Memorandum by Mr Timothy Bush (ADT 10)
I have pleasure in submitting written evidence
to the Committee.
I was the chair of the Institute of Chartered
Accountants in England and Wales' (ICAEW) Competition and Choice
working group set up under the then Department of Trade and Industry,
which then evolved into the Financial Reporting Council's (FRC)
project on the same issue. I am a past member of the Governing
Council of the ICAEW and an investor, an FSA registered fund manager.
I am the Investment Management Association nominated representative
on the Urgent Issues Task Force of the Accounting Standards Board
(ASB). I have analysed banks in particular since 2006.
I would also be prepared to give oral evidence.
I am writing solely in a personal capacity with no paid interest
or other conflict of interest with the subject matter.
As the Committee is seeking evidence about the
role of the auditor and risk, my evidence sets out
and explains the context and purpose of the accounting
and auditing provisions of the Companies Act. The Companies Act
2006 (previously the 1985 Act) has Section 837 which very simply
defines the output expected of audited accounts as:
"the [audited] accounts must have been
properly prepared, or only be defective in ways immaterial
in determining whether the distribution [ie a dividend] is
in breach of this Part of the Act. (Source: Palmer's guide to
Company Law 2006).
The Act is seeking that accounts are sufficiently
reliable so that companies will not pay dividends out of capital,
such as when they are actually making losses. This objective is
a stress test a sense check. However, audits have appeared to
fail (clean opinions were given on banks about to collapse) because:
the auditing standards give auditors
the objective of auditing by the "accounting standards framework".
That falls short of setting out the full implications of S837
when the "accounting framework"
is IFRS (which for banks and listed companies has been the case
since 2005), IFRS accounts cannot deliver that objective, because
IFRS in parts positively overstates financial assets and
profits. It has the wrong risk model
overstating assets and false profits
is almost bound to lead to companies, but particularly banks,
getting out of control and misleading themselves as well misleading
This has happened because IFRS has wholly replaced
the Accounting Rules that were in the Companies Act itself and
had had proper legislative scrutiny. Section 837 is still intact
and it is still the law but there has been no functional mechanism
to deliver it.
The inconsistency between what accounting standards
(IFRS) and auditing standards set out and what the Companies Act
really requires was flagged by institutional investors in 2005
upon the launch of IFRS. The accountancy regulators dismissed
those concerns. But since then IFRS has merely taken the self-referential
compliance model already set by the auditing standards that bit
further. So similar flaws have passed up the chain via IFRS to
the directors and their business control systems as well.
Banks traded, priced credit and paid dividends
when they weren't really making the "profits" that they
were showing and thought they were making. The banking crisis
is largely due to faulty numbers. Post Enron accounting reforms
have not worked as the medicine was the disease.
It is therefore encouraging that Parliament
is looking at this matter in some detail.
S1.1 This evidence covers two distinct areas;
the role of auditors and the relevance of accounting/auditing
standards in that role (to cover questions 5-9) and audit firm
concentration (to cover questions 1-4). It sets out a case which
explains why the audits of some banks have come under question
from politicians due to their apparent failure to identify the
true state of those banks that were on the brink of collapse.
Or put another way, why auditors were the dogs that did not bark.
S1.2 Some banks were following capital destructive
business models, essentially lending at below true cost, and in
some cases having no capital at all. They were showing an accounting
illusion of capital and profit, but they received unqualified
audit opinions on their accounts, and paid dividends.
S1.3 Given that the accounting provisions
of the Companies Act were established in 1879 explicitly to serve
a banking solvency function and given that Parliament was assured
in 2006 that the function of auditors of accounts had not changed,
something has come adrift for questions on their role to be asked
at all. In reading evidence recently given to the House of Commons
Treasury Committee I conclude that neither the accountants, nor
their regulators conveyed to that committee the true purpose of
the statutory auditor. This evidence may explain why.
