Examination of Witnesses (Questions 1-49)
Michael Power, Vivien Beattie and Stella Fearnley
12 OCTOBER 2010
Q1The Chairman: Good afternoon.
I am sorry we have started a little bit late, but this is our
first meeting since the recess and we had one or two matters to
cover. Welcome to the Economic Affairs Committee. This is our
first public meeting of the new Parliament and the first hearing
in our inquiry into the issue of auditors: the market concentration
and their role. There are just one or two formalities that I have
to say at the beginning of this: copies are publicly available
of Members of the Committee's entries in the Register of Interest
and of declarations of interest relevant to this inquiry. At this
first session, each Member who feels that he has even a remote
interest to declare will do so to get it on the record. Two Members
of our Committee, Lord Currie and Baroness Kingsmill, are not
taking part in this inquiry because they felt they were too conflicted.
I welcome Professor Beattie, Professor Fearnley and Professor
Power. We start our inquiry with an extremely well qualified group
of witnesses. We are very grateful for the written evidence that
you have given and for coming. I would be grateful if you would
speak loud and clearly for the webcast and the shorthand writer.
I know that Professor Power has to leave at 4.45 pm. Could I just
say if, in answer to some of our questions, the first person who
speaks in a sense speaks for you all, and if you do not wish to
add to it, please feel free not to speak. Just come in if you
have something fresh to say because we have a lot of material
to get through. Would anyone like to make an opening statement?
If so, could it please be brief? Professor Beattie.
Professor Beattie: Just to preface some of the
remarks we might make later on, and to point out that, post Enron,
what happened in the UK was there was a very strong enforcement
regime put in place in relation to audit and accounting. In that
situation, the quality of the outcome from the whole process very
much depends on the quality of the accounting rules that are in
place. When we came to 2005, under the EU, International Financial
Accounting Standards were put in place and while they are often
talked about as being quite principles-based, in fact there are
quite a lot of de facto rules there because there's a lot of detailed
guidance. They are certainly more rules-based than UK accounting
was, or UK GAAP still is. What we lost in that process of moving
to IFRS for UK-listed companies was the true and fair view, the
prudence principle and the principle of substance over form. The
research that Stella and I, with a colleague, have carried out
in the last two or three years into accounting and auditing—and
I guess why we're here today—has pointed up quite strong
concern amongst expert preparers in the UK, by which I mean finance
directors, audit committee chairs and auditors of listed companies.
They are concerned about the accounting model; they are concerned
that we have lost the true and fair view and these principles
of substance over form and prudence, that we have moved to a compliance-driven
tick box kind of process where judgment has been lost; they are
concerned about the excessive length and complexity of financial
statements nowadays; and are concerned that, under IFRS, there
are a number of quite dysfunctional outcomes. Although it is not
specific to the research we carried out, we are also aware there
is quite a deep level of concern about the particular outcomes
in the accounting model with respect to banks. Thank you.
Q2 The Chairman: Thank you. We will
move straight on. The point you raised, which is also expressed
in your written evidence, will be one that we will certainly be
exploring as one of the issues in our session here today. Thank
you for that. I am going to start with the first question and
then move to my right. In doing so, I have to declare a past interest
as a member of several audit committees and chairman of one. I
am currently chairman of three pension fund trustees which, of
course, have auditors, and I am chairman—although I do not
think this is quite so relevant in this context—of the House
of Lords Audit Committee. The first question I wanted to ask you
is: what, in your opinion, are the reasons why there has been,
and continues to be, so much attention to the issue of audit market
concentration and audit quality?
Professor Beattie: To some extent, it is because
the audit product is unobservable and, in a sense, that makes
it quite mysterious. The whole process of accounting and auditing
is what underpins the capital markets, which is fundamental to
the economy. So people have particular concern that the way in
which we obtain trust in the information upon which the capital
markets are based does have integrity and can be relied upon.
Professor Power: I would agree with that. There
are a number of issues around the audit concentration question;
one is a systemic issue, what would happen, what would be the
nature of the market if a firm were to cease to exist and what
that would mean for competition. A more serious issue is it is
not a market at all, in the sense that there are not willing buyers
in which one ordinarily thinks of markets. There are enforced
buyers by statute and that also confuses the market analysis to
a certain extent. Therefore there are issues of concentration
and, descriptively, there is undoubtedly concentration amongst
a small number of firms at the top end of this rather artificial
market. Those issues become more poignant because the demand side
is rather difficult to observe and perceive.
Q3 The Chairman: Do you think there
would be a bigger problem if the Big Four became the Big Three?
Professor Fearnley: There are conflicts of interest.
The Chairman: Please speak up a bit.
Professor Fearnley: Sorry. There are conflicts
of interest within the big firms obviously for work they do for
companies. Every firm has to have a bank, a banker of its own.
So if there were three firms I think the conflicts of interest
would be extremely problematic for auditors to be able to act
for certain companies, particularly the large ones where—for
the size of the organisation and, if they are international, for
the scope of the organisation—they do need to use one of
the largest firms.
Q4 The Chairman: We will come on
to possible solutions later but one last question from me. It
really touches on what Professor Beattie said at the beginning.
Do you think the audit of financial statements prepared under
IFRS has negatively impacted audit quality?
Professor Beattie: To an extent, the accounting
rules are very rigid and the auditing standards, which auditors
are required to use, and the ethical guidance for auditors are
very detailed now. I think that certainly does have an impact
on the quality of the outcome, yes.
Q5 Lord Lipsey: Could I have a supplementary?
You said it would be very serious if four became three. How great
is the risk that four might become three?
Professor Fearnley: I don't think I can assess
that risk. The risk obviously is a litigation risk. If one looks
at what has happened since the collapse of Andersen, where people
learnt a great deal from allowing that to happen, where an issue
does come up in the firm they do try to handle it and try to deal
with it now in a better way than happened with Andersen. I would
hope that the firms themselves would be able to manage the situation
rather better than happened in the US.
Professor Power: I don't think we can rule out
dramatic loss of franchise value, shock events. There are plenty
of examples of those in recent history so I think the risk is
there.
Q6 Lord Lawson of Blaby: I would
like to ask a string of interrelated questions but would be grateful
if you would address all of them and not just one of them. They
are all connected. Even with four, that is high degree of concentration
and in some sectors—notably banking, which is particularly
important, particularly sensitive, as we have learnt recently—the
concentration is particularly marked. The first question: leaving
aside whether it goes from four to three, are you concerned about
the existing concentration and in what direction do you think
we might move to allay that concern if you are concerned? The
second one—I will confine myself to two aspects of this—I
think relates to the question. These firms have accountancy and
audit business but they also have business outside accountancy
and audit of an advisory, consultancy nature and so on. Do you
see any benefit from having a structural separation, so that accountancy
firms have to stick to accountancy and audit and do not do this
other work? You mentioned Andersen; of course Andersen did hive
off their consultancy completely. I think there were concerns
at the time about the mixture of the two. So if you could address
those two questions I would be grateful.
Professor Power: I will start. I think the issue
of whether concentration bothers us or not is the question of
the source of the concentration. On the one hand, one can argue
there are economies of scale that accrue to the large firms. They
are able to muster technical expertise in very specific areas,
as you have mentioned, Lord Lawson, the banking area in particular.
In my experience, one of the things finance directors are interested
in is being able to compare themselves with a peer group of some
kind and to know whether their accounting policies are more or
less in line with what other people in the industry are doing.
