Examination of Witnesses (Questions 291-351)
Mr Ashley Almanza, Mr Robin Freestone, Graham Roberts
Esq and Mr Martin ten Brink
7 DECEMBER 2010
Q291The Chairman: Good afternoon, gentlemen.
Apologies for starting a little late, but we had quite a number
of internal matters to discuss today. Welcome to the Economic
Affairs Committee. For the record, copies of Members' interests
on this matter are available on the register of interests and
where Members have new interests to declare they will do so during
the course of our hearing. Thank you all very much indeed for
coming. We'd be grateful if you would speak loud and clear for
the webcast and the shorthand writer, and when we get to questions,
in order to save time, if you actually agree with the comment
that has been made by the first speaker please don't just repeat
it. But if you have a different point of view or something else
you want to say, by all means come in on any question. Would any
of you like to make an opening statement or will we go straight
to questions?
Mr Almanza: Straight to questions.
Q292The Chairman: Straight to questions, good,
thank you very much. Well, I'll kick off with the first question,
and that is that I recognise that today we're talking mainly,
but not entirely, to companies who have a major global reach.
Therefore, as some of you have stressed in your evidence to us,
it's important to have auditing firms that have the same global
reach. I think it's also clear that in the written evidence you've
given us you tend to feel that, from your point of view at least,
there is competition. You are satisfied with the situation in
relation to the Big 4, and you don't share some of the misgivings
that have been made to us by a number of other witnesses about
the lack of competition and the difficulties of the next tier
being able to expand their businesses and get more options and
opportunities because of the restriction, as they feel it, of
competition and choice. So we do recognise that you are by and
large representing that particular sector. But could I just ask
you two questions to begin? One is would you all share the same
sort of comfortable view of the present situation if the Big 4
came down to Big 3? And the second is could you as experienced
finance directors and others cast your views a little wider and
answer the question: are you happy about the predominance of the
Big 4 in the auditing world generally and for companies in the
250 and so on where a lot of the concerns have been expressed?
Who would like to kick off?
Mr Almanza: Shall I go?
Mr Freestone: Yes, sure.
Mr Almanza: Big 4 to three firms I think would
be regarded by most large companies in the UK, certainly by our
company, as an unwelcome change. While I would agree with your
comment earlier that large corporates in the UK, by and large
tend to find sufficient competition is provided by the Big 4,
going to three I think would undermine that and would be unwelcome.
As to whether we're happy with the current state of affairs, I
think that certainly we're content in general terms with the service
provided and the competition that we observe in the market today.
Q293 The Chairman: Any other views?
Graham Roberts: I would like to add to that
in that context there's a tremendous increase in the amount of
transparency through the operations of the FRC and the AIU in
terms of audit quality. There is a measure of audit quality out
there and certainly I've not observed any weakening in that quality
just as a result of a move down from six to four.
Q294 Lord Lawson of Blaby: May I
move on to a slightly different area, IFRS in general and mark
to market in particular? We have had, as you will know, some evidence
suggesting that a number of aspects of IFRS are, in fact, inferior
to UK GAAP and in serious ways. So far as mark to market accounting,
I think that what has emerged is some evidence that while this
may be a brilliant convention 90% or 95% of the time, at the peak
of a bubble and also at the depth of a serious recession it produces
unwelcome results in totally different ways. I can spell those
out, but you will be well aware of them. So, do you have any observations
about either IFRS or mark to market?
Mr Almanza: Yes. I think that all large companies
in the UK have had to invest a lot of time, effort, money, so
it's been on the one hand a net cost to us but on the other hand
we see IFRS is conveying significant benefits to our shareholders
and to shareholders and the public in general. Because a global
standard, we think, delivers a net good for companies, investors,
society, so we're strong supporters of IFRS in a general sense.
More specifically, mark to market has limitations.
I think IFRS recognises today those limitations. On the point
that you were making, Lord Lawson, about it measuring values at
the top or the bottom of the market, I think what we would say,
at least I would say, the objective of financial statements ought
to be to measure objectively the value and if market value happens
to be high or low that's what it's measuring. So the volatility
that has been seen in reported results reflects underlying volatility.
I think a valid question, though, for standard setters and policymakers
to ask is: what are the limits of mark to market accounting and
IFRS? Where assets and liabilities are not traded in a liquid
market, you can get quite odd results by trying to mark to market,
and I think that's a legitimate question for standard setters
and policymakers to keep in view. Certainly, it's one that as
a company and as a group of companies we do comment on when the
ISB consults.
Q295 Lord Lawson of Blaby: So in
your opinion, just to press it, there is a genuine problem there
that needs to be resolved and has not yet been resolved and the
example I think you're absolutely right to point your finger at,
where there is not a very large market, not a very wide market,
but there is, as it were, a price. At the top with a financial
bubble, as we saw before the banking crisis broke in a number
of cases, that enabled huge paper profits which could never have
been realised in the real world to be declared on the basis of
which there were substantial distributions either in bonuses to
the management or in dividends to shareholders. That was a real
distribution of rather phoney, spurious, evanescent, ephemeral
profits, which caused a considerable weakening, therefore, of
the institutions concerned. And then again at the bottom end they
had to relax it because it was a Doomsday machine where there
was a market price that was so underwater that something had to
be done about it. So these are serious defects and, as far as
I can understand your general answer, you agree with that. I'd
be grateful if you could let us know what you think the remedy
should be.
Mr Almanza: Just to clarify, I'm saying that
the primary underlying problem is that prices were inflated or
depressed excessively. And I think that that was widely apparent.
You didn't need to look at the mark to market accounts of any
of these institutions, companies, organisations to divine that
there was an asset bubble. There was plenty of well-informed commentary
around annual report and accounts suggesting that there was an
asset bubble, for example, and I think there was plenty of commentary
in the immediate aftermath to suggest that the market had overshot
in the other direction. So I think that's the primary problem.
