Big Four expect a grilling from Lords audit inquiry

THE LORDS may have passed the halfway mark in their closely watched inquiry into auditors, but they are still far away from achieving consensus on some of the long standing issues which plague the industry.
The Lords’ Economic Affairs Committee has grilled acad­emics, auditors, technical experts and regulators during the inquiry, now into its sixth week. But those who counted on a sedate inquiry would be disappointed with heated questioning so far led by Lord Lawson, the vociferous former chancellor to prime minister Margaret Thatcher.
Whether he’s taking aim at auditors, who he described as, “one of the dogs that didn’t bark”, or regulators, who “were asleep on the job”, Lawson’s comments have come to sum up the bewilderment and frustration felt by the Lords investigating why auditors failed to sound any alarm in the lead-up to the crisis.
The House of Lords’ inquiry may at first glance be about market concentration, but the questioning has meandered down a number of side alleys including accounting standards, banking law and the break up of the Audit Commission. It’s a scattergun approach, which has seen the Lords dust off old debates surrounding conflicts of interest and fair value accounting, while also posing penetrating questions about auditor scepticism and regulator engagement.
But the hearing which promises the most drama is when the Big Four front up to answer questions about their role in the crisis. Among them will be the auditors of Northern Rock, Royal Bank of Scotland, Bradford & Bingley and Lloyds Banking Group. And, if questions asked so far provide a guide, the primary defence of auditors – that it was not their job to raise the alarm- will not be enough to win over a sceptical panel of Lords.
Peers have already made clear they won’t accept “tactical risk spreading” or attempts to “dilute the blame”.
“I still don’t understand why auditors looking at banks’ balance sheets, seeing huge levels of gearing, seeing all kinds of complex instruments, did not feel it necessary to at least ring a little bell,” said Lord Forsyth.
“I find it difficult to understand, given what auditors are meant to do, that on looking at these expanding balance sheets and the makings of a crisis they did not sound the alarm,” he added.
When Richard Sexton, head of audit at PwC, was grilled on Northern Rocks’ liquidity issues in 2007, he retreated to a strict interpretation of auditors’ responsibilities.
“Our job is to look at the presented historical information and whether it represents fairly the actions of management and the board in managing the assets and liabilities of Northern Rock in this case. That is what is presented in the notes to the account on which we have expressed an opinion,” he answered at the time.
“The information required to be audited was thoroughly audited and presented in the financial statements for all to see.”
This standard defence has slowly deteriorated since 2007. The intervening years have seen the Big Four soften their stance and, sensing the wind of change, attempt to embrace and own the reform agenda.
“What we do remains largely defined today as it was in the era before [new] technologies were available to us, trapped
in time by a combination of regulation and conservatism,” said John Griffith-Jones, senior partner at KPMG, earlier in the year.
PwC chief Ian Powell echoed the remarks during a speech last month: “The audit profession should examine its role and responsibilities and how they should be changed.”
PwC is the first firm to
take action in this regard, embarking on the noble but risky route of asking its
major clients to publish more internal information on risk management.
However, it’s unlikely this conciliatory approach will win over the Lords, intent on forcing the accountants to accept some share of the responsibility.
Testimony by the Big Four will be crucial to the inquiry’s outcome. So far the Lords have failed to pin down specifically how audit firms themselves could have failed in their responsibility, instead highlighting only structural issues.
Some of the more extreme reforms floated during the inquiry, however, come with their own set of economic consequences. The idea of mandatory auditor rotation, which has been raised, may only increase the overall cost of audit, forcing companies to continually tender and then re-educate new auditors on their business practices.
And whether this will solve the competition issue is also uncertain. Simon Michaels, senior partner at the UK’s sixth largest accounting firm BDO, said it may “compound the concentration issue”.
“While audits are put out to tender, those that are put out by the non-Big Four firms are generally sucked up by the Big Four and it’s very difficult for the non-Big Four to win them back,” he told the inquiry.
Another emerging theme has been auditors’ relationship with regulators, specifically the Financial Services Authority.
The last 12 months has seen the FSA steadily applying pressure on the Big Four to speak to regulators about worrisome issues discovered in the course of their audits. Auditors, keen to maintain strong ties with their clients, have resisted attempts to rat out their companies to regulators. Instead, they say their clients should speak to regulators themselves.
This approach, however, won’t satisfy the FSA, which has said it wants a wider range of powers over auditors, including public censure, financial penalties, or the power to disqualify individual partners.
An appearance by the Big Four will see these issues laid bare under the harsh glare of the Lords. At the heart of the inquiry is a question of allegiances.
The Lords will insist they should rest with shareholders, and, while auditors are likely to agree, the truth of the matter will remain, as ever, elusive.