Examination of Witnesses (Questions 235-290)|
Mr Scott Halliday, Mr Ian Powell, Mr John Griffith-Jones
and Mr John Connolly
23 NOVEMBER 2010
Q235The Chairman: Good afternoon, gentlemen.
Sorry we've started a little bit late but we had one or two matters
to discuss. This is the sixth evidence session of our inquiry
into auditors: market concentration and their role. I should say
at the outset that a number of us have declared relevant interests
in relation to this inquiry and these are available in the register
of members' interests and also in the room and I don't propose
to ask members today to repeat all of that. Thank you, gentlemen,
very much for coming. We would be grateful if you could speak
fairly loudly and clearly for the benefit of the webcast and the
shorthand writer. In order to save time, because we have a lot
to get through, I would imagine that sometimes in the first answer
to the question, the response will have given a lot of the material
that all of you wanted to say, so don't feel it necessary to repeat.
Simply, if you want to add, please do, but don't feel it necessary
to repeat what's been said by the first respondent. Would any
of you like to make an opening statement or can we go straight
into questions? Mr Connolly.
Mr Connolly: Thank you and thank you for providing
my firm the opportunity to contribute towards your deliberations
on auditor market concentration and allowing me a few moments
to make some remarks. Just a few things I would like to say. First
of all, competition and choice in the market is vital but this
must not be at the expense of quality, which really is so essential
to the proper workings of the global capital markets and financial
stability. I do think the degree of concentration in the audit
market has arisen as a direct result of market forces and, in
particular, the demand from investors for audit quality as well
as appropriate capability to undertake complex audits across the
world. That said, we would welcome, in my firm, even more competition
but, again, not at the expense of quality. I think the solution
is to encourage additional competitionand here liability
reform is very relevant in terms of how that would influence increased
competitionand importantly, to protect against the risk
of four becoming three. Here the focus should be on contingency
planning such as the living wills approach that has been discussed
I think the role of investors is important.
They are extremely keen on improving competition. I was a member
of the Market Participants Review Committee for the FRC and it
was clear that there is a keenness to increase the level of competition
but, again, not at the risk of quality. I think the role of the
Audit Committee could be further enhanced in this respect with
clear disclosure required of the reasons for auditor appointment
and reappointment including consultation by the Audit Committee
Chair with major investors.
Turning to the financial crisis, a topic you've
been addressing, I do believe that auditors performed well in
the highly complex circumstances of the financial crisis. We did
draw the attention of regulators and Government to going-concern
issues on high impact clients but there are important learnings
and we particularly support the positive steps being taken by
the Bank of England in respect of banks and other financial institutions
in going back to what is described as the 1990s approach of trilateral
meetings between supervisors, clients and auditors. All of our
firms are actively involved in trying to deliver that change.
We do support the current relook at accounting
standards relating to the timing of loss recognition.
A final point; I do think the focus on non-audit
services is somewhat misguided. I believe there are very tough
safeguards in place already. This is evidenced by the most recent
consultation paper put out by the Auditing Practices Board, which
did not show that, in the last year, there were management consulting
fees paid to the Big Four by FTSE 100 audit clients. Where non-audit
fees are paid, typically these are for audit-related pieces of
work such as half-year reviews and independent opinions on financial
information, again particularly in investment circulars. Thank
Q236 The Chairman: Thank you very
much. We'll be covering all of these issues and I should say,
of course, that we've all read the written evidence that you've
given to us for which we thank you very much indeed. That's been
very helpful. Can I start with the first question. It's been clear
from a lot of the evidence that we've received that there is a
great deal of concern about the present audit concentration in
the Big Four and particularly, of course, if you look at the FTSE
100 or the FTSE 250, nearly almost all the audits in the FTSE
100 are now carried out by the Big Four and most of them in the
FTSE 250. There is also the concern that you've just mentioned,
Mr Connolly, of four moves to three. So we've had a lot of evidence
of concern about this. Are you happy about the present degree
of concentration in the Big Four?
Mr Griffith-Jones: I'm not sure "happy"
is quite the right word. It is the way it is. I know you've had
a lot of evidence that it was eight, then it was six and then
it became four. I think it's fair to say that concentration is
the natural order of events in our industry. It's a very technical
industry. There are many other industries in the world where you
get maybe not four but a limited number of players who play at
the top of the league and then quite a diaspora underneath them.
I think the natural tendencies to globalisation, the skill set
required and the amount of investment required to keep the audit
process up to date and a sort of magnet like approach to getting
the best people to come and work for us naturally reinforces the
arrangements, which is why we need a regulator to prevent it getting
any more concentrated than it is at the moment. I wouldn't say
it was a good thing and if you ask us whether we would prefer
that there were six and we didn't have to sit here answering this
question, I think we'd all be very happy to be in that position.
Mr Powell: It's worth adding to that as well
that the concentration that's there is the result of market choice.
I think that it is a very complex product and I think the market
does look at the scale and reach of the services that it needs,
so as our clients have become more global, as they become more
multi-national, they look for that sort of degree of coverage
from the audit firms that service them. I think when you start
to look at the level of investment that's required across the
world, I guess it is understandable that it has come down to a
relatively few firms that can afford that level of investment.
Just to give you an example, at PwC, our new audit approach has
cost something like $400 million to roll out across the world.
The UK share of that is about £40 million. So to be able
to service clients that are very complex, that cover so many different
territories, with real qualityand that is the ultimate
focus of everything that we do, the quality of the auditthen
I think you do need this sort of scale of operation to be able
to make that investment.
Mr Halliday: If I could just add from a competition
standpoint, there's a great deal of competition. I think the question
is, is there enough choice in the market. I would argue that the
profession would improve itself by having increased choice in
the market and I think there are some things that this Committee
is considering that could help that. For example, removing the
only Big Four clause from any banking agreements would be a positive
step. I think also encouraging audit committees to really step
back and take a look at the complexity of the audit that they
need to have executed by the firm and challenge themselves whether
a second tier firm could really be well positioned to execute
that audit versus one of the Big Four firms. Part of the solution
also has to be for the second tier firms to really rise up and
continue to invest to build the global network that the four of
us are privileged to be a part of. With the Big Four firms, they
need to continue to invest and scale up their business globally.
80% of the FTSE 100's revenues are earned outside of the UK and,
therefore, their desire is to really have a firm that can serve
them around the world.
Mr Connolly: If I can add one small point to
the obvious question of whether another firm could emerge as a
competitor, there's no doubt that it won't happen quickly but
in the case of my own firm, if I go back just 15 years, my own
firm had 4% of the FTSE 100 audits and now we have over 20%.
Q237 The Chairman: I was going to
ask you about that. I think it is 22%, from what you said in your
evidence. How were you able to bring that about?
Mr Connolly: First of all, a small amount, but
only a small amount, relates to the action we took when Arthur
Andersen imploded around the world and we did hire in this country,
and in a number of other countries, but in this country, we didn't
buy the business but we hired all of the partners and all of the
staff. That did facilitate some of the clients, not all of the
clients, that they'd had previously, joining us. That added four
or five FTSE 100 clients to the roster we had. Mostly, it has
been about significant investment every time an opportunity has
arisen to compete for a new client and having some success in
Q238 The Chairman: So would it be
fair to say, if content is not the right word, you do share the
general unease about the fact that it could be four coming down
Mr Connolly: No, I don't share that. I would
be uneasy about it going down to three; I don't see that is on
the horizon at all.
Q239 Lord Tugendhat: Perhaps I may
ask a supplementary before the main question. You are only four,
as we've just been saying, and you are fulfilling an absolutely
vital function. I just wondered whether you would regard your
relationship with your clients as being much the same as any other
commercial relationship between a buyer and a seller or whether
you would feel that because of the nature of the service you're
providing and the very small number of people providing it at
your level, that this is something in the nature of a public good
from which benefits and dis-benefits flow to all citizens; not
just your clients but the whole investment community; anybody
who buys stocks and shares however small. Would you regard your
service as a public good that should be judged on that basis?
Mr Connolly: Certainly the relationship is different
for the reasons you've outlined. The stakeholder community is
very wide. Conventionally, if you have a customer and supplier
relationship, then there's a narrowness about who the customer
is and who you're acting for, whereas in the case of audit, we
have to recognise that, first of all, the primary client is not
the management who might hire you but is the investor, the owners
of the company. But we also have to recognise that the relevant
interested parties are very wide indeed. Speaking for my firm,
and I've no doubt this would apply to each of my colleagues here,
we believe that our responsibilities go well beyond serving just
the team of people who might hire us when we talk about the client.
