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

Examination of Witnesses (Questions 504-553)

Mark Hoban MP, Edward Davey MP and Richard Carter

25 JANUARY 2011

  Q504The Chairman: Good afternoon, gentlemen, and thank you very much for coming. I think you know the form of these Select Committees extremely well, although the House of Lords Select Committees are not quite as rumbustious and political sometimes as those in the other place. The only thing I would ask you is to give your name when you first speak, for the benefit of the Hansard writers and the text we eventually publish. You will probably have seen a little bit of what we have been doing, and you will know that we are now concentrated on three main topics: the first is the topic that we started with and is the main topic, which is the issue of the Big 4, competition and choice. But we have also been looking quite heavily at auditors and the banking crisis and also at the impact of IFRS on auditing. Some of the questions we may ask you are pretty technical, so we are quite happy with short answers so that we can concentrate on the big issues. I want to kick off on the Big 4. I think the general attitude of most of our witnesses has been that this is a serious issue. Even the Big 4 were concerned about the risks and dangers of coming down to the Big 3. It is not too difficult to produce recommendations that have had or are likely to have little effect, so we are looking to see if we can find recommendations that might have some effect. But first I ask you to establish your position. Is the Government concerned by the domination of the Big 4 in the audit market, especially if—as seems possible—it were to be reduced to the Big 3? What measures would you support to increase choice in the audit market?

  Edward Davey: Chairman, if I may, I'm Edward Davey. I'm the Minister for Employment, Postal Affairs and Consumer Affairs in the Department for Business, Innovation and Skills; and, yes, we do have concerns about this. We certainly welcome your inquiry to help shed more light on this debate and indeed extend that debate more widely. I would say we have some serious concerns, particularly on the effect on competition and the problems that that could cause, whether in terms of lack of choice or higher fees and so on. I'm very happy to lay out a whole number of measures that we are considering. I should say that I know some of your witnesses have suggested there is a huge systemic risk here. I'd like to say that we don't see that quite in the way that I think some of your witnesses have done, partly because audit is only one element of the assurance that investors and capital markets can have. There are accounting standards; there is internal audit; there are audit committees; there are credit ratings; insurance markets, and so on, which will play a part of that wider assurance piece. I think we should be very clear that none of the Big 4 is too big to fail. But yes, we have some serious concerns. We do think there should be contingency planning but I think our major concern is to ensure there is improved competition. There are obviously two elements of that: the demand side and the supply side. On the demand side I think can we persuade firms to change their auditors more frequently and look at other auditors outside the Big 4, particularly obviously in the FTSE 100 and other big listed companies. There are some approaches that are quite regulatory, but we are not attracted to a very heavy-handed approach. I wouldn't want to shut the door on it but that is not our first approach. We do believe that, by getting greater transparency and more disclosure by companies, particularly through the organ of the audit committee, we can give greater information to investors, to the capital markets, about how decisions are made when a firm takes on an auditor. I think we would be looking to see greater disclosure and transparency about the procedure adopted on taking on an auditor; how long a firm has used its existing auditor; what its policy is on testing the market for other auditors. I think we would like to encourage greater transparency and disclosure from audit committees—this would allow investors to have that information so they can challenge those decisions. Maybe there is a role for further development of the relative new Stewardship Code in this area. Is there a role for the FRC's guidance on audit committees to be looked at and possibly made mandatory? So I think there are some ways we can tackle this from the demand side, and I'm particularly keen to do that. That is the real problem; I think a lot of the larger companies have wanted to seek security in going for one of the Big 4 and I think we have to challenge that culture, that status. On the supply side, I think there are companies in the UK which are more than capable of taking on some of the large, complex audits. I think people sometimes think that outside the Big 4 there aren't the skills, but I believe—certainly from the evidence I've seen—that there are the skills there; there are British companies which are a very large footprint in audit; they operate in many different markets. There may be a lot of things that can be done there, but I would put a lot more emphasis on the demand side and the sorts of measures I've talked about with respect to transparency and disclosure.

  Q505  The Chairman: We will come back to the supply side because we are very much aware of some of the difficulties facing the next tier of firms in competing in the Big 4 market, and I'm not sure I am quite so sanguine as you are that there are possibilities there without help and assistance. But for the moment I want to focus on two things. You mentioned contingency planning in the possible situation of going down to the Big 3. I think it was the Big 4 auditors themselves, when asked this question, who said: "Well, contingency planning is for the Financial Reporting Council". Don't you think it is for Government?

  Edward Davey: I think it is probably for all the players if they are meeting their responsibilities; Government would clearly have a role in thinking about what would happen in such an event. There are some obvious things that one would look at: extra time for filing, for example, when the contingency actually happened. You mentioned the supply side, and I don't want to give you the impression that I don't think there are some supply side responses, particularly with respect to contingency planning. So, for example, we could look again at the restrictions on shareholding by non-auditors in auditor companies because that might potentially provide capital, both for existing firms or firms that were struggling and needed recapitalising. So I think that those rules and flexing there could help the supply side, particularly in terms of contingency planning for this area. I would hope that the Big 4 would look at living wills. I think they have a responsibility to think about what would happen and to plan for that.

  Q506  Lord Tugendhat: In view of the concern you expressed, I do think the Government itself could do a great deal more. Government departments and Government agencies make a great deal of use of auditing firms. At the moment I am chairman of Imperial College Healthcare—so I am involved in that world—and the Department of Health always uses the Big 4 in dealing with health trusts; Monitor always use the Big 4. There is a tremendous flow of business from the Department of Health and I think from other Government departments as well. I recognise some of it is quite complex stuff; some of it is quite high profile stuff like commercial concerns. You want the seal of good housekeeping that the Big 4 provide but it does seem to me that, in the light of the concern you express, the Government has plenty of scope to provide work for non-Big 4 firms in a variety of Government departments and Government agencies.

  Edward Davey: I wouldn't disagree with that. In general, the Government is very keen at looking at how we procure goods and services and to see if that can be improved, with a particular emphasis on seeing if we can ensure that SMEs—who often complain that the procurement system works against them—can access public procurement. I am working with the Minister for the Cabinet Office on this issue, both in terms of how it affects our domestic workings, and indeed with respect to reform proposals that are coming from Commissioner Barnier with the Single Market Act. So I think procurement generally is important and—to speak to your point—with respect to the procurement of business services, particularly audit. Indeed there is a role and I wouldn't want to give you the impression we're closing that off; far from it. We want to encourage a very competitive market for procurement of Government services including audit.

  Lord Forsyth of Drumlean: We are talking as if there was a choice for most firms but in fact, if you take product or area specialisation and you take conflicts into account, actually choice is very limited. Listening to what you are saying, in terms of perhaps we could encourage people to look at wider alternatives when they come up for tender—I can't remember the exact figure, I think it was every 48 years that an FTSE 100 company changes auditor--do you not think that perhaps the department is just a little bit complacent on this? Because listening to what you are saying I'm thinking, "Is it going to make any difference to the practical choices available to boards?" I suspect not. On the point about systemic risk, we had evidence earlier—I am sure we will come onto this—from one of the firms that they had signed off the accounts of the Royal Bank of Scotland, because they knew that the Government would be there to bail them out, without a word to shareholders. It is possible to get everyone in a room and for Lord Myners to give a nod and a wink and everyone to go out with a policy change, which no one is aware of. That does seem to me to indicate a degree of risk that we have seen in the past and I can't, for the life of me, see why it couldn't be repeated in the future.

