Examination of Witnesses (Questions 50-82)
Mr Charles Tilley, Ms Helen Brand, Mr Robert Hodgkinson
and Mr Iain McLaren
19 OCTOBER 2010
Q50The Chairman: Welcome to you all. I am Richard
Best. I am taking the chair because Lord MacGregor cannot be with
us today. The interests of the different Members are in the Register
and people will declare any special interest in today's proceedings.
Two members of the Committee, Lord Currie and Baroness Kingsmill,
are not taking part in this inquiry but the rest of us are. Let
me get you in the right order. Ms Brand, Mr Tilley, Mr Hodgkinson
and Mr McLaren, you are all extremely welcome. Thank you very
much for joining us and thank you for the extensive written evidence
that we have received from all of you. We would be grateful if
you could speak in a loud clear voice for the transcript and for
the webcast that will be made. When we come to the question time,
please do not repeat what has already been said by one of your
colleagues. We will take silence to mean you agree with what has
already been said, since we have got all four of you behind us,
but if you disagree with anything that has been said please do
join in. Would any of you or all of you or none of you like to
make an opening statement, or can we go straight into the question
Mr Tilley: Thank you. If I could have a brief
opportunity to make an opening statement, and thank you for that
opportunity. I represent CIMA. Our members do not undertake audit
activities themselves but are in senior positions in business
and are therefore very interested in the effectiveness of audit.
At the present time we believe that audit itself is fit for purpose
in terms of the review of financial statements. Having said that,
we believe that there is a missed opportunity in that audit is
narrow in terms of its focus on the financial statements and there
is obviously a great interest in knowing about the long-term financial
sustainability of organisations. The annual report is an important
mechanism in communicating the stewardship of the board in judging
whether the company is being run in an effective, sustainable
manner. Putting those statements together is very challenging
to do well and we believe well managed businesses do that well.
If they find putting those statements together difficult then
potentially it is because they are not so well managed.
So we believe that reporting at the front end
of the annual review is very important. There are various initiatives
being undertaken to look at that but I think an opportunity is
there for assurance of that report and therefore looking at the
long-term sustainability of the organisations. Just one other
point to make: this is obviously a global issue as well as a national
issue, requiring, therefore, international agreement in many aspects
and we should not underestimate that challenge. Thank you very
Q51 The Chairman: Thank you. Does
anybody else wish to make an opening statement? Good. Well, perhaps
we could go into the questions. I would like to begin with one
about the professional bodies themselves, if I may. As an outsider,
you seem a somewhat fragmented group in that there are, I think,
six professional bodies representing accountants and indeed auditors.
Do you think that this makes for the most efficient way of operating
and do you think possibly it means that today we will get some
contrasting views, because some of you may have more of your membership
and your income from the Big Four firms of auditors and some of
you may not? Might there be something helpful to us today in getting
some contrasting views or is there a major downside in having
so many bodies all representing the profession?
Ms Brand: Thank you. I think that as in the
audit market, competition in the professional bodies is also healthy
and it probably does drive up quality and standards in that respect.
ACCA, as you are probably aware, is a global organisation. We
now have over 50% of our membership and 85% of our student base
outside the United Kingdom, so I think we do operate in different
kinds of markets and we do deliver different things to the market.
So I think there is value in the diversity that you see before
you and I do think there is a possibility you will hear some different
views as we go through this today.
The Chairman: Thank you very much.
Mr McLaren: I would take the point on efficiency
but it has to be balanced with what we give the public interest
and business, in terms of being diverse. There is no doubt that
the reputation of all our professional bodies relies on the quality
of the people that we manage to attract and I think it is accepted
that a very good job has been done there. We get very high-quality
graduates and non-graduates into the accounting professions. But
it seems to me if we were to consolidate, one of the things that
would be lost would be an element of competition. Certainly, in
terms of audit training we compete vigorously, particularly with
the English institute, and our customers tell us that they appreciate
that. No one in this day and age likes to have a sole supplier.
It is a very risky position for a busin`ess and I think there
is quite a compelling argument to continue for that reason. I
think the other thing that should be borne in mindif there
were great public interest drivers to achieve consolidation maybe
they would take precedenceis that at the end of the day
we are all member organisations with long histories. My own is
156 years. Given that they are membership organisations, what
we hear from our members currently is that they would not welcome
any consolidation. In fact, contrary to perhaps public perception,
Scots CAs pay £100 a year more than their English counterparts
for that privilege.
The Chairman: Thank you very much. No
more comments on that?
Q52 Lord Tugendhat: Do you think
there is strong competition in the audit market for the audit
of large entities? I am thinking not just of FTSE 100 but of the
top echelon of FTSE 100, in particular the banks. Do you think
there is strong competition? If so, can you tell me, please, how
does it manifest itself?
Mr Hodgkinson: Maybe I could start off by saying
of course there is concentration for the largest audits and that
is recognised. I think that also therefore has an impact on choice
but I think we need to distinguish the range of choice from the
degree of competition. So far as the public are concerned I think
the question around concentration is whether the audit market
works in delivering quality and innovation and whether auditing
regulation works in terms of public accountability. I won't answer
at too great a length but there is plenty of evidence that we
can bring forward to say that the audit market delivering good
outcomes happens but that is not grounds for being complacent.
Certainly my body is very keen to show that we've been contributing
to thinking about how you can enhance public confidence that,
despite lack of choice, there is competition and it is delivering
Q53 Lord Tugendhat: I am not clear
how it manifests itself. One can compete on price, one can compete
on service, one can compete on the fact that one has a record
that people do not get into trouble if they follow your advice.
I have hired auditors in my time. I would be interested to know
how you think they compete with each other. What are the selling
Mr Hodgkinson: I think rather than focus on
the selling points, which are important, it is worth looking at
this from the buyer's perspective. Audit committees have over
the past 10 years assumed a far greater role in making sure that
the choice of auditors is being exercised in a competitive and
challenging way. So there are audit committees and the guidance
and reporting that they produce about what is happening in the
audit. We also need to bear in mind that buyers of the service
have a lot of evidence to hand on the results of public inspections.
