Supplementary memorandum by Baroness Hogg
and Mr Stephen Haddrill, Financial Reporting Council (ADT 27)
AUDITORS: MARKET
CONCENTRATION AND
THEIR ROLE
We are pleased to provide the Committee with
this further letter following up on the issues that were raised
in the course of our oral evidence on 9 November. This letter
also responds to the Committee's request for further information
on contingency planning on how to respond to the withdrawal from
the audit market of one of the Big Four and issues concerning
IFRS and the Companies Act 2006.
1. FRC STRUCTURE
AND POWERS
The regulation of accounting and audit has evolved
from a self-regulatory system and today it is the Financial Reporting
Council (FRC) which provides oversight of the auditing, accounting
and actuarial professions. We believe that further steps are necessary
to strengthen the FRC's position as an effective, independent
regulator.
In order to facilitate this transition, the
FRC needs increased powers to:
— Gather information on failed companies
to establish whether governance or audit failures were contributory
factors;
— License auditors of public interest entities;
and
— Investigate and discipline misconduct
by auditors.
Legislative change is also needed to enable
the FRC to rationalize its current structure and ensure that information
can be freely exchanged internally.
In future we believe the FRC should have a greater
capacity to be proactive in identifying and responding quickly
to problems in capital markets. We currently have powers to monitor
the quality of audit, and we review 300 sets of accounts each
year. We also conduct investigations into potential misconduct
by members of the accountancy and actuarial professions. However,
we have limited powers to inquire into the accounting judgements
of companies that have failed; our investigations into misconduct
cannot compel evidence from, eg, directors who are not accountants
and are very time consuming; and our audit inspections are established
for the purpose of annual monitoring, and have insufficient powers
for exploring urgent issues that fall outside our routine monitoring.
This means that we are dependent upon the goodwill of the firms
in helping us to understand whether there are any lessons to be
learned in other areas, for example from the collapse of a number
of companies supplying the public sector.
We believe that additional measures could be
taken to strengthen our independence and enhance audit quality:
Information sharing
The FRC believes that better information sharing
across our organisation and with fellow regulators, would benefit
the market and help to spot and manage risks.
There are currently restrictions on information
sharing between some of the FRC's operating boards. For example,
under current legislation the Financial Reporting Review Panel
(FRRP) is unable to share information on companies whose accounts
it may be investigating with the Audit Inspection Unit (AIU).
We would ask the Committee to support legislation which will enable
effective information sharing across the organisation.
Licensing
The increasing complexity of global business
practice and enhanced investor expectations of the auditors of
public interest entities require auditors to have a greater degree
of expertise and experience to manage adequately the risks involved.
We therefore propose an additional licensing
regime for auditors of public interest entities. The need for
this is shown by the evidence of the AIU's 2010 Annual Report,
published in July 2010, which concluded that "the number
of audits assessed as requiring significant improvement at major
firms is too high" and among other firms a higher proportion
of audits conducted required significant improvement. We believe
a new regime for auditors of public interest entities should be
provided by the FRC while the professional accountancy bodies
should retain responsibility for the oversight of smaller firms.
The ICAEW, in their letter to the Committee
of 23 November about the audit inspection and monitoring regime,
suggested that the existing regime could achieve our goals. It
is correct that the Audit Registration Committee (ARC) has responded
to individual reports made by the Audit Inspection Unit (AIU).
However, the regime currently operates within very tight parameters.
The AIU is restricted in the action it can request the ARC to
take; its efforts to broaden the definition of what is a public
interest entity have been challenged; as has its wish to undertake
non-routine inspection work without seeking the ARC's permission.
Discipline
The current professional disciplinary regime
is complicated and is not as independent or effective as it should
be. At present the Accountancy and Actuarial Discipline Board
(AADB) is required to consult with the relevant professional body
before it can begin a disciplinary investigation. It has no statutory
powers to obtain evidence.
