Hound of the bank villains: the Treasury Select Committee on audit industry's trail

Entrenched and trenchant positions, major disagreements, little fresh
thinking and meagre insights on the way forward ­ and that was just the
accountancy profession. MPs seemed bemused and angered by some of the responses
of the profession’s representatives called as witnesses in the ongoing
parliamentary enquiry into the banking crisis by the Treasury Select Committee.

However, it is possible that radical proposals, which would impact the
relationship between the finance director and auditor in the financial services
industry, may emerge from the investigation. Labour MP for Leeds East, George
Mudie, called for banks to be subject to a “deeper audit” to examine systemic
risk, and for auditors ­ with the knowledge of the bank ­ to report areas that
are not working to the regulator.

Promising direction
Paul Boyle, outgoing chief executive of the Financial Reporting Council, called
the idea “a promising line for further study” but added a note of caution,
saying, “It needs to start with what communications are currently taking place ­
and remember auditors are not currently responsible for changing the behaviour
of the banks.”

Committee chairman John McFall wondered whether auditors had asked the right
questions of bank FDs over the past few years. Michael Power, professor of
accounting at the London School of Economics, re-iterated the purpose of an
audit. “It may not be reasonable to expect that auditors would be challenging
business models and raising strategic issues. That is not their job and if we
want to make it their job, then things would have to change substantially,” he
said.

Both the ICAEW and the FRC claimed that, following the Enron scandal seven
years ago, there had been a significant refocusing on audit quality. “In part,
that has come from the existence of an independent regulatory agency, the FRC,
which is focusing on the auditors’ attentions to audit quality,” he said.

However, he added, “That does not deal with the fundamental questions about
whether the audit is focused on the right things. Auditors are currently focused
on what parliament has asked them to focus on. It is possible to change that
role.”

ACCA’s managing director, Helen Brand, said the external audit would only
have a limited impact in this kind of crisis, but suggested there is room for
improvement in the audit function “which auditors are now starting to address”.
She added, “There is an ‘expectations gap’ about what auditors can provide.
There is room for improvement within the audit and risk management functions and
this involves all stakeholders in the process.”

Auditor value
Boyle described the audit as “a hugely valuable activity that would really be
missed if it were not there. The value of an audit is not in the beauty and the
elegance of the financial statements you see, it is the difference between those
financial statements and what would be produced if management were not subject
to independent review, either from over-optimism or simple error.”

Putting audit in a wider context, Power said auditing is one part of a wide
and complex network of institutions which provide trust and stability in an
economic system. “I do not think we understand well the inter-connectivity that
supports this system of trust and assurance.”

Prem Sikka, professor of accounting at the University of Essex, presented a
diametrically opposed analysis.
Attacking the auditors and the banks, he called for a fundamental change in
accounting and auditing. He said the banks failed to give any figures about the
state of the credit crisis and that auditors are too close to companies. “The
auditors claim confidentiality on their working papers and the FSA has basically
been operating blind, assuming the auditors would alert anybody to any risks or
problems.

Our system has fallen apart. The model of commercialised accounting firms
regulating another bunch of commercial entrepreneurs cannot work and is broken,
” he said. He said the markets had totally discounted audit reports and ignored
financial statements and that the FRC had been asleep on the job. Northern Rock
was the warning, but it did not result in the FRC scrutinising the reports and
accounts of the banks.

Apart from the dissenting voice of Professor Sikka, who repeated his
long-held view that the audit process should be nationalised (well if it is good
enough for the banks), there were few suggestions from the FRC, ACCA or the
ICAEW on the way forward for post-crisis banking audits, except perhaps for
revisiting the issue of risk management.

Greater independence
When asked about the future, Robert Hodgkinson, the ICAEW executive director of
technical strategy, said, “In the Audit Quality Forum, which the Institute
hosts, we are looking to take onto our agenda the potential role auditors have
in systemic risk issues and making sure there is a wider understanding of the
independence framework.”

The committee said it was unhappy that, a year after it drew attention to the
fact that the auditors of Northern Rock had been paid “substantial sums” for
providing comfort letters for off-balance securitisation, the practice had not
been stopped. Deputy chairman Michael Fallon said, “What we have been asking
for and recommending is a clear distinction between audit work and comfort and
securitisation work that is off the balance sheet. You are telling us that it is
continuing and you are happy for it to continue.”

Less than impressed
The MPs seemed equally unconvinced by some of the evidence they heard from bank
auditors, John Hitchins, leader of PricewaterhouseCoopers’ UK banking practice
and Brendan Nelson, vice chairman of KPMG in the UK. Nelson told MPs, “Auditors
have discharged their responsibilities diligently in the context of what the
statutory audit responsibility represents.” The MPs criticised PwC for its
argument over cross-selling of services with the regulator, the Audit
Inspection Unit, in relation to the work it performed for Northern Rock.

Nick Ainger, Labour MP for Carmarthen West and South Pembrokeshire, said, “Do
you not understand that this type of refusal to acknowledge a regulator’s
judgement brings the whole industry into disrepute? People out there ask: ‘Is it
right that an auditor of a bank which subsequently failed and had to be bailed
out by the British taxpayer not only took fees for the audit, but also took
£700,000 off that bank for other types of advice?’”

Speaking after the session, ACCA’s Brand said, “Over 100 years ago, an
English judge said in the celebrated Kingston Cotton Mills case in 1896, that
the auditor is a watchdog, not a bloodhound.”

Whatever type of breed auditors may think they are, as far as MPs are
concerned, their role in the banking crisis could lead to them ending up in the
dog house.