Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 160-179)



  160. I can see, from your answers, you very much want this to work and be a success, but it is still not clear to me how it would work. We have these three Boards that report, in some way, to the Review Board, but I am not at all clear, from your answer, whether you would be seeking information from companies about their practices, or whether you would wait for reports to come to you; if so, how would you field them through the different elements, which I think all have an interest in the public interest? So how would you ensure that each of the auditing companies are truly working in the public interest?
  (Sir John Bourn) If you talk about the firms, you are right to say that I and my colleagues have no jurisdiction over the firms, our jurisdiction operates through the accountancy bodies, that is the six institutes which operate in the United Kingdom and Ireland, and in what they lay down about the professional skills and behaviour of their members, and it is by extension from the institutes into the firms that the operation of the system goes forward. It is quite right to say, we do not control the firms, that is right, but we do have a handle on the institutes and do have a handle on the standards they lay down for all the behaviour of their members.

  161. So you operate as an influence?
  (Dr Reeves) If I could answer, Chairman, in the sense that, yes, we do have a programme which looks at the self-review function, in terms of looking at what the accountancy bodies do, in terms of accounting firms, but through that mechanism we do have quite an input, in terms of what the firms are doing. If I could use one example, and that is the project on quality control, where we will be looking at the functions of the Joint Monitoring Unit, between September and December, and that project itself will actually look into, firstly, the culture of the accounting firms themselves, particularly in terms of their effectiveness and also their transparency. And, I think, in terms of analysing the firms' approach, we will be looking at all sorts of issues, like independence, like the personnel management within the company, the audit performance, audit methodology, so we will be looking at a whole set of criteria whereby we can judge, firstly, what the accounting firms are doing themselves, and, of course, by accounting, I mean the auditing aspects of the accounting firm, but also to look in terms of what the accountancy bodies do in terms of their review of these processes and see if they are efficient and effective. It is interesting to note, Chairman, that Harvey Pitt made a statement, the other day, that the era of self-regulation for the profession is over. I think it is fair to place on record, at the moment, we do not believe, at this stage, we can make that statement, it would be premature; what we do have, and Sir John has already referred to it, is a programme of looking at the work of the bodies themselves, the two obvious ones are discipline, which we have actually produced a study of already, which we hope to publish in early September, the other one is a quality control project I have talked about. And, it is funny, they are the first two projects, yet they are the two examples used by Harvey Pitt to suggest that self-regulation is dead. So we think, at this stage, that statement is premature; we would like to come back, possibly, at a later date, maybe December, to see if that statement is validated, or otherwise; but, so far, it is important to focus on these two areas, of discipline and quality control. And, I suppose, in terms of looking at the culture of the firms themselves, I think two other aspects come in, in terms of that study; one is to look at the whole aspect of ownership of the Joint Monitoring Unit, is it more effective, in terms of being owned by the Accounting Bodies, or should it come to another external regulator, and, of course, although that is not an issue of substance, it is very much an issue of perception, and some people say perception is nine-tenths of the law. So I think that is an important issue. And, I suppose, the final issue coming out of the ownership will be the funding, if we do have to take on additional responsibilities, whether it be ourselves or another external regulator who will pay for those additional responsibilities, will it be the CCAB, will it be industry, or will it be Government, or indeed a combination of those sources. So I think the final point I would make, Chairman, is that we do have, albeit an indirect influence, but we do have an influence, over of accounting firms.

Mr Beard

  162. Just following that, what are the sanctions that are available to you if someone does not conform with the rules and precepts that you have laid down through either of the organisations?
  (Sir John Bourn) I think we have two sanctions, if our recommendations are disregarded, although it is fair to say that the six institutes have said they have set this up on the basis that they will undertake to implement the recommendations, although there is a clause which, in a sense, would allow them to seek, with reasons, not to accept. But, essentially, they have said, "We've set this up, we know that people will expect us to follow it, and we will undertake, unless we're really pressed, to accept the recommendations." If they did not, we have two sanctions; one is the great sanction of publicity, "The rules say we're set up, we've published our recommendations, they have been turned down," and, beyond that, resignation. None of us is in this for anything but a concern to do our best to make this work; it is no skin off our nose if we give it up. We want it to succeed, but we have nothing to lose, in a sense, by our resignations, if we felt that our well-argued recommendations were turned down thoughtlessly, carelessly, or by special interest.