I think the remedy is for standard setters and
policymakers to recognise that mark to market accounting really
works best in markets where assets and liabilities are traded
in depth and with liquidity. So, active markets are clearly priced
on a regular basis by many participants. Where you had what I
think you referred to as spurious profits, the biggest problem
would probably tend to be where you had very few participants
in a market and there wasn't an actively traded or quoted or observable
market. Other than that, I think IFRS should report what it sees
rather than try to correct what the market establishes as a price
or a value.
Q296 Lord Lawson of Blaby: Yes, I
go a long way with your analysis, although I would push it a bit
further. But what I'm not clear is what your proposed remedy is.
Mr Freestone: Could I suggest one that might
help, but I'm not sure it doesn't have its own faults. I think
the issue with fair value accounting, which is where mark to market
has come from, is that it values things at a point in time. And
the benefit of that is that there's an objective value if there's
a decent market, as Ashley says. The downside, of course, is that
that market may not always be rational and, therefore, sometimes
those values may be either over-inflated or depressed. I think
the concept of fair value has become a value at a point in time,
largely at our balance sheet dates, and therefore if you're looking
at a fair value that isn't at a point in time, that is some form
of average, that might mean that values weren't always taken at
points that were either very high or very low. That's quite a
departure in terms of how values are set compared to how accounting
standards are phrased today.
Q297 Lord Lawson of Blaby: Would
you recommend the use of that?
Mr Freestone: There are certainly benefits to
it. It brings back into debate all those questions about how that
average is struck and many other things that would materialise
from going that way, but it would move to a less point-in-time-orientated
valuation. That would be the benefit.
Q298 Lord Best: It has been suggested
that one of the reasons why there was a good deal of contentment
with the audit arrangements that companies like yours have is
that there's a rather cosy relationship between the firms of auditors
and your own companies and, indeed, that some senior staff move
between the audit firm and the major company. Do you think that
this is a misapprehension or are those personal relationships
where people have moved one way or the other, really leading to
a position in which the degree of contentment that you seem to
have with your auditors is perhaps a little too cosy?
Mr Almanza: I think as a general matter the
cosy relationship is not something I've observed. I think the
cornerstone of a healthy relationship between auditors, companies
and shareholders is the board and the audit committee. If you
have a board that comprises primarily clearly independent directors
and an audit committee that comprises solely independent directors,
then that's the principal axis through which the relationship
between the auditor and the company should operate. Again, in
my experience it's pretty rare for senior members of an audit
firm to leave that firm and become senior members of the executive
or management team in the client company where they're exercising
judgments over financial reporting, financial control and so on.
Many companies just prohibit it outright; you may not do that.
You do get exceptional circumstances. There have been, of course,
exceptional circumstances where that occurs, but I think the root
of this is the audit committee. If you have an independent audit
committee, an independent board, they "own the relationship"
with the auditors and their interests are closely aligned with
the auditors. They want an objective view as to whether or not
management is preparing accounts that fairly reflect the business.
Q299 Lord Best: We know you don't
go out to tender very often and it's very rare to change your
auditors, but do you think that this concentration in the hands
of the Big 4 leads to higher audit fees than would be the case
if there was a more competitive environment out there?
Mr ten Brink: I'm not sure that the relationship
between concentration and audit fees is all that obvious. I believe
there are a number of important aspects to consider in what determines
the cost of external audits. Equally important is the way that
the company has set up its internal processes, systems, activities
and, therefore: what is the audit effort required to actually
come to an opinion? So what is the degree of commonality and standardisation
in those processes? Is it one accounting system or is it multiple
accounting systems that need to be considered? Typically, those
aspects have a fundamental impact on the effort associated with
the audit and, therefore, the cost.
Q300 Lord Tugendhat: Can I come back
to the relationship with the auditors? It has been suggested to
me by an executive at one of the banks that got into trouble that
under the previous regime there was far too cosy a relationship
between the relationship partner and the Chief Executive of the
bank concerned and that the Chief Executive of the bank concerned
rather overawed the relationship partner. Now, inevitably, the
Chief Executive and the relationship partner are going to have
a relationship that is closer than other executives, apart from
yourselves perhaps, but in your long experience of your profession
have you noticed a tendency on the part of some Chief Executives
to have a rather domineering relationship with the person who
is auditing them?
Mr Almanza: I haven't and I think it would be
a cause for concern if that was something that the board observed.
Q301 Lord Tugendhat: Certainly, in
my experience, which happily is not the same as the one I've just
reported, I have noticed that sometimes the Chief Executive is
a rather stronger character than the person who is auditing the
firm and that on second thoughts the auditor doesn't always have
quite the same opinion about an issue that was concerning him
that his first thoughts were. He was no doubt convinced by the
strength of the argument, but Chief Executives are strong-minded
individuals. None of you have noticed this phenomenon?
Graham Roberts: If you take a long-term view
there's been a fundamental change in the relationship between
auditors and companies caused by the rather poor standard of accounting
we had at the back end of the 1980s and the crisis and the response
to that. So when the Financial Reporting Council was created and
the various bodies like the FRRP and audit committees began we've
been on a trajectory of some time of professionalisation of those
audit committees and the relationship now is much more driven
around the audit committee and the audit committee chairman. And
certainly in terms of decisions around auditors, that has much
more moved towards the non-executive rather than management, and
I think that is probably one of the reasons why. Leave aside one's
views on the banking side, we've had very few audit failures in
the UK over the last 10 to 15 years in terms of scale.
Q302 Lord Tugendhat: So if a phenomenon
of the sort that I was reporting on occurs, it is likely to be
a reflection of the Chief Executive's dominance overall, including
of his non-executive directors, rather than a problem that is
specific to Chief Executives and auditors?
