Examination of Witnesses (Questions 403-446)
Mr David Pitt-Watson, Mr Paul Lee, Mr Iain Richards,
Mr Guy Jubb and Mr Robert Talbut
11 JANUARY 2011
Q403The Chairman: Gentlemen, good afternoon and thank
you very much for coming to this Select Committee meeting of the
Economic Affairs Committee. As you know, we are coming rather
towards the end of our inquiry and I think we are particularly
interested in having your views on the subject of our inquiry
this afternoon because we haven't really looked at this to date.
I just have to say at the start that copies are available of Members
of the Committee's entries in the Register of Interests and also
those that they have declared as relevant to the inquiry. I should
be grateful if you would speak loud and clear for the benefit
of the webcast and the shorthand writer. Since there are five
of you, if one of you responds first to the question and you all
agree, you don't necessarily have to say that; just nod or keep
quiet. But we're happy to hear from all of you. I should like
to begin with the first two questions that are fairly general
and I think will probably be setting the tone for some of the
subsequent, more detailed questions that you will be getting.
The first question is: is the standard audit report useful to
Mr Richards: Perhaps if I start on that one.
The audit is valued. The audit report adds little value of itself
and it tends to be fairly anodyne. The times that it tells us
anything, it signals anything, it's often far too late in the
day and very often when an issue does arise you have a history
of clean audit opinions behind it. It is binary, yes or no. There
are some other elements of the audit that get reported on, some
on an exceptional basis, and I think there is considerable scope
to enhance audit reports and make them far more useful to shareholders.
Q404 The Chairman: Well, we will
be following that up, how you can enhance the audit reports, but
is that a general view? When you say the audit is valuable, you
mean the underlying work done to produce the standard boilerplate
stuff in the annual reports?
Mr Richards: The general concept of an audit.
There obviously have been concerns about some individual audits
and concerns about the nature of audits under the standards, but
the fact that we have an audit is valued by investors.
Mr Pitt-Watson: Chair, may I expand on that?
I think audit and accountancy are absolutely fundamental to the
integrity of our capital markets and the good governance of our
companies. In the UKand this is different from other countriesthe
role of the auditor is to provide the information necessary to
allow shareholders to play their role as owners of the company.
The existence of the audit in itself, like the existence of lots
of information, does not require that it's given to the shareholder
and then the shareholder acts. The very fact that this is going
to become a document that is given to shareholders changes the
behaviour of companies and, in that sense also it, is fundamental
to the good governance of companies in this country.
Q405 The Chairman: As you know, this
was a quote from a Hermes publication and it seemed to raise the
question that one was really doubting the standard audit report
but it wasn't querying the underlying work that's gone into it.
Mr Lee: That's absolutely right.
Mr Jubb: One of the challenges for investors
is that the output of the audit is the audit report and that is
what we see. We have very little transparency currently as to
what the actual audit process involves. This is where the audit
committee clearly plays a very important role on behalf of the
board and on behalf of shareholders, but it is the audit report
that is the aspect that investors ultimately see. As my colleagues
have referenced, the reliability that we have to place upon audited
financial information is the lifeblood of capital markets. If
we didn't have an audit that would clearly be a matter of great
Mr Talbut: If I may just add on that one. The
point is that the more information that is going to be available
to shareholders the better position that shareholders are in to
be able to discuss that information with members of the audit
committee or elsewhere within the company and, therefore, discharge
their duties as institutional shareholders of the company. I think,
in particular, that the type of information that would be extremely
useful to understand within a better quality audit report would
be issues where there have been questions of judgement, perhaps,
or nuance within the report and accounts, or where the particular
issues were where there might have been more contention between
the company and its auditors. Because those are types of things
that it would be much easier for shareholders then to be able
to have further questioning on and, as I say, properly discharge
Q406 The Chairman: Well, I think
that's of interest to this Committee as well because we would
be interested to know your views as to what kind of information
and where the relationships aren't quite right at the present
time. We will be following that up. Does anyone else want to add
anything on the actual report?
Mr Jubb: You asked about the usefulness of the
report. Let me just take it one layer down into the content of
the report. One of the criticisms that I think most investors
and certainly we have of the audit reports is that they are very,
very standardised in their content. They are oftenI have
used the expression elsewhereriddled with "get out
of jail free" clauses in terms of what is in there. The aspects
that colleagues were referring to, such as matters of emphasis
just to help guide the investor and reader, would make the audit
report a good read rather than otherwise.
Q407 The Chairman: As you know, we
have been partly looking at the question of audit market concentration
in the Big 4 and I think it would be fair to say that we are getting
quite a lot of concern from a number of our witnesses on those
grounds and particularly, of course, if the Big 4 came down to
the Big 3. I'd just like to know from the investors' point of
view whether this audit market concentrationwe note also
that there are very rarely changes of auditors among the FTSE
350 and especially the FTSE 100, so there is a longstanding relationship
therecauses unease among investors.
Mr Lee: Shall I take that first? Absolutely
it does. I think the major concern is the lack of competition,
but particularly the lack of competition on audit quality. I think
it was very clear from the evidence that you received from the
Hundred Group that the only competition that they experience is
on price and certainly that is all that we are aware of occurring
in the market. Part of the problem is the invisibility of audit
quality. We've all referred to problems with the audit report
not providing useful information. That's just an example of the
lack of information there is about audit quality. In the absence
of that information it's no wonder that there's no competition
on that topic.
Mr Jubb: Could I add a slightly different shade
to that, because from our standpoint, while we believe strongly
that the concentration of audit markets is fundamentally unhealthy
and represents a systemic risk that has the potential to undermine
confidence, it is not so much the competition issue but it is
the lack of choice that is the area of particular concern to us.
We made representations to the European Commission and others
in 2009 asking them to address this particular issue with a sense
of alacrity. But we have come to this position where we are no
longer comfortable with relying on market forces to create the
resolution to this. We do believe that there has to be some regulatory
or governmental intervention. We have waited a decade, give or
take, for market forces to make a change and the strength of the
oligopoly is not making any progress.
Q408 The Chairman: Quite a bit of
the evidence we have had suggests that in the global market in
which so many companies, particularly in the FTSE 100, now operate,
you do need to have that global reach from the auditors. That's
a very expensive thing to provide. A great deal of expertise is
required worldwide and this very much restricts the scope of any
others entering the market. Have you any comments on that?
Mr Talbut: A particular point that I would emphasise
on that one is that while we may well accept that with some of
the very largest, the most international, companies, that is a
reasonable argument, we don't believe that that, therefore, applies
right the way down the size scale. The degree of concentration
within, for instance, the 250 companies within the UK is broadly
similar to the degree of mix within the 100 companies. Now, I
think that there are many, many companies within the 250 where
those arguments of extreme complexity and extreme internationalism
of the business just does not apply at all. But it doesn't appear
that the market is operating, even within those sub-100 companies,
to introduce a greater degree of competition and choice. I would
echo the point that has already been made; we don't believe that
reliance upon market forces will bring about any fundamental change
in this marketplace whatsoever. There have been plenty of opportunities
over the last 10 years or so for there to be and the Market Participants
Group came up with a set of other possible recommendations that
should be implemented. I would still observe that there is relatively
little movement taking place in terms of the degree of concentration.
That is why I would certainly support the idea of, within the
250 companies at least, a forced degree of intervention in the
marketplace to lessen the grip of the Big 4 within the marketplace,
to be overseen by the FRC, so that there is a reasonable opportunity
of starting to create another organisation that can take on a
number of audits. Given the fluidity between the 250 and possibly
moving up to the 100, that would, over time, I think, bring about
a better opportunity of improving competition and choice in the
larger companies as well as the 250 companies.
Mr Lee: Robert is absolutely right that the
argument about internationalism doesn't apply to many companies
in the 250. There are certainly a number of companies in the FTSE
100 to which that argument does not apply. Admittedly, many are
very multinational but not all are and it would be entirely possible
for certain of them to be audited by a decidedly smaller, less
Mr Jubb: To develop the theme further, we have
suggested to the European Commission that it should send a clear
signal to the Big 4 networks to give the Big 4 networks time within
which to organise their affairs in a way that will enable the
global service to be provided but, at the same time, will enable
greater choice without prejudice to audit quality; but within
that message make clear that it is prepared to intervene in order
to take action in the event that the Big 4 and other firms do
not take action consistent with that objective.