Some of the large firms are very well equipped to do that and
to provide the technical support, and that is what they would
say about the concentration anyway. So there is an element of
concentration which may have to do with natural forces of economies
of scale. Equally, I think there are some self-reinforcing myths
about "big" being better quality that are shared, to
a greater or lesser extent and more or less explicitly, by regulators,
institutional investors and others. When I talk to the finance
director of the board that I am on about using a non-Big Four
auditor for the audit process he says, "Well, the market
wouldn't like it. The institutional investors would find that
very odd". Why? "Well they would". So I think there
are these sets of beliefs that circulate about "big"
being equated with quality. No one wants to break rank and that
is another source of, not so much concentration, as market freezing.
So I think if you are going to dissect it in those two ways, you
have two different kinds of diagnoses that point in different
directions. For the other question, I for one am not in favour
of structural separation for all sorts of reasons, even though
that is a bit countercultural at the moment. There are a lot of
synergies and benefits between advisory work and auditing. I am
sorry that so much attention has been given to this particular
issue because it detracts from the really important issue, that
of audit quality. The provision of other services is neither here
nor there when it comes to the audit as audit.
Lord Lawson of Blaby: Do either of the other
witnesses wish to add anything before I come back?
Professor Beattie: I would simply say, yes,
I would say I was worried about the level of audit concentration
from a commonsense perspective. When you look at the structure,
the fact that after the Big Four there is such an enormous gap
before you get to any of what might be called the Group A or major
firms means that, even if they were to combine together, it would
hardly have a significant impact on the listed audit company market.
There is an issue where concentration is sometimes even higher
at sector level. I could certainly provide evidence if you split
across, say, 34 sectors of industry a few years ago, exactly what
the breakdown was for each of the Big Four and for each of the
six next biggest audit firms and for the rest combined. It is
quite scary how sometimes in some sectors one of the Big Four
has more than 50% of the market, in terms of the audit fees they're
bringing in. It is important to understand how audit market concentration
changes over time and the dynamics of that. What happens is that,
as firms publicly join in the alternative investment market—initially
many of them before they come on to the main market—and
at that level of entry, if you like, to the market, almost 50%
of these companies have a non-Big Four auditor. There are a lot
of companies coming on to the AIM but at some particular point
in their growth, either at that secondary market or in the main
market, they seem to feel compelled to switch to a Big Four audit
firm, either because they think the public perception demands
that or some of the shareholders demand that, or the audit committee
members and audit committee chair feel more safe if they have
a Big Four auditor behind them. So it makes it very difficult
I think—if you understand that structure of the market and
the dynamics of change, how difficult a problem this is to try
and change.
The Chairman: It would be helpful if you could
let us have a note on the point you raised earlier about the research
you did.
Professor Beattie: I am happy to give information,
yes.
Q7 Lord Lawson of Blaby: I have one
supplementary. Professor Power pointed out that there are advantages
in size as well as disadvantages. I think we are all well aware
of that. The question is: where does the balance of advantage
lie? That is what we as a committee have to decide first and then
whether there is any remedy that we think is necessary. I had
the impression from Professor Beattie that she was more concerned
with the disadvantages and felt that there should be some movement,
therefore, to deal with that. Is that correct?
Professor Beattie: I think I would say that
is true, yes. It seems quite an extreme level of concentration
in the market and not graduated at all, the four and then quite
a big drop.
Professor Fearnley: Lord Lawson, I think the
problem is that it is not an issue which is peculiar to the UK.
The concentration is not like the supermarkets in the UK. This
concentration is global. This is something the committee needs
to consider when you consider what the solutions might be, because
it is a much bigger issue than looking at a monopoly or looking
at oligopoly just in the UK.
Q8 Lord Tugendhat: If I may just
ask a supplementary, please. Professor Power emphasised the quality
of the audit but, even among the Big Four, do you feel that they
are able to provide a similar quality of audit to each of their
customers in an area like banking? I remember years ago when I
was chairman of Abbey National, we had Coopers and Lybrand as
our auditors and we were the biggest banking relationship that
Coopers and Lybrand had. They then merged and became PricewaterhouseCoopers,
as a result of which we would have gone down to the third of their
banking customers. So we put it out to tender. We went to Deloittes
and we again became the biggest banking relationship, and it was
understood that Deloittes would not take on another banking relationship
without consulting us about the terms of it. We were very much
concerned that if we were the number three at PricewaterhouseCoopers
we would not have the best team. I think back on it and feel that
we made the right decision. I cannot help feeling that when you
have only four auditors, however big, it is very difficult for
them to provide an equally good and thorough service to each of
their relationships.
Professor Power: It is a very good point and
this is digging below the surface, if you like, and looking at
the kind of manpower model that different firms use and the particular
forms of expertise that they deploy. Clearly, if somebody is working
on a specific audit they are not working on another one so you
are getting that kind of differentiation. Finance directors are
quick to say they are not happy with audit teams and changes happen
in that sense, but I think what your question is getting at—and
I think it is a very intriguing one—is that you obviously
were an informed purchaser of audit services. I am not sure that
is the case any more. I think audit committees go by franchise
value alone and do not analyse audit teams, and what is on offer
and capabilities, in any more depth than that. I may be wrong
on that but that is just an assumption. So one of the issues that
your question surfaces—and I welcome it, and it is a challenge
for this committee—is, whoever it is that purchases audits,
audit committees in conjunction with finance directors, how to
make them more informed purchasers and have more nuanced conceptions
of quality in order to freshen up the market.
Q9 Lord Forsyth of Drumlean: In the
investment banking world they say no CEO was ever fired for hiring
Goldman Sachs as opposed to hiring somebody that nobody had heard
of. Is not the problem that, in a culture where people are protecting
their backs, it is the easy solution and the one for which you
are not going to be criticised if things go wrong. So when you
say they should be looking for quality, are they not also thinking
about the extent of the risks that apply to them as directors
and sitting on an audit committee, but especially if they are
non-executive directors?
Professor Power: As a non-executive myself I
can say absolutely that you take the easy route of equating large
franchise value with quality because that is what you can defend
ultimately. I suppose the purpose of this committee, and this
whole area, is that we have to find some way of disturbing that.
Q10 Lord Forsyth of Drumlean: Is
not the other problem that if you are dealing internationally
and you say, "Well, we will get X to look at this",
and everybody knows that X is one of the Big Four, people will
have a confidence in that because they know of it, whereas if
it is Bloggs and Snooks, whom they have never heard of, it is
more difficult?
Professor Power: Absolutely right, and the confidence
may be justified as well in some circumstances.
Professor Fearnley: As the chair of an audit
committee of a significant charity, we have just done audit tenders
and we appointed the safest firm, which is what you do. Picking
up what Lord Smith said if I may. Sorry, Lord Maclennan, I beg
your pardon.
The Chairman: Lord Tugendhat.
Professor Fearnley: I think we have to make
a distinction, when we are looking at audit, between the quality
of the audit that is performed and the service quality that is
provided to the client. The client does not always see the quality
of the audit itself. Therefore, the client wants the service and
they want things to happen as they do, but the quality of the
audit is quite often unobservable to the client themselves. This
is an issue for the firms that, if they do not deliver an audit
in the right compliance mode, then they will have the audit inspection
unit after them. So they have to go through all that. One of the
issues that has come out from the research that Professor Beattie
and I and another colleague have done is that they are complaining—both
the firms and the companies—that it has become a very tick
box activity, and the auditors are spending their time meeting
the requirements of the inspections rather than meeting the requirements
of their clients. There is also the other issue of the ethical
standards prohibiting certain services. Some of the auditors have
said to us that they no longer have access to the directors, chief
executives or the chairman of the company because that is now
against the ethical standards. So we have to look at how you achieve
the balance between the proper role of the auditor and how the
auditor can help the business. I think this is quite an interesting
dilemma because auditors have to be independent and have to comply
with the rules but we are losing something along the way in the
current regime that we have.
