AS LORD MYNERS told our House of Lords Economic Affairs Committee inquiry into auditing, “the financial crisis revealed the failure of just about everybody… the auditing profession cannot be excluded”. Yet, until our inquiry there had not been much focus on the role of auditors. Indeed, John Connolly, chief executive of Deloitte, surprised our inquiry by declaring “auditors performed well”. The Committee found such a view “disconcertingly complacent”.
For in the run-up to the financial crisis, auditors signed off some banks’ accounts as going concerns without any qualification only for them to go belly-up within months, triggering enormous bailouts from taxpayers.
Furthermore, communication between bank auditors and the Financial Services Authority had almost broken down prior to the crisis, as the FSA itself admitted and the Bank of England confirmed to us. Our Committee concluded this was a “dereliction of duty” by auditors and regulators. Such regular confidential discussions used to be the norm, helping the regulator identify potential systemic risks and keep on top of the banking system. So the Committee recommended mandatory private meetings between regulators and bank auditors, a proposal supported by institutional investors.
Accounting standards also contributed to the banking crisis. Under International Financial Reporting Standards (IFRS) – which became mandatory for EU listed companies in 2005 – provisioning for possible future losses is near impossible. IFRS also encouraged a box-ticking culture instead of auditors’ traditional aim of providing a true and fair view of a company’s financial position. Prudence must be restored as the guiding principle of audit.
Auditors’ poor performance in the banking crisis also weakens any case for leaving intact the Big Four’s market dominance. Not that the case for preserving the oligopoly was ever strong. The lack of choice – 99 of the FTSE 100 are audited by the Big Four – has long been worrying.
Plus the problem could quickly worsen if a Big Four firm collapsed, and we were left with only three. Government and regulators should promote living wills which would set out how an audit firm would segregate, under regulatory supervision, how good and failing parts of the business will be separated and funded.
Many proposals for increasing competition and improving audit quality were heard in our inquiry. Among those the Committee endorsed were mandatory tendering of auditors by large companies to give non-Big Four firms a chance of breaking in – currently FTSE 100 companies only change auditors every 48 years on average.
The work of the soon-to-be-abolished Audit Commission – which as a standalone entity would be the fifth largest audit firm in the UK – should be used to help form the basis of a new competitor to the Big Four. Risk committees should be encouraged, especially at banks, with advice being provided to them by firms other than the external auditors.
But our view is that, while helpful, these measures alone will not solve the lack of competition and choice. More radical measures are needed and many would require global agreement. But someone has to take the lead which Britain, with its extensive financial services industry, is well-placed to do. So the Office of Fair Trading should launch a competition probe into the UK audit market, the Committee concluded. All possible remedies must be examined, including the ones we recommend, to increase choice in the audit market.
Reliable audited financial statements are essential to the functioning of capital markets. A competition probe is now overdue.
Lord MacGregor is chairman of the Lords’ economic affairs committee
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