Memorandum by the Institute of Chartered
Accountants in England and Wales (ADT 6)
INTRODUCTION
The Institute of Chartered Accountants in England
and Wales (ICAEW) welcomes the opportunity to submit evidence
in response to this House of Lords Economic Affairs Committee
inquiry.
ICAEW is committed to working with Government
and regulators as well as wider market participants in order to
help maintain economic confidence. Our 134,000 members work across
every sector of the economy leading and advising organisations
of all sizes. They include auditors, executive and non-executive
directors, investors, regulators and wider market participants.
By drawing on their collective expertise we are well placed to
comment on the issues raised by the Committee.
BACKGROUND
While it will take a number of years before
the causes of the financial crisis are fully understood, evidence
to date indicates that it was caused by a combination of sub-prime
lending and a dramatic fall in property prices in the US. The
collapse in confidence across capital markets that followed was
fuelled by doubts about the viability of financial institutions
holding significant assets that depended directly or indirectly
on property lending or wholesale market funding.
Concerns about the relative strength of the
capital base of these institutions led to a meltdown in the liquidity
available to them, which cumulatively resulted in a sharp contraction
of funds available to the banking system generally and the ability
of banks to provide credit to consumers and businesses. As financial
institutions have come under pressure from regulators to restore
capital ratios to prudent levels this has continued to limit the
amount of lending that is taking place, resulting in a significant
decline in economic activity.
The speed at which all this happened was dramatic.
A number of well known financial institutions were swept away,
amalgamated or nationalised. Governments across the world were
forced to underwrite failing industry sectors at a cost of many
billions. Orthodoxies that governed economic behaviour over the
previous decade were thrown into question. The real economy is
only beginning to move from recession to fragile recovery.
In these circumstances it is right that our
financial systems be scrutinised. All market participants need
to think hard about the lessons of the past two years and be prepared
to take the necessary steps to ensure that the risk of this happening
again is mitigated.
The audit profession, which plays an integral
part in the effective operation of capital markets and the wider
economy, is no exception.
The past 24 months have tested auditing reforms
adopted in the UK after Enron as well as the work undertaken through
avenues such as the Audit Quality Forum. The evidence to date
suggests that in the main, auditors have been performing an important
role with diligence in the face of challenging economic circumstances
and that recent reforms are holding up well.
Part of the auditors' contribution has been
to challenge asset valuations, which has contributed to companies
having to revalue their assets, in certain cases requiring a considerable
reduction in values in order to give a true and fair view in accordance
with the relevant financial reporting framework. These revaluations
have contributed to the falling financial performance of banks,
reductions in share price and criticism of their directors in
general meetings of shareholders as well as the media.
However, over the past 18 months ICAEW has been
examining what lessons can be learnt from the crisis and how audit
needs to evolve to meet changing market expectations. Our Financial
Services Faculty has led on this work. Key recommendations are
included in the report "Audit of banks: lessons from the
crisis" which we have appended to this submission. In
particular, we believe that improvements can be made in terms
of the way risk is reported by banks. We also think there is a
need for better dialogue between auditors and bank supervisors.
To this end and at the request of the Bank of England we are participating
in a Working Group to look at the flow of critical information
on banks between the regulator and auditors.
This House of Lords Committee inquiry is a timely
and important contribution to the current debate. It builds on
the Committee's June 2009 report into Banking Supervision and
Regulation to which ICAEW also submitted evidence.
Three key points inform our written submission:
— This has not been an audit driven crisis
and UK audit quality remains world leading.
— The audit profession, along with other
market participants, must nonetheless reflect on what lessons
can be learned from what has happened over the past two years.
— This has been a global crisis and reform
proposals must therefore be capable of implementation across markets.
UK audit firms belong to international networks
and audit UK businesses that are international in their operations.
We urge the Committee to ensure that hasty responses to the current
crisis at the national level do not inadvertantly sow the seeds
of a future crisis.
ICAEW has been invited to give oral evidence
to the Committee in October when we will be happy to expand on
any of the points set out in this submission.
RESPONSES TO
SPECIFIC TERMS
OF REFERENCE
Why did auditing become so concentrated on four
global firms? For example, do economies of scale make it too difficult
for smaller firms to compete?
1. The current concentration of firms providing
audit services to the listed company sector has largely been driven
by the behaviour and economic choices of these companies as well
as the growth strategies of these firms.
