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

Supplementary letter from Mr Ian Powell, PricewaterhouseCoopers (ADT 36)

  I am now responding to the requests for additional information that were set out in your letter of 1 December. These are addressed in the appendix to this letter.

  In response to question 271, relating to the audit of the Bank of Ireland, I would like to advise you that the Irish member firm of the PricewaterhouseCoopers (PwC) network has been the sole auditor of the Bank of Ireland group since 1990. PwC is structured as a network of separate member firms, owned and operating locally in a number of countries around the world. As a result, I am not able to provide you with further information about this audit.

  If the Committee would like to discuss any of these issues in more detail with my firm's banking or accounting experts, I would be happy to make the necessary arrangements to assist.

4 January 2011


Q283.   Going concern judgements

  1.1  As requested, we address below how going concern judgements were reached as part of audits of banks before and during the financial crisis of 2007-09, including the following specific issues:

    (a) In the case of Northern Rock, the basis of the unqualified going concern judgement reached for financial statements for the year ending December 2006, before Northern Rock collapsed in 2007.

    (b) How auditors reached unqualified going concern judgements on banks for the year ending December 2007.

    (c) The basis for going concern judgements on banks' financial statements in December 2008.

  We respond to each of these issues individually in paragraphs 1.4 to 1.13 below.

  1.2  The primary significance of the going concern disclosure is in relation to the basis on which the financial statements have been prepared. The requirement for management to assess, and auditors to review, going concern is within the context of selecting an appropriate accounting basis for items within the accounts. The auditor is only required to conclude whether there is any material uncertainty that may cast significant doubt on the company's ability to continue as a going concern and to report only if any such material uncertainty is identified. The crisis has shown that neither the purpose of these disclosures nor the auditor's reporting duty is well understood and, arguably, that neither meet the common expectations of readers of financial statements.

  1.3  At Annex A[46], we attach a copy of our written submission dated January 2009 to the House of Commons Treasury Select Committee inquiry on the Banking Crisis (Session 2008-09) which sets out, inter alia, a summary of the requirements relating to the audit of going concern, including the additional considerations that are relevant in a banking environment. In particular, these involve a consideration of sources of liquidity and the adequacy of an institution's capital, but are not a guarantee of future solvency. Our comments below should be read in the context of that submission. Auditing standards are explicit that a review of going concern is not undertaken to provide shareholders with any guarantee that a company will continue to survive.

 (a)   Northern Rock—financial statements for the year ended December 2006

  1.4  At Annex B[47], we attach the follow-up written memorandum dated January 2008 to the House of Commons Treasury Select Committee inquiry on Northern Rock "The Run on the Rock" (Session 2007-08) with respect to the audit of Northern Rock. This identifies the considerations and actions that were taken in respect of the financial year ending 31 December 2006 including the work we carried out in respect of management's assessment of the bank's going concern status prior to signing the 2006 financial statements in January 2007.

  1.5  As indicated in that evidence, at the time of the conclusion of our audit in January 2007, Northern Rock had a history of profitable operations and had a track record of ready access to funds at low spreads over LIBOR from a wide range of sources, indicating willingness by lending institutions and investors to provide finance. In addition to these positive trading and financial characteristics, we looked at the post year end trading results, the most recent reports to the bank's asset and liability committee and studied the bank's operating plans. We also studied external information about forecasts for the UK domestic mortgage markets. None of the information available to us indicated anything that would constitute a "material uncertainty" that "may cast significant doubt" that Northern Rock may not be a going concern and consequently, in accordance with auditing standards[48] we concluded that in our opinion there were no matters relating to the going concern basis of accounting that were required to be reported to shareholders.

 (b)   Audit opinions on financial years ending 31 December 2007

  1.6  Whilst Northern Rock was unable to obtain refinancing in August 2007 it is notable that other banks were all still funding themselves in the short term wholesale markets at the end of 2007 and market conditions were still showing signs of easing when the banks announced their results in February 2008. Auditors, therefore, had no reason to believe that a going concern qualification was appropriate with respect to the financial reports for the financial years ending 31 December 2007.

  1.7  In terms of capital requirements the banks PwC audited were still profitable in early 2008 and had levels of capital well above regulatory minimum requirements. The outlook for 2008, both in terms of the banks' internal profit forecasts and external economic forecasts, did not appear to pose any threats to capital adequacy based on the conditions prevailing in January and February 2008.

