and corporations) are the way forward. The position taken up by the accounting industry is that society should continue to give it privileges, status and niches even though accountants accept no responsibility when people rely to their detriment on accounting’s product.

10.3. An important lesson for accounting from the current financial crisis is that financial markets are not natural constants that produce outcomes we all must accept because they follow some natural laws. Merely serving the needs of investors and creditors in financial markets without any attention being paid to where the boundaries of those markets are drawn and what their consequences are is a key reason for the crisis and accounting’s role in that crisis.

10.4. Financial accounting has stepped into arenas, which is not fit for. It claims to mimic economics but a view is that "Economics, as it has been practiced in the last three decades, has been positively harmful for most people [24] ". Now how can accounting deliver positive results about economic phenomena when the underlying activity is harmful? There little consideration of economic developments by accounting regulators.

10.5. The shift from industrial capitalism to finance capitalism and the accompanying growth in the use of complex financial instruments has been treated by accounting standard setters as a technical valuation issue. The wisdom is that all that you need to do is to discount future cash flows or build models and all will be well even though there is little chance of being able to ascertain their current value. Accounting standard setters, borrowing from neoclassical economic theories, have prescribed complex rituals to assign values based on uncertain future outcomes, which then have an aura of exactness and masquerade as an objective measures.

10.6. The key question should be whether such complexity and reckless gambling (often implicit in derivatives) should exist at all? The marketing of medicines requires rigorous checks to consider their harm potential. The seller must demonstrate the social benefits, but financial instruments can be marketed, packaged, sliced and diced without any checks on their potential for harm. No accounting standard setter has ever alerted the public to the harmful potential of financial instruments, or the valuation methods advocated by it. This abdication of duty is complicit in the financial crisis. If the role of accounting is to call powerful corporations and economic interests to account then standard setters should have considered the harm that their rules would do. They should not be permitted to issue an accounting standard until those issues are addressed. But such issues have not received attention in the past and there is no sign that they will in the foreseeable future. Thus, we are left in ad hoc rationalisations and justification of fair value, mark-to-model/myth and other varieties of accounting.

10.7. The shift from stewardship accounting to market-based accounting has had profound influence on bank financial statements. Under the influence of Chicago economics, the view is that somehow company balance sheets should equate with market values of companies. This is not feasible. Accounting’s adherence to economic myths cannot be claimed to have made accounting a particularly valuable social activity.

10.8. The links with market values inevitably import volatility to company accounts and also delay the recognition of losses. They also create panics, as evidenced by the loss of pension rights by millions of employees. The fair value of pension liabilities fluctuates and takes little account of the long-term position. In many cases, markets are thin and virtually non-existent and fair values of assets cannot really be found in any objective way. Therefore, models have been built to generate accounting numbers. The difficulty is that these numbers are not capable of verification, a traditional feature of financial reporting and auditing. The accounting numbers are just the outcome of a model rather than representative of some notion of historical cost, exit or entry values. The use of models has also changed the nature of accountants’ craft. Rather than boasting some expertise on making judgements about valuations, accounts have now become slaves to a model. Rather than showing scepticism they are now focused on checking the assumptions built into models. Episodes, such as those relating to the demise of Long Term Capital Management (LTCM) show that even winners of the Nobel Prize in Economics could not build good economic models and their hedge fund collapsed. What chance is there that accountants can do better?

10.9. A ‘true and fair’ views sounds very persuasive, but in practice has been reduced to a box-ticking approach by accounting firms. ‘True and fair’ can invoke references to morality, justice, ethics, good, honourable and many other qualitative characteristics, but such matters rarely appear on the checklists used by accounting firms. The preparation and audit of company accounts has become a mechanical process. An engineer is unlikely to build a bridge without consulting research, but most accounting practitioners do not read any research papers. They have little interest in research. Their notion of research is primarily learning about the latest accounting standard rather than anything about the production of standards, choices of accounting, limitation of accounting and the crisis of banking or capitalism. Many of the accounting standards today advocate the use of discounted future cash flows (e.g. for financial instrument, pensions, leases). These approaches were advocated in scholarly journals over 50 years ago. Now, the accounting education process is mostly about learning the rules and with little emphasis on reflection. The result is that hardly any new ideas for tackling accounting challenges are emerging. Perhaps, markets are not really interested in any intricate meaning of ‘true and fair’ and are more preoccupied with the bottom line. If so, then it is for the regulators to ensure that company accounts do connect with socially desirable characteristics and accountants are equipped to meet those obligations.

11. What are your views on the current incurred-loss impairment model and its role in the banking crisis? Do you consider that proposals to move to an expected-loss model will address criticisms of the current accounting rules?

11.1. The incurred-loss impairment model seems to have been developed by the IASB without much public debate. The key idea is that toxic assets can only be written down when there is observable objective evidence that a loss has been incurred. The difficulty with this is that there can be various probabilities attached to the events that might lead to a loss and the outcome may not be certain for some time. Meanwhile balance sheets can continue to show an asset as good even though there is a good chance that it may become bad. The model does not enable banks to set aside profits or build reserves to cancel out toxic assets. The model also enabled banks to front-load income i.e. they could recognise interest income even though it has not yet been received. Any delays in receiving were merely treated as roll-overs, or deferments. Thus the model enabled recognition of higher income but low recognition of losses. This suited executives whose remuneration is linked to earnings as it enabled them to collect high bonuses.

11.2. A move to an expected-loss model may mitigate some of the problems of the incurred-loss model, but it needs to be accompanied by appropriate disclosures.

12. What is the best method of accounting for profits and losses in trading instruments? Are there any alternatives to mark-to-market or mark-to-model that might better represent a ‘true and fair view’?