The Chairman: I am sure we will come back to
that in subsequent questions. Thank you.
Q11 Lord Best: I have to declare
some interests: I am the chair of the audit committee of the Royal
Society of Arts and I am the chairman and an ex-officio member
of the audit committee—but I attend only one of its four
meetings in order to get that little bit of distance—of
the Hanover Housing Group. The first one uses Deloittes, the second
one KPMG. So I declare those interests. Would it be fair to say
that there really is not any great competition between the Big
Four themselves in the audit market? I notice that the Office
of Fair Trading in its submission to us says, "The OFT considers
that competition in the market for audit services in the UK may
be limited", and I notice that of the FTSE 350 top companies
only about 2.5% have changed their auditors in any one year. There
is pretty good stagnation there. Do you agree that there is not
much competition going on out there?
Professor Power: Yes, there are very few transactions
and most of those probably take place because of mergers and aligning
auditors in groups, and all that kind of stuff. I think it is
well known that there are quite high switching costs for clients
as well. So I think those two forces reinforce what you say.
Professor Beattie: I would take a different
view. It is quite true that the rate of turnover is very low but
I am not sure it is quite fair to deduce from that there is a
lack of competition. I am relatively distant from seeing this
first hand but from the case study evidence that we are getting,
from talking to the finance directors, the audit committee chairs
and the audit partners, reading that evidence it seemed quite
clear to me that all parties felt that it was quite a competitive
market, in the sense of if they did not satisfy the other party
then there was always a threat and sanction that there would be
some change. Often the change does not have to happen for the
potential for change to make the market competitive.
Q12 Lord Best: Would it be fair to
say that there are quite high switching costs and very little
incentive to switch?
Professor Beattie: I would absolutely agree
with that. There are very high switching costs but if the relationship
is not working then there comes a point where that is worth taking
on.
Q13 The Chairman: Is that not often
achieved by changing the audit partner rather than changing the
firm?
Professor Beattie: That can happen as well.
Requests can be made and that can be done.
Q14 Lord Lipsey: It seems to me that
there are two sets of factors leading to the concentration in
this market. The real advantages the Big Four have, as a result
of being so big, are global reach and a great variety of skills
and the semi-psychological advantages they have that nobody gets
sacked for hiring them and so on. Are the real advantages so great
that it is a waste of time thinking you can break up this monopoly,
because you would lose far too much, or are the psychological
factors very important too and therefore there is a possibility
of extending beyond the Big Four if we take the right regulatory
measures?
Professor Beattie: I think you are absolutely
right. There is both the perception problem and the reality problem.
In thinking about the concept of audit quality—we have talked
about audit firms size being very much seen as a mark of audit
quality—the other mark that exists is indeed industry specialisation.
Academic research will demonstrate that both of those are seen
as marks of quality and, indeed, audit firms can potentially get
a premium on audit fees if they have both larger size and industry
specialisation. Ultimately that specialisation does exist at the
people level, as Professor Power has said. It goes right down
to the audit teams and the people in a particular industry will
know all of this. Indeed when Andersen failed studies were undertaken
to look at where the Andersen firms went, whether they chose to
go with the firm that took over Andersen or whether they decided
to follow the audit team if they went somewhere else. That is
some of the reality of it. There is undoubtedly a big perception
problem. A study which has just come out in America suggests that
there seems to be a greater inclination of companies in America
to move to what is called the second tier, and even the third
tier. The study is monitoring the stock market reaction to these
audit firm changes and finding that, whereas they thought they
might be negative, they are becoming more positive. The study
was suggesting there might be some hope for these kinds of market-led
solutions to the problem of audit concentration; that is to say,
trying in part to change the perceptions of people out there and
make it acceptable to have a lower tier audit firm. But that is
in the US. I have no sense of that in the UK at the moment.
Professor Fearnley: From our case study research,
obviously we intentionally talked to companies that had a second
tier auditor, and provided the companies did not get too big—and
these were all main market listed companies—they preferred
the second tier auditor. They thought they received a better personal
service because they were more important to that firm than if
they were a small listed company with a large firm; they felt
that they were treated better. The view very much came out that
if we get beyond a certain size we will probably have to change,
or if we become more international we will have to change, because
we are not sure that this particular firm can provide us with
that level of service that we will continue to need. The issue
with the concentration is particularly with the largest firms
with the big international reach. I do not think they have a choice,
even if they wanted one.
Q15 Lord Lawson of Blaby: May I ask
a question arising from that? Do you think there is a danger that
if a very large company has a second or third tier auditor, and
therefore that company's business is hugely important to that
particular auditing firm, that the auditing firm might not be
as critical when criticism is warranted?
Professor Fearnley: There are ethical standards
for auditors which prohibit them taking on a client above a certain
size. I can't remember the exact figure but I can provide you
with that, Lord Lawson, if you would like to see it. There are
restrictions that you cannot become too economically dependent
upon one client. And one could say in some ways that actually
prevents the growth of the smaller-tier firms into the market.
But then the economic dependence is such a risk.
Professor Power: If I may, I think that's a
very important point, but I think it applies equally to the Big
Four. I think the unit that we should think about in terms of
independence—the relevant unit—is not the whole firm;
it is the partner and his or her client bank. So if there is a
partner with 12 clients, and the 12th one is absolutely massive,
there is where your independence threat bites. That can be a small
firm, a medium firm or a large firm. I think that some of these
aggregated dependence levels for firms as a whole are not very
meaningful in accessing that particular problem.
Q16 Lord Hollick: I was interested
in your comments, Professor, about the greater readiness in the
United States for companies to have second or third-tier auditing.
Is there any evidence to suggest that the anxiety of large companies
about moving from large audit firms to second-tier audit firms
justified? Have they been punished by banks or the market for
doing that? Is there any evidence that the next tier cannot provide
the same level of audit support, particularly given your earlier
remark that this has become increasingly a box-ticking exercise,
rather than one where great judgment and expertise has to be applied?
Professor Beattie: There is a stream of research
that will look at how the market responds to the announcement
of an auditor change. In particular, you'd be interested in studies
that look at changes from top tier to lower tier; and that normally
would have negative market reaction. The investors don't like
that change to a small tier auditor. There is another stream of
research that is particularly popular in the US academic world,
which looks at what they call a proxy for audit quality, being
the abnormal accruals of the company. It's a bit of a red herring
because audit quality is inherently unobservable. This is the
problem for academics wanting to research this. So they come up
with all sorts of ways of looking at it—looking at the qualified
audit opinions and the incidence of those or abnormal accruals.
I think it would be fair to sum up that body of knowledge as saying
that it does seem to provide some evidence that the big firms
seem to provide higher quality audit. But are they defined by
that proxy, which I have reservations about. So it is a bit difficult
to give a definitive answer.
Q17 Lord Tugendhat: Just following
Lord Hollick's point, we received a huge amount of submissions.
I cannot remember which one I am about to quote, but one of them
pointed out that the concentration is much the same in most of
the large economies.
