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

Memorandum by Mr Graham Roberts (ADT 38)


  1.1  I am writing in a personal capacity. I am the Finance Director of The British Land Company PLC, a FTSE100 company. I am also a non-executive director and Chairman of the Audit Committee of Balfour Beatty plc, a global infrastructure business with a turnover exceeding £10 billion and operating with 50,000 employees in 100 countries.

  1.2  The first 20 years of my career were spent in the auditing profession of which 12 years as an audit partner, initially at Binder Hamlyn and subsequently Arthur Andersen.

  1.3  I have therefore seen many sides of the audit debate and its practical application. I also worked at the most senior level at the last audit practice to compete for global clients with what is now called the big 4 but was originally the big 8.

  2.   Competition. Auditors are an important part of the regulatory framework. I do not however believe competition makes for better regulation or better auditing.

  2.1  It is not the number of firms engaged that matters to audit quality but the number and quality of committed auditors employed and the support framework around them.

  2.3  When competition in auditing was introduced in the 80s, the response from Boards and auditors was enthusiastic but destructive to the reputation of financial reporting in the UK at that time. The regulatory regime did not cope nor did checks and balances within the firms and their clients. There were lots of causes but failure to counter the negative effects of increased competition was at the heart of it.

  3.   Quality. The regulatory response to the 80s/early 90s debacle in particular the establishment of the FRC and related bodies and the development of audit committees has created a virtuous circle of open communication and checks and balances.

  3.1  As a result there have been precious few "audit failures" since the mid 90s in the UK compared to other countries. None have had systemic consequences (but see banks below.) I think the overwhelming evidence is that financial reporting has been improving at a time when the number of firms has been reducing.

  3.2  The increased presence and quality of audit committees improved the reliability with which the auditor's views are heard and discussed in the right way in the boardroom.

  3.3  Also audit firms became bigger and this was important because businesses going global were increasing in size and complexity. The perception of financial independence is essential and if the clients get larger so must the firms. This for me was an important driver for the merger in 1994 of my then firm with Arthur Andersen.

  3.4  Any regulatory proposal arising from the Select Committee's review should in my view ensure that the firms can at all times demonstrate financial independence.

  4.   Professional scepticism. Whilst not all auditors will be perfect all the time, I believe the firms' cultures have moved dramatically over 20 years to be the best available framework for nurturing and exploiting the talent we have in this field. We also remain spoilt in this country in finding that audit firms have been able to position themselves to source better quality enquiring minds direct from university than other regimes where the profession is less well established or regarded, including the US.

  5.   Today's Boardroom challenge. The boardroom challenge, I believe, is to improve the non-financial aspects of corporate reporting and ensure in the process that boards and investors understand the risk tolerance and risk management of businesses.

   5.1  Not that business should stop taking risks—that remains essential to create wealth.

  5.2  The boardroom scandals in the UK of the last 15 years have not been around financial misreporting but were more to do with the failure to assess and adequately communicate business models and risk. The massive increase in disclosure obligations over this time horizon has also added to the problem of seeing the wood from the trees: an issue for preparers as well as readers of Company Reports and Accounts.

  5.3  Markets can work for the good to act as a check on excessive risk taking and weak business models but both need to be visible to the market. Transparency in this area is the next Holy Grail but it is not an easy challenge. The hardest part, I think, is articulating risks that are not the day to day risks companies manage but the remoter risks which are accepted, as they are deemed remote and are uninsurable, but if they happen can be very damaging, if not fatal.

  5.4  Boards probably spent more time and money assessing and protecting themselves from the notorious year 2000 IT risk than any other remote likelihood, high impact risk. That seemed to many an unnecessary expense, viewed with hindsight, but I know of no company with IT dependency that gambled and did no preparation.