We believe that the independence of the process
is compromised by the requirement placed upon the AADB to consult
and seek the agreement of the professional bodies—this is
the product of the previous self-regulatory system that we believe
should now come to an end.
To address this issue we therefore propose the
clarification and streamlining of the AADB's discipline scheme.
All disciplinary cases relating to public interest audits should
fall to the AADB in the first instance.
Where the market has been misled deliberately
it is important that a robust sanctions regime is in place to
deal with such behaviour. We are concerned that this does not
exist at present and that the sanctions available to the FRC are
limited, meaning that the most appropriate remedy is sometimes
not available to us. We would therefore like a more tiered sanctions
regime to be put in place which, accompanied by other changes
outlined in this letter, would strengthen the FRC's independence
and contribute to the better operation of the market.
Taken together we believe these measures would
significantly improve the accountability of the audit profession,
strengthen the FRC's independence and put in place a robust sanctions
and company investigations regime in the public interest.
2. FRC GOVERNANCE
The governance structure of the Financial Reporting
Council was significantly strengthened three years ago, reducing
a large representational council to a Board of 16 members (currently
consisting of a non-executive Chairman, the Chief Executive, 6
chairmen of the operating bodies and 8 independent non-executive
directors). However, further changes under consideration for the
coming year are intended to have the effect of increasing the
majority of independent directors on the Board. These are selected
to provide a wide range of skills and experience in business,
investment institutions, the professions and policy-makers, including
those affected by the work of the FRC. However, as the table below
shows, there are no practising auditors on the Board, nor on the
boards of the bodies responsible for auditor discipline.
BREAKDOWN OF
FRC BOARD MEMBERSHIP
| Board | No of members
| Current Big Four accountants or auditors
| Ex-Big Four accountants or auditors
|
| FRC Board | 16 |
0 | 3 |
| Accountancy and Actuarial Discipline Board (AADB)
| 10 | 0 | 2
|
| Professional Oversight Board (POB) | 11
| 0 | 2 |
| Board for Actuarial Standards (BAS) | 16
| 0 | 0 |
| Accounting Standards Board (ASB) | 10
| 3 | 1 |
| Auditing Practices Board (APB) | 15
| 5 | 4 |
| Financial Reporting Review Panel (FRRP) |
29 | 4 | 5 |
| TOTALS | 107 | 12
| 17 |
There are specific rules in the FRC constitution pertaining
to the AADB, which must always contain a lay majority, and the
POB, where no board member can be a practising auditor and a majority
of members must have been out of practice for at least five years.
3. WITHDRAWAL FROM
THE AUDIT
MARKET OF
ONE OF
THE BIG
FOUR FIRMS
The FRC has been concerned for some time that the failure
of one of the Big Four audit firms would have serious implications
for the stability of the capital markets. The disorderly movement
of partners and audit teams to other firms could result in companies
not being able to produce audited reports and accounts on the
timescales expected by the markets.
The FRC has therefore put forward proposals aimed at addressing
this issue and we have discussed our recommendations with both
the Government and prudential regulators.
The key issues that the FRC believes need to be addressed
are:
— The need for a clear statement that the government/competition
authorities would break up a "Big Three";
— A resolution regime and internationally agreed mechanism
to ensure the orderly wind-up of a failing firm;
— A system for ring-fencing healthy parts of the network;
— An early warning system of significant threats to
operations; and
— Living wills for accountancy firms.
Tackling this issue will require action and agreement both
internationally and across a range of UK regulatory bodies and
competition authorities. The FRC has written to the Financial
Stability Board (FSB) and recommends that the UK Government takes
up the issue with the FSB with a view to it being discussed at
G20 level in due course.
The FRC does not believe that any of the Big Four should
be seen as too big to fail. In particular, the taxpayer should
not be expected to subsidise losses and regulators should not
hold back from disciplinary action against misconduct. The value
of audit depends wholly on confidence in its quality. Firms must
not be disincentivised from the pursuit of quality by expectations
of state protection.
