Auditors: EAC Report

Lord MacGregor of Pulham Market Excerpts

Wednesday 14th March 2012 Grand Committee

Moved By

[Lord MacGregor of Pulham Market]

That the Grand Committee takes note of the Report of the Economic Affairs Committee on Auditors: Market concentration and their role (2nd Report, HL Paper 119).

[Lord MacGregor of Pulham Market]

My Lords, pressures on the parliamentary timetable and the queue of Lords Select Committee reports awaiting debate have meant that it is almost a year since our report was published. There have been some important developments since then, progress on which it will be interesting to discuss today, but many of the issues are still alive and highly topical. As chairman of the committee I am therefore pleased to introduce the report.

When we first decided to look into the oligopoly of the audit profession, some, I think, thought it a somewhat dry and limited if not esoteric topic mainly of interest to the accounting profession. It became rapidly clear to us that this was not so. It was a fascinating inquiry, sometimes taking us in unexpected directions. The serious issues surrounding the current oligopoly I will touch on in a moment. However, as our inquiry progressed, two other important themes emerged on which we have made recommendations: namely the inadequacies of the roles played by auditors and of the dialogue between auditors and regulators leading up to and during the financial and banking crisis—and this became an important issue for us as a result of our probings at the hearing we had with senior partners of the big four auditors themselves—and, secondly, concerns about the effect on audit of the adoption of international financial reporting standards. I shall touch on all three. This widened our inquiry considerably. Our report contains 204 conclusions and recommendations. I hope to cover the main themes but inevitably I shall have to leave a number of issues to others.

Before I do so, I should like to thank most warmly our committee clerk, Bill Sinton, and his staff, Stephen Seawright and Karen Sumner, the committee assistant, for all their invaluable help and hard work. In particular, I thank our special adviser for this report, Professor Andrew Chambers, professor of corporate governance at London South Bank University, whose expertise and advice was invaluable.

First, I turn to the market concentration of auditors. The need for a reliable audit was recognised by this House as early as 1849, when a Select Committee looking into financial scandals in the railway boom was credited with helping to establish the accountancy profession. Certainly by 1872 the Great Western Railway had an audit committee and an external auditor, who was called Mr Deloitte.

Rigorous and trustworthy audit has long been recognised as vital to the proper running of capital markets. Without a clear and reliable system of assurance that accounts show a true and fair picture of a company’s financial state, there is no basis for investment decisions. It has long been a statutory requirement for large firms to be audited every year. The annual audit has become an essential underpinning of financial markets, especially since they have gone global. While offering a statutory service, audit has become a large and prosperous profession. Auditors have built on large firms’ legal obligations to buy their services by selling a range of other financial consultancy services to their semi-captive audit clients.

In recent decades, as financial markets became global, the main audit firms have become very much larger and more dominant as they spread beyond national borders and as they consolidated and concentrated among themselves. By the 1980s we had the big eight international audit firms, mostly international federations of national partnerships. By 2002 mergers and the disappearance of Arthur Andersen had brought the big eight down to the big four: Deloitte, PwC, KPMG and Ernst & Young. No regulatory barriers prevented this concentration in this country or elsewhere. The big four greatly outweighed second-tier audit firms in both size and global reach; and there is always the risk that withdrawal or disappearance of one of the big four could leave us with an even more dominant big three—a point to which I shall return.

So the problem is easy to identify: the big four firms’ oligopoly, especially in the United Kingdom. In the UK, the big four audit 99 of the largest firms listed in the FTSE 100 index. In certain markets, such as banking, there is not even a big four but effectively a big three, since Ernst & Young does not audit banks in the UK. It is questionable whether large banks in the UK have any real choice of auditor, and that may well apply to some other financial institutions as well.

An auditor to a FTSE 100 client remains in place for 48 years on average. Barclays has had the same auditor, PwC or its predecessors, since 1896. The picture is similar in the next ranking FTSE 250 large companies, almost all of which are audited by the big four. A FTSE 250 auditor remains in place for 36 years on average. This does not look like a competitive market.

Witnesses from the big four assured us that the large-firm audit market in the UK is fiercely competitive, but we were not convinced. The market is clearly an oligopoly, with all the attendant concerns about competition, choice, quality and conflict of interest. I must say that I was much struck during our hearings by the fact that almost all of our witnesses without exception agreed that there was a risk that the big four might become a big three, and then there would be a major problem. That included the representatives of the big four. However, finding solutions was not so easy.

The Financial Reporting Council—and I am delighted to see its current chairman, the noble Baroness, Lady Hogg, here today—produced a set of recommendations from its market participants group in 2007. However, in our view—and I think there is general agreement on this—this had little or no effect in lessening the dominance of the big four. The then Minister at the Department of Business, Innovation and Skills, Mr Edward Davey, outlined a number of measures that echoed the approach of the FRC, an approach that we described as having palpably failed. We would expect exactly the same results for the measures which he advocated to our committee as the FRC’s measures have had. As we have said in our report:

“It may be sensible to introduce these measures on their own merits. But they do not add up to a policy of creating greater competition and choice, of altering the current oligopolistic situation, or of addressing the risks of the Big Four coming down to a Big Three”.