  Edward Davey: If I can deal with your suggestion that the Government is complacent on this and make it absolutely clear that we are not. That is why I am so welcoming of this Committee's inquiry; why I was keen to come and give evidence and why we have been focusing on this within the department working with the FRC and others. The question is: what do you do? We think greater disclosure and transparency; to give greater publicity to this fact that some companies have used the same auditor for 48 years. That is information that I'm not sure how many investors, including institutional investors, are absolutely aware of. Getting audit committees to improve their communication with their investors I think is incredibly important and encouraging investors, through things like the Stewardship Code, to look at that information.

  Q507  Lord Forsyth of Drumlean: Sorry to interrupt, but if there is only one other auditor you could appoint how does that solve the problem?

  Edward Davey: Let me take some issue with that as well, because I made it clear that I do think there are—outside the Big 4—some very reputable, very professional and expert audit firms. The reason that they aren't chosen sometimes seems to be because of the purchasing propensities of the bigger companies, in order to try to say they have gone for one of the Big 4 so that must be okay, rather than going for another firm that might be equally as good or even better. So I think what we have to challenge is this culture and we're determined to do that.

  Q508  Lord Smith of Clifton: When we had the second-tier representatives here they showed a marked reluctance; certainly they didn't want to touch the FTSE 100. They just wanted a little bit more share of the FTSE 250. So you had a rather cosy reinforced cartel of the Big 4, with the second-tier accountants not being that keen to have much more business.

  Edward Davey: I am surprised to hear that. I didn't read that in the evidence and it probably should have been brought to my attention. But certainly in our engagement with them I think we've taken away a slightly different message. It may be that this year and next year they couldn't take on half of the audit contracts of the FTSE 100, but they seem to me to have the ambition to do an awful lot more than they're currently doing, and the question is: what could Government policy do to assist that? And I think it's trying to ensure that corporates are forced to disclose, and indeed therefore think about how they go about the process of appointing auditors, get their investors more involved in that decision process and asking the sort of tough questions that I think haven't been asked in the past.

  Q509  The Chairman: We had some of the investing institutions in front of us and I have to say they were highly critical of the present situation, and I rather doubt whether greater transparency or a bit more dialogue would solve the problem. I think if you simply went down some of those sorts of recommendations, they might help a little bit but the very strong position of the Big 4 would remain.

  Edward Davey: I have to say I think that is contestable. I do think it's up to shareholders to make the appointment of auditors, not Government. I think if they are given the information and Government assist them to have that information, and indeed, assist the process of communication by seeking that the audit committee thinks more carefully about its responsibilities, I think that can make a big difference and I don't think we should underestimate it. Look at the other options: the other options that are being discussed are quite regulatory; mandatory rotation of auditors, for example. The question is: would that work? It would certainly impose an extra burden on the companies who are purchasing the auditing services, not just on the auditors. No doubt they would pass the extra costs on. Would it result in reduced concentration? I'm not so sure. I'm not sure if there would be evidence where that has been looked at, and I think I am right in saying it was looked at in Italy where they went down this road, but did it have the effect that some people thought it might? Actually, it had the reverse effect. So I think some of the alternatives that are put forward need very careful examination because there could be perverse effects.

  Q510  The Chairman: Finally, can I just take you up on the shareholders appointing the auditors point. In theory, shareholders do appoint the auditors at the annual general meeting. I think in most annual general meetings—certainly all those I have attended—the item that goes through fastest is the appointment of the auditors. Has that ever been challenged by shareholders; a recommendation that is given?

  Edward Davey: I certainly wouldn't dispute that point and that observation; I've seen that observation myself. So the question is: how can we deal with that? I personally believe that the sort of disclosure and transparency we're talking about—the changes to the code for the audit committees or making the FRC's code mandatory—would have an impact. One other thing that we're certainly thinking about is whether or not it is right to ensure that the auditor turns up to the AGM. Of course they can be heard. They have the right to be heard and the right to take questions, but as a normal practice maybe they should be obliged to turn up to the AGM. I think that sort of approach is the right way to try to change what we've seen in the past that, I agree with you, isn't satisfactory.

  The Chairman: I thought they usually did.

  Q511  Lord Hollick: You mentioned that the Government had under consideration some measures that might increase the choice in the audit market. Could you share those with us and also could you say which of them you might support?

  Edward Davey: In terms of helping the middle-size, middle-ranking, audit companies to grow, I do think the demand side is the most powerful side. I don't want to reiterate the points I've made in that area, but they are going to grow if they have more contracts and if companies and their shareholders seek to ensure that it's not just the Big 4 taking the big, juicy contracts. But I did say earlier, particularly in relation to the question on contingency planning, whether or not we could look again at the rules on non-auditors controlling shareholdings in auditor companies, and whether that could be reviewed so that they could attract more investment. I have to say—in parenthesis—that when we talk to some of the more likely candidates for expansion they don't necessarily see that shortage of capital is their main problem. They focus on the demand side, which is why I placed such emphasis on that.

  Lord Lawson of Blaby: There are three issues on our plate: the oligopolistic nature of the audit business, so far as large companies of FTSE 100 are concerned, is one of them; accounting standards, which you mentioned en passant earlier on and about which we have received a lot of disquieting evidence, which reinforces the doubts that some of us had before we embarked on this inquiry; and perhaps most of all there is the question of the huge problem there is in the banking sector, which is a global problem but is particularly important to this country because of the ever importance of banking and financial services to our economy. I think those last two are bigger problems. Nevertheless, that doesn't mean to say that the oligopolistic nature of the audit business for large companies is not a problem, not a cause for concern. It has been put to us that the Government—as part of its cull of quangos—is abolishing the Audit Commission. Here you have a resource, and it has been put to us that it might make sense for this resource to become a competitor of the Big 4, so that you have five and you have a greater degree of competition. I wonder whether you feel there is anything in that?

  Edward Davey: If I can say initially—and I am sure your Lordships are aware—there is an inquiry in the other House, with the Select Committee on Communities and Local Government looking into that decision by the Secretary of State and asking some detailed questions. I certainly wouldn't want to, in anything I say, make any prejudicial remarks with respect to that inquiry. But I did note when the Secretary of State announced his intention to do this that one of his key objectives was more competitive and open markets for auditor services for local authorities and other public bodies. I think that certainly speaks to your agenda and, as you would expect, I very strongly support the Secretary of State's statement in this regard.

  Q512  Lord Lawson of Blaby: I think that those who put this to us—and I am just repeating evidence that we have received—didn't assume that the Audit Commission, which in some guise or other remains in being, building on the expertise it has acquired since Michael Heseltine proposed it should be set up in the 1980s; they didn't assume that this would just be for local authorities and public bodies, but that it might compete with the Big 4 for all the sorts of clients that the Big 4 have, whether they are in the private sector or in the public sector.

  Edward Davey: Well, I think the skills and the expertise and the track record that the Audit Commission has built up would certainly make it a competitor for not just public sector contracts. I wouldn't disagree with the thrust of what you're saying. I haven't read all the evidence that you received, but no doubt some of us have made similar points. I think one should remind ourselves, though, that the Audit Commission doesn't do all the audits itself, it contracts out audits to many other auditors. So it's not as if you have a massive building with a whole set of auditors who now have nothing to do, and suddenly can be taken over or moved into another company. So, let's look at the actual nature of how the Audit Commission contracts and encourages those audits to be undertaken. So, I'm not against the thrust of what you're saying, far from it, and I'm pleased—very pleased—that the Secretary of State for the Department for Communities and Local Government has made the statements that he has.

