Audit: time for change

As the world awoke from the banking crisis, the finger of blame was being pointed firmly at the greedy bankers, inept rating agencies, cowboy traders and reluctant regulators. The generally held view was that auditors had come through virtually unscathed.

The head of the UK’s reporting regulator, Paul Boyle, articulated this belief in October 2008 at Mansion House in London when he said that, for all intents and purposes, “so far, at least, auditing has had a good crisis”.

“I have heard some criticism of the work of auditors but they have also been a mix of the ‘too lax’ and ‘too strict’ varieties of criticism,” he said at the time.

There was a brief moment when the spotlight swung to auditors during a Treasury Select Committee hearing. One auditor was, it seemed, left to answer the tough questions for the entire profession. On 7 December 2007, Richard Sexton, head of audit at PwC, was hauled before the committee examining the collapse of Northern Rock.

Committee member and Conservative MP for Sevenoaks, Michael Fallon, grilled the well-spoken Sexton on PwC’s audit of Northern Rock. Sexton did what most auditors do when their backs are against the wall; cite a strict interpretation of the rules.

“You have audited and provided comfort to the biggest banking disaster for 150 years,” accused Fallon.

“We have provided audit services in connection with auditing standards and guidance from the UK Auditing Standards Board and the International Auditing Standards Board and performed the duties required of statutory auditors,” Sexton responded.

By 2009 it seemed a truce was reached, with Sexton co-authoring a paper with committee chairman John McFall, in which both agreed “the corporate reporting model is broken”.

“We should waste no time in establishing a progressive programme of activity over the next two years to consider how the reporting and audit model can be strengthened to enhance regulatory and investor understanding,” the pair wrote in their paper.

Auditors weren’t the problem, it was the reporting model, the audit structure, the guidelines and standards with which they followed.

There was some initial soul searching within the large accounting firms and accounting institutes but also pride that, unlike the last major crisis, auditors were not in the crosshairs.

Among regulators there remained a single lingering question. If auditors had not
revealed the catastrophic risks carried by major financial institutions which led to the financial crisis, what was the point of audit?

Repo men

From April 2008 through to September 2008, at Lehman Brothers’ Seventh Avenue headquarters in New York, each senior executive would be welcomed each morning to an email titled “Balance Sheet and Disclosure Scorecard”.

Somewhere between the global and regional net balance and cash capital schedules was a figure under the heading Repo 105 transactions.

Repos are corporate slang for repurchase transactions and are common among financial institutions, often used to raise short-term capital. In economic terms, the transactions closely resemble loans with assets often sold off one day, only to be repurchased a few days later.

And, like a typical loan, the asset often remains on balance sheets. Lehman Brothers, by manipulating a technical accounting definition, recorded the transactions as sales and removed the assets from its balance sheet.

About two years later, the strategy caught the attention of Anton Valukas as he poured through documents produced in the lead up to the bank’s collapse. Valukas was appointed by the US Southern District Bankruptcy court in New York, to search out a path to litigation against Lehman Brothers and its auditor Ernst & Young.

He was particularly interested in the timing of the transactions, which s eemed to take place during sensitive reporting periods, when all eyes were on banks’ balance sheets.
His report was unsealed and released to the public in March. The splash it caused sent ripples out across the Atlantic to the UK’s shores, where newspapers quickly consumed and regurgitated the nine-volume report.

“Will Repo 105 bring down Ernst & Young?” screamed the Mail on Sunday. “Ernst & Young questioned over Lehman gimmick,” said The Times.

“The Valukas report paints a damning picture of the bank’s final two years, branding it a hothouse institution so obsessed with growth that senior executives said openly that they did not want to hear ‘too much detail’ about the risks they might face in case it held them back,” The Times reported.

Critically, the report said E&Y’s actions could constitute professional negligence. E&Y has consistently denied any wrongdoing since the report’s release and said it would fight the claims.

But it was bad news for all auditors, long considered an afterthought of the crisis, now under the public and regulatory microscope.

Less than two weeks after Valukas’ report the Treasury Select Committee released its own report into banks and cited the Lehman Brothers example.

“The current audit process results in ‘tunnel vision’… The recent revelations about Lehman’s use of Repo 105 illustrates the extent to which audit reports can seemingly omit crucial information,” the committee said.

The UK’s reporting regulator, the Financial Reporting Council (FRC), said it would also “ascertain the facts on how the repo transactions were accounted for and audited in the UK” and “asked Ernst & Young to provide further information in relation to what happened in the UK”. E&Y said it would “co-operate fully” with all the requests.

Last month the industry watchdog, the Accounting and Actuarial Discipline Board, said it would also investigate E&Y.

Audit reform is being taken up at a European level. Newly sworn in European Markets Commissioner Michel Barnier said in April that it was “the right time to launch a real debate at European level on the subject of audit”.

“This conviction is reinforced by the questions recently raised in the context of the audit of the accounts of the American bank Lehman Brothers,” he said.