Professor Beattie: Yes.
Lord Tugendhat: But the outlier is France. In
France I think the Big Four have only 61% of the market, whereas
even in Italy they have a very high proportion. To what do you
attribute this, and do you think that the 40% that are not done
by the Big Four in France are any worse audited than the corresponding
firms in the countries where the Big Four have such a large share?
Professor Beattie: I don't know about the 60%
to be honest. I'm not sure I can, off the top of my head, offer
you an answer to that. I don't know if any of my colleagues can.
Professor Power: There is more of a tradition
of joint audits.
Lord Tugendhat: I am sorry?
Professor Power: There are more joint audits
in France and that's a very important feature of the audit landscape,
which should be taken into account.
Q18 Lord Tugendhat: More choice?
Professor Power: Joint audit. So you have auditors
from two different firms and they co-operate and divide up the
work and liaise.
Q19 Lord Tugendhat: We used to have
that here. Again thinking back, I was a director of NatWest in
the 1980s and they had two of the biggest audit firms. I don't
know whether they had a better audit than having only one, but
it was not uncommon here.
Professor Fearnley: I think that is pretty well
gone from the UK now, but it has been a tradition in France, and
that tradition continues.
Q20 The Chairman: Do you see advantages
in that in helping the second-tier firms to have substantial clients
in a bigger market?
Professor Fearnley: I think it is one of the
possible ways of opening up the market to the second-tier firms,
if they were to share an audit. But the other thing you have to
bear in mind with the very large companies, if we went that way,
is who would the joint auditor be, because it could just as easily
be another of the Big Four firms. All these things need to be
considered, but the likelihood is it could annoy the companies.
Now, if you are worried about annoying the companies, that is
another matter, because it would not be as efficient and it could
cost more. I know there are various firms who think this would
be a possible solution.
Q21 Lord Hollick: Is this just the
French being French, or is it—
Professor Fearnley: Well, I think it is the
French trying to stop oligopolies.
Q22 Lord Smith of Clifton: It would
not be so efficient in one sense, and it anticipates a question
coming on later. As for efficiency and having two people looking
at it, it might lead to a greater degree of scepticism than if
you have just one looking at it, and so it would be more efficient
if that company was in trouble in some sort of way, like the banks
were.
Professor Fearnley: I am not sure, Lord Smith,
that it actually works like that. What they do is divide up the
work between them.
Lord Smith of Clifton: A subcartel of a cartel.
Professor Fearnley: Yes; and of course if you
have a very large firm and a very small one, the very large firm
would probably do most of the work. Two eyes are always better
than one. But you would have to talk to a French auditor to understand
how it works in detail. I think that would be the best approach
to it.
The Chairman: We must move on because I want
to get some of the questions that impinge on the opening statement
by Professor Beattie.
Q23 Lord Moonie: Chairman, can I
also declare a general interest as chairman of an audit committee
who uses the services of companies who have given us evidence
and will be giving us evidence. I am trying to think very hard
of what possible advantage I could get for myself out of that
but I can't really think of any. Never mind, the declaration is
made. Can I ask you, on a slightly different tack, what would
be the implications of the statutory requirement if an audit were
dropped and assurance needs were left to the market? In other
words, what is your view about liberalising the audit markets,
so that all or most clients may choose whether or not they have
an annual audit?
Professor Power: We have liberalised a bit of
the market at the small end of things, and interestingly enough
there are problems there of audit quality, and the POB has reported
on that. At the top end of things, we obviously can't know for
sure. I think there would be, in the short run, quite a bit of
uncertainty. Obviously as an academic it's an idea that intrigues
me because I don't bear the costs of any change. But I think what
we would see, if that were to happen—and it would be assuming
issues of law and so on could be overcome—is a real demand
would be visible for a more differentiated range of assurance
services—to use a better word—focused on the kinds
of things that investors might want. I think boards of directors
would have to raise their game in thinking about audit. Investors
would absolutely have to raise their game in thinking about audit.
I actually think it is not insurmountable; there would be a kind
of market solution. Instead of the black box of audit quality—this
compliance product we've been talking about—I think there
is the potential for a much more differentiated range of audits
focused on different things at different prices. So there would
be a spotlight on the board. I think the internal audit function
would be drawn into the universe that we're talking about much
more, and I think it would be most interesting—in our sense
of interesting. The barriers to that are that people think there
are big changes to the law that would be needed and it's just
simply unthinkable for a whole range of institutions at the moment.
But I think it should be talked about.
Professor Beattie: Before audit was required
by law, voluntary audit—companies choosing to have an independent
person audit the financial statements—was something that
happened as a response to agency problems, so it was a way in
which companies could signal their quality to say, "We're
very happy to have independent people audit voluntarily".
Evidence exists that there would still be quite a demand for audit
and there would be a signalling process in place. But interestingly
this was one question that we asked in the survey side of our
research, where we put about 15 suggestions of proposed change
in the area of audit and accounting. Of those 15, this was the
idea that came right at the bottom in terms of the extent to which
people thought it would improve financial reporting integrity.
Indeed all three of the parties' expert preparers thought it would
moderately undermine financial reporting integrity were this to
happen.
Q24 Lord Lawson of Blaby: May I ask
just one supplementary? Of the companies that do not legally require
an audit now, because they are SMEs—or whatever you like
to call them—what proportion do in fact, despite that, have
such a provision, and what proportion choose to avail themselves
of this dispensation?
Professor Beattie: I don't have that information
to hand; I am sorry, Lord Lawson. I'm sure I could dig it out
and provide it in due course, if that were helpful.
Lord Lawson of Blaby: Thank you very much; that
would be helpful.
Q25 Lord Forsyth of Drumlean: We
have pretty well explored a variety of the reasons why people
might choose to have a Big Four firm but, looking at this objectively,
are there really any circumstances where a client is effectively
obliged to hire a Big Four firm?
Professor Fearnley: It's a size issue, Lord
Forsyth, and a specialist industry issue. But it is size and global
reach.
Q26 Lord Forsyth of Drumlean: I do
not know a great deal about the way that the Big Four organise
themselves, but certainly when Arthur Andersen collapsed in a
heap it turned out not to be one large global organisation but
a series of discrete partnerships, and I suspect that is probably
true of the Big Four as well. Certainly also within their own
internal structure they tend to be centred around particular partners.
The smaller firms are involved in networks with other firms around
the world, so does size really matter here?
Professor Fearnley: Certainly the evidence we've
had from our case studies is that the networks of the smaller
firms are not as strong and they don't have an office everywhere.
Perhaps that is an exaggeration, but the larger firms have a presence
in many more places in the world. Companies don't like paying
huge travel costs. This may seem a very basic thing, but they
want a local auditor within reasonable reach of having to do the
work. And so I think it is quite simply an issue of availability
and an issue of resourcing when the company gets very big. And
if you get into the banking sector and the oil and gas sector
there's also a very important issue of specialist knowledge. You
couldn't appoint an auditor who didn't have enough specialist
knowledge in those areas.
Q27 Lord Forsyth of Drumlean: Can
you just help me with that? When you say "specialist knowledge"
in the oil and gas sector, what kind of specialist knowledge do
you need to have in order to do the audit? I am struggling to
understand that. What would you need to—
Professor Fearnley: The biggest criticism or
the worst criticism that a client can make of an auditor is that
they do not understand our business. And it is important for an
auditor to understand the way the business works, because you're
not just ticking the numbers that come out of it, you have to
understand where the numbers come from and how they work. The
more complex a business is and the more complex the risks in that
business are, the more you need someone who can address those
risks, because it isn't just sitting in a room checking numbers.