12.1. A return to ‘prudence’ can constrain premature recognition of profits and provision of anticipated losses. However, the approach also has the downside it may enable management to build big bath provisions and use them to smooth earnings. This should be accompanied by effective disclosures.

13. Did IFRS accounting standards contribute to a box-ticking culture to the exclusion of promoting transparency and a ‘true and fair view’ of the business?

13.1. The tick-box mentality is deeply embedded in accounting and auditing practices. It is encouraged by professional education. Accounting firms see the tick-box approach as a way of increasing efficiency i.e. the necessary tasks have been performed. Partners performing reviews of audit cannot replicate the field work to see that the necessary task have been carried out. The size and order of the file and related schedules rather than the quality of work impresses partners. Perhaps, with an eye on possible litigation and reviews by regulators they devote attention to compliance with accounting and auditing standards.

13.2. In this environment, IFRSs have further deepened a tick-box approach as accounting standards are often presented in a formulaic way. For example, there are tests to determine whether a lease is a finance/capital lease or an operating lease. Such an environment has constrained any scope for professional judgement.

13.3. ‘True and fair view is often linked to notions of transparency. The notion of transparency is appealing but remains elusive. Each accounting standard is accompanied by the rhetoric of transparency but we are no closer to it today than in 1969 when the UK embarked on a programme of accounting standards. Despite a raft of accounting standards, Citigroup is estimated to have some $1.1 trillion of assets off balance sheet [25] . Banks had around US$5,000 billion of assets and liabilities off balance sheet (Financial Times, 3 June 2008). Some banks have shown assets, especially subprime mortgages, at highly inflated values and derivatives have long been a powerful tool for inflating company profits by hiding losses and hence the risks of company operations.

13.4. Even today, some five years after the banking crash, regulators have little idea of the exposure of banks and the risks to the entire financial system. Here is an exchange in the House of Commons:

Austin Mitchell: To ask the Chancellor of the Exchequer what the notional value of derivatives held by the banks regulated by the Financial Services Authority is; and what information is held about the maturity and exposure of such derivatives.

       Greg Clark: This information is not currently available. The shortfall in information available to regulators on derivatives during the financial crisis led the G20 in 2009 to propose that all over the counter derivative trade information should be reported to Trade Repositories. This requirement, which is expected to enter into force in the EU by the start of 2013, will allow information on all derivatives trades to be made available to the relevant authorities.

(Source: Hansard, House of Commons Debates, 22 Oct 2012 : Column 619;

13.5. Yet the missing assets, liabilities and derivatives exposure did not attract any opprobrium from auditors. A key element in this state of affairs is the control and colonisation of standard setting institutions and the economic interests of accounting firms. The Big Four accounting firms invest around $1.5 million each year in the IASB and major corporations also provide money. The payoff is friendly accounting standards whilst some issues are organised off the political agenda altogether. A good example is the neglect of the calls for Country-by-Country reporting and complete absence of standards that would require banks to provide information about tax avoidance schemes.

14. Do we need a special accounting regime for banks? If so, what should it look like?

14.1. Yes, we need a special accounting regime for banks.

14.2. It is very odd that regulators place reliance upon financial statements published by banks but do not set accounting standards for banks. In view of the shortcomings of IFRSs, it is doubtful that the financial statements result in prudent accounting. In addition, banks are also implicated in tax avoidance and operate through numerous offshore entities and special purpose vehicles to shift profits through transfer pricing and other strategies. The resulting financial statements are a poor vehicle for prudent banking or regulatory interventions.

14.3. Accounting standards for banks are now formulated by the International Accounting Standards Board (IASB). The IASB is a private sector organisation owned by a Foundation located in Delaware. This ownership structure enables it to avoid tax on its income. Such an organisation is unfit to make rules on accountability for others. The IASB is bankrolled by the Big Four accounting firms and major corporations, including banks. It lacks independence from the organised interests and has failed to introduce any standard that requires banks to come clean about their special vehicles, offshore structures or even their transfer pricing practices.

14.4. There is also a divergence of opinion about the purpose of financial statements. The accounting standard setters (e.g. the IASB, FASB, ASB) argue that their purpose is to enable investors, creditors to make predictions about earnings, future cash flows and performance and seem to believe that balance sheets should represent the market value of the firm. This is an impossible aim as the contents of financial statements depend on political and economic vagaries of their time. In contrast to the direction of accounting standards, the 1990 House of Lords judgement in Caparo Industries plc v Dickman & Others [1990] 1 All ER HL 568 stated

" I see no grounds for believing that, in enacting the statutory provisions [requiring publication of audited company accounts] Parliament had in mind the provision of information for the assistance of purchasers of shares or debentures in the market, whether they be already the holders of shares or other securities or persons having no previous proprietary interest in the company ...... For my part, however, I can see nothing in the statutory duties of a company’s auditor to suggest that they were intended by Parliament to protect the interests of investors. ... I therefore conclude that the purpose of annual accounts, so far as members [shareholders] are concerned is to enable them to question the past management of the company, to exercise their voting rights, if so advised, and to influence future policy and management. Advice to individual shareholders in relation to present or future investment in the company is no part of the statutory purpose of the preparation and distribution of the accounts. ... As a purchaser of additional shares in reliance on the auditor’s report, he [the shareholder] stands no different from any other investing member of the public to who the auditor owes no duty".

14.5. Thus from auditing perspective company accounts are backward looking and have no relationship with any investment purpose, or protection of the public and are not designed to directly assist the regulators. It is difficult to see how the present form of financial statements can adequately assist regulators, markets and savers. There are a residue of past practices and need to be reconstructed.