Q240 Lord Tugendhat: Thank you. Then
to come to my own question; the ABI wrote, and I do emphasise
it was the ABI in 2006, "We are not comfortable with a position
where large firms could determine the shape of regulation by threatening
to withdraw from the audit market". Obviously they feel that
you do threaten, or you did threaten, to withdraw from the audit
market. Do you regard that, first of all, as a reasonable assessment
and secondly, would you agree that since you are only four, any
threat to withdraw could be said to be an abuse of a statutorily
Mr Powell: Certainly from PwC's perspective,
we see audit absolutely at the heart of our brand. We see it as
fundamental to what we do. We have no intention of withdrawing
from the audit market. We see the investment we make and the people
that we recruit, the development of the procedures and systems
that we have, are all really designed to get better and better
quality of our audits into the future. So we don't see it as a
threat from a PwC perspective.
Mr Griffith-Jones: It would be highly irresponsible
to threaten it if we didn't mean to go; of that there is no doubt
in my mind. Ultimately, if the job became impossible to do and
we really were going, I suppose we have a duty to tell people
we're going, but we have no such duty and while I don't know what
the ABI reference was to, certainly my firm, as far as I am aware,
has never played chicken with the ABI, or indeed for that matter,
anybody else about leaving the audit.
Q241 Lord Tugendhat: Can I just come
back to Mr Powell's answer? You said audit is absolutely central
to what you do. I wonder if you could just give me your descriptor,
as it were. I notice in The Financial Times on 15 November,
they were reporting some of your activities and they describe
PwC as the "professional services firm". Is that the
way in which you would describe yourselves?
Mr Powell: We would, yes. We offer a wide range
of services to our clients, but right at the heart of the brandand
really the brand has been built off a high quality audit practice
for the last 160 years effectively as an organisation,
while we believe it is important to invest in other areas of the
business, we also see audit as absolutely fundamental to what
Mr Halliday: Can I just add from Ernst &
Young's standpoint, we are deeply committed to the audit market
share. We would have no intention to exit it and it defines our
brand around the world. It is what we are at our core.
Following up on your question about the relationship,
it is very different. One of the cornerstones of our profession
is that we maintain an independence from our clients both in fact
and in perception and also that we ensure we maintain a healthy
degree of professional scepticism as we go about executing our
audit work. I do think the relationship is very different from
a typical vendor/customer relationship.
Mr Connolly:: Can I just confirm for
the record that Deloitte has never threatened to withdraw from
the audit market, so I don't know what is being referred to in
the remarks that were made.
The Chairman: Please don't feel that
you need to reply to every question. Lord Smith.
Q242 Lord Smith of Clifton: How competitive
can the large company audit market really be when it is so highly
concentrated and tendering and switching rates are so very low?
Mr Powell: Just to kick off on that one; fiercely
competitive. Every audit that comes up for tender, I think my
competitors would also agree, is ferociously fought. I think that
the costs of a major audit tender are significant for all of us
and I think that the evidence of this is that although there's
only four of us in this marketplace, any marketplace that you
are in a bidding situation, a bidding environment, the audit is
a tender. So where you have at least two people starting to bid
against each other, I think you are going to get a ferociously
competitive situation. Certainly if you look at the pricing of
audits over recent years, if you look at the competition that
there is between certainly the Big Four firms on every audit tender,
it is significant.
The only other thing I would add on this as
well is that really the appointment of auditors is undertaken
on an annual basis and so, at the end of every year when the audit
is reviewed, it is the role of the audit committee to look at
the efficiency, the way that the audit is being done, the quality
of the audit and that is a tough discussion. It's not as though
there is an automatic rollover of audit appointments at the end
of every year. There is a responsibility on the audit committee
to review the audit and there is an extensive debate on the quality
of the audit at that point before the re-appointment.
Lord Smith of Clifton: Presumably audit
committees vary in the assiduity with which they carry out their
Mr Powell: I think the guidance that's been
given to audit committees by the FRC is pretty stringent. The
way that the audit committees have to report in terms of their
report to the AGM, their report in the annual report is well laid
out and so I think there's quite a lot of focus on the audit committee.
So overall, audit committee quality is good. I'm sure it would
be the case that different audit committees operate at different
levels but broadly, the quality of audit committee debate is intense.
Q243 The Chairman: I declare an interest
as a member of audit committees in the past. Is there really that
ferocious a debate in most of them? It is the one item in the
AGM that passes without any comment ever I think. I noticed from
Oxera's Consulting Report in 2006 that more than 70% of the FTSE
100 has not held a competitive tender in the last 15 years. That
doesn't sound like a very lively competitive tendering market.
Mr Powell: Certainly speaking to our audit partners
and the discussions that are undertaken with audit committee chairs
each year end, these are professional, businesslike discussions
As regards the rotation of auditors or the changes
in auditors, I guess that also reflects the fact that there is
a cost to a company of making that kind of change. Also, there
is the discussion that's ongoing about the overall quality of
the audit as they perceive it. So if a client is happy with the
quality of the audit and is happy with the provision of the services,
then that is the depth of the discussion in reaching the decision
whether they want to go out for an audit tender or not. It is
important that the audit choice is the choice of the client as
to whether or not they want to go out for tender.
Q244 Lord Forsyth of Drumlean: I
don't want to press you on this but just on the Chairman's point
about Oxera. I must say I find it very difficult to take this
argument that it's really competitive when, according to their
figures, which I see you're not really disputing, the switching
rates for a FTSE 100 company are every 48 years; for a FTSE 250,
every 36 years and for all listed companies, every 25 years. How
can you possibly argue with a 4% churn every year that that's
a competitive market?
Mr Griffith-Jones: I think it's important to
understand what happens before it actually gets as far as a tender.
Let us assume that there is unhappiness or relative underperformance,
which is the most common cause of potential tender. We as a firm
obviously would take such circumstances very seriously and basically
offer to either change the team or improve the procedures or essentially
to be given another year to sort ourselves out. If you look at
it from the audit committee's perspective, it seems like a logical
decision to say, "Okay, let's see: either yes or no".
Very frequently, they decide pragmatically and they decide, I
hasten to add, not us. It doesn't happen all that often, but it
does, of course, happen, that they decide whether to go for a
tender or for rotation. Now, you also have to bear in mind that
audit partners since, I think, 2005 or 2006, have had to rotate
every five years and the team under them, by natural affluxion,
rotates as well. So it's not as though the same people are doing
the audit year after year.
Lord Forsyth of Drumlean: In 48 years,
they'd all be dead; long since retired.
Mr Griffith-Jones: But seriously, you have a
new team. From the public good angle, you have a new team looking
at the audit on a rotation basis every five years without changing
firm and given the loss of corporate knowledge by changing, and
you weigh up the respective advantage and disadvantage of that,
I can only tell you that is my perception of why it is the clients
that decide to keep us because it's certainly not us who have
the right, as it were, to stay there indefinitely.
Q245 Lord Hollick: I want to take
up Mr Powell's point about the cost of moving from one auditor
to another. It would be interesting for the Committee to know,
as a percentage of the annual audit fee, what is that cost and
would it not be the case that in a truly competitive marketplace,
the incoming auditor, the winning auditor, if you like, would
ease the path and sharpen their pencil to remove this problem?
Mr Powell: I would guess that it would be the
cost of disruption to a company as well in terms of the need to
be involved with a new team. That loss of corporate knowledge
that has just been referred to would also be an additional cost.
We did some work on this as a firm to try to just evaluate what
the potential cost of a move could be and the estimate was between
£500,000 and £1 million in terms of the disruptive cost,
I think it's fair to say that might not be substantial in the
overall context but I think in terms of a cost that might not
need to be incurred because people are satisfied with the quality
of the work that is being done, that is something people take
Mr Halliday: I would offer to the Committee
a couple of thoughts on this because I think it's an important
area around audit committees. I apologise for my voice; I'm fighting
off a cold. One of the things that we see in some countries around
the world is that there's a statutory reporting relationship between
the external auditor and the audit committee. So it is by law
clear that the audit committee is hiring the firm. I would offer
that as something to think about as well as requiring that all
fees paid to the external auditor are approved by the audit committee.
Together with that you might consider a report that was externally
issued by the audit committee that talked about the duties that
are carried out in performing this important governance function.
So I would offer those things for the Committee to reflect on.