Q28 Lord Forsyth of Drumlean: Isn't
the other side of that that if you have a small concentration
of people who are perhaps doing the big oil companies, perhaps
they won't have the same degree of scepticism that might be required?
Professor Fearnley: I think the scepticism issue
has been a little bit overplayed because, as Professor Beattie
and I have already said, what we have found is we have a very
compliance process-driven system now, which has knocked quite
a lot of scepticism out of it. Providing they are complying with
the system then that has created a bit of a problem there, because
there is less focus on the output than there is on the process
of actually getting to it. So I think that is an issue. But I
don't think there would necessarily be less scepticism. I think
there would be more understanding. If you look at different companies
in the same industry sector you do understand how those companies
work and the sort of things that went wrong in company A that
you can look out for in company B. If it is a straightforward
business it's not so difficult.
Q29 Lord Forsyth of Drumlean: It
did not quite work out with banking though, did it?
Professor Fearnley: Well, it was going wrong
in all of them, wasn't it, I think was the problem?
The Chairman: That will lead us on to the next
question from Lord Hollick, because I think we are now moving
into some of the territory that you, Professor Beattie, outlined
in your opening remarks.
Q30 Lord Hollick: Moving on to the
banking crisis, do you think that the auditors—as they considered
making their going concern judgments before the crisis—should
have drawn attention to the systemic risks that, with hindsight,
became very clear?
Professor Fearnley: Do you want to do that one?
Professor Beattie: I can start. When you say,
"Should they have?", there is in one sense. What the
auditors will do today is very much they will do exactly as required
by the regulatory regime and that's it. So they don't go, in any
sense, an extra mile if they don't think it's quite right. This
is the problem with the true and fair view and the substance over
form concepts going. We had them in UK accounting rules, but they're
not embedded in IFRS rules. So to say, "Should they have
done so?" -- well I'm not sure they were required to do so
under the accounting rules and the regulatory regime. But of course
then there's a secondary question, a normative question. Putting
aside the regulatory regime, should they have done so from a public
interest perspective? And I suppose it would be easy for me, because
I'm not in the profession, to say yes. But we were struggling
because our hands were tied by this regulatory regime, which had
become so powerful and almost a crippling judgment in a way. I
don't know if my colleagues want to follow up.
Professor Fearnley: You see I think when you
have a very strong compliance enforcement regime—which is
a very good thing—everybody wants to keep out of trouble.
The way you keep out of trouble is to comply with the rules. Besides
which, you can't get sued if you've complied with the rules, and
that is of course very helpful as well. So I think this is the
situation that people have been in. This is what happened in France
with the Société Générale, where they
actually flouted the IFRS rules and they brought the loss in in
the year before they should have done—according to the rules—and
they were given a real hammering. But my view is that if they
had produced their accounts without disclosing that loss everybody
would have fallen about laughing because they knew the loss was
coming. But they were given such a hammering about that that I
think everyone took fright and said, "Well if we're all going
to get really badly criticised for using the true and fair override,
we won't do it anymore. We'll just comply with the rules".
And I think this is one of the unfortunate things about the situation
that we've got ourselves into. We'd like to see things like prudence
and substance over form coming back into the accounting regime
and go back to the provisions in the Companies Act, which make
it very clear that you adopt prudence and substance over form.
But I think the problem is if you have mark to market you can't
have prudence.
Q31 Lord Hollick: You paint a rather
alarming picture, if I may say, of auditors not applying common
sense to a situation. The IFRS, as I understand it—or maybe
I don't understand it—still requires you to look at the
going concern. And to establish whether or not a bank or a financial
institution is a going concern you obviously have to look at both
sides of its balance sheet, you have to look at the quality of
its loans and you have to apply appropriate scepticism to the
judgment measure to test it. Now none of those things are banned
under IFRS, are they?
Professor Fearnley: Certainly one of the problems
with the banking crisis was that under IFRS the mechanism for
providing for loan losses changed. And as a result the loan losses
went down, because they were looking at incurred loss, ie make
a provision if there's evidence of a loss, rather than make a
provision where there's a risk in the portfolios. That made a
very big difference because it freed up capital for the banks
to lend more. If you'll excuse me saying so, Chairman, if you
let a bunch of little boys loose in the sweet shop without any
supervision they'll eat all the sweets. This is the sort of issue—that
if you give people the opportunity to do these things through
legitimate mechanisms in the accounting particularly, they will
do it. I think what disappoints me about my own profession is
that they didn't stick their heads over the parapet and say not
that we're not doing the job properly but, "Hey, there's
something wrong here". And to be honest the Financial Reporting
Council didn't either, because I think they were so obsessed with
getting global accounting they lost sight of the quality of what
was coming out, and I think this is a very significant issue.
Professor Power: I think you should also bear
in mind the mechanisms for making a public statement in the area
that you're mentioning just didn't exist. There's an audit report.
Qualifying the audit report of a bank is almost unthinkable, and
there's not much in between. There's communicating with regulators,
which is being addressed now, but there weren't really the mechanisms.
So even if there were concerns, and concerns were raised with
management about the aggressive nature of the business model and
the balance sheet gearing and so on, where do those concerns go?
There were not institutionalised mechanisms. If you're saying
that some lone partner should have blown the whistle on Northern
Rock, I think that is completely unrealistic. It just simply wasn't
their job as described by the system, as Vivien has said, and
there weren't the mechanisms to do so. So I think it wasn't really
the auditor's job to spot what nobody else knew in the market.
Q32 The Chairman: If the auditor
was concerned about that, isn't it an issue that they should be
drawing first of all to the attention of the audit committee and
then to the board?
Professor Power: Absolutely, and that may have
happened. I don't know whether those conversations took place.
But the mechanisms that might matter might be more of a public
nature, or at least a line of supply to the regulator.
Q33 Lord Lawson of Blaby: Following
on from what Lord MacGregor just said. Do you think this would
be wholly improper? If they had identified that it was a problem
but there was nothing within their statutory duties they could
do about it—I do not know what the relationship is—might
they have not said to the FSA, "There is a practice going
on which I think you ought to look more closely at than you are
at the present time"?
Professor Power: There's absolutely no way that—
Lord Lawson of Blaby: Did they say that?
Professor Power: Well I don't know, but let's
think about how professional firms work. If I'm an audit partner
of a bank I don't just go directly to the FSA, I go through various
hoops in my own firm to discuss the issues and it gets dealt with
by the risk committee of the firm and that's usually where it
sits. So if there's any contact with the regulator it is top of
the firm to top of the regulator, rather than the individual partner.
So I think it would be a very brave partner leading an assignment
who would unilaterally take that kind of action, and indeed the
mechanisms wouldn't have been there.
Q34 Lord Forsyth of Drumlean: Are
you hinting that this could be commercially damaging for the firm
and, therefore, was not going to happen?
Professor Power: I beg your pardon?
Lord Forsyth of Drumlean: Are you hinting that
because it might be commercially damaging for the firm's relationship
with their clients that it would not happen? Is that what you
are implying?
Professor Power: That may be the case but I
am thinking of the psychology of the lead partner on the particular
assignment. They are required to take that kind of matter through
the, for want of a better term, bureaucracy of the firm and their
risk management processes.