  Q513  Lord Forsyth of Drumlean: Chairman, just to follow up on Lord Lawson's point. I think it was Baroness Hogg wearing her official hat who put this suggestion to the Committee, and the point that she was making was consistent with what the Secretary of State has said. A lot of this work will just leak out into the Big 4 and other accountants, and there is an opportunity here for the Government to seize the initiative and create a fifth force. But that would require proactive action by the Government, not just a general statement of, "We wish the private sector to—" The point that you make, Minister, is about the nature of the Audit Commission itself, in terms of the work that it contracts out. It would require a policy decision to go out and create a fifth force and not a decision to allow that work to be put out to tender and dispersed through the existing market. So, it does require proactive action. Would you be against that?

  Edward Davey: As I said very clearly, we welcome this decision from the Department for Communities and Local Government.

  Lord Forsyth of Drumlean: No, I am not asking about the decision on the Audit Commission. I'm asking what your view—

  Edward Davey: I think you are asking me to make a decision on a matter for which I am not the responsible Minister. I'm not trying to not answer your question, Lord Forsyth. What I am not doing, as a Parliamentary Under-Secretary in the Department for Business, Innovation and Skills, is making a policy statement on behalf of the Department for Communities and Local Government. What I can say is: we very much support that decision that they have taken; we are engaged with them in how that will develop and we do see an opportunity to improve competition in this market, and I think, given—

  Q514  Lord Forsyth of Drumlean: Forgive me, I'm not asking you about the decision that has been taken by Eric Pickles. I am asking you whether your Department support the idea of taking proactive action to create a fifth force, in line with what Baroness Hogg said. If you are not able to answer that question, I think it would be very useful to have a response that represents the Government's view on what is a very important proposal, which is time limited.

  Q515  Lord Lawson of Blaby: If I may supplement what Lord Forsyth is saying, I don't think you can just say, "Well, this is a matter for the Department for Communities and Local Government", because that is only the case for the Audit Commission as presently constituted. Of course you're ending that, so if this new role were to receive governmental support it would not be a matter for the Department for Communities and Local Government.

  Edward Davey: I accept that. I would repeat my remarks that I think somehow this is presented as, "Here is a fifth competitor that can suddenly be wheeled out"; it fails to understand the nature of how the Audit Commission commissions its work. It is not that there is a whole set of auditors that can suddenly be transformed into a fifth firm. I think that is the point I have made and I would ask you to reflect on that. Let me ask my colleague Richard Carter to maybe elaborate a little further.

  Richard Carter: Thank you. Richard Carter, the Director of Business Environment in the Department for Business, Innovation and Skills. In terms of the future of the Audit Commission, in terms of its overall size, as the Minister has said, if you were to establish it as a stand-alone audit firm at the moment, we believe it would represent about 10% of the audit market in terms of revenue. So it will be a sizeable force but it wouldn't necessarily be an enormous force. In terms of thinking about its future, of course, there are two questions. The first question is: who is going to do the auditing in the future? And part of the thrust of the Government's proposals is that, in the longer term, the decision about who is the auditor will be taken by the public body that is being audited. So, that is one set of questions. Another crucial question is: what happens to the staff of the Audit Commission, in particular to make sure that there are arrangements for the continuation of audit services, in the short to medium term, until such time as the bodies re-let the audit contract? This is quite a complicated balancing act. In addition, there is also a concern—which will certainly be felt in the other place—about making sure that the full value is achieved for the taxpayer in terms of any transfer of the assets. But one of the things that the Secretary of State for Communities and Local Government is very much taking into account in his decision-making are the issues around audit competition, around the structure of the market, and so on. So, I'm not in a position to give you the complete answer now because that is work in hand. But I hope I can reassure you that issues around the structure of the market are, indeed, being taken into account.

  The Chairman: Given that the suggestion came from the Chairman of the Financial Reporting Council and, therefore, should be taken seriously, we will obviously be doing just that and if there are any further points that you'd like to put to us in writing that would be very helpful. I think Lord Shipley wants to come in on this one.

  Q516  Lord Shipley: Yes, because with my local government background I have a lot of experience of working with the Audit Commission. They do do a lot of work directly and they do have a lot of staff who are auditors, and the 10% figure has been very helpful. Of course one of the problems that we might get, if those staff are simply swallowed up in the main by the Big 4, would mean that we were going to have decreased competition rather than the potential for increased competition. The advantage of having a public sector body that might then start to do private sector work—because the quality of the auditors is such that they could do that, and to have a private sector company outside of the Big 4 that might then have a public sector expertise—is that everybody could gain from that situation. Now, I understand that it is difficult to make commitments given work going on in the other place, and so on, but it seems to me there is an opportunity here and I just wondered if you might agree.

  Edward Davey: I entirely agree that there is an opportunity here. I hope that is helpful.

  Q517  Lord Best: We are tackling this work from basically a national perspective, but we are well aware that the EU is looking at these matters as well. Do you think that the best level is the national, is it the European, or should we be looking up to the G8 and the G20 before making recommendations in a global economy?

  Edward Davey: I think the national level is the appropriate level and I think that is for the foreseeable future. That is not to say that we could not improve the co-ordination between audit regulator supervisors, both within the EU and across the globe. As you know, there is quite a lot of co-operation already. That clearly needs to be built on and improved, but I certainly don't see a role for an EU regulator here or, for that matter, a global regulator. I do think some sort of college or co-operation between the national bodies is the appropriate way forward, and I know that has quite a lot of support among the auditor community. I think the only other thing I would say is that in this area—because as you say it is quite complex and many of these companies operate, the audit companies that is, all over the globe—decisions that happen, as a result of changes of auditors in this country, can have an impact across the globe as well. It is quite possible that if a few of the FTSE 350 changed their auditors that we'd see their subsidiaries around the world changing their auditors, too. So what we do in this country can have a big impact. We can't always say that in every area of policy, but I think that is the case here.

  Q518  The Chairman: I can see that in the case of some of the FTSE 350 companies but very often the real problem lies with the FTSE 100 companies, where the argument runs that they are global companies and they need auditors who have a global reach and, therefore, it isn't just a problem that we can tackle here in the UK.

  Edward Davey: The point I was making was that even for a FTSE 100, if they were to take a decision I think that would flow through to their subsidiaries elsewhere, and I do think there are audit companies outside the Big 4 who are capable of doing that. I want to say that quite firmly, because I think there is this impression around that that is not the case and we need to challenge that. I would urge you, if you feel the evidence is sufficient, to make that clear. That is certainly our finding in the analysis that we've done. Unless that is understood by FTSE 100 companies, and others, I don't think we will change the purchasing behaviour and I don't think we will improve competition and choice.

  Q519  Lord Forsyth of Drumlean: I quite agree with what you said on that point, but just on this issue of increasing competition and choice, the EU ownership rules for auditing firms limit outside shareholders to 49% and require a majority of the management board to be EU-approved auditors. Are these restrictions really necessary?

  Edward Davey: No.

  Lord Forsyth of Drumlean: Splendid.

  Edward Davey: Sorry, I thought I had covered the point earlier, so that is why I was restricting myself to a one word answer. We do think these rules should be changed and, of course, we will need to work with European partners to do that. I believe the European Commission has suggested that this measure should be changed themselves. I'm just looking to my colleague to check that that is what—

  Richard Carter: It is one of the things that they are considering as part of their current Green Paper on Audit. The Minister has given you the Government's response to the question.

  Q520  Lord Forsyth of Drumlean: So when can we expect a result?

  Edward Davey: I can't give you an exact date. I am very happy to make some enquiries and see if there is a clear timetable, but I hope it won't be too long. Probably months rather than years, I would hope, if we can get agreement.

  Q521  The Chairman: But the UK Government is pressing for changes in this area?

  Edward Davey: Yes, absolutely.

  Q522  Lord Hollick: Is there a more fundamental change that could be introduced, which is to say that the annual audit would no longer be mandatory? For instance, should there be monopoly rights for the auditing profession? For instance, we have heard some suggestions that there might be an insurance product, which could be purchased by companies that would give the assurance to their stakeholders. Has the Government considered any of these options?