Mr Connolly: Can I just add a point that I think
is relevant. Increasing the rate of change in auditors, at the
end of the day, is up to the companies. That, in itself, doesn't
necessarily deal with this concentration issue. There are a small
number of countries in the world, not many, where there is mandatory
rotation but it doesn't lead to a change in concentration. In
Italy, for example, there is mandatory rotation and the Big Four
still dominate the audit market. So that, in itself, doesn't lead
to change. I think requiring audit committees formally, making
it a legal requirement, for them to record and report in some
detail how they arrived at the decision to appoint, reappoint
or not reappoint the auditor would be helpful because that would
cause the audit committee to focus explicitly and that might lead
to consideration, particularly in the light of the sort of statistics
you referred to.
The Chairman: We must move on because
we have a lot to cover. Lord Hollick.
Q246 Lord Hollick: We've received
a number of suggestions about how to address the concerns about
the dominance of the Big Four including breakup, prohibition on
consulting for audit clients, joint audits, abolition or relaxation
of the statutory requirement for audits, and the appointment of
advisers to board risk committees, independent of the auditor.
It would be interesting to know your views on the feasibility
of these measures. Do you think they would be desirable?
Mr Connolly: First of all, I think the concept
of independent advisers advising risk committees is a good one.
If that was adopted, I think that is a good change. I really don't
see that some of the other options that are referred to would
be feasible. I'll just pick on one of them and perhaps colleagues
would pick on others. When we talk about the concept of breaking
up the Big Four, firstly it's a fairly artificial thing to seek
to achieve but clearly, if the law said in this country that we
had to divide ourselves in some way, then we would have to do
that. We do have to remember that doesn't solve the situation
globally because we have big global networks and if we divided,
my firm illustratively, into two, then one of the firms perhaps
would have a global network and the other one wouldn't. Now, if
in fact we said, "Well, what we'll do is you can both use
the same global network", then you ask the question, "Well,
has that really achieved anything if the same firm outside of
the UK is continuing to do all of the work for each of these two
firms that have been broken up?" particularly recognising
the comment made earlier that 80% of the business of FTSE 100
companies anyway is outside of the UK. So I really don't see the
feasibility of that.
Mr Powell: Just to add on the breakup point
as well, to break up the firms would restrict the amount of investment
monies that would be available in order to continuously improve
the quality of the audit service and to serve increasingly complex
and multi-national organisations.
Q247 The Chairman: What about the
prohibition on consulting? What impact would that have; what effect?
Mr Powell: From PwC's perspective, less than
10% of our consultancy business is spent on audit clients, so
it's a relatively small amount. Interestingly as well, this is
a highly regulated and reviewed area. The AIU review this as part
of their annual procedures in looking at the audit services that
we've offered. Also there's been quite a lot of consultation on
this. I think the APB have had consultation papers out twice in
2009 and again in 2010. There was a lot of response to those consultation
papers with overwhelming views that the way that things are organised
at the moment is working and that the discretion that's left with
audit committees, and is left with clients and with the audit
firms as well to review our relative independence in terms of
the provision of those services, seems to be working.
Mr Halliday: One of the things our firm is very
focused on is globalising our network. If you look at the activities
that we've undertaken across the Americas and also across the
Asia-Pacific region really to accelerate the globalisation of
our firm they really had two main drivers. One is what the market
was asking for, to be able to serve them on a seamless, consistent
and cross-border basis, but also at the heart of it was to improve
the quality of the audits that we would execute. When you think
about a company that has far flung operations somewhere on the
other side of the world but they're headquartered right here in
the UK, we will undertake, in this effort to globalise the firm,
strengthen our processes to be able to best serve those clients
around the world. That's why the scale in size, coming back to
your breakup point, is so important for the firms to be able to
continue to execute high quality audits for companies that have
far flung operations around the world.
Mr Griffith-Jones: Shall I deal with joint audit?
I think you've had evidence from Mazars, but the only country
really that has a major interest in joint audit is France. I think
it's important to realise that part of the reason the French had
joint audit was to protect the French national auditing profession
from what they regard as the Anglo Saxons and by having joint
audits, they had one of the big firms and one French firm. Over
time, this has condensed down. Now, if you take the CAC 40, which
is the top 40 companies in France, there are five, not four. In
fact, Mazars' market share is pretty much identical to KPMG's
in France but it hasn't led to any broadening. There was a sixth,
which was called Salustro, which merged with KPMG three years
ago. So joint audits, per se, don't enhance competition. What
they do question is whether they improve quality. I know the French
argue that the system works, as far as they're concerned, perfectly
satisfactorily, but we have had various examples in the UK, while
not necessarily joint audits in the sense of being joint at the
top, but having more than one audit firm involved where fraud,
and particularly fraud, has deliberately got through the cracks
by playing the two firms off against each other in different jurisdictions
or different year ends. I refer particularly to BCCI which was
probably the most famous example, and without prejudicing my colleagues
around the table, Parmalat is another example. While there is
no strong evidence either way that two firms are better than one,
there is some evidence that two firms can lead to a weakening
of the audit relationship where someone is deliberately trying
to commit fraud; not, I may say, where there's an accidental error.
Q248 Lord Lawson of Blaby: May I
follow on from what Mr Powell said? I think I heard you say that
it's only 10% of cases where you do internal audit or other consultancy
type stuff for clients for whom you are the external auditor.
Mr Powell: Yes. Not internal audit but in terms
of our consulting business fee, only 10%.
Q249 Lord Lawson of Blaby: How about
internal audit? What is the percentage for internal audit for
external audit clients?
Mr Powell: As a firm, we don't outsource internal
audit functions at all to audit clients.
Q250 Lord Lawson of Blaby: So, in
fact, since this is so small for you, all this stuff, it wouldn't
be of any great concern for you if that were prohibited.
Mr Powell: I think there's a wider discussion
about this as well, which is around the capacity, if you like,
of firms to recruit the very best people and to develop those
people as well. For example, if you are recruiting great graduates,
they come to our firm because they want to gain great business
experience across the whole gamut of the business. So they want
to work in audit, they want to work in consultancy and over the
years, as they develop their experience, because we're a firm
that can offer those of kinds of experiences, as they move back
into audit practice, they are much better auditors because of
the quality of the training and the experience that they've had.
I'd argue that we are better auditors because of the other services
that we offer as well.
Q251 Lord Lawson of Blaby: But you
don't need to offer them to the same client; that's the point.
Of course you can offer these services. The question is whether
you should offer them to the same client. As I understand it,
it's pretty small beer, the extent to which you do this and, therefore,
you wouldn't be greatly exercised if that was prohibited.
Mr Powell: But it would be an artificial restriction
if we couldn't offer those services to all of our clients. Ultimately,
it's the client's choice as to whether they buy those services
from us or not and it is heavily regulated. It is reviewed. We
review our own independence. We take this very, very seriously
in terms of whether any of the work we undertake for our audit
clients could ever be prejudicial to our independence. I think
it is highly regulated. If our clients buy services from us, and
I'm sure that you've seen the trends as well, generally non-audit
services to audit clients over the last few years have reduced
and I think that generally, our clients look to buy from their
audit firms when they feel as though they can get the very, very
best from their audit firms. I think if we said, "Look, we
won't sell any services to our audit firms", that would be
a restriction on the choice of clients. Also, it would prevent
them from making a decision as to whether they're buying the best
services or not.
Mr Halliday: I think one of the areas on this
subject that's being looked at is the disclosure of the non-audit
services. The Auditing Practices Board is looking at improving
that and adding more transparency to the nature of non-audit services.
Q252 Lord Hollick: Is there not a
conflict of interest though at the heart of this because you're
providing advisory services, let us say, on taxation and tax planning,
which is a major part of the professional services you supply,
and then another group from your firm come along and audit the
same thing? Doesn't that present you with a real conflict of interest?
Mr Powell: No because the independence rules
are very strict on this. They're reviewed by the audit committees;
they're reviewed by ourselves in terms of the provision of those
services. We would not put ourselves into a self review situation
where we had to audit a work that was undertaken by the firm in
a different way. So the independence rules are very strict on
this. As I say, we apply them and so we are very careful not to
put ourselves into a conflict situation.
Q253 Lord Hollick: Who would audit
that work then?
