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

Examination of Witnesses (Questions 169-234)

Mr Philip Collins, Mr David Stallibrass, Baroness Hogg, Mr Stephen Haddrill, Ms Sally Dewar and Mr Richard Thorpe


  Q169The Chairman: We are here for the inquiry into Auditors: Market Concentration and Their Role. Copies are available of Members' entries in the Register of Interests and of the declarations of interest relevant to this inquiry. I thank all six of you for coming, and thank you very much for your extremely helpful written evidence. I make the usual request, for the benefit of the webcast and the shorthand writers: please speak loud and clear. When we reach the questions, because we have a lot to get through this afternoon, if you agree with whoever is answering first, please simply nod or just say nothing. But I rather suspect that, given the range of witnesses we have this afternoon, that will not happen very often. But if it is possible please do, so that we can get through as much as we possibly can.

  Would any of you like to make an opening statement or shall we go straight on to questions?

  Baroness Hogg: Whichever you would like, my Lord Chairman. We have a very short one, if you would like, but if you want to go straight to questions, we're very happy as far as we are concerned.

  Q170  The Chairman: If it is very short, please do, Baroness Hogg.

  Baroness Hogg: We would just like to say we think this is particularly timely. The FRC has been voicing its concerns about the actual and potential threat toward equality from market concentration for several years. As you know, in 2006, we set up the Market Participants' Group of investors, companies and audit firms, to explore ways of getting the market to work better. But in our latest report we made it clear that, whatever benefits there may have been from this work, concentration is as great as ever. So we do believe the time has come to consider more radical measures than we can pursue on our own and we hope that the combination of your Lordships' inquiry here, and a European Commission Green Paper from Brussels, which has some potentially disturbing elements, will act as catalysts to action at both national and international level.

  Of course, we are not a competition authority and you will get a much better view from our neighbours down the line on the proper limits of competition policy here. Our focus is on the quality of audit and the contribution it should make to our objective, which is promoting good corporate governance and corporate reporting in order to foster investment. So it is from that perspective we would now urge consideration of further actions at national and G20 level. That does not of course mean we support all the solutions being canvassed.

  Meanwhile, there are a number of lessons we have learnt at the FRC, over the past few years, about what is needed for us to pursue our objectives fully. A number of these relate to our roles with respect to audit regulation. As you know, my Lord Chairman, the FRC was created out of a range of regulatory and self-regulatory bodies for standard setting, guidance giving and disciplinary actions in the fields of audit accounting, reporting and governance, to which have more recently been added the actuarial profession and investor stewardship. This has been a journey along which great progress was made by Stephen and my predecessors, but we believe more needs to be done to make the whole greater than the sum of the parts; for example, by transferring licensing authority for listed company auditors from the institutes to the FRC and giving us greater investigatory and information sharing powers. But since some of this would require legislation—both primary and secondary—we are very grateful for any opportunity we may have this afternoon to explain our thinking to the committee. Thank you.

  Mr Collins: Thank you very much, my Lords, for inviting us here today. We are a competition authority and the mission we have is to make markets work well for consumers and, in this case, for the users of audit services. In the context of audit services, our concern is whether competition is working in the market in a way that means that those who use the services, who are a diverse range of interested parties, investors, financiers and regulators, among others, and not just the companies who commission audits, get the information that they require.

  We consider that the competition in the market for audit services to large companies may be limited, as a result of barriers to entry and expansion, switching costs and limited choice in firms. We observe low levels of tendering and switching, high concentration and some evidence of high fees. There may be other effects of a lack of competition, such as low quality and lack of innovation, which are perhaps best judged by others, including the FRC.

  High concentration may also contribute to a risk of systemic failure in the audit market. Barriers to entry might make it difficult for mid-tier firms to step up to replace one of the Big Four firms if it were to exit the market. Thus we think that the market, as currently structured, may not operate in a way that works well for users, particularly by delivering optimal efficient outcomes for those users. So one question is: what to do about it? The key issue here appears to us to be whether regulation should seek to set only the outcome of the audit process; that is, stipulate the content and quality of an audit, or whether in addition it should seek to better harness market forces, in a way that focuses not just on the audit process itself but on stimulating both companies and firms supplying audit services to focus on what users of those services need and require.

  Regulating quality is important, but a danger with regulating only the content and quality of audit is that efforts of market players can become focused mainly on satisfying the regulator, in all likelihood at or just above the acceptable level. Regulating outcomes is particularly difficult where the product is as complex and the quality is as hard to discern as with audit.

  We therefore think it is important that regulation harnesses market forces, so that firms offering services to companies are incentivised to satisfy the needs and requirements of users. To this end we think that consideration could be given to a reduced form of statutory audit combined with such other measures, including a clear statement about the level of assurance provided by an audit. This would then leave it open for companies to supply further assurance about various aspects of their activities, which are important to their investors and to other interested parties, in addition to the statutory audit, but on a voluntary basis. In this situation one could envisage a prohibition on auditors supplying non-audit or non-assurance services.

  Another key question is: can we in the UK do something on our own? The answer to this is unclear, given the extent of international regulation of auditing. But we can lead by promoting both international debate and potential international action. That is why, for instance, we have sought to raise the issue for discussion among other competition agencies, including the European Commission, and international bodies such as the OECD. In particular, we are seeking to raise the issue of how merger regimes in different countries might react to a failure of a large audit firm and subsequent disposal of its assets. We also plan to make a submission in response to the European Commission's public consultation on audit policy, and we will continue to liaise with the FRC, which over the past few years has been taking the lead in seeking to address market issues through the Market Participants' Group, as you have heard. Thank you very much.

  Q171  The Chairman: Thank you very much. I think we have already established that there is a great deal of concern about the dominance of the Big Four, the impact on competition and choice, and the risk of a failure of one of the Big Four. What is much less clear to us at this stage is what the answers are, and I notice that there is already some difference in the opening statements we have had, and in the evidence. For example, one of the FRC's comments in its paper is, [odq]Market-led solutions have not proved effective and therefore a regulatory solution should now be considered[cdq], whereas the OFT's preference is for changes to be delivered through the market. So these are all issues I think we will be exploring this afternoon.

  Could I begin by asking you the question: do you think there has been regulatory capture by auditors and auditor firms themselves? Then perhaps to the FRC: is the danger greater in the FRC where auditors play a very active part and, in particular, where the Big Four play an active part in seeking solutions?

  Baroness Hogg: Before answering that question, may I just go back to this point about market solutions, because it is possible that we're using the language in different ways and, therefore, you might be led to consider that the difference is greater than it really is. The market solutions referred to in our paper were those that came through the Market Participants' Group; that is, those that came out of an engagement of discussion with investors, audit firms and ourselves. I think we want to go with the grain of the market in the economic sense quite as much as the OFT does, because that is the powerful way to do it. We have a number of specific suggestions that, in that sense, are very much market-based, which I would love if I may to come back to. Might I do that now or would you like me to answer the question?

  Q172  The Chairman: I think answer the question because we will come back to that again later.

  Baroness Hogg: Okay. On the issue of regulatory capture, I think the journey of travel at the FRC has been exactly in the opposite direction. That is to say, it was born out of a quasi self-regulatory system and over time, under Stephen and my predecessors, a greater degree of independence has been created in the structure. For example, the AIU has become more transparent and more public, where it sees issues to criticise in the audit of listed companies. But we feel that there is further to go on this journey. I touched on some of the issues in my opening statement but if I may I will ask Stephen to pick up on that.