  5.5  Had Northern Rock articulated internally and externally the risk of wholesale funding dependency would that have driven a discussion at board level and with the regulator about a plan B? The risk of deep sea oil and gas drilling seems clear to me and should have logically led to a dialogue between BP and its peers with the US government on catastrophe risk management drilling off the US coastline well before this incident. I wonder if that happened?

  6.   Relevance to auditors. I think we have made great strides in achieving reliable financial reporting in the UK. The next step has to be improving how well business communicates on non-financial matters, specifically risk management and business models. It needs to do so in a way which is better than the boilerplate disclosures seen in US style reporting and be accessible to investors and commentators. It will not be easy, particularly with the most complex groups.

  6.1  I think in the future that Boards and Audit Committees may well want more external independent evaluation of how they articulate their risk and reward strategies and profile and that audit firms may well need to recruit new skills to fully contribute by questioning the quality of disclosure rather than merely confirming management has evidence to support what they are saying. Today auditing remains a financially orientated process but should, in my view, evolve to a broader business reporting process to support boards in improving governance and transparency.

  6.2  The sting in the tail of this proposal is that the investment needed to evolve in this direction can probably only be made by global giants. Access to capital is an issue as well as intergenerational profit sharing at the firms, ie investing for the future poses serious challenges to the firms' demography and reward structures.

  6.3  I believe the debate about increasing competition is the wrong discussion. Changing the mix of skills to support boards in their wider reporting responsibilities is a more valuable goal. I understand the FRC are looking into the role of auditors in non-financial reporting. I think the role of auditing should be resolved first before any conclusions are reached on auditor market concentration risk.

  7.   The banks. The most extreme corporate scandal and the most challenging for outside observers to grasp is the banking crisis. The scale and complexity of our banks clearly posed difficulties for their Boards and Audit Committees in understanding fully the risk profile of their businesses. This appears to have been the same for their auditors and regulators.

  7.1  I was impressed by the clear articulation in the Treasury paper issued in July 2010 on the "regulatory underlap" between HM Treasury, the FSA and the Bank of England, which was the source of the systemic weakness in the banking regulatory model. I think a similar description would be fitting for the micro-regulatory environment specifically the interaction between auditor, Audit Committee and FSA on individual banks supervision.

  7.2  I was involved in bank auditing in the early 90s under the previous regime when banking supervision was done by the Bank of England and found the bi-lateral and tri-lateral meetings very effective in ensuring the auditor's scope of additional work for regulatory purposes covered the areas the regulator should be aware of. I understand this effective method of communication fell into disuse under the FSA.

  7.3  Without good dialogue between regulator, bank and auditor it is hard to see how auditors or regulators can do their jobs effectively. The biggest risk that does not seem to have been articulated was the business model weakness around the potential loss of wholesale funding.

  7.4  Yet the consequence on asset values of such extreme liquidity loss is severe. Add to that the excessive leverage of certain structured products which amplify losses to catastrophic proportions in a liquidity crunch scenario. The weaknesses of mark to market accounting did not help either, nor did the widespread failure to understand the difference between accounting for losses on an incurred basis rather than an expected basis.

  7.5  Looking at the complexities of all these interlinked issues, there is a question in my mind about what reporting lines best suit bank auditing compared to other businesses that are less financially geared and so less susceptible to sudden failure through loss of creditor or depositor confidence. For example, uncertainties surrounding going concern spelt out in an auditor's report on a bank can rapidly become an unfortunate certainty. That is not necessarily in the public, depositors' or the investors' interests. The risk that caused the uncertainty needs instead to be communicated swiftly and dealt with well before any annual report is signed off and through a three way dialogue between auditor, board and regulator.

  Ensuring such communication works effectively is essential.

  8.   A repeat of Andersen? On a pragmatic basis I cannot see on a global basis how the regulatory mistakes that created four from six can be unwound, without risk to audit quality. I think instead the answer lies in a version of the "living wills" approach to banks and not in seeking the riskier rapid expansion of the smaller firms. This would of course require global coordination amongst regulators.

September 2010

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