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


Supplementary memorandum by Professor Stella Fearnley, Professor Vivien Beattie and Tony Hines (ADT 3)

RE: EVIDENCE GIVEN AT THE HEARING ON 25.01.2011

  At the committee's request we have reviewed the evidence relating to questions 540-547 given by Mark Hoban MP (MH), Ed Davey MP (ED) and Richard Carter (RC). The following issues were referred, to and we comment on each in turn based on our own research and also on publicly available sources.

    1. Whether, since the introduction of IFRS in the UK for 2005 year ends, accounting and auditing has become more rules based than principles based;

    2. Accounting measures economic value much more than historical cost;

    3. IAS 39 the financial instruments standard is under revision;

    4. The only IFRS standard which is significantly different from UK GAAP is IAS 39;

    5. Accounts are not a substitute for prudential returns;

    6. Asking auditors to change their traditional binary approach (to reporting) would create a lot of difficulties;

    7. The losses sustained by the banks were greater than the bonuses and dividends paid out;

    8. The position of the principle of prudence under IFRS.

1.  WHETHER, SINCE THE INTRODUCTION OF IFRS IN THE UK FOR 2005 YEAR ENDS, ACCOUNTING AND AUDITING HAS BECOME MORE RULES BASED THAN PRINCIPLES BASED

  There is a difference of opinion between MH and ED on this matter. Our research with finance directors, audit committee chairs and audit partners of UK listed companies finds that these three preparer groups believe that accounting has become more rules based and auditing is more process driven then under UK GAAP and UK auditing standards. We attach chapter 14 of our forthcoming book which the Committee may find helpful.

2.  ACCOUNTING MEASURES ECONOMIC VALUE MUCH MORE THAN HISTORICAL COSTS

  This statement by MH does not reflect what IAS 39 actually delivered in the crisis, as the economic value of the loans and financial instruments was grossly overstated. Therefore the accounting model, as applied in the crisis, could not be relied on to deliver economic value as it did not distinguish in all cases between price and value. It failed.

3.  IAS 39 THE FINANCIAL INSTRUMENTS STANDARD IS UNDER REVISION

  This revision was referred to by all three witnesses. However we have two major concerns about the need for revision. First, the IASB has set itself up as a body fit to set accounting standards for the whole world and yet, within two years of its standards being adopted in the UK and the rest of the EU, the banking sector, which is at the heart of a capitalist society, was reporting grossly inflated profits in compliance with this new regime. Second, because of the convoluted process of agreeing change, which is inevitable with a body which purports to serve the world, it will be some years before IAS 39 is changed and adopted by the financial sector. This time delay was referred to by Steve Cooper, an IASB board member, in his evidence to the Committee on 18 January 2011. Some minor changes have already been made to IAS 39 but profits could continue to be misrepresented until all the changes are agreed and introduced.

  Our view is that the IASB cannot be trusted to deliver high quality standards.

4.  THE ONLY IFRS STANDARD WHICH IS SIGNIFICANTLY DIFFERENT FROM UK GAAP IS IAS 39

  Our research indicates that IFRS differed from UK GAAP much more widely in 2007-8 that ED suggests eg accounting for: intangible assets and goodwill; employee benefits; share based payments; deferred tax and segmental reporting. All of these topics were the subject of criticism from preparers. Also there was wide criticism of the complexity of the standards and length of disclosures required. Concerns were expressed that non-accountant board members had difficulty understanding their company's accounts after the change to IFRS. The UK Accounting Standards Board has been changing UK GAAP to IFRS but originally major differences existed between the two.

5.  ACCOUNTS ARE NOT A SUBSTITUTE FOR PRUDENTIAL RETURNS

  We find this comment by MH disturbing. This is a view included in the IASB's latest conceptual framework for the preparation of financial statements (IASB, 2010). This framework now claims that:

    "the objectives of general purpose financial reporting and the objectives of financial regulation may not be consistent, hence regulators are not considered a primary user and general purpose financial reports are not directed to regulators and other parties. " [F OB10 and F BC.1.20-BC 1.23].