Only last month the Audit Inspection Unit published detailed reports
on its examination of individual audits, and the results of examination
of individual audits are communicated to the audit committees
involved. So I think that the public can have a degree of confidence
that auditors are challenged and there is always that threat of
Q54 Lord Tugendhat: Let me ask you
one other question. We have only four big audit firms and we don't
have that many big banks either for that matter. You have a situation
where one of the big banks puts its audit out to tender and an
audit firm is anxious to secure that piece of business. Even in
a big audit firm there is a limit to how many good auditors you
have. Isn't there a danger that in order to get the business of
the newcomer, bank A, the existing client, bank B, finds that
its audit team is a bit denuded? There is a limit to how many
auditors you have. They are not all equally good. Can you really
tell me, hand on heart, that a firm of auditors can offer an equally
good service to three banks rather than if it had only one bank?
Mr Hodgkinson: That is a good question and it
is not the sort of question that maybe I can best answer because
it is precisely the sort of question that an audit committee chair
would put to people proposing for their audit, and it is a valid
question. There is always this trade-off that we have to deal
with. Some of the entities at the top end of the FTSE that we
are talking about are hugely complex, difficult organisations
to audit and talent is limited. That is part of what has driven
Q55 Lord Tugendhat: But if I may
say so, and I have been on audit committees doing this, you are
telling me what the audit committee might ask. You are a professional
outfit. Can you not give me an opinion as to what the answer to
my question might be rather than telling me I must go and ask
Mr Hodgkinson: Well, both in the work that we
do and the Audit Inspection Unit does the question would relate
to the fundamental ethical obligation on professional accountants,
including auditors, which is not to take on work that you are
not equipped to take on. That is the starting point for professional
responsibility. So it is the sort of question that is asked of
Q56 Lord Tugendhat: I can see that
you are reluctant to give a view on the question I have asked.
Mr Hodgkinson: The results of the public inspections
indicate that that isn't a problem. When you look at the reports
of the Audit Inspection Unit I would struggle to recall one that
questioned the industry expertise and competence of audit teams.
There are other issues but I do not think that fundamental
Q57 Lord Tugendhat: It is some years
since I have been in a position on an audit committee, but certainly
when I was that question did arise and I remember we took a view
that the firm of auditors already was unable to provide a service
of equal quality, but maybe things have changed since then.
Mr Hodgkinson: I would think you would therefore
switch the auditor if that is the case. That is the market discipline.
Q58 Lord Smith of Clifton: You say
under the professional ethics a company should not take on an
audit if they were not competent. Would one of the Big Four say
they cannot do it because they do not feel they have a range of
expertise to handle this additional client? Has there ever been
a case where they have said, "We'll have to withdraw from
this tender because we don't feel we have a sufficient number
of experts to handle this particular large client"?
Mr Hodgkinson: Well, I am sure there has been.
I am not privy to the audit tendering process, but it would also
be part of the assessment of the audit committee as to who to
invite to tender. I am pretty convinced that expertise is not
at the heart of the concerns that we need to address. I accept
there are concerns about consequences of concentration, non-audit
services and audit expectation gaps but, if I might say so, it
is an unusual challenge of expertise.
Q59 The Chairman: Can we have a view
from Mr McLaren and then from Ms Brand?
Mr McLaren: I was in a Big Four as an audit
partner for 27 years, until about three years ago, and I take
your point, no, I do not think there ever has been a case to my
knowledge where the firm has declined. There may have been a conflict
in perceptions because you had another client who might take a
dim view, but that is a separate issue on which you have to form
a view. If we just go back to banks, banking is a global business.
I certainly know within my old firm from people who had worked
in Deutsche Bank that it was all conducted in English. The Germans
speak good English and came across here; Dutch people move across;
I think Deloitte have moved American partners. For these very
large clients that you are talking about there is not an issue,
because the big firms will look at them on a global basis and
there is enough resource to deal with that. The other point I
would make is I think you are all aware of the five-year rotation
for these clients. So you do have an ongoing pool of partners
who perhaps come off one of the very biggest banks, might be doing
some other less important work and then that can be incorporated
along with another bank if the opportunity came along. So I really
do not think that in practice in my experience there is a fundamental
Ms Brand: I was going to agree about competence
not being the issue around this but I do think, as was suggested,
there is a risk associated with the small number of firms available
to conduct the audit and that risk of failure of one of those
firms does create an issue. ACCA would certainly be supporting
moves to broaden that choicegenuine choice, so they can
compete properly for those auditsto mitigate that risk
Q60 Lord Maclennan of Rogart: Analogous
to the medical profession, would there be any advantage in centrally
undertaking a proportion of the annual audit work that relates
to systemic risk so that the results of the work could be made
available to audit firms to factor it in to their individual audits,
such as, for example, a consideration of banking clients as going
Mr Tilley: I think that process has taken place
in the past. The Financial Reporting Council addressed precisely
the issue of a going concern about this time last year and I think
it was very helpful to audit committees on one side and the audit
firms on the other in terms of addressing the issues that arose.
I think identifying systemic risk more widely and what could possibly
be done would be extremely challenging.
Q61 Lord Maclennan of Rogart: My
understanding, Mr Tilley, is that the Financial Reporting Council
engaged in that after the event.
Mr Tilley: It was after the start of the financial
crisis but it was extremely helpful in terms of addressing the
year-ends that were coming up. It was either last year or the
year before. Iain, I don't know if you can remember.
Mr McLaren: The year before.
Ms Brand: The year before.
Mr Hodgkinson: Could I just talk about something
as well that has been and is in progress to help with the issue
that you identify? We produced a report on Audit of banks:
lessons from the crisis, which was looking at things that
could actually be done, and on 22 November there will be, as we
recommended in that report, a coming together of investors in
financial services, financial institutions and their auditors
to talk about concerns affecting the industry as a whole for the
coming reporting season. It was a suggestion that we made in that
report that we are acting on that there should be wider sharing.
Whether it directly fits the medical analogy I do not know, but
we are trying to make sure that concerns can be voiced and shared
ahead of the reporting season.
Q62 Lord Lawson of Blaby: I would
like to come in on the question of the banks, because that is
what concerns me very greatly indeed. It is quite clear, and I
think it is generally accepted, that the banking supervision in
this countrynot exclusively in this country, but let's
focus on this countryfailed badly. This was a combination
of a flawed system and unsatisfactory performance by the supervisors.