Q35 Lord Tugendhat: We all want to
learn lessons from the crisis we have been through, so my question
is not directed to the past. Would it be helpful for the future
if, when the regulator has particular systemic concerns, or particular
concerns about particular practices, it issued a public instruction,
or a private instruction—I do not know which you would prefer—to
the auditors to make inquiries along those particular lines and
to satisfy themselves on the point about which the regulator has
expressed concern?
Professor Power: The regulator has a lot on
its mind at the moment, as you might imagine. I do not know, but
I think those lines of communication are beginning to free up
in exactly the way that you are suggesting.
Q36 The Chairman: Forgive me, Lord
Moonie, for a moment, but I know, Professor Power, you have to
go very shortly and there is a question we wanted to ask you that
I know you are particularly interested in, so can I just ask it?
What in your view are the hallmarks of a profession, and do you
think auditing measures up as a profession?
Professor Power: That is a very interesting
question, Chairman. I will have to search around for a definition,
but I think there would be a kind of consensus that it involves
something like esoteric knowledge, which is hard won through an
apprenticeship of some kind; some kind of natural monopoly, recognised
and licensed by the state because of the nature of that knowledge
and its public role; a degree of autonomy, whereby in return for
state recognition professionals are allowed to control their own
work and define this thing called "audit quality"; and
backed up by a service ideal, which is to do with ethics and dependence.
And I think all those four components more or less would characterise
what we mean by "profession" today. Now, from the comments
and the questions that we have made already, at least two of those
components are looking pretty fragile as benchmarks of professionalism
in the current world because, if you have a large firm that needs
to make sure that there is consistency over the hundreds of audits
that it runs on a yearly basis, staffed by my sons, who are in
their 20s and other young people, then you need to run a machine
and you need to bureaucratise the delivery of that audit in such
a way that it is a standardised product. That is perhaps more
remote from this professional ideal. So I think there are forces
of standardisation around in the audit area that go against these
professional characteristics, as I've described them. Now that's
not to say that it's all gone and it's all over but I always find
it very striking that professional institutes play much less of
a role these days than they did when I qualified. So I think the
role of professional institutes has changed commensurate with
the greater commercialisation and standardisation of the craft
in this space.
The Chairman: Thank you. I know that you have
to go, so please feel free to go if you need to.
Q37 Lord Moonie: Just talking about
your professional institutes, it is even more the case in banking
nowadays. There is a lack of standards that were applied when
my brother, for example, qualified 40 years ago in what does apply
today. On the question of risk—I am trying to tease it out;
you have partly answered it, I think—how reasonable is it
to expect an audit firm to be able to quantify risks which have
not been adequately quantified, or not transparently enough quantified,
by the companies concerned? This is not just a matter for financial
services, where everybody has held up their hand and said, "We
didn't understand what was going on". But in oil exploration
and a whole host of specialised areas, how reasonable is it to
expect that audit companies have this level of expertise?
Professor Fearnley: I think you have to draw
the distinction between financial statement risk, which is what
the auditors are about, and operational risk, which is what is
within the organisation itself. Obviously, the auditors are responsible
for looking at the financial statement risk and making sure that
their opinion holds up against the risk of misstatement in the
financial statements. But I think the operational risk is something
that is up for grabs, as to who are the best people to be able
to address that. I don't think it's necessarily the auditors;
I think it depends on the nature of the business. If it's a very
complex business you could need specialist people to be able to
understand what the risk of a blow-out in an oil company is, or
what risk of a problem in a gas company is, or any of those sorts
of risks. As we focus more on the risks within business, it's
down to the business to sort out how they deal with that in many
ways.
Q38 Lord Smith of Clifton: Yes, turning
from process and that sort of thing to the structural problems,
which are almost explicit in our terms of reference, if it were
decided that the Big Four market should return to, say, a Big
Eight or even a Big 10, how might that be achieved or is that
impossible?
Professor Beattie: There are a number of ways
that that could be achieved and some of them we've touched on
already. I feel qualified to comment on what some of the possibilities
might be. Whether they're practical or not, I would hesitate—as
an academic, to be honest—to comment. At the moment, because
of concerns, not so much about competition but about lack of choice
in the audit market, there was quite a lot of debate a few years
ago and it was decided that we should start to see if market-led
solutions would make a difference—for example, that being
to try to address the perception problem, in particular, and encourage
audit committee chairs to think about the possibility of taking
a non-Big Four firm. That has been ongoing for some years and
there have been regular reports from this group. To be honest,
it doesn't seem to be making a discernible difference. So that's
the easy approach. There are the radical ideas, by which I mean
things like, "Let's break up the Big Four". Maybe that
would be possible. I think you would have to ask the Big Four
whether that would be possible.
Lord Smith of Clifton: We will.
Professor Beattie: I am sure you will. Forcing
or inviting or encouraging the smaller firms to merge wouldn't
make a huge impact because they're so far behind the Big Four.
I don't think the idea of joint audits is particularly a great
idea. We had one case when we did a previous study in a different
regulatory regime, and in that particular instance of a joint
audit there was the big firm and then the little firm doing a
little corner of the audit. That did not seem to be successful
at all from what we saw. What other possibilities are there? I
don't think it's a good idea, for example, to open up the audit
market in the UK to non-EU audit firms, because I think there
would be problems with culture clashes, certainly in the first
while. There are a few other ideas. One might be to say—as
I mentioned previously—that a lot of these smaller listed
companies already have a non-Big Four firm, but at some point
they jumped ship. If they could be encouraged, in a real sense,
to stick with the non-Big Four firm you would get a more middle-of-the-road
organic solution perhaps, because these non-Big Four audit firms
could grow as their clients grew and became bigger. They could
grow together potentially. But that is limiting the choice of
those companies, potentially unreasonably, if they feel they want
a Big Four firm.
Lord Smith of Clifton: It does raise the question,
if the firm is going from AIM to FTSE and doing splendidly, on
the chances of small second-tier or third-tier audit firms growing
with them pari passu—you would have to start investing capital
into the audit firms to enable them to do that.
Professor Beattie: Yes, and get the people.
Q39 Lord Smith of Clifton: Looking
at that, is there any possibility of firms generally becoming
less, as it were, a partnership and more floating as ordinary
stock companies, so that some of these second or third-tier firms
could acquire more capital in order to expand?
Professor Fearnley: I think there are one or
two firms who have been listed; there's Tenon. But one of the
concerns I have about it is that that is putting market pressures
on the performance of the firm itself. Therefore, there is an
incentive to go for profit at the expense of performance, which
of course is the very last thing we want to encourage with audit
firms. Whatever solutions we look at I think there are very big
risks. Of course if the firms were allowed to raise capital on
the way, I am afraid it is the big firms that would raise the
most, so they might finish up shutting all the others out anyway
because you couldn't say, "It's only firm X or firm Y that
can raise capital". I would be uncomfortable with that. My
feeling about this, which we know is a very difficult problem,
is to ask the firms themselves to come up with proposed solutions—I
can't imagine they'd like it very much—because they're the
ones who would have the best idea of what could be done. If the
Committee is minded to consider that there are not enough firms
out there, then let's see what they have to say.
Q40 Lord Tugendhat: Can I ask you
about the tension between public service and profit maximisation?
We are dealing with very responsible people in the big audit firms
and very high ethical standards, but when you have eight players
in a market then people don't feel they have very special public
service duties. When you are down to four fulfilling an absolutely
vital function, there is a real element of public service about
it and the whole edifice of trust in public accounts depends on
a very small number of firms. Do you feel that in that situation,
the balance between maximising their profits and their public
service duty is more or less correct at the present time? How
would you articulate this tension and where the balance lies?