  Mr Haddrill: First of all, at the moment we are not the body that registers an audit firm to be a public interest auditor, an auditor of listed companies. That is done by the relevant institute, generally by the Institute of Chartered Accountants in England and Wales. We think that there should be an additional registration of such auditors by the FRC in future. On the basis of that, that would enable us to exercise a wider range of sanctions, should we find something wrong in the way that the auditor is conducting its affairs. At the moment the only sanction we have is to recommend to the institute that it removes the registration from the audit firm. That is obviously a nuclear option. It is not an option in our control. It is an option for us to recommend it to the institute. We would expect them to enforce it but we don't have that power.

  If we had registration in our own hands we would wish to seek a wider range of sanctions, including being able to set conditions on how the audit firm does business in future, if there is evidence that it is doing it wrongly; to set fines; maybe to ask a particular partner to be removed from the list of people who do public interest audit work. At the moment we do have a responsibility to register these bodies that set qualifications, the institutes themselves. But our only sanction if they don't do their job properly is effectively to wind them up and to remove that qualification, that registration. So again, in relation to the institutes, we would also want a wider range of sanctions to exercise.

  Next, we wish to be able to conduct—much more easily than we can at the moment—preliminary investigations when something has gone wrong. This may be something that we come back to when we talk about the financial crisis and what's happened since then. But at the moment it's quite difficult for us to conduct a comprehensive investigation into whether or not there has been an audit failure, if we don't have some real hard evidence of that being available. We have very limited powers to call into account and to question directors, for example, unless they happen to be accountants. So we find it quite hard to get a thorough review of whether something has gone wrong and would like our investigatory powers to be strengthened in that respect.

  Finally, we still have problems, because of the way that we have been set up and the way the legislation works, in passing information from one part of the FRC to another. That is something that we think should be dealt with as part of any set of changes.

  Q173  The Chairman: We may come on to that later. But pursuing the question of regulatory capture for a moment and how far you have got—given, of course, that I think a lot of the evidence we are getting, and no doubt from some of you, goes way beyond pure accountancy and wants to look at systemic risk and all those sorts of issues in companies—can you tell us what proportion of the FRC's board and committees are members of the accountancy profession? Of these, how many work for the Big Four and would any of the chairs of FRC committees fail the criteria for independence in the FRC's corporate governance code? You may not be able to answer the statistical questions at the moment but perhaps you could let us have a note.

  Baroness Hogg: The key first point I would like to make is that we do not have practising practitioners on the two disciplinary bodies. That is to say, we don't have them on the POB and we don't have them on the AADB.

  You have described them as [odq]subsidiaries[cdq] but they are in fact operating bodies, and one of the issues that Stephen has been alluding to is that a lot of the powers are vested in the operating bodies rather than the FRC itself, which is an umbrella. So each of these is drawn broadly from the communities of investors, auditors, actuaries, accountants, people with experience on company boards, and the FRC board itself is a mix of these qualities.

  But we have quite a complicated board because the board is made up at the moment of the chairmen of all the operating bodies and it is a very debateable point whether those are non-executive, because they are non-executive with respect to their membership of the FRC board, or executive, because they are chairmen—some of them executive, some of them non-executive—of the distinct operating bodies. Then we have other members of the board who have no other position within the FRC framework. I'm sure I have made that even more confusing than it was to begin with, but we asked exactly the question you asked, my Lord Chairman, and it is very difficult to answer in terms of the structure of the FRC.

  Q174  Lord Tugendhat: I listened with great care to Mr Collins and I thought perhaps I wasn't going to need to ask this question—which is the first of two—about why it is that the OFT has never done an inquiry into the audit profession? I heard exactly what you said, I think, but it is such an extraordinary situation, with four firms dominating to the degree that they do, that I would have thought that a report setting out the considerations, the dangers, the reasons why you are not recommending further action, or why you might have recommended further action, it does surprise me that you have never done it.

  Mr Collins: Perhaps I could reply looking at history, and I think you have already heard evidence about the way in which the 16 firms have reduced to four over the last 30 years. I think that is roughly the way it has gone. Of course, there was a significant change in the latter part of the last decade, with the merger between Price Waterhouse and Coopers and Lybrand. Then, of course, there was the unexpected collapse of Arthur Andersen. When Arthur Andersen collapsed we did have a look at the market and we said we felt at that time, given the fact that the market was in transition as a result of bits of Arthur Andersen going in different directions, that, while we would keep the market under review, we didn't think at that stage a detailed investigation was appropriate. You will recall in fact that the Price Waterhouse, Coopers and Lybrand merger had in fact been cleared by the European Commission, I think, in 1998.

  If we move forward, the action then moved to the FRC, because, from 2006 onwards, it constructed the Market Participants' Group, which was working with the industry. We didn't feel it was appropriate at that stage, given that work going on, to carry out a review. Now we see the outcome of that review, and I think it is public that the FRC will not produce a final report until after this committee has reported. We will have to consider the position then. But the thing I would emphasise is that, because of the nature of this market—we can see it purely from a UK perspective—it is a very international market. We have to look in terms of what the solutions might be and what is practical in an international setting. So it is a market in which we have a keen interest but it is not a market in which we felt it appropriate, in the last seven or eight years, to conduct a detailed review because other things had been happening.

  Q175  Lord Tugendhat: The other question I wanted to ask arises almost from something you said when you talked about consumers of audit services. Could I ask you whether you feel that one ought to look at this market as being one in which you have suppliers and consumers, like many other markets, or is the nature of audit such that one ought to regard audit as a public good from which benefits flow for all citizens, or if not all citizens at any rate all investors, benefits and disbenefits, because it is not just the owners of the company, it is the whole investing community? So it is a public good, isn't it? Or would you say not?

  Mr Collins: It's a public good, in the sense that it's a statutory monopoly regulated by statute and it's put there for a good purpose, which is to protect the public in the broadest sense. In that sense, one might regard it as being in the public interest or a public good. But I was very clear in my opening remarks to say that, so far as consumers are concerned, we recognise that it was a very broad category of interested parties who are concerned to see high quality and reliable audit services being provided. So I don't think it's necessarily a question of supply or demand or public good or not. Clearly, the audit requirement is there for a purpose and the question is: are the different users—and there are a diverse range of users—getting the benefit of the services that are being provided?

  Q176  Lord Levene of Portsoken: We have seen in the last couple of years some pretty spectacular disasters hit the banks, and yet they were all audited. Why have there been no regulatory sanctions against the auditors who gave unqualified opinions on those banks just a few months before the real facts came out?

  Baroness Hogg: There are two big questions here and it's an extremely important challenge. Question one I think is: did auditors fail in the sense that there was professional misconduct? The second question is: did audit fail, in that it did not perform the function that one could reasonably have expected it to do?

  With respect to auditors' responsibility in this area, or the power to act, is with ourselves and the FSA. The FSA—I know Sally will want to say more about this; I shouldn't talk about the FSA—in carrying out its investigations while it has the power to disqualify auditors, probably most relevant to this immediate point of misconduct, has the responsibility to refer to the AADB—one of our operating bodies—any evidence it may come across that might lead to a finding of professional misconduct. So I can mention them, because they are in the public domain: the AADB is considering investigating the auditors of Lehmans and, in a specific area of its activity, JP Morgan.

