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

Supplementary memorandum by Mr John P Connolly, Deloitte (ADT 33)

  I am writing in response to your letter of 1 December 2010 following my appearance before the House of Lords Economic Affairs Committee on 23 November. I have set out below the answers to each of the questions set out in your letter. For the avoidance of doubt, my response is on behalf of Deloitte LLP and I am not speaking for the other firms who appeared at the same hearing.

Q283.   Going concern judgments as part of the audit of banks before and during the crisis

  The Committee asked for details as to how going concern judgments were made for the years ended 31December 2007 and 2008. Before explaining the judgments taken for these years, it is worth looking at the definition of going concern as set out in paragraph 25 (then paragraph 23) of International Accounting Standard 1 Presentation of Financial Statements:

    "When preparing financial statements, management shall make an assessment of an entity's ability to continue as a going concern. Financial statements shall be prepared on a going concern basis unless management either intends to liquidate the entity or to cease trading, or has no realistic alternative but to do so. When management is aware, in making its assessment, of material uncertainties related to events or conditions that may cast significant doubt upon the entity's ability to continue as a going concern, those uncertainties shall be disclosed. When financial statements are not prepared on a going concern basis, that fact shall be disclosed, together with the basis on which the financial statements are prepared and the reason why the entity is not regarded as a going concern."

  The wording used in the equivalent UK GAAP standard, FRS 18, is slightly different but this has no effect in practice.

  lAS 1 refers to liquidation and cessation of trade. It is frequently the case that the companies require access to finance that is not guaranteed for a year from the date of approval from the financial statements, eg a simple manufacturing company that is dependent on annual renewal of an overdraft. The job of directors in considering whether or not there is an uncertainty as to going concern, and of auditors in auditing going concern, is to consider whether such finance will, in all probability, be available if required. For banks, the same considerations apply—banks have always lent long but borrowed short (whether through wholesale funding or deposits by retail customers)—and the requirement is therefore to consider the availability of that finance to them. This includes the likely state of the wholesale markets, retail markets and other sources of funding which would include, for example, the Bank of England's liquidity scheme and the Treasury's credit guarantee scheme.

  In forming our opinions on financial statements, we consider not only whether to draw attention to a significant uncertainty as to going concern, but also whether the disclosure within the financial statements is appropriate. For example, if we concluded that there was concern, but not significant concern, we would not be required by auditing standards to include an emphasis of matter in our opinion. Indeed, doing so might make a minor concern result in a run on the bank, thereby creating a self-fulfilling prophecy. We would, however, expect to see adequate disclosure of the facts and circumstances and assumptions made by directors, and to be able to see evidence to support these. If we were of the opinion that the disclosure was inadequate, or the disclosures were unreasonable, we would qualify our opinion. In considering the adequacy of disclosure, we have regard to the guidance issued by the Financial Reporting Council following consultation with all interested parties including companies, investors, auditors and the FSA. It is worth noting that the financial statements of banks for the years ended 31December 2007 and 2008 have been subject to reviews by many organisations, including the FSA and the Financial Reporting Review Panel, and no material misstatements have been identified, nor have any been restated.

Audits for the year ended 31 December 2007

  During the early months of 2008 we carried out our audits of the financial statements of our banking clients for the year ended 31 December 2007. At that time, audit teams on our banking clients considered going concern having regard to the above definition. We concluded that, based on conditions in the market at that point, we did not have significant concerns about going concern for the majority of our clients. This assessment was reached after considering both the state of the banking market and the actions of the Treasury, the Bank of England and others following the collapse of Northern Rock. In addition to auditing going concern, we audited the disclosures made by such clients and, for example, the financial statements of The Royal Bank of Scotland Group plc contained extensive disclosure to the shareholders around risks including the risk of steep falls in perceived or actual asset values accompanied by severe reduction in market liquidity, dislocated markets, recent market volatility and illiquidity and the further write downs that may adversely affect the group's future results, together with detailed numerical analysis of the liquidity position.

  At this point in time, nobody (including the Bank of England, other central banks, governments, regulators, economists and analysts) had predicted the total market dislocation that would occur later in 2008; particularly the sudden and unexpected demise of Lehman Brothers on 15 September 2008 brought about within a few days a total meltdown in global liquidity for banking institutions.

  We did, however, identify concerns around one of our "monoline" banking clients (those banks where the majority of their business was concentrated in narrow markets). We had discussions with the FSA as to the judgments being made by the directors and ourselves and managed to obtain sufficient evidence that the directors' assessment of going concern was reasonable in the circumstances, supported by judgments as to what was reasonably probable, and by disclosure as to the extent of the factors taken into account and the liquidity position of the entity. Subsequently this entity was the subject of a merger and in its merged form continued to be a going concern.