S1.4 Because of the way the law relating
to auditors is constructed, the audits of banks should identify
true solvency. The position that regulators should instead is
false. Regulators did not have the resources or global proximity
to the businesses, auditors did. The contractual purpose of the
Companies Act auditor is to avoid management operating under or
presenting an illusion, business is more dynamic than regulation.
S1.5 However the accounting standards introduced
in 2005 can mask true solvency, and do not even purport to seek
to show that. It is therefore my conclusion that there is an
absolute incompatibility between Company Law and key parts of
IFRS (the International Financial Reporting Standards of the IASB)
that for banks means an absolute danger.
S1.6 IAS 39 (the accounting standard that
deals with most of a bank's balance sheet and profits) conflicts
with the Accounting Rules of the Companies Act. It is therefore
not surprising that the delivery of IFRS accounts and the audit
thereof will be defective in comparison to what the Companies
Act intends of both accounts and audits. Rather than functioning
as a reliable basis for controlling and monitoring banks, inside
and out, IFRS has had the dual effect of helping some of them
to get out of control and obscuring that. The incompatibility
is not merely against the intent and spirit of the law but
is contrary to specific statutory provisions of the Companies
S1.7 Because the UK's accounting standards
board (ASB) had set generally good standards whilst sitting below
the Companies Act's Statutory Accounting Rules there may have
been a general presumption that IFRS was merely an internationalisation
of what the ASB had done. But, what the ASB had done was properly
restricted by the Statutory Accounting Rules set down by Parliament.
S1.8 However, IFRS did not merely replace
UK Accounting Standards, it also replaced the Accounting Rules
contained within the Companies Act that were consistent with the
purpose of the law and drafted with legislative levels of scrutiny.
IFRS has quite simply frustrated the delivery of the accounting
model and audit that Parliament intended because IFRS is set without
equivalent legislative scrutiny by a body with very different
objectives. IFRS seeks to value companies at a point in time ("decision
usefulness") rather than ensure their safety going forwards
(stewardship). IFRS also frustrates Section 386 which requires
that companies by their books know where they are with reasonable
accuracy at any time. That is difficult if the accounting standards
do not achieve it.
S1.9 The way that the law is still structured,
Sections 830-837 (Capital Maintenance), are still paramount outcomes,
but complying with IFRS may well break that part of the law, despite
being the expected method of delivery. Instead of a health check
of a business, the model that part of false positives. Very dangerous
E1.1 I set out when and how I first concluded
that there were severe technical problems in accounting and then
auditing that have contributed to the banking crisis to the extent
of being a primal cause.
E1.2 In early 2008, I produced a brief analysis
of problems with banks and their accounts, and having sent that
to HM Treasury I was immediately asked to meet officials in July
2008, where I ran a model (similar to that the FSA now has) past
members of the Financial Crisis Team. I gave them my view that
I thought that accounting standards were not only covering up
problems in banks but were causative of them. Why cause? Because
people plan and budgetand then monitor thatby numerical
outcomes. If accounting standards produce a false profit
as a numerical outcome, things will go awry right from the start.
E1.3 That presentation was summarised by
an official as the first time that anyone had "managed to
explain [to them] what no one else had managed to explain".
At that stage only Northern Rock had collapsed, although Bradford
& Bingley had had a failed rights issue. Investors were firstly
blamed for being unsupportive of banks and there was a prevailing
view that the pre-emption rights issue period was too long.
In reality the market was suspecting that other banks too might
be bustand also need to be nationalisedbut the numbers
did not show it. Attention had been overly focussed on "liquidity"
(asset/liability maturity profile) rather than capital solvency/adequacy
(the amount by which assets exceed liabilities). All banks
have a liquidity problem, that is their public benefit, they borrow
short-term to lend long term. Liquidity matters most when people
will not lend to what they suspect might be a bust bank (liabilities
exceed assets). Banks were operating under and presenting an illusion.