Q409 The Chairman: I think it's clear
that a lot of the recommendations, many of them quite small, that
have been made in the last 10 years have not produced much result.
Is that what's driving you to looking for more of a regulatory
or even legislative solution?
Mr Jubb: Yes.
Mr Talbut: We have been talking about this issue
for years and years and there is no movement whatsoever. There
is no change in the concentration and there appear to be far too
many vested interests in preserving the status quo.
Q410 Lord Lawson of Blaby: Have you
put your specific proposals in writing?
Mr Richards: Yes, and I've handed them to the
clerk ahead of the meeting. If I may, I fully agree that an ultimatum
has to be given to the Big 4 that the market needs to change with
a specific deadline and some measures agreed in terms of the targets
for change, but that of itself won't be effective. Within the
markets, there are some very entrenched perceptions in audit committees
that the Big 4 is what you need to go for. That is reinforced
by the fact that investors and the markets prefer the Big 4. In
the absence of any real insight into the audit, big is safe. So
the market punishes people who don't go for the Big 4. The bankers
take exactly the same approach. You may have seen there's been
a debate around some of the clauses in debt instruments requiring
the use of Big 4 firms. So there is a very persistent attitude
throughout the market and through the players in this dynamic,
all of whom tend to focus too much on the Big 4. So just tasking
the Big 4 without changing other things isn't adequate. There
needs to be a wider range of change. Audit committees need to
be forced to be much more transparent and thoughtful in what they're
doing, and the audit committee report does need to be beefed up.
Equally, the position of investors and shareholders needs to be
addressed and one of the ways of doing that might be to ask the
FRC to review the stewardship code to incorporate this whole area
of auditing and accounting more specifically within it. But unless
there's a package of reforms, any one reform is unlikely, of itself,
to be effective.
The Chairman: I'm afraid the Committee
haven't seen the written evidence that you've given. Certainly,
if we have any further questions on it, we would like to come
back to you.
Q411 Lord Moonie: You say that it's
not price that you're concerned about but quality. Surely, if
appropriate external standards are set and rigorously applied,
the number of firms available to you is largely irrelevant because
the appropriate standards are being applied anyway. What counts
is that you have an audit committee that does its job.
Mr Richards: If I may come back on that, I think
there are two things. Between the Big 4 dominance of the markets
and standards that have become much more process-orientated, the
audit has become commoditised. So competition does not appear
to be around audit quality. That seems to be confirmed by the
ongoing findings of the Audit Inspection Unit that has repeatedly
raised concerns about the appraisal of audit partners or Big 4
firm partners, which gives inadequate emphasis to audit quality
compared to other things. I believe, in its most recent report
in relation to PwC, it noted that the proportion of KPIs for partners
relating to business growth had been increased from 25% to 40%,
while those relating to quality had been reduced from 25% to 20%,
and there are a number of other indicators that illustrate the
emphasis away from audit quality.
Q412 Lord Hollick: Mr Richards, you
mentioned that investorsnot your exact wordstake
comfort from the fact that one of the Big 4 is auditing a firm.
Is there any evidence in the experience of the four firms you
represent that companies are punished in any way for not having
one of the Big 4 or that you avoid making investment in them because
they don't have one of the Big 4 audit firms?
Mr Richards: Perhaps I may give an example of
the opposite. It was a case where we didn't own any of the shares,
Sanctuary. The auditor was a tier A firm that was seeking to blow
the whistle on bad practice, accounting problems and internal
control failures within the company. It was sacked by the directors,
who brought in a Big 4 firm. The shareholders said nothing. There
was no issue made of it. There is anecdotal evidence that people
in discussions persuade companies perhaps to go the other way
and also in the market reaction, which is something that the academics
have looked at. There is evidence of it.
Mr Lee: There certainly is a perception that
investors favour the Big 4 and one thing that we and five other
institutions, including Iain's, did five years ago was write to
all the FTSE 250 companies and say essentially, "It is not
necessary, in our view, for you to be audited by one of the Big
4. Please take a look at the tier A firms". In the five years
since, the one thing that has happened is that the market has
moved entirely in the other direction. So not only did we get
a very limited response to our letters; the reaction over time
was entirely contrary to our aspirations.
Mr Talbut: When surveys have been undertaken
of the attitude of institutional investors towards the Big 4 and
other, say, tier A organisations, it is true to say that there
is a perceived issue with respect to the very largest companies
going for an organisation that is not one of the Big 4. It's not
a majority at the moment but there is an increasing proportion
of shareholders who would say they would be quite comfortable
if a tier A firm were to be doing the audit of certain, say, mid-sized
type of companies. But that information does not seem to being
acted upon by audit committees or the board as a whole.
Mr Jubb: It is relevant to share with you that
very little engagement takes place between audit committees and
institutional investors about choice of auditors and audit matters.
Last month the Institute of Chartered Accountants of Scotland
published a document called The Future of Assurance. Declaring
an interest, I was Deputy Chairman of the Working Group that developed
the document. In line with the point made by my colleague, it
has recommended that there should be included in the UK Stewardship
Code for Institutional Investors a principle whereby institutional
investors, for their part, will engage with companies and thereby
audit committees about the quality of corporate reporting. But,
equally, there is a suggestion in that report that every five
years the audit committee should undertake a detailed evaluation
of the service provided by its auditors and engage with its principal
investors to discuss the findings of that so there is a forum
for the dialogue to take place about the suitability of auditors
and indeed the very quality of the service that is provided. That,
sadly, is not currently taking place.
Q413 The Chairman: You expressed
your concern about the dominance of the Big 4. How much evidence
is there that that dominance is actually detrimental to investors?
Mr Jubb: The evidence is perhaps embedded in
your opening remarks in terms of the common sense of the issues
concerning what happens when you have the Big 4 and it then goes
down to the Big 3 and the Big 3 then become the Big 2. There are
inherent issues in terms of the issue of liabilitywhich
I know is a very important part of the equation and is part of
the solution that needs to be considered. In particular there
are issues as to the attitude of regulators and others in terms
of taking action which could bring down one of the Big 4, or indeed
one of the Big 6 even, in a manner that would precipitate the
consequences that judgement suggests is not going to be healthy
for the capital markets and could undermine confidence in them.
Mr Richards: If I could add to that; the other
aspect that is significant for investors is the commoditisation
of the audit versus the reliance that we place on the audit to
provide not just the internal discipline but the external signalling
when it is appropriate. If you look back over the crisis and you
look at the lack of signalling given by auditors and what happened
to the banks, there has been a problem.
Mr Lee: I will take that slightly further. I
think possibly we are seeing some complacency among the Big 4
firms. Iain has already referred to the work of the Audit Inspection
Unit. A lot of what it discovered was the Big 4 pushing at the
edges of the ethical standards, for example; trying to see what
additional non-audit services they could squeeze in under the
radar. These sorts of activities, I think, are a sign that the
Big 4 are confident in their market position and don't feel the
need to maintain standards quite at the height that we would wish
The Chairman: We would like to come back
to the point about the banks specifically on its own because,
as you may have noticed, we have been having a lot of evidence
Q414 Lord Smith of Clifton: Gentlemen,
following on from the last set of questions, what would you say
should be the minimum number of active audit firms needed to constitute
a genuine competitive market for the audits of the FTSE 350 companies?
Mr Richards: It would be very easy to sit here
and say that we would love to have the Big 8, the way we did back
in 1987. The reality is that it is not particularly feasible.
If you look at the largest firms, you would have to merge the
next six audit firms in size just to equal the smallest of the
Big 4. If you did that, you would then also risk leaving an even
bigger gap between the then Big 5 and the rest. You may potentially
raise issues, particularly if they are going to throw that resource
at trying to capture large company audits, in reducing the choice
for smaller firms. In terms of trying to tackle this issue, I
would hope to see a range of packages that would see another Big
5 firm evolve and, if we are lucky, potentially a Big 6. But I
think you have to be progressive about that to avoid unintended
consequences for the medium and smaller size companies.