What concerns me in the context of our inquiry is that I know
of no case where auditors caught catches which the supervisors
dropped. I know of no case where bank auditors assisted the supervisors
in catching the ball. Therefore it is in that context I would
like to ask you what you think should be done. I shall make it
a bit more specific. You will have read the document by the Financial
Services Faculty where among their specific recommendations, if
I may read them out, they said that auditors should "be proactive
in setting up regular meetings with supervisors". They should
"be open in dialogue with supervisors; and raise concerns
at a higher level within the regulator if they consider that the
level of engagement from supervisors is inadequate". Do you
agree with that? What should be done about it? Do you feel inhibited?
When I framed the 1987 Banking Act, which is concerned largely
with this area, I had considerable resistance from the accountancy
profession, who said that confidentiality prevented them from
saying anything at all to the supervisors. Do you still hold that
view? It does not seem to me that it is in the public interest.
Mr Hodgkinson: Can I respond in the first instance?
There were a lot of points, so forgive me if I do not pick them
all up. The Financial Services Faculty report I must agree with
since it is ICAEW's Financial Services Faculty that raised that
point and we have already started to take pragmatic proposals
to carry forward that suggestion and establish the protocols for
re-establishing better dialogue. I think there will be three meetings
before Christmas of a group that we helped to convene, with the
Bank of England, the FSA and the major audit firms, to look at
how that dialogue works better. Maybe if I just go back to the
point that you made about auditors catching things. It is one
of the difficulties of the audit profession and the public trust
in it that when auditors catch things or influence outcomes it
is quite invisible. That is just because of the nature of the
reporting that auditors do. I think some of the research from
Professors Beattie and Fearnley, who I know you have spoken to,
helps to show that a lot happens behind closed doors and that
the audit process does change outcomes but it does it in a way
that is not readily apparent. That leads to proposals for a longer,
more informative form of audit reporting, which always hit problems
because there are difficulties about having the auditors talking
about what has happened behind closed doors. Our proposal in that
Financial Services Faculty report, to try and bring some sunlight
into this and break this logjam of audit reporting, is to say
that audit committees do have the opportunity to report in a more
freeform way that auditors do not have under auditing standards
and that they should take the opportunity through the audit committee
report to talk about the value that has been derived from the
audit process and how they have looked at particular areas of
significant judgement, and benefited from the audit process. I
am trying to set up some practical ways of addressing that the
real deep-seated problems are recognised.
Q64 Lord Lawson of Blaby: If I can
come back and make it more precise, it is not the audit committees
that I am concerned about, who are a group of amateurs; it is
the professionals. Let me make it specific. Supposing, as the
auditor of a bank, you take the view either that the business
model is a very hairy one, as was clearly the case of Northern
Rock for example, or you takeand these overlap slightlythe
view that this bank is taking excessive risks, or you take the
view that they do not really understand fully the risks that they
are taking. In the first instance, you would report back to the
audit committee, and you might go higher in the company, but if
they do not change would you then go to the supervisors to say,
"Nothing specific, but I think you ought to take a look at
bank X. We are somewhat concerned about it"? Would you say
that? Did you say that?
Mr Hodgkinson: I am not an auditor. I cannot
speak on whether people did, but we clearly want to make sure
that the communication channels exist to do precisely that and
that is why
Lord Lawson of Blaby: I don't believe
it did happen. So if you're saying it should happen in the future,
I am very glad.
Q65 Lord Maclennan of Rogart: This
is somewhat similar ground, because I just wanted to clarify Mr
Tilley's answer to my earlier question. What he reported as having
happened with the Financial Reporting Council was, as I said,
after the event. Is there any professional consensus among the
regulators as to the appropriateness of advising auditors, and
particularly perhaps the smaller audit companies that are not
able to do the systemic research themselves, of the existence
of factors that ought to be taken into consideration when they
are conducting their individual audits?
Mr Tilley: The role of the auditor as currently
defined today is to report on the financial statements in accordance
with accounting standards and regulations. That is their role.
The issues of systemic risk, I believe, fall to the regulators
around the world and, as well, the boards of the companies. I
believe those are where the responsibilities sit.
Q66 Lord Hollick: Mr Hodgkinson,
sticking with the financial crisis and the banks, in your submission
you say, "We have seen no hard evidence to support claims
that auditors were not exercising a high degree of professional
scepticism". Is there any evidence to suggest that they were
exercising any professional scepticism? It seems to me on the
question of liabilities and funding of liabilities and the terms
under which mortgages were being written in the years 2005 to
2007, there was ample ground for expressing scepticism. But where
is the evidence that there was scepticism coming from the audit
Mr Hodgkinson: I think it is worth acknowledging
that professional scepticism is central to what auditors doso
central that it runs through the auditing standards; it is a golden
thread through auditing standards. So you will find, if you look
at the reports produced last month for the major firms that indeed
there are some references on individual audits. Yes, there could
have been more scepticism, but the suggestion that there is a
pervasive issue, and it is not one in which there are points to
pick up on in individual cases, I think is misconceived. I suppose
that is why as a body, as a profession, we are ourselves a little
bit sceptical about the broad-brush allegation that there has
not been scepticism, because it is at the heart of what an audit
is. The audits of the major firms and public interest entities
are being looked at in great detail and there are, on public record,
the reports of the results of those inspections. In the overwhelming
majority of those reports, there is evidence that scepticism is
being applied. We also need to bear in mind that scepticism is
not something where the more of it you have the better. Professional
scepticism is about striking a balance, because if people were
to show unrestrained scepticism we would still be waiting for
the first audit to be finished. It is about knowing when to question
further and when to say, "We move on" because otherwise
you get something that is unproductive. Striking that balance
is an important activity and it is right at the heart of audit,
so there is no problem here in focusing attention on it and saying,
"We need to examine it".
The Chairman: Let's hear from Ms Brand.
Ms Brand: I think while we would agree that
within the scope of the audit, as it is currently constituted,
scepticism was demonstrated or there has not been evidence that
it was not, we feel that there may be need to evolve the technical
scope of that audit moving forward and not to say, "This
is the audit. This is how it will be forever", particularly
looking at issues that maybe start to address Lord Lawson's point
around internal controls, governance and, most importantly, the
financial assumptions underpinning a business model of an institution.