  The story is not over yet, but I shall park that for a moment and talk about the role of audit and did audit fail. That is a challenge that again we have tried to tackle jointly, in terms of a consultation document on the role of audit and auditors in general in macro-prudential regulation, and the extent to which the audit process and the regulation of audit was doing its job. You will have received a copy of the joint consultation paper we put out on this issue, which raised a number of questions about this. The FRC has also put out a paper on the subject of the degree to which auditors exercise professional scepticism. I would like if I may to ask Stephen to pick up on that and our other specific actions in the [odq]did audit fail[cdq] area, which is going to be a debate for some time.

  We have to steer a course between asking too much of audit and assuming in some way that it can perform the function of management, which it can't and mustn't, or expecting too little, which is our challenge at the moment—was too little expected?

  Mr Haddrill: I think firstly there is a combination of the role of audit and the role of the accounting standards themselves. The accounting standards set what the management prepare and then the auditors audit that. So first of all, I think it's important to look at the two together. Secondly, we feel that there is quite an obvious danger in the auditors having to sound the alarm just as a crisis is happening. What we need to make sure of is that the auditors are in a position to send an early warning signal; perhaps it was a matter for 2006/2007 rather than 2008/2009.

  I think the nature of that early warning signal is around the quality of the management's reporting on risk, as it sees it facing the business, and the assurance the auditors can give that the business has gone through a good quality process in assessing risk and then reporting on it. Also, the auditor explains to the investor clearly what assurance they can give and what the audit isn't covering, because I think sometimes there is a misconception that the audit is providing more assurance than perhaps people should rest on. So there are areas where we are exploring whether the auditor can do more, but I think it's a question of doing it at an earlier date.

  On the question of scepticism, essentially what the auditor is doing is looking at the judgments of management. They must be challenging those judgments and that requires them to be sceptical. They need to challenge them when the sky is still fairly blue and the cloud is quite a long way out on the horizon, not just when it has actually started raining. That scepticism is something we want to see built more into the training and qualification process, particularly of the audit partners. There is very little formal qualification required after an auditor has been qualified as a partner to do public interest audits, but in the 25-year period after that has happened the world moves on. I'm not saying that they clearly don't try and keep up, but there isn't a formal process. Clearly the financial services regulation requirements have moved a lot in that period as well and need to be fully understood. Thirdly, there is this question about the scepticism being enhanced by dialogue with the regulators who see the macro picture, not just the micro picture, in the individual business that's being audited. I know that's something that the FSA is seeking to address.

  Baroness Hogg: Before we pass over, there is just one final piece of the jigsaw, which is in our camp, where Stephen rightly emphasised the role of the company in reporting appropriately on the business model and the risks. In the new version of the corporate governance code there is much greater emphasis on these reporting responsibilities. So it doesn't all fall to the auditor, it does fall to the boards of companies as well, and one of the most important early reviews that we carried out was of the Corporate Governance Code, in parallel with the Walker report on governance in financial institutions.

  Q177  The Chairman: Does the FSA want to comment?

  Ms Dewar: Yes, thank you. There are a couple of things I would say, and I absolutely support what has been said already: the focus we would have at the FSA is on the firms we regulate and the approved persons. So in that context we have brought a number of disciplinary actions against the accountants who were approved persons, so it was in their capacity as approved persons. That was for failed firms during the crisis.

  But we don't take it as the FSA's role to take the lead in bringing the disciplinary action against accountants and auditors for professional failings. As Baroness Hogg has said, we would work with the FRC to let them know of failings that we think we have found, or issues that we have come across, as part of our normal "business as usual" work. We will discuss that with the FRC and will pass that information on, and then they would take it forward through their disciplinary board.

  In respect of client assets where the assurance of the audit is to the FSA specifically, then we have taken action ourselves and we have made referrals to the institute, which is taking those cases forward, so there are several cases going through that process.

  The Chairman: I know there are a number of Members of the committee who want to follow this particular issue up before we return to others.

  Q178  Lord Lawson of Blaby: Thank you. If I may summarise the answers we have heard to Lord Levene's question, it is that you were asleep on the job and, to the extent that you were half awake, your eye was not on the ball. I think it might be helpful to go over the background to this because it is a rather important issue. As Baroness Hogg will be aware, when I was Chancellor in 1984 I set up a committee to look into the question of banking supervision in this country and to make recommendations, and I appointed the then Governor—Robin Leigh-Pemberton, now Lord Kingsdown—as chairman of the committee. Among its important conclusions were that the iron curtain of confidentiality that separated bank supervisors from bank auditors should be replaced by a regular dialogue. This was incorporated into the 1987 Banking Act as a further safeguard, as one of the provisions of the Act—and this has not been repealed so far as I am aware—that bank auditors could disclose information to bank supervisors if they felt it right to do so, with protection from any action for damages that might be laid. What has happened to this regular dialogue? Of course, the institution is mainly culpable.

  Obviously it is the FSA who had the main responsibility—and I will come on to them in a moment—and they are the principal culprit in this area. But presumably, the FRC was monitoring what was going on in this: what the FSA were doing; whether the FSA was adequately satisfying its statutory obligation—and indeed commonsense obligation—to make sure that this regular dialogue would take place. I don't think the FRC is the principal culprit here, but I was slightly shocked when we asked the question in the call for evidence, "Were auditors sufficiently sceptical when auditing banks in the run-up to the financial crisis of 2008?" and the FRC's answer was, "See paragraphs 2.9 to 2.11 of our submission for our comments on scepticism". So I looked at those comments on scepticism and it just says, "Application of appropriate professional scepticism is vital", and then it goes on with a lot of waffle. There was not one mention of banks, as if we hadn't had this appalling banking crisis, which has dominated what has happened to the economy since then.

  The FSA does a little bit more—as well it might, because it is the responsible authority. It says, "As a result of lessons learned from the crisis we have adopted a more intensive supervisory approach. We recognise that in the past bilateral meetings between the FSA and the auditor of a supervised firm took place on an ad hoc basis". Those are pretty weasel words, "ad hoc basis", so I would like to get the facts. Can you please tell me, in regard to Northern Rock, Halifax Bank of Scotland, the Royal Bank of Scotland and Bradford and Bingley, precisely how many of these meetings took place in 2006, 2007 and 2008?

  Ms Dewar: Chairman, I can't give you those statistics now but I'm very happy to put those in writing.

  Lord Lawson of Blaby: Well, I don't think that is an adequate answer to everything that I have tried to put across. However, there was a requirement in the 1987 Act—that's a long time ago, 20 years before the crisis—to strengthen the supervision of banks by having this regular dialogue and I don't believe this regular dialogue happened or, if it did happen, it didn't happen at a sufficiently high level or with sufficient frequency. Although, as I say, Baroness Hogg's outfit is not primarily responsible, I don't believe that they were checking adequately on whether this was going on because certainly nothing at all happened.

  Q179  The Chairman: So we will look forward to your note but perhaps you could answer the question now more generally?

  Ms Dewar: Absolutely. So, as we've said in our note, and we've said in our lessons learned from the crisis, there was not an embedded philosophy of direct engagement with the auditors as part of an ongoing—

  Q180  Lord Lawson of Blaby: But there should be. It was a requirement of the 1987 Act. Why did you ignore the legislation?

  Mr Thorpe: I think the requirement is certainly on an auditor. There is a requirement both under our legislation and under European directives for auditors to inform us of anything they find, in the course of their audit, which is of material significance to us as a regulator. We get relatively few of those notifications.