Mr Jubb: Having been in complete agreement perhaps
thus far, perhaps I may inject a bit of differential opinion.
I am not quite so reticent about suggesting that one can have
a larger number of major networks beyond five or six. I do recollect
and I did operate in the days of the Big 8 Plus 2. It is useful
to remember incidentally there were Plus 2 in those days as well.
In terms of the approach that I was articulating earlier whereby
the major networks should organise their affairs and be given
time to do thatand that will obviously involve discussion,
in part, with their clientsI believe it is in their gift
to organise their affairs in a way that could have a larger number
than just the five or six global networks. I am not of a view
that one should stipulate what the number should be but I am entirely
clear that eight was a comfortable number. When we had eight I
felt that we had choice.
Q415 Lord Lawson of Blaby: The normal
thing to do when you have lack of competition and a fear, which
you have voiced, of excessive concentration is not to promote
mergers among smaller companies but to split upbust, trust-bustthe
large ones. I am surprised, given the views you have generally
expressed, that you have not commented on this. The other thing
that is related to that is that obviously this is an international
business. The United States is particularly important. The United
States has a great history of being interested in trust-busting
of one kind of another. Is there any movement, as far as you are
aware, in the United States of concern about the concentration
and a feeling that some kind of trust-busting might be in the
interests of the economy?
Mr Richards: An in-depth study was done by the
Government Accountability Office in the US--I cannot remember
off the top of my head whether it was in 2000 or 2002--that identified
all of the types of issues that are being debated today but it
did not come up with any specific recommendations in the terms
of the cost-benefit analysis. It didn't see the case as being
made and, in the absence of a sufficient problem with anti-competitive
practices, didn't feel that intervention was warranted; though
it noted that it was a situation that needed to be kept under
review. I am not aware, other than a subsequent review by the
American Anti-Trust Institute, that there has been any other detailed
examination in the US that has been published.
Mr Talbut: If I could come back directly on
your point. My comment earlier on was very much along the lines
that the organisations should be compelled to give up market share.
That is not necessarily about splitting one of the Big 4 up but
I think if you were to move down that road you could create a
fifth or a sixth organisation over a reasonable period of time
and that would have the effect that most of institutional investors
would like to see.
Mr Lee: I am not sure whether, in the context
of a dynamic such as we are talking about, you wouldn't see partners
shifting from one of the existing Big 4 to the fifth or the sixth
and leading to that effect without the need for trust-busting
in any form.
Mr Jubb: The views on trust-busting were also
inherent in my earlier remarks but it is perhaps the threat of
trust-busting, along the lines I have previously suggested, which
may help to deliver the solution in a way that causes the larger
networks to move forward. In terms of the global and US aspects,
we believe that this approach should be championed at the G8 or
G20 levels in order to provide some leadership and indeed the
requisite commitment. We would observe that a network is only
as strong as its weakest link. Even if the UK, of itself, were
to take a bold step in this regard, that could provide some form
of catalyst for change that would otherwise have wider, global
Q416 Lord Lawson of Blaby: You have
not answered one of my questions. Do your opposite numbers in
the United States share the concern that you have voiced today?
Mr Jubb: We and a number of my colleagues here
do engage in informal discussions with other investing institutions
in the United States. Also I Co-chair the Global Auditor Investor
Dialogue which brings together a number of major global investors
in the United States and in Europe with senior representatives
of the Big 6 auditing networks to converse informally on policy
and practical issues. Two years ago a working group that was derived
from the Dialogue developed some Disclosure Guidelines, which
I shall gladly submit as evidence. They were designed to assist
directors and audit committees regarding what should be disclosed
on audit matters. Among other things, it dealt with the issues
associated with the rotation and selection of auditors.
The Chairman: It would be very helpful
if you could let us have that.
Mr Jubb: I would be very pleased to do that.
Mr Richards: If I could just add to that; the
large focus in terms of action in the US in relation to auditors
tends to be after the horse has bolted, in that they then sue
them. That tends to be the focus in the way market investors decide
their reaction to and interest in the audits. In terms of the
engagement with auditors, I believe that the situation and access
to the whole debate is much harder over there than it is here.
Here we can, at least at times, get access to audit committee
chairmen. It is not as easy in the United States.
Q417 The Chairman: In terms of the
Big 5, I think one suggestion that has been put to us is that
the Audit Commission might become one of the Big 5. Have you any
comment on that?
Mr Richards: I am not aware enough of the Audit
Commission and its work to have a well-founded view about that.
The Chairman: Fair enough.
Q418 Lord Shipley: Can I move us
on to your views on the mandatory rotation of the audit firmsmaybe
five, maybe seven years or whateverand whether you think
that might improve independence and quality? Might it also encourage
firms that are non-Big 4 to become more active in the large company
Mr Richards: I look around. "No",
I think, is a fairly common answer you will get from shareholders.
We believe that it risks being detrimental to audit quality. If
I can characterise this rather crudely; if you appoint a new auditor
in a reasonable-sized company they have a period of learning.
If that were to be, say, a year and a half before they were completely
up to speed and then they would have a period in which they provided,
if I can call it that, a full-service audit. Then they would have
a period at the end where their commercial interest would be to
rotate their best people on to new clients; so you would have,
if you like, a wind-down period. What you might risk ending up
seeing is three years of lower quality audits for every four years
of full-service audits. The other point I would make is that if
you require mandatory rotation there is no reason why, if I were
a company, I might not say, "This time I'll have PwC and
next time I'll have KPMG and the time after that I'll have PwC",
and so it goes on. So just mandating rotation would need to be
thought through very carefully in terms of the potential impact
to the quality of audit but, equally, just having rotation might
not change anything. Indeed, if you took it down beyond the mid-250
it might give the Big 4 a greater opportunity to expand their
current market dominance. So there is a whole series of issues
that give people concern about the proposal. Where we looked at
the issue, the next step we took was to consider whether there
should be mandatory tendering of the audit. But, again, many of
the issues were very similar and it wasn't clear to us that we
could make a strong case for it.
Mr Lee: We would actually disagree with the
perspective that changing an auditor reduces quality. The main
evidence that it might do so seems to come from a study by FEE,
which is the profession's own lobbying organisation in Europe.
The evidence that we have from the Audit Inspection Unit in the
UK is that audit quality improves in the first couple of years
of an audit because the audit firms put in a lot more work to
make it work. That is why we would be quite strongly supportive
of mandatory tendering. We would not be supportive of mandatory
rotation. We think the discipline of going out to the market on
a regular basis ought to be enough to drive people to look at
audit quality, as well as looking at price.
Mr Talbut: Something else I would like to add
in on that one is to refer to the fact that what we are looking
for here is not only greater competition but we are also looking
for greater choice. I think that simply looking for mandating
rotation does not seem to me to be attacking the idea of how we
introduce greater choice to the marketplace. By choice, what I
am referring to is trying to break away from the homogeneity of
audits that we have at the moment so that, prospectively, we have
organisations trying to compete for the audit on slightly different
criteria. Coming right back to some of our initial responses to
you, there does not appear at the moment to be the incentive or
opportunity for organisations to come up with innovative approaches
for how they wish to compete. We, as shareholders, have little
or no information on the basis on which an audit is awarded. At
the moment the prime criterion appears to be cost rather than
incorporating a lot of other criteria that we as shareholders
and other outside parties might like to see incorporated into
that decision-making process.
Mr Richards: If I can add to that, I think it
is not just cost. The term that is generally bandied around is
the value-added services that can be derived from the audit firm.
These are the non-audit services. One of the key interests from
our point of view is putting audit committees much more on the
spot; to make them much more accountable and transparent in the
reporting they have to make in the audit committee report to explain
what they have done in reviewing the audit relationship the non-audit
services; in reviewing audit quality; whether it should be put
out to tender. A whole range of information around that provides
shareholders with a much more qualitative insight into what is
really going on and the fact that this is being addressed in a
substantive and prudent way.
Q419 The Chairman: Would it not be
likely that if you did that you would get the same response from
the companies as you gave us in your first response? They would
demonstrate all the reasons why you wouldn't want to have a change
of audit in the same way as you said that mandatory rotation would
not necessarily lead to a better result?