The Big Four are now global networks. This gives them resilience
against the collapse of one part of the network. Resources can
be transferred and loss of business need not be catastrophic.
However, as audit business is dependent on client and investor
confidence, the networks' strength can also be a source of vulnerability,
as such loss of confidence in one country becomes contagious.
The FRC believes that the networks are strong enough to survive
a failure in most markets, but not in the US or probably the UK.
The adequacy of response to a crisis is therefore of particular
importance in both countries.
Governments and regulators have liaised closely in the past
if a network has been threatened to ensure any necessary action
is co-ordinated and consistent. The international nature of the
firms and of market confidence requires this. Such action has
been specific to the cause of the problem.
The success of such action depends on the authorities having
enough time before failure becomes catastrophic. To that end,
the FRC has agreed with the firms a protocol providing for the
early warning of any significant threat to UK operations, including—to
the extent known—from overseas.
Such measures are valuable, but are not capable of ensuring
against failure. Audit failure may have been so serious that the
firm needs to close. Early warning depends on failing parts of
the firm not keeping their problems secret from the network. News
that damages confidence can have a very rapid impact, as seen
in the wake of Enron.
Governments and regulators do, therefore, need to be clear
what their policy and plans will be if a network collapses. This
needs to cover two major issues: how is audit work to be conducted
in the short term and what long term structure is proposed for
the audit market?
More work needs to be done on devising a vision for a longer
term structure ahead of a crisis. The audit market would face
major challenges if it was shared between just three firms. Depending
on which firm failed, there could be no competition for the business
of large companies in some sectors, such as energy and insurance.
In all sectors, conflicts of interest would arise between audit
and non-audit business as the remaining three sought to pick up
clients of the failed firm. We therefore believe that a market
dominated by three firms is not desirable. However, in a crisis
it could come about by default as the partners and teams of the
failed firm would be rapidly recruited by the other large firms.
To reduce the risk of this, we propose that the competition authorities,
in the EC, UK and US in particular, should indicate in advance
of failure how they would be likely to respond. A statement in
advance that they would act to break up a Big Three would help
to prevent this being created. We believe collaboration between
Governments, competition bodies and audit regulators to consider
market structure in the event of a major failure should be initiated.
At the point of crisis, the authorities need to act to preserve
market confidence consistent with their longer term vision. If,
as we believe, that vision should not foresee the creation of
a Big Three, the failing firm will need to be kept as a viable
operational entity until new arrangements for handling its work
are put in place. Under current legislation, this is not easy
to achieve. Partners and employees cannot be forced to stay with
the firm, nor can clients.
Finally, whilst public authorities need to plan their actions,
we believe the firms' own plans also need to be developed fully.
The concept of living wills could be borrowed from the financial
services sector. These would set out how a firm would segregate,
under regulatory supervision, how good and failing parts of the
business will be separated and funded.
It is vital that cross-border contingency plans are put in
place and to achieve this we recommend that the Government engages
first with the Financial Stability Board and then at G20 level
to coordinate action that will lead to a plan being put in place.
4. IFRS AND THE
COMPANIES ACT
2006
The FRC has studied carefully the issues raised in your letter
and we hope that the following response will help to clarify the
Committee's understanding of the issues relating to IFRS and the
Companies Act 2006.
The FRC has consulted BIS and shares its view that the adoption
of IFRS was in conformity with the Companies Act 2006 because:
— The use of IFRS for the consolidated accounts of all
groups listed in the EC was expressly mandated by the EC in 2002.[45]
— In addition, the EU gave individual Member States
the right to decide whether to require the use of IFRS for the
preparation of individual accounts of listed companies and their
subsidiaries, and for any other companies. Following a consultation
in 2002,[46] the UK Government
resolved to permit the use of IFRS by such companies.