14.6. Accounting and auditing rules for banks should be formulated by the banking regulators and approved by the relevant parliamentary committees. The committees can call for evidence on the appropriateness of the proposed rules. The rules can develop particular measures of capital, leverage and other key variables. They can require disclosures about the quality of profits and whether they are sustainable. For example, for the last five years of its life Bear Stearns profits came almost exclusively from speculative activities. No organisation can continue to pick winners indefinitely. Yet the quality of profits did not result in any red flags from auditors and the rules did not require any commentary form directors either.

15. Are there any interim measures (such as mandatory disclosure) which could be introduced in the meantime?

15.1. Yes. All banks should be required to adopt Country-by-Country (CbC) reporting. Under this, banks would be required to publish a table showing the assets, liabilities, profits, losses, taxes and employees, etc. for each country of their operation. All organisations already have this information. Thus, the cost of producing the information is very low. The current segmental reporting accounting standard (IFRS 8) does not provide such information and in any case leaves management to decide the material segments. Consequently, little is known about the activities of banks in tax havens and the risks related to those activities.

16. What are your views on current proposals for improving disclosure and dialogue (with particular reference to discussion papers issued by FSA/FRC)?

16.1. The arrangements for a dialogue between auditors the financial regulators were introduced by the Banking Act 1987, as the then government sought to rebuild the reputation of the City of London. The dialogue has been surrounded by secrecy and has probably been poor.

16.2. The FSA/FRC discussion papers attach little weight to the oddities of the arrangements. Auditors are not directly appointed by the FSA and audit reports are not addressed to the FSA. Auditors owe a ‘duty of care’ to the company and not to any state designated regulator. It is too easy for present auditors to hide behind claims of a duty of ‘confidentiality’ to their client banks and thus limit the quality of dialogue.

16.3. Auditors insert disclaimers in audit reports. For example, they say that

"Under section 235(1) of the Companies Act 1985 (or "Under section 495(1) of Companies Act 2006") we have a duty as auditors to report on the annual accounts of the company. This duty only extends to a report to the members of the company as a whole and not to an individual shareholder or group of shareholders or to a third party. We cannot be held responsible by any third party who uses or places reliance on our opinion in order to make a decision to enter into any type of transaction with the company".

In the light of such clauses it is difficult to see how the banking regulators can place reliance on any dialogue with auditors. To be effective, financial regulators need to be able to act on a real time basis and need timely information, especially as instability in the financial sector can infect the whole economy. Therefore, ex-post dialogue is of little value.

16.4. The key step must be to eliminate accounting firms from the audit of banks and for regulators themselves to direct audit all banks on a real-time basis. This client/auditor interests and arguments about confidentiality will not obstruct effective regulation. This proposal also reduces the long chain of communication implicit in the FSA/FRC papers.

17. Is there a problem arising from the difficulty of qualifying the accounts of a bank? Should auditors be able to ‘grade’ accounts – from AAA down? What would be the effect of this?

18. Should the scope of audit be widened so that auditors can better express a broader view of the business? For example should auditors comment specifically on issues such as remuneration policy, valuation models or risk?

These two question seem to overlap and therefore addressed together.

18.1. The auditors are appointed to give an opinion, but they have continued to shirk their duties by pretending that they cannot qualify bank accounts because this would somehow result in a self-fulfilling prophecy and the bank receiving qualified audit opinion would somehow die. Let us look at the reverse of this. At the onset of the banking crash, all distressed banks received an unqualified audit opinion (see Appendix 1 [26] ). If audit opinions have this miraculous power of life and death then all the distressed banks should have continued unscathed. However, that was not the case. Most banks needed financial support from the state. Markets, investors and governments did not believe auditors, possibly because they have little confidence in the integrity and independence of auditors. It is disturbing that auditors have been paid vast sums to give an honest opinion and then failed to do so.

18.2. There is already a scope for auditors to issue a variety of opinions ranging from adverse opinion, disclaimers and emphasis of matter, depending upon the kind of material uncertainties and disagreements. Thus auditors can choose from various opinions. They can also speak at AGMs on any matter relating to financial statements and also have important statutory rights in relation to resignation and removal and can speak on matter relating to financial statements. The problem has been auditors have been unwilling to exercise their powers and inform the readers of accounts.

18.3. The grading of banks accounts into ‘AAA’ is a recipe for creative games and is undesirable. This will also raise questions about director duties. Does lower grade mean lower director obligations? It will deepen a box-ticking approach as inevitably there will be issues about what needs to be done to secure ‘AAA’, ‘AA+’ ‘AA-‘ and other varieties of grades. The subtleties of the games will be lost on the ordinary public and will not serve any purpose though the exercise will no doubt generate vast fees for accountancy firms branching out into this new form of consultancy.

18.4. One of the ironies of the auditing scene is that audit failures are rewarded with more fee earning opportunities. Auditors have failed to adequately discharge their duties, but they may now be asked to take on more tasks for even more fees. If the Commission’s proposals were to be enacted then an even higher proportion of the UK GDP will be invested in accountancy surveillance. With some 340,000 professionally qualified accountants, the UK already almost the highest numbers of accountants per capita in the world. This has neither resulted in good audits, good corporate governance nor good financial reports or freedom for tax avoidance, frauds and fiddles. It is really time to look for alternative reforms which can deepen democratic accountability and also wean the UK off its obsession with calling accountants to look at and report on everything. These would include

· Empowering bank employees, savers and borrowers to cast a binding vote on executive remuneration

· Public availability of the remuneration contracts.

· Remuneration contracts should not solely be based to financial performance as accounting numbers are highly malleable. Instead, they should also take account of service to the community, maintenance of branch networks, fair access to finance by the less well-off, loans to SMEs, regulatory failures, etc.