  163. You do not have a sanction withdrawing credentials from anyone?
  (Sir John Bourn) No, we do not have the sanction of, as it were, saying the institutes were not able to practise, that is right.

  164. The Financial Services Authority, as the chief regulator, in much of this, has got a special relationship; what is your relationship with the Financial Services Authority?
  (Sir John Bourn) Of course, the Financial Services Authority does not regulate the activities of the six institutes, but, naturally, we have talked to the Financial Services Authority. Our first piece of work was the preparation of this document, which I know has been circulated to you, on "Protecting the Public Interest", in which we set out our concerns, and invited representations from the world at large, but, in particular, of course, from the FSA, from the institutes, from all concerned. So our relationship with the FSA is one of, if you like, co-operation between people who are in the same line of business but do have separate responsibilities within that.

  165. Who would do any negotiating between you, would it be your own Board, the Review Board, or would it be the Auditing Practices Board?
  (Sir John Bourn) I and the Director, for example, have talked to Sir Howard Davies, and, if I have got concerns, I talk to him.

  166. Who, in the organisation, or the system, as it is set up, is responsible for negotiating common standards, say, with the European Union and the USA?
  (Sir John Bourn) Perhaps Mr Fleck could take that, from the auditing side.
  (Mr Fleck) On the auditing side, Sir, the short answer to that is, the DTI is the member of the European Committee on Auditing, not the Auditing Practices Board, but the DTI work very closely with the Auditing Practices Board, and the Auditing Practices Board has a designated member who is responsible for looking into and monitoring progress on the international stage, and making recommendations as to how that is co-ordinated, harmonised and how we ensure that our views are properly represented on the international stage.

  167. The Auditing Practices Board has produced guidance for auditors on their relationships with audit committees, presumably, to try to ensure the audit is as objective as possible. How successful has that been?
  (Mr Fleck) We have been very strong supporters of the role of the audit committee throughout the life of the Auditing Practices Board, the former Auditing Practices Board, which dates back to the early nineties, and have been extremely anxious to ensure that our guidance supports a candid, independent interface between the auditor and the audit committee. So our guidance, which is SAS 610, is directed at ensuring that all the key issues are brought to the attention of the audit committee, and that the audit committee, therefore, is cognisant of the difficult judgements that are made in the course of arriving at the audited accounts. Now one of the difficulties is that our remit extends to one side of this information exchange only, to the auditors, and one of the things that the Auditing Practices Board is keen to do is to participate with an appropriate body, whether it be the FRC or the FSA, or whoever, in developing joint guidance, both to the audit committee and to the auditors, so that you have an integrated interface, instead of us simply making a one-sided set of recommendations. We believe that, in conjunction with the appropriate body, we could give guidance as to the sorts of questions, sorts of issues, of a penetrating nature, which would help the audit committee discharge its functions, and, frankly, we would urge that there be a requirement that there be an audit committee, instead of, at present, it being at the instance of the individual company.

  168. Why could you not just publish advice to audit committees anyway?
  (Mr Fleck) Sir, I think that goes back to our charter, our remit, and the difficulty that inevitably exists when you trespass outside it. We have tried to do it, if I can put it this way, by reverse engineering, by indicating to the auditors what they might expect to be asked, and have encouraged audit committees to have regard to that. So it is really the obverse of a mould.
  (Sir John Bourn) I think, if I could add to that, in response to our document, overwhelmingly, the evidence reaching us has been, it underlines what Mr Fleck has said, that a very important and valuable development would be to have the audit committee, in which you had non-executive directors responsible for the determination of who the external auditor was, the remuneration of the external auditor, the determination of what non-audit work he might be asked to do. So that this was not a sort of trade-off between the executive management of the firm and the external auditor but determined by non-executive directors on the audit committee, able to testify to the shareholders the decisions that had been made with a degree of independence on these matters. And this, as I say, is what is coming through, loud and clear. I cannot jump ahead of what my colleagues on the Review Board will say, but I think it is fair to say today that we are very much influenced by these concerns which are being raised with us, and, if I may chance my arm with my colleagues, I think, will want to make recommendations along those lines.

