Auditors acted as “cheerleaders” for questionable bank reporting

AUDITORS FAILED IN THEIR DUTY to expose the risks accumulating banks’ balance sheets and acted as “cheerleaders” for questionable reporting practices, a damning report into the banking industry has found.

The Parliamentary Commission on Banking Standards (PCBS), set up by the government in the wake of a string of scandals involving the industry, found bankers, regulators, investors and auditors all failed to understand the risks building up in the banking system.

According to evidence collected by the PCBS, the overly close relationships between banks and their auditors meant that “at best, auditors did not act as the last line of defence against banks’ questionable reporting on their own businesses and, at worst, they were cheerleaders for it.”

“Auditors failed to act decisively and fully to expose risks being added to balance sheets throughout the period of highly leveraged banking expansion,” the report said.

The PCBS was also critical of the “flawed” accounting standards banks use to compile their accounts and auditors use to vet them, which, it said, were “not fit for regulators’ purposes.”

The incurred-loss model used by IFRS for valuing banks’ assets and liabilities has long been criticised for allowing banks to pay out on unrealised profits by not forcing them to make adequate provision for loans that could go bad.

“Audited accounts conspicuously failed to accurately inform their users about the financial condition of banks,” the report said.

Introducing an expected-loss model was welcomed as beneficial by the PCBS, though it raised concerns about the slow pace of change and “the particular effect this has on investor confidence in the balance sheets of banks”.

In addition to reporting under IFRS, the PCBS recommended that banks be made to create a separate set of accounts for regulators, “according to specified, prudent principles” that should be externally audited and called for the Bank of England to commission a “periodic report on the quality of dialogue between auditors and supervisors”.

“We would expect that for the dialogue to be effective, both the PRA and the FCA would need to meet a bank’s external auditor regularly, and more than the minimum of once a year which is specified by the Code of Practice governing the relationship between the external auditor and the supervisor,” the PCBS said.

The report also found that internal auditor functions “lacked the status to challenge front-line staff effectively” and recommended that preservation of internal audit’s independence should be “the responsibility of a named individual non-executive director, usually the chairman of the audit committee” and that “dismissal or sanctions against the head of internal audit should also require the agreement of the non-executive directors”.

Ian Peters, chief executive of the Chartered Institute of Internal Auditors said: “Blurred lines of accountability combined with poor controls presented a major threat to the banks and must be the focus of reform in the banking sector. The report recognises that internal audit must play a central role in that reform and we welcome its recommendations to support that role”