Auditors: Market concentration and their role - Economic Affairs Committee Contents

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.

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