 (c)   Audit opinions on financial years ending 31 December 2008

  1.8  In the context of the financial statements for the year ending 31 December 2008, two factors were again particularly relevant for management's assessment of going concern status and the auditor's review of that assessment: liquidity and capital adequacy.

  1.9  On liquidity many of the banks were, post the Lehman Brothers collapse in September 2008, dependent on the Government and the Bank of England for liquidity support, given the freezing of the wholesale markets.

  1.10  There were two principal schemes that were relevant in our assessment of the going concern status of banks: the Bank of England Special Liquidity Scheme and the Government's Credit Guarantee Scheme.

    (a) The Bank of England Special Liquidity Scheme

    Under this scheme, first published on 21 April 2008[49], banks could borrow from the Bank of England against various types of securities lodged as collateral. On 8 October, the government announced that the scheme would be extended and widened as part of the UK support package for banks. Full details of this scheme, including the level of support available, were published in final form on the Bank of England website by the time the relevant audit opinions were published in February/March 2009.

    (b) Credit Guarantee Scheme

    The second scheme allowed the banks to issue medium term debt securities guaranteed by the UK government. Full details including the aggregate limit across the industry had been announced by HM Treasury on 13 October 2008 as part of the UK support package[50].

  1.11  During this time, this firm's banking audit partners were having tripartite meetings with the Bank of England and clients to understand how the schemes would operate and what sums were available.

  1.12  All the banks which we audited had been advised of their allocation under the Government guaranteed medium term debt scheme by the time the opinions for the financial years ending 31 December 2008 were issued.

  1.13  In order to support our audit opinions, we reviewed our individual clients' forecast requirements, and the various stress tests which they carried out and ensured that their funding needs were matched by the available finance for which we had external evidence.

Q288.   Impact on bank audits of IFRS accounting standards

  2.1  As requested, we address below the impact on bank audits of IFRS accounting standards in the two main areas addressed by Mr Timothy Bush in his written and oral evidence to the Committee: the classification and measurement of financial instruments and the impairment of loans. References to UK GAAP relate to the standards that were applicable for UK banks prior to the implementation of IFRS for listed companies in 2005. As a general rule, UK listed banks also adopted IFRS for the individual accounts of their subsidiaries at the same time, which was permitted, although not required, under the Companies Act.



  2.2  Under UK GAAP only limited guidance was provided on the accounting treatment of derivatives or other financial assets and liabilities. To address this deficiency for banks, the British Bankers' Association issued a series of Statements of Recommended Practice (BBA SORPs) which were initially best practice but which were made mandatory for banks for accounting periods ending on or after 22 June 2001[51].

  2.3  Under the Companies Act 1985[52] banks were allowed to fair value financial instruments. The BBA SORPs recommended that assets carried in a bank's long term (banking) book should be accounted for at amortised cost (including derivatives hedging positions in the banking books) and that assets carried in a bank's trading book should be carried at fair value. Transfers between books were permitted. There was no guidance on how to determine the fair value of financial instruments.


  2.4  The relevant international accounting standard addressing the classification and measurement of financial instruments is IAS 39 "Financial instruments: Recognition and Measurement". This requires financial assets to be classified into four categories which drive their subsequent measurement. The four categories are:

    — Financial assets at fair value through profit and loss (essentially all derivatives, all assets held for trading and other financial assets that the company has elected to carry at fair value)

    — Loans and receivables.

    — Held to maturity investments.

    — Available for sale financial assets.

  2.5  Loans and receivables and held to maturity investments are carried at amortised cost. All other financial assets are carried at fair value, with fair value movements taken to the income statement for financial assets at fair value through profit and loss and through other comprehensive income for available for sale financial assets.

Impact on bank audits

  2.6  The main relevant impact of the change from UK GAAP to IFRS in the context of the classification and measurement of financial instruments was in relation to investments carried for long term purposes in the banking book. In order to meet the criteria for classification as held for maturity investments and thus to be carried at amortised cost, banks needed to demonstrate a positive intention and ability to hold investments in corporate or government debt to maturity. Since many of these investments were held in liquidity portfolios, it was not possible to demonstrate such a positive intention and ability and, consequently, significant portfolios of such assets were reclassified as available for sale and carried subsequently at fair value. They were also subjected to more stringent impairment rules that required fair value losses to be recognised in the income statement if there was a significant or prolonged decline in fair value below cost.