· The models used by banks for valuation and risk assessments should be publicly available.

· Banks often rely on credit rating agencies to grade their financial products. Their models should also be publicly available.

· No bank should be able to launch any financial product without prior testing and the results of that should be publicly available.

· Bank directors should be held criminally liable for publishing misleading accounts.

18.5. It is difficult to have any confidence in the current auditing arrangements and it needs to be reconstructed. Piecemeal tinkering, as suggested by the Commission, will not be productive. The auditing model is broken, rooted in the era of industrial capitalism and is unfit for the era of finance capitalism where money travels instantaneously and the valuation of assets and liabilities is based on complex mathematical models which mimic markets. Nick Leeson, of Barings fame, has argued that neither the regulators nor the auditors understood the business models of banks.

18.6. Large accounting firms have been involved in money laundering [27] , tax evasion/avoidance, bribery, corruption and operation of cartels [28] . One would have thought that in a civilised society such organisations lack the social, ethical and moral credentials to be a pillar in the regulatory arrangements. By what moral standard can their role in a rgewualtory system be protected, or enhanced?

18.7. Accounting firms have a history of non-cooperation with regulators investigating banking frauds.

18.7.1 When a US Senate Committee investigating the BCCI frauds sought information from its auditors Price Waterhouse, the firm refused. The request was channelled through the New York office. The reply to the Senate Committee [29] was that "The main audit of BCCI was done by Price Waterhouse UK. They are not permitted, under English law, to disclose, at least they say that, to disclose the results of that audit, without authorization from the Bank of England. The Bank of England, so far -- and we’ve met with them here and over there -- have not given that permission. The audit of BCCI, financial statement, profit and loss balance sheet that was filed in the State of New York was certified by Price Waterhouse Luxembourg. When we asked Price Waterhouse US for the records to support that, they said, oh, we don’t have those, that’s Price Waterhouse UK. We said, can you get them for us? They said, oh, no that’s a separate entity owned by Price Waterhouse Worldwide, based in Bermuda". The Committee was unable to secure co-operation from the UK firm.

18.7.2 The UK investigation of banking frauds has also been hampered by auditing firms. For many years, Barings’ consolidated financial statements had been audited by the London office of Coopers & Lybrand (now part of PricewaterhouseCoopers). Its Singapore affiliate became auditor of BFS for the year to 31 December 1994. In 1992 and 1993 BFS was audited by the Singapore firm of Deloitte and Touche (D&T) and reported their findings to Coopers & Lybrand (C&L) in London for the purpose of its audit of the consolidated financial statements of Barings Plc. It should be noted that the audit opinion on consolidated financial statements was issued by C&L’s London office and it "placed reliance on D&T’s opinion in their audit of Barings’ consolidated financial statements [30] ".

The Bank of England explained that it was unable to fully investigate the auditing aspects because the auditing firms did not co-operate. Its investigators reported, "We have not been permitted access to C&L Singapore's work papers relating to the 1994 audit of BFS or had the opportunity to interview their personnel. C&L Singapore has declined our request for access, stating that its obligation to respect its client confidentiality prevents it assisting us. …….We have not been permitted either access to the working papers of D&T or the opportunity to interview any of their personnel who performed the audit. We do not know what records and explanations were provided by BFS personnel to them. ……. [Consequently] we have not been able to review and conclude on the adequacy of the work performed by BFS’s auditors …" (pages 15, 17,153, 158 of the Bank of England report; see footnote 30).

The above examples show that there are too many difficulties in securing information and co-operation from auditing firms. Little is known about the overall structure and control.

18.8. The private sector auditors of banks have failed. Despite queues outside Northern Rock and demise of many US banks, all major banks received unqualified audit opinions from PricewaterhouseCoopers, Deloitte & Touche, KPMG and Ernst & Young. Private sector auditors have a history of silence and are immersed in too many conflicts of interests, as evidenced by their silence at Barings, Bank of Credit and Commerce International (BCCI) and other debacles. Accounting firms have shown no interest in serving the public or the state.

18.9. The system for auditing banks needs to be redesigned.

The audits of all banks should be carried out on a real-time basis directly by the regulator, or an agency specifically created for that purpose. Thus auditors would not be selected by the auditee nor directly remunerated by the auditee. The state designated auditors would be funded by a levy on financial enterprises. Their work would be subject to an oversight by Parliamentary committees. Auditing standards would be approved by parliament. The objectives of the newly constituted auditors would be to safeguard the integrity of the financial system and protect the interests of taxpayers, depositors and borrowers rather than solely be concerned with the interests of the investors. The proposed arrangements would reduce enhance the regulator’s knowledge base and capacity for timely interventions. In the era of instant movement of money ex-post audits are of little use. For ideological reasons, some would object to such as proposal, but auditing is simply a means to an end. That end is to secure confidence in the system and check poor banking practices. Some elements of this proposal were envisaged in the US in the aftermath of the 1929 Wall Street crash. The crash highlighted shortcomings of audits by the private sector auditors. Lynn Turner former chief accountant of the US Securities Exchange Commission (SEC) explained [31] that "when the legislation creating the SEC was first drafted in the early 1930s, it included a provision making the SEC the auditor for public companies. Then, at the last minute, the legislation was changed. [. . .] Toward the tail end of the Congressional hearings on the Senate side, the head of the New York State Society of Certified Public Accountants – who was also the head of Haskin and Sells – now Deloitte Touche – went down to Washington and testified and convinced the guys to let the CPA firms to do the auditing. The legislation was revised and hence the external auditing function that we have today".