— The necessary changes to the legislation to reflect
these, and other, changes to the UK legislation came into effect
on 12 November 2004.[47]
We would also like to address the underlying concern that
IFRS resulted in financial statements that showed a higher profit
(or smaller loss) than would have been the case under UK GAAP.
Whilst it is right that the introduction of IFRS led to certain
situations where profits could differ from those under UK
GAAP, it is not the case that IFRS would always result in a higher
profit than UK GAAP. So, for example, while the UK GAAP requirement
to amortise goodwill would result in a reduction in profit as
compared to IFRS, in contrast the effect of discounting financial
assets carried at amortised cost when there is evidence that there
has been an impairment loss under IFRS would result in a lower
profit than under UK GAAP.
The FRC has consulted with BIS and shares its view that the
introduction of IFRS did not give rise to breaches of sections
830 and/or 831, Companies Act 2006.
Those sections prescribe the manner in which a company must
determine the profits that it has available for distribution.
They provide that the profits as shown by a company's financial
statements should be the starting point for determining the profits
available for distribution. They then provide for various adjustments
to be made to take account of a number of factors. Once those
adjustments have been made, it is for the directors of the company
to decide the amount of any dividend to be paid to shareholders.
Directors make such decisions:
— in the light of the company's "realised profits"
as defined by section 853(4), Companies Act 2006. The method of
calculating profits regarded as realised "in accordance with
principles generally accepted at the time when the accounts are
prepared" is set out in "Guidance on the Determination
of Realised Profits and Losses in the context of Distributions
under the Companies Act 2010[48];
and
— having regard to their fiduciary duty to act in the
best interests of the company.
In summary, whilst the accounting framework determines the
calculation of the profits shown in the financial statements,
the decision as to the amount of any distributable profits
to be paid to shareholders by way of dividend is determined by
reference to the company's realised profits (as defined in accordance
with section 853(4), Companies Act 2006).
The FRC shares BIS' view that, for these reasons, changes
are not required to either IFRS or to the Companies Act 2006 in
order to reduce any possibility of illegality.
The FRC has urged the IASB to learn lessons from the financial
crisis and a number of changes have been made as a result, for
example to standards on the accounting for financial instruments.
Other standards that have been reviewed, and where the FRC has
been active in influencing proposals, include insurance accounting
and leasing.
I understand that the Committee has invited Roger Marshall,
interim chairman of the ASB, to give evidence to the inquiry on
18 January on the effect of changes to accounting standards and
he would be delighted to expound further on these points.
5. INCREASING CHOICE
IN THE
AUDIT MARKET
In our oral evidence to the Committee on 9 November we set
out several specific proposals to expand choice in the audit market
which we feel it would be helpful to expand upon.
Audit Commission
We believe that the abolition of the Audit Commission provides
an opportunity for one or more non-Big Four firms to expand into
that market and grow significantly. This could be the catalyst
to encourage a fifth big player in the audit market. If the existing
Audit Commission was kept together as a standalone entity, it
would be the fifth largest audit firm in the UK. A strategic alliance
with another mid-tier firm would enable it to access the corporate
market as well as the public sector.
Our objective in making a recommendation in this area is
to ensure that the audit market does not become concentrated still
further as a result of the Government's decision to abolish the
Audit Commission. We recognise the practical difficulties that
may need to be overcome to ensure the UK complies with European
law relating to the procurement of public contracts but believe
the prize of greater competition in the market makes this proposal
worthy of further consideration.
Banking covenants
The FRC echoes concerns that have been raised by auditors
from mid-tier accountancy firms that restrictive bank covenants
could contribute to audit market concentration and restrict choice.
We recognise that in essence the issue is a commercial one although
we believe there is sufficient anecdotal evidence to require a
further investigation in to this issue.
The Lending Standards Board (which replaced the Banking Code
Standards Board) is currently consulting on the Lending Code.