Professor Fearnley: I think that's a very difficult
question to answer. If I can perhaps be a little unkind about
my profession—which is fair enough I suppose—I think
the accountancy profession, along with other professions, loses
the plot from time to time and has to be pulled back from what
it was doing before. We've seen this historically over excessive
low balling, and of course this is why in the audit area it has
gradually become more and more externally regulated, so that we
can be sure that they don't lose the plot. I think in the public
interest areas now, with the regime we have, it would be quite
difficult for the firms to lose the plot. The problem that we
have of course is that the standard setters have lost the plot,
so that is not very helpful to us in that sense. I believe now,
if we didn't have the problem with the underlying accounting standards,
we would have a regime that is pretty good at keeping everything
in order.
Q41 The Chairman: Do you want to
elaborate on that point, because I think you touched on it earlier?
Professor Fearnley: The standard setters losing
the plot?
The Chairman: Yes.
Professor Fearnley: I think that when we went
over to international financial reporting standards in 2005, the
quality of what was delivered at that time was not good enough
and I think it was rushed to get it into the EU by the deadline
that the EU wanted. Certainly, from our research, we were astonished
by the barrage of criticism that came from the preparers about
the quality of these standards. The criticism wasn't about it
being a lot of work, because professions are used to work and
finance directors are used to change; it was about some of the
underlying principles, such as the removal of prudence and the
effective loss of "true and fair". These were the concerns
that fed through and there were criticisms of the mark-to-market
regime, although our work was not particularly focused on the
banking sector. So we weren't investigating the banking sector,
but the criticisms were across the board. I think the problem
you have is that the standards setter does not have the right
degree of accountability, because if you have aspirations to be
global, or you are global, then who are you accountable to? And
the more people you're accountable to, the less you're accountable
to any of them. This is the issue, and we don't have a general
election every five years for the standards setting board so we
can kick them out if we don't like what they're doing. So it's
an extremely difficult situation. This is why we suggested, in
our submission, that we should have maybe a European standard
setter that had more direct accountability to the countries that
it was serving. If we go with the US, we will finish up with US
accounting and we will finish up subject to the vagaries of the
US political system, which would be distinctly uncomfortable for
us. So I think we're getting to a point where I believe there
are serious concerns about the accountability of the standard
setter, and maybe we should have US GAAP, European GAAP, Asian
GAAP, and just let people develop as they are. Before anybody
starts to say, "We want it the same around the world",
there isn't much else that's the same around the world, so how
do we think we can get accounting the same around the world? With
technology as it is now, it's not that difficult to change between
one thing and another. You may not be aware, but there used to
be a statement that you had to file in the US that showed the
differences between US GAAP and UK GAAP, and that was jolly useful
because it showed you where the bodies were buried. It was an
extremely useful statement. It gave people the chance to compare:
is this way of doing it better than that way? There is no one
way of accounting for anything, and yet we are being told by these
people, who I call dangling regulators—who in fact are sitting
in a hot air balloon just off the east coast of the US—that
they believe there is only one way. Well, of course, there is
more than one way.
Q42 Lord Tugendhat: You touched earlier
on the question of trust; the question of whether Chinese or Indian
or other accountancy firms would come in and you said—if
I understood you correctly—that it would not fly because
it would not have the credibility. But when you mentioned the
way in which the US insists on imposing its own standards in many
areas, can one not imagine a situation—perhaps in the mining
industry to begin with—where the Chinese would say that
they don't trust the accounts of BHP unless they can have Chinese
auditors looking at them? And given the dependence of BHP on the
Chinese market, it might be difficult for BHP to resist having
a Chinese auditor alongside its regular western auditor. I wonder
whether, given the growing power of China, the dependence on the
Chinese market of a number of companies—I only pick mining
as an obvious example—one couldn't find the Chinese, in
the first instance, insisting on some element of Chinese auditing
of the accounts of companies that manufacture to a large degree
within that market
Professor Fearnley: If we get to the situation
where an economy, such as the Chinese economy that is growing—as
we know—very rapidly, makes those requests, I think those
requests have to be considered at the time. As we are at the moment,
I think that there are cultural issues. I think that is one of
the cases for a joint audit because one obviously has to satisfy
the regulator. Enforcement is national because we don't have such
things as global corporation laws or global laws, and I think
it will be a long time—if ever—before we are able
to achieve that. So I think one needs to look at degrees of co-operation
that can be achieved, almost on an ad hoc basis, where these requests
come in. This is one of the challenges: how do you make an international
body accountable? Where is its residence? Who is the lead regulator?
This was the problem we had with the Icelandic banks: who was
the lead regulator? Going back a few years, this was the problem
with BCCI. I think that is going to be a growing issue for us.
Q43 Lord Lawson of Blaby: I have,
I must say, considerable sympathy with your magnificent outburst,
Professor Fearnley.
Professor Fearnley: Sorry, sir, it was a rant.
Lord Lawson of Blaby: Yes, all right, your magnificent
rant. I have considerable sympathy with it. On a matter of detail,
because of your last point about the enforcement being national,
which is an important point, I am slightly doubtful about your
idea that a European GAAP is more sensible than a UK GAAP, but
leave that to one side. I would like to ask one specific point,
which you have raised on two occasions now, and that is the malign
effects of mark to market accounting. I address myself particularly
to banking, where it is quite clear that mark to market accounting
had a malign effect, both at the top of the cycle and at the very
bottom; two different malign effects but in both cases. Yet mark
to market accounting was brought in because of the unsatisfactory
and rather creative character—or so it was felt—of
the old fashioned, former form of accounting. So what is the solution?
Can you tell us what you think should be done? It is a to start
on this subject now so if we could have a note, Chairman, on mark
to market accounting—what you think about it, what its effects
are and what should be done about it—I think that will be
extremely helpful.
Professor Fearnley: Yes, of course, we will
provide something of that nature for you. People have thrown away
the idea of historical costs as being no use, but at least you
know what someone paid for something. There are ways of disclosing
or providing information about what is a realised gain and what
isn't,. But one thing I would like to say to the Committee, which
I think is a serious issue that's slightly connected to the mark
to market issue, is that we don't have an adequate definition
in this country of what is a distributable profit. Therefore,
when dividends are being paid out, and particularly if they're
being paid out of unrealised gains in some way, it gets terribly
messy. Could I ask your Lordships to get that looked at because
it is an issue?
Lord Lawson of Blaby: Absolutely. It is not
just dividends; the bankers' bonuses were paid out of completely
fanciful paper profits as the result of a bubble, and there was
never any real profit—or certainly not remotely on that
scale—there at all, but the bonuses were real enough.
Professor Fearnley: But if we get to the position
of eroding the capital of the company—we don't want to be
there. Well of course we did, because the taxpayer had to cough
up.
The Chairman: Can we just let Professor Beattie
comment on that.
Professor Beattie: I think it's a related idea
here and it picks up something that was mentioned before. We talked
about risk and financial statement risk and operational risk,
and we're very much focused on the accounting model for the financial
statements. Perhaps some thought could be given to the fact that
the annual report of companies is broader than just the financial
statements and the notes to the accounts and increasingly what
might be called the "front end" of the accounts. Particularly,
there is a tension being placed on what is becoming semi-regulated,
which is the management commentary or the business review, operating
the financial review. We have different terms but, effectively,
the same piece of narrative that sits at the front of the accounts
is a kind of storyline for the financial statements. Traditionally,
it has been almost non-existent; recently it's growing and growing.
