New FSA powers will force auditors to speak out

Bold new powers to disqualify audit partners are part of a larger push to
provide an “incentive” for auditors to co-operate with regulators, a senior
Financial Services Authority figure has said.

The FSA is seeking new powers to censure, penalise or disqualify individual
auditors after it found the profession failed to challenge management bias in
the lead up to the banking crisis.

Richard Thorpe, accounting and auditing leader at the FSA, told Accountancy
Age that the sanctions are an attempt to “align auditors’ incentives with those
of the regulator”.
“Our current power to require a regulated firm to change its auditor would be
disproportionate for that purpose, which is why we have asked whether there
would be value in us having a wider range of powers, including public censure,
financial penalties, or the power to disqualify individual partners,” he said.

The proposed powers, outlined in a discussion paper jointly authored by the
Financial Reporting Council (FRC) and the FSA, has sent shock- waves through the
audit profession already facing reform on a number of fronts in the wake of the

The FRC is planning to examine the role of audit later in the year. Last
month the European Commission also released a Green Paper into the future of
banking and plans to release an audit- specific discussion paper later in the

The ICAS, ICAEW and ACCA are also examining the future of audit along with
the UK’s largest six firms which are internally working on ways to reform the
audit model. The FSA and FRC questioned whether auditors “paid adequate
attention to management bias indicators” with concerns they displayed a
“worrying lack of scepticism”. Auditors have become reluctant whistleblowers
according to the FSA, which wants to be told about serious accounting issues.

“Auditors rarely report to us under their whistleblowing obligation,” Thorpe
said. “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

The FSA also complained auditors wait too long to highlight issues, sometimes
waiting until annual meetings to speak out.

“It would be better if significant financial reporting issues were raised
earlier in the process than is currently the case,” Thorpe said.

The FSA’s concerns grew out of the banking crisis when, it claims, auditors
failed to adequately challenge valuations for complex financial instruments.
These assets have no observable market inputs and must be marked to a model.

The regulator fears these valuations reflect the some- times optimistic
expectations that underpinned the model and was subject to little chal- lenge
from auditors.

The body wants auditors to take alternative models into account when
inspecting a firm’s valuation method.

According to the body, valua- tions lacked consistency across the major banks
with auditors failing to adequately challenge management assumptions. Asset
valuations played a significant role in the crisis.

John Hitchins, UK banking leader with PwC, said banks who faired poorly
during the crisis had suffered from poor communication on valuations between
management and audit committees. “I am aware of significant differences in the
quality of information supplied to audit committees between institutions,” he

The banking industry has become a particularly problematic area for auditors
and regulators. Large banks find it extremely difficult to change auditors owing
to conflict of interest rules. Audit qualifications are also extremely rare
because of the catastrophic affect it could have on a bank’s share price.

“It would be impossible for any major financial institution to be qualified
in any way,” Thorpe said. He added there are avenues open for auditors to avoid
qualifications including approaching audit committees or the FSA itself.

The FSA wants to improve its relationship with auditors, which has
deteriorated since 1997, when the body was carved out of the Bank of England.

Figures close to the FSA say conversations lack the candour once displayed in
meetings with the Bank of England.

The discussion paper comes less than a month before the release of the FRC’s
Audit Inspection Unit’s reports, widely expected to concentrate on bank audits.
Reaction from the audit industry was mixed last week.

Michael Izza, chief executive of the ICAEW, said the discussion paper “posed
some tough questions” for auditors who are continuing to learn lessons from the

He said the profession was asking itself how the audit model needed to evolve
to meet changing market needs.

“Any response to this ques- tion must be evidence-based,” he said.

It remains unclear how any new powers might fit within the FSA’s structure.

The FSA faces an uncertain future with widely publicised plans to hand over the
bulk of the body to the Bank of England again. The body said it is too early to
comment on where the proposed new powers may sit within the body.

The deadline for responses to the discussion paper is 29 September 2010 and
views will be incorporated into a consultation document later in the year.

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