Mr Richards: We recognise that there is always
a risk of boilerplates. That is what we have had to date, despite
some very good efforts to try and instil a bit more life into
audit committee reporting. Unfortunately there is always the influence
of the lawyers in the process and that does seems to get in the
way. I think the more we create a framework that calls for it
and articulates it effectively, the greater the opportunity for
us to engage and pin people to the table about some issues that
are important in this area.
The Chairman: I am bound to say I was
a bit surprised at your first answer because it seemed to me to
give a total justification for the situation we have at the moment.
Q420 Lord Shipley: Can we just be
clear whether everybody agrees with the position that has been
set out: there is mandatory rotation and there is mandatory tendering.
Earlier on this afternoon there was mentionI cannot recall
the precise wordingof the Big 4 getting too comfortable,
or something like that. I am not clear how you think that issue
should be addressed. Would mandatory tendering provide that extra
spur to making the Big 4 improve quality and independence and
Mr Talbut: From my perspective I don't think
mandatory tendering would have any impact in diluting the power
of the Big 4. I think you would simply find that the audit would
just simply go around those organisations that are homogenous
in terms of the service they provide. We need to think about other
solutions if we are going to try and dilute the power of the Big
4. Our position was that we were comfortable with the idea that
the audit partner has to be rotated because he has the prime responsibility
for the quality of the audit within the organisation. We are somewhat
ambivalent about whether rotation would have any meaningful impact.
Q421 The Chairman: Mr Richards, you
referred to the fact that it was a benefit to the Big 4 in terms
of their audit that they could provide non-audit services as well.
I know there are certain qualifications around that but, nevertheless,
most of them do in some form or another. Looking for something
that would help to break up the monopoly, would you make that
Mr Richards: I wouldn't make it impossible but
I think that there needs to be a much more rigorous look at the
area. The UK, in my view, has a relatively permissive regime.
Just by way of example, if you compare it to the French system
or the US system, you see the average ratio of non-audit fees
to audit fees in the FTSE 100this would be 2009was
a little over 40%. In France it would have been about 5%. In the
US it was just over 26%. In the UK the largest ratio of non-audit
fee to the audit fee was 380%. In France it was 44%. So there
is a very significant economic interest in higher-margin, non-audit
services. The Big 4 have very clearly stated their intention to
maximise that. This rolls back into our concern about the commoditisation
of the audit; the comments that have been made about loss-leading
and issues that exist around the use of shortcuts and managing
timesheets, discounts and so on.
Q422 The Chairman: I don't know what
the statutory position is in France and the USA. Perhaps you could
enlighten us as to why they have a different situation.
Mr Richards: In the US Sarbanes-Oxley was very
strict in prohibiting a whole range of non-audit services that
had been major revenue generators for the accounting firms. In
France the model is slightly different. You can provide only very
specifically audit-related services unless there is some compelling
reason. I can't remember the precise wording of the structure
but, again, it is quite prohibitive about non-audit services;
whereas the UK system encompasses all sorts of areas in terms
of corporate finance; IT and HR; internal audit, where they say,
"You can't do that little bit of it but you can do all sorts
of other parts of it". The whole area just seems obfuscated.
From our point of view the one that has been of particular concern
has been tax advice. Obviously as shareholders, when it comes
home to roost, we are the ones left picking up the tab. Where
you see FTSE 100 companies facing actions for recovery of sometimes,
billions in unpaid tax that has been unpaid due to whizzy tax
schemes, we would like to think that the one person in there being
sure that prudence is being applied is the auditor. Obviously
if they have been providing tax advice, tax management and planning
advice, there is a conflict.
Mr Lee: I am sure the Committee would not expect
me to agree wholeheartedly with what Iain has just said, not least
because I have been a member of the Auditing Practices Board throughout
the period that we've just been considering the issue of non-audit
services. What has come out of that process is a much greater
understanding of what is audit, what are audit-related servicesI
suspect that when we look at reporting out of the US and out of
France and other markets we see the audit bundled together with
these audit-related issuesand a much clearer breakdown
of what the genuinely non-audit services are. The conclusion that
we reached on the board was that many of the non-audit services
were appropriate to continue to be provided by the auditors. We
tidied up a number of areas and removed certain aspects. But the
big change that has come out of that review of the regulations
is a move to generate much more disclosure on the nature of non-audit
services provided by the auditors and that greater disclosure,
going forwards, will be very useful to us as shareholders in calling
the audit committees to account. I would agree with Iain that
the one area where there remains a question markthat is
a personal question mark in my own mindis on the issue
of tax. Certainly looking at the statistics that we have, that
is the one very sizeable remaining area of non-audit services.
That will, in time, be looked at again.
Q423 Lord Hollick: Several of you
suggested that the company's annual report should include a more
informative and direct report from the audit committee, which
could cover the reasons for choosing an auditor and the reasons
for going to a tender. It could also possibly lift the veil a
little on the discussion between the auditors and the audit committee
and shed some light in your cave on what were the particular issues
of concern. What would you like to see in this audit report, if
indeed you think there should be one?
Mr Richards: I think you have hit the nail on
the head with what you say because you have raised a point about
the key issues discussed between the audit committee and the auditors
that I would highlight from the list of recommendations that the
Scottish Institute has set out in its report that my colleague
Guy Jubb referred to, which is quite fulsome in articulating what
people would like and I think is extremely welcome. One point
that I would highlight from it is the one you make: that it needs
to include perhaps a summary of the key issues discussed between
the audit committee and the auditor.
Q424Lord Hollick: Would that not spook investors?
Mr Richards: This is a very interesting point.
It's one that is thrown out repeatedly. It is one that we have
had thrown in our face in questioning going concern statements
over the past few years. When the going concern statement was
first introduced it was the common assertion, "This will
force companies into liquidation; you will ruin them". The
ACCA did a study of it in the years that followed and found that
exactly the opposite happened. It allowed issues and problems
to be addressed earlier and, whether it was by way of an emergency
rights issue or a restructuring of the company, the survival rate
increased. Regrettably, we slowly drifted back into, "Let's
keep a lid on everything; sweep it under the carpet and hopefully
everything will be okay", and the going concern statement,
in my view, has been slightly debased.
Mr Talbut: I don't think it would spook investors.
It would help redress the balance somewhat in that the report
and accounts are starting to become marketing documents on behalf
of management rather than necessarily providing the type of objective
and, dare I say, prudent view as to how that company has been
managed over the previous period and what they believe the outlook
Mr Jubb: Shareholders would rather know the
truth and, in terms of how it is communicated to the market, if
there is a particular aspect that has the potential to spook the
market and spook investorsthis can be very critical in
financial services companies and the confidence that pertains
in those sectorsthen a great deal of care and thought has
to go in as to how the communication of these issues to the market
and to shareholders is handled.
Q425 Lord Lipsey: As parliamentarians
we are held to account by a website called theyworkforyou,
which analyses our voting records and so on and holds us to account.
In theory you would think the auditors should have a site called
theyworkforyou where you as shareholdersthe people
who, after all, are supposed to be getting benefit from this operationfind
out what they are up to. Instead of which what we find is very
short audit reports and a group of people who seem to be in an
extremely intimate relationship with the finance directors, directors,
the audit committee chairman and so on of the firms they are auditing.
Isn't there something wrong here?
Mr Lee: There is indeed something wrong. Possibly
the most useful thing that I have done as a member of the Auditing
Practices Board is to change the word "client" in the
ethical standards, which was the term that was used for the company
being audited, to the "audited entity". But that use
of the term "client" for the company being audited is
what every single auditor does and that is just the term for it;
whereas, in fact, shareholders are the underlying client and yet
we have no relationship and no real opportunity, as yet, to have
that relationship. There is an opportunity to change that. With
audit firm governance shifting, we may now have some non-executive
directors on the audit firms with whom to have a dialogue. We
are certainly eager to have that. The firms are moving slowly
in that direction.
Mr Richards: If I can come back. It's true that
there is a focus towards the shareholder and the audit but I think
we need to be realistic about what's implied by what Paul says.
It is a duty owed to the body of shareholders as this ephemeral
concept. It is not a duty owed to individual shareholders. So
there is no real direct duty of care to an individual shareholder.
