Accounting: Four play – is non-audit work in jeopardy?

You can bet your bottom dollar that bankers will do
everything in their power to resist binning bonuses, however much tabloids
scream and the Treasury Select Committee disapproves. And the auditing
profession will surely adopt a similar approach to the call from the influential
MPs that they should relinquish non-audit work for the banking sector.

While berating bankers about bonus culture could not be labelled a surprise,
the specific suggestion to strengthen auditor independence did catch the
profession on the hop.

Despite highlighting evidence it received that having no non-audit work could
lower the quality of the audit because of ignorance about the client’s
activities, the Committee remains concerned. It accepts that independence is
just one of several determinants of auditor independence. But the report,
Banking Crisis: Reforming corporate governance and pay in the City,
adds: “We believe that, as economic agents, audit firms will face strong
incentives to temper critical opinions of accounts prepared by executive boards,
if there is a perceived risk that non-audit work could be jeopardised.”

Despite the arguments of auditors, it has chosen to believe the view from the
investment community, who are sceptical that the audit approach would be
rigorous if millions of pounds in consultancy fees hang in the balance.

The question of independence had been picked up in an earlier report from the
same committee on Northern Rock. The run on the Rock concluded: “There
appears to be a particular conflict of interest between the statutory role of
the auditor and the other work it may undertake for a financial institution.”
This focused on concerns around auditors earning fees from work arising from
securitisations, especially where assets were held off-balance sheet.

While this is a hoary old argument, the MPs have given it a fresh twist in
saying the problem is exacerbated by the concentration of audit work in so few
major firms. So to boost investor confidence, the committee calls for
prohibition on non-audit work and demands the Financial Reporting Council start
a consultation process.

In many ways, the rest of the conclusions of the committee were in line with
the thinking of the accountancy profession. Over issues such as going concern,
complexity, the relationship between auditors and regulators, the importance of
fair value and the interference of the European Commission in the work of the
International Accounting Standards Board, the profession could have hardly asked
for more support from the MPs.

But with tens of millions of pounds being spent by the banking sector on the
services of auditors (if not audit), the MPs couldn’t resist the idea of
prohibition as a way of improving corporate governance and that could hit
auditors where it hurts ­ in the pocket.

Big money is involved as can be shown by a couple of random examples: in
2008, HSBC auditor KPMG earned $90.4m from the banking group, of which $48.6m
was audit fees. Figures from Barclays’ accounts for 2008 show that it paid
PricewaterhouseCoopers a total of £52m, of which £38m was for audit and
audit-related services (prior year’s figures: £44m and £29m, respectively).

The FRC will have to respond. But the first off-the-record reaction is little
short of scorn. The MPs suggest a model for the structure of the audit
profession which the UK would share with no other leading country, except
France.

Michael Izza, chief executive of the Institute of Chartered Accountants in
England and Wales, questions the conclusions on auditor independence but accepts
that “further work needs to be done in this area to demonstrate to market
participants how far the profession has come in recent years and, therefore,
welcome the proposed FRC review of this issue.”

At best, if the MPs get their way and audit firms are banned from offering
non-audit services to their banking audit clients, all you are likely to see is
an expensive merry-go-round of professional services firms passing work between
themselves, with maybe the odd scrap thrown to non-Big Four firms and niche
players. That may well be possible, but you won’t find bank auditors saying that
it makes them more independent.

The profession thought the auditor independence question was a closed one ­
it worked hard on the problem of audit independence post-Enron and thought most
criticism and critics had been silenced. But the question of audit independence
is at its most critical when audit appears in bad shape.

Certainly when audit was little more than a loss leader and consultancy was
the sexy go-go area, it was reasonable to suggest that audit independence was a
delicate flower in danger of being trampled. As audit has recovered its status
and self-esteem, dangers to audit independence now seem more theoretical than
real. Even so far in this recession and financial crisis, auditing doesn’t
appear to have been battered too harshly.

But the profession needs to answer the real problem the MPs have unearthed.
They have stumbled across the problem that the profession has been struggling
with ever since Arthur Andersen collapsed: how to introduce more competition
into the audit market. The answer so far is: don’t know.