And I think with the complexities of accounting nowadays, there
is an increasing need for perhaps a piece of narrative that may
be given some attention by the auditors. At the moment auditors
are required to look at this storyline for consistency with the
financial statements. It would be possible to give more attention
to that part of the annual report of the company. That is where,
perhaps, one could address some issues to do with what are the
operational risks? Is there something in the financial statements
that because of the accounting model is not telling us a very
good story? I'm suggesting that we broaden it out a little bit
to look beyond the financial statements to the complete report
of the company.
Q44 The Chairman: You have answered
the question I was going to ask you. But can I touch on a small
part of it? That would include, presumably, the audit of a client's
risk management, for example, and what was being done on the risk
side, as well as corporate governance and as well as the front
end of the annual report and accounts. Would this change the skills
and the nature of the audit profession or do you think it would
be capable of doing that?
Professor Beattie: I think it would quite significantly
change the skills required for the auditor and they may, indeed,
need to bring additional expertise from not the traditional accounting
route to do some of this. Professor Power mentioned that if we
get away from the word "audit" and we think more of
this word "assurance", which is used to be inclusive
of audit but potentially encapsulates other kinds of assurance,
the auditor might decide it was possible to give assurance on
the process by which information was created by management and
say that that was reasonable. A much bigger task would be to ask
the auditor to give assurance on the content of that information,
and that would most definitely require quite a range of skills.
Professor Fearnley: You need to be a little
bit careful because if we are worried about the competition and
choice and power of the audit firms, there is an issue of do you
want to make them any more powerful and how is the best way to
do it? There certainly needs to be more done but the real question
is: who should do it?
Q45 Lord Lipsey: This is a fascinating
tack we are going down, but it almost suggests that the focus
of our inquiry should not be too much on just the concentration
into the Big Four, but into the rules that the Big Four and all
the other accounting firms are employing. This might have a more
revolutionary effect than simply trying to break that dominance
of the Big Four. Is that a fair summary of your position?
Professor Fearnley: Audit is very old fashioned,
in the sense that it goes back to company law when it was a very
simple issue: the auditor reported to the shareholders at an annual
general meeting and then the shareholders decided whether they
were going to approve the accounts or kick the directors out.
It doesn't work like that anymore and I think a root and branch
consideration of what the audit should be now. By the time you
get to the issue of the annual report with the audit report on
it, the only new information in there is what the directors get
paid, because all that other information is now out in the market.
I think we need to be thinking about whether we should just start
from the first principles of looking how the market works now
and what is the best way of providing third parties with assurance
about it because there is so much stuff coming from on websites
and everywhere. It's not as it was when company law set the process
up.
The Chairman: I think we are coming to the end,
because we have had a long session, but there were a couple of
questions that we wanted to ask you at the end. Lord Best, would
you like to deal with the first one?
Q46 Lord Best: The first one is who,
in fact in reality, does determine which firm of auditors is appointed?
I don't know if you have done any research on this. Is it management?
Is it audit committees? Is it the board?
Professor Beattie: I think we would feel that
we have done some work on this, some of it is going back to the
mid-1990s, and the work from the 2007 and 2008 case studies tells
a slightly different picture. So I think, whereas in the mid-1990s
it was very much the finance director who was in the driving seat
in all of this, and what recommendations they made to the board
at the time would probably have been carried through. The shareholders
would very seldom challenge that. One of the significant changes
in the regulatory landscape is the rise in the role of the audit
committee in companies, which we would see as a very strong positive
in all of this. It makes the relationship in audit not so much
just the finance director and the audit partner. They were the
primary two people involved but we now have the third person,
which is the audit committee chair, as a three-way thing, and
in the background the audit committee. I think who determines
which firm is appointed would probably be very much the audit
committee chair with some consultation with the finance director.
Would you agree?
Professor Fearnley: Yes, and certainly when
I was involved in an audit appointment a couple of weeks ago,
three of us listened to the presentations: myself, the chief executive
and the finance director, and we agreed between them, and the
audit committee had delegated to me the responsibility for agreeing
who should be appointed. But it's very much the audit committee
chair engagement and the audit committee, so it isn't just the
executives now. Given that the auditor spends a lot of time with
the executives, they have to get on with each other. If they don't
like the audit partner and they don't think they can work with
that person, then they won't get appointed.
Q47 Lord Forsyth of Drumlean: Just
on that point. I am not very good at this, but if I am sitting
on an audit committee and we are going to reappoint the auditors,
I am very heavily influenced by what the management have to say.
And although you may have a private meeting where you say to the
auditors, "Is there anything you want to tell me?" or
whatever, because you are not involved in the detail of the audit.
And one of the worries that I find, sitting on an audit committee,
is because you are influenced in that way, does it encourage the
auditors to form a relationship with the management and, even
though you have the audit committee, in practice you're very much
influenced by the management view. If I am the auditor wanting
to get reappointed, I only need to suck up to them.
Professor Fearnley: I think that has always
been the case that the auditor has to get on. But since we've
had the changes with the audit committee more involved, and the
increased enforcement, out of our case study research we haven't
found any evidence of auditors rolling over and going along with
things that management wanted that they didn't think were right.
That still comes down to the individual audit partner. There is
always going to be that type of situation. It's better than it
was because we found that when we did the study in the 1990s that
there were real spats between the finance director and the audit
partner, and the finance director would threaten the audit partner
with a tender.
Professor Beattie: What seems to have happened
is that the personal relationships, which did matter in the mid-1990s
enormously, were very critical to the whole process. Because we're
now in this strong enforcement regime, strong ethical guidance,
everybody is trying to just comply with the rules. It's in everybody's
interests to comply with the rules and, in a sense, the personal
relationships are far less important that they were so many years
ago.
Q48 Lord Best: Is it regarded as
good practice, perhaps promulgated by the professional institutes,
that every so many years one goes out to tender? That would—I
can tell—be much ignored, but is that not something that
even the professional bodies regard as good practice?
Professor Fearnley: There's no guideline on
that at all. It's entirely up to the company to decide whether
it wishes to do that.
Professor Beattie: The audit committee is required
each year to review the quality of the audit and ensure it's satisfactory
and review the selection of the firm and ensure it's appropriate.
I think it would feel if it had done that—and assured themselves
on that front—it wouldn't be necessary to periodically change
auditors for the sake of it.
The Chairman: One last quick question and a
quick answer.
Q49 Lord Lipsey: Magic wand: you
can do one thing to increase competition in this industry. What
would it be?
Professor Fearnley: I don't have an answer to
that I am afraid, Lord Lipsey, but my view would be—which
I've mentioned before—to ask the firms because they would
know better than we would what could be done.
Lord Lipsey: Yes, but they also have a huge
vested interest against telling us.
Professor Fearnley: Indeed, but I am sure your
Lordships would be able to get something out of them.
Lord Lipsey: We are not allowed to use rack
and thumbscrews anymore, unfortunately.
The Chairman: I think the fact we have taken
so long in this first session is a reflection of the excellent
start you have given to us, even if you have left the last answer
to us and not to you. So thank you very much indeed for coming.
We are very grateful for your contribution. Thank you.
Professor Fearnley: Thank you for inviting us,
Lord MacGregor.
| 