  Edward Davey: First of all, as I am sure you know but it is worth stating for the record, the audit isn't mandatory for many small companies at the moment. I believe, and the Government believes, there is a strong case for taking away the mandatory requirement for an audit from medium-sized companies, and I think that would have a real advantage. If a company decides to go for an audit voluntarily, I think that sends a very strong signal to investors and to the market. So I don't see some systemic risk for deregulating here and taking away mandation from medium-sized companies.

  Q523  Lord Hollick: Can you give us a sense of how many companies that might cover if you were to apply it?

  Edward Davey: I think it is a significant number, in tens of thousands not hundreds.

  Richard Carter: We can give a note about it.

  Edward Davey: We can give you an exact number. From my memory, I think the brief I read some time ago talked about 32,000 companies but I would be very happy to come back for absolute clarification of the exact figure.

  Lord Hollick: And what sort of—

  Edward Davey: Our preliminary analysis shows it is 32,385.

  Q524  Lord Hollick: Good memory. What sort of size of company would that take us up to then?

  Edward Davey: We can give you figures on the turnover of what that would cover. It certainly wouldn't cover the FTSE 100, of course, and I'm just reading the footnote of the briefing. That covers companies which meet two out of the three EU criteria of turnover more than £6.5 million and less or equal to £25.9 million; total assets of more than £3.26 million and less or equal to £12.9 million; and more than 50 and less or equal to 250 employees.

  Q525  Lord Shipley: Could I ask you about the statutory annual audit and just refer briefly to your memorandum of evidence, and three very short extracts in paragraph 15 in which you say, at the very end, "Financial directors and investors do however find audit valuable in checking company compliance with accounting standards and other regulatory requirements, while they do not find value in the very limited—and often boiler-plate—qualitative assessment currently provided". You then go on in paragraph 21 to say, "There could also be more disclosure about the risk position of the company, and key judgements taken during the course of the audit". But in paragraph 25 you then go on to say, "It is therefore not obvious exactly how to achieve more informative disclosure of the affairs of companies, either by management or by the auditors". And I think the question that the general public would be interested in—particularly those who went through the banking collapse, people who lost share investments, and so on—is the statutory annual audit enough to meet today's needs, and should auditors provide assurance in other areas, such as risk management, corporate governance and the business model, as well as just financial statements?

  Edward Davey: I think the annual audit for the larger companies is very important. Could the information, the communication to investors, shareholders and the wider markets, be improved? Yes, and the Government position is very clear that we believe the audit committee is the best way of doing that and that they should be talking not just about how they have gone about appointing their auditors—as we talked about at length earlier—but about what judgements the board has taken in terms of its accounting strategies. Are they quite aggressive in the approach they have taken to accounting? What are the risks they see and what judgements lie behind their approach? So I think that would assist a lot of people to try to understand what lies behind the statutory annual audit, but I think it is important that audit committees improve on that.

  Q526  Lord Shipley: So would you be prepared to legislate for that situation?

  Edward Davey: I said earlier that the guidance that the FRC provide to audit committees, the code of practice, covers many of these points, and the question is: should that from the FRC's position become mandatory? I think we are very much attracted to that approach. You did ask, Lord Shipley—I'm afraid I didn't answer the question—about whether auditors should provide assurance in other areas as well. I think there is a real balance to be had here about making sure independence isn't questioned—and they certainly can provide services without threatening independence, but that is an issue to consider—and whether auditors are appropriate to analyse the risks in a particular area. In the work we're doing in the wider corporate governance field with our consultation on narrative reporting, to which we will be responding to the responses shortly, I think we will be looking at how we can encourage corporates to be more broadly open and transparent about their risks. I think there are some companies who are doing a very good job in putting forward their reports; reporting very fully about the risks that they see; how they are managing those risks; who they are getting in to help them manage their risk. But I'm afraid there are others who aren't. So I guess I am agreeing with you that we need to see more broadly across the piece a better performance in providing assurance to shareholders and investors that the risks are being properly dealt with. I'm not sure if auditors are always the people to do that.

  The Chairman: There are one or two issues we'd like to continue to look at in relation to competition and choice in the audit market, but I think we'll move on now to the next major area in relation to the banks.

  Q527  Lord Smith of Clifton: Minister, you will understand in asking this question I'm just a warm-up act for Lord Lawson. The auditors failed to warn of the impending financial crisis, even though they had more in-depth knowledge of their banking clients' affairs than any other outside party. What changes would the Government like to see to avoid such failures in the future?

  Edward Davey: Well, I am the warm-up act for my colleague here.

  Mark Hoban: I'm Mark Hoban. I'm the Financial Secretary to the Treasury. I'm responsible within the Treasury team for the financial services sector. For the sake of transparency, I also ought to add that I'm also a chartered accountant and—prior to coming to this House—I worked for PricewaterhouseCoopers. Having started my professional career with Deloitte Haskins & Sells, I've seen the concentration in the audit market from the Big 8 to the Big 4 at first hand. In the context of the question you asked, Lord Smith, I think that to be fair to auditors there are few that can claim with any conviction that they foresaw the impending financial crisis. There are a number of players one would have expected to have seen the signs: boards of directors; management; regulators; central banks, and so the auditors weren't alone in not identifying the financial crisis. Of course, the role that auditors play is to comment on the financial statements rather than on financial stability. So I think we ought to put their role in proper context and have realistic expectations of what they are able to deliver. In terms of what we can do to avoid such failures in the future, clearly the Government has set in train a wider series of reforms around financial regulation, including replacing the FSA with new regulators and giving the new regulators greater powers. There is clearly a debate going on at a global level around increased capital through Basel III, increasing liquidity, greater measures at a European and global level for co-ordination of regulation tackling crisis management. So a number of measures are in place already to look at these areas. But, as Ed has said, there are a number of areas in the audit field where there is work ongoing looking at some of the disclosure around narrative reporting; about risks and some of the judgements that are being made. But also I think an area that the FRC highlighted in their evidence to you, increased scepticism by auditors. But I suspect increased scepticism doesn't just apply to auditors, it applies to others when dealing with financial institutions as well.

  Q528  Lord Lawson of Blaby: May I follow that since Lord Smith mentioned me? Incidentally, it's very good to have a Financial Secretary in front of us since it was a post I held a little over 30 years ago. I am very pleased we have a distant successor here. We are not interested primarily here in apportioning blame. We are interested in what to do. There is no doubt about it, that the auditors were among the dogs that didn't bark and should have done but they weren't alone in this. But the question is: what can be done to make it better in the future? Clearly, it is a very serious issue. Sir John Vickers made a speech over the weekend in which—I'm paraphrasing him—he said this wasn't a storm of such great magnitude that any structure would have buckled. It was because there was a bit of a storm and the structure was so rickety that it failed. Therefore, it is very important that we put a more robust structure in place. I know that is something that the Government has very much in mind and so does the Bank of England and, of course, so does Sir John Vickers. Now, the question is: what is the place of auditors in this? On the evidence that we have had so far, I am not clear about whether the auditors recognised that there was something seriously amiss but didn't do anything about it, partly because if you qualify or hint at any reservations about a bank's accounts that could have a very serious effect in itself, or whether they just didn't know, in which case clearly it is a bit alarming. What I am getting at is this: that one thing that I introduced, and I thought it was quite an important part of the 1987 Banking Act, was there should be a compulsory private dialogue between the regulator—or supervisor, as he was known in those days, but that doesn't make much difference—and the auditors. They should each speak privately to each other. The auditors should say, "Well, there is something that we're concerned about regarding this bank that you as the supervisor, or regulator, ought to have a look at and we don't want to qualify the accounts because that could mean a huge loss of confidence, a huge run on the bank. But this is something that you ought to have a look at". Equally, the regulator—the Bank of England as it was then and now is going to be—should say to the auditors, "There is a particular area that is of concern to us as the supervisory regulatory authority. Will you make a point of looking very closely at the banks that you audit, how they shape up in this area?" This worked for a number of years after the passing of the 1987 Act and then, as I understand it, with the transfer of responsibility for bank regulation, bank supervision, to the FSA the responsibility wasn't altogether abolished but it was greatly watered down, and in practice this didn't happen. As I understand it now, the Bank of England is looking at reinstating this very important safeguard, this process. I wonder if you could say, first of all, what your general views are on this important area and, secondly, if you could give us a progress report. I know you're not the Bank of England but you're obviously very much connected with what is going on. Can you say whether any progress is being made under these talks that, as I understand it, the Bank of England are having?

