Accounting – Letter of intent: Don't blame the auditors

An open letter to Treasury Select Committee chairman John McFall says auditors aren’t to blame for the crisis

23 Mar 2009

By Peter Williams

Dear John,

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, though weaknesses in the system of auditing, regulation and supervision exacerbated the problems caused by your favourite people, the bankers. You will also have established that banks are incredibly complicated organisations, both in sheer size and by way of the many different businesses and business models existing behind the façade ­ further complicated by the lack of business model homogeneity in the sector. Auditors are expected to get their heads around the business and pass opinion… well, on what, exactly?

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 that 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 of their number collapsed, it would render bank sector auditing near impossible.

Even allowing for this difficult backdrop, given the scale of the crisis, the audit profession can and should help. Your Committee could ask 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 start reviewing the Auditing Practices Board’s practice note 19, on the audit of banks and building societies in the UK. 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 their views and concerns 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, they should review all banks’ accounts, no sampling here. You may want to ask them to furnish you with a report before your inquiry ends later this year, 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. Business reviews are required to refer to the main trends and factors likely to affect the future development and performance of the company: banks should be doing this, too.

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

Yours in hope,

Peter Williams

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