It is to this nebulous concept of the shareholder body as a whole
and that creates a bit of a fudge in terms of our ability to engage
them. The more specific issue that comes up as investors is that
many of the types of conversations we might want would give us
access to privileged inside information and clearly that would
create issues for us that we would need to be very careful about.
Mr Pitt-Watson: Yes, I think you are getting
to the heart of some of the difficulties here because fundamental
to this is that the auditors are working for the shareholders
to help in the good governance of British companies. Actually
the auditors are appointed by the audit committee and with very
close relations to the finance director. Your question was: why
don't the shareholders create something called theyworkforyou?
Well, we don't have that for auditors. We don't even have that
for directors, which you might think was even more important.
In part that is because most of what shareholders are doing has
to do with the buying and selling of shares rather than the owning
of companies. The five people that you see here today are a very
substantial proportion of the resource of the investment industry
that takes any interest at all in auditing and accounting standards.
That may not be the way that we want the world. But it means that
the audit is even more important, because there aren't going to
be the thousands of people who work in the fund management industry
calling companies to account every time they hear a piece of news
that is problematic. We absolutely depend on the auditor who does
have substantial resource looking into the company and making
sure that it is presenting a full and fair picture so that people
behave in the right way without the shareholders having to intervene,
rather than because that report shows something that's problematic.
But your question is as much a question about the problems of
the fund management industry as it is about the audit industry,
Q426 Lord Lipsey: I was going to
say if you think of the sort of thing that might happenif
shareholders determined that they were going to change the nature
of the relationshipone thing would be, as I understand
it, that the appointment of the auditors has to be confirmed at
the annual general meeting. If there were more revolts against
that then you would find quite different sets of practices developing
among the auditors and the companies that employ them.
Mr Talbut: I suppose the point about that is
that we don't have the information on which to make a decision
about whether we should reappoint them to be auditors. It could
be seen as just a purely arbitrary or spiteful decision, "We've
just chosen you as a test case. We're going to boot you out".
Whereas I'd like to be in a position to have the information,
to have the dialogue and then make a decision as to whether I
would wish to have that auditor continuing to audit that particular
company and producing the audit report.
Q427 Lord Lipsey: You might have
to be rather robust in the examinations if there's something arbitrary
about it and just give it a go on a few occasions, particularly
where there is some obvious piece of evidence that the work hasn't
been done right.
Mr Richards: The problem is that although we
do; the difficulty is not enough of us do and we vote against
a notable number of audit appointments during the year. It can
be for a variety of reasons relating to the audits and to the
accounts. But I think companies know that we are in such a small
minority that they shrug their shoulders. We did have some discussions
and raised the issue that maybe shareholders should be involved
in the selection and appointment of auditors, using a model similar
to Sweden. I have to say that the reaction among the investment
community was less than enthusiastic. I think there is a certain
element of truth that currently the investment industry doesn't
have the resources, time or the skills or indeed inclination to
do that but it's certainly something that might be thought about
in the future.
Mr Jubb: This relates to the suggestion, as
previously mentioned, that as the Stewardship Code evolves--because
auditing is central to good stewardship--there should be a principle
in the Stewardship Code that provides that those institutions
who sign up to it do adopt a higher duty of care and engagement
on audit and corporate reporting matters.
Q428 The Chairman: I'm very anxious
that we shouldn't take up recommendations that will lead, as in
the past, to nothing happening in practice. If I could just explore
this one a little bit further. I think it would be fair to say
that the item at the annual general meeting dealing with the appointment
of the auditors is the one that goes through fastest and without
any questioning in practically every case. Would recommendations
along any of these lines make any difference?
Mr Jubb: I believe that they would in terms
of the engagement and the understanding that goes into the decision
that institutional shareholders make to approve or otherwise the
election of auditors at the AGM. You will be familiar with the
way in which corporate governance and stewardship operates in
the UK, whereby part of the role of the institutional investors
is to exercise influence so that resolutions that come to the
AGM meet with their approval. At the moment, as colleagues have
indicated, we do not have sufficient information. By putting into
the code a principle that we subscribe to, it gives our clients
and others a basis on which to hold us to account as time goes
by. That hook of accountability is not currently there and if
it were adopted, in that way or some other way, it would enable
progress to be achieved.
Q429 The Chairman: Would that be
a general view of the other four or other three institutions?
Mr Pitt-Watson: Yes. I was a partner in Deloitte
for a number of years. I work for Hermes now and I speak very
much here in a personal capacity. I think there are things that
you can do--it's really important that they are done--that nudge
the audit towards doing what it "says on the tin"; (That
is the governance role we discussed earlier) But that is quite
difficult to bring about. Some nudges could be structural with
the involvement and shareholders and all the rest of it. I think
probably many more of them have to do with the role of the audit
and the regulator, which I know Lord Lawson has taken a great
interest in, and also what the audit is and the insistence for
example, that the audit is, for the shareholders. What Paul did
at the FRC is extremely important: that the Big 4 don't think
that the client is the company but they do think that it's the
shareholder; that the principles are true and fair. We`ve talked
a lot about prudence, but the accounting principle of prudence
is a principle that's been changed for neutrality. That needs
review. We want to watch out for those sorts of things and I think
that your Committee might want to focus on those as well as on
the structure of the industry.
Q430 Lord Moonie: What, if anything,
do you think can or should be done to promote shareholder engagement
in the appointment and reappointment of auditors?
Mr Jubb: It has been suggested in this Institute
of Chartered Accountants of Scotland report that every five years
the audit committee should engage with its principal shareholders
about the quality of service and other aspects surrounding the
auditors and the relationship that subsists. If that approach
were adopted as a matter of good practice, it should enable a
sensible dialogue to take place and enable shareholders to exercise
influence, consistent with their responsibilities, either to institute
change or otherwise. At the moment, sadly, that dialogue, as we
have represented, doesn't take place.
Q431 Lord Best: You think that UK
corporate governance is too light in this regard. What changes
would you wish to see; aspects of the UK Corporate Governance
Code becoming mandatory; in particular the question of whether
every FTSE 350 company should have an audit committee? I am just
picking up various points that you were making on audit committees.
Mr Jubb was saying that they don't consult and talk to the investors.
The audit committees don't add that line of communication and
Mr Richards was saying that they sometimes are the ones that insist
on the Big 4, on continuing the concentration. I didn't get the
impression that you felt very strongly that audit committees,
as such, would make a huge difference to anything; a mandatory
requirement for them.
Mr Richards: To the best of my knowledge I can
think of only one FTSE 350 company that doesn't have an audit
committee, which is Daejan Holdings, which is effectively a family-controlled
company even though it's listed. Four of the five directors are
family members. There is not even a single independent director
and they've decided that the whole board should act as the audit
Q432 Lord Best: Is this the whole
350 you're talking about? Only one in the whole of the 350?
Mr Jubb: In 1979 I wrote an article for the
Journal of Accountancy called The Objectives and Advantages
of Audit Committees and I was informed regarding that by Sir
Brandon Rhys-Williams, who was a member of the House of Commons.
At that time audit committees were not prevalent in the United
Kingdom and he made particular representations in the House of
Commons to encourage progress. To a large extent, following Sir
Adrian Cadbury's Report on the Financial Aspects of Corporate
Governance, we now enjoy audit committees being, as we have indicated,
throughout the FTSE 350. What we are lacking is the communication
and dialogue regarding the work that the audit committee does
on behalf of the board and on behalf of shareholders as well.
That is very important to the future.
Mr Lee: When the European Commission, a few
years ago, proposed making audit committees mandatory across the
EU we opposed it simply because introducing mandatory requirements
into corporate governance in some way absolves shareholders of
the responsibility to get involved and to change things that they
don't like. We'd far rather that the responsibility sat very clearly
on the shoulders of the shareholders to seek the governance structures
and frameworks that they want. That would be our perspective on
any move in that direction.
Q433 Lord Smith of Clifton: The problem
is that one reads countless articles in the financial press of
shareholder passivity, which you gentlemen represent presumably,
and you can't have it both ways. Either you are going to be active
or some other check has to come in.