Those are the kinds of forward-looking aspects of an organisation
that maybe the audit could start to move into in its technical
scope. The unwelcome message that comes with that, though, is
that then we do feel the liability issue would need to be looked
at for auditors because they would be taking on a greater scope
of work with more risks associated with it. Maybe that issue would
need to be addressed again and looked at again with that widened
scope of the audit.
Q67 Lord Tugendhat: Can I ask a very
brief question? If a situation arises in which the auditors are
sceptical about a point, the sort of point that Lord Hollick raised,
and they are worried and they press the audit committee and the
management on that point, do you think it would be helpful if
the audit report stated that we were concerned about this particular
issue but we were convinced by management that it was okay? I
am not suggesting a question and answer but that the auditors
would register that they had expressed a doubt on something and
that they had been convinced by management.
Ms Brand: One interesting suggestion that has
come up in the work we have been doing globally, and this was
in an audit forum we held in Singapore, was that maybe the publishing
of the management letter might be a useful form of exposure for
those kinds of issues, because in that letter you would have the
response of management. Of course, that would have to mean that
you do not then start holding back in the management letter, but
that might be one mechanism to achieve that.
Q68 Lord Lipsey: Picking up on Ms
Brand's point about the scope of audit, if you pick up an annual
report now there is an awful lot in there that is not in the audited
financial statements. The input of auditors into the rest of the
report is somewhere between limited and negligible, if I am not
misrepresenting it. Don't you want to see a bigger role for your
members in approving more of the annual report so that investors
really can have confidence in the thing as a whole and not just
in the numbers you have put in the bag?
Ms Brand: Of course, my members do both auditing
and are accounts in business. Yes, we do see there is a wider
role. At the moment, the auditor does have to look at the entire
report and say whether it is consistent with the financial statements,
so there is that review already and if there are inconsistencies
it may be necessary to restate the financial statements. If they
were to audit fully a 600-page annual report then the second audit
would still not be finished. It would have to be focusing on the
particular issues I raised or a selection of issues that were
particularly pertinent to the future sustainability of that business.
Q69 Lord Lipsey: If a company is
doing a due diligence document, the whole thing is subject to
due diligence and you usually have an accountancy firm as well
as your solicitors over on your shoulder making sure it is all
correct. Is it really so formidable a task to say you should audit
the statements of an annual report in the same way?
Ms Brand: I think some form of assurance might
be the way forward. Whether that is the full audit is a different
Mr Tilley: I think this is a hugely important
point. At the moment, we are getting to a point where we have
annual accounts with 500, 600 pages and one questions who reads
all of the pages that are there. We need to think about whether
we can change the reporting model. For instance, do we have at
the front of the report, set out very clearly, what the business
model is, how it works in the environment that the business is
operating inits marketplace, its competitors and so forthand
then how that business model is sustainable going forward into
the future? The financial statements are hugely important and
the foundation, if you like, of any business but reporting on
the sustainability of the business model is crucial. How can auditors
do that? I think that is a very challenging issue. Helen has already
raised the issue of liability, for instance, but I think it is
more about assurance over the processes of putting together the
report that talks about the business model and what its ongoing
sustainability is. One needs to be thinking about the future of
the annual report and how the front end is structured, and ensuring
that that report is balanced so that the views expressed in it
cover both the positive and the negative issues. That is the real
challenge. The assurance over the processes that go forward, with
management and the board putting forward to their shareholders
and other stakeholders how they have run the business, is a key
area that should be looked at.
Mr McLaren: My own institute has a project under
way just now on the future of assurance, drawing people in from
academia and the profession and a large component from industry.
There is a consensus emerging that, as Charles was saying, we
need something to look at the front end, the prospective statements,
including not just viability and going concern, but other statements
that really are of interest to what investors and the community
at large are looking for. The past is the past. Yes, you want
to know its right, tick, and that's the statutory bit, but the
bit about the future is of real interest when public companies
are making announcements to the market. The thinking that has
been touched on alreadyand this is not finished, but when
it is we will be happy to pass a copy of our work to the Committeeis
that the split should also have a slightly different form of report,
so it would be assurance but not "true and fair", in
other words correct. It would be something like perhaps "balanced
and reasonable", because I think you have to be careful.
The auditor is one removed. To pick up something that was said
earlier about exposing management letters and the discussion about
whether you should extend the audit report, in my view you want
to keep the nuclear option. I also think there are some issues
about what you can say in private to an audit committee in a company
that, if you try and expose it to the public, will get inevitably
watered down because of litigation. Coming back to the fundamental
point, we believe there is an interest in some form of assurance
over that front end but that perhaps it cannot be done to the
same standard as the historic numbers can be audited.
Mr Hodgkinson: I appreciate a lot of the comments
that have been made and I agree with a lot of them. However, I
think it is quite important that we do not just agree in principle
and then say, "And it is a huge task". I think it is
important to start making some progress here and getting some
runs on the board. In the report that Lord Lawson referred to,
we said that this is something that people can start experimenting
on. We do not have to say that the whole 400 pages is going to
be subject to an audit opinion, but we could start to see some
innovation and market experimentation with audit committees on
behalf of the board saying, "It would enhance the credibility
of our annual report if we said we have asked the auditors to
look at this particularly important table, these particularly
important numerical disclosures or a high-level risk statement.
Here's something specific that we've worked on". It would
allow some differentiation and experimentation on which you could
build to incorporate it into law.
The huge risk in just saying, "Let's make
a legislative or regulatory change with no real experience"
is you get the sort of problem that we saw in the United States
after the Sarbanes-Oxley Act, where there was an extension of
the audit that looked quite innocuous, it took a few words of
legislation to say that auditors should report on the effectiveness
of internal control over financial reporting. It has taken eight
years to finally get a kind of truce on which companies would
be subject to that requirement, what the criteria would be for
reporting and how auditors would do the work, and it cost American
business a lot on the way. So I think we need to look, as we do
in our report, at ways of getting real experimentation and innovation
based upon what people think would be of value rather than grand
sweeping regulatory gestures.
Q70 Lord Hollick: Within the auditing
profession's monopoly rights to practise, is it acceptable for
audit firms to decline to audit high-risk clients?
Mr McLaren: If I can start off, I am not aware
of anyone not having an audit, at the end of the day. Given the
market-based system that we have just now, any market participant
must be entitled to exercise the right, for whatever reasons,
to decline to go forward. As was discussed earlier, they may feel
they do not have the competence or that there are inherent conflicts.
