Memorandum by Mr Graham Roberts (ADT 38)
1. INTRODUCTION
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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