Mr Freestone: I certainly would have thought
so, and I would have thought in that scenario the audit partner
should have sufficient backup in the form of technical departments
and other people that he or she has to convince back at their
audit firm such that that pure relationship between one individual
in the company, whether it be the Chief Executive or the Chief
Financial Officer, and the single auditor is not the be all and
end all. It's the relationship between several other parties within
the audit firm and, indeed, the audit committee as a whole that
would override that relationship in most normal circumstances.
Q303 Lord Moonie: Anybody changed
their auditors recently?
Mr ten Brink: 2005.
Q304 Lord Moonie: In that case it's
actually appropriate for me to ask the next question. If and when
you put an audit out to tender, do you invite bids from non-Big
4 firms, Plus 2, mid-tier, with an open mind as to who you might
select?
Mr ten Brink: We certainly have an open mind,
but considering the footprint of our operations, We have appointed
one of the Big 4 as our audit firm. Having access to consistent
and high quality audit services in multiple locations, and therefore,
contracting with a firm that has that global reach is important
to us. We have operated under a joint audit model and we found
that model to be more cumbersome. It creates additional interfaces.
It requires additional measures to ensure audit quality and consistency
and ultimately has a cost-increasing factor.
Q305 The Chairman: Can I ask about
tendering? In terms of competition and choice and acknowledging
that you take the view that you have to have one of the Big 4
for the reasons you've already described to us, why is it that
so very few tenders are actually done and even rarer for an audit
firm to be changed? And we've seen the figures on this.
Mr Almanza: I think one of the reasons is that
audit firms know that we have a choice and that very often is
all you need to keep their pricing and the quality of their service
honest. So, for example, some companies pre-qualify without going
to tender. So I don't know whether that's in your statistics,
but you'll go and engage with the competition and pre-qualify
them. Your auditor will know; you'll be very open with your auditor
that that's what you're doing. And that will certainly cause them
to stay on their game and price competitively and, I think, deliver
quality. I think that's one of the reasons that you don't get
change very often.
If I may, the other reason that audit committees
may be reluctant to go beyond that unless they feel they really
have to is that changing the audit engagement does bring increased
risk and they will keep that in mind when they're thinking about—
Q306 The Chairman: How many of you
actually have done pre-tendering? Have you any idea, apart from
yourselves which I'd be interested to know, of what the overall
statistics are?
Mr Almanza: I can't say I know the overall figure.
We have done it.
Mr Freestone: We've done it, too.
Mr Almanza: I don't know what the overall statistics
are, but we could certainly get that information if you're interested.
Q307 The Chairman: And you've changed?
Mr ten Brink: We changed in 2005 when we changed
from a joint audit model to a single auditor.
The Chairman: So there was a particular
factor there to—
Mr ten Brink: Indeed.
Q308 Lord Tugendhat: I know that
so many companies reply as you did and I quite understand the
nature of your reply about the international scope of your business,
but I was very surprised in the letter we got from Peter Williams
of The Hundred Group in which he says, "We do not feel the
audit market is unduly concentrated. Indeed, we see that in some
arenas there is a Big 6 of accountancy firms providing increased
competition". Nobody else who has come before us has talked
about a Big 6. Everybody seems to agree that there is a Big 4
and the reasons for it people tend to give are much the same.
Since this is the view of The Hundred Group, I wonder if you could
explain it to me, please.
Mr Freestone: Maybe I should try. Certainly,
when we look at other services we don't always just go to the
Big 4. So we've approached other, smaller firms to come and help
us with things like intangible valuations. When we have to make
an acquisition we have to get that acquisition valued, the intangibles
valued, and we will ask smaller firms to tender for that sort
of business. We have had one instance recently where a smaller
firm came and helped us out with some bookkeeping in a smaller
subsidiary. So when it comes to non-audit services we certainly
will try and use the smaller firms in those particular instances.
Q309 Lord Tugendhat: That's not quite
the same as saying there is a Big 6. In which area of activity
can one possibly say that there is a Big 6? FTSE 100 doesn't have
any non-Big 4; FTSE 250 hardly.
Mr Freestone: Not for auditing, no, but certainly
for the other services that we—
Lord Tugendhat: But it says "audit
market" here. This is a view put forward by Mr Peter Williams,
"We do not feel that the audit market is unduly concentrated
... in some arenas there is a Big 6". So perhaps it just
wasn't very precisely drafted.
Mr Freestone: I think there were separate sentences
there. I think when it comes to audit services per se four is
probably sufficient. If we were to go through a full audit tender
process, looking at four is probably enough.
Q310 Lord Hollick: In the same letter,
Mr Williams says, "In particular, we note the high level
of competition demonstrated during an audit tender process. In
our experience, this process brings out a high degree of competition
in terms of emphasis of approach and on audit fees paid".
So he's clearly very approving of this process. But this seems
to be a process that few companies undertake on a regular basis.
Now, I think three of you have said you've recently had an audit.
Is that part of a regular process? When you do it, is it at the
behest of the audit committee? What were the criteria, without
going into any sort of confidentiality issues, that you had in
mind when you looked at it and what swung it which way?
Mr Almanza: I think it's important to differentiate
between a prequalification process and a full tender process,
and I think again we may be guilty here of conflating the two
and using slightly imprecise language. I think, as is the case
here today, there are many more companies that would run a prequalification
process than would go the next step to a full tender and a change
of auditor. I think it can be initiated by the audit committee
or management, but in any event it will always require, in my
experience, the approval of the audit committee. My guess would
be most likely it would originate from the audit committee but
it wouldn't be unreasonable, I think, for a finance director to
say, "I think we ought to test the market". And so long
as the audit committee was comfortable with that and understood
the reasons, because there can be many reasons for the finance
director saying that, that would be fine. The criteria would commonly
be capability in your industry sector. So there isn't equal capability
and capacity in each of the Big 4 in all industries. So you would
look at industry capability, capacity, and their geographic footprint
and capability around the world and how that matched with your
own and indeed your plans to grow in the future. I think those
are the important criteria.