In my experience, I do not know that anyone has ended up without
Q71 Lord Smith of Clifton: This is
the low bowling question: isn't it time that the auditors simply
agreed to stop doing non-audit work for their audit clients, rather
than hiding behind ever more complex and refined rules to allow
them to assert that there is no problem? This is the argument
that there are Chinese walls. You bowl over the tender, then you
say to them, "Ha ha, but then you need our consultancy services
to get you up to scratch". What do you have to say about
Mr Hodgkinson: I think the short answer would
be, "No, it isn't time to do that" but let me give a
little bit of colour to that. We fully recognise that the fact
that auditors provide non-audit services to audit clients raises
a question and there is a clear need for the public to be reassured
that auditors are being objective and they are standing up to
the companies that they audit. That is the point of substance,
that we want to know they are being objective and stand up to
the companies they audit when they need to. This is something
that has absorbed a huge amount of time, rightly, over the past
10 years, latterly with the Auditing Practices Board at the instigation
of the House of Commons Treasury Select Committee suggesting the
sort of outright ban that you have alluded to. After quite an
exhaustive process of public consultation, there is no substantial
body of opinion that wants that outright ban. There are benefits
in a market system of companies being able to engage their auditors,
who are trusted and seen as having a degree of objectivity, to
do non-audit services, subject to the sort of controls and safeguards
that are needed to reassure the public and selective bans on things
that are not appropriate.
So this is an area of acute concern that the
outright ban solution is not appropriate. I think we need to keep
the approach under review. We need better disclosure, because
one thing which I think is now agreed out of the recent APB, Auditing
Practices Board, discussion is that some non-audit services are
very related to the audit and if we want to look at how the audit
will develop in a marketplace, it would be through auditors providing
some audit-related services which make the audit more valuable.
So in the public disclosure, enabling people to see audit-related
disclosure as different from perhaps more contentious non-audit
services, will also be helpful.
Ms Brand: To add to that, I do think in the
current economic environment where we are looking for business-led
recovery, the very valuable advice, particularly at the smaller
end of the market, that auditors give to their clients is particularly
important. From all of our research, the most trusted advisor
to small businesses is the accountant and I think to risk removing
that advice from them would be dangerous in the current environment.
So I think that does have to be borne in mind.
Mr McLaren: There were 150 responses to the
Auditing Practices Board's consultation paper on non-audit services
at the beginning of the year. Only three peoplean academic,
a politician with well known views on this matter and one othersupported
an outright ban. So the market response is certainly not there.
Of course, at the end of the day, in my view, the audit committee
needs to step up to this plate. The auditors cannot force those
other services on them. Okay, it is easy for management, but we
have talked already about having audit committee reports individually
signed as the auditor now signs, and having to articulate why
they have gone to the auditor for services. Some are very self-evident:
capital transactions, where you require a long form or a comfort
letter and working capital letter. It is much more efficient to
have that done by your auditor, but it needs to be challenged
and the audit committee is the place to do that and to articulate
to investors why they are comfortable and investors then can make
up their minds.
Mr Tilley: Just building on the point that has
just been made, my experience would be that audit committees focus
very clearly on the issues where the auditors are providing services
which are beyond the audit and are very careful to guard against
the importance of the independence of the auditor going forward.
So I think it is an area which further work can be done on, but
the audit committee is very cognisant of it.
Q72 Lord Lawson of Blaby: If I may
come in on this, and broaden it slightly to relate to not merely
auditing and advisory services, but also external audit and internal
audit, I think the same issue arises. One of you, if not more
than one, at some point stated how international you are now,
but if I am not wrong, in the United States it is not permissible
to be the auditor for a company and provide the consultancy advice
for the same company. I think it is also not permitted now to
do the external audit and the internal audit, because they see,
quite rightly, that there is a conflict of interest. If I may
express the conflict of interest in a way that picks up on what
you said, you said that the golden thread running through auditing
was scepticism. But that is not at the heart of these other services,
so there is a real fear that the proper scepticism of the external
audit will be watered down because of the internal. Even if you
tell me that never happensand I rather doubt whether I
would entirely believe you, bearing in mind the size of the fees
involvedwould it not reassure the public if there were
Obviously there is plenty of capacity. The Big
Four are not going to wilt away if they are prevented from doing
internal audit or advisory consultancy work for the same company
they are doing the external audit for. They will be able to survive
that and they will continue to be great companies. Helen Brand
was saying that these services are useful for companies. They
are, but they don't have to be done by the same company. I think
that they should be done, but not by the same company. I am puzzled
by the way that you, at one and the same time, seem to say that
it is perfectly all right, perfectly kosher because of these Chinese
walls, there is absolutely no contact between the two, and then
you say the great advantage of the same firm doing it is the contacts
and the synergy. I do not think you can have it both ways.
Mr Hodgkinson: Just to pick up on a number of
the points that you made there, I think that the stark contrast
between the United States and the rest of the world, which I also
read in last week's Economist, is a simplified view, because
there is no simple permission in ethical standards here that external
auditors can do internal audit work. The key principles involved
make it pretty clear that a certain characterisation of internal
audit cannot be done. Where there is a management role, where
there are decisions about what controls should be adopted, about
where priorities are in internal control, that is completely out
of bounds. However, it is recognised that some companies, and
some audit committees, might benefit from the auditors doing some
work to check on things in a way which is complementary to their
audit work, which would help the work of the audit committee.
That is particularly important for smaller listed companies who
might have challenges in recruiting a full internal audit function
with the right skills. But it is absolutely clear that that cannot
involve having the external auditor as head of the internal audit
function. It needs to be owned within the company.
When we talk about the kind of safeguards on
non-audit services, it is not primarily about Chinese walls. That
might be one of the safeguards, but there is no presumption that
every non-audit service must have a Chinese wall, making sure
there is no interaction. You need to make sure that the risks
that could be involved in having interaction do not threaten the
objectivity or the appearance of objectivity of the audit work.
So the approach is a little more subtle and
it does place a huge reliance on professional responsibility.
In fact, it was my institute that came up with this idea of threats
and safeguards to auditor independence. We have striven to make
people think about these issues: do not just have simple blanket
prohibitions or permissions which say, "You cannot do internal
audit" and then we get an esoteric debate about what is internal
audit. People should be thinking about the issues involved and
the real threats to the objectivity of the audit.