  Mark Hoban: I agree with you, Lord Lawson. I think it is important that there is a dialogue between auditors and the regulators. I know, from a conversation I have had with auditors, that it is something that they felt was lacking in the existing regulatory regime. As you say, the requirement in the Banking Act was replaced in FSMA by an information gateway, which was meant to facilitate a dialogue, but I think it—

  Q529  Lord Lawson of Blaby: But didn't mandate it.

  Mark Hoban: Absolutely, and I think it fell into not quite disrepair but—

  Lord Lawson of Blaby: Desuetude?

  Mark Hoban: Desuetude is a very good way of putting it. Clearly, the FSA and the FRC have looked at this and are looking to strengthen it. I don't want to steal the Bank of England's thunder. They are looking at this very carefully and they will make an announcement. But I am clear in my own mind that if the bank were to say that we need this in the statute, then I would be happy to see that happen.

  Q530  Lord Lawson of Blaby: I am glad to hear that, and I hope that this will happen. May I just ask one further question on this area, which I think has been mentioned by one of my colleagues already? We were very concerned that the auditors were either given to understand by the previous Government, or assumed, that major banks could not be allowed to fail, were too big to fail, and, therefore, they were rather too relaxed in the way that they audited these banks. What do you feel about that?

  Mark Hoban: I read the evidence that my predecessor, Lord Myners, gave the Committee and I have seen the letters that I think he submitted to the Committee. I don't wish to speak for him or the previous Government on that dialogue.

  Lord Lawson of Blaby: No, speak for yourself.

  Mark Hoban: I think that the judgement that both boards of directors and auditors make on going concerns is a matter for them. To be absolutely clear to the Committee, I have had no discussions—and nor has the Treasury—with auditors about the 2010 reporting season.

  Q531  Lord Hollick: Minister, you used the word "scepticism", which I think is something we have been in search of as we've talked to many of the witnesses. It seems to have been absent in a number of important ways. You just talked about "going concerns". When we had the audit firms in, they emphasised that they were relying very much on what the board told them, what the directors told them and the executive told them, when they formed their judgement about the going concern of banks that they signed off on, which within a few months—in some cases weeks—were failing, in effect. I think it is difficult to see that scepticism was applied there. They seemed to be, dare I say it, somewhat spoon-fed by the directors and took it at face value, and I think—and we will perhaps come to this later—there is a concern in the profession that they are legally liable or have an increased legal liability if they apply judgement. I think that brings us to the point that a number of witnesses have made—it is also made in the BIS submission—which is the gap between what the auditors are offering and what the public, the users of accounts, are expecting. This is clearly a very difficult issue. In terms of having a financial system and financial institutions where the public, all of the users and lenders to those institutions, can have confidence in them, what measures do you think, given your experience before you were in Government as well, could actually be brought into play to try and help narrow this gap, to reintroduce scepticism and put that at the heart of the auditors' judgement?

  Mark Hoban: I certainly think that auditors and others need to be much more sceptical and much more challenging of management in forming conclusions on a whole range of judgemental areas for company accounts. I think some of the work that has been done around corporate governance since the financial crisis also speaks to that. But I think we also need to be very clear about what it is we are asking auditors to do, what they should be responsible and accountable for, and also what the role of prudential supervisors is. I see a set of accounts as not a substitute for prudential supervision but a starting point for it, and prudential supervisors who are publicly accountable for the safety and soundness of the financial system need to overlay on those accounts their judgements, whether it's through Basel III and the capital rules there, or whether it is their own understanding of a firm's business model. So I think we need to be very clear about what it is we expect from auditors and what it is we expect from prudential supervisors.

  Q532  Lord Hollick: One of the suggestions is that the audit report might shed more light—and this is something that the shareholders were in favour of—on some of the key discussions that take place when forming their judgements. Do you think that that would be a good idea or do you feel that that would possibly destabilise the situation?

  Mark Hoban: I am wary about treading on to the territory of my colleagues from BIS. I understand the appetite for more assurance, but that comes at a price and at a level of risk. How do you ensure that if that debate is made public that there is the right level of comfort in place for both the auditor and the company about that? I think that is a challenging area and I think it is an area that previous Governments have looked at as well, and it is an ongoing debate among institutional investors, auditors and companies. I think it is a challenging area to get right, to try to achieve that public understanding and acceptance, at the same time recognising some of the challenges that flow from those.

  Edward Davey: If I may, I think where we've reached in our analysis and where we think we should push on this is—and I'm repeating myself, I'm afraid—the role of the audit committee's report in trying to assist that dialogue and assist that understanding. I think you are absolutely right about the expectation gap, but in the review that we have undertaken of the academic literature, both the empirical evidence and the theory, it is quite clear that the expectation gap has been noted over the decades; that people think the audit can withstand a collusion between directors to defraud their investors, and often it is very difficult to be absolutely sure that it could do that. Equally, if there is a financial meltdown, it is not clear that audit can—in the theory of audit—give the reassurance in that sort of external environment when that is so challenging. So, the expectation gap is a real one; it's there in audit theory, and the question is: how can we improve procedures so people understand that and maybe it can be closed a little bit. That is why we think the audit committee has a bigger role than in the past.

  Q533  The Chairman: You have pretty well answered the question I was going to ask, but let me just ask it in case there is anything you want to add. In the context of a dialogue between the auditors and the regulator or the Bank of England, some information may flow back to the auditors that causes them concern which, basing their clearance of the accounts on the results of the year and, possibly even in terms of a going concern, they are not really able to express in their audit judgement. Yet, because of the knowledge that they may acquire that gives them concern, they may be misleading investors.

  Mark Hoban: I think one would expect auditors, in trying to identify the risks attached to the audit and to a company's accounts, to take into account the knowledge they gain from a regulator. If there is a particular concern about an area of business, I think the auditor would want to take that into account. Of course, one of the changes we are proposing, in terms of financial regulation, is a much more explicit dialogue about the risks that the macro financial regulator—the FPC— identify and what the appropriate response to that would be, in terms of a regulatory response. In a way, it is building on the work that the Financial Stability Report published by the Bank of England already does. So, you would already expect auditors to take that into account, but the judgement is theirs about how that then flows through to the financial statements and their opinion on the financial statements.

  Q534  The Chairman: For example, if the regulator raised concerns about subprime mortgages, and the possible consequences of too much investment in subprime mortgages or CDOs, or whatever, would you expect the auditor to go back and challenge that in the bank before they made a judgement on the accounts?

  Mark Hoban: I am not an auditor and it's a long time since I've practised, but one would expect that auditors would take into account those sorts of issues and think about the valuation risks they attach to a book of mortgages in the subprime market. But, of course, I think one of the challenges is to provide the evidence to support a particular view.