  We are concerned that this statement implies that accounting information as mandated by the IASB is not for regulators. If accounts are claimed to be general purpose this makes no sense as the objectives of other users may also differ. We do not understand where regulators get their information from if it is not based on the audited accounts. Protection of capital is a primary issue for shareholders, regulators and other users of accounts.

  Our view is that it is an attempt by the standard setters to deny their responsibility to regulators and to make their framework fit with what they are currently doing and wish to do going forward.

6.  ASKING AUDITORS TO CHANGE THEIR TRADITIONAL BINARY APPROACH (TO REPORTING) WOULD CREATE A LOT OF DIFFICULTIES

  We do not support this comment by ED. He does not explain what sort for difficulties would be encountered and it would be helpful to know. We can see no reason why the auditors should not provide more information about the quality of earnings. The more responsibility is passed on to the audit committee, the less valuable audit becomes. It should be borne in mind that although audit committees are usually composed of independent directors, they are still directors of a company under the UK unitary board model, thus they are not independent to the same extent as auditors are required to be.

  Our view is that auditors do not wish to change their audit report and prefer further responsibility to be passed on to the audit committee, probably because of liability concerns. The audit committee, although making a valuable contribution to the integrity of financial reporting is not a substitute for the auditor. Auditing requirements are not subject to an EU regulation and could change under UK law and regulation.

7.  THE LOSSES SUSTAINED BY THE BANKS WERE GREATER THAN THE BONUSES AND DIVIDENDS PAID OUT

  RC made this point. Our view is that it would have been even more disturbing if the banks had paid out all their false profits in bonuses and dividends and added nothing to reserves. This comment does nothing to mitigate the effect of imprudent accounting.

8.  THE POSITION OF THE PRINCIPLE OF PRUDENCE UNDER IFRS

  There is some confusion about this issue. RC and ED refer to prudence. RD refers to the IFRS standards and ED refers to the IFRS Framework. These are different documents. The IAS Framework (for the preparation and presentation of financial statements (2001) which is currently applicable is subordinate to the standards themselves. Para 3 states that if there is a conflict between a standard and the Framework, the requirements of the standard prevail. The 2001 Framework sets out primary qualitative characteristics of financial statements and includes prudence as part of the qualitative characteristic of reliability. Other principal characteristics are: understandability; relevance; and comparability.

  Prudence is defined as:

    Assets or income are not overstated and liabilities or expenses are not understated.

  A caveat continues:

    "The exercise of prudence does not allow, for example, the creation of hidden reserves or excessive provisions, the deliberate understatement of assets or income or the deliberate overstatement of liabilities or expenses, and therefore, the financial statements would not be neutral and therefore not have the quality of reliability. " (para 37)

  The other characteristics of reliability in the 2001 Framework are: faithful representation; substance over form; neutrality and completeness. IAS 39 as a standard would override prudence. Our view is that the prevention of hidden reserves or excessive provisions and the overstatement of liabilities or expenses is a matter for auditors not standard setters. Even if there was what is often referred to as "earnings management" in the banks, this would be preferable to the imprudent outcome of IAS 39.

  The Committee may also wish to note that the IASB Framework has recently been revised (IASB, 2010) and both prudence and reliability are no longer in the Framework. The current primary characteristics are: relevance; faithful representation (with a subordinate quality of neutrality); comparability; verifiability; timeliness; and understandability.

  Our view is that leaving prudence and reliability completely out of the current Framework takes away some the judgements that auditors may face and denies the principle of substance over form for shareholders and regulators. Faithful representation and verifiability are much easier to check. The new IASB framework is now the same as the US Framework and therefore is subject to greater influence relating to litigation defence. This again undermines the value of audit.

  We hope these comments are helpful for the Committee.

3 February 2011




 
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