Mr Powell: The question is whether that work,
as it's done, needs to be subject to audit. It really works the
other way. If we are the auditors of an organisation, if we review,
let's say, a piece of tax planning and say, "We can't do
that piece of work because we would bring ourselves into a conflict
situation", that piece of tax work would be done by someone
else. That piece of work wouldn't be allowed by the company; it
wouldn't be allowed by the audit committee; and we wouldn't take
Mr Connolly: I think this is the point because
there are explicit rules already in existence that fundamentally
say that you cannot audit your own work and there's then a whole
range of very specific exclusions. To the point that Lord Lawson
made, as a matter of fact, the APB's recent paper, as I referred
to earlier, did not show that in the last 12 months, FTSE 100
companies paid anything to their auditors for management consulting
services. Where you get into some difficulty from the perspective
of the companies, if you just have a blanket elimination of doing
anything other than the audit, is those areas of work where the
client concludes that because of the special knowledge and experience
that the auditor has, there are certain things that they would
have a preference for the auditor to undertake and it might be
because of security, confidentiality and speed; but they can still
only select things that would not cause there to be an independence
issue for the auditor.
Q254 Lord Levene of Portsoken: In
effect, the audits that you are doing are reports to the owners
of the businesses, which are the shareholders. To what extent
do you have a dialogue with large shareholders of the principal
companies in the FTSE rather than just talking to the companies
Mr Griffith-Jones: At the moment, very rarely,
if at all and that's through convention and the way it is. The
audit committee is taken to represent and act in the interests
of the shareholders. The shareholders are not very active in coming
to general meetings with our firms. We offer to meet them on a
general basis. The issue of meeting on a specific client is clearly
confidentiality because what they want to know is something of
market advantage to themselves and clearly, unless you had all
the shareholders in the room at the same time, to talk to one
group of shareholders in advance of another and to give qualitative
views on one's clients would not fit comfortably into the rules
in the way they are operated at the moment.
Mr Powell: It is going to be interesting under
the new audit firm governance code as well because one of the
requirements of the code is to facilitate the dialogue between
investors and between the auditors. There's not much guidance
in the code as to the best way to do that. We've put together
our public interest group, which is five senior people. We are
working with them to decide what is the best way to try to meet
that requirement of the audit firm governance code. I think there
will need to be some dialogue between investors. We just need
to design what the best way to do it is. This is a brand new code.
It's only just at the point of being rolled out during the current
year ending 30 June 2011. As we're working through that, that
is going to be an interesting area as to how we stimulate that
level of discussion between auditors and investors.
Q255 Lord Levene of Portsoken: Would
you welcome the opportunity to have that dialogue?
Mr Powell: Yes, we do; very much.
Q256 The Chairman: Are there any
other comments that any of you want to raise on all the different
alternatives and suggestions that have been put to us and that
Lord Hollick referred to?
Mr Griffith-Jones: Can I just come back, very
briefly, to this question of risk committees? I think it possibly
goes into the banking agenda which I suspect we may get to later.
I personally believe that the auditors have an important potential
role to play around the risk area and to mandate the auditors
out of the loop because the risk advisers have to be, as it were,
not the auditor would be a mistake; we need to be careful with
the definitions that we use. I quite accept that they shouldn't
be advising but if the consequence of having a separate set of
risk advisers is that the auditors do not get involved in risk,
I think that would be to miss a major learning from the financial
crisis and that we must be careful how we structure those rules.
I also think that the chances of a risk adviser being another
audit firm are by no means 100% and it's certainly not a way of
increasing competition. It may be a better way of auditing banks
but put forward as a solution to competition, I do not think it's
a particularly valid argument.
Mr Halliday: I was just going to offer that
this is a really important area for the Committee to reflect on
because I think trying to better identify systemic risks that
exist in different sectors is one of the learnings from this.
If you look at the banking crisis, all four of us had meetings
with the Bank of England around trying to improve the dialogue
between the Bank of England and the firms. I think there's more
that can be done in that area including the use ofI think
they are referred to as 166 reports in this countryand
more of a dialogue going both ways with auditor and the regulators.
One of the things FRC has done is that next week, or the next
two weeks, we're going to be visiting with them on what are the
systemic risks going into this year end reporting season. I think
those are healthy discussions because all of us are going to come
at from a little different place but I think if we sit down and
create a dialogue to occur, we'll have a better opportunity to
identify the systemic risks that are in those sectors.
The Chairman: This is an important area
and we will be coming back to that later. Lord Tugendhat.
Q257 Lord Tugendhat: Just coming
back to the French situation, I understood you to say, and others
have said, that the joint audits haven't led to an improvement
in the quality of audit and I can imagine that is so. What they
surely do provide the French with is some element of insurance
if anything happens to one of you. One of the systemic risks,
which we have at the moment, is that there are only four of you;
there were five and Arthur Andersen came unstuck. We live in a
world in which some of the largest banks in the world have suddenly
had to go into government ownership virtually. We don't know what's
going to happen. The substitutes bench argument for developing
a reserve capability in the event of a crisis in one or other
of your firms; surely the insurance argument has some strength.
Mr Griffith-Jones: The only answer I can give
is that it hasn't created a substitutes bench in France. There's
one more but they were always there and they were there because
of the way it was structured originally. So the other mid-sized
firm is not on their substitutes bench any more than it is on
the UK substitutes bench; at least at the top end of the market.
Mr Halliday: I think you have to keep at the
heart of it that it is good for the quality of executing the audit.
If you just think about two vendors or two firms having to have
two dialogues with management, two dialogues with the board, there's
an opportunity for gaps to exist. To turn the argument around,
you could argue there's more systemic risk because if something
went wrong with that company and there was damage to the brand
of the two firms that audited that company, the result could be
the collapse of two firms. Our firm strongly believes that having
a single auditor will resolve in the best communication with the
board, the best communication with management and resolve in the
highest quality audit.
Mr Powell: It's worth noting as well that there
is nothing that prevents a joint audit. It's the fact that the
market, over a period of time, has decided that these are not
as efficient and maybe from a quality perspective as well. I can't
remember when the last joint audit fell away but it was probably
in about the last five or six years. The choice is there if people
want to have a joint audit but it's the market that has chosen
that joint audits are not something they would want to buy.
The Chairman: We have spent quite a bit
of time on this question because it is very much at the heart
of one part of our inquiry. I think on the next questions, if
we could move a little swifter, it would be helpful. Lord Lipsey.
Q258 Lord Lipsey: Thank you. You
were just referring on risk committees to the evidence given by
Baroness Hogg and it led me to reflect that a few years ago, the
FRC put forward a number of proposals which it said would be a
market-based solution to the problems of concentration. When she
appeared before us, Baroness Hogg--and I don't like to summarise
her too briefly--said that these had not worked and came up with
the suggestion, for example, which you just made with regard to
risk committees. My question is this. The new publication from
the FRC jointly with the ICAEW, the audit firm governance code
to which you also referred a minute ago, Mr Griffith-Jones, that
came in in January 2010 possibly with similar sets of objectives.
I wondered if there was any chance that would be any more effective
than the last FRC market based solution.
Mr Griffith-Jones: I sat on the body that generated
the code, so I declare an interest in it as well. I think it's
an excellent idea. Mr Powell said they've just announced their
public interest group; we're on the cusp of announcing ours. Benefits
will be felt and I would hope it would promote confidence in all
the firms that adopt it. It includes the next four down the list.
I do have to say that then you will have eight firms all complying
with the code. So whether it will be a point of major differentiation,
I can be less certain, but I think it will lead to an absolute
improvement in overall quality.
Mr Halliday: The UK should take great credit
for the production of the UK governance code. It's being adopted
and looked at across the globe right now. As a result of it, our
global board has decided to implement the UK audit firm governance
code at a global level and we are in the process of putting independent,
non-executive directors on to our global governance code. Obviously
one will also be domiciled here in Britain but one will be from
the Americas, one from the continent of Europe and one from the
Far East. It will really be consistent with the global nature
of the firm in which we operate to have those independent directors
up at the global level evaluating and overseeing what we're doing.
This is a huge step forward for the profession and I think the
UK should take credit in driving this.
Mr Powell: One big advantage of this, having
had the benefit, if you like, of the very first meeting of our
public interest board, is the quality of people that are prepared
to act on these bodies. They're not the sort of people who would
put their names to something that wasn't likely to have real teeth
and to work. The real big advantage of this is transparency because
one of the big reasons for having independent non-executives,
on the audit firms is also to look after the public interest as
well. So as we analyse the code and as we decide the best way
to apply that, working with our public interest board, one of
the key areas, as we referred to earlier in terms of the discussions
with investors, is going to be around transparency. That will
be one of the big benefits.
Q259 Lord Lipsey: So just to be clear,
it will deliver quality, you hope. It will deliver transparency.
It is not particularly about widening choice and dealing with
the widening choice issues.