E1.4 The official commented that speaking
to long only investors (ie not short sellers) tended to show a
convergence of interest with HM Government's interest. I replied
that it was because long investors also had diverse economic interests
rather than narrow vested interests. I also commented that I thought
that before long the government would also be an equity investor
in more banks than merely Northern Rock. The team was impressive
and quick on the uptake.
E1.5 My analysis was then, and still is,
that problems have arisen quite simply due to changing accounting
standards in January 2005. Checks and balances inherent in
the accounting model replaced in 2005 were taken out and not compensated
for. These changes not only affected regulated banks (ie deposit
taking institutions) making loan advances, but also unregulated
non-banks undertaking similar activity, such as Cattles plc (not
regulated as a deposit taking bankbut making loans to customers
by a doorstep collection model). It is difficult to blame faulty
regulation where there wasn't any (other than consumer protection
regulation) in the case of Cattles which had existed since 1927.
E1.6 It is positive that of all regulators
working in this area Lord Turner of the FSA has best articulated
the issues that others have not.
The accountancy regulators still don't give a coherent explanation
for things. They are embarrassed. Furthermore, standard setters
resemble lobbyists, selling their standards rather than writing
them properly. They don't even do impact assessments.
E1.7 The statutory requirement of auditing
and accounts flows from the 1879 Companies Act, and followed the
collapse of the City of Glasgow Bank in 1878, which had been a
fraud. Before that when their commission was not compulsory, matters
followed common law.
E1.8 The law is constructed such that the
law is framing a private contract that is albeit compulsory. The
parties are the company and the auditors. This differs from regulation,
which is not contractual, the parties then are the regulated party
and the regulator. An analogy is the legal requirement for a driver
to have third party insurance. Whilst the government demands the
contract, it is not a party to the contract. The audit though,
is not insurance, but assurance, to detect and deal with risk
and negligence, including fraud.
E1.9 The framework of the 1879 law is intact,
and is now the 2006 Companies Act (previously the Companies Act
1985 and preceding acts, and is set out too in case law).
Clauses particularly relevant to accounts and the audit and its
1. The accounts that are published comply with
the accounting framework (IAS accounts or Companies Act accounts)
and give a "true and fair view" (ie a sufficient output).
Section 393 (and the auditor opinion thereon, Section 495(3)(a)
2. The books of account that are kept privately
at all times are suitable to inform the directors of where the
business is at all times. Section 386 "adequate accounting
records" (and the auditor opinion thereon, Section 498).
3. The firm link between the statutory audited
public accounts and the legality of dividends declared off of
those accounts. Sections 830, 836, 837. Sections 837(4) is
wholly about the auditor duty in that regard. He must always
conclude whether the accounts are suitable to be used for declaring
a dividend even if his opinion is qualified. The statutory
duty is so positive so as to require the auditor to report to
shareholders on that matter over the heads of the directors if
4 Section 532 prohibits the auditor from
contracting with the company to limit liability. This appeared
in 1929 as auditors had been contracting with the directors, or
having provisions put into company articles to limit their, and/or
directors' liability. This remains subject to a modification in
the 2006 Act under Section 534-538 allowing limitation
to an amount that is "fair and reasonable in the circumstances".
E2.0 The requirement in 1 above is about
transparency. The requirements in 2 and 3 link both the public
audited accounts and the private books of account with solvency.
The Companies Act is very simply aiming to protect creditors from
companies funding dividends and losses from creditors. Hidden
losses in a bank will mean that it is taking in deposits to pay
shareholders and managers, and hidden ongoing losses means
it is making mispriced loans.
E2.1 The requirement in 4 was to prevent
"take the money and run audits", ie the statutory condition
of having one was met, but the contractual efficacy was limited.
Sections 534-538 were placed into the Companies Act in 2006
only after a conditional agreement with sceptical institutional
investors (concerned then about poor quality audits of some public
companies) that auditors would strive to adhere better to
the intent of the Companies Act with respect to their statutory
The terms of that agreement encountered problems
at the outset due to the problem set out below (E4.1).
