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 ifas seems possibleit 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 committeesthis
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 believecertainly from the
evidence I've seenthat 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 Healthcareso I am involved
in that worldand 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 SMEswho
often complain that the procurement system works against themcan
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 andto
speak to your pointwith 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 tenderI 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
earlierI am sure we will come onto thisfrom 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 areoutside
the Big 4some 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 meetingscertainly
all those I have attendedthe 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 aboutthe
changes to the code for the audit committees or making the FRC's
code mandatorywould 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 sayin parenthesisthat
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 Governmentas
part of its cull of quangosis 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 initiallyand
I am sure your Lordships are awarethere 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 usand I am just repeating evidence
that we have receiveddidn'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
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 pleasedvery pleasedthat
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
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
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 concernwhich will certainly be felt in the other
placeabout 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 workbecause 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 expertiseis
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 areabecause
as you say it is quite complex and many of these companies operate,
the audit companies that is, all over the globedecisions
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
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
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
Q523 Lord Hollick: Can you give us
a sense of how many companies that might cover if you were to
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 limitedand often
boiler-platequalitative 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
inparticularly those who went through the banking collapse,
people who lost share investments, and so onis 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 auditorsas we talked about at length
earlierbut 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 ShipleyI'm
afraid I didn't answer the questionabout 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 questionedand they certainly can provide services
without threatening independence, but that is an issue to considerand
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 andprior
to coming to this HouseI 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 whichI'm paraphrasing
himhe 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 regulatoror supervisor, as he was
known in those days, but that doesn't make much differenceand
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 regulatorthe Bank of
England as it was then and now is going to beshould 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
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
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 discussionsand nor has the Treasurywith
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 monthsin some cases weekswere 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 thinkand
we will perhaps come to this laterthere 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 madeit is
also made in the BIS submissionwhich 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
Q532 Lord Hollick: One of the suggestions
is that the audit report might shed more lightand this
is something that the shareholders were in favour ofon
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
Edward Davey: If I may, I think where we've
reached in our analysis and where we think we should push on this
isand I'm repeating myself, I'm afraidthe 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 canin the theory of auditgive 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 regulatorthe 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
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 puzzlingI
am not an accountantis 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 whatlooking with the
benefit of hindsightcommonsense 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
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
toin the face of the stampedesay 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 toand
acknowledging all the measures in the Banking Act 1987is
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 questionas others haveabout 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 recognisedand you picked it up, Lord Tugendhatthat
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 unaliketo put it that waybut 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 ageand I recognise the necessity
for thatand 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
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 aboutI think, read alongside
the auditcan 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 questionedthis is the technical bit, but
there is something behind itwhether 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 similaressentially
the sameas 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 onI 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 avoidin so far as any standard
canthe 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 technicaland I apologise if I haven't explained
it as well as I mightbut 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, andI am not a lawyerI 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 knowI understand that the Government
is concerned about bank bonusesbonuses 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
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
instrumentsthe more exotic onesare 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 timenot with an
auditorwhen 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 offand their reputation
would be better offif 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 100let alone a bankthe 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.
The Chairman: Finally, then, to competition
and choiceand fairly brieflythere 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 advisedand I assume correctly sothat
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 thisobviously,
it's a very important issue of policyand 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 offin their view, in an open waywith
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 answerhow
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 answerI think you will know the feeling,
although you probably never had to have inspiration the way that
some of us doand 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