  169. Thank you. There do appear to be many different expectations of what an audit can achieve, notably in relation to the prevention and detection of fraud, and these expectations, particularly after Enron and Equitable Life , and various things, seem to be diversifying and increasing. But the Auditing Practices Board, as I understand it, consulted on the matter, and there was apparently little support for increasing the scope of the audit. Can you comment on that?
  (Mr Fleck) Through the nineties, we have published, I think, five or six publications, which I think the Clerk has had copies of, in the course of which we have identified many of the issues, bluntly, which have been the subject of quite a lot of discussion in recent times. We did so because there has been for a long time what is known as the expectation gap, a gap between what people understand can be achieved by an audit and what the audit itself can achieve. And so we were concerned, when we were first established, to flush out those issues, to put up some ideas as to how they might be addressed and to understand what, frankly, the relevant business community and society at large thought about those ideas. It was remarkably striking that many of those ideas were thought not to meet a cost/benefit analysis, in that the additional work, the additional cost, was thought by a wide range of constituent bodies not to be worth the benefits that would flow from it; and that applied not just to the companies and their management, it applied to institutional investors, it applied to regulators and it applied to Government. Now those comments were made in the context of a discussion about when the public interest necessitated that extra work, and I think what is most significant, bluntly, about Equitable Life and Enron, in particular, is that we have seen the cost and the price of the failing move beyond simply a redistribution amongst interested parties to affecting society at large, and moving on to affect the confidence in financial reporting. And I think that there is a reasonable prospect, and certainly we would hope, at the APB, that that will give added support for some of the ideas that we have been looking at over the past; so that the truth of the matter is there has not been the support for the extension of the role of the audit and the cost involved in doing so, not just in money terms to the accounting firms but also to management and to the companies themselves.

  170. Even though it might be a way of overcoming the lapse of confidence that the public have, and overcome this?
  (Mr Fleck) I think one has to be careful, in making the jump, that the additional work would necessarily, and I underline the word necessarily, prevent some of these things happening. I think it would reduce the prospects of them, but there is a judgement to be made as to how much of the situation, the problems, you would resolve. At the end of the day, you would probably improve the quality of the audit judgements; the question that ultimately one has to ask is, would one increase the prospects of finding senior management misconduct and dishonesty, because that, with collusion, involving third parties, is exceptional difficult to detect, unless you are sitting there, monitoring the activities of the company virtually at all times. And that is partly a product of technology, it is partly a product of the complexity of the business transactions, the multiplicity of relationships that people have with other advisers, the investment, the banking community, and so on. So the challenge is to find the right balance between getting the benefits without aspiring to something which is not deliverable.
  (Sir John Bourn) If I could just add, I agree with what Mr Fleck has said, but I think, as well, there are aspects to be taken forward here. There is something called the Fraud Advisory Panel, which is a panel of lawyers, accountants, the National Audit Office and others, who are interested in this issue. Of course, you cannot run a kind of Gestapo, overseeing the details of people's behaviour, but you can actually do a lot to promote a climate and a culture where people are alive to the prospect of fraud, and you can do something with the development of whistle-blowers and the protection of whistle-blowers, as in the public sector, or the Public Interest Disclosure Act, of providing protection for people who are prepared to speak up. So, within a difficult area, I think there is scope for improvement. And, again, if I may refer to our own work, in the public sector, we actually get a lot of pointers around fraud by people who do come to us, as the external auditor, drawing them to our attention. And that, I think, is something that can be encouraged; and a climate in which you have a tougher, more independent audit committee, as we have already in some companies, but would hope to have more, will be the kind of organisation where people who wish to speak up, and there are more and more of them, because, in the climate of society, there is a greater willingness to speak out, and I think that has to be taken into account and this opportunity seized. And, I think, within the context of what Mr Fleck was talking about, that is something that I and my colleagues in the Review Board are interested in, to see what we can do to make this more effective, without erecting an absolutely impossible quantity of laws, rules, regulations, spying on people, Gestapo-type system.