E2.2 The UK Companies Act Accounting Rules
("Accounting Rules"), and hence the audits thereof,
were for banks in substance loan quality stress tests.
The Companies Act positively requires this for dividend safety/capital
maintenance to ensure that dividends are paid from firm, not
transient or unstable asset values.
E2.3 However the requirements of the Act
have not been backed up properly by functional standards since
2005. The accounting standards have failed to support the Act
and the auditing standards then failed to pick it up also. But
if the accounting standards regime is faulty, then to the extent
that these can apply to how companies account perpetually throughout
a year (as IAS 39 does), it is difficult to see how an auditing
standard can fully correct it at the end of a year. Information
drives behaviour at all times.
E2.4 The root of the accounting/auditing
problem (and indeed the problem manifests before the auditor even
starts work) is the change to International Financial Reporting
Standards (previously called International Accounting Standards)
in 2005. I will not generally refer in this evidence to the problems
with "fair values" in the context of banks with trading
books, but instead the "sister" of fair value,
incurred loss provisioning (see in more detail later E3.5),
also a part of the controversial standard IAS 39. That change
took out the critical stress-test-for-dividend and capital maintenance
purposes, to the extent of being wholly at odds with the intent
of the Companies Act. It is possible to make a simple
link between the lack of ongoing accounting failing to be a stress
test from 2005 with regulators in 2010 rather late in the
day having to do it instead. That is not what Parliament intended.
OFF, IFRS REQUIRES
E2.5 There is also another crucial test
that fell away after IFRS was implemented in 2005. That is the
test of not allowing values from one group of assets to cover
up losses in others.
The Accounting Rules forbid "netting off" different
things, with a rise in one asset perhaps compensating for the
fall in another, but IFRS permitted/required this so as to accommodate
fair values of compound assets such as CDOs (collateralised debt
obligations). Under IFRS what is valued and disclosed is the sum
of the parts at a point in time. IFRS was not only not revealing
of the underlying components nor their individual true condition
or their risk of losing value, but it also did not even account
for things that were already deteriorating.
E2.6 Under the Accounting Rules, it is forbidden
in principle for the illusion of value to be created by essentially
an insurance policy sitting on top of a pool of decaying assets
(some CDO's carried default protection, as either insurance or
derivatives). However, the IFRS methodology served to replace
primary and reliably audited information from banks themselves
with secondary information from markets, hence inherently
second-hand, that was reliant on other agencies, such as the credit
rating firms. It has had the impact of delaying the accounting
for losses inside CDOs that were often there from inception. Some
CDO investments (which could be held on treasury books, banking
books, or trading books) were approaching £1 billion
in value. So covering up losses within that package is a serious
E2.7 Under IFRS CDO's were fair valued as
a whole from 2005-2007 with virtually no disclosure of what they
comprised. In the first quarter of 2008, it became widely understood
that there were such poor loans in some CDO's that the insurance
in place was from a few and interconnected counterparties and
hence that protection was also risk. Only then did the Financial
Stability Forum (not the IASB) set a standard to disclose what
assets CDO's comprised and what their loss rates were, and the
source of the insurance/derivative cover.
E2.8 From speaking with bank directors in
2007, 2008 and 2009, is was clear that the lack of public information
was met by a lack of information on their part also. That is not
surprising given the size of banks. Directors receive distilled
information just like the public does. The problem was that
complying with IFRS can distil information in such a way that
does not match with business risk. Losses were occurring in
2006 that did not get accounted for until the first quarter of
2008. There was a mismatch between the real estate foreclosure
notices in the USA and the transmission of these losses to the
accounts of banks, though the losses were there. In the age
of the internet, for modern accounting to delay loss recognition
by at least 15 months is a remarkable phenomenon.
E2.9 Unlike IFRS being accepting of (and
incentivising the production of) complex instruments valued as
one thing, the Companies Act Accounting Rules are seeking to pull
things apart to expose the fundamental parts. The accounting question
is what is the cost of each item, and what is the diminution/risk
to values of any of the parts.