  Q181  Lord Lawson of Blaby: So they didn't find anything wrong?

  Mr Thorpe: No. We talked to them about that and they say that they give us relatively few of those notifications, because it is their practice to require their client to tell us of the issues that they found during the course of their audit. We don't think that goes far enough, and in the discussion paper that we published on it with the FRC we have made it clear that we would expect them to make the notifications to us, in addition to anything that we hear from their client. We expect that to go on during a process of more rigorous bilateral discussions with them, which we're now setting in place. But primarily, the onus is on them to inform us of issues that they find rather than on us to discuss issues—

  Q182  Lord Lawson of Blaby: So it was the auditors who were culpable then?

  Ms Dewar: Nevertheless, as part of our supervisory engagement programme, we absolutely should have had a two-way dialogue with the auditors. So regardless of where the onus lay the responsibility was on both sides. We have changed our supervisory approach to embed that and have made sure that that change is embedded within the framework.

  Q183  Lord Lawson of Blaby: That is excellent to hear, but just going back on what happened, because it is relevant to our inquiry, which is basically into auditing and auditors, the auditors failed then? They were culpable?

  Ms Dewar: The requirement was on the auditors to come to us with specific examples of—

  Q184  Lord Lawson of Blaby: Do you think on reflection, bearing in mind the gravity of the banking meltdown, they did what they should have done sufficiently frequently?

  Mr Thorpe: We have no evidence that there were examples of information that they should have given to us, which we didn't get direct from their clients.

  The Chairman: Lord Tugendhat, do you want to come in on this one? We will continue to pursue this.

  Baroness Hogg: I am so sorry. Lord Lawson did have some challenges for the FRC as well. May I just say very briefly, Lord Lawson, that I am sorry if you thought our efforts to keep our evidence at a disciplined length left you short of what you would have desired. We were asked in the call for evidence not to repeat things that we'd recently published. I'm very happy to supply you with a copy of our paper on auditor scepticism and I hope that will fill in some of the gaps you found.

  Lord Lawson of Blaby: Specifically about banks, that is what I'm talking about.

  Baroness Hogg: Indeed.

  Q185  Lord Tugendhat: I have a small point in addition to Lord Lawson's point. In the year that he was off this Committee we had an inquiry into the banking crisis and I remember at that point asking, both the auditors and the banks, to what extent there were regular informal contacts between the banks and the auditors, in which the auditors talked about general issues that had arisen, points that were common across the board and points of potential danger. My recollection is that they said that these meetings had taken place quite regularly but had then fallen away. Nobody seemed clear whether they had fallen away because the FSA didn't want them or the banks didn't want them, but they hadn't taken place for some time prior to the crisis but they had further in the past. Perhaps, when you answer Lord Lawson, you could also say when this regular practice fell away.

  Ms Dewar: Are you referring here to the engagement between the FSA and the auditors, and not to the banks and the auditors?

  Lord Tugendhat: No, I am referring to the auditors and the FSA.

  Ms Dewar: Absolutely.

  Q186  The Chairman: I haven't read the paper on scepticism and the auditors but what we are talking about now, does that not require a different set of experiences and range of skills different to what auditors currently have?

  Mr Haddrill: Yes, we think it does and that's why in our paper we're consulting on how that might be improved. The world is moving on quite significantly and the accounting standards themselves have moved a lot over recent years. Of course we've moved from a system based upon accounts drawn up on an historic cost basis, where the numbers are the numbers, to accounts that are much more based upon market values. Of course those market values may be there but they may also require some construction, some judgment, and the management has to exercise that judgment. Those judgments are crucial and the crucial thing is that the auditors have the ability to challenge the judgment of people who are very expert themselves, particularly in the banks. So that is an area where we think that the firms need to be very much up to speed and very current, and so on, for the future.

  Q187  The Chairman: In trying to challenge management's judgment about areas they've entered into and invested in heavily, and so on, are we asking too much of the auditors to bring a different judgement and a different range of knowledge to bear?

  Mr Haddrill: I certainly wouldn't ask an auditor to supplant their judgment for that of management. It is a question of challenging the judgment of the management, knowing what are the right questions to ask and being able to follow through on that when the auditor is there with the audit committee; in effect, to empower the audit committee itself to be challenging of the company.

  Q188  Lord Lawson of Blaby: If I may, I will ask our two witnesses from the FSA for information and clarification. Are you saying that the auditors didn't notice there was anything wrong with the banks, or are you saying they did notice and they didn't tell you, or are you saying they did notice and they did tell you but you didn't do anything about it? Which of the three is it?

  Ms Dewar: They didn't come to us and talk through the issues that they may or may not have had regarding the firms that they were auditing. So it's not that they brought issues to us and we didn't do anything about it; we had very few conversations of that description.

  Q189  Lord Lawson of Blaby: Did they not bring it to you, do you think, because they didn't notice that there was anything wrong or because, for one reason or another, they didn't feel that they should tell you?

  Ms Dewar: I think that's impossible for us to make a judgment on.

  Lord Lawson of Blaby: Thank you.

  The Chairman: I know this is a very important topic but we have others to deal with so, Lord Levene, last point on this one.

  Q190  Lord Levene of Portsoken: Can I just go back to my original question? We have heard evidence about who did or didn't say what to whom, and whether they should or shouldn't have done. I think it is undisputed that there were real problems that hadn't been shown up by the auditors. Has any form of sanction been taken against them for giving unqualified opinions on the accounts when in fact there were these huge problems, which they had responsibility to look for and said nothing about? Was there any form of sanction against any of the auditors for not having brought that up?

  Baroness Hogg: May I come back? I indicated to you, Lord Levene—and as I said, these two are in the public domain, so I can mention them—the auditors of Lehmans and the auditors of JP Morgan are already being investigated by the AADB.

  Q191  Lord Levene of Portsoken: So it is work in progress?

  Baroness Hogg: Exactly.

  Q192  Lord Best: Returning to the issues of concentration of audit in the hands of the Big Four companies, I know that the FRC has been looking at the recommendations it made in 2007 from the audit choice Market Participants' Group. You are now up to your fifth progress report looking at that, and in that report you say that the majority of your recommendations, which are intended to allow the audit market to work more efficiently and in the medium to long term to increase audit choice, have now been implemented. But would you accept that they haven't achieved very much?

  Baroness Hogg: As I said in my opening statement, and as we say in that report, we are very clear that market concentration is as great as ever. So we are very clear that they haven't had an impact on market concentration.

  I don't want to brush aside some of the improvements that have been introduced through this group; for example, I think the focus on audit firm governance has been important and has been internationally leading in putting pressure on the audit firms to improve their own systems of governance. But in terms of market concentration: as I said to begin with, we believe that actions, which are beyond our ability to do ourselves, need to be taken.

  There is one on which I think this Committee could have a very important immediate effect, because it's an issue that is live at the moment and can go the wrong way: what happens to the work that was previously done by the Audit Commission? I think if that slips into the hands of the Big Four that will be, at the very least, a big missed opportunity to increase the strength of work done by the non-Big Four firms and I think action needs to be taken. We have made this point to Government, of course, but making it to you may prove much more effective.

  Q193  Lord Best: Could you say a little bit more about that action? What do you think should be done to avoid that danger?

