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

Examination of Witnesses (Questions 291-351)

Mr Ashley Almanza, Mr Robin Freestone, Graham Roberts Esq and Mr Martin ten Brink


  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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