Mr Powell: Only to the extent that, as the audit
firms are more transparent, people can look at the way that the
firms are run and make a decision as to whether they want to move
to a wider choice.
Mr Halliday: If there was an Andersen moment
involving one of the Big Four firms, having independent non-executive
directors who could step in and assist in that situation would
be very helpful.
Q260 Lord Best: It has been suggested
that audit is implicitly a form of insurance, even though obviously
it isn't formally that, and we have heard the views of Professor
Joshua Ronen of New York's Stern School of Business. Do you think
there is any merit in Joshua Ronen's financial statements insurance
approach? Is there anything in this?
Mr Connolly: I have to say I'm not an expert
in the detail of what he has proposed but I did, in the light
of this prospective question, spend some time looking at it. I
am aware that this has been around for seven or eight years as
an idea and that it has explicitly been examined in the US by
the SEC and rejected as something that is not practical. When
you look at the detail of the proposals I think one of the key
features is the assertion that audit quality would be improved
if the auditor was doing the work for somebody or is hired by
somebody other than the company.
Again, even when you read the detail, there
is a suggestion that the intensity of the auditors' work would
change. I find it very difficult to appreciate why that is a platform
for the new idea. But it also is extremely costly. It introduces,
again as far as I can see, a new layer of activity. It talks about
each company having underwriting reviewers who would examine the
entity and their control environment and the probability that
there could be an accounting error. So another raft of activity
would take place which would have to be paid for.
The audit still has to be done, so the audit
cost doesn't change, and you then get right down to the heart
of it and that is: is the insurance going to be available? Now,
when we look at the insurance that is available for firms like
our own in respect of audit failure, it is very, very limited
indeed. There is not enough insurance in the insurance market
to cover the market capitalisation of a single FTSE 100 company,
let alone the whole market, so I do not know why there is the
view that this insurance would exist.
A final point that I would just make, which
I did find fairly odd, was that companies would pay their insurance
premium as well as all of these other costs and if the auditor
qualified the financial statements and then there was a failure,
the insurance doesn't pay out because the accounts were qualified.
They only pay out if a mistake is made when the accounts weren't
qualified. So it just seemed to contain a lot of very impractical
features to me and it does seem that experts, much more expert
than me, have examined it in some detail and rejected it as being
Mr Powell: I would also disagree with the statement
that an audit is an insurance. I think there is quite a distinct
difference between insurance and assurance and I think that audits
add a lot more value to the development of businesses, and to
giving assurance as regards trust in capital markets, than just
underwriting a loss.
The Chairman: That is a fairly comprehensive
demolition, so we can move on.
Q261 Lord Levene of Portsoken: Would
you agree that by about the middle of 2007and I am talking
about the banks nowthe writing was sufficiently on the
wall about the global financial crisis for auditors to have sounded
serious notes of caution well before their report on the 2008
year-end statements? Was this a failure of the audit and, if there
are lessons learned from that, what changes are going to be made
to try to avoid it in the future?
Mr Powell: Can I pick up on the last point first,
which is that I think there are lessons to be learnt from this.
I think everybody has lessons to learn, including us as auditors.
One of the key elements for me is, when you look back at the Banking
Act 1987, there was real encouragement at the time for a dialogue
between regulators and auditors. That seems to have slipped away
with the FSMA Act and we referred to it a little bit earlier in
terms of the discussion that is ongoing with the Bank of England
and the regulators as to how we can rebuild that communication
between auditors and regulators to try to make sure that there
is a sharing of information as we come into more difficult times.
Q262 Lord Lawson of Blaby: If I may
come in on that particular point that you raisedI was the
author, as you know, of the 1987 Banking Act and the provision
for there to be a regular dialogue between auditors and regulators
was something that I attached enormous importance to. To begin
with, that happened. But, as you say, it slipped away; it stopped
happening. Can you explain why?
Mr Powell: It didn't transfer across as compulsory
Lord Lawson of Blaby: No, it stopped
Mr Powell: I think you would be reassured by
the discussion that we had with the Bank of England, with the
other regulators. There is a working party on this between the
six big audit firms and the regulators at the moment to see how
we can develop that and get that back into being an automatic
part of the relationship between regulators and auditors.
Q263 Lord Lawson of Blaby: May I
pursue this further, Chairman? I was slightly surprised. In his
opening statement, presumably on behalf of all of you, Mr Connolly
explicitly saidand I think I took this down right; if I
didn't I'm sure he'll correct methat, so far as the question
of auditing the banks is concerned, the auditors performed well.
That seems to me to be extraordinarily self-satisfied in the light
of what we now know to be the case. How do you justify that statement?
Mr Connolly: First of all, let me say I wasn't
representing my colleagues when I made that statement.
Lord Lawson of Blaby: All right. On behalf
of yourself then.
Mr Connolly: So on behalf of myself
Lord Lawson of Blaby: You would know
about it because you were the auditor of the Royal Bank of Scotland
Group, weren't you?
Mr Connolly: That's right.
Lord Lawson of Blaby: Which went belly-up
within a few months of your giving it a clean bill of health.
Mr Connolly: Yes. Well, of course, it didn't
go belly-up. It was supported and that's
Lord Lawson of Blaby: No, it went belly-up.
That's why it was supported.
Mr Connolly: There is a difference. No, there
is a very important difference. But, first of all, in terms, the
question that Lord Levene asked and which you are pushing back
on now is, "Was there a failure of audit?", and I don't
think there was. I think that the environment was such that the
complexity of the financial environment at that time caused there
to be a hugely intensive effort from auditors, recognising the
onerous nature of their role. As a consequence of that, we dealt
with very significant complex audits and had very important decisions
to make around our audits.
I think that it's relevant to note that the
independent inspectors who look at the work of auditors have generally
found, from their reviews of all of the firms, that the bank audits
were of a high quality. That is what they reported. In no case
has there been a requirement to restate the financial statements,
which would have been required if the financial statements had
been incorrect. On the point you're making about "Did it
go belly-up?", one of the vitally important issues we all
faced was how we dealt with the going concern question.
All four of the people here had detailed discussions,
instigated by the Big Four, with Lord Myners because of the circumstances
we were in. It was recognised that the banks would only be going
concerns if there was support forthcoming. The management of the
banks, first of all, who make the initial decision as to whether
they conclude they are still a going concern, had to take into
account all circumstances, including the likely availability of
support, in concluding that they were a going concern. We had
to take into account all the available evidence in reaching that
conclusion. I think it was a proper and appropriate act from the
four firms to seek to understand the likelihood of support being
forthcoming and I can only say that had we concludedand
I assume had management of the banks concludedthat there
was not going to be support, then a different audit opinion would
have been given.
Q264 Lord Lawson of Blaby: I find
that absolutely astonishing.
The Chairman: So do I.
Lord Lawson of Blaby: Absolutely astonishing.
It seems to me that you're saying that you noticed that they were
on very thin ice but you were completely relaxed about it because
you knew that there would be support; in other words the taxpayer
would support them, so there was no problem. That's what it seems
to me you just said.
Mr Connolly: No, not at all. What we were aware
of, very aware of, was that the consequences of reaching a conclusionhad
that been the proper conclusion to reachthat a bank was
going to go
Lord Lawson of Blaby: Belly-up.
Mr Connolly: Belly-up, to use your term. The
impact that that could have had was huge. The requirement of the
auditor is to satisfy itselfthe requirement first of all
starts with managementthat that will not occur; however
it might not occur, that that will not occur.
Q265 The Chairman: But I think you
said at one point, "likelihood of support", and then
at another point, "availability of support". What conversations
did you have with Government to enable you to come to that conclusion;
that it was likely to happen?
Mr Connolly: We had conversations that sought
to understand the likelihood of support being forthcoming.
Lord Lawson of Blaby: At what point?
Mr Connolly: I believe the initial meetings
we had werewas it December?
Mr Griffith-Jones: December 2008.
Mr Connolly: December 2008 and later again in
Q266 Lord Forsyth of Drumlean: Are
you saying that, looking at the position, you thought that the
bank was likely to be in trouble but you couldn't possibly say
that because that might precipitate the crisis and, therefore,
by giving assurance you took the view that the accounts were okay?
Mr Connolly: I think it would be wrong to say
we couldn't possibly say it if it had to be said.
Mr Powell: I think, just in general terms on
thispersonally I wasn't at that meeting although my firm
was representedthe reason that banks got into real difficulty
was the closure of the wholesale markets, and the closure of the
wholesale markets in the second half of 2007 created real difficulty
for many banks. As the auditors, one of the things that we have
to do is look forwardand it's the same whether it's a bank
or whether it's any other type of firmat the liquidity
that is available. One of the key questions around the banks in
signing off the audit opinions at the year-end 31 December 2007
was, "Is there adequate liquidity available to this bank
to enable us to form the view that the bank is a going concern
and we can sign off a going-concern audit opinion?"