  Baroness Hogg: Point one: Government have to feed the message through all parts of the body public that it is now looking to tender that work, that at the very least they should not feel it necessary to go only to the Big Four. That would be key stage one. I would rather hope that Government could be more proactive in that regard. I just want to put down a marker because I think it would be a big missed opportunity if that challenge for public procurement weren't marked at this point.

  Q194  The Chairman: So you are not suggesting that there should be firms that should be excluded from competing for that work?

  Baroness Hogg: No, I think it's better done by indicating to those concerned that, as most of them are largely domestic operations and activities, there is no reason why they need international network, Big Four, accountancy firms to carry out that work.

  We also have concerns about the ownership rules. We understand why the ownership rules are there, but we think they are a barrier to entry into the market. We think there is another immediate opportunity to break up the market, in the sense of enlarging it in terms of where risk committees are now being put in place, as you know, by all the major financial institutions. At least one chairman of the committee has said to me—and I hope it is becoming best practice—that the risk committee should be advised by someone who is not the firm's auditors. That might be a route in, not just to spread the work around the same group but also around specialist firms, particularly if something was done about the ownership rules and new kinds of work to new kinds of firms that would help to break up the market at the edge. We think it would be important, both in terms of the quality of advice to companies and in terms of the nature of the audit market itself; risk evaluation work rather than the full audit story that would still be required by the audit committee.

  We had one other thought at this point, which I forget.

  Mr Haddrill: The one other thought was one that's already been raised in evidence to the committee, which is about the nature of bank covenants and the requirements of the banks. That is something that perhaps between us and the OFT we might explore.

  The Chairman: I wonder if you could give us a more developed note on both those points, because we haven't enough time to go into it today, but it would be very helpful if you could.

  Q195  Lord Hollick: It has been put to us by Mr Hodgkinson of the Institute of Chartered Accountants in England and Wales that, if there was one measure that would assist in widening choice in the audit market, it would be to "oblige regulators to consider how regulation affects availability of choice", and to "make it a criterion for regulatory action because it is clearly in the public interest" to do so.

  Baroness Hogg: I think what we've said this afternoon illustrates the importance we give to the issue of choice, because we believe it would. So we are inclined to emphasise the ultimate objective, but yes we go with the flow of that argument very much. Did you want to add something, Stephen?

  Mr Haddrill: Yes. I think this goes to the point that Lord MacGregor made at the beginning. I don't think there is a difference between the position outlined by the FRC and by ourselves. We're looking at the way in which regulation can be used as a lever, in the right way, to drive market forces and therefore to promote choice, as opposed to regulation being seen in a rather negative way, inhibiting market development.

  Baroness Hogg: Exactly.

  Q196  Lord Lipsey: It came as a surprise to me that, in the course of much of the evidence we have taken, there has been less focus than I would have expected on the oligopolistic nature of this market and more emphasis on the kind of standards that are imposed, particularly international standards under the International Financial Reporting Standards. People say this is a lot of box ticking rather than proper auditing; that it's moved us away from prudence and true and fair in favour of that; that the increased complexity of the process, under these very complicated rules applied internationally, helps the Big Four maintain their grip on the market; and so on. Do our witnesses this afternoon have a view on these contentions or do you think that the problems, if there are any, lie in oligopoly essentially?

  Baroness Hogg: I think we can't get away from the problems of oligopoly, but I think we and the standards setters are looking at what role they may or may not have played in the events of the past few years. I think the protagonists of UK GAPP and IFRS are sometimes more ready to see the weaknesses in the opposite camp, than to recognise the weaknesses in their own standards. I think all standards did need reviewing in the light of what has happened, but I also think that you can't load on to that the responsibility that should rest still with the boards of companies and their auditors. Stephen, would you like to say more about the standards point that Lord Lipsey is raising?

  Mr Haddrill: Firstly, UK GAPP is not a particularly simple or thin set of standards. It runs to well over 2,000 pages, so let's remember that. Secondly, the adoption of international standards hasn't removed the requirement on auditors to exercise their scepticism and to challenge the management. Nor has it removed the true and fair concept, the true and fair override. But UK GAPP for listed companies was superseded some years ago by international standards. At the time that it was superseded it did not have some of the key elements it would need in order to cope with the modern capital market. It didn't have a standard on derivatives, for example. So clearly it would have had to grow and develop and become, I fear, rather more complex in relation to a rather more complex set of financial instruments that the market has been developing. So you can't look back to an old world and say, [odq]We must get back to that[cdq]. The accounting world has had to move with the financial world. I think we feel that there are certainly things that need to be improved in international standards. Rather too little disclosure is being required, too much is being reported in aggregate, and we put pressure on the International Accounting Standards Board, along with others, to address that and it has responded. So I am certainly not saying that international standards didn't require change. They do require change. I hope that they are being changed, but I don't think that UK GAPP is a sort of nirvana we should look back to.

  Q197  Lord Forsyth of Drumlean: We've had pretty strong evidence in this committee, particularly from Professor Stella Fearnley—I am sure you are familiar with her—which is very explosive in its view. She argues that the move towards the new standards resulted in the seeds of the crisis that we had in banking. For example, she argues that it made subprime lending appear very much more profitable in the short run than was otherwise the case. I must say, in talking anecdotally to accountants and others about this issue, a light goes on and they say, "Yes, there are problems in moving away from prudence and fair value and that the new standards did introduce a box-ticking culture". I am just a little surprised that you seem to be playing this down very considerably, whereas the evidence we've had has been remarkably consistent in its view that there is a problem here and that it contributed to the crisis. It is not the source of the crisis but it contributed to it. As with sat-navs in cars, people thought that they were going on a particular journey but they were somewhere else.

  Mr Haddrill: I think perhaps I was trying to balance the evidence you have had rather than say that there is no problem. Certainly if you move to fair-value accounting and mark-to-market accounting, you do have more volatility obviously because the market is more volatile. We would accept that. But also we would have concerns about an historic cost basis to accounting, where the historic number may be certain and may not move but it is no longer a reflection of the value of the assets, so we needed to move on.

  As regards prudence, it is there in UK law; it's written in the standards. The words in it may not appear quite so evident but also, of course, it is reinforced by the financial regulatory system, by the work of the FSA and the other financial regulators. So, together with the other points I was making, I think there needs to be a degree of balance in the argument that has not come from just looking at the previous evidence.

  Q198  Lord Forsyth of Drumlean: But going back to the questions that Lord Lawson was asking about banking, it does appear that people were in their silos ticking the boxes and not exercising prudential judgment.

  Mr Haddrill: I think people were too confident that the world would carry on booming as it had been booming.

  Q199  The Chairman: Is that an excuse?

  Mr Haddrill: It is not an excuse. I am just trying to reflect reality, and I think what we need is an accounting—

  Q200  Lord Forsyth of Drumlean: You mean they wouldn't have had as much money if they had put up a red flag?

  Mr Haddrill: I think we need an accounting world and an audit world that recognises that booms turn into bust rather earlier and that the concept of expected losses is recognised faster than it has been under the current system. So there certainly needs to be change, but I don't think it's the move from UK GAAP to international standards that is at the heart of the problem.

  Mr Thorpe: On the point of true and fair, the discussion paper published jointly with the FRC says explicitly that we would expect auditors to do more to ensure there is sufficient information in the accounts to show a true and fair view. There are requirements under IFRS for that to be done, so we have emphasised that.