Q311 Lord Hollick: Did your tender
process lead to a change or lead to improved financial terms with
your existing auditor?
Mr Almanza: In our case, we didn't make a change.
As I alluded to earlier, we felt we'd done enough to satisfy ourselves
that we were getting good quality and good value for money, but
also doing this periodically is one way of keeping things honest,
if you like. Forgive me, I forgot the second part of your question.
Q312 Lord Hollick: Did it lead to
a reduction in the fees of your existing auditor?
Mr Almanza: Hard to say, but I suspect it kept
them pretty keen.
Graham Roberts: I think there's another feature,
which is why maybe the turnover rate is relatively low, which
is the companies are also quite often in constant change. There
are changes of business structure, changes of management; you
can have quite a high level of management swing. In the consideration
for audit tenders you also need to bear in mind that if there's
a loss of knowledge or a change of structure of the business it
may not be a good time for that sort of process if it leads to
a change of auditor and a loss of knowledge.
Q313 Lord Lipsey: You are not bankers
but your companies suffered as a result of the economic problems
of the last few years. Now, when the Big 4 came before us, they
tried very hard to convince us that audit was splendid in all
essence, it's just not their fault that anything went wrong, but
it's probably fair to say that the Committee wasn't instantly
convinced, which has caused the Committee to ask for additional
evidence from them in an attempt to substantiate this case. They've
got obviously their own cause to plead. Looking at it more objectively
from your situation, do you really feel they did a good job in
auditing the banks as the crisis broke?
Mr Almanza: Well, in my case I can't say I'm
a great student of precisely what they did in executing their
audit of banks. I would venture as far as to say, though, that
there were many contributing factors and one would have to look
at management of those banks, boards of those banks, investors,
regulators and auditors to form a view of what contributed to
the failure. I would also say that many of the warning signs were
clearly there. Of course, it's easy to say that in hindsight,
but actually there were a lot of people—I wasn't one of
them—who were saying that in advance and you could see it
in the annual report and accounts. So to the extent that matters
were being reported clearly and risks identified and auditors
were taking that into account, I would look beyond the role of
auditors to the underlying problem, which is—
Q314 Lord Lawson of Blaby: If I may
come in, I know that you're not a banker and that none of the
four of you are bankers, but you and your colleague on your right
are here representing The Hundred Group, which does include banks.
Mr Almanza: It does.
Q315 Lord Lawson of Blaby: I think
that what Lord Lipsey said was not that auditors were uniquely
culpable but maybe there was a failure of auditors among the other
failures. So I think that is what needs to be addressed.
The Chairman: Could I just follow that
up by saying you said that in advance lots of us knew all the
problems that were around among banks or words to that effect.
The issue that we've had with the auditors is that they were certifying
these banks as going concerns when there must have been a lot
of concern as to whether they were going concerns.
Mr Almanza: I agree, and I think that, to try
and answer all three of those questions, that is a proper question
to ask and to be examined, but it needs to be done in a specific
way rather than a general way. In other words, the Audit Inspection
Unit or the appropriate body ought to be looking at the audit
files and asking, "Well, what questions did you ask to satisfy
yourself that this was a going concern and what evidence were
you provided with? What view did you take, for example, on dependence
on wholesale funding as opposed to term funding in arriving at
a view on going concerns?" So, I think it's a proper question.
I'm afraid I don't have the answer but I think it would be right
for the AIU or some other body to pick up those audit files and
ask those questions in a very specific way.
Q316 Lord Lipsey: There are specific
issues, but there's also a sort of general issue involved, which
is that if we take the view that they failed to spot what was
going on in the banks, the worry for you and, indeed, for your
shareholders must be that they have failed to spot things that
are going on in individual firms, perhaps for a quite different
set of reasons than applied in the bank. You present a picture
in your evidence, and I quite see why, of the good service you're
getting and how satisfied you are with all this. Surely there
is somewhere in the back of your mind a lurking fear that these
people aren't the capable professionals that from day to day they
may appear.
Mr Almanza: I'm doing all the talking. I may
have to answer but—
Mr Freestone: I think that companies are very
focused on risk. Certainly, we spend significant amounts of time
assessing risk, applying "Turnbull" principles, looking
at probabilities of risks arising and how we mitigate those risks.
We try and encapsulate that in a relatively small, somewhat unread,
section of the annual report called "risk and uncertainty".
I think when one of these issues arises you would look at that
section and say, "Was that risk suitably flagged?" Now,
it may be that that section is not as prominent as it should be.
It may be that the probabilities of risk are not particularly
well talked about there. It may be that mitigation of that risk
and how management is managing that risk is not always talked
about in the way it should be. But I do think it's up to the management,
actually, to define the risks and uncertainties of the business
and manage those and the auditors to comment upon them.
Q317 Lord Hollick: But if I may,
we heard last week from Mr Powell that it's not the job of the
auditor to look at the business model. So, that makes it rather
difficult for them to comment sensibly on the risk management
of the business if they don't, in fact, have a view and don't
fully understand the business model.
Mr Freestone: Well, the risk section is within
the directors' report that the auditors comment upon in terms
of it being consistent with the numbers in the accounts. So they
do look at that. They may not explicitly make a comment on it,
but they certainly are reading it and making sure that it's consistent
with the rest of the numbers in the accounts.
Q318 Lord Hollick: But do they not
make a general statement about the going concern nature of the
business? It struck many of us last week when we heard them say
this that it was rather difficult to form a view about the going
concern if, in fact, you didn't look at the business model and
how it related to the risk and the management of risk.
Mr Almanza: They are required to form a view
on going concern as the basis of the preparation of the accounts
in 99.9% of all cases.
Q319 Lord Lawson of Blaby: Going
concern implies looking into the future, not just looking at the
past.