Mr Lee: My colleagues have already suggested
that there is an appetite among shareholders to be more active
on these issues around audit. The problem historically has been
that investors simply don't have the information, either about
individual companies or frankly about the market as a whole. That
means that the individuals who might become more active in particular
institutions feel uneducated, under-informed and, therefore, unable
to make difficult judgements. That is now changing. We hope it
will change further as audit committee reports improve and as
audit reports also improve. Once we have the basis to take judgements
and decisions, those judgements and decisions will be taken and
they'll be taken actively.
Mr Pitt-Watson: But even at that, Paul, we still
need to address the issue of investor passivity. I'd have to say
I would excuse my four colleagues here; these are people in the
investment industry that devote their lives to trying to be proper
active investors and hold companies to account. But I think if
the Committee is thinking about how much you can place on investors
picking up the baton and running with it, I think you need to
have a degree of scepticism about just how much will be done.
I think the story that Mr Richards told you about an audit appointment
would be one that I would bear in mind in thinking about this.
It's not that all of us in this room wouldn't want to see more
action. It is just that the fact of the matter is the structure
of the market is mainly about the trading of shares rather than
about the owning of shares and it's in that ownership function
that the audit is fundamental to the integrity of the capital
Q434 Lord Lawson of Blaby: I absolutely
agree with you and agree with Lord Smith. Investor passivity is
the rule and activity is the very small exception. My very dear
friend, Alastair Ross Goobey, who used to work for me before he
went on to higher things, blazed a trail in investor activism.
But although he blazed that trail, and this was a long time ago
now, very few followed him. Therefore, I have to say I am not
optimistic of anything happening on that front although it would
be very desirable if it did.
Mr Lee: A few of us had the privilege to work
Q435 Lord Lawson of Blaby: Perhaps
I may move on to the issue of the banks, which is certainly the
area that concerns me most. We have been through a real banking
disaster and although there is no evidence at all to suggest that
the auditors were responsible for the disaster, there is equally
no evidence that they, in any way, reduced the disaster. What
is to be done to prevent a similar disaster in the future? I'd
like to start by referring backI hope I've not misunderstood
or am misquotingto something that Mr Richards said in this
very context. He said that there should have been some signalling
by the auditors. I should like to know exactly what he meant.
Mr Richards: If you look at banks, and many
people have, there were a number of issues that were very apparent
in the banking system that were of concern. Some of those were
the result of imprudent standards. I would highlight specifically
loan loss provisioning as an example of that. Some of the concerns
were slightly harder to put your finger on around things like
going concern. The issue has been that the audit has been rather
compromised in terms of the impact that IFRS has had on what scope
the auditor has to play. Just using the loan loss provision example,
if the standard says, "You will not make any provision until
the loss occurs", which is ultimately what IFRS IAS 39 says,
there is very little that the auditor can do to say, "Listen
management, you're not being very prudent about it". Having
said that, I noticed in the Daily Telegraph yesterday there
was a very interesting article about Santander finding its way
around IFRS to ensure that it remained prudent. I suppose technically
they may have been in breach of the standards; in this case, good
for them. The other issue within that context is that the standards
specify a process that shall be followed and then allow huge discretion
in the assumptions used. I'm thinking fair valuation here on the
mark to model basis. I will give an example. We had a company
chairman come in to see usa company we held more than 10%
ofabout a very significant valuation and he wanted our
view about it. It was very quickly apparent to us that the valuation
was not one we could agree with. The numbers and valuation had
been agreed with the auditors and the brokers. The assumptions
used in it were aggressive, with a capital A, particularly around
the volatility used in the model. The actual final number that
we agreed on was slightly over a third less in terms of the valuation
of the instruments. This highlights the issue and, having spoken
to members of the profession about this, you getand I will
characterise it slightlya finance director who approaches
the auditor and says, "What's the range of fair values that
would be acceptable under the standards?" The auditor might
say, "Well, it's between 70 and 140 and we think the reasonable
prudent number would be about 95". The FD says, "Thanks,
140 is just what I was looking for. Thank you very much",
and it's compliant with the standards. I'm exaggerating slightly
but the auditor is then in the invidious position of having very
little leverage under the way that the standards work to push
back on that. I know there are many auditors who have done a very
good job in some circumstances in trying to do just that, but
the auditor is operating in a system and is somewhat constrained
by the standards framework and the way it has developed. Clearly
the process-orientated model helps them with their liability exposures
and every time there is an audit failure, "At all material
times we complied with the standard", is the first thing
they will say.
Q436 Lord Lawson of Blaby: That is
interesting, but may I come back to the more general point? If
there is any signalling, if there is any querying of the going
concern--and it is suggested that this, in general terms, should
be nothing that shareholders should worry about--or if the accounts
are qualified in any way--the Big 4, in their evidence to us,
in fact, said, "We couldn't do that because banks depend
on confidence and the confidence effect would be so damaging to
the banks"do you believe that that is the whole truth
or do you believe that they did not spot what was amiss?
Mr Pitt-Watson: There's a sort of circularity
in this as well. I made a point about information. The fact you
know that information is going to be declared changes the way
in which you behave. If you are a bank and you think there's any
difficulty about your loan book and that that's going to be declared,
you would change what you would do in your business practice.
That is what we, as investors, and what we as society, are looking
for; not something where somebody says, "Oh, you're not a
going concern any longer. You're bust and the shareholders have
to dive in". So I would just think about that element. If
you ask the auditors about this, particularly if you ask them
privately, you might ask, "Look, I thought we had this true
and fair view that was supposed to be an override". In fact
this weekend I was emailing one of my former colleagues who is
a very senior auditor. He said he would agree that the true and
fair view should override the rules but it's difficult to put
into effect when a general rule is laid down so emphatically by
the standard setters. If you set that together with the point
that Iain has made about the behavioural situation that you're
in, where the company manager may want an asset valued highly
on their books, perhaps because their bonus might be based on
that, you've got yourself a really difficult issue. The importance
of being able to make sure that anything that we do is reinforcing
professionalism and reinforcing principles and that the rules
are there to help the principles is, I think, something that this
Committee might want to focus on.
Mr Richards: The FSA has admitted that there
was a problem here. There are areas that are properly accounting
but the difficulty with them in saying that something is true
and fair is that it doesn't necessarily reflect the risk involved.
This is where the concern around the relationship between the
auditor and the regulatory authorities becomes so important, particularly
in relation to things like prudential risk. IFRS is extremely
procyclical. It facilitated and exacerbated the credit bubble
and then brought it home to roost in the crash and crisis. The
issue then is that there were some very clear risks inherent in
what was reflected in bank accounts. They may not have justified
a going concern statement at a given point in time but the risks
were extremely material. There were valuations that frankly I'm
not sure were necessarily rigorously carried out on some instruments
where reliance on netting off against credit default swaps was
fictional given that the CDS markets, which hit US$66 trillion
at their peak, were 80% naked and the counterparties could never
have met their exposures. Reliance on an instrument like that
to support a toxic instrument that you are carrying on your balance
sheets is imprudent, in my mind, but it's acceptable and allowed
under the standards. The difficulty is, as these issues emerge,
over how they are addressed and just looking at a going concern
statement isn't necessarily the solution. There needs to be a
much earlier stage of involvement where the prudential regulators
can be involved. Equally, we would look to see the prudential
regulators being much more forthright and open to talking to the
auditors about their perception and awareness of risks that are
relevant to the audit.
Mr Talbut: From my perspective I think effectively
what I would guard against is the situation whereby we are afraid
to alter anything because in a crisis situation there will be
a problem. We would like to see changed behaviour in more normal
circumstances that makes it less likely that we will end up in
a crisis situation. Therefore, we think that the emphasis upon
prudence and taking a conservative approach has been considerably
lost in the way in which the accounting standards are operating
and in which managements want those accounting standards to operate.
Mr Richards: If I could add an extra point;
in terms of sweeping everything under the carpets, that has had
a material cost to the taxpayer and to shareholders. By sweeping
some of these issues under the carpets, distributions have been
made and bonuses had been paid that were imprudent. The gap and
the hole, in terms of cash, that resulted has had to be plugged
and double-digit billions of the money pumped into the banks went
to plug the gap created by both the bonus distributions and the
dividend distributions that were made just preceding the crisis
and some fairly significant capital raisings.