  On the point that Stephen was making about the current accounting standards, the area of subprime loans is one of the few areas which is not at fair value under current international accounting standards; it is at historical cost. It is subject to an incurred-loss model and it would be better if we moved to an expected-loss model, and that is under way. But the accounting we currently have for loans is the accounting we have had for loans for the last 30-odd years.

  Q201  The Chairman: Mr Haddrill, in your last answer to Lord Forsyth's point, are you arguing that there should be more economist input into some of these issues rather than purely accountancy ones?

  Mr Haddrill: I'm going to leave a much more senior economist than me to answer that question.

  Baroness Hogg: I think all skills are needed to review what we have. The issue of volatility is a big challenge, isn't it? Like Stephen, moving back to historic cost accounting, it would seem to me not at all helpful. If I look at the industry with which I was involved for many years, private equity, one of the big issues was clinging on to assets valued at cost and, as soon as companies took the view that they should move off costs, that was an important contribution to restoring confidence in the market in those assets.

  Mr Haddrill: To some extent it comes back to Lord Lawson's point, which is the need to supplement the numbers by a degree of understanding of what the macro-prudential position is and to feed that back into the market. That is part of the role of the regulator in those discussions.

  The Chairman: Lord Forsyth, perhaps you would like to move on to the next topic.

  Q202  Lord Forsyth of Drumlean: I gather that one of the Big Four firms has recently embarked on a growth strategy, where the key driver is the development of non-audit services to be provided to audit clients. Is that something to be approved of?

  Baroness Hogg: Certainly not. We made that clear in public, in the AIU report to the firm itself; absolutely not.

  Q203  Lord Smith of Clifton: Would there be advantage in the audit profession centrally undertaking analysis of systemic risk, which audit firms could factor into their individual audits; for instance, into their consideration of their clients' going concerns? Might it help level the playing field between the Big Four and the others if this happened?

  Baroness Hogg: Analysing systemic risk is very much the responsibility of the regulators. I think we need more input—going back to Lord Lawson's point, with which I absolutely agree—into the macro-prudential framework from the audit firms. The paradox is that we have an oligopoly but we did not get the potential benefits from having an oligopoly, which is that they all ought to have known what was happening. Somehow we did not achieve this and we have to make sure we do in future, while at the same time addressing the oligopoly. I'm not sure it would have the effect on competition that you suggest but maybe I am missing the point you're making here.

  Q204  The Chairman: I don't know if you have something to say on that, Ms Dewar, because I think you have spoken in public and done quite a lot of work on that subject?

  Ms Dewar: Yes. We would definitely say that audit firms have a role to play in contributing to the financial policy committee debate. So in terms of macro-prudential issues, we don't think that should be a separate routine. We think that should be part of that FPC committed environment, and that can be through either the communication channels they have through the regulator or through other sources directly to the FPC.

  Equally, we think it is important that audit firms get together and we are now facilitating a forum where we and the audit firms get together. We discuss macro-prudential issues and we try to do it cross-sectorally, so we have sessions on banking and insurance separately to try to look at the bigger issues cutting across the market. So I think there are two ways that they can get into that debate.

  Q205  Lord Smith of Clifton: When this suggestion was put to the professional bodies in our inquiry, they highlighted the Auditing Practices Board's guidance on going concerns. But that guidance was issued after the crisis had occurred, and it was on the initiative of the regulation not of the profession. Doesn't this response suggest that the profession thinks the regulator is their agent?

  Baroness Hogg: No, I don't think so. It was issued at a very critical moment and Stephen and I were talking about this just before we came in. Stephen, I think you should—

  Mr Haddrill: The real fear at that moment was that the auditors would not be able to sign off the accounts of a wide swathe of British business not just the banks. Because of the problems in the banks, the banks couldn't guarantee to continue the lending that they were giving to those companies. So, as far as we were concerned, it wasn't just a matter of the guidance that we had to give to the auditors, it was a matter of bringing together investors in the corporate world with the audit profession to work out how on earth this was going to be addressed so that we didn't have a horrible, unintended consequence of audit that firms were being described as not being going concerns when clearly they were healthy businesses. I feel that the strength of the FRC then was being able to mobilise the corporate world and the investment world, as well as the audit world. That is generally what we try and do.

  Baroness Hogg: And alert government to the issue at the same time.

  Q206  Lord Smith of Clifton: May I ask about the practicalities of mobilising the corporate world with the auditors and yourselves, and so on? What series of meetings took place?

  Mr Haddrill: I will give you a more detailed response in writing because it is slightly before I joined, but we had quite an extensive set of consultations that were done between the senior staff of the FRC and people from those different bodies. We created an urgent issues group to look at the issue and come up with recommendations.

  Mr Collins: Obviously we think it is important that the audit firms and the regulators should get together to discuss these issues. We would obviously have concerns about the competition implications, to make sure that the scope of those discussions was appropriately restrained and was not going into other areas, which they should not be discussing, as a result of the encouragement of the regulator, from a purely competition-law point of view. Obviously, where you have a tight oligopoly and a regulator meeting to discuss common issues, there is certainly a risk that the audit firms might go away with the impression that they could have other discussions on matters that were outwith that narrow subject.

  Q207  Lord Smith of Clifton: How do you draw the boundary lines on that?

  Mr Collins: The answer probably is that you would need to have good advice on what was and was not permissible to discuss.

  Baroness Hogg: I think what Stephen is describing is our perception of an important systemic risk, on which we thought it appropriate to take action and to alert government. If most of corporate Britain had suddenly been forced by what was happening in the storm in the banks to declare themselves to be no longer going concerns it would have been a very serious systemic issue.

  Mr Collins: This is the problem in other areas where government seeks to get businesses together to discuss common problems affecting an industry or a sector. We think it's very important that, where that happens, it's made quite clear what the ground rules are and that there are certain things that it is permissible to discuss and certain things that it is not permissible to discuss. After dialogue with us, the business department did produce some guidelines for engagement between government and business in relation to competition issues.

  Q208  Lord Smith of Clifton: How do you know when these conversations are taking place?

  Mr Collins: We would expect the regulator—as we would expect government departments—to be sensitive to the competition issues that arise from getting competitors together in the same room, just to make sure that they are aware of the issues, and, by and large, we find most regulators are.

  Q209  Lord Forsyth of Drumlean: Chairman, I don't want to digress from what we're thinking of, but I am rather fascinated by that point. These rules or guidelines you have given, would they enable the banks to get together to discuss bonus policy, for example?

  Mr Collins: No.

  Q210  Lord Lawson of Blaby: First of all, to clarify my request for information which Sally Dewar very kindly said that she would provide us with, when I said all the meetings that took place with the FSA and the auditors of Northern Rock, HBOS, RBS and Bradford and Bingley, in 2006, 2007 and 2008, I didn't want a composite figure for the three years, but in each year how many meetings there were with each institution. The only other thing that I would like to ask, which is in the same area, is that, right at the beginning, Mr Haddrill, I think it was, said that what you need is early warning. Once the crisis hits, if there is something said it might even make matters worse—what you need is early warning. Without making matters worse, that is certainly true if the thing is in public, if you're talking about a qualification of the accounts or something. But there are all sorts of things that could be done privately, so I don't think you should say, "Oh well, it's too late to do anything". But quite apart from that, I would be interested to know what early warnings did take place?

  Mr Haddrill: I was talking about what was revealed publicly through the audit report and through the reports and accounts, rather than—

  Q211  Lord Lawson of Blaby: Yes. But in your recollection what early warning? You said there should be early warnings and you were talking about something public. I am very ignorant; can you tell me what early warnings there were because I don't recall any?