The discussions that have been referred to were
around, "Is there adequate liquidity or is there likely to
be liquidity provided to these banks to survive?" That was
the depth of the discussions, as I understand it, in 2008. Based
on the assessment that we took as the four large audit firms,
and based on the assessment of the availability of that liquidity,
we then had to go away and our auditor partners had to form a
view as to whether or not we could sign off a clean going-concern
opinion on those facts. That is the process that we went through
to enable us to form that opinion.
Q267 Lord Lawson of Blaby: But the
question of liquidity in the wholesale market and so on was only
one of the elements. It wasn't the only element. There was also
extremely risky business being undertaken which was a threat to
solvency. They were not insolvent at that time but there was a
threat to solvency there and that is clear. So I am still astonished.
I am still not clear, first of all, whether you thought that,
as Mr Connolly says, it was perfectly all right because there
would be a bail-out or whether you didn't notice there was anything
wrong or whether you did notice something wrong but you thought
you shouldn't say anything to the regulators. As far as I can
make out you didn't say anything to the regulators at that time.
Mr Powell: No. Can I just talk you through the
Northern Rock situation?
Lord Lawson of Blaby: Yes.
Mr Powell: Just a little bit of history on Northern
Rock: we signed off the audit opinion on Northern Rock, which
was for the year ended 31 December 2006 on 25 February 2007. At
that point the wholesale markets were open. Commercial paper in
Northern Rock was heavily oversubscribed. As the year went on,
I think one of the early signs in this was when BNP Paribas, I
think it was, issued a statement that there were liquidity issues.
That was on about 9 August 2007.
Now, in the early part of September 2007 we
spent time with Northern Rock and we formed the view that there
was something that we needed to report to the FSA. So our contact
with the FSA was on 11 September 2007 when we called the FSA to
say that we had concerns about the going concern of Northern Rock.
That was followed up by a letter and then quickly followed up
by meetings with the FSA. So I think it is wrong to say that we
didn't say anything to the regulator. I know that is just the
Northern Rock example. I can't speak for what
Q268 Lord Lawson of Blaby: You say
you did that with Northern Rock. What did the FSA do when you
Mr Powell: Well, we reported it to the FSA.
I think the Bank of England were involved as well at that point
and so Northern Rock asked for emergency support from the Bank
of England on 13 September 2007 and were granted that.
Q269 Lord Lawson of Blaby: So it
was at the last minute. Since we're talking about specific banks,
may I ask a question? It's very dangerous to ask a question to
which you don't already know the answer, so I am laying myself
wide open, but did any of your four great companies audit either
Allied Irish Banks or the Bank of Ireland?
Mr Powell: I'm not sure. I'd have to get back
to you on that one. We didn't audit Allied Irish but I don't know
whether we audited Bank of Ireland.
Lord Lawson of Blaby: So you don't know?
Mr Powell: Well, it would have been audited
Lord Lawson of Blaby: Your colleagues
don't know whether they did?
Mr Connolly: I know we didn't.
Mr Halliday: I know they're not us.
Mr Powell: Which would tend to imply it was
Q270 Lord Lawson of Blaby: Yes. That
sounds circumstantial, yes. So did you notice anything wrong?
Mr Powell: I can't speak on Bank of Ireland,
to be perfectly honest. I mean, whether that was one of our audits
or it was audited by our Irish firm as well, as opposed to the
Q271 Lord Lawson of Blaby: Your Irish
firm is wholly owned, isn't it?
Mr Powell: No, it's not wholly owned.
Lord Lawson of Blaby: It's wholly separate,
Mr Powell: Well, the structure of an organisation
like PwC is a series of network firmslocal partnerships.
But I can look into the Bank of Ireland situation if you would
like a written response on that to give you more detail on it.
Lord Lawson of Blaby: I think it would
be of some interest, yes.
Mr Powell: Okay.
Q272 Lord Tugendhat: I was going
to ask the Irish question but that's been asked, so I shall ask
a different question. The situations that arose at the Royal Bank
of Scotland and HBOS, for that matter, and Northern Rock were
all, at the time that they arose, unprecedented. Nothing like
it had been seen in the professional lives of the people concerned.
If I might ask you this: do you feel that at the top of your own
firms you were sufficiently abreast of the potential dangers at
RBS, at HBOS and at Northern Rock or was this information of a
very unusual nature kept too close within the audit teams responsible
for those banks?
Mr Connolly: Speaking in my case, I have a reasonable
degree of confidence that knowledge that was possessed by those
undertaking the audits would not have been retained with those
partners who were undertaking the audit, primarily because there
was an awareness of the significance of the complexity of the
marketin our case, particularly recognising that the lead
partner responsible for the Royal Bank was one of our most senior
partners in the top leadership team.
Q273 Lord Tugendhat: In the case
of HBOS and Northern Rock?
Mr Griffith-Jones: Certainly in our firmand
I am aware of thisthere were very intensive and weekly
telephone calls between the senior bank auditors over the 2007
year-end. So I think we were completely aware of what was going
on in the world but, like most other people in the world, didn't
appreciate what was going to happen, especially to Lehman Brothers,
in September 2008.
Q274 Lord Forsyth of Drumlean: Just
on that point, can I ask a question? I have asked it a number
of times during the course of this inquiry. I don't understand;
seeing balance sheets being so extended, seeing the kind of growth
that there was at Northern Rock, seeing the multiples that were
being lentwhy would that not sound alarm bells among the
auditors at an earlier stage and some questions about "Is
it really sensible to be lending 39 or 40 times?" or whatever
the number was? Why did that not happen?
Mr Griffith-Jones: With hindsight, it is, of
course, a pretty good question and I'm sure people have struggled
to answer it.
Lord Forsyth of Drumlean: But when we
discovered the extent to which the balance sheets were extended
we were all shocked.
Mr Griffith-Jones: The first point is that the
auditor's primary role is to count the score at the end of the
accounting period and that they do. It is a look-back exercise.
Sure, it has this obligation to look forward on a going-concern
basis but not a look-forward other than that. So we are not trying
to forecast next year's profits.
Secondly, it is not responsibleand this
is interesting learning from the whole thingfor making
an assessment of the risk of the business. So, for example, if
you have a company that has leverage of 100 times and a company
that has no leverage at all, the audit report is the same, or
up to now has been the same. It is not the role of the auditors
to say to the company, "Your business model is different
from your competitor's business model". Whether it should
be, going forward, is an open question but it is not a statutory
obligation and it is not a generally understood one. It is the
role of the auditors to point out weaknesses in controls. But
weaknesses in controls as opposed to a different business strategy,
I would suggest, are rather different things.
With respect to Mr Powell, who should probably
speak to Northern Rock rather than me, everybody knew what Northern
Rock's business model was. Everyone was buying shares and indeed
rating Northern Rock extremely highly because of their rather
clever business model, which with hindsight, of course, was not
the case. But I don't think it was the auditors primarily or particularly
Q275 The Chairman: Maybe I am getting
the wrong impression but I got the feeling that you were suggesting
that there was sufficient concern at the top levels of your firms
and also in relation to the possible viability of support from
the Government that you were raising these issues before you signed
off, which suggests that you were having concerns about it being
a going concern.
Mr Powell: I think that was
Mr Griffith-Jones: That was 2008it is
rather important, thatnot 2007.
Mr Powell: It was for the year ended 31/12/2007.
So as we moved into 2008 we were looking at the audit opinions
on those banks that had year ends of 31 December 2007. Clearly
the market had moved at that point. Everybody was aware of it.
At the tops of our organisations at that time, we didn't have
hindsight either. But we were heavily involved as soon as we realised
just the scale of the issues and what the issues were. Sorry,
just to complete the point as well on Northern Rockwhen
you're undertaking an audit you do look at the market conditions
that were extant at the time of signing off of the audit. As I
said earlier, the wholesale markets were open. Northern Rock was
able to finance itself at that point in time. It was only the
closure of the wholesale markets later in the year that really
brought Northern Rock into the difficulties that it had.
Q276 Lord Levene of Portsoken: I
think I may have missed something here. You said that your job
primarily is to look back and report on what has happened and
not look forward. But how can you give an opinion on whether it
is a going concern if you're not looking forward?