18.10. No doubt there would be considerable opposition to the above proposal as auditing firms would not wish to lose their niches, but the present auditing arrangements have too many deficiencies and cannot form the basis of any effective system for regulation of banks. Some of deficiencies are as follows:

· The present auditing model does not reflect the current realities. For example, following the Companies Act and other laws, the audit report is addressed to shareholders. This is not appropriate. Firstly, shareholders are not the owners of banks. The average share holding periods for US and UK banks’ shares fell from around three years in 1998 to around three months by 2008 [32] . Shareholders function more like traders and speculators and do not have a long-term interest in the welfare of banks. Secondly, shareholders do not provide most of the risk capital. For example, the 2011 annual accounts of Barclays bank show assets of £1.56 trillion and capital of only £65bn, i.e. gross leverage of 24 times. In other words, shareholder provides only about 4% of its capital and the remainder is provided by other stakeholders, including depositors and lenders. The 2011 annual accounts of Royal Bank of Scotland (RBS) show assets of £1.5trn against a capital of only £76bn i.e. a gross leverage ratio of nearly 20. So shareholders provide only about 5% of its capital. Other stakeholders have no rights in relation to auditors. The deposit protection scheme provided by the state spreads the risks on to taxpayers, but the auditors do not owe any ‘duty of care’ to taxpayers or citizens either. The present auditing model is based on a fiction of shareholder ownership and risks and is utterly inappropriate for the 21st century.

· The present auditing model expects one set of business entrepreneurs (auditors) to invigilate another (company executives). Their success is measured by fees, profits and clientele rather than performing any service for the state or society. External auditing is out of line with the common sense approach in other sectors. There are audits in many walks of life. For example audits are conducted by immigration officers (e.g. checking passports, visas), health and safety officers, fire officers, hygiene inspectors, trading standards officers, etc. In all of these cases, the auditee neither directly hires nor directly pays the auditors. These auditors are respected and even feared. The entirely opposite happens has been happening at banks. Rather than effective watchdogs auditors have functioned as puppies and poodles.

· Auditing firms have been auditing the same bank for years and become too cosy with directors. PricewaterhouseCoopers (and its predecessor firms) have audited Barclays Bank since 1896. Indeed, the average audit tenure at FTSE100 companies (banks are part of that) is 48 years. Seemingly, no lessons have been learnt from the 1970s, 1980, 1990s and the current banking crash. Accounting firms oppose rotation of auditors by claiming that due to knowledge deficiencies audit failures may occur in the early years of audits. This claim is problematical. For example, accounting firms compete to win new clients. If their assertions are correct then they must have done poor audits for all of their new clients. Yet they have never acknowledged the delivery of poor audits.

· The auditing industry has been unable to reconcile its quest for higher fees with effective audits. This much has been evident not only from the current banking crash, but also from the audits of Barings, Johnson Matthey, Bank of Credit & Commerce International (BCCI) and the mid-1970s banking crash. It is fashionable for auditors to claim that the sale of consultancy services to audit clients somehow does not impair their independence. This defence of the niches shows no regard for long established evidence. Ever since the 1970s, authoritative investigations in frauds and corporate collapses have drawn attention to the silence of the auditors, their fee dependency and collusive relationship with corporate executive. A few examples will provide an indication.

A 1976 report of the Department of Trade and Industry (DTI) inspectors on the silence of auditors at Roadships Limited [33] stated that ""Independence is essential to enable auditors to retain that objectivity which enables their work to be relied upon by outsiders. It may be destroyed in many ways but significantly in three; firstly, by the auditors having a financial interest in the company; secondly, by the auditors being controlled in the broadest sense by the company; and thirdly, if the work which is being audited is in fact work which has been done previously by the auditors themselves acting as accountants ... We do not accept that there can be the requisite degree of watchfulness where a man is checking either his own figures or those of a colleague. ... for these reasons we do not believe that [the auditors] ever achieved the standard of independence necessary for a wholly objective audit."

A 1976 DTI inspectors’ report on Hartley Baird [34] found that the company was having difficulties in repaying loans. But the financial problems were covered-up by manipulation of the accounts. The report stated that the auditors were ineffective because of their close connections with company directors and suggested rotation of auditors.

A report on the 1978 collapse of the Grays Building Society [35] noted the folly of allowing the same firm to audit a client for forty years and said that the auditors silence was due to cosiness with directors.

A 1979 report on Burnholme and Forder [36] said that "in our view the principle of the auditor first compiling and then reporting upon a profit forecast is not considered to be a good practice for it may impair their ability to view the forecast objectively and must endanger the degree of independence essential to this work".

The audit firm’s strategy was summed up by memo from the senior partner advising audit staff [37] that "The first requirement is to continue to be at the beck and call of RM [Robert Maxwell], his sons and staff, appear when wanted and provide whatever is required" (DTI, 2001, p. 367). Robert Maxwell had a known dubious business reputation and was a fraudster.

In 2003, a [former] Ernst & Young partner was arrested on criminal charges for allegedly altering and destroying audit working papers and obstructing investigations relating to NextCard (SEC press release, 25 September 2003). He became one of the first cases to be tried under the Sarbanes-Oxley Act 2002. He pled guilty and admitted that "he knowingly altered, destroyed and falsified records with the intent to impede and obstruct an investigation by the Securities and Exchange Commission (SEC) … by not informing the SEC of these alterations and deletions that he knowingly concealed and covered up an original version of the documents with the intent to impede, obstruct, and influence an investigation of the SEC (Department of Justice press release, 27 January 2005).