We outlined in Appendix 3 of our report 34 individual measures which had been put to our committee in one form or another for dealing with this situation. In our analysis we read carefully through all of them and rejected a considerable number, including the proposal for joint audit committees which the European Commission has now advocated. At a seminar which I addressed in the City attended by senior accountants and regulators, one leading key participant described our report as a,

“road map for future action”.

I turn now to a few of the key recommendations. Although our committee contains members with much experience and expertise, our part-time committee simply did not have the time or the resources, including substantial dedicated staff, to address all the highly complex issues stemming from market concentration. By far our most important recommendation was therefore that the OFT should conduct an investigation into the audit market in the UK, with a view to a possible referral to the Competition Commission to analyse all the issues in depth. Frankly, this has been fudged for some years. We felt that such an investigation was overdue, and I have been delighted to see that the OFT, at our prompting, swiftly took up the matter and the Competition Commission is now carrying out that review.

We recognised the international dimension to the issues, but felt that the UK could give a lead internationally by undertaking such a review. Concurrently we have the European Commission’s inquiry, and our committee was able to have a hearing last month with Jonathan Faull, the Director-General of the Internal Market and Services Department of the European Commission. Like us, the Commission is concerned about competition and choice. It points out that in most member states the big four audit more than 85 per cent of large listed companies. The Commission’s proposals are now before the European Parliament. Some of them are in similar directions to our own recommendations, but the Commission’s remit does not cover pure competition issues, which are the preserve of national authorities such as the Competition Commission.

We had a range of other recommendations, which I have no doubt the Competition Commission will look at more fully, and I touch on them only briefly. We recommended that FTSE 350 companies should carry out a mandatory tender of their audit contract every five years, and that audit committees should be required to include detailed reasons for their choice of auditors in their report to shareholders. We recommended greater involvement of institutional investors in audit matters, although I have to say that I do not overestimate the likely impact of this. We took up the suggestion of the noble Baroness, Lady Hogg, that the abolition of the Audit Commission would provide an opportunity to increase competition and choice in the audit market if it formed the basis of a substantial new competitor to the big four. There have been developments on this, which the noble Baroness will no doubt comment on.

We put particular stress on the need for separate risk committees in banks and major financial institutions, and other large companies where appropriate. We believe that every bank should have a properly constituted and effective risk committee at board level. It should be one of the duties of the external auditors to ensure that this is done. This is relevant to the accountancy marketplace in the sense that such committees will increasingly require specialist skills and external advice. We saw scope for this advice being provided by a firm that is not the company’s auditor, which could open up opportunities for the second-tier accountancy firms.

Next, we were struck during our inquiry by the fragmented and unwieldy regulatory structure that governs accountancy and audit in the United Kingdom, with overlapping organisations and functions. This seemed to us inefficient and unnecessary. It also seems to offer too much scope for regulatory capture, especially since present or former big four partners hold so many positions on the various bodies and committees. Other professions have only one regulator—for example, the General Medical Council. We noted that the Financial Reporting Council has been seeking wider powers that would help promote some rationalisation of the regulatory maze. I look forward to hearing what the noble Baroness, Lady Hogg, has to say about progress on these matters, which our committee strongly supported. If it does not achieve real impetus towards rationalisation, we recommended that the Government should stand ready to impose a remedy. Perhaps the Minister will comment on that.

Finally, because of the concerns about the big four moving to a big three, we recommended that the Government and regulators should promote the introduction of living wills for big four auditors. There are many other recommendations that I have not had time to deal with and which others may wish to mention. As I said earlier, I hope that all of them will be considered by the Competition Commission in its inquiry.

I now turn to the other two areas. First, as our proceedings continued, it became clear that there were shortcomings of auditing during the financial crisis. Banks were audited and certified as going concerns just before they had to be rescued by taxpayers to avoid collapse. We were not particularly impressed by the defences produced by the auditing firms themselves, and there have of course since been highly critical reports on Northern Rock, RBS and HBOS. The value of audit here was at best questionable, even allowing for the issue—which we acknowledged—that panic might have followed if auditors had publicly questioned the accounts of banks. However, confidential dialogue between auditors and bank regulators does not run these risks, and it was on this that we focused. We were shocked to discover that the dialogue on these lines—which was required by statute under the Banking Act 1987, and which I am sure my noble friend Lord Lawson will wish to refer to—was virtually non-existent in the run-up to the crisis. We described the lack of meetings between bank auditors and regulators during that period as a dereliction of duty.

Part of the problem was the separation of powers and duties between the FSA and the Bank of England, which this Government have now rectified. However, we also recommended a statutory change to ensure that confidential dialogue between bank auditors and financial regulators takes place regularly. We welcome the introduction by the FSA and the Bank of England of a code of practice to encourage dialogue. I also note that the Institute of Chartered Accountants in England and Wales has just produced its good practice for bank auditors, audit committees and executive management in this regard. However, in its briefing for this debate, the ICAEW says that it does not see a need to prescribe this dialogue in law. That was not the view of our committee at the time that we did our report, and I for one still do not agree. If we are to avoid the bad habits and mistakes that emerged during the financial crisis, I continue to believe that the statutory requirement for dialogue between auditors and regulators is necessary. I will be interested to hear the Minister’s response.

