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
APPENDIX 1
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.
CLASSIFICATION AND
MEASUREMENT OF
FINANCIAL INSTRUMENTS
UK GAAP
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.
IFRS
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)
— 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.
IMPAIRMENT OF
LOANS
UK GAAP
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.
IFRS
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.
INCREASING TRANSPARENCY
OF THE
AUDIT
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.
EXTENDING THE
SCOPE OF
THE AUDIT
IN RELATION
TO NARRATIVE
DISCLOSURES
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.
THE ROLE
OF THE
AUDITORS IN
RELATION TO
FINANCIAL INSTITUTIONS
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.
WRITTEN ANSWERS
TO QUESTIONS
NOT ADDRESSED
AT THE
HEARING ON
23 NOVEMBER 2010
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:
(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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