Mr Powell: Well, I think Mr Griffith-Jones did
add as well that while you look at a snapshot of a balance sheet
and a business at that point in time, you do have to do the look
forward. We look forward at liquidity as a minimum of 12 months
but if a company, for example, produces forecasts that go forward
18 months or two years, we look as far as we can into the future.
Q277 Lord Lawson of Blaby: But following
on from Lord Levene's point, Mr Connolly said that the likelihood
of there being official support was a factor in his thinking.
The likelihood of official support implies that, without it, it
wouldn't be a going concern. So I don't see how you can answer
Lord Levene's point when that is a factor.
Mr Connolly: It certainly was a factor and I
think the key thing to recognise is that the judgement, first
of all, that the management and the directors have to make is
that their organisation is going to continue for a period of at
least 12 months and the auditors have to reach a similar conclusion
or modify their audit opinion. The mechanisms that are going to
be adopted in order to provide that confidence can be varied and,
in the environment we were in, there was absolutely no doubt at
all that one of the key features of giving assurance that the
banks were going to continue was the likelihood of Government
Q278 Lord Hollick: Speaking on the
going concern point, if we go back to the end of 2006, I think
you said, when you did the audit for Northern Rock, in order to
form a judgement about a going concernnot just the scorekeeping
element of your jobyou would have to form a judgement about
the business model. As Lord Lawson said, Northern Rock was financed
on one side by hot money and on the other side was making some
fairly adventurous loans or high-risk loans. At the time did it
occur to the audit teamwas there any discussion within
your firm or other firmsthat there was a danger in this
model? It goes to the heart of the going-concern judgement; frankly,
as an investor that is what we hang a great deal of faith on.
That is the assurance that we are looking for.
Mr Powell: It's not the job of the auditor presently
to look at the business model of a business. That is the job of
management. It's not the auditor's job to give a view as regards
the actual model that is put together.
Q279 Lord Hollick: How do you form
a judgement about the going concern?
Mr Powell: I wasn't a member of the audit team
on Northern Rock but I think that the way that the audit was undertaken
at the year-end was: you would look at the business model; you
would look at the liquidity effect of that business model; and
you would make an assessment as to whether or not the markets
would support that liquidity into the business in forming your
view. Our audit team did extensive work in auditing the year ending
31 December 2006 to make sure, assuming that the markets would
continue as they didand there was no evidence at that point
that we were going to go into a wholesale global meltdown of the
financial services sectorthat that model would be sustained
for the next 12-month period by the markets and by the continued
rolling of the commercial paper. Then, of course, it comes down
to the disclosure that goes into the accounts of Northern Rock.
So we formed the view that there was adequate disclosure of the
financial position of Northern Rock for the users of the accounts
on Northern Rock to take a view, whether they be investors or
whether they be other users of the accounts.
Q280 Lord Lipsey: I have an increasing
Alice in Wonderland feeling about this discussion, quite frankly.
I'm a naive amateur in this field but I expect "going concern"
to mean that a business can pay its debts as they fall due, but
you meant something quite different. You meant the Government
will dip into its pockets and give the company the money and then
it can pay its debts as they fall due and you gave an unqualified
audit report on that basis. If you had said, "We are satisfied
that support will be available from Government that will enable
it to continue as a going concern", of course you wouldn't
be subject to this criticism. But instead, where your duty is
to report to investors the true state of the company, you were
giving a statement that was deliberately designed to mislead markets
and investors as to the true state of those banks. That seems
to me to be a very strange thing for an auditor to do.
Mr Powell: No. The reason that I disagree with
that statement is that I think when you look at the audits at
the two-year endsso let's look at 31 December 2006nobody
could perceive the crisis that was coming. So on the assessment
that was made at that point on the availability of liquidity,
you have to assume that when you're trying to form a view as regards
the going-concern nature of an organisation, it's not just going
to run completely into a brick wall at some point during the next
12 months. You make an assumption, a realistic and educated assumption,
as regards the market conditionsthe way the market is likely
to go. So that is the year-end 31 December 2006, before the financial
Post the financial crisis the assessment that
the auditors then need to make is whether or not there is going
to be adequate liquidity going forward, wherever that liquidity
might come from. In the audit considerations in relation to the
year-end 31 December 2007, the view that we formed as auditors
was that there would be adequate liquidity available to enable
us to sign off the financial institutions that we were auditing
at that year-end. Those were not misleading statements. They were
statements that gave full disclosure and were based on an assessment
of the liquidity at that point in time.
Q281 Lord Lipsey: How is that full
Mr Powell: I think you have now gotten on to
another interesting point, which is about how do we get more transparent
in terms of the audit work that we undertake; in terms of the
debate and the discussion that goes on behind the doors, if you
like, in forming a view as regards the going-concern nature of
a set of accounts, and not just publishing a binary audit report.
It was pretty clear that, as we came through that year-end, the
amount of time that was spent in looking at going-concern, and
whether clean-audit reports could be signed as regards those financial
institutions was absolutely intense. So the real question wasas
a reader of a set of accounts at that point you would look at
the audit report. You would see a binary audit report and you
would not know the level and degree of challenge that had gone
on behind the scenes or how the auditors had gained comfort. Maybe
that is another one of the key lessons going forward: how do we
improve the transparency of the debate that the auditors have
undertaken in forming their going-concern view.
Q282 The Chairman: Can I just raise
a point here because you know that it's been put to us, and we're
very interested in this, that going forward auditors should have
more dialogue with the Bank of England in its regulatory role.
In fact we had a discussion with the Governor about this particular
point last week. If this does go forwardand one can see
very much the advantages from the bank's point of view and from
the global knowledge and so on and impending problemswhat
problems does that create for you as an auditor, because you will
sometimes be talking to the bank about issues, issues that we
have already discussed this afternoon, that do cause worries about
going concern and that's a dialogue with the banks that the investors
are not aware of?
Mr Halliday: That's why the Bank of England
has formed this committeeto look at the competition laws
and make sure we're not afoul of any of the competition laws and
also to begin to think through some protocols because I think
we need to have an open, transparent discussion with our bank
clients around how this will operate and get those things on the
table and get some protocols laid out up front.
Mr Powell: So the working group on this is ongoing
at the moment to try and help us work through the thought process
as to what conversations we can have; how do we satisfy client
confidentiality, for example. That is the remit of the working
group at the moment.
Q283 The Chairman: But it includes
issues about worries about going concern.
Mr Powell: It does.
Mr Griffith-Jones: I think there is no getting
away from this dilemma that the banking industry is, to an extent,
built on confidence. It borrows short and lends long and it always
has done. Full disclosure is absolutely fine in a stable environment
and everyone asks for transparency but, come a crisis, the Government
of the day and the Bank of England of the day may prefer for the
public not to know. With respect, it's not our role or we're not
powerful enough, put it whichever way you want to put it, to control
events in those circumstances, which is why the working party
has this somewhat sensitive issue to think about before we can
put into effect a useful dialogue. But would a dialogue have been
useful, with hindsight? It most certainly would have.
Mr Halliday: I think it's important that it's
two-way as well. It's not just the firms coming to the Bank of
England but it's also the Bank of England sharing with the firms
their concerns of risks as well.
The Chairman: We've obviously not been
able, this afternoon, to spend as much time as we would like on
this issue but you can see how critical it is to our thinking
in relation to our report. So if you would like, on reflection,
to submit another note to us about thisbecause I realise
that there are some remarks you may have made which you would
prefer to work through more carefullythat would be very
helpful. Lord Forsyth, do you want to raise one more issue on
this before we move on?
Q284 Lord Forsyth of Drumlean: It's
related. We've heard evidence from Professor Fearnley, Timothy
Bush and others who suggested that the introduction of less prudent
IFRS standards was a key factor in the banking crisis. The question
really is: do you think IFRS accounting standards led bank auditors
to a tick-box approach instead of scepticism and prudent judgement
on client banks as going concerns? The argument is that under
the old UK GAAP system there was a degree of prudential judgement
required and that the effect of IFRS has been to mean that you
could say, "Well, we've done the audit but we haven't looked
beyond it"; exactly the discussion we've had. How much has
the change in accounting standards contributed to this problem?
Mr Powell: Okay. Just to kick off on this one
as well, ultimately accounting reflects a business. It's not the
other way round. So whichever accounting model that you go for,
it's going to have to reflect exactly what happens. I think if
you look back to UK GAAP say 10 years ago, obviously things needed
to change. UK GAAP didn't, for example, have a standard on "How
do you account for derivatives?" So there were new businesses
and new business models that were starting to be introduced. Then
IFRS came in and the new rules were applied. I think overall IFRS
probably helped in the actual recognition of some of the problems
earlier than maybe they would have been recognised under UK GAAP.