Q73 Lord Lawson of Blaby: The Americans
did change their legislation following the Arthur Andersen, Enron,
experience, didn't they?
Mr Hodgkinson: Yes, they tightened it up, but
theirs is a far more rules-based approach, rather than one which
encourages people to think through the issues and not just say,
"Have we ticked a box which says that we are doing a service
which is permitted?" Under the international framework which
we follow, you can tick a box, but you are not through when you
have done that. You still have to ask the question whether you
are facing a risk, a threat to your objectivity or how that is
perceived. We go beyond that tick in the box approach.
The Chairman: Before Ms Brand comes in,
Q74 Lord Tugendhat: In the written
evidence which was given to us before we started, one of the Big
Four, I think it was Deloittethere may even have been twosaid
that auditing FTSE 100 companies was one of their less profitable
lines of business and almost gave the impression that they were
doing it as a public service. If this is a less profitable line
of business for them, it suggests to me that perhaps the non-audit
services are a more profitable line of business for them, and
that there is a danger therefore in their principal function being
perhaps relatively underpriced and their subsidiary function being
the one where the money is. I think that comes back to the conflict
of interest point that Lord Lawson made.
The Chairman: Let's just
hear from Ms Brand.
Ms Brand: It was on the previous point. I just
want to say that one of the issues that we think audit committees
should be looking at in relation to the internal audit / external
audit, the profession has to hold its hands up: the perception
of that is not great, and I think that audit committees ought
to be asking, "What will the perception of the shareholders
be of this?" So it is not only the ethical standards and
so on, but the perception this is creating.
Mr McLaren: In relation to your point about
profitability of audit, I think that is common currency and understood.
I think you perhaps have the proportions wrong on the percentage
of activity that is audit work relative to the non-audit, consultancy,
tax and other business. Audit will be 30%, 40% maximum, so it
is the minority activity. I think what it gives the firms is a
licence to operate from that base, which is perceived around the
world to be high standard, for all the reasons that are troubling
us in other wayswhy is there not enough change, and so
on. The fundamental market response is that people are happy with
what they are getting. There is enough competition, they have
the global reach and they do a good job. So you have them leveraging
off that into other areas where they can make a better margin,
and that is the business reality.
Mr Hodgkinson: Could I just make one other point
there? The disclosure of margins by area of business is something
that came out of the Financial Reporting Council's study on the
Market Participants Group into competition and choice, and was
meant to be a disclosure that would provoke the sort of challenge
and inquiry that you have embarked upon. It is good to have that
into the public domain. I do not think that the differences in
margins are that stark as to raise fundamental issues, but the
fact that that information is being disclosed on the basis of
guidance that ICAEW prepared is a helpful contribution to the
Q75 Lord Hollick: I have long been
concerned about the situation around tax advice and their auditing
tax. I think it is still the case that many companies use their
accountants to come up with very sophisticated, shall we say,
tax schemes, and then the audit side audit them, so the risk to
the firm is substantially high. One of you talked earlier about
this. Isn't that a no-go area where they should not be on both
sides of the street; they should not be marking their own exam
paper, if you like? Isn't that one such area?
Mr Hodgkinson: The area of tax, you are quite
right to highlight, is an area of concern. The way it is phrased
in the ethical standards is that it is not a no-go area, and there
are some real, practical issues here, particularly at the smaller
end of the market. For most businesses, that use of their accountants
to help with tax work is quite important. But the way that the
issue is framed, I agree that many peopleif they are on
audit committees or even if they were managementwould have
a concern. You need to make sure that auditors are not auditing
their own work, that self-review threat is recognised and there
is a potential conflict. That is recognised, and I think that
the market has moved on, so that businesses and their audit committees
would be far more likely now, particularly at the top end, to
separate the provision of those services.
Q76 Lord Lawson of Blaby: If I can
pick up on something that Mr Hodgkinson said, which is slightly
relevant; I am not persuaded that it wouldn't be both in the public
interest and in the interests of the corporate sectorand
possibly even in the interests of diversity, as it were, within
the accountancy professionif there were a necessary separation
between the company that did the auditing and the company that
did the consulting, the tax advice or whatever it happens to be.
But in your defence of the status quo, you explained that auditingI
was not quite sure of the connection, but it is an important point
all the samewas not just a matter of box ticking, and that
in the United States they did need to make this separation because
in the United States auditing is much more a matter of box ticking.
The evidence that we were given last week was that in fact auditing
in this country has become very much a matter of box ticking.
I do not know whether you read the evidence that was given to
us, but that was clearly what came out of these very expert academics
in the subject.
Mr McLaren: Could I kick off on that? I am obviously
three or three and a half years out of date, and maybe it has
changed, but I doubt it, fundamentally. I did understand the point
that the academics were making and, in part, the balance of our
audit inspection, which I think is a good thing, inevitably focusesas
has been discussed here earlieron what you can see out
of an audit, and you can't see the inherent quality, unfortunately.
You can see a file that is full of points. So I think there is
a real issue about that sort of review driving box ticking. The
big firms will now be more and more putting checklists together
so that when you are AIU inspected, you will have the perfect
file, so you do not get adverse comment. I understand that there
can be a rather large jump to say that auditors have thrown their
scepticism and their professional training out of the window.
I think that is a jump too far.
Personallywe talked about it earlierthis
scepticism project I think is a good one. There was one thing
that I saw as an elapsed auditor; one of the statements was that
there has been far too much focus on corroboration rather than
challenge. That struck a chord with me because I realised that
post the AIU requirements for absolute documentation there probably
had been a drift that way. I am not suggesting for a moment that
all scepticism on key issues has gone out of the window, but the
fact that this has been raised and will perhaps be embedded in
the training in a formal wayit was a sort of by-product
before throughout the trainingI think will be healthy.
If there is an expectation here, and if there is any issue in
reality, I think it will help address that.
Mr Hodgkinson: I recognise the concern about
box ticking, but I am not sure this is an either/or question.
Box ticking is a pejorative term. I think the challenge is to
make sure that, having done what you have to do to show you have
complied with standards that have been set to build the accountability
of the auditing profession, you do not say, "Well, that's
the end of it". You still have to have that professional
judgement that says, "Are there things that there might be
no box to tick, but I think I should do them? Overall, does the
answer, even with a sheet full of ticks, mean I'm still unhappy?"