Mr Almanza: Twelve months. It does, it implies
looking ahead 12 months, and I think again what I'd say on this
is that a common cause of failure in banking—and I said
at the start I'm not a great student of this—was an assumption
that banks would have access to capital in the wholesale markets,
that credit would be available, and it turned out that the wholesale
markets weren't there when they were needed. That was an assumption
being made by management teams, boards, investors in these companies.
Some investors were going in the other direction, of course. Some
investors were shorting these companies because they took a different
view on that assumption about the availability of capital. And
the auditors in coming to a view on going concern—and I
make this as a general statement; you'd have to look at each specific
case—must have in the case of going concern come to the
view that sufficient financial resources, sufficient access to
capital would be available for that organisation for the next
12 months. There's no other way around that. You have to come
to the view that that's the case. I don't know that it would ever
be possible to redefine the terms of an audit and audit scope
such that the auditor would be required to get that judgment right
in all cases. This is in no way a special pleading for any special
interest group, but many people got that judgment wrong: regulators,
shareholders, management teams, boards made an assumption and
that turned out to be flawed. I guess in the going concern report
that may have been an assumption that was made. It needs to be
checked but I think it's not a bad question to ask.
The Chairman: Well, that is actually
what we're following up with the Big 4 because we were not very
happy with the answers we were being given. Of course, we have
looked at some of the others, like regulators, in this Committee
as well, but this is a focus on auditors.
Mr Almanza: Yes, I understand.
Q320 The Chairman: I wondered if
any of the others of you had anything to say on this because it's
an important subject for us.
Graham Roberts: I would like to make an observation
just specifically around bank auditing. I did audit banks in the
early 1990s, and one thing that has puzzled me in this process
is the apparent falling away of the dialogue between the audit
firms and the regulator. I think it was an important thing because
a going concern statement is a nuclear option for a business built
on confidence and, therefore, certainly in those days back in
the early 1990s it was a very powerful means of ensuring that
the regulator was aware of the micro regulatory risks. The regulator
is in a better position to see the whole market than any auditor
can be, but for some reason I understand that fell into disuse,
presumably after the FSA took over the—
Lord Lawson of Blaby: That appears to
be the case.
Graham Roberts: And that I just don't understand
because as an auditor of a financial institution you need that
dialogue.
Q321 Lord Hollick: Do you think the
audit as presently constituted gives you good value for money?
There's been one suggestion I think from an American academic
that, in fact, it's an assurance policy and, therefore, why not
make it an insurance policy and do away with the audit? Obviously,
there are a number of different uses and purposes for the audit.
Do you think that from a company point of view it's value for
money and do you think from your shareholder point of view it
provides good value for money in giving them a really clear, objective
view about the business and how it's performing financially?
Mr Freestone: I think the fundamental requirement
that I have in my job and as we have as a finance function within
the company that I work for is to get the numbers right. That's
what we're trying to do because the prospect of a qualified audit
report or a restatement in a subsequent period of those numbers
is daunting. One doesn't want to get into that position. So what
I rely upon the auditors for is to make sure that we get the numbers
right, and that's why we want high quality at a reasonable cost.
Clearly, they're doing other things because frankly they're representing
the interests, really, of financial stakeholders external to the
management team and, therefore, they're doing a lot of other work
to make sure that they can give that assurance to other parties
who are going to use the accounts as well. That bit is not really
for me, that's for the shareholder, the potential shareholder,
the bankers, the other people who want to look at the accounts.
So, the bit that they do, which is help me make sure the numbers
are right in the first place, is certainly something that I rely
upon. Could we get it cheaper? Possibly, but I think there's also
an issue about quality. We want to make absolutely certain we're
getting the best advice to achieve that objective.
Mr Almanza: I think the other thing we get is
our auditors—and I think many companies would find themselves
in the same position—happen to audit other companies in
our industry and so they do provide us from time to time with
non-competitive but nevertheless valuable insights, "Well,
this is how other companies do it", process improvements,
that sort of thing. Our audit committee also asks in the absence
of management for the auditors to benchmark management's financial
judgments, estimates, and significant accounting policies those
against others in the same industry. So, "Where would you
rank this management team on a scale of one to 10? Conservative?
Aggressive?", that sort of thing. And I think that that adds
a lot of value to the audit committee and provides a lot of perspective,
context, even assurance for the non-executive directors, which
you wouldn't get from an insurance policy but you can get from
auditors.
Q322 Lord Shipley: As a new member
of the Committee, I declare my interest as a member of the audit
committee of One North East, the RDA for the north-east? The auditors
are KPMG and the National Audit Office. I think Mr Almanza talked
about commentary in annual reports about an asset bubble arising
and later you made a reference to the fact that the environment
was getting more difficult generally and you could see it in the
annual report. I just wondered if you could say a little bit more
about whether you would welcome the extension of the scope of
a mandatory audit into providing assurance on narrative assertions,
including descriptions of the business model, in the annual report.
In other words, should it be extended into the narrative that
has been produced in the annual report?
Mr Almanza: My own view is that would be very
difficult to achieve. I think that it is along the lines that
Robin said, it's the role of management and the board to ensure
that the business model, the risks and the mitigation measures
taken to manage those risks—and there's always an amount
of residual risk that shareholders take in exchange for the return—are
best done by management and ultimately the board. I think it's
quite difficult for an audit firm which, today at any rate, the
profession focuses very much on ensuring that the financial statements
provide a true and fair view of the underlying business, rather
than providing or passing a judgment on the business model per
se. They are required to ensure that the directors' report and
the narrative in the directors' report is not inconsistent with
the rest of the financial information that's being presented.
I personally think it would be difficult and I'm not confident
we'd get an effective product in the end. I think the auditors,
whatever product they produced, would have to be so heavily qualified
I query whether investors would get real value.
Q323 Lord Shipley: Can I press you
then? I'm not clear who it is that you think is responsible for
disclosing potential problems. So, there are various people who
can, but it seems as though you're saying that actually it is
those for whom the audit is being done.
Mr Almanza: The disclosure obligation rests
with management and the board of directors. They should be properly
describing the business model, the risks that they're taking and
how those risks are being managed.