Finally—and now I get on to the matters that are rather abstruse for many of us—on accounting standards, we heard considerable evidence that the introduction in 2005 of international financial reporting standards, the IFRS, in place of the old British generally accepted accounting principles, GAAP, had led to sharp reductions in the quality and reliability of large-firm audit, especially of banks.

Witnesses told us that under IFRS rules auditors cared more about compliance with rules than with exercising professional scepticism and careful judgment to reach a true and fair view of clients’ accounts as required by company law. In short, so it is said, the auditor’s abiding principle is now box-ticking instead of prudence. The argument runs that superficial conformity with the rules can disguise underlying faults that it was the auditor’s skill and duty to detect under the old system. Banks in the crisis were a case in point. Unlike GAAP, IFRS takes account only of losses already incurred, not of expected losses. In these litigious times it is perhaps understandable if auditors feel safer monitoring compliance with a set of rules and exercising judgment. However, the public interest is not served if, as critics allege, IFRS audits are failing to give a true and fair picture. I note that the new chief executive of the Royal Bank of Scotland has recently referred to the Alice in Wonderland nature of some aspects of the bank’s results.

This is a complex area, and I do not pretend that we will get to the bottom of it all—although there are members of my committee who are better equipped to do so than I am. The Government gave a lengthy but somewhat holding reply in their official response to our report on this, and we have since had correspondence with Norman Lamb, the new Minister for Employment Relations, Consumer and Postal Affairs in BIS, in which he states:

“I consider that the changes in IFRS introduced since the financial crisis and the further changes proposed to be implemented should help to achieve accounting rules for banks which are crisis-neutral, provided they are endorsed by the EU, and provided they are properly applied the next time that valuations come under pressure”.

That is pretty guarded. On the issue raised by Mr Andrew Haldane of the Bank of England that new standards are needed for bank audits, he referred to the preliminary report of the Sharman committee—under one of our colleagues, the noble Lord, Lord Sharman—and said:

“The Sharman panel are considering the responses to this Report at present. We await their conclusions with interest”.

It would be helpful to hear from the Minister when we can expect definitive government decisions on this matter.

To conclude, it has been a fascinating and rewarding inquiry that has led to action. I am most grateful to all my colleagues for their substantial contributions to it.

--- Later in debate ---

[Lord MacGregor of Pulham Market]

My Lords, I thank my noble friend Lady Wilcox for that very helpful and comprehensive reply. We have had a high-quality debate, rich in contributions, and I am particularly grateful to the noble Baroness, Lady Hogg, for her kind words about our committee’s report. I cannot begin to sum up the debate properly as it would take much longer than this reply is conventionally allowed. However, I will quickly make five points.

First, it is unfortunate that such a high-quality debate has taken place in the Moses Room because of the pressure of legislation in the main Chamber. However, I hope that this report will be widely read and followed up. Secondly, we are probably going to face a House of Lords reform Bill, but if anyone had followed this debate they would have seen the high quality of debates that take place in this House and would not always necessarily occur in the other place. I say that fully aware that at least half of the colleagues who have taken part in this debate have, for a long time, been in the other place. I am not criticising the other place, but the contribution from those who would probably not have stood for election to Parliament has been very valuable in this debate and it shows the quality of the House of Lords on topics such as this.

Thirdly, I say to my noble friend Lord Stewartby, who was sceptical about whether we had found answers on the first part of our report, where the main thrust is about the oligopoly of our auditors, that we never expected to have a magic wand and find a magic solution. As I said at the beginning, finding solutions is not so easy. I hope that a number of issues that we have put forward and that have been pursued further will help to deal with a number of aspects of this. However, of course, the problem we face of finding a way of extending the major auditing firms beyond the big four is a very difficult one.

Fourthly, as I said at the beginning, some thought that this study would be rather dry and esoteric. I think that is largely because of the title we gave it, which probably put a lot of people off. However, it has been clear from this debate that the issues we have raised go to the heart of many aspects of our financial, economic and business life; not to mention, as my noble friend Lord Lawson pointed out, behavioural and cultural attitudes. It is a much more widely based debate than one just dealing with audit matters.

That leads me to my final point. The noble Lord, Lord Currie, very kindly said that this debate was merely a staging post, and I entirely agree with him. Clearly, this issue will be debated further and I hope that at some stage our committee will be able to come back to it again. This will not be immediate, because we have just agreed that our next topic will be the economic implications for the United Kingdom of Scottish independence, so that will obviously take up much of the next year. However, I hope that we can come back to address these issues in one way or another because there is clearly still so much to be followed through.

I thank all those who have contributed and particularly all my colleagues on the committee for all that they have done and all the hard work that they have put into it. I think it has been well worth it.

Motion agreed.