In September 2005, Japanese regulators arrested four partners of ChuoAoyama PricewaterhouseCoopers for allegedly helping executives at Kenebo, an audit client, to falsify company accounts. (Financial Times, 14 September 2005). The four were suspected of working with two Kanebo executives to produce false consolidated financial statements showing that Kanebo's assets exceeded its debts in fiscal year 2001 and 2002. In reality, its debts exceeded its assets by Y81.9bn and Y80.6bn, respectively. Subsequently, the regulator stated that "ChuoAoyama PricewaterhouseCoopers admitted the facts charged in the Kanebo accounting fraud scandal [1] " and that the four "willfully certified Kanebo's falsified annual reports for the five periods, ending March 1999, March 2000, March 2001, March 2002 and March 2003, as not containing such falsities".

18.11. Similar concerns about auditors being cosy with companies by selling consultancy services and through longevity in office have been raised by episodes, such as Enron, WorldCom, BCCI and others. Concerns about auditor independence have been raised by the collapse of Lehman Brothers where auditors allegedly advised the bank on creative accounting schemes.

18.12. The above is part of a larger amount of evidence which shows that accountancy firms priorities fees over everything else. They cannot form a reliable pillar in an effective system of banking regulation.

· Recent events relating to LIBOR manipulations at Barclays Bank and UBS suggest that auditors failed to adequately evaluate internal controls. The US regulators have drawn attention to hundreds of thousands of suspect money laundering transactions at HSBC and Standard Chartered Bank, but auditors seem not be aware of such failures. The silence of the auditors is price of close financial relationship between auditors and banks. Auditors receive audit fees, non-audit fees and insolvency work from banks. Accountancy firms also collaborate with banks to design and market tax avoidance schemes. The fee dependency affects the quality of judgements made

· The auditing industry and banks would say that audit committees act as buffers. However, the value of presently constituted audit committees must be doubted. The audit committees consist of non-executive directors who owe their position to patronage of executive directors and are rarely able or willing to make critical evaluation of directors’ decisions. They are not elected by the stakeholders and thus cannot be called to account by the parties affected by their decisions. They collect large amounts of fees for relatively little time and are not in a position to invigilate auditors. Audit committees have been spectacularly unsuccessful at banks and hardly any made any public criticisms of the shortcomings of auditors or financial reports of banks.

· For any system of auditing to work there must be effective checks and balances. Yet auditing lacks that. Cases such as MAN Nutzfahrzeuge AG & Anor v Freightliner Ltd & Anor [2007] EWCA Civ 910 ) show that auditors can be negligent yet escape liability. It is difficult to see how such a regime can form the basis of effective regulation of banks.

· There is little effective professional discipline of accountants. No accountancy firm has ever been disciplined by any professional body for selling aggressive tax avoidance schemes. No action is taken even after the court/tribunals have declared a scheme to be unlawful.

· There is little effective action for audit failures. A recent example is about the Farepak debacle, which occurred in 2006. On 15 November 2012, the FRC announced that it is to examine the alleged audit failures by Ernst & Young in 2005. This is part of a long list of do little approach/

· There are no independent standards for auditors. In principle the Financial Reporting Council (FRC), but it is too close to accounting firms. It has acted more as a cheerleader rather than an effective regulator for the industry. It is hard to find any standards on the public accountability of auditing firms who enjoy the state guaranteed market of external auditing. What fees and profits do accounting firms make from tax avoidance? What is the composition of audit teams? The FRC has failed to examine the internal culture of auditing firms even though evidence suggests that significant part of work is falsified.

· Despite the recommendations contained in the House of Commons Treasury Committee’s report on Northern Rock, it has failed to ban the sale of non-auditing services by auditors to their audit clients, or cap the tenure of auditing firms. Its cosiness with the auditing industry, or is it blindness, is apparent from the rules for non-executive directors. In folklore non-executive directors must have a degree of independence even though they are not required to give an opinion on financial statements. The UK Combined Code on corporate governance (issued by t he Financial Reporting Council) , which gives no enforceable rights to any stakeholder or regulator, requires that non-execs must not have been an employee of the company in the last 5 years, must not receive income other than director fees and most not serve as a Non-Executive Director for more than 9 years with the same company. However, the equivalent rules do not apply to auditors. There are no limits on the auditor’s tenure and they are not required to act exclusively as auditors.

18.13. This section has provided only part of the evidence to argue that the present auditing model has failed. Auditors have not been the eyes and ears of regulators and cannot serve the public interest. This model should be replaced and the state itself has to take responsibility for directly auditing banks.

19. What would be the effect of using return on assets as a performance measure in banks, as opposed to return on equity?

19.1. The return on equity is influenced by leverage and accounting games played by directors. Return on equity may have some significance if shareholders were the owners of companies or the main providers of capitals. Neither of these propositions is true as shareholders have only a short-term interest in companies and in most banks only provide around 5% of total capital. Some may wish to use market prices of equity to measure performance, but markets are not necessarily rational. In the words of Lord Adair Turner, former Chairman of the Financial Services Authority, "the collective market view was that risks to bank credit-worthiness had fallen steadily between 2002 and 2007, reaching a historical low in the early summer of 2007, the very eve of the worst financial crisis for 70 years. Neither CDS spreads nor bank equity prices provided any forewarning of impending disaster: instead they validated and strongly reinforced a surge of over-exuberant and under-priced credit extension to the real economy [38] ".

