Don’t blame the auditors

In investigating the banking crisis from every angle, you have called many
eminent witnesses, including representatives of the auditing profession. They
will forgive the comment, but they are all from the Establishment, so it may
benefit the Committee to hear from a different perspective: that of Financial
Director, whose editors and journalists have, for the last 25 years, been
commenting on, inter alia, financial reporting and auditing issues.

You will have established that this banking crisis was not spawned primarily
by an auditing crisis.

Re-reading the evidence from your audit panel session, perhaps you may have
felt somewhat frustrated by the lectures you got on what audit was (and was not)
designed to do, roles, you are told, laid down by parliament. This is defensive
and unhelpful. Forget the talk of watchdogs and bloodhounds: in essence,
auditors have one definite role and one possible one. The definite ‘do it now’
role is to comment on the financial report at a particular moment in time. This
brings its own problems: you try valuing complex derivative products. The other
possible role for a statutory audit is to see whether a bank has enough capital
and reserves to see it through a financial or economic shock. But it is, as you
may have gathered, not a burden the auditors want to shoulder. They believe it
is the work of the board or the regulator. Why do auditors fight shy of
extending their remit? Well, one part of a bank may have 10,000 models for
100,000 transactions.

At the moment, auditors look at the bank systems and controls and how they
generate the model. In other words, the audit is about the reliability of the
processes rather than whether individual models are giving the right answer. To
go to this level of detail you would have to increase the audit resource several
fold. Moreover, while ‘going concern’ may look at particular funding questions,
concerns about future risk do not currently lie within the auditor’s remit.

Another intractable problem you should be aware of is the scarcity of bank
auditors. The best of them probably number only hundreds across the globe. The
idea one can just magically conjure up bank auditors is fanciful, made worse by
the size and scale of multinational banks, meaning that audit work is, in
reality, the sole preserve of the Big Four. Conflicts of interest abound and if
one collapsed, it would render bank sector auditing near impossible.

Even allowing for this difficult backdrop, the audit profession can and
should help. Your committee could ask the government to engage the Financial
Reporting Council to take the lead on examining key aspects of bank auditing and
involve external stakeholders such as bankers, regulators and investors.

There is an obvious agenda in the working group. The first task should be to
review the Auditing Practices Board’s practice note 19, on the audit of UK banks
and building societies. Updating may not be possible yet, but it will have to
happen. The FRC should work with the Bank of England and the Financial Services
Authority to review the relationship between auditors, regulators and banks to
ensure there are no gaps in regulation and that auditors have the freedom they
need to express views on banking clients.

The FRC’s Audit Inspection Unit should re-examine all the audit files of the
banks to ensure the work is of sufficient quality, relevance and consistency.
Finally, the Financial Reporting Review Panel is examining the banking sector as
a priority, but explicitly, it should review all banks’ accounts, no sampling
here.

You may want to ask them to furnish you with a report before your inquiry
ends, focusing on the requirements for companies to comply with the business
review, where the Companies Act 2006 has introduced two important changes. The
review is now meant to help shareholders assess how the directors have performed
their statutory duty to promote the company’s success. All business reviews must
contain a description of the principal risks and uncertainties facing the
company.

That’s a substantial and important to-do list for starters, which the
auditing profession should be encouraged to adopt.

This is an abridged version of an article that first appeared in
Financial Director. See the full article and other features at
financialdirector.co.uk/comment/