2. When the audit committee of a listed
company looks to appoint an auditor, what drives this choice is
the need to ensure that the firm has the necessary breadth and
depth of expertise. Those who appoint auditors should not be motivated
by the need to ensure diversity in the audit market but the need
to ensure auditors do the best job for their shareholders. From
the perspective of the individuals who make these appointments
there are incentives to gravitate towards an internationally recognised
brand with the global reach that this brings.
3. While greater choice across the FTSE
audit market is clearly something we would welcome what matters
ultimately is that audit quality remains high.
4. This issue of market concentration has
been looked at by the UK Government and the European Commission
both of whom commissioned independent research[5]
in this area. It was also examined by the Audit Quality Forum,
whose work fed into a two year project undertaken by the Market
Participants Group (MPG) of the Financial Reporting Council. The
MPG identified a range of long-term, market driven steps that
could be taken to increase competition and choice which are now
being implemented. It is too early to assess the impact of these
measures (the Audit Firm Governance Code for example was only
introduced earlier this year) and they should be kept under close
review. It is also worth noting that the European Commission is
likely to revisit the issue in its forthcoming Green Paper on
audit.
5. Economies of scale certainly create barriers
to entry. The Oxera report made the point that "any new entrant
would need to overcome perception barriers and demonstrate sector-specific
skills, international coverage and high quality staff to win audits".
This is not easy given the difference in size between the four
largest firms and other major international networks. Other barriers
also exist. For example, the European Union's Directive on statutory
audit sets certain minimum control requirements for audit firms.
These may prevent external capital providers funding a smaller
firm as it seeks to become larger.
6. It is also important to remember that
the current situation has arisen through market demand with the
largest firms growing their audit services to meet the global
needs of their clients. In many ways this process has been a success
story for the UK economy as the UK arms of the dozen or so largest
international network firms as well as many of the mid-tier practices
have been at the forefront of driving quality, innovation and
capability in this industry sector.
Does a lack of competition mean clients are charged
excessive fees?
7. No. We are not aware of any evidence
to support a claim that audit clients are charged excessive fees.
While there are relatively few firms currently serving the listed
company sector those that serve the market compete fiercely with
each other on price as well as other differentiators. Competitive
tendering or the threat of it across this sector ensures the firms
are kept on their toes.
Does a narrow field of competition affect objectivity
of advice provided?
8. No. In our view the competitive structure
of the current audit market does not have a significant bearing
on auditor objectivity. Of far greater significance is the investment
in training and development within the firms and the professional
standards and ethical codes to which auditors must adhere, as
well as the regulatory and oversight regimes that are currently
in place to ensure that quality and objectivity are maintained.
The learning and professional development students must undertake
in order to qualify into the profession requires them to develop
a range of skills in ethics, professional judgement and scepticism
intended to ensure the objectivity of their work.
9. In January 2010 the FRC and ICAEW published
the Audit Firm Governance Code. The Code applies to eight audit
firms that together audit about 95% of the companies listed on
the Main Market of the London Stock Exchange. For these firms,
the Code sets a benchmark for good governance which other audit
firms may wish to voluntarily adopt in full or in part and requires
explanation for non-compliance. The Code sets out expectations
of the role of independent non-executives in the firms' governance
structures. It also codifies much existing good practice and references
matters that audit firms must comply with as regulated professional
partnerships.
Alternatively, does limited competition make it
easier for auditors to provide unwelcome advice to clients who
have relatively few choices as there is less scope to take their
business elsewhere?
10. No. Again we would argue that the competitive
structure of the current audit market does not have a significant
bearing on auditor objectivity. Auditors are subject to significant
independence requirements which are designed to protect objectivity
and the ability to challenge and disagree with directors' opinions.
What is the role of auditors and should it be
changed?
11. Auditors give shareholders confidence
that financial information reported by a company is "true
and fair". They do this by following a process whose standards
are set and enforced by independent regulators. The role of auditors
under UK law is explored in detail in the Audit Quality Forum
publication Audit Purpose which is available on the ICAEW
website at www.icaew.com.
12. An audit does not provide absolute assurance
about the state of a company's financial health. The operation
of a business involves judgements on a wide range of areas and
this brings with it risk. No matter how strong financial reporting,
auditing and corporate governance measures may be, they cannot
eliminate bad business models or poor judgements by directors.
13. In the wake of the financial crisis
all market participants need to reflect on what lessons can be
learned to help mitigate the risk of these events happening again.