  Q535  Lord Lawson of Blaby: But they didn't, did they?

  Mark Hoban: There is a wider question about people's understanding of some of the complex markets around financial instruments, where I suspect there is a large degree of ignorance about some of the future—

  Q536  Lord Lawson of Blaby: The auditors are ignorant? Are you saying the auditors are ignorant?

  Mark Hoban: No, I think there is a lot of concern, Lord Lawson, about the complexity of some of those instruments and how they were understood; how they were used and what the consequences were, and I think that is one of the strands that comes out from a number of reviews of the financial crisis. I don't think it relates specifically to auditors.

  The Chairman: We will be coming on to FRS and that sort of issue as well, which is relevant to this.

  Q537  Lord Forsyth of Drumlean: There was nothing complicated or difficult about understanding balance sheets that had been stretched to beyond the point of commonsense, of 40 times and more. One of the things that I find very puzzling—I am not an accountant—is that I don't really understand why an auditor could look at a balance sheet that was so overstretched and not express concern, and the cynical part of me thinks, "Well, perhaps the audit fees were not as important as the other fees that were being paid by some of these banks to the Big 4". That is where I think there is an issue here about systemic risk. To take Lord Hollick's analogy, all the incentives were to take the gap as being much narrower than what—looking with the benefit of hindsight—commonsense would tend to indicate, that the auditors should have been more on top of not the complex multiple derivatives, the exposures, and all the rest, but the bare facts that you had banks lending money on a scale relative to their assets that was obviously unsustainable.

  Mark Hoban: But at the same time, Lord Forsyth, I think that there were a number of people in the same boat, not least of which were the management and directors of some of these banks, the regulators and credit rating agencies. There are a number of players in this financial crisis who could take some of the blame for this, and I think that needs to be recognised as well.

  Q538  Lord Forsyth of Drumlean: But I am not seeking to apply blame, and for all these people I can make the same argument that it wasn't in their financial interest to—in the face of the stampede—say to everybody, "Stop", because they would have been run over. But, as a layman, I think the auditors would be the chaps who would press the alarm bell when the business model was clearly moving into a position that was unsustainable. Some people have given us evidence and they have said, "No, no, that is not the role of auditors", and you have been very careful in saying what you think the role of the auditor should be. But I am asking you whether you think that, perhaps in those circumstances, it is not surprising that the auditors didn't raise the alarm?

  Mark Hoban: I am not going to express a view on whether auditors, because they perceived a conflict of interest, didn't sound the alarm bell. I just think there are a lot of people who didn't sound that alarm bell; and ultimately the responsibility for running that business is down to directors and the management. We have a regulatory regime that is set in place to deal with the prudential supervision of these institutions and in a way, if you look outside the company, the people who then have the biggest responsibility for the safety and soundness of the financial system were the regulators, not the auditors.

  Q539  Lord Forsyth of Drumlean: But what needs to be changed in your judgement?

  Mark Hoban: In respect of the auditors or more widely? I think that more widely there needs to be a much better focus on prudential supervision than there has been, and that is part of the thrust behind the reforms that we announced last year that we're working through at the moment. In terms of audit, I think that Ed has outlined some of the areas where improvement needs to happen and I think that the area I would add on to—and acknowledging all the measures in the Banking Act 1987—is that improved dialogue.

  Lord Forsyth of Drumlean: With the benefit of hindsight you don't see any need for—

  Mark Hoban: Clearly, we need to look at what they report, and I think we are going to come on to accounting standards shortly. There are a number of areas that we need to learn from on this where actually we can improve the rigour of the process. But I think there is a duty on all of us who engage in the financial services businesses to be much more sceptical than perhaps we were. A number of people believed we had suddenly moved to a new form of stability and events proved us wrong.

  The Chairman: As you say, we are about to come on to accounting standards so I'll ask Lord Tugendhat to lead off on that.

  Q540  Lord Tugendhat: Lord Hollick asked a question—as others have—about lack of scepticism, and it has been put to us that one effect on audit of the adoption of the IFRS accounting standards, with their greater emphasis on compliance with rules than the old UK GAAP, has been to lead to a tick box approach and rather to blunt the exercise by auditors of an independent, prudent, sceptical judgement. You have had experience as an auditor before the change, and now you're a Minister in the world in which the change has occurred, so you have an interesting perspective on that. I wonder whether you would agree that one consequence of this change to IFRS might perhaps have been to blunt the scepticism, which seems to have been one of the causes of the problems?

  Mark Hoban: Shall I kick off on that on financial services, and perhaps, Ed, you might want to broaden out the debate? I think it is recognised—and you picked it up, Lord Tugendhat—that there was a shift between UK GAAP and IFRS, a move to a much more rules-based approach to accounting standards. When you have a more prescriptive approach, I think the challenge comes to ensure that the standards keep pace with the instruments you are trying to value and to measure. Clearly, in the aftermath of the financial crisis, a lot of work is going on in respect of IFRS9, to update it to make sure it does reflect more carefully some of the complexity of derivatives. I think it is important those standards remain up-to-date and reflect what is current practice in capital markets, rather than what may have been the case in the past. I think the other point I would make is that there has been a change in philosophy over a very lengthy period of time about how you look at accounts: you measure economic value much more than historic cost; present a more accurate snapshot of the value of a business at a particular time, and value the assets and liabilities it holds. There are merits in that approach, but I would say that I think the accounts are there to measure the assets and liabilities of the company, I don't think they are a substitute for prudential returns.

  Edward Davey: I have to say, I am not a chartered accountant by training, but certainly, the advice I have had is that there are more similarities than are often given credit to between UK GAAP and IFRS, and that they do operate on the basis of "principles". I think that has to be remembered when we are engaged in this debate. Whether the impact on IFRS, on audit, had a major change, the evidence in terms of the crisis does not appear to be there. We have been looking for it and we haven't seen that.

  Q541  Lord Tugendhat: Let me come at it in a different way. I can well believe that the two are more alike than unalike—to put it that way—but there are lots of these phrases like if somebody is not "a fit and proper person", or "true and fair accounts". It is quite difficult to describe precisely what they mean but, a bit like an elephant, you know it when you see it. Because we live in a more legalistic age—and I recognise the necessity for that—and because everything has more rules written down than it used to, and because we live in a global financial system and not a tight little city where everybody knew each other, we do have to operate on a much more formalised basis than was the case in the past. I totally recognise that. Nonetheless, it does seem to me that the idea of "true and fair" is something that is not just reflected in the absolute figures, it is reflected in the smell and the feel and all that sort of thing. I tend to feel that one of the things that has come out of this inquiry is that auditors have been doing it by the book and that the idea of "feel" and "sensibility" and, "Does it look quite right?" and, "Can you feel it?" has rather gone by the board. I see Lord Forsyth nodding. I wonder how you would react to that.

  Edward Davey: There is a problem for an auditor in having to make a decision, isn't there, because they really have a binary decision, haven't they? They either have to clear the accounts or not, and the question is: should we tinker with that approach or can we try to give the sort of sense that you are talking about in a different way?

  Lord Tugendhat: Not different, but in addition to.

  Edward Davey: Well, in addition to, so more information is out there so people can look at it and make judgements about it and respond to it. I have to say, that is why we keep stressing the role of the audit committee. I am sorry I keep coming back to that, but that is very much our position: that the role of the audit committee can be expanded to improve that communication. And the reports of the audit committee, if they can be expanded in the ways that we have talked about—I think, read alongside the audit—can begin to enable people to understand the underlying judgements, whether or not this company is quite aggressive in its approach to meeting accounting standards, and so on. So I think that is the way forward. I think asking auditors to change their traditional binary approach would create a lot of difficulties.