E3.0 The difference between IFRS and the
Accounting Rules for 2005-07 is stark. With the Accounting
Rules any part of a CDO going down would show as a loss (and
reduce profit, capital and dividend capacity), IFRS masks that,
indeed the market value of the whole thing could be shown as going
up (these were called by the IASB "day one gains").
E3.1 Historic cost accounting (which IFRS
has replaced in key places) can be disparaged by invoking the
linguistic inference of a lack of modernity. One significant public
benefit of historic cost accounting, is the simple fact that the
impact of some things going down, cannot be masked by other things
going up! Things held that are going down is business risk, things
going up whilst not sold is merely opportunity. Under the Accounting
Rules, insurance is at best a contingent asset, and a prudent
view would require an auditor looking at the counterparty risk
before even considering it having any accounting value.
E3.2 Other problems with IAS 39 included
a total lack of business substance. It required banks to legally
designate on an asset's inception the accounting classification
of either trading or to maturity or to treasury, irrevocably irrespective
of the real business use of the asset. Given that IAS 39 gives
trading assets profit for going up, in a rising market it incentivises
designating assets as trading assets, leading to hoarding rather
than selling. Yet commercially the term "trading" implies
inventory, goods to be sold in the short run. Not only is the
classification misleading, but, as with recent cocoa prices, prices
might be high merely because banks were holding on to assets in
a rising market due to other buyers being there, or a lack of
liquidity due to hoarding. The Accounting Rules forbade taking
a profit from merely holding assets, so such problems do not arise.
With IAS 39, once a "designation" had occurred, directors
and auditors were unable to change the accounting, even if they
disagreed with it. It is easy to envisage how situations could
get out of control in quite profound ways.
E3.3 Churchill referred to the architecture
of buildings, in particular the Palace of Westminster, as shaping
the behaviour of those in it. Accounting standards are directly
analogous as forming the core architecture of the financial system.
When an accounting standard enables a profit from building a house
of cards people will tend to build them.
E3.4 Other than till money and office buildings,
a bank exists as paper contracts and the business can only be
described and controlled, by looking at numbers which pull of
all of that together. A bank that gets it numbers wrong may "overtrade",
essentially self-finance, by taking in deposits and issuing its
own paper whilst paying out too much as either; more bad loans,
pay, taxes or dividends.
E3.5 This critical problem can be summarised
by comparing these extracts from the two standard systems (ie
Companies Act accounts versus IFRS accounts).
IAS 39: incurred loss. BC 109 "For a
loss to be incurred, an event that provides objective evidence
of impairment must have occurred" and "Possible or expected
future trends that may lead to a loss in the future (eg that unemployment
will rise or a recession will occur) do not provide objective
evidence of impairment." (Chuck Prince the former CEO of
Citigroup called this "Dancing until the music stops).
The Accounting Rules. Clause 19. "The amount
of any item must be determined on a prudent basis|.and
in particular, only profits realised at the balance sheet
date are to be included in the profit and loss account."
This was then interpreted by the British Bankers Association standard
("BBA-SORP") for banks (franked by the ASB). "The
balance sheet amount of advances should reflect any diminution
of their ultimate realisable value below their cost."
And "To cover the impaired advances which will only be
identified as such in the future, a general provision should
E3.6 The BBA-SORP/Accounting Rules test
required a bank in valuing loans, and taking profit, and hence
in pricing credit, to take a prudent view of the future, by taking
past experience of lending and recessionary cycles. The loss from
the test "any diminution" is proportional to the quality
of the borrower and his collateral, and general provisions should
reflect that. However, IFRS, positively forbids looking at the
past or the future. The auditor of a bank operating that system
as its provisioning model therefore really has nothing better
to go on. And for those inside a bank the question "how are
we really doing?" becomes a difficult one.