To this end ICAEW has recently published a set of recommendations
for improving the audit of financial institutions, Audit of
Banks: Lessons from the Crisis published in June 2010:
Risk information is often presented in a piecemeal
manner in bank annual reports, spread between the audited financial
statements and the unaudited front sections. Banks need to focus
on clearer presentation which allows users to understand the big
picture, which is currently often obscured by the volume of detailed
information. Summary risk statements are a potential way of providing
this big picture. Auditors should be asked to provide assurance
on new summary risk statements to provide confidence to readers
of financial statements.
Audit committees have an important role to play
in supporting better reporting. Auditors play a key role in making
sure audit committees are equipped with the information they need
to perform their role. A guide to good practice in audit committee
reporting would help improve performance.
Insufficient information is provided under the
current framework about the work that underpins an audit. This
makes it difficult for investors to assess the performance of
bank auditors or to understand the key areas of challenge. To
address this gap, banks should confirm that key areas of judgement
discussed with auditors are set out in the critical accounting
estimates and judgements disclosures in the financial statements.
Our Financial Services Faculty is setting up a forum for investors
and auditors to help make the audit more transparent. Auditors
should also have more involvement in reporting on the front sections
of annual reports. Their responsibilities for this are currently
very limited.
Dialogue with supervisors
Regular exchange of information between auditors
and bank supervisors enables both parties to perform their duties
more efficiently and effectively. Dialogue between auditors and
banking supervisors was not consistently good enough before the
crisis, with the regulator not placing sufficient value on such
dialogue. There have been improvements in both the frequency and
quality of dialogue but this remains variable and is dependent
upon the attitude of individual supervisors. Further improvements
are needed, including improvements to promote greater consistency
between supervisors and ensure that discussions are a two-way
process for information sharing.
Auditors and other external experts have particular
skills that can support banking supervisors in performing their
functions. Supervisors have the power to utilise these skills
but have done so rarely, typically only where particular problems
have been identified. There is scope for making greater use of
external experts on a thematic basis, as part of supervisors'
overall monitoring regime and as preventative or diagnostic measures.
Were auditors sufficiently sceptical when auditing
banks in the run-up to the financial crisis of 2008? If not, was
the lack of competition in auditing a contributory factor?
14. Notwithstanding concerns expressed recently
by regulators we have seen no hard evidence to support claims
that auditors were not exercising a high degree of professional
scepticism in the run-up to the financial crisis whether as a
result of a lack of competition or any other factor. Successive
reports from the independent Audit Inspection Unit (AIU) have
indicated that UK audit quality remains high.
15. The increased number of going concern
qualifications and "emphasis of matter" modifications
in audit reports over the past two years[6]
suggests that auditors have continued to push back where they
felt the need to do so.
What, if anything, could auditors have done to
mitigate the banking crisis? How can auditors contribute to better
supervision of banks?
16. Auditors were operating in the same
environment as other market participants including regulators
and Government and, like these other market participants, did
not anticipate the systemic collapse in confidence across the
capital markets that was fuelled by doubts about the viability
of certain specific financial institutions. As the House of Commons
Treasury Committee (TSC) concluded in May 2009 "we have received
very little evidence that auditors failed to fulfil their duties"[7].
17. The banking crisis did however highlight
weaknesses in the level of dialogue between auditors and bank
supervisors. Meetings between auditors and the FSA were too infrequent,
the range and quality of information shared by bank supervisors
with auditors was limited, and the FSA had no obligation to share
relevant information with the auditors. In hindsight, better channels
of communication may have helped mitigate some of the effects
of the crisis.
18. The need to improve the level of engagement
has been acknowledged by the FSA and this has been improving since
the start of the crisis.
19. Moving forward, auditors have an important
role to play in better supervision of the banking sector. Auditors
and other experts have particular skills that can assist banking
supervisors in performing their functions.
20. As part of the improved dialogue between
auditors and supervisors there needs to be a better balance of
information shared. Currently there is a duty on auditors to report
matters to the FSA which may be material to their supervisory
responsibility but no corresponding duty on the FSA to share information
with auditors that may be material to the audit. It would also
be helpful for auditors to raise concerns with senior management
within regulators if they consider the level of engagement from
the supervisory team is inadequate.
21. To support the regulator in its supervisory
work auditors could look at areas of risk in greater detail during
the audit. Under section 166 of the Financial Services and Markets
Act (FSMA), the FSA can commission a report to be prepared by
a "skilled person" (s166 reports). Skilled persons include
bank auditors. These reports could be used by the FSA on a thematic
basis, or as a diagnostic and monitoring tool where the regulator
is seeking to identify risks or problems in the system, or in
assessing performance or compliance. The resulting exchange of
information could be a powerful tool in the better supervision
of banks.
