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

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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