Changes proposed to IFRS

  2.7  As a result of the financial crisis, and with the encouragement of the G20, the IASB is proposing a series of fundamental changes to financial instruments accounting, to be embodied in a portmanteau standard known as IFRS 9 "Financial Instruments". These revisions are being completed in phases, the first of which, on classification and measurement, was published in November 2009.

  2.8  The new standard acknowledges the need to address the rationale for holding financial assets in determining the appropriate accounting treatment. Under IFRS 9, financial assets are classified as either carried at amortised cost or at fair value on the basis of both the entity's business model and the contractual cash flows of the instrument. If an asset is held within a business model whose objective is to hold assets in order to collect contractual cash flows, and the contractual terms of the asset give rise to cash flows on specified dates that are solely payments of interest and principal, they are carried at amortised cost. All other financial assets are carried at fair value with fair value movements taken to the income statement.

  2.9  This simplification of the classification model is likely to result in more debt instruments held in banking books being carried at amortised cost.



  2.10  Under UK GAAP, banks established loan loss provisions in accordance with the BBA SORP on Advances. Banks made specific provisions in relation to assets for which there was objective evidence of impairment and, in addition, made general provisions (eg 1% or 2% of a mortgage loan book) to account for unidentified losses that were likely to exist, based on past experience, at the balance sheet date for those assets without specific provisions.

  2.11  Under the recommendations of the BBA SORP, loan losses were only recognised where an impairment event had been observed or, in the case of general provisions, where past experience indicated that an impairment event was likely to have occurred even though it had not yet been specifically identified. This is known as an "incurred loss" model.


  2.12  The IFRS requirements for loan loss provisions are set out in IAS 39. This standard, like UK GAAP, requires the application of an incurred loss model but IAS 39 provides more detailed guidance than UK GAAP and does not distinguish between specific and general provisions. Specifically, IAS 39 requires banks to recognise a loss when a credit event has happened—in other words, when the payment status of the borrower has deteriorated since the loan's origination to such an extent that the loan is impaired.

  2.13  Under IAS 39, impairment is only recognised when there is objective evidence that the loan has been impaired since the date on which it was originated. This objective evidence may relate to an individual borrower (for example, a default in payment of interest or an indication that they are in significant financial difficulty) or to a portfolio of similar loans (such as an increase in the number of credit card borrowers who have reached their credit limit and are paying the minimum monthly amount). For loans that are not individually significant, the assessment of impairment is carried out on a portfolio basis.

Impact on bank audits

  2.14  In practice, there was relatively little difference in the aggregate amount of loan loss provisions recognised by UK banks under UK GAAP and under IFRS. This was partly due to the fact that the two most significant differences between the two models had an offsetting effect on each other. IAS 39 requires there to be objective evidence to support the level of provisions made. This resulted in the release of excess mortgage provisions by some banks. However, IAS 39 also requires expected losses on impaired loans to be discounted to take account of the time value of money. This was not required under UK GAAP and consequently resulted in increased provisions in some cases.

Changes proposed to IFRS

  2.15  One major criticism of the accounting during the financial crisis was that an incurred loss model tends to result in a deferral of the recognition of losses during an economic downturn. If losses cannot be recognised until a credit event has happened, it is not possible for banks to make additional provisions for losses which they can reasonably expect to be incurred as the cycle continues.

  2.16  In response to this criticism, and with the encouragement of the G20 and the Financial Stability Board, the IASB has issued proposals as part of the second phase of its review of financial instrument accounting for a fundamental change to the accounting for loan loss provisions. The proposal is to replace the current incurred loss model with an expected loss model, that will require a bank to recognise the losses it expects to incur on the loan and to update those expectations regularly. The proposals have been issued for consultation and are now being redeliberated by the IASB. It is anticipated that this phase of the financial instruments project will be finalised by June 2011.

Q290.   Audit report scope

  3.1  We welcome the opportunity to respond to your request for us to address the areas which wider audit reports might address. We are in no doubt that audit needs to change to respond to the lessons from the financial crisis. We summarise below some of the initiatives we are pursuing to achieve this.