E3.7 This is an extract from Lord Turner's
letter to the Chancellor, on the Dunfermline Building Society
which failed and needed to be bailed out. It indicates the problem
with incurred loss provisioning, suggesting that the auditor (using
IFRS) felt its loans were understated.
"In December 2007 as part of the ARROW
work, the FSA discussed the Society with its auditors, who informed
the FSA that overall the Society was well controlled and who suggested
that the commercial loan loss provisions, given the benign
market, may not have been entirely justified, ie may have been
slightly higher than justified."
E3.8 If one wished to invent a bank that
would collapse, but appear profitable, even when audited, right
up to the point of collapse, one could (with IFRS as the standard
(i) lend as much as possible.
(ii) take as little collateral as possible and
charge a premium for that lending risk.
(iii) compete for marginal business to grow as
fast as possible.
(iv) experience no losses in reported performance,
indeed show growing profits and capital until the bank falls over.
E3.9 None of these things need to be malign,
merely a product of group think, caused by rosy internal and externally
audited numbers from assuming that these numbers are sustainable.
This is accentuated if ones competitors are equally dysfunctional
from doing the same things. Any business can sell goods at below
cost, but obscuring that is precisely what IAS 39 accounting achieved
for high risk lending by some banks.
E4.0 If accounting and auditing standards
do not address the full scope of the law, then clearly audits
will not deliver what is expected under the full scope of the
law. The audit is intended as a check (a lookout) to then be a
check (a brake). With IAS 39 both functions are ineffective.
THE 2006 ACT
E4.1 Other than auditor liability limitation
which was new, all clauses mentioned in E1.9 by their 2006 Act
references were carried forwards from the 1985 Act to the 2006
Act. However, Sections regarding the "true and fair view"
were absent from 2005-09.
E4.2 The IAS Statutory Instrument
(which implemented IFRS in the UK) excised the Companies Act Accounting
Rules and deleted the applicability of UK Accounting Standards
Board standards, for IFRS companies. However, the Statutory Instrument
also excised the "true and fair view" objectives from
the 1985 Companies Act for IFRS using companies, and that excision
was also replicated for Companies Act (non-IFRS) accounts as well.
E4.3 Although "true and fair view"
clauses were then put back by the Companies Act 2006, different
parts of the new Act were invoked at different times, therefore
these clauses were not operative from 2005-09. Given that
the true and fair view is a backstop precisely when an accounting
standard or its application might be defective, its absence corresponded
with precisely the period that problems were in the banking sector
due to just that.
E4.4 The problem of the result of the Statutory
Instrument was identified by institutional investors and one large
accounting firm, and then supported by politicians and then the
other accounting firms, but not regulators.
The essence of investor concern was the following:
(i) true and fair view as an overarching objective
of Companies Act accounts is a backstop for precisely when accounting
standards are defective or inadequate in the circumstances.
(ii) Company law has also never defined the true
and fair view, merely set the context for it. However, IFRS defines
true and fair view as not only the product of applying
IFRS, but applying IFRS for the purposes set out in IFRS.
(iii) IFRS as to purpose, is not only
not silent on dividend assurance and capital maintenance, but
the IASB was opposed to the construct that audited accounts were
for dividend assurance and capital maintenance for the benefit
of creditors and members.
The stated purpose of IFRS is "to be useful for users"
(iv) IAS 39 was known by many to have been "the
and it was not apparent that the IASB had fully appreciated its
problems with it. Also IAS 39 was inherently inconsistent with
dividend assurance and capital maintenance.