  Q542  Lord Forsyth of Drumlean: I am sure, Minister, you spend a great deal of your time going around seeing companies. As an exercise, ask the finance director what they think about this issue of whether the accounting standards have moved towards a box ticking culture and away from getting a prudential, fair and accurate view of the accounts. I will be surprised if you don't find, as I've found, that there is a pretty universal response. So it's not so much about the auditors, it is about whether we have moved to a box ticking culture, and whether that was one of the ingredients that helped to create the crisis we had. It is that. The evidence we have had in Committee has been very striking. Some of it is controversial, but one person gave us evidence, which went through each of a number of examples and showed how the change to IFRS had made the position worse. It is that, I think, that Lord Tugendhat is talking about.

  Edward Davey: As I understand it, the shift to the more rules-based approach has tended to be in the financial instruments zone of accounting, rather than in some of the accounting practices of the firms that you describe, Lord Forsyth. I'm sure that is an area you will want to explore, and I would encourage you to do that. But I think that is where the shift has been and where, perhaps, the focus of debate needs to be.

  Q543  Lord Forsyth of Drumlean: What changes would you like to see in the area that you have identified?

  Edward Davey: As I understand it, there are some proposals that are being evolved by the different accounting bodies to try to see whether or not they can take a better account of financial instruments. But I am going to turn to my colleague, who may have a better grip of the detail there.

  Richard Carter: I think it is fair to say that one of the lessons to learn, from the last couple of years, is that the financial standards in relation to financial instruments do need revision; the IASB has that work well in hand. There will be tricky judgements because, on the one hand, one wants to make sure that one is producing enough clarity so that any auditor entering the same business would reach more or less the same conclusions. On the other hand, it has to be something that enables the auditor to say, "Hang on a moment, I don't quite believe what I'm being told by the business. I need to make further inquiries. I need to be appropriately sceptical". It also needs to be capable of producing information at the end of the day which is useful for investors in terms of deciding whether or not the directors are indeed discharging their responsibilities properly in terms of running the business.

  Q544  The Chairman: You use the word "clarity". One of the impressions we're getting is that sometimes there has been a fudge in some of these areas of financial instruments. I was going to ask you what sounds like a very technical question, but I hope it draws attention to the point that we are all trying to raise with you. I don't know if you have seen the evidence from Professor Fearnley and Tim Bush that we have received, but they have questioned—this is the technical bit, but there is something behind it—whether IFRS is in full conformity with all the relevant provisions of the Companies Act 2006 and an associated statutory instrument. That statutory instrument requires prudence, no booking of unrealised profits, and recognition of contingent liabilities, among other things, and therefore that only profits realised at the balance sheet date are to be included in the profit and loss account. They have suggested that IFRS has submitted a neutral requirement for a prudent one and that, in so doing, IFRS is not in full conformity with UK law, and they go into areas like mark to market, which is different under the old SORP, the Statement of Recommended Practice that the bankers followed, and IFRS itself. So two questions: do you think that in fact IFRS may not be in full conformity with UK law in the Companies Act 2006; and, secondly, in the discussions with IASB that you have referred to, will you be pressing more for the old SORP kind of basis, which is the prudent basis, rather than the one which IFRS has at present?

  Edward Davey: If I may, Chairman, I will start the answer and then hand over to Richard to complete it. But your very important point about whether IFRS is in conformity with UK law; I believe, in their evidence, the Financial Reporting Council said it was, and confirmed that. I'm not sure whether they gave you the references but, as I think you will know, the use of IFRS was expressly mandated under European law in 2002 for consolidated accounts of all listed groups. That proposal was consulted on in the UK in 2002 and the UK resolved to go ahead with that, and legal effect was given in 2004. So, as I understand it, there is no question about legal conformity. It conforms. The argument that is put, that somehow IFRS has led to a loss of prudence, I think, to say the least, is contestable. As a matter of judgement, prudence is not a single point on a scale and I think it is simply not the case that IFRS has meant that prudence has been thrown out of the window. That is not how I understand it, but I wonder if Richard wants to add to that?

  Richard Carter: Shall I start with the difficult word, "prudence". It is difficult, partly because you will not find it defined in companies' legislation, but I take it to mean that gains and assets aren't overstated and that losses and liabilities aren't understated. I am supported in that view by looking at some of the wording in the Financial Reporting Standards, and I can find almost identical wording in the framework that the International Accounting Standards Board uses. So I think, as a concept, it's something that you can see running through both of them. I certainly agree there are questions as to whether or not that concept was something that the standards in force at particular times, with the benefit of hindsight, sufficiently developed and sufficiently included. If you want the history of the accounting rules, it is worth bearing in mind that up to 2004, if you wanted any guidance at all on any of this area, you wouldn't have found it in company law and you wouldn't have found it in the UK's own accounting standards. You would have had to go to the Statement of Recommended Practice issued by the British Bankers' Association and approved by the Accounting Standards Board in order to be able to fill in some of the key lacunae as to how to treat the general statements and standards when doing the specific audits of banks. This was a fairly standard approach where if you had specific areas of the economy that needed specific guidance about how the general standards applied, then an appropriate body would draw up a Statement of Recommended Practice, and the Accounting Standards Board would then decide whether or not it was prepared to agree to that. That was the process it followed in relation to banks. In 2005, when the ASB approved a new standard in relation to financial instruments, which was very similar—essentially the same—as the one being used internationally, the British Bankers' Association people decided that there was no longer any need for the Statement of Recommended Practice, because they thought that the effect of what was being introduced mirrored what the Statement of Recommended Practice had said, so it was therefore unnecessary. With the benefit of hindsight, were the arrangements in place ideal? No. Would you have got a better answer under the Statement of Recommended Practice? I have my doubts. You might have got a slightly different one. But if we look at the scale of changes that were going on—I think a lot of the debates about: was banking accounting prudent or not?—effectively what was going on in the real economy meant that we risked focusing almost on the wrong question, as it were.

  Q545  The Chairman: I was going to say that some of the points in the SORP would have been better followed than the strict IFRS definitions. Therefore, I'm wondering what changes you're seeking in IFRS in the current review?

  Richard Carter: I'm not, as it were, sitting here with a package of 25 changes, which I want to see made in terms of, "Change this sentence to say that sentence", or whatever. What I'm saying is: what I think we would like to see emerge from this review is a standard that people can understand; a standard that people can apply; a standard that people have confidence in, and will avoid—in so far as any standard can—the sort of issues we've had over the last couple of years. For instance, if you want a particular area, quite a technical area around loss provisions, historically we've been in a situation where the banks' accounts would only take account of those losses that they already knew had been incurred. But there is the suggestion, which I think is probably quite a good one, that going forward they should also take account of those losses that they expect are going to be incurred because of something which is going to happen in the future. That is quite a significant change. At one level it sounds technical—and I apologise if I haven't explained it as well as I might—but in practical terms I think that could be very important. Would it have produced a significant difference three or four years ago? I don't know.

  Q546  Lord Lawson of Blaby: Clearly, we know from what has happened that this accounting was not prudent. It may have been legal, and—I am not a lawyer—I am prepared to accept that it was legal, unless it has been demonstrated otherwise. But it clearly wasn't prudent. Unrealised profits on financial instruments, under the mark to market or fair value accounting, or whatever you like to call it, could not possibly have been realised in practice if everybody had wanted to realise it, or even if a large number had wanted to realise it. Because there would have been a sell-off of these instruments; no way could these profits have been realised. Therefore, it was completely imprudent. Yet, as we know—I understand that the Government is concerned about bank bonuses—bonuses were paid out--real bonuses, realised bonuses, if you like--were paid out of these unrealised and mythical profits. That surely must give rise to some concern. That surely must make you feel that there is something amiss?