  171. In the context of what Mr Fleck has said and what you have just said, Sir John, how would you define the role and the purpose of an audit?
  (Sir John Bourn) The purpose of an audit; well I am defining this, Chairman, as somebody who is not an accountant, and that is perhaps a strength and a weakness. I see the purpose of the audit as giving you reasonable assurance that what the accounts tell you about the use of money by the organisation is overwhelmingly likely to be correct. I do not think it gives you the final truth, because, in a way, what would that be? Some of these issues depend upon definitions of terms. But it gives you something, perhaps almost akin to your own housekeeping accounts, to know where you are, to warn you of areas of weakness and to prevent you finding yourself suddenly with the rug pulled from under your feet. This is one of the things about Enron; it went down so quickly, why was this? Because, as it is now increasingly appearing, the audit was not being done properly, it was not, in fact, warning certainly the shareholders, certainly not warning them of the way in which the company was operating.
  (Mr Grant) Just to return to one of Mr Beard's points before, and that was in relation to responses to the work that APB has done on fraud. And I think your analysis of the reactions, in other words, saying that more auditing was not necessarily the answer, is absolutely right; there was, however, considerable support for developments in company law, in order to increase responsibilities on directors and in order to improve the transfer of information between directors and employees of companies and auditors. And I think the APB was very pleased with the way that a number of these ideas were picked up, with the work that the Company Law Review Group has done over the last few years, and we look forward with enthusiasm to improvements in the legal structure involving fraud in companies.
  (Mr Fleck) That is absolutely correct.

  Mr Plaskitt: Just to follow up on this. Sir John, twice this morning you have been asked by separate members of the Committee to define the purposes of an audit; your answer has been consistent, because I have written it down both times, and you have indeed said the same thing, however you said two things which are slightly worrying to me. The first time you were asked, you said its purpose is to give some degree of assurance, then I think the second time round you said a general assurance, that what you are seeing in it about the company's handling of its money is, firstly, you said, broadly correct, and then the second time round you said likely to be correct. Now I am not reassured by those two definitions, because does not this go to the absolute heart of the matter; if all you can say, in your position in this whole business, is talk about general degrees of assurance and that things are broadly or likely to be correct, if that is as far as you can go, and your Board can go, and no-one else, it seems to me, is in a position to go any further, does not that suggest that there is just an inadequate framework of control on the auditing business in this country?


  172. I think the second thing was, Sir John, you used the phrase "reasonable assurance", now that is a lawyer's word, "reasonable", and there has been many a fight over that word "reasonable"?
  (Sir John Bourn) I will come in on this and then ask Mr Fleck, who is the real practitioner in this. When audits started, there was the idea that you would follow through and look at every transaction that the organisation had undertaken and see what money was involved in that, and then you would be able to say, with 100 per cent degree of assurance, "This money came in in this way, and it went out in that way." And if you look at the early stages of auditing, as they were called, the world of tick and turn, you went through all the transactions, and, in that sense, you got to 100 per cent; and that is how the Comptroller and Auditor General, in the 19th century, he started, he had to do it that way. But, of course, in an increasingly complex society, you cannot look at all the transactions that an organisation undertakes and check up on each one of them. So you have to have an approach which certainly examines some of the transactions, on a sample basis, so that you get the degree of assurance that comes from that, you have to look at the system of financial management, you have to pursue aspects of what are called analytical review, which is around whether this organisation, with a workforce, for example, of ten thousand people, what is its wage bill like, is it more or less what you would expect. Now, in terms of assurance that the accounts do give a true and fair view of the financial transactions, that is not 100 per cent, and it is not anywhere near it, but it is still worth having, because it does tell you and does give you, I did use the word "reasonable". The Chairman quite rightly says, this is a loaded word and capable of all kinds of manipulation. But what it does give you is a degree of assurance that you do know where the money came from and where it went. It is not 100 per cent, it cannot be 100 per cent, but it is worth having; and the point is to make it more worth having by the activities of the Auditing Practices Board, and also, of course, the accounting standards side of this, because the accounting standards lay down how the accounts should be kept, as Mr Fleck said, it is a co-operative activity here. So I think that the audit is worth having, and it can be better, and I hope that myself and my colleagues will help to make it better.