Reviews for the half year ended 30 June 2008

  We continued to have regard to these risks in carrying out half-yearly reviews for the period ended June 2008. For example, the half yearly report on The Royal Bank of Scotland Group plc for the first half of 2008 on which we reported drew attention to significant losses and credit market write­downs, the difficult operating environment, unprecedented market conditions, the dislocated trading environment for credit markets and equities and the anticipation that the credit environment would become more challenging and that the difficult conditions in the financial markets look set to be compounded by a deteriorating economic outlook. The bank was nevertheless operating within its capital adequacy requirements.

Audits for the year ended 31 December 2008

  Following the global liquidity meltdown which occurred following the demise of Lehman Brothers, the state of the banking market had changed dramatically. We recognised that forming a conclusion on going concern, and the degree of uncertainty, would be hard for the directors of the banks when they approved the financial statements for the years ended 31 December 2008. We did not soften the standards that we applied in considering going concern, because the accounting and auditing standards remained unchanged. We were, naturally, concerned that if we modified or qualified our auditors' report on going concern grounds that this would have brought about a banking collapse within a few hours as a result of the inevitable response of speculators and depositors, and therefore felt that it was important for the government to be aware of our concerns and of the need for the directors of the banks to be able to consider carefully the evidence of potential government support, given the virtual closure of the wholesale markets. The Big 4 firms approached the government in November 2008 and asked to meet Ministers to discuss the extent to which action was being taken to support the going concern position of UK banks. A meeting took place between the CEOs of the Big 4 and Lord Myners, the then City Minister, on 16 December 2008 at which the Minister provided evidence of the Government's actions and the extent of their commitment which would support the management, directors and auditors in forming their view on going concern.

  As auditors, we also considered the evidence obtained by the directors of our banking clients. This included an assessment of the recapitalisation scheme, the Bank of England's Liquidity Scheme and the Treasury's Credit Guarantee Scheme. Based on this evidence, the directors, and we as auditors, concluded on the majority of our clients that it was sufficiently likely that the support would be available to avoid uncertainty as to liquidation or cessation of trade, and hence, having regard to the definition in lAS 1, significant uncertainty as to going concern. Nevertheless, in doing so, we did audit the disclosures made by those banks in their financial statements around risk and liquidity. For example, the financial statements of RBS contained extensive disclosure of the liquidity provided by central banks in a number of jurisdictions and the support from UK Government on which the bank owed its continuing independence. The annual report also included a going concern statement which referred explicitly to the UK Government's support for the group.

  We had one client where there was concern as to the availability of support. In that case, we felt unable to give an unmodified opinion without an emphasis of matter as to a significant going concern uncertainty. We initiated a call to the FSA to meet our duty to report to them. When it became clear that support would not forthcoming, the directors concluded that there was significant going concern uncertainty and the tri-partite authorities instigated the special resolution regime. As a result of this, we were never required to issue an audit opinion on the entity in question.

Q287.   The impact on bank audits of IFRS accounting standards

  We do not agree with the assertion that the loan loss impairment and fair value accounting ("marking to market") requirements in IFRS were a cause of the financial crisis. Both accounting conventions were well understood and were established ways of measuring financial assets, including those assets of banks, at a particular point in time. In the case of loan loss impairment requirements they illustrated at the balance sheet date how much losses have been incurred by the bank in lending money. With respect to marking to market it showed clearly the value of a bank's trading positions and value of its more complex structured investments. Both conventions were transparent in the accounting policies of financial statements and their application consistently portrayed to investors the state of play at the balance sheet date. It is entirely right that emerging from the financial crisis questions have been asked by the G20 Countries and other constituents whether the accounting conventions could be improved in order to make the information at the balance sheet date more relevant.

  The two key questions that have emerged that need answering by standard setters and all stakeholders, including investors, regulators, preparers and auditors are firstly, should all financial assets be measured at fair value, and if not, which financial assets should be measured at amortised cost (and therefore subject to impairment accounting), and secondly, can the impairment model be improved? We are entirely supportive of the IASB and the U.S. FASB working jointly to finalise their reforms by June 2011. Much progress has already been achieved. IFRS 9 Financial Instruments, issued in November 2009, simplifies and improves the distinction between what should be at fair value and what should not. Further, we support the IASB and FASB's current work in proposing amendments to the impairment model so that it is more forward looking in capturing expected losses, not just currently incurred losses. It is right that accounting standards are subject to continuous improvement to ensure that the financial results that flow from applying these standards are more relevant. The completion of these reforms by June 2011 and, it is hoped, the speedy endorsement of IFRS 9 by the European Parliament will ensure UK banks and their investors can take advantage of these reforms as apply as early as is practicable.