  Edward Davey: Lord Lawson, I think no one who has lived through that period and seen the damage done to our banks, and to the global economy, would be complacent in any of these areas. As I said right at the start of my remarks, one of the reasons why we welcome your inquiry is that we want to expose some of these very significant issues. The question I think you're driving at is whether or not the move to IFRS created the approach that you have described, and whether or not, if we'd had UK GAAP, it would have been avoided. I have to say I'm not sure. I don't think the evidence is clear on that at all.

  Q547  Lord Lawson of Blaby: What are we going to do about it? That is the real question.

  Edward Davey: As Richard was saying, there is an awful lot of work being done on all aspects of the crisis to see whether or not different aspects of the regulations need to change. Richard mentioned the change to how we look at bank losses and see whether ones that are expected to happen should be taken account of in terms of provisions. I think it is right that all those types of regulations, around these particular financial instruments—the more exotic ones—are considered.

  Richard Carter: If I may, I think it entirely right that there needs to be debate about the role of fair value. If one is looking at valuing a building, does one assume one is selling it in a fire sale, when everybody else is looking to sell their property in the adjoining streets, in which case you get a very low value, or do you assume that you are going to sell it in an ordinary market? I think there are similar issues when one looks at some of the treatments of financial instruments. I agree that there clearly were significant issues about how they were treated. I think we need to try to make sure that we end up in a better, happier place, which doesn't involve everything automatically having to be marked fairly to market when it's not appropriate. Under one set of potential American proposals, for instance, there would have been a need for a lot more fair value accounting, but I think that is something that it's pretty clear that neither the UK nor indeed Europe would be happy with. But equally, if one has something where one has absolutely no involvement in looking at the real, realisable value of the assets, then one has to answer the question of: do you have a set of accounts that tells you enough about what is going on in the company? That is why these things all become so complicated. One other point I would just make in passing is that whilst none of us really needs to pause on the scale of what happened in the last couple of years, the losses were immensely greater than all the bonuses and dividends that the banks had paid out over the financial cycle.

  Q548  Lord Tugendhat: I would like to make an observation, and you may or may not wish to comment or agree with it. One of the problems about the excessively rule-based approach on the one hand, and the too small number of auditors on the other, is that in practice an auditor is not going to give up a client because it doesn't smell right. I have a long memory, like other people here, and I remember a time—not with an auditor—when Cazenove decided that they could no longer do business with Conrad Black. It wasn't that Conrad Black had done something illegal. He hadn't. It was just that Cazenove, who were very shrewd people, took the view that it didn't smell right and they would be better off—and their reputation would be better off—if they dropped him as a client and he could find another advisor, which of course he did without any difficulty. Now, they could do that because there were lots of other financial advisors he could go to; it was done very quietly; it was done very discreetly. But the combination of this excessively rule-based approach means, first of all, that smell does not feature much in the way in which people approach it; and, secondly, it is inconceivable that an auditor could give up a client, because that would be such a major crisis. If one of the Big 4 gave up a FTSE 100—let alone a bank—the heavens would fall. So the people are trapped into relationships, and I think that is a point that perhaps contributes to some of the difficulties that we've been inquiring into.

  Edward Davey: I think a lot of what you say has strong value. What we should note, though, and this is from the ethical standards of the professional bodies in this area, is that no auditor should be dependent on one single client so that they can't walk away. That is a very important ethical standard, and auditors are expected to adhere to it.

  Q549  Lord Tugendhat: It is not that they are dependent. It is just that the scandal that would arise would be so great because they wouldn't be able to go to anybody else. There is no choice in the audit market, in effect, if you have three people dealing with the banks. Whereas, when you had eight big auditors, if somebody felt discreetly that they would prefer not to have a relationship, it was possible for a relationship to change. But in practice, I don't think it is now.

  Edward Davey: I don't want to rehearse all the arguments we had at the beginning of the session, Chairman, about the importance of increasing competition and choice in the audit market. I think that there is agreement there, and I just think that it would be wrong for me to say that there are auditors who failed to walk away from particular clients, because I don't have that information. But it is important that the ethical standards are held to, and the professional bodies look at that very seriously[32].

  The Chairman: Finally, then, to competition and choice—and fairly briefly—there are a couple of questions more I think we need to ask you to finish.

  Q550  Lord Lawson of Blaby: I would like to follow on from Lord Tugendhat, who made a number of points. One of them was, in effect, audit timidity, or you might call it something else, but they don't want to lose the business and therefore that makes them a little more timid in what they say and do than is ideally desirable. There is another way in which timidity comes in that is connected, and that is their liability. We have been advised—and I assume correctly so—that whereas the Companies Act does allow a cap to be put on liability of auditors, in practice that doesn't happen. Do you think it might be desirable, to counter auditors being unduly timid, if the idea of a cap on the auditor's liability were to be a practical reality more often than a purely theoretical possibility?

  Edward Davey: We have looked at this—obviously, it's a very important issue of policy—and our conclusion is that we shouldn't put a cap on. We have no plans to do so. We went about this by looking at the academic evidence, because if there had been evidence that the benefits of doing this would exceed the cost, then obviously we would have considered it carefully. But the liability does drive quality of audit, and there is quite strong evidence from the academics in this regard.

  Q551  Lord Lawson of Blaby: I am not suggesting for a moment there should be zero liability.

  Edward Davey: No, but as soon as you put a cap on it, then the question is: is that going to reduce quality? And that is a concern that we have. So that's not the road we want to go down. I would also make this observation, because in the department we have been evaluating the Companies Act 2006, in which the option of a company agreeing a cap with its auditor was put in. So it wasn't the Government putting in a cap, but enabling a company with its auditor to agree that they would have a cap. We found that something approaching 17% of medium, large, public and quoted firms have taken steps to adopt or actually adopted auditor liability agreements, and about 9% have actually signed such agreements with their auditor. So there has been some take up of that option within the Companies Act 2006. Therefore, companies can negotiate that cap if they think it's appropriate. They trade that off—in their view, in an open way—with how they think the auditor will respond.

  Q552  Lord Lawson of Blaby: Of these 9%—I don't know the answer to this question, it is always dangerous to ask a question if you don't know the answer—how many involved the Big 4?

  Edward Davey: I don't know the answer to that, but I am very happy to get you that answer. I have just magically remembered the answer—I think you will know the feeling, although you probably never had to have inspiration the way that some of us do—and the answer is zero.

  Lord Lawson of Blaby: I thought so, yes.

  Q553  The Chairman: Finally, you will have seen that Lord Myners suggested last week that this question of the audit market should be referred by the OFT to the Competition Commission. You may not have a view on that, but can I ask you if you have?

  Edward Davey: I am the Minister for Competition, so obviously I have a lot of views on a lot of issues around competition. On this particular one I might want to give a pass, if I may. I think I have made it clear that we have huge concerns about competition in this area. I have laid out a whole set of actions that I think should be taken, particularly on the demand side, and I think in the first instance we should be cracking on with those types of measures before we have any referral.

  The Chairman: Thank you very much indeed. All three of you have given us a great deal of response, information and help. It has been a very interesting session for us. I'm not sure we have the answer yet as to how you deal with the question of the Big 4 becoming the Big 3, but we will do our best to find some answers too. It has been a very helpful session, very interesting responses, and we are very grateful to you. Thank you all.

32   Note by Witness: It might be useful for the Committee to know that when an auditor ceases to hold office, under s519-521 of Companies Act 2006, he must deposit a statement (which is sent to the company, the shareholders and Companies House) which sets out the circumstances connected with his ceasing to hold office Back

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