  Mr Haddrill: No. I would agree with you. That is my point. I believe that the description of risk, in relation to the collapse of the credit markets and so on, is something that didn't happen.

  Q212  Lord Lawson of Blaby: So, in your judgment, the auditors were highly culpable because they should have given early warnings and they didn't?

  Mr Haddrill: I think a very large number of bodies and institutions were culpable of not identifying the problem.

  Q213  Lord Lawson of Blaby: Yes, but this inquiry is into audit. Of course, I am not saying the culpability is solely that of the auditors or of the auditors and the FSA. The bankers themselves can't avoid their share of the responsibility. But our inquiry is into the accountancy trade and the auditing, so that's why I focus on that.

  Mr Haddrill: Yes.

  Baroness Hogg: But where these two are linked is in the nature of corporate reporting, and what is described in annual reports by companies as the risks to the business. I think that is the link, and the role of the auditors in the debate with the companies about what is said—

  Q214  Lord Lawson of Blaby: I am sorry to interrupt. I thought Mr Haddrill—if I am wrong, I misunderstood him—was saying there should have been early warnings.

  Baroness Hogg: That is if the risks to the business had been described in ways that identified the risk of what happened in the credit market. For example, if you look at what the banks before the crisis described as the chief risk they were facing over the coming year—I can't remember which of the banks in the most difficulty the year before said this—the articulation of their greatest risk was bird flu. So we are talking about the articulation of risk and the debate.

  Q215  Lord Lawson of Blaby: Okay. The banks pulled the wool over the eyes of the auditors.

  Baroness Hogg: No. They didn't articulate the risks as well as they might have done.

  Q216  Lord Lawson of Blaby: Were they aware of them?

  Baroness Hogg: That is the big issue, isn't it?

  Lord Lawson of Blaby: Were the auditors aware of them?

  Baroness Hogg: That is the dynamic of the debate that we would like to see.

  Q217  Lord Lawson of Blaby: What do you think; do you think the auditors were aware and, if not, why not?

  Baroness Hogg: I think it varied between auditors.

  Mr Haddrill: I think that there was insufficient recognition of the risks. Of course, there were a huge range of people, including ourselves, who did not anticipate that risk sufficiently well.

  Baroness Hogg: Absolutely.

  Mr Haddrill: I think we have to include auditors among everybody else in that group. Sir David Walker has identified the need for a bigger focus on risk by management through the risk committee of the bank. We obviously support that, and we would say that what we want to see in future is more of that scepticism and challenge at an early stage exhibited by the auditor. I don't believe that challenge was there in those early years, or sufficiently early, and I think, to some extent, that's not so much a failure of auditors but a failure of the audit system, and that is what we must put right.

  Q218  Lord Forsyth of Drumlean: Chairman, I am struggling a little here. In answer to an earlier question you said that people thought that good times weren't going to end or words to that effect. That I can understand but I am struggling to understand why auditors looking at banks' balances sheets, seeing huge levels of gearing, seeing all kinds of complex instruments—and there were warnings in the market about it in the run up to that—would not feel it necessary to at least perhaps ring a little bell. Listening to Baroness Hogg saying, "Well, they had to rely on what they were being told"—

  Baroness Hogg: I don't think I said that, did I?

  Q219  Lord Forsyth of Drumlean: You said they had to rely on the information that was being provided to them. I think you said. If I have misquoted you, I apologise.

  Baroness Hogg: Sorry, I don't think I did.

  Q220  Lord Forsyth of Drumlean: But I find it difficult to understand, given what auditors are meant to do, why no one looking at this—expanding balance sheets and the makings of a crisis—did not sound the alarm. So I am with Lord Lawson. I am puzzled.

  Baroness Hogg: We are not privy to every conversation between the auditors and the companies, so I am a little reluctant to specifically allocate blame between them.

  Q221  Lord Smith of Clifton: What I find unsatisfactory, my Lord Chairman, is that there is a tactic of risk spreading by saying, "Well, we were all a little bit to blame". So who do the police charge for the crime, the lot of you? It is happening all the time with the evidence that we are getting here. No one is sneaking on anyone else but they're not accepting any of the blame either; they're trying to dilute it.

  Baroness Hogg: I think we very specifically did just now with Stephen.

  Ms Dewar: Chairman, I think one of the things that might be quite helpful is to make the comparison between what we have done, from a purely regulatory perspective, with the firms as to how you might tackle this issue. It's a macro issue. Firm supervision was being performed at a micro level and one of the things that we have been looking at is how we make the system safer and more secure for the future. It is to create this financial policy committee, whose whole aim is to look at the picture from a macro perspective and to take the broader view rather than the firm specific view, which then feeds back into our micro supervision context. There is probably something to be said for looking at auditing and what happened there in the same context. The auditors were looking at their individual firms and not standing back and saying, "What does that tell me about this sector as a whole?" So there are probably some comparisons to be drawn.

  Q222  Lord Lawson of Blaby: I'm afraid I don't buy that. It is true that there was a failure of macro supervision but there was a failure of micro as well. Take Northern Rock, which was the first to go over. Northern Rock had a business model with an excessive dependence on wholesale funding, which was a complete nonsense as a business model. He was taking an ever bigger share of the mortgage market. Why? Because it was taking ever bigger risks. So there was a huge failure of micro-prudential regulation there.

  Ms Dewar: Sorry, apologies, I wasn't trying to say that there wasn't a failure of micro supervision. I was trying to say that in the context of where the macro analysis was coming from in order to also look across a sector piece, as opposed to just being firm specific. So I wasn't trying to discharge responsibility from the micro; I was trying to look at it from a macro context.

  Q223  The Chairman: I think the inquiry into Northern Rock, you accepted, showed failings at the micro level by the FSA?

  Ms Dewar: Absolutely. My response was trying to draw away from that and say there were also failings clearly from a macro perspective, and what can you do to try and look at those.

  The Chairman: Yes, and the kind of issues that Lord Lawson was raising in relation to Northern Rock. Yes.

  Q224  Lord Forsyth of Drumlean: Chairman, if we take Lord Lawson's example of Northern Rock and the FSA and their involvement, you have come clean on that—I have no idea who the auditors were for Northern Rock but you could equally apply it to other banks—I can't understand why the auditors did not see this hugely expanding balance sheet, this huge risk that was being created because of the reliance on wholesale funding, and why they would not ring an alarm bell. Why did that happen, because, rather naively, I thought that's what auditors were meant to do?

  Mr Haddrill: I think the lesson you have to learn—and the lesson they should learn—is that they should have rung an alarm bell more strongly.

  Q225  Lord Forsyth of Drumlean: But why didn't they?

  Mr Haddrill: One gets back into the realm of spreading blame, which I don't want to do after what Lord Smith had said. I suspect that we have a complicated system where different institutions are relying on each other. After all, Northern Rock, as Sally has mentioned, has been regulated by the FSA. I think it ended up with quite high levels of capital but they obviously weren't adequate for the job in hand.

  Q226  Lord Forsyth of Drumlean: As a matter of interest, who were the auditors of Northern Rock?

  Mr Haddrill: I can't recall I'm afraid.

  Secondly, there is the question of the accounting standards, what they required and whether the management was strictly following them. Then it comes down to this third issue about whether there is adequate scepticism being applied on top of that. I think that's where there was some failure to apply that degree of scepticism.