Q290.   Other possible assurance services

  In Q290, Lord Lawson asked us to provide a note of other areas which wider audit reports might address. We believe that it should be for regulators, banks and auditors to discuss which areas should be the subject of additional work by the auditor, bearing in mind that the risks may be different for different banks. Clearly some of the areas covered by the annual report are matters of subjective judgment for investors to take decisions based on whether they agree with management's views. However, other areas are ones where there is objectively verifiable information on which auditors might report, given a suitable framework for management to prepare their reporting and for auditors to audit it. This could include the outcome of management's stress testing exercises, accuracy of reporting of large exposures, accuracy of regulatory capital ratios and liquidity reporting and information on mortgage lending practices.


In recent years the share of non-audit fees in the Big Four's total fees has fallen sharply, partly because fees for "audit-related work" (including "extended audit services") are reported as if they were fees for auditing. So that we can have a clearer picture of how much fee income you earn for work you do for audit clients which is not essential in order for you to provide your audit opinion, could we please have a breakdown of the proportion of total fees earned from:

    (a) essential audit work

    (b) "audit-related work" excluding "extended audit services"

    (c) so-called "extended audit services", and

    (d) consulting and other services?

  We do not allow clients to report fees for "audit-related" work as fees for auditing. Whilst the existing disclosure rules are unhelpful (for example, by categorising fees for the audit of subsidiaries as fees for non-audit services), we believe there is an important distinction to be made between "audit-related fees" and other non-audit services. This distinction is not made in the current law, although it has been recommended by the Auditing Practices Board (APB) in their recent consultation draft on non-audit services. We believe that it is important to distinguish between audit-related services and non-audit related services. For example, audit-related services include the interim review of a listed company's half-yearly report, work on regulatory returns to the FSA and (for those entities with a listing in the US) auditing of internal control under Sarbanes-Oxley. These are services which can only be provided by law from the auditor or would normally be expected of the auditor. This is appropriate, as they are all independent assurance services and all require the same standard of independence as is required for the audit of the financial statements. In particular, the role of "extended audit services" is minimal in driving the fall in non-audit fees. There are occasional requests from clients that fall into this category, but we do not actively target such opportunities and it is not part of our growth strategy which focuses on the sale of non-audit services to non-audit clients.

  We do not separately collect data on "extended audit services" as part of our financial reporting systems as there is not currently a requirement to separately disclose such amounts; our systems collect the information based on the categories required by law. However, we did carry out an exercise for the Audit Inspection Unit's review of this issue which formed part of their 2009-10 inspection cycle which provides information as to the scale of the issue. During the most recent year, our fees to the FTSE 100 were as follows:

£m£m % of audit fees
Audit fees90.587 100.0
Other services pursuant to legislation 13.83015.3
Pension fund audits 1.7792.0
Other non-audit services:
—  Extended assurance0.075 0.1
—  All other services37.031 40.8
37.106 40.9
Total143.302 158.2

  We identified only £75,000 of "extended audit" services (less than 0.1% of audit fees) which comprised two engagements: independent assurance on sustainability disclosures for one client and independent assurance carried out for the audit committee (rather than management) of another client. Neither of these amounts was disclosed as audit fees. The remainder of other non-audit services were primarily tax and corporate finance services. We had no fees for internal audit, valuation or litigation work.

  We attached a copy of our submission to the Auditing Practices Board's recent consultation on non­ audit services to our original submission in response to the Committee's call for evidence. This submission contains more detail of our thinking in this area. In particular, we commend to the Committee our thoughts on reforming the disclosure regime for non-audit services (as we believe this to be an issue of perception, rather than reality); that restricting the choice of advisors that may be used when there is no independence threat may increase costs for British businesses, harming recovery and growth. It should be borne in mind that non-audit services supplied by auditors can be very much in the public interest. For instance, companies subject to hostile takeovers may be unable to issue timely defence circulars without the involvement of their auditors to provide independent verification of their contents; bringing in a new provider would take too long as that firm would not have the existing knowledge of the company. Similarly, companies in distress would be less likely to secure additional or continued finance without the rapid involvement of their auditors to challenge the assumptions underlying cash flow forecasts supplied to banks. Without such services, UK job losses could be much larger than would otherwise be the case.

Should audit firms be free to provide internal audit services to their audit clients? If they do, isn't it extremely unlikely the external auditor would ever tell the audit committee that the internal audit is rubbish?

  We do not agree that audit firms should be free to provide internal audit services to their clients. The existing APB Ethical Standards for Auditors prohibit us from doing so when either we would place significant reliance on the work of internal audit as part of our external audit or we would undertake part of the role of management. We support these standards and believe they provide adequate safeguards such that it is very unlikely that as external auditors we would be commenting on the quality of our own internal audit work.

  Please do not hesitate to contact me if you require any further clarification of the answers above.

17 December 2010

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