Q324 Lord Tugendhat: We've heard
a lot about audit committees naturally enough in this discussion,
but I'm sure you're aware that when she appeared before us Baroness
Hogg made a suggestion about risk committees. She was suggesting
that risk committees be required to seek independent assurance
and that was also a suggestion in the Walker Review, which I recognise,
of course, was devoted to banks. Then when they came before us
on 23 November, the Big 4 supported the suggestion, though they
also made a pitch for the external auditor to be permitted to
give this independent advice. So, I have two questions. First
of all, do you think that there should be new audit provisions
requiring board risk committees to seek independent assurance?
And secondly, depending on your first answer, do you think it
would be helpful if that independent advice came from somebody
from outside the magic circle of the Big 4?
Graham Roberts: Certainly, I think the risk
committee or the audit committee—and in some businesses
it may be more appropriate for the audit committee to encapsulate
the risk committee, it depends on the nature of that business—are
tasked and take on the role of ensuring that the disclosures,
et cetera, on business model and risk are fair in the annual report
and in so doing should seek the necessary assurance that they
consider is appropriate. I'm not convinced that all of that needs
to be independent. Some of it may be, it depends on the nature
of it, and some of it could be done by an internal audit function
operating towards the Chairs. In my experience, the audit committees
have a good feel for what they should seek assurance on. Some
of that may be from the external auditor, but I don't think that
actually mandating it is necessarily a step that is required.
Q325 The Chairman: May I ask you
in what order would you rank these parties in terms of their relative
influence and, indeed, what should be their relative influence
on the choice of auditor: shareholders, the board, the audit committee
and management?
Mr Almanza: You might get four different answers
here, I don't know.
The Chairman: That would be very interesting.
Mr Almanza: I would say the audit committee,
the board, shareholders, management. That would be mine.
Q326 The Chairman: The management
should be bottom in terms of the influence?
Mr Almanza: Yes, and let me explain why I say
that, because ultimately this is put to the shareholders every
year so if they have an objection they can intervene in a very
clear and direct way. I think it's more difficult for management
to do that. I recognise that management and the finance director
will have the most ongoing contact with the auditors and from
an appearance point of view it's possible one could think that
management has a lot of influence. But I'll go back to my earlier
comment—if you've got a properly constituted board and audit
committee of truly independent directors, that won't be the case
in my view.
Q327 The Chairman: Well, I'd be interested
to hear what the other three think because I presume you've talked
about this beforehand and you might have a different view. Would
all of you put management bottom of the list in terms of their
influence on the choice of auditor?
Mr ten Brink: Yes, I would say that all four
of them have an important role to play and their own responsibility
to exercise in that selection process in determining who the auditor
is going to be. So I'm not sure whether I would necessarily talk
about relative influence or a relative order. I think it's important
to recognise the individual role of each of those four players
in the process, so to speak.
Graham Roberts: Yes, and I would put the audit
committee/board at the top of that. Certainly, with the change
to a majority of independent non-executives, I think that has
shifted the balance of those judgments from where it might have
been 20 years ago and the pre-eminence for the shareholders who
vote. And clearly, in my view, if there's a vote or a large abstention
around an auditor at an AGM then that is something that should
prompt a dialogue.
Q328 The Chairman: But on the shareholder
position, I can't recall any situation, any AGM, where the recommendation
of the board as to the auditor has been challenged in any way.
It seems to me it's the item on the AGM that just goes through
on the nod every time.
Mr Almanza: Yes, maybe we're answering this
question in too strict a fashion, in other words looking at who
has the ability to influence the auditor if they choose to exercise
that influence. In practice, if you were going out to tender,
would management have more influence? Possibly yes, but I would
agree strongly with Graham's comments that the audit committee
ought to be in the driving seat and in my experience are in the
driving seat.
Q329 The Chairman: But given that
there is very rarely a tender and hardly ever a change of auditor,
what would you think of arrangements whereby the external auditor
was appointed independently of the board of management, for example
by a shareholders' panel or independent regulator?
Mr Freestone: Well, I think it has some benefits
and some risks. I think one of the things that I've found over
many years of being audited by different firms is that the most
important factor in the quality of that audit is knowledge of
the business by the auditor. The greatest fear I have is that
they miss something because they didn't actually understand the
business. My worry about repeated changes of auditor is the risk
that comes with that. Clearly, the perception of independence
increases but actually, from my perception, the risk increases
because we have then a brand new audit team who don't actually
understand much about the business for the first, maybe even the
second year. So I think it has some appeals but it also has some
risks to it.
Q330 The Chairman: Any other views?
Mr Almanza: Yes.
The Chairman: I was told there might
be four different views.
Mr Almanza: Yes. On this question, I don't think
it's an attractive idea. I think that a cornerstone of UK corporate
governance is the role of the board and I think, at the risk of
repeating myself, an independent board and independent audit committee
is the route to go. I think if we were to go down the road of
regulators appointing auditors, for one thing that would require
us to build regulatory capacity, substantial capacity, to deal
with different industries and I think that would add a lot of
cost. I share Robin's concerns. I'm not sure we'd get a better
outcome.
Graham Roberts: I agree with that. I think also
the audit committees could probably do more in articulating their
activities in this particular field and being available for discussion
with the shareholders, which I think is a preferable route to
a shareholder panel.
Mr ten Brink: I do support the earlier comments
made. I would also say that the importance of compliance is primarily
the responsibility of senior management and the board. It is part
of the licence to operate, so the interests of the board and senior
management in preserving that licence to operate I think is undisputed;
thereby giving them the responsibility to determine who the auditor
would be I think entirely logical.