Lord Lawson of Blaby: Everything you
say seems to me to be absolutely fair and accurate and you have,
in fact, said that there was clearly some degree of audit failure
and yet nobody has been sued. It's true that in the United States
Ernst & Young have been sued over the Lehman Brothers auditing
but that's an isolated incident, so far as I'm aware, on the banking
front and it is in the United States. So maybe you accept the
view and indeed Mr Jubb did suggest that there is a particular
sensitivity in the financial services sector and, of course, that
sensitivity is highest in the case of the banks. I do understand
there is a point here about what would be the effect on confidence
and on the share value and on the viability of the bank if there
were to be a negative auditor's report. So we come back, as a
sort of fall back, to something you, Mr Richards, referred to
a moment ago and something which I have been very concerned about,
as you know, over a number of yearsI think I introduced
the requirement in the 1987 Bank Actprivate discussions
between the auditor and the regulator if the auditor has concerns
about a bank, but he feels, for the reasons I have just indicated
a moment ago, he should not qualify the accounts in any way but
he will go and speak to the regulator. That means that the auditor
is saying to the regulator things that he is not telling you,
as shareholders. I hope that does not give you cause for concern.
I don' know what conclusion we will come to but it is very important
that we should be satisfied that if we do think that this dialogue
needs to be beefed upit was rather watered down, so far
as I can see, when the change of regulatory authority from the
Bank of England to the FSA occurred; there was still an obligation
but it was a weaker obligation and, indeed, very much less happened
in the way of dialoguethat you would not be at all concerned
Mr Lee: We would not be concerned by such dialogue.
We would welcome it.
Mr Pitt-Watson: Indeed, I think there might
be more to your proposal as well, Lord Lawson, both in terms of
what the issue is and what we might do about it. Also I think
it is something on which we might be able to get political consensus.
In the first half of last year I was part of the Future of Banking
Commission. It was sponsored by Which?, but it was chaired
by David Davis. Vince Cable was one of the members, as was John
McFall. So it was a cross-party commission and, like you, we were
investigating the role of audit; although not in as much detail.
I noted and we were concerned that the managing director of the
FSA told us that, in thinking about the audits of banks, it is
not the purpose of the audited accounts to forecast potential
losses on loans. It seemed to us that if that was what the regulator
thought a year ago, after the crisis, we have a problem here.
Because it means that absolutely safe loans and absolutely unsafe
loans, in the mind of the regulator as well as in the mind of
the auditor, could conceivably have been put on the balance sheet
at the same value and, therefore, encouraged poor lending which
generated the "profits" and, therefore, the bonuses.
If we're thinking about what we doI was reminded of my
old textbook on that auditing and accounting term: There seems
to be no limit to the optimism of businessmen; the first line
of defence for investors and creditors is the vigilance of the
practising accountant. How is it that we manage to get that vigilance
back? I should have thought a huge focus on principles over rules.
Opposition to such a proposal creates a really ironic debate,
"If we do this on principle and then we measure something
wrong, then shareholders come back and sue the auditor".
So instead of doing what it is that the shareholders and the governance
system need, which is the rules helping the principles auditors
say, "Well, we'd rather do just the rules". That was
the quote that you had from my former colleague. I think, also,
you could question the principles themselves. In particular I
learned in accounting, that it should be prudent and objective
rather than neutral. Again, prudence we have talked about and
I think most investors would say, "Gosh, prudence and objectivity;
that would be something that we would want to see". Then
the final thing is the reinstatement of discussions. If I was
advising this Committee, I think you might think about how extensive
you want these discussions to be. I think they could be quite
extensive. Not just simply the auditor going and seeing the regulator
and saying, "I'm a bit concerned about this", but something
that is reasonably formal; that should perhaps include the audited
entity, perhaps the chair of the audit committee of the audited
entity. It used to in the past, for example, include commissioning
by the regulator of the auditor. I don't think that many investors
would object if the regulator was to say, "Look, the auditor
is going to charge for this but we're going to make sure that
this system is stable". As I say, those were the sort of
things that we were discussing in what was a cross-party group,
and I think they may have some relevance for the sort of issues
that you are thinking about.
Q437 The Chairman: On that last point,
just to be clear, these discussions that you are talking about,
between the auditor or the chairman of the Audit Commission and
the regulator, would be in private.
Mr Pitt-Watson: Would be in private, yes.
Q438 The Chairman: And you were quite
happy with that as investors?
Mr Pitt-Watson: Yes.
Mr Jubb: There is one supplementary, if I may,
however. The institutions represented here are long-term investors.
When a bank is failing, other than the exceptional circumstances,
it is our clients who have to provide that additional capital
to support the entity going forward. One of the aspects of the
discussions that has to be contemplated, as well as being bilateral
between the regulators and the auditors, is that there should
be some understanding of the mechanism that enables long-term
institutionslong-term institutionsto be brought
into that dialogue in a regulatory compliant way to help formulate
the solution if additional capital is required to enable the company
to continue forward. Most of the institutions here, I am sure,
will have capability to deal with such information in a regulatory
ring-fenced, compliant basis to enable that to happen.
Mr Richards: If I may add one extra thing to
this dynamic that we are all supportive of. In the Equitable Life
case, Lord Penrose, even though the standards were not within
his locus, went to great pains to point out that the standards
set the threshold so high that, for all material purposes, it
was very hard for the auditor to ever justify talking to the regulator.
The report is quite revealing and I think Lord Penrose made a
rather tart aside at the end of his recommendations to note that
it seems that the auditors can say they complied with the standards
at all material times. I think, in looking at this, we have no
insight in terms of what dialogue did take place between the auditors
and the regulator. But I think, in looking at this area, it is
important not to take for granted that the obligations on the
auditor at the moment are necessarily correct and it is something
that is worth examining to ensure that they would be effective
and were effective.
Q439 Lord Hollick: There is quite
a degree of unanimity among you about the emphasis on prudence
in terms of accounting and re-examining the rules. Is that unanimity
expressing itself in dialogue with the audit firms, with the banks
that you are continuing to be a shareholder in? Is your enthusiasm
for this change of direction, change of emphasis, re-examining
the rules, shared by the banks and the financial institutions
in which you invest? Have you had discussions with the FSA about
Mr Jubb: Just yesterday I had a working lunch
with the chairman of one of the major British banks and the aspect
of prudence and the importance of prudence was emphasised in our
discussions. If I could take this further into the market conditions,
one thing that markets do not like is after the audited accounts
come out, you then have further provisions that are made on a
drip-feed basis thereafter. We were emphasising the importance
of this, to the chairman of the bank's board, to ensure that appropriate
prudence is put into place. So I use that as timely evidence that
this is more than rhetoric; it is in fact put into practice.
Mr Talbut: From my perspective, we certainly
have, when we have spoken to the regulator and also to many other
financial organisations--I suspect others have as wellexpressed
our scepticism with the issue of fair value accounting and the
part that it played in the lead-up to the crisis and then in the
crisis and even after it. We are still dealing with the crisis.
So our scepticism--this is not allowing us to get to what we think
is the correct answer in terms of the valuation of these organisations--is
something that we have expressed.
Q440 Lord Lawson of Blaby: Following
on from that, the emphasis on prudence and the move from neutrality
to prudence, as Mr Pitt-Watson said in the very interesting evidence
he gave a little while back, I think probably most of us would
think that is right. But how do you square thatand maybe
this is what you are getting atwith mark-to-market accounting?
Because at the height of the financial boom, at the height of
the financial bubble, nothing could be less prudent than mark-to-market.
So how do you square that circle?
Mr Talbut: That one is exactly true. You couldn't
square the two and that was a significant element, we would suggest,
behind the troubles that led up to the crisis.
Q441 Lord Lawson of Blaby: So what
is the solution?
Mr Lee: The one regulator that Lord Hollick
did not ask whether we were having dialogue with was the International
Accounting Standards Boardas was, now the IFRS Boardand
we are certainly having dialogue with that board. They were, historically,
very much in favour of fair-value accounting, mark-to-market.