But IFRS is not perfect and I think it is reassuring that the
standard setters are now reviewing IFRS, particularly as regards
recognition of when loan impairment should be recognised.
Q285 Lord Forsyth of Drumlean: I'm
sorry to interrupt you but I am interested in the specific point
that IFRS introduced a box-ticking culture rather than the old
requirement to take a prudential view and also, for example, it's
been suggested that IFRS meant that the banks could delay recording
actual losses while booking paper profits. There are specific
criticisms of the rules but the broad philosophical attack is
that we've moved to a box-ticking practice rather than a judgement
and that is what most people would expect from an audit.
Mr Powell: I don't think that is a fair reflection
of the work that is done by auditors in that IFRS is a set of
standards. The application of it has a judgemental element to
it as well.
Q286 The Chairman: So you say that
Mr Powell: Pardon?
The Chairman: You say that that evidence
is just wrong?
Mr Powell: This is obviously a pretty complex
area and I think that there are some areas about IFRS that are
good and that I think have helped and I think there are other
areas that need review, which is exactly what the standard setters
are doing at the moment.
Mr Connolly: I think you are trying to get specifically
to, "Is it box-ticking?" I think it would be quite a
simplification to suggest that was the case. I think at the heart
of the specific issue that is now under reviewand I think
we would all support that review taking place and it probably
will result in a changewas that for many years there was
a view held that the fact that judgement could be applied to decide
what kind of provisions might be required against the value of
assets and you could look forward and contemplate what the ultimate
value of those assets would be in doing that.
A view that was held that resulted in change
was that that was too lax and, as a consequence of that, there
were all sorts of suggestions, particularly in financial institutions
but not just financial institutions around the world, that the
inability to understand quite how thatwhether that judgement
was one that was very conservative or the oppositeled to
failure to be able to make proper comparisons and understand the
financial results more effectively. The change that came in was
to say that a loss has either occurred or it has not occurred.
It is not a question of "might it occur". It is "has
it occurred?" and only if the loss has occurred were you
able, under IFRS, to recognise the loss.
Now, if we say, "Isn't that box-ticking?",
if that is what you mean, then that was the case; the loss had
either been incurred or it hadn't been incurred. I think it was
the G20 who recommended, and there is now a review that will perhaps
lead to, a move back to need to recognise losses if you expect
they will occur. That definitely will require much more judgement
but will be open to more latitude in terms of the exactness.
The other feature of IFRS that is more often
picked upon and used as a, "Wasn't this"or some
have even said, "Didn't this cause the crisis?"which,
I think, again, would be unfairwas those assets that had
to be mark to market and there was criticism. I mean the clarity
was that you had to value these assets at market value. Often
the market was disrupted by the conditions and the view was held,
"Well, it is the marketwe accept thatbut isn't
this a distorted market? So shouldn't you be using something different?"
I am advised, and I'm not an expert on banks or auditing banks,
that that has been very significantly exaggerated as a feature
because the relative proportion of assets that are dealt with
in that way is very low.
Q287 Lord Forsyth of Drumlean: Chairman,
I'm conscious that there isn't time to do this now. I don't know
whether you've had a chance to look at the evidence that came
to us, but there was one piece of evidence that went through each
of the banks and explained how the change in the accounting rules
made the system worse. It would be very helpful to have your written
comments on thatperhaps the clerk could send itbecause
it does seem to be a very important factor. In talking to finance
directors and people outside, there does seem to be some concern
that the old prudential judgement has been undermined as a result
of the move to IFRS and that is purely anecdotal. But you seem
to be saying that that isn't an issue.
Mr Halliday: I think one of the keys here is
to get one consistent global accounting policy globally, one standard,
and we believe that is IFRSthat IFRS should be applied
consistently around the world. I also think it's important to
step back and challenge ourselves on the heels of this Committee
and say there weren't a lot of restatements or errors noted in
valuation through this crisis. What can be done maybe to increase
the financial reporting and the disclosures of these things? What
needs to change in the financial reporting model in addition to
get one globally consistent set of accounting policies?
Q288 Lord Forsyth of Drumlean: Where
my question is going, to the evidence we've had, is that people
were too concerned to do thatto get a global system of
accounting agreedand not concerned enough about the effect
that that would have on telling people what was going on in these
banks. That's the accusation.
Mr Powell: We will set out our views in writing
on this as well but it's pretty clear, given the depth of review
that is ongoing by the standard setters at the moment as regards
IFRS, that maybe things did go a bit too far and took out some
of the judgement that should have been in there.
The Chairman: This is clearly another
area of great interest to the Committee and, therefore, I would
strongly support Lord Forsyth's suggestion that you send us a
Q289 Lord Lawson of Blaby: I will
ask one more if we've got time on a different matter, although
I think this is the key issuethis whole question of auditing
the banks. Indeed my question links up with that. It is about
one of the things that I introduced in the 1987 Banking Act, as
part of the requirement for there to be a regular dialogue between
the regulatorat that time the Bank of England and it's
now going to be the Bank of England againand the auditor.
As one of you said, it should be a two-way thing but a regular
dialogue. I am still puzzled and dismayed by the fact that that
went into disuse. It was never repealed. It just stopped happening,
to all intents and purposes. But one of the things that buttressed
that was that I provided in the Act that auditors would not be
liable in any way for any adverse consequences that flowed from
telling the regulator that there was something wrong with this
particular bank's accounts. I know that at the time the auditing
firms felt they needed that protection and the Act gave them that
protection. Now, are there occasions when, today, you are inhibited
from saying publicly, in any qualification to the accounts or
whatever it is, that you have any reservations because of the
fear of litigationthat, even though you think in your heart
that there ought to be a qualification, the concern for litigation,
which could be extremely expensive, inhibits you? Do you think,
if that is so, that there might be a case for some kind of provision
which would limit the damages to which you would be subject in
the event of litigation going against you?
Mr Connolly: If I could offer a view first:
first of all, I do agree with your observations about the circumstances
that prevailed with the Bank of England and that did enable special
pieces of work to be undertaken without risk. They were specific
pieces of work and that was valuable. I certainly believe that
we live with the risk, in the risk environment we're in, and we
develop our opinions in a way which is appropriate, recognising
that that risk is there and not in any way interfered with by
the level of risk we run. We recognise that we have unlimited
liability but I'm very confident that at no point does the existence
of that risk cause there to be an opinion other than the appropriate
opinion. In most cases, of course, I would suggest that failure
to give the right opinion is more likely to lead to litigation
because litigation mostly arises where a company has failed and
you really don't want to be in a position where you had not given
the right audit opinion in those circumstances.
But to the general pointwould we prefer
there to be more protection?yes, of course we would. I
think also if there was more protection it would encourage, potentially,
an extension of the market. For some of the medium-sized firms
at the moment, the horror of dealing with clients of a scale that
could wipe the business out at a stroke if they happened to have
a problem must be a barrier to entry. But even more valuably perhaps,
if there was more protection then it is more likely to create
an opportunity to extend the role of the auditor to report on
things that we don't have to report on now but might be valuable.
I think a dialogue around what further things could we report
on that we don't have to report on now would be very valuable.
But you could only entertain those if there was a measure of protection.
Q290 Lord Lawson of Blaby: Could
you let us have a note on what things you think it might be a
good idea if you were able to report on that you don't report
on at the present time?
Mr Connolly: Yes, absolutely.
The Chairman: Are there any other comments
on the liability question?
Mr Griffith-Jones: Only the rather obvious one
that, in the matter of protecting us from going from four to three,
the litigation risk is, certainly in my firm and I'm sure in all
the others, the biggest risk on our risk register. Without the
protection and without the insurance market it's probably the
single most likely cause of there only being three of us in front
of you at another time.
The Chairman: Gentlemen, thank you very
much. We've had a long session and we've already asked for three
notes. We haven't been able to cover two other subjects we were
intending to discuss with you but could I ask you, as you're very
important witnesses to us in this inquiry, if you could also let
us have a note on the breakdown of fees as between audit and non-audit
and also a question in relation to providing internal audit services
as well? I will make sure our clerk lets you know exactly what
it was we were interested in but, in order not to prolong this,
perhaps you could very kindly let us have a note on these matters.
It's clear from the discussion we've had that it's been a very
interesting and helpful session to us and we look forward to your
further notes. Thank you very much indeed.