Q331 Lord Lawson of Blaby: I would
like to pick up on a remark that Mr Roberts made a little bit
earlier when he said, and please correct me if I've got it wrong,
that the requirement for there to be a private dialogue between
bank auditors and the supervisors or regulators, which I put in
the 1987 Banking Act—and it was a requirement, it wasn't
just permission—ceased with the transfer of responsibility
for the supervision and regulation of banks in 1997 from the Bank
of England to the FSA. And I wondered whether at the time anybody
said, "Hey, wait a minute" or was it just an oversight
and nobody noticed it was happening or nobody cared, they couldn't
care less? Did anybody say, "Hey, wait a minute, this is
a rather useful dialogue"? Did the supervisor say it? Did
the FSA say that? Did the auditing firms say, "Well, thank
God we don't now have to talk to the supervisor or regulator"
or did any of the auditing firms think this was a bit odd, this
suddenly being dropped? Or did nobody notice what was going on?
Graham Roberts: I think that is the question
I would have liked an answer to myself. I don't know the answer
to that. Clearly, I was not engaged in that activity at that time,
but I think it's actually the seeds of the gap that opened up.
It's just a personal view from a distance.
Q332 Lord Lawson of Blaby: Do any
of you have anything to add to that answer?
Mr Almanza: No, I don't.
Mr ten Brink: Not really.
Lord Lawson of Blaby: Thank you. Well,
we'll have to pursue it further.
Q333 Lord Best: Yes, I think we've
done quite a bit on the role of the audit committee, your views
on that, and we've done quite a bit on the cost of the audit.
But perhaps I could move to a question about the desirability
or otherwise of the same firm of auditors providing non-audit
services to you as look after your main audit. Is that another
characteristic of cosiness or is this a helpful and useful thing
to have the same firm doing consultancy work for you on other
matters?
Mr ten Brink: We apply very strict rules to
the provision of non-audit services by the external auditor. In
such incidental cases clearly it is key that there isn't a conflict
of interest, which is why we apply separate approvals, why there
is appropriate disclosure to the audit committee of such incidental
use, but it can be of value where it concerns an acquisition or
a divestment and where matters of valuation are involved. The
auditors may have access to the information required to provide
that specific service. But it's incidental and it's not material
in terms of the overall cost of the audit. So, we do apply very
strict rules in that respect.
Q334 Lord Best: Does everybody else
apply strict rules?
Mr Almanza: We do. Our audit committee oversees
those rules, sets the budget annually and outlaws completely or
prohibits completely certain work. So, yes, management is bound
by rules set by the audit committee and I expect they're pretty
similar to Martin's rules.
Mr Freestone: We have the same.
Graham Roberts: So do we.
Q335 The Chairman: Does that mean
that you think we in the UK could go as far as the Sarbanes-Oxley
Act, under which I understand most audit work by auditors is outlawed
for companies with primary or secondary listings in the United
States?
Mr Almanza: We're no longer dual registered
so I'm not current with ACC requirements, but certainly we were
listed in New York post Sarbanes and not all audit work was outlawed
then. I'm not sure it's the case now.
The Chairman: Not all, but I understand
most is.
Mr Almanza: Yes.
Mr Freestone: Significant elements. We are governed
by Sarbanes-Oxley. We have a US listing. The rules that we just
talked about actually take that into account.
Q336 The Chairman: I assumed it had
done, actually. Would you think there would be an advantage in
extending that here?
Mr Freestone: I think the Accounting Practices
Board is looking at this at the moment to establish whether the
line of what can and can't be done by audit firms is in the right
place. I think I'd wait to see the outcome of that study.
Q337 Lord Shipley: Can I just clarify?
I didn't fully understand whether each of those answers applied
globally or whether they were a UK answer. Do you apply the same
rules in all countries automatically?
Mr Almanza: Yes.
Q338 Lord Shipley: There's no doubt
about that and there's no first tier and second tier or anything
like that?
Mr Almanza: That's correct.
Q339 The Chairman: So that means
that if those of you who are in that situation have to abide by
the Sarbanes-Oxley Act, that's something you apply globally?
Mr ten Brink: Globally applicable, indeed.
Q340 Lord Lipsey: There is a balance
to be struck here because many companies see advantage in their
auditors conducting consultancy work for pretty obvious reasons.
They know the business already and, therefore, you're not having
to spend a lot of money, time and effort bringing them up to square
one. Do you think, in fact, the rules might have gone too far
and be a bit too tight?
Mr Freestone: No, I think there's a real issue
with audit firms conducting consultancy that then results in some
change to financial process or financial systems and then auditing
those. So I think actually that would not be sensible.
Mr Almanza: I agree. I don't think it's gone
too far.
Mr ten Brink: I agree.
Q341 Lord Moonie: The last question
that we have on this sheet suggests asking you what you think
would most assist in widening choice, but from your answers tonight
you don't really seem to think there's all that much necessity
in widening choice. So I was just wondering if there was anything
at all you would particularly like to change in this issue—
Mr ten Brink: Well, maybe the obvious point
to make is that as an international company the degree to which
we have consistency and alignment between the regulatory frameworks
obviously does help to create more of a level playing field. Will
that bridge the gap between the Big 4 and the next tier? I think
the reality is that it will require very significant investment
of a tier two audit firm to actually position itself as one of
the tier one firms. So, that reality is out there and undisputed.
Q342 The Chairman: Do you think there's
no way that a second tier firm could become a big fifth?
Mr Almanza: I don't agree with that. I think
they can, and my answer to that and to Lord Moonie's question
would be while we don't generally see a problem with four, we
certainly wouldn't like to see it go to three and we'd welcome
a fifth, and I think most FDs would say that. But I think this
is a question of investment by the second tier firms. There is,
as far as I can see, nothing preventing them from merging or investing
more in creating a global network. After all, the Big 4 arose
out of consolidation and it's not clear to me what's preventing
second tier firms from pursuing that strategy if that's what they
want to do.
Q343 The Chairman: But you've said
twice, Mr Almanza, that your fear would be of a Big 3 and that
you would not welcome that at all. If there became a risk of a
Big 3 or if it happened, what do we do?