E4.5 A summary of the key changes from the
above is set out in this table. The grey type is to demonstrate
the various levels of confusion created after 2005.
|Position||Pre-2005 accounts of all companies
||Companies Act accounts 2005-09
||IFRS Accounts 2005-09|
|True and fair view override ||Yes
||No, or at best unclear.||No, and no evidence of it being used in a UK bank, (it was used in France).
|Prudence as an overriding accounting rule?
||Yes||Accounting Rules are intact, but the ASB put IAS 39 into FRS 26 (see below)
||No. Imprudent provisioning was compulsory for banks (including banking subsidiaries), and this standard applied listed entities (their consolidated accounts) and for the individual company accounts of bank holding companies.
|IAS 39 (with its incompatibilities.)||N/A The BBA-SORP required loans to be carried at "not more than their ultimate realisable value below cost."
||IAS 39 was incorporated into UK FRS 26, despite being inconsistent with the Accounting Rules of the Companies Act, (incurred loss provisioning, below).
|Incurred loss provisioning. Forbids adjusting loans for inherent credit risk.
All this meant that from January 2005 a bigger fog than usual
descended around the banks' accounts.
E4.6 However a fog in objectives was already in place
around the auditing standards.
|Position||UK Auditing Standards to 2005
||ISA from 2005|
|An auditing standard dealing with the matters in the 1985 Act equivalent to the 2006 Act of 836 and 837?
||No. In some supplemental guidance, on a form of words when an auditor qualifies his opinion. |
But, this does not indicate the dividend test as a criteria for qualification, ie it does not direct auditing in that direction. +
|Materiality objective in auditing standards?
||Accounting materiality [ie relevance for auditing purposes is: "Material in the context of the financial statements taken as a whole"*
|Fraud and error? Both are relevant to capital/dividend safety.
||Auditing standards consistently emphasize the role of directors/managers to find fraud. This is somewhat odd as auditors use auditing standards not directors.
# ISA International Standards of Auditing.
* But, Section 837 does not restrict accounting materiality
to this very general sounding criteria. Paying dividends out of
capital (depleting reserves) by only £1 is a breach of the
law (when and if reserves get that low). Company Law expect
dividends to be what the company can bear and expects the
accounts to reflect that. FSA banking regulatory capital is merely
an additional constraint to that, essentially adding to share
capital as the balance sheet grows.
+ this omission therefore might lead auditors into believing
that if their audit and the accounts comply with accounting standards
and auditing standards, then they have achieved their objective
and do not have to qualify their opinion. The auditing standards
are therefore appearing to set a passive and reactive rather than
an investigative objective.
E4.7 In contrast to that, Section 837 is very clearly
expounded in HMRC material,
it is an acid test, but it is surprisingly absent from much regulatory
material, to the extent that even some regulators seem to have
missed its significance in what they are regulating.
What is most relevant is that Section 837 is entirely incompatible
with "incurred loss" provisioning.
E4.8 Reasons for this acid test not being more clearly
set out in auditing standards might include:
(1) auditing practice is global. The USA does not have an
equivalent acid test (in statute) for the auditors, hence the
US profession is unlikely to wish to see it in international auditing
or accounting standards.
(2) the UK accounting profession might prefer it was not in
the law. Any focus on it betrays the concept of "an expectation
gap" as somewhat of a fig leaf.
(3) external audit quality inspection processes established
under self-regulation have been founded on auditing standards
as the quality yardstick, rather than these more explicit parts
of the law. "The inspection gap" then matches the expectation
gap by inspecting "in accordance with standards". It
holds up the fig leaf.
Butas has happenedwhen accounting standards
are faulty, there is no clear audit objective to follow either.
The law requires the audited accounts to reflect the business
condition, in numbers, and an assessment of proper control (Section
386), so that dividends can be paid, or withheld. Auditing standards
are a fudge.
E4.9 The recent criticism of auditors arises despite
much more audit regulation. Yet from 1879 to 2005, in the current
and former sterling area, banks did not collapse systemically
with no regulator and in places no lender of last resort. All
of this area applied a similar accounting, reporting and governance
system, the Companies Act.
E5.0 I believe that there has been an insidious problem
with a "too few to fail" attitude within the regulatory
That has manifested in regulatory support for sheltering auditors
from civil liability claims.
It is a classic manifestation of regulatory capture.