So I do not think it is an either/or, and there is certainly no
going back to a world in which professionals might just say, "I
know I've done a good job and I'm not accountable for saying how
I've done it". I think it is both. You have to have the demonstrable
compliance with standards because that is the way things have
gone, but you also have to make sure that is not at the expense
of standing back and saying, "Do we overall have the right
opinion? Are there more things we should be doing?"
Q77 The Chairman: It has been suggested
to us that a different way of reducing the audit market concentration,
which is the concern of our inquiry, would be to follow the French
example and make it compulsory for the audits of the large firms
to be joint audits, bringing on another bunch of auditors. How
does that play out in your professional bodies? Do you like the
sound of that?
Mr McLaren: I have been involved only once in
a joint audit. They were reasonably popular in the 1970s and prior
to that, and in part, I think the French started doing this in
the 1960s. You did not have the global reach, but businesses started
going global and getting bigger. You have to remember the Big
Four only came into existence from 1987 through to 1998; there
was a Big Eight or Big Ten prior to that. So I think that joint
audits arose out of that. I was involved in one, as I say, many
years ago. It was not a very satisfactory arrangement for either
party because, as I have explained earlier, there is a dynamic
nature to audit, which is the actual tone of the questions and
so on. The file of the conclusions cannot give any truth about
that. So you only have part of that sight of the audit that you
have to jointly sign up, so you are relying wholly on the quality
of the other firm, and inevitably there is going to be, at the
very best, inefficiency while you assure yourself that that is
up to your standards.
Turning to the modern day, I think Denmark had
this, as the French did, and abandoned it in 2001 because they
found that it was just causing additional costs for no business
benefit whatsoever. I think the final point I would say, as there
has been inevitably a focus on the financial crisis and the audits
of banks, the reality is you could get no one to take joint accountability
for a bank audit other than the Big Four at this point in time.
There are not the basic skills. You could share a bit of the audit
with someone, but you could not have joint opinions, which is
what the French system has. From personal experience and other
observations, I would not think that this is a runner to address
the problem of concentration.
The Chairman: Any other comments?
Mr Tilley: I am also an ex-Big Four partner,
and my one experience of a joint audit was similar, but I would
emphasise the accountabilityor loss of accountability and,
in particular, the risk of things falling through the cracks.
I think it can become a bureaucratic nightmare, and very importantly
there is the issue of moral hazard, which is that the company
can play one auditor off against the other.
Mr Hodgkinson: Could I just add a couple of
reflections? You are right to refer to French practice, and I
do not think we should out of hand suggest that the French might
not have good ideas which work in their environment, but as Iain
said, that practice is quite long-established. I think it is the
sort of thing that people should actively consider. Let's just
be clear, what we have at the moment is a permission to do joint
audits. An audit committee could appoint all the Big Four, if
you wanted to, to be joint auditors. There is no market prohibition
on this, and if people saw an advantage in doing it, they could
experiment with it. I think the issue is that if nobody is doing
it and they have the choice, then you would need to be pretty
certain before mandating that they should make the choice. It
might be for the reasons of cost and potential ambiguity that
colleagues have referred to that people do not do it. But companies
can experiment with this if they want to, and who is to say that
there might not be ways of it working, but to mandate it as a
way of improving quality or addressing the concentration issue
is something that you need caution on before going that way.
The Chairman: A blind alley. Ms Brand.
Ms Brand: I don't have any additional points.
The Chairman: No points. Lord Tugendhat,
would you like to take the next one?
Q78 Lord Tugendhat: The question
I wanted to ask concerns regulatory capture. Again, we keep coming
back to the fact that there are the four big auditors, but as
there are just the four big auditors, to what extent do you think
they dominate the governance of professional bodies? Their opinion
must weigh very heavily. Do they generally speaking follow the
same line and take the same view or not?
The Chairman: We have three ex-partners
from those firms.
Mr McLaren: Indeed. Well, speaking from an institute
point of view, do they influence the profession? Our governance
is surprisingly underweight. We have a council of 32 in Scotland,
and including myself and one other retired, there are only two
other active Big Four partners out of 32, and three of those are
public interest members. So in a sense, they are under-represented
there. Looking at presidents, I looked back the last 15 years.
There have only been five that have come from Big Four backgrounds.
So, certainly on the governance side there is not an issue.
You talk about regulatory capture and we talked
about the AIU. When I was in the Big Four I was subject to the
AIU inspection on one of my FTSE 350 clients, and I can assure
you it is a very rigorous process. But, yes, there are issues.
You will see on the latest overall report that there are what
they call serious failures or significant deficiencies. I cannot
remember the term, but they are a major category. They do a report
on smaller firms, and smaller firms markedly get a poorer score
there. Now, that is inevitably reinforcing the view that big is
better and so on. Yet there is a body of thought that the Big
Four have all the resources to defend themselves, take a lot of
time, a lot of resource, which perhaps the smaller firms do not
do. The other point is that the focus of that report is on failings.
I know and we know as an institute and I am sure the other institutes
know that the good firms do not get put up in lights. In the small
firms, half of them are probably doing an excellent job, as good
as any of the Big Four, but it does not come out. So, I think
there are issues in terms of regulatory capture which happen,
if you like, as by-products. They are not intended, but they are
by-products of some of the regulatory environment in which we
Mr Hodgkinson: May I just make a couple of additional
points? I would echo the points about representation in our governance
structure. When you look at current Big Four partners or recently
retired, that's one of our three office holders from that background,
but only three out of 16 board members and only 11 out of our
council of 101. The constituencies are very broad in which our
members are represented. As a very tangible proof that we can
do things which on the face of it you might not think the firms
would welcome, I was project director on a recently completed
project to draft an audit firm governance code, which will apply
to the eight largest firms with effect from 1st June this year.
That is something which we were entrusted with by the Financial
Reporting Council, which I think evidences a degree of confidence
that we would establish something which was demanding and perhaps
not immediately popular. That, for example, will call upon the
major audit firms to have independent non-executives in their
governance structure. So, I think that is very tangible evidence
Can I just make one final point about the perception
of the dominance of the Big Four? We need to be very careful here.