How much information should bank auditors share
with the supervisory authorities and vice versa?
22. As a guiding principle, bank auditors
should be prepared to disclose anything to bank supervisors and
vice versa. How this can be achieved in practice is something
ICAEW is currently working on with the Bank of England, the FRC,
the FSA and the major audit firms.
If need be, how could incentives to provide objective
and, in some cases unwelcome, advice to clients be strengthened?
23. There are already very strong incentives
for auditors to be objective. They report in accordance with independently
set standards on the truth and fairness of financial statements,
adhere to rigorous independence and ethical requirements and are
subject to regulatory oversight. All of these requirements act
as a check and balance on the professional judgement that they
exercise. In recent years the AIU has also reported annually on
the quality of individual firms, providing another important incentive
for auditors to be objective.
Do conflicts of interest arise between audit and
consultancy roles? If so, how should they be avoided or mitigated?
24. Yes. Conflicts of interest are one of
a number of potential sources of threats to auditor independence
which arise as a result of self-interest, self-review, advocacy,
familiarity and intimidation. These threats are dealt with through
effective disclosure as well as a regime of safeguards, selective
prohibitions on consultancy services and, crucially, review by
the audit committee, which is central to UK corporate governance.
25. There will be always be specific circumstances
where the provision of non-audit services is unacceptable and
ICAEW believes the current framework should be kept under constant
review. However, there is no evidence that the provision by auditors
of non-audit services to listed entities that they audit has actually
compromised audit quality and we do not believe that the provision
of these services diminishes audit quality. Our understanding
is that the overwhelming majority of respondents to the current
Auditing Practices Board (APB) consultation on non-audit services
see the current regime as largely effective and reject outright
prohibition of non-audit services as proposed by the TSC in favour
of better disclosure provisions.
(a) Should more competition be introduced
into auditing? If so, how?
26. As a general principle we support greater
choice in the audit market. We also believe the current industry
structure is the result of market dynamics which would limit the
effectiveness of any direct market intervention. Market based
measures such as those set out by the Market Participants Group
of the FRC should prove most effective and durable over time.
(b) Should the role of internal auditors
be enhanced and how should they interact with external auditors?
27. Yes. Internal auditors should have a
leading role within an organisation in providing assurance on
the management of risk. The remit of internal audit should, in
theory, be very wide-ranging across all parts of an organisation.
Although its role is set by the board, the audit committee and
management, in practice what internal audit can actually achieve
is limited by resources and expertise. Their work should be focused
on areas of greatest risk within the organisation which often
go well beyond financial risks and controls.
28. The relationship between internal and
external auditors is established by standards for external auditors.
It is good practice, even if external auditors decide not to use
the work of internal auditors, for there to be good communication
between the two functions. Internal audit can be a useful source
of information about the risks and controls within the organisation
and how management are addressing these issues. However, external
auditors do need to remember that internal auditors are responsible
to companies and not investors and be mindful of this distinction.
(c) Should the role of audit committees
be enhanced?
29. Yes. Audit committees have a vital role
to play in terms of promoting good corporate governance and in
challenging management. Their responsibilities have evolved over
time and been considered again by the Walker Review on Corporate
Governance in Financial Institutions, and also by the recent wider
review of corporate governance conducted by the Financial Reporting
Council. In particular we would support more information being
made available by audit committees about their discussions with
auditors, to provide evidence that auditors are performing their
duties with due rigour, to ensure wider stakeholders are better
informed about the way in which audit committees handle their
governance responsibilities and to provide greater clarity around
the nature of the judgements the company has made in the accounts.
(d) Is the auditing profession well
placed to promote improvement in corporate governance?
30. Yes. Although it is for companies themselves
to determine their governance structures, auditors are an integral
part of the corporate governance process and have a duty to report
matters of significance and provide challenge to management's
critical accounting estimates. This normally happens through the
audit committee.
31. ICAEW has established a working party
that will publish guidance in early 2011 to strengthen the consistency
and quality of communication between auditors and bank audit committees.
This will improve corporate governance in banks, as it will enable
audit committees to better challenge executive directors on accounting
judgements and estimates and financial statement presentation.
24 September 2010
5 Oxera Report and London Economics Report. Back
6
Deloitte research. Back
7
Treasury Committee Report: "Reforming corporate governance
and pay in the City", 15 May 2009, paragraph 221. Back
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