Mr Plaskitt

  173. Thank you. I think what you are saying is, just to be clear, that an audit is not a definitive statement of how a company is handling its finances?
  (Sir John Bourn) If, by definitive, you mean 100 per cent, a guaranteed account of every penny accounted for, that is right. That is still worth having.

  174. But you have also got to keep your fingers crossed?
  (Sir John Bourn) But you need to know in what sense your fingers are crossed, not in a kind of arbitrary, hopeful, guessing sort of way, but to know the degree of risk involved in the audit procedures. And not only, and here our reference, I think, to the relationship between the external auditor and the audit committee is crucial, because the external auditor is able to say, "We've looked at this, and overall the audit may be of the kind to give a company a clear certificate, but there are areas that we're concerned about, we tell you that you need to pay attention to this area, this area and this area; and next year, when we come to do it, we'll be interested in what you've done about it, because we see weaknesses there."

  175. So it is the case that all audits carry with them an element of risk?
  (Sir John Bourn) Like most aspects of human activities, yes. But perhaps Mr Fleck could add something to that.
  (Mr Fleck) The audit opinion is an expression of view as to whether or not, from an historic point of view, what has happened in the past, the accounts show a true and fair view; those terms have been carefully used over many years, because the truth reflects the integrity, and the fairness reflects the judgements that are necessarily made. Because, in the composition of a set of accounts, in addition to your actual transactions, which should be correct, you have estimates which are fair judgements and you have the application of principles, which are decided in accordance with standards set by the Accounting Standards Board, or the Auditing Practices Board, which direct people as to how best you can achieve a fairness structure. I just wanted to come back to your "fingers crossed" analogy. One of the key skills of an auditor is the way in which he approaches the audit, and that is the planning, the analysis of the systems and the checking of the internal controls, and the degree of comfort that you get from understanding the integrity of the systems is what enables you to accept the inevitable sampling process. There are companies that have, in the financial world, I am not exaggerating, 100 million transactions a year; you cannot check them all, you have got to have a systemic approach to it, a conceptual approach to it, and it is the integrity of the development of those systems for checking it, for reviewing it, that leads you to be able to express the view, with varying degrees of confidence, that the accounts show a true and fair view.

  176. So you are reinforcing the point that an audit cannot be a complete statement of how a company has handled it finances?
  (Mr Fleck) You cannot check every transaction, no.

  Chairman: On the Company Law Review, Jim Cousins.

Mr Cousins

  177. Chairman, if I may, I would like to just pursue some of these issues we have just now been talking about in that context. Mr Fleck, at the heart of the Enron affair was the creation of a number of Special Purpose Vehicles, which were not properly recorded in the accounts. Now the evidence we have had from the Bank of England on this point draws our attention to the fact that this may be less of a problem in the British context, because, and I am quoting here the Bank of England's document to us, the problem may be less acute under UK standards because they include a true and fair override in the preparation of accounts.
  (Mr Fleck) Yes, that is correct.

  178. Now could you tell us just how many cases you are aware of where, in the context of giving a true and fair view of a set of accounts, difficulties, or issues, with Special Purpose Vehicles have, in fact, been referred to?
  (Mr Fleck) Sir, I hope you will forgive me if I just go back one step, on that. Because the first point to make is that our law is different and our standards are different, in relation to Special Purpose Vehicles. We actually have the concept of control in the Companies Act, so you could not have the American analogy over here as a matter of law or standards. The second point to make is, the Auditing Practices Board does not see sets of accounts and have the opportunity to review how they have come to be concluded in the way that they have; we learn about them through the activities of the FRRP and other bodies. Speaking from a personal point of view, I am aware of a number of occasions when the true and fair override has been used, but not in the context of a Special Purpose Vehicle.

  179. Just to be clear about this, you see, at the heart of the Enron affair is this issue about Special Purpose Vehicles. Now our laws and standards are framed differently, and the Bank of England tells this Committee, "Well, it may not be an issue for us, in the context of our laws and standards, because there's this true and fair override." And when I ask you, can you provide an example, just one, one example, of where this has actually happened, you cannot give me one?
  (Mr Fleck) No, Sir, partly because the law is different, and therefore you do not get to the same stage of exercising the true and fair override to correct the position.

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