But, perhaps the sharpest attack came from the Financial Services Authority last week, which had been eyeing auditors’ role in the crisis for some time.

The body, together with its smaller sister-regulator, the FRC, released a discussion paper which, aimed at prompting debate within the industry, read like a frontal assault on auditors’ independence from their clients.

The paper did not attack the structure of audit or the firms, but auditors personally, their behaviour and apparent tendency to rubber stamp management decisions.

“In some cases that the FSA has seen, the auditor’s approach seems to focus too much on gathering and accepting evidence to support management’s assertions, and whether management’s valuations meet the specific requirements of accounting standards,” the report stated.

Lurking beneath the words seemed to be a festering resentment of some auditors who, in the FSA’s view, had failed to sound the alarm bells in the lead up to the banking crisis.

Auditors had become very reluctant whistleblowers, the FSA believed, rarely approaching regulators with their concerns and preferring instead to solve difficult accounting issues with their clients behind closed doors.

Regulators not only wanted the industry to evolve, it wanted auditors to change their attitude, to exercise more judgement and, if need be, rat out their clients. In response, auditors advised caution.

“It is not for us to present an alternative view and try to get management to accept it as better than theirs,” PwC’s Richard Sexton said.

But it seems the rules are changing for auditors. Now, everything was up for grabs.

Time for change

It was manifesto season in late April. The ruling Labour Party had released its offer of “a future fair for all” while the Conservatives invited the British public to “join us to form a new kind of government”. The Liberal Democrats, were promising “change that works for you”.

Among auditors, it wasn’t the political messages that raised eyebrows as much as a sentence buried on page 26 of the Lib Dem’s manifesto.

“We will reintroduce the Operating and Financial Review (OFR), dropped in November 2005, to ensure that directors’ social and environmental duties will have to be covered in company reporting.”

The extra reporting requirement was scrapped by the then chancellor Gordon Brown in 2005. However, with its possible reinstatement came the possibility of reform in another area closer to auditors’ hearts – liability reform.

Senior auditors had been whispering for some time about reform. The large six audit firms said they would take on extra reporting responsibilities for a price and that price was to rein in their liability.

“The concession that the profession will have to make for additional liability limits will be to extend work that the auditor does at the front of the book,” said Graham Clayworth, audit partner at BDO in April, hoping to capture the winds of change.

Following the election, those winds of change quickly turned into a gale. The release of Valukas’s report into the Lehman Brothers collapse combined with a number of active and pending investigations into audit reform led to the inevitable conclusion that, whether the audit industry wanted it or not, change was coming.

It was in this climate that one of the senior audit partners in the country, agreed to speak at a little known industry event organised by Scottish accounting institute ICAS, focusing on the usefulness of audit.

Inside the ornate Stationers’ Hall, in the shadow of St Paul’s Cathedral, Ian Powell, managing partner of PwC UK, spoke to an audience of senior accountants about the
need for change.

“It is clear from the number of senior figures from the business, investor auditing and regulatory communities that are here today that there is a real appetite for a debate on the future of auditing… we want to play a part in that discussion,” he said.

But it was not his comments that dominated discussion but rather his fellow speaker, Guy Jubb, investment director and head of corporate governance at Standard Life Investments, who seemed to best articulate the frustrations from investors who had long sought audit reform.

“I think that the auditing profession, if we may call it a profession, has to be adaptable to change, otherwise it may wither on the vine,” he said.

The starting gates seemed to have officially opened. Auditors moved to seize the momentum.

Leaked copies of a “landmark” speech by KPMG’s John Griffiths Jones appeared in the Financial Times on 17 June, in which he called for reform. “What is the point, they and others ask, of doing extensive and increasingly elaborate audits of the financial accounts of our banks, when audits failed to identify the huge and systemic risks which led to the near collapse of the global banking system in the autumn of 2008?” Griffiths later told an audience of mostly accountants at the ICAEW headquarters.

This month, Steve Maslin, senior partner with auditor Grant Thornton, suggested auditors could look towards a future where they answer questions at analyst briefings.
The ICAEW released its own study which found that “insufficient information is provided under the current framework about the work that underpins an audit”.

ICAS also commissioned academics from Glasgow Caledonian University and the University of Stirling, who found investors and shareholders would welcome an enhanced audit role on management statements at the front of annual reports.

But, while the firms and professional bodies seem to be focused on changing the structure of audit, regulators are more intent on changing auditors themselves.

Richard Thorpe, accounting and auditing leader at the FSA, said he wanted to see auditors report better and more often to regulators. “Auditors rarely report to us under their whistleblowing obligation… They argue that this is because they get their clients to inform us of problems, but we believe it would be better for the auditor to inform us himself,” he said.

The list of suggestions over what new audit responsibilities could look like continues to grow and the only real consensus now seems to be that things can’t remain as they have been.

An FSA investigation, separate studies by the FRC, the European Commission and a number of accounting institutes calling for change, coupled with possible legal action against E&Y over its audit of Lehman Brothers show that, in the financial world, there is no such thing as a good crisis.