Mr Almanza: That's a very good question. I'm
afraid I'm not sure I have the answer. I think something we have
discussed with the FRC before is that the regulator needs a contingency
plan, if we lost another firm, for an orderly transition of those
audit accounts to a new firm. And that seems to me to be a fairly
low cost, sensible idea that the regulator has a contingency plan
to assist the transition of those audit clients to new auditors,
although in many cases I suspect companies would be acting promptly
out of self-interest. But beyond that I'm afraid I don't have
a specific suggestion.
Q344 The Chairman: Anyone else?
Graham Roberts: The only difficulty with that
is that it needs to be on a global regulation position because
that's where the difficulty arises. If a firm is not there in
the US how do you get a US subsidiary audited? So it's actually
I think a combination of global regulators.
Q345 Lord Hollick: As members of
The Hundred Group, you're in a unique position to know what the
real concerns are today of the top 100 company finance directors
in this country. What are the one or two things that are right
at the top of your agenda about the audit process?
Mr Almanza: Do you want to answer this or should
I?
Mr Freestone: You have first go.
Mr Almanza: It sort of picks up a theme from
the previous two answers. Something that concerns us deeply is
the idea that we'll end up with multiple regulatory regimes, one
in Europe, one in the UK, and for those that are dual registered,
another in the US. We are following closely and with some concern
the EU Green Paper on auditors. There are aspects of that that
I think overlap with what we've discussed today. What would we
welcome? We'd certainly welcome improvements, but I think we would
say more regulation is not necessarily better regulation. So harmonisation
of regulation between Europe and the UK would be high on our agenda
insofar as the role of auditors is concerned.
Q346 Lord Lawson of Blaby: But on
that front, what's your biggest specific concern about the EU
Green Paper?
Mr Almanza: I think I'm concerned about the
notion that regulators will appoint auditors rather than audit
committees. I'm concerned about mandatory joint audits. I think
that, as I said earlier, there's no reason to prevent second tier
firms from consolidating if that's a strategy they wish to pursue.
I think that there is a risk there that we create regulatory capital
for second tier firms. So, for one, I don't support that. Those
would be two factors I would highlight. Robin?
Mr Freestone: Well, I think on the joint auditors,
the worry then, of course, is that that means that in looking
for a firm to provide consulting services you've got a choice
of two if you want a firm to do that internationally for you.
So you've then effectively locked out two firms if you have joint
auditors, which is unhelpful in the context of what we've just
talked about. So I think that is a worry.
Q347 Lord Tugendhat: May I ask a
different question? I address it to Mr ten Brink, if I may. The
banking issues are all fresh in our mind because the crisis occurred
recently. Rather longer ago Shell had a problem over its reserves,
as I recall, and the details of that are much less clear in my
mind. But basically, as I recall, the problem was over the assessment
of your reserves and the reporting of them, and a senior Managing
Director and your predecessor or whatever, maybe predecessor but
one, I don't know, lost her job as a result. Now, could you tell
us in that particular issue when the figures, to quote somebody
a moment ago, were spectacularly wrong, what was the role of the
auditors? Did they spot a problem? Did they warn of a problem?
Was there any fallout on the auditor's reputation as well as on
the top management at the time, or was this rather like the banks,
an event where a bombshell occurred and it emerged that the auditors
had been blindsided by it?
Mr ten Brink: Maybe two points to make. The
first point is that the disclosure of proved reserves is in actual
fact not in scope of the audit assignment. So the auditors did
not have a formal role to play in that particular case. I guess
I would point to the fact that the company self-declared the misreporting
of proved reserves, this was not by an external event that it
got recognised. It was internally that the management and the
board actually took its responsibility to provide openness about
the situation and then institute an independent investigation
to determine the causes and the extent of the issue. It's a rather
different context, I believe, in terms of circumstances and what
has occurred.
Q348 Lord Tugendhat: I know there
have been all kinds of changes in the company, partly no doubt
as a result of that and partly because you've changed your structure
and so forth, but do the auditors have a role now in relation
to the assessment and reporting of reserves?
Mr ten Brink: They do not have a formal role
in that process, so that's subject to limited audit requirements.
There is an independent review through a reserves committee, which
is constituted in the company, which reports ultimately to the
audit committee. So that provides an independent assurance in
terms of the correctness and completeness of the numbers that
we disclose.
Q349 Lord Tugendhat: And who does
that?
Mr ten Brink: That's a group of fairly specialist
people with particular expertise around making these kinds of
assessments, both from a technical and a commercial perspective.
Q350 Lord Lawson of Blaby: Sorry,
are they employees of the company?
Mr ten Brink: They are employees of the company.
Lord Lawson of Blaby: Right, so they're not
independent?
Mr ten Brink: They provide an independent line
of assurance to the audit committee.
Q351 Lord Tugendhat: I see. Do you
see any similarity at all with the problems that you ran into
over the reserves? What's in my mind is that here we had the banks,
I'm thinking particularly of Northern Rock, perhaps, where it
had a very particular business model that everybody praised at
the time, I quite agree, the shareholders and everybody else.
And it collapses and the auditors hadn't given a breath of warning,
nor did others, I quite agree. But I was wondering whether you
saw any similarity between this enormously embarrassing incident
in your corporate history and the problems that have afflicted
the banking industry.
Mr ten Brink: Indeed, a serious problem for
the company, one that in the context of the profitability had
somewhat limited impact on the financial results that we reported,
so I would find it difficult to draw the parallel with a bank
that ultimately collapsed in this particular example that you
quote.
The Chairman: Gentlemen, we've covered
a wide range this afternoon and it's clear that there are in this
some big and difficult issues with which we're grappling. If in
the light of this exchange there are any other points that you'd
like to put to us in writing, please do. But meanwhile, we thank
you very much for your contribution this afternoon.1
1 Questions 352, 353, 354 and 355 unallocated.
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