Large audit firms’ role in the financial crisis is under close scrutiny
UPDATE 21 June 2011: The Government has now responded to the House of Lords committee’s Report. We discuss the Government’s response in this post.
The House of Lords Economic Affairs Committee (the Committee) today published its report (the Report) on its inquiry into “Auditors: market concentration and their role”. The Report makes draws some forthright conclusions about the large-firm audit market in the UK and makes many recommendations to correct the perceived inadequacies and failures of that market. The Report can be read here.
The Committee concluded that the large-firm audit market (meaning Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers) in the UK is “clearly an oligopoly with all the attendant concerns about competition, choice, quality, and conflict of interest. It gave no warning of the banking crisis. The narrowness of the assurance it offers is much criticised. Its regulatory structure…is complex and unclear”. Regarding what the Committee calls the “banking meltdown of 2008-09″, the Committee states that “the complacency of bank auditors was a significant contributory factor”. Either the auditors were “culpably unaware of the dangers, or, if they were aware of them, they equally culpably failed to alert the supervisory authority”.
The Report is one of number of workstreams in both the UK and at the EU level which are looking at the role of auditors, the purpose of the company audit and the relationship between auditors and regulators following the financial crisis. Those workstreams are briefly discussed at the end of this post.
The Committee’s recommendations are not binding on any party and there is no obligation for the Government or any regulatory body to take them up. However, the recommendations will certainly be of interest to the EU internal markets commissioner, Michel Barnier, who is engaged in his own work on the role of auditors – see the end of this post – and who does have power to lead the creation of European legislation.
The Committee: Principal recommendations
Three principal recommendations are made by the Committee:
- OFT inquiry: There should be a detailed investigation of the large-firm audit market by the Office of Fair Trading, with a view to an inquiry by the Competition Commission.
- IFRS: Prudence should be reasserted as the guiding principle of audit. See “IFRS” below.
- Banking regulation: The new framework of banking supervision should provide for bank audit to contribute more to the transparency and stability of the financial system, in particular through dialogue between auditors and supervisors.
Many other recommendations
Amongst the Committee’s many other recommendations are:
- Mandatory audit tender: FTSE 350 companies should carry out a mandatory tender of their audit contract every 5 years, and the Audit Committee should include detailed reasons for their choice of auditors in their report.
- Corporate governance code change: Audit committees should discuss the audit with principal shareholders every 5 years, with the audit committee’s report detailing significant issues raised during the audit; the UK Corporate Code and the Stewardship Code should be amended to reflect this.
- Public sector work: The Government should make greater efforts to enable non-Big Four to win public sector work.
- Restrictive bank covenants: The Office of Fair Trading should conduct a market study of restrictive bank covenants. We discussed this issue in this post.
- Risk committee advice: Bank risk committees should be advised by a firm that is not the bank’s auditor, as a means of providing opportunities for non-Big Four audit firms to enter the large company market.
- Scepticism: Auditors’ tradition, prudent scepticism should be defended and promoted. We discussed this issue in this post.
- IFRS: The use of IFRS should not be promoted beyond larger, listed companies.
The Committee is critical of the adoption of International Financial Reporting Standards (IRFS) and the more rules-based approach of IFRS compared to previous accounting standards, which “leave less scope for the auditor to exercise prudent judgement”. The Committee cites a specific failures of IFRS being its inability to account for expected losses – which prejudiced the usefulness of bank audit – as “at present IFRS permits recognition only of incurred losses, not expected losses”.
Other workstreams on audit and auditors
There are a number of other regulatory examinations currently in progress on the work of auditors and the role of the audit.
- The Financial Services Authority and the Financial Reporting Council (the FRC) are jointly looking at “Enhancing the auditor’s contribution to prudential regulation“.
- The Auditing Practice Board is examining how to “raise the bar” of auditor scepticism.
- The FRC is working on “Effective Company Stewardship – Enhancing Corporate Reporting and Audit“.
- The APB tightened the ethical standard for auditors in December 2010.
- The European Commission has a green paper on “Audit Policy: Lessons from the Crisis” (summary of responses here).
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