  3.2  The way auditors communicate externally needs to be revisited to improve understanding and raise the awareness of the value added by an audit. The current statutory audit report is formulaic; there is no opportunity for the auditor to give any commentary on how they have done their work. To change the statutory audit report would take time. In any event, it may be better to leave it in its current form to preserve the clarity of its purpose. We think the most immediate way to give greater transparency to the audit would be through further disclosures in the audit committee's report where there is greater discretion over content.

  3.3  We are discussing this idea with our listed clients to see if, working together, we can agree to give public disclosure to some of the key matters which, as auditor, we are obliged to report to their audit committee. This would include the significant risks of misstatement addressed by the audit and the key judgments made by management in preparing the financial statements. The results of this initiative will be available as the next round of annual reports become available in the spring and Committee will be able to take account of this in developing their thinking further.


  3.4  The crisis has called into question the effectiveness of some of the narrative disclosures that accompany financial statements. These include the description of the inherent risks in a particular business and the uncertainties and judgments that underlie a set of financial statements. In general terms, the auditor is currently required to report, by exception, if they identify errors or matters where the information given in those disclosures is not consistent with the financial statements.

  3.5  The clarity of some of these disclosures could be improved. We also accept that the assurance that can be derived from the auditor's reporting as described above is not clear. Reporting and assurance over these matters inevitable interact; and so standards and practice for both need to be considered together in order to give clearer and better assured information:

    — We think that improvement in the clarity of disclosure of these matters by companies is primarily a matter of encouraging adoption of good practice (for which there are examples). Further detailed rule making is, in our view, likely to be counter-productive. It would not be appropriate for auditors to be required to offer their own commentary or volunteer new information as such disclosures must remain the responsibility of the directors.

    — However, auditors already act as agents to encourage such good practice and this could be further enhanced if they had a more explicit assurance role. We recognise that some companies have reservations about this and any change would need to be framed in a way that an auditor would be competent to do. We are currently working on proposals for how this could be made workable.


  3.6  The Committee is already aware of a paper prepared by the Institute of Chartered Accountants in England & Wales "Audit of Banks: Lessons from the Crisis". We support its main findings including the following which relate specifically to the role of auditors:

    — Better two-way communication between regulator and auditor to enable both parties to perform their roles more effectively; and

    — Greater scope for private reporting by auditors to supervisory regulators.

  3.7  We also support a closer working relationship between auditors and banking and other supervisors and we are participating in the working party sponsored by the Bank of England which is currently considering this.


Question One—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?

  4.1  The summary schedule below identifies the following analysis of the figures for the financial year ending the 30 June 2010 for PricewaterhouseCoopers LLP:

(a)Essential audit work £522.8m (57.7%)
(b)Audit related work £ 25.2m (2.78%)
(c)Extended audit£15,000 (negligible proportion)
(d)Consulting/other £358.0m (39.52%)

  4.2  As explanation for category (a), extended audit work is essentially work carried out at the request of clients as part of the audit that is not required to support the audit opinion. A recent review carried out at the request of the AIU indicated that we only did this for one client and that the amount involved was negligible.

Question Two—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?

  4.3  Under UK Ethical Standards for auditors (ES 5), audit firms are not allowed to provide internal audit services to an audit client where it is either reasonably foreseeable that the auditor would place significant reliance on the internal audit work or the work would require the audit firm to undertake part of the role of management. Consequently, as I indicated in my response to question 249 at the 23 November hearing, as a firm we do not provide any outsourced internal audit functions to audit clients.

  4.4  This Standard otherwise permits the provision of internal audit services provided that the auditor is satisfied that there is informed management and that appropriate safeguards (such as the use of separate teams and the review of the work carried out by an independent partner).

  4.5  The Auditing Practices Board recently consulted again on this area but is not proposing to prohibit all internal audit services to audit clients provided the threats and safeguards approach is properly applied.

  4.6  The International auditing standard (Clarity ISA 265 on "Communicating deficiencies in internal control to those charged with governance and management") that deals with this area requires the auditor to communicate in writing significant deficiencies in internal controls identified during the audit to those charged with governance on a timely basis. An internal audit function is regarded as an internal control over financial reporting.

4 January 2011

46   Not published here. Back

47   Not published here. Back

48   ISA 570 para 7. Back

49   Bank of England's Financial Stability Report (June 2009). Back

50   Bank of England's Financial Stability Report (June 2009). Back

51   FRS 18 "Accounting Policies" published by the Accounting Standards Board in December 2000. Back

52   Schedule 9. Back

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