E5.1 However, as we have seen there is a widespread recognition
of the moral hazard of a "too big to fail" situation
with banks. The same problem arises with audit firms. If poor
auditing can lead to banks failing (as was held in cases in the
UK in the 1990's and 1980's), then the combination of "too
big to fail" (banks) and "too few to fail" (auditors)
is a lethal combination.
E5.2 Standards (accounting and auditing) are heavily
influenced by the profession itself, a part of which has a vested
interest in obscuring its statutory test of audit quality, which
is an acid test, and replacing it with a far woollier one
for public consumption and professional inspection. I have observed
regulators not believing what Parliament intended, they then overlook
it and hence themselves unknowingly subvert it. A significant
part of the regulatory oversight system has very little grasp
of the scope of the law as opposed to the standards. I have yet
to see any evidence that the UK's FRC uses information on successful
auditor litigation (ie contractual failure) as a criteria for
audit quality. It instead inspects according to (regulatory) standards
with the lesser tests. It is checking false compliance, and driving
a paradigm of "good" corporate governance on that model.
E5.3 Essentially Enron and the then collapse of Anderson
was the tip of an iceberg that has unfortunately been hit twice.
The lessons of that crisis were not learned and many of the remedies
since have been quack medicine.
E5.4 Currently there is talk of auditors doing more on
"risk", and auditing risk statements. It is quite easy
to see its attraction as both a distraction and a way of extracting
more fees. The competitive advantage to accountants should be
around numeracy. The risk to a bank is not getting money back
having lent it. The key issue is getting the numbers right, and
delivering as the law already requires but the standards have
not delivered. Banks overstated numbers to one degree or
other most probably from early 2006, or earlier in some cases,
due to the problems with IFRS. That was the problem, more words
and more fees around the more words are not going to address that.
Other suggested remedies such "talking more to the FSA"
will not help either party much if the auditor has not bottomed
4 August 2010
Answer to Justine Greening MP from Margaret Hodge MP, Minister,
July 2006. Back
Evening Standard, June 2008 http://www.thisislondon.co.uk/standard-business/article-23498600-a-principle-we-must-save-at-bb.do Back
"Are banks different?" Lord Turner, January 2010. http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2010/0121_at.shtml Back
House of Lords, Caparo vs Dickman, 1990. Back
Also called "UK GAAP". Though UK GAAP, is Companies
Act formats and rules, and then Accounting Standards Board Standards. Back
NAPF/Morley Fund Management, "Bringing Audit Back from the
Brink" and "Undermining the Statutory Audit" 200-05. Back
Financial Times, Barney Jopson, 24 June 2005. Back
Companies Act, Schedule 2, Part 2, Clause 21. http://www.opsi.gov.uk/si/si2008/uksi_20080410_en_9£sch2-pt2 Back
Letter from Lord Turner to the Chancellor, Alastair Darling MP,
SI 2004/2947. Back
Financial Times-John Plender. 10 July 2005, "Battle for truth
in European Accounts". Back
IASB Conceptual Framework Project. IASB 2005. Back
"Following the Money", The Enron Failure and the State
of Corporate Disclosure, Brookings Institution, USA, http://reg-markets.org/admin/authorpdfs/redirect-safely.php?fname=../pdffiles/phpD9.pdf Back
Soc Gen in 2008 overrode IFRS, to match the losses of unauthorised
dealing, with the period in which the positions had been started.
The IFRS treatment would have shown a profit for 2007, as the
positions were in the money, with the losses being deferred until
HMRC manual-notes on Company Law aspects of dividends, http://www.hmrc.gov.uk/manuals/ctmanual/ctm20095.htm Back
FRC/FSA consultation July 2010 on matters arising from the results
of inspections of bank audits. This does not mention the impact
of potential overvaluations of assets found in the inspections
with the impact on dividends. Back
New York Times, http://www.nytimes.com/2005/06/25/business/25nocera.html Back
FRC delegations to DTI in 2004/2005 to support a liability cap.
Opposed by HM Treasury. Back
"Regulatory Capture" Stigler, Chicago, Nobel Prize