However, the Code applies only to private individuals and micro-entities
and so is not an appropriate vehicle for addressing the bank covenant
issue. In the absence of a similar Code for larger entities, we
would urge a greater level of dialogue between the British Bankers'
Association, lending institutions, audit firms and regulators
to address the issue as soon as possible.
Risk committees
The FRC would encourage banks and other systemic institutions
to use non-Big Four firms as a source of advice to their risk
committees. This would give such firms an exposure to large companies
they might not otherwise have access to and may in time provide
them with the opportunity to tender for the audits of some of
these entities.
Ownership rules
The FRC believes that serious consideration should be given
to amending the current rules on audit firm ownership which would
allow audit firms to access external capital.
In principle we believe that it should be possible to change
the current rules governing the ownership of audit firms without
risking audit quality. Alternative ownership structures, including
the possibility of raising capital from external sources, have
the potential to make it easier for firms to invest to allow them
to expand into the market for the audits of the largest companies.
Research carried out by Oxera has indicated that the cost of capital
in a partnership was considerably higher than in an ownership
model which allowed for external investment.
6. GOING CONCERN
The FRC meets with market participants regularly to discuss
their concerns and identify issues that need to be addressed.
This engagement intensified following the collapse of Lehman Brothers
in September 2008. During 2008 the FRC held two meetings with
market participants, and a further two meetings were held in 2009.
Typically, these meetings involved: companies, corporate treasurers,
auditors, investors and business organisations. These formal meetings
are held in addition to ad hoc meetings held throughout the year.
The FRC issued guidance to the market in 2008 in response
to concerns in the market that auditors would find it difficult
to sign off the accounts of a large number of companies as going
concerns because of the state of the credit markets.
7. EARLY WARNING
SIGNALS
In our oral evidence we suggested that the audit process
should be capable of providing an early warning signal to the
market—something that was not delivered in either 2006-07
or 2007-08. We believe that the market is capable of providing
more signals and the creation of a Market Participants' Group
comprising regulators, auditors, finance directors and investors
would enable warnings to be identified and discussed by the market.
These issues could be addressed through market information, guidance
or regulatory action. The FRC would be well placed to convene
such a group and we would welcome the Committee's support for
such a proposal.
8. SCEPTICISM
The FRC believes that company boards have a responsibility
to encourage a culture of professional scepticism by auditors.
The Committee requested further details on the work the FRC has
undertaken to encourage auditors to demonstrate appropriate professional
scepticism. We attach as an Appendix a discussion paper which
we published in August 2010, along with another paper published
jointly with the FSA and which deals with the financial sector
specifically. We are currently analysing the responses to these
consultations and will announce the outcomes in 2011.
The Audit Inspection Unit's 2010 annual report also called
on auditors to exercise greater professional scepticism particularly
when reviewing management's judgements relating to fair values
and the impairment of goodwill and other intangibles and future
cash flows relevant to the consideration of going concern.
We hope this supplementary submission is helpful to the Committee.
As we say in our written evidence, we stand ready to play our
part in implementing policies that will both enhance competition
and quality in the audit market. We look forward to the Committee's
analysis and recommendations.
22 December 2010
45
Regulation (EC) No 1606/2002 of the European Parliament and of
the Council of 19 July 2002 on the application of international
accounting standards (the IAS Regulation). Back
46
International Accounting Standards "A Consultation Document
on the possible extension of the European Regulation on International
Accounting Standards", DTI, dated 30 August 2002. Back
47
SI 2004 No 2947 The Companies Act 1985 (International Accounting
Standards and Other Accounting Amendments) Regulations 2004. Back
48
ICAEW Technical Release-Tech 02/10. Guidance on the determination
of realised profits and losses in the context of distribution
under the Companies Act 2006. Available at: http://www.icaew.com/index.cfm/route/155791/icaew_ga/en/Technical_and_Business_Topics/Technical_releases/Tech/TECH_series.
This guidance is issued following public exposure and independent
legal review. Back
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