19.2. All accounting related measurements are malleable and can easily be manipulated and thus should not be the sole basis for assessment of performance. The classification of assets in balance sheets depends on whatever the politics of accounting permit. Today companies may include intellectual property on their balance sheet, but not so long ago this was not the case. Banks show goodwill (difference between the purchase price of an entity and the fair value of net tangible assets) on their balance sheet on the assumption that this will enable them to earn superior profits. At times of economic recessions, such assumptions are unreasonable. Even at other times such assumptions are problematical because no one can measure the so-called superior profits. It may also be argued that goodwill is the outcome of a book-keeping quirk rather than a representation of any economic substance. Nevertheless, bank balance sheets have shown this as an asset. Even the profit side is problematical because banks, and other corporations, do not recognise the full social cost of their operations. Bank accounts only recognise private costs and even these are subject to accounting games. Management have plenty of discretion on accruals and shuffling of costs. For example, depreciation is an integral part of accounts, but the charge to the profit and loss accounts depends on assumptions about the future life of the assets, impairment and residual values. Corporate profits can also be increased through curtailment of research and development, lack of investment, wage freezes, dilution of employee pension rights and tax avoidance, all of which have serious consequences for the long-term welfare of organisations.

19.3. Non-financial measures should also be used to complement any measure of performance. These include mattes such as investment, job creation, providing finance to emerging businesses, staff training, staff retention, staff welfare, maintaining branch networks, customer satisfaction and freedom from regulatory action. Such variables require bank directors to think about the long-term rather than just the short-term.

20. Are the amendments to the Financial Services and Markets Act 2000 regarding dialogue between regulator and auditor sufficient, or does further work need to be done in this area?

20.1. Reliance on accounting firms to invigilate banks is unlikely to be productive. It has not yielded positive results. The firms have a history of failures and are mired in conflict of interests.

20.2. An alternative institutional structure (briefly sketched above) is likely to be more effective and will to provide regulators with real-time information

21 December 2012


Audit Report OF Major Banks just before the Banking Crash

Year Date of Audit Fee (Millions)

Company Country End Auditor Audit Report Opinion Audit Non-Aud

Abbey National UK 31 Dec 2007 D&T 4 Mar 2008 Unqualified £2.8 £2.1

Alliance &

Leicester UK 31 Dec 2007 D&T 19 Feb 2008 Unqualified £0.8 £0.8

Barclays UK 31 Dec 2007 PwC 7 Mar 2008 Unqualified £29 £15

Bear Stearns USA 30 Nov 2007 D&T 28 Jan 2008 Unqualified $23.4 $4.9

Bradford & Bingley UK 31 Dec 2007 KPMG 12 Feb 2008 Unqualified £0.6 £0.8

Carlyle Capital

Corporation Guernsey 31 Dec 2007 PwC 27 Feb 2008 Unqualified N/A N/A

Citigroup USA 31 Dec 2007 KPMG 22 Feb 2008 *Unqualified $81.7 $6.4

Dexia France/ 31 Dec 2007 PwC 28 Mar 2008 Unqualified €10.12 €1.48

Belgium +

Mazars & Guérard

Fannie Mae USA 31 Dec 2007 D&T 26 Feb 2008 Unqualified $49.3 ---

Fortis Holland 31 Dec 2007 KPMG/PwC 6 Mar 2008 Unqualified €20 €17

Freddie Mac USA 31 Dec 2007 PwC 27 Feb 2008 *Unqualified $73.4 ---

Glitnir Iceland 31 Dec 2007 PwC 31 Jan 2008 Unqualified ISK146 ISK218

HBOS UK 31 Dec 2007 KPMG 26 Feb 2008 Unqualified £9.0 £2.4

Hypo Real Estate Germany 31 Dec 2007 KPMG 25 Mar 2008 Unqualified €5.4 €5.7

Indymac USA 31 Dec 2007 E&Y 28 Feb 2008 *Unqualified $5.7 $0.5

ING Holland 31 Dec 2007 E&Y 17 Mar 2008 Unqualified €68 €7

Kaupthing Bank Iceland 31 Dec 2007 KPMG 30 Jan 2008 Unqualified ISK421 ISK74

Landsbanki Iceland 31 Dec 2007 PwC 28 Jan 2008 Unqualified ISK259 ISK46

Lehman Brothers USA 30 Nov 2007 E&Y 28 Jan 2008 Unqualified $27.8 $3.5

Lloyds TSB UK 31 Dec 2007 PwC 21 Feb 2008 Unqualified £13.1 £1.5

Northern Rock UK 31 Dec 2006 PwC 27 Feb 2007 Unqualified £1.3 £0.7

Royal Bank of UK 31 Dec 2007 D&T 27 Feb 2008 Unqualified £17 £14.4


TCF Financial Corp USA 31 Dec 2007 KPMG 14 Feb 2008 Unqualified $0.97 $0.05

Thornburg Mortgage USA 31 Dec 2007 KPMG 27 Feb 2008 Unqualified $2.1 $0.4

UBS Switzerland 31 Dec 2007 E&Y 6 Mar 2008 Unqualified CHF61.7 CHF13.4

U.S. Bancorp USA 31 Dec 2007 E&Y 20 Feb 2008 Unqualified $7.5 $9.6

Wachovia USA 31 Dec 2007 KPMG 25 Feb 2008 Unqualified $29.2 $4.1

Washington Mutual USA 31 Dec 2007 D&T 28 Feb 2008 Unqualified $10.7 $4.3

Notes: 1) Data as per financial statements and statutory filings shown on the respective company’s website.

2) ‘Audit fee’ also includes ‘audit related fees’

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

[1] The Guardian, Guardian loses legal challenge over Barclays documents gagging order, 19 March 2009 (

[2] HM Treasury press release, Government action halts banking tax avoidance schemes, 27 February 2012 (

[3] US Senate Permanent Subcommittee on Investigations (2008), Tax Haven Banks and US Tax Compliance, Washington DC: US Senate.