That is changing and they have, in recent years, become much better
at listening to investors. Investors, frankly, have become much
better at talking to them and that dialogue is leading to a change
in the sorts of standards that are coming forward. They are changing
the way in which financial instruments will be dealt with; the
way in which loans will be dealt with in the books. So, over time,
those concerns are evaporating but we are continuing the dialogue
with the board.
Mr Pitt-Watson: I think one must recognise,
however, that it has to be the principle that has the override--objectivity
says mark-to-market is pretty good; prudence says there may be
some circumstances in which you want to be thinking about whether
that is sensible or not. I think the danger, at a fundamental
level, of hundreds and hundreds of rules is that you encourage
innovation to go around the rules. So rules in a system don't
prevent people who are unprincipled within that system. I don't
mean that in a negative way, but rules encourage people to try
and go around them. The only way that you can overcome that, I
think, is with principles and with professionalism. That is why
the statement that I gave from my former colleague seems to me
to be so informative; that if you have too much weight on the
rules so that there is not an encouragement for the professional
override of them, whether it is on banking loans or anything else
that we are looking at in audit, then we will give ourselves a
problem. We don't have shareholders that are going to hold companies
to account. We desperately depend on auditors being able to do
that for us. We desperately depend on their judgement.
Q442 The Chairman: Of course, also
the judgement of the chairmen, chief executives and boards of
the companies concerned, which we are not dealing with at the
Mr Pitt-Watson: Exactly. It needs to be right
through the system, doesn't it? And the role of the auditor within
this system is to be able to be like the inspectorate, the eyes
and ears, who, in extremis, reports back to the shareholder so
that the shareholder takes action and changes the operations of
the board of directors. But because the board of directors knows
that this report is going to come out telling the truth, the whole
truth and nothing but the truth, they will therefore run their
company, naturally, in the way that they ought to, which is in
the interests of the shareholders, taking into account wider society.
Mr Richards: It has always fascinated me that
the purpose of the audits isn't defined in legislation. There
is no defined purpose for it although it is articulated, or it
was articulated, by the Law Lords in the Caparo case. The
auditors have two, if you like, objectives. The first one is to
protect the company itself from errors, omissions or wrongdoing
and the example that was given was improper distributions from
capital. The second is to signal to the shareholders to enable
them to enable them to carry out their stewardship duties of the
company. It was rather well articulated and, alongside adopting
the necessary principles to support the true and fair view. Having
a clear articulation and effective purpose for the audit would
be very useful as well because it's often obfuscated in debates
and its absence often leads to standards being interpreted in
its particular way.
Mr Jubb: To take that one stage further, the
Caparo judgement was the legal judgement that enshrined
the responsibility of the auditors to the shareholders of the
company collectively in that regard. If there were to be better
articulation of the role and purpose of the audit, there should
be also better articulation of to whom the auditors are accountable,
because as we are currently sitting, it is in relation to the
shareholders taken as a whole. In terms of litigation, this is
one reason why in the United Kingdom it is primarily in relation
to rights issue documents, where the audit report is enshrined,
that litigation arises, rather than in relation to the individual
audit reports on individual sets of accounts. The Caparo
judgement is something that needs to be considered within that
Q443 The Chairman: I do not want
to prolong this too long but this has been a very interesting
session for us. Can I just ask a couple of questions to be absolutely
clear about the last part of the discussion we have been having
and particularly to Mr Richards? In terms of the position of the
auditors in relation to the banks at the end of 2007 and the end
of 2008I am summarising very briefly and probably inadequatelythe
evidence we were getting from the auditors on that was that in
2007 they were working according to the accounting rules and looking
at the situation as it was before the end of 2007, at the end
of the year-end. In terms of 2008, they were able to get comfort
from the fact that they had discussions with certain Treasury
Ministers who indicated to them what the Government would be prepared
to do. Would you be criticising the auditors in both cases on
Mr Richards: You touched on a number of issues;
if I take them in reverse order. I think it is very dangerous
to create a situation where going concern can be contingent on
all sorts of unrealised discussions. Ultimately, what you might
end up with is, "We are going to need a rescue rights issue
but we reckon there's a possibility the market will support it.
Therefore, it's a going concern". I've replaced the taxpayer
with the market in that case. We saw a couple of banks that ran
into trouble trying to get their rights issues away and I think
it's very dangerous to start accepting implicit contingencies
within the going concern concept. Going concern is already limited
to a 12-month period. It's quite a significant restriction. There
are a lot of other things that going concern is important for
and feeds into, not least distributions. I think if you start
creating flaws within the going concern statement, we are looking
for trouble. That is not to say that it is necessarily improper
for prudential regulators and the authorities to be taking a more
strategic view about issues. We don't know what went on; so it's
very hard for us to comment. Coming back to the point-in-time
position, this is one that is always very interesting. Let's take
fair value: mark-to-market as opposed to mark-to-model. This is
something that can go terribly wrong and I think in the banking
scenario we saw this, particularly around some of the toxic assets
that were around. If we take just a simple one, the CDO; a lot
of the values that were attached to that were not ones that could
ever be realised in full when there was a problem and reliance
was placed, as I mentioned before, on credit default swaps and
you get a mismatch. Fair value does not reflect the fact that
you may be able to sell some of it in the market but if you tried
to shift any significant amount, that value doesn't apply. You
have a very notional value, but you're not looking at the depth
and liquidity that underpins it. So I think there were question
marks about whether some of the valuations of instruments were
really substantive and true and fair.
Q444 The Chairman: Is that not also
criticism of the rating agencies?
Mr Richards: I think the criticisms of the rating
agencies are well-known. There was a very big problem; worse than
a big problem. They were appalling.
Mr Pitt-Watson: Lord MacGregor, this is a cumulative
thing, isn't it? Actually, if we'd had more conservative accounting
then the profits and the equity of the banks would have been lower;
the bonuses wouldn't have been so big; they wouldn't have loaned
out so much more money. I am intrigued that when HBOS was taken
over by Lloyds that, of their £432 billion loan book, Lloyds
said £186 billion of that was not business that they would
have wished to do. It would have been helpful, maybe it did happen,
if whoever was auditing HBOS had said, "Your loan book seems
to us to be rather different from the loan books that we're finding
in other banks". Perhaps there should be some provision behind
this. But, of course, if the regulator was saying that the purpose
of audited accounts is not to forecast potential losses on loans,
you can see how it is that the auditor might prefer not to have
that awkward conversation. And if that awkward conversation is
not had, you then end up finally with collapse, rather than with
having this sand in the machine that slows things down before
you get to having to consider going concern issues, which come
at the very end in 2008.
Q445 The Chairman: Normally, with
some of our witnesses, we have asked them at the end a sort of
all-embracing question, "If there was one measure that you
would want this committee to recommend, what would it be?"
I think as a result of this conversation, it is quite difficult
to answer that but if any of you would like to try, please do.
Mr Richards: If I can, it's a package that involves
the reference that was made earlier about setting a clear ultimatum
to the Big 4 that is time-defined in terms of output. I think
by making it an ultimatum, you have to look at the tangible actions
that would be taken if the outcome sought wasn't achievedwhether
that would be the introduction of joint audits, mandatory tendering
of audits, rotation or some other direct interventionand
support that ultimatum with a package of measures that I hope
we have tried to outline in terms of seeking greater transparency
in audit committee reports, more enhanced audit reports and increased
governance arrangements, including changes to the Stewardship
Q446 The Chairman: Anyone else, or
are you happy with that?
Mr Jubb: I couldn't have put it better myself.
Mr Pitt-Watson: I think, pragmatically, the
way we can most easily get improvement is by focusing on how we
get the principles and the professionalism back into thisand
also I would follow up on some of the questions that Lord Lawson
was asking about the reporting of the audit to the regulatorthose
two, I think, are pertinent and important issues where a push
from the House of Lords would make a difference to the outcome
of the debate.
The Chairman: Gentlemen, I think the
length of the session demonstrates how helpful you have been to
us. Thank you very much indeed.
1 Note by Witness: I incorrectly suggested
that this was not included in the ICAS recommendations. It is:
"In relation to the external audit process the audit committee
report should include: Details of the key areas discussed between
the audit comittee and the external auditor during the audit process,
including the main areas of audit challenge." Back