  Baroness Hogg: There is also the issue of whether, in their annual reports, sufficient effort was made to describe—and there is greater pressure coming now—the nature of the business model and the risks involved in it, which is a good discipline for just forcing more disclosure of what the business is doing out into the public domain, and into the hands of shareholders, which is another piece of defence. You need them all.

  Q227  The Chairman: If any of you would like to add a written note to what you have been saying on this issue, please do.

  Can I come back to the question of the substantial domination of the Big Four in the audit market, and ask you a question. Obviously this is in relation to widening choice and competition. I think the FRC has admitted that some of their earlier recommendations haven't yielded very much, but what we—

  Baroness Hogg: We have more than admitted; we have been shouting it.

  The Chairman: Yes. Anyway, you have made it clear.

  Baroness Hogg: Thank you.

  Q228  The Chairman: What one or key measures would you recommend for taking this further?

  Baroness Hogg: The immediate two I would focus on are the opportunity presented by the abolition of the Audit Commission and the opportunity to use the development of risk committees to develop another source of advice, which may bring into the market possibly different kinds of firms or encourage existing firms to step up on a range of work that is not quite so requiring of a global network as traditionally auditing a big international company has been supposed to do. I think it's a real opportunity for entry into the market and/or development of a firm, below the size of the Big Four, to come into the market there. I think it is important to look at ownership rules and the banking covenants apiece. Those were our four, weren't they? All of them could potentially make quite a difference.

  Q229  The Chairman: FSA?

  Ms Dewar: I think we would look at greater rotation. We think that that is an area worth pursuing. Clearly, you need to consider the unintended consequences of any proposal that you put forward, but certainly some jurisdictions have used it and we certainly think it's something that should be considered as part of the thought process.

  Q230  The Chairman: OFT?

  Mr Collins: Can I just go back to a comment Professor Power made in response to question 23 from Lord Moonie on the first day. He talked about the opportunity to offer a differential range of assurance services to companies and, building on what Baroness Hogg has said, the idea of introducing into the regulation of auditing and accounting forms of incentive to encourage, first of all, firms to look at different sources of audit and non-audit services, and secondly, to encourage other firms to come in. I think the example she had given, for instance, of the use of different firms for risk committees, is potentially a very interesting one.

  I think it's important that if you narrow the scope of the formal statutory audit, with the idea that businesses can then seek other assurances elsewhere, that has to be on a voluntary basis. But clearly there would have to be some element of regulation around that to make sure that there was consistency and appropriate standards. I would also support the other points that have been made.

  Q231  The Chairman: Would any of you recommend what one witness has put to us to follow the French system of compulsory introduction of joint audits?

  Mr Haddrill: Joint audits are possible in the UK. We have been rather nervous about that approach on a compulsory basis, not least because the evidence we've seen in the UK has been that it's been relatively inefficient in terms of the way the audit is conducted. We've also had concerns about problems arising in the gap between the two. The French believe that they have resolved those problems. We talked to some French companies, some of whom have told us that it's a nightmare and that the auditors spend all their time passing the buck between them and warring with each other. Others have said that their auditors have got on extremely well with each other and it's been beneficial because they've had two sets of eyes. So we are concerned about the risks, but it's something that we will look at.

  Baroness Hogg: Introducing separate advice for risk committees is akin to that, but with very defined jobs. So you shouldn't have—I bet you do have some—turf wars, but still it's fairly defined what the two are doing with different responsibilities.

  Q232  Lord Tugendhat: First, I wish to follow up on my question and on Lord MacGregor's question. I can well believe that a joint audit would be very tedious and may well be more difficult to run than a regular audit, but coming back to this whole question of the Big Four, and if one went down then there would only be three: there is a substitute bench argument for having a joint audit not because it is good in itself but as a substitute bench. Would you buy that proposition?

  Mr Haddrill: Yes, I do buy that proposition and that is one of the reasons why we don't rule it out. My nervousness about it is that it used to happen in the UK but companies have abandoned it.

  Lord Tugendhat: Yes, I remember.

  Mr Haddrill: Therefore, I think we need to explore, in a bit more depth, why companies thought it would be such a bad idea. Was it just that they were persuaded into it by the Big Four or was it causing them unnecessary cost and trouble?

  Q233  Lord Tugendhat: The real question I wanted to ask you is this. Without going back over the exchanges that Lord Lawson has had with you and learning from the past, would it be helpful if one of two things happened, or perhaps even both: one is that if the regulator is concerned about a particular situation—a Northern Rock type of situation, or something less alarming than that—it should instruct auditors to probe into that particular area, or those particular areas, and report back to the regulator? In other words, the regulator would say, "We're concerned about this. We want you to look at it and we want you to tell us what has happened". That is one suggestion for the future.

  The other suggestion is: if the auditors are worried about something, and they debate this with management but in the end they say, "Okay" and they approve the accounts, would it be helpful if it was flagged that the auditors had queried a particular point and that they had, in the end, been satisfied? It would not be a Hansard report of the debate, but just that here was a point that worried them, they queried it and they were satisfied. What do you think of those two possibilities for the future?

  Ms Dewar: I will answer the first one in terms of suggestions for the future and in terms of instructing auditors or other third party advisers to do what we would in terminology terms describe as "a deep dive". So, if we were concerned, we would go into a firm and go through a particular system, a control failing, or a particular asset portfolio, for example, as we already do. So we do it in two ways: we do it through external advisers. We don't just focus on the Big Four for that, we cut across all the audit firms for that. We have also very much enhanced the discipline internally to enable us to have the skills to do it within the FSA. So that point was one of the lessons learnt from the crisis. Section 166, we already used but not to the extent we do now. So we have definitely put more focus on that one. In terms of the second point, I don't know—

  Baroness Hogg: I think one way of achieving what you are suggesting, Lord Tugendhat—which I think has a lot of merit in it—is to up the requirements of audit committees to report on the dialogue with the auditors. That should have two beneficial effects: one, to ventilate some of the issues in the way you suggest; but secondly, to do key stage one, which is to ensure that the debate with management, that precedes an audit committee, is fully ventilated with that audit committee.

  Q234  Lord Tugendhat: It has been suggested to me that it might be helpful if the audit committee dominance was reduced. In the past, they weren't as powerful as they are now or had this special position. If the dialogue was reported to the whole board, things that the auditors had grown accustomed to might seem more alarming.

  Baroness Hogg: I think this is a very difficult question. I have sympathy with what you say, having sat on the board of a big US company. Sarbanes-Oxley very much diverted almost all the activity in this field, and that to do with risk, to the audit committee. If you sat on that board, and you were not on the audit committee, you felt extremely exposed in terms of being isolated from the key debates.

  Lord Tugendhat: Yes. That is the sort of thing I am thinking of.

  Baroness Hogg: On the other hand, we think it is very important to build up the role of the audit committee, because that is where, if you get a good audit committee chairman and a good committee, you will have the real dialogue, and debate and the right level of challenge. So I don't think we want to give up on audit committees, but I think it is very important that the reporting process from the audit committee to the board and the audit committee to investors is full and transparent.

  The Chairman: I think we must leave it there. We have had a very long session covering a lot of points, which, as Baroness Hogg said at the beginning, are very timely for consideration at the moment. So I thank you all for your papers and for attending and we look forward to getting the further notes that you offered to us. Thank you very much.

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