[4] US Senate Permanent Subcommittee on Investigations (2009), Dividend Tax Abuse: How Offshore Entities Dodge US Taxes on US stock Dividends, Washington DC: US Senate.

[5] US Senate Permanent Subcommittee on Investigations, (2003). US Tax Shelter Industry: The Role of Accountants, Lawyers, And Financial Professionals - Four KPMG Case Studies: FLIP, OPIS, BLIPS and SC2, Washington DC: USGPO; US Senate Permanent Subcommittee on Investigations (2005). The Role of Professional Firms in the US Tax Shelter Industry, Washington DC: USGPO

[6] US Department of Justice press release, KPMG to Pay $456 Million for Criminal Violations in Relation to Largest-Ever Tax Shelter Fraud Case (

[7] BBC News, Barclays Bank told by Treasury to pay £500m avoided tax, 28 February 2012 (

[8] The Guardian, HSBC Jersey accounts investigated by UK tax authorities, 9 November 2012 (

[9] The Guardian, RBS avoided £500m of tax in global deals, 13 March 2009 (

[10] The Daily Telegraph, RBS staff held in tax fraud investigation, 11 February 2012 (

[11] As per Prudential Plc v Revenue & Customs [2007] UKSPC SPC00636 (

[11] Oc)

[12] US Department of Justice press release, UBS Enters into Deferred Prosecution Agreement, 18 February 2009 (

[13] Deutsche Bank Group Services (UK) Ltd v Revenue & Customs [2011] UKFTT 66 (TC).

[14] Nation of Change, Who takes the Gold for Tax Avoidance in 2011, 9 April 2012 (

[15] See UK Africa All Party Parliamentary Group, (2006), The Other Side of the Coin: The UK and Corruption in Africa, AAPPG, London.

[16] This is from a document obtained by BCCI’s liquidators for litigation against the Bank of England. The quote was reported in The Independent, 13 January 2004; dock-over-bcci-collapse-572886.html

[17] As per US Senate Foreign Relations Subcommittee on Narcotics, Terrorism and International Operations, The BCCI Affair: Hearings Part 1 – August 1, 2 and 8 1991, Washington DC: US Senate Committee on Foreign Affairs

[18] Chapter 1 of the United States Senate Committee on Foreign Relations, The BCCI Affair: A Report to the Committee on Foreign Relations by Senator John Kerry and Senator Hank Brown , December 1992 . Washington: USGPO

[19] For example, United Kingdom Treasury and Civil Service Select Committee (1991), Banking Supervision and BCCI: The Role of Local Authorities and Money Brokers , London: HMSO; United Kingdom Treasury and Civil Service Select Committee (1992), Banking Supervision and BCCI: The Response of Bank of England to Second and Fourth Reports from the Committee in Session 1991-92 , London: HMSO; United Kingdom Treasury and Civil Service Select Committee (1992), Codes of Practice and Related Matters , London: HMSO; United Kingdom Treasury and Civil Service Select Committee (1992), Banking Supervision and BCCI: International and National Regulation, London: HMSO; United Kingdom Treasury and Civil Service Select Committee (1992) Banking Supervision and BCCI: International and National Regulation, London: HMSO.

[20] Hansard, House of Commons Debates, 22 July 1991, col. 755, 761

[21] Bingham, The Right Honourable Lord Justice (1992), Inquiry into the Supervision of The Bank of Credit and Commerce International , London: HMSO.

[22] Professor Prem Sikka v The Information Commissioner and the Commissioner of Her Majesty’s Treasury, available at

[23] The report can be seen on a non-government website (

[24] Chang, H.J. (2010). 23 things they don’t tell you about capitalism. New York: Bloomsbury Press.


[25] Bloomberg, “Citigroup's $1.1 Trillion of Mysterious Assets Shadows Earnings”, 14 July 2008 (

[26] Sikka, P. (2009), Financial Crisis and the Silence of the Audi to rs, Accounting, Organizations and Society, 34(6/7): 868-873.


[27] For some evidence see, Mitchell, A., Sikka, P. and Willmott, H. (1998). Sweeping it under the carpet: the role of accountancy firms in moneylaundering, Accounting, Organizations and Society, Vol. 23, No. 5/6, 1998, pp. 589-607.

[28] Sikka, P. (2008). Enterprise Culture and Accountancy Firms: New Masters of the Universe”, Accounting, Auditing and Accountability Journal, Vol. 21, No. 2, 2008, pp. 268-295.

[29] United States, Senate Committee on Foreign Relations (1992). The BCCI Affair: A Report to the Committee on Foreign Relations by Senator John Kerry and Senator Hank Brown, December 1992. Washington, USGPO.

[30] Bank of England, (1995). Report of the Board of Banking Supervision Inquiry into the Circumstances of the Collapse of Barings, London, HMSO.


[31] Lynn Turner Says Unless Big Four Change, Bring on SEC as Public Auditor, Corporate Crime Reporter , February 14, 2007.

[32] Speech given by Andrew Haldane, Executive Director for Financial Stability at the Bank of England, on 24 October 2011 (

[33] Department of Trade and Industry, (1976c). Roadships Limited , London, HMSO.

[34] Department of Trade, (1976d). Hartley Baird Limited , HMSO: London

[35] Registry of Friendly Societies, (1979). Grays Building Society (Cmnd 7557), London: HMSO.

[36] Department of Trade and Industry, (1979). Burnholme & Forder Limited , London, HMSO.

[37] UK Department of Trade and Industry, (2001). Mirror Group Newspapers plc (two volumes), London: The Stationery Office.

[38] Lord Tuner, Market Efficiency and Rationality: Why Financial Markets are Different, London School of Economics Lecture, 12 October 2010 (




Prepared 8th February 2013