There is a dominance at the top end of the market, but across
the broad swathe of British business there is competition. Even
if you look at the AIM market, which is where a lot of IPOsinitial
public offeringshappen, there's far more dispersion and
there is a lot of capability outside the Big Four. So, I would
not want any impression left with this Committee that there were
four firms and nobody else. There is a very broadly based profession
of 15,000-plus firms who are dealing with their specific markets
doing audits, and what we are talking about is a concentration
at the very top end of the market, which is around capability
to do those sorts of audits. But I would not want the idea that
somehow there are four audit firms only. There are very capable
Q79 Lord Smith of Clifton: The absence
of the Big Four shows how relatively unimportant the professional
institutes are because they go off and make their money and they
do not give back to the profession. The wealth of their experience
should be put back into the experience. It is no good just having
the little minnows getting their CVs, working up the professional
organisations, when you have an absentee landlord. It is not regulatory
capture; they should be there in rather greater numbers.
Mr Hodgkinson: Well, if I gave that impression
that would be wrong. The firms are very important in the underlying
technical work that we do and their contribution is very important.
I was saying in the governance structures there is a fair reflection
of our underlying membership, which is predominantly not in practice,
predominantly not in the Big Four and predominantly not auditors
within the Big Four. It is something which we monitor very zealously
to make sure that our structures are reflecting the underlying
membership, and that is an appropriate balance. There is certainly
no feeling that the major firms absent themselves from the professional
Ms Brand: I am sorry, just one aspect further
on the governance point in terms of regulation and discipline
within our organisation. That is overseen by a regulatory board
that has a majority of non-accountants on it and is chaired by
a non-accountant. So there is no capture on probably the most
critical part of the organisation in relation to the issues we
are discussing today.
Mr McLaren: I would add to that in our discipline
the majority are independents. I took the trouble to find out
how many Big Four members we had out of our 18,000, and it is
15%, one in six. So, the point is, it is in proportion for a membership
The Chairman: Well, Lord Maclennan, would
you like to ask the final question?
Q80 Lord Maclennan of Rogart: If
there is one measure you would propose to assist in widening choice
in the audit market, what would it be?
The Chairman: Can we ask you to have
a go at that tsunami?
Lord Maclennan of Rogart: Then I have
Ms Brand: It would be to remove restrictive
covenants. I think that the situation where banks or organisations
themselves are stipulating upfront that they will only employ
a Big Four firm probably is a restriction of fair trade and it
is something that I think the OFT is looking into. We would support
that further investigation.
Mr Tilley: I think it is a very challenging
question, but I believe that the missed opportunity that I referred
to earlier in terms of assurance over narrative report in the
front end of the accounts could potentially offer the opportunity
for smaller firms to be involved.
Mr Hodgkinson: Oblige regulators to consider
how regulation affects availability of choice. Make it a criterion
for regulatory action because it is clearly of public interest.
Q81 Lord Maclennan of Rogart: May
I just ask whether any of these three issues have been considered
by the CCAB and, if so, where did the balance of opinion lie with
respect to them? I recognise that it is a consultative not a legislative
body, but it would be interesting if you could give us any evidence
from that source.
The Chairman: Can any of you speak on
behalf of the CCAB?
Mr Tilley: I was at the CCAB only yesterday.
I think the issues we have just referred to have not been specifically
addressed by the CCAB, but I think it would be fair to say that
all of the bodies represented here are talking about these issues
in common. It is something that we might take away and consider.
Mr McLaren: Can I finish off just by saying
I think liability is an issue that needs to be looked at. There
are obviously the changes in the 2006 Act which have not stuck
for reasons that are I think well rehearsed. I think proportionate
liability may encourage some mid-tier firms to perhaps have a
go. I agree with Helen on restrictive covenants, but I think we
have to be realistic here that if you have done a leveraged buyout
and you have put many millions behind a business, you are going
to change a restrictive covenant into an auditor suitable and
the default position currently will be, "Go to a Big Four
and you'll get our immediate tick; go to someone else and you're
going to have to convince me." So, I think we have to be
The final thing I would say, because I sit on
a number of audit committees and I am chair of a FTSE 100 audit
committee, I really do think there is more mileage in putting
audit committee chairs, as I said, under the spotlight to account
to the shareholders why there has not been an audit tender. We
now have the default position, of course, of nine years for directors
or then you are not independent. Perhaps we could have 10 or 12
years and, if not, you would have to explain. That would mirror
what is happening in other governance areas. I think more can
be done through the audit committee to perhaps have some effect
on this. I think we have to realise that changing this concentration
issue may not be possible because of the gap, and if it is to
be achieved, it is probably going to be quite a long haul.
Mr Hodgkinson: Final word, picking up on Lord
Maclennan's challenge there. The forum in which these issues are
addressed is the Financial Reporting Council with its regular
reporting on the Market Participants Group report rather than
being in the CCAB. All the issues that have been addressed, including
the one about restrictive covenants, were addressed by the Market
Participants Group three years ago and they are subject to continuing
review. There is on that question of governance the question as
to whether the recommendation they did make, which was that there
should be disclosure, has been followed and whether more disclosure
is needed or whether there needs to be some more direct action.
The forum in which these issues are addressed exists, but I do
not think that the simple overriding criterion referred to of
making choice an issue for regulators in their determinations
is something that they have considered, but they might want to.
Q82 Lord Lawson of Blaby: I do not
want to detain the Committee, but I did not fully understand the
proposal that Mr Hodgkinson made when we went along. I do not
want him to elaborate it now, but do you think it would be possible
to ask him if he might let us have a brief note spelling out precisely
what he is proposing and how it would work out in practice?
The Chairman: That would be very helpful
if you could do that for us.
Mr Hodgkinson: Thank you.
The Chairman: Thank you all very much
indeed. We heard about dropping catches, runs on the board, low
bowling, and it is time I think to draw stumps. Thank you all
very much indeed for joining us. We much appreciate it.
Lord Smith of Clifton: On behalf of Baroness
Kingsmill, who has had to exempt herself from the Select Committee,
one of the things we were looking at was the question of gender
balance in the workforce. The financial sector is represented
here overwhelmingly by one and it is a delight to have Ms Brand
here representing 51% of the population.
The Chairman: And we are not doing so
well here. Thank you all very much for joining us. It has been
19 Question 63 unallocated. Back