Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 200-219)



  200. On a mandatory basis?
  (Sir John Bourn) Yes, and there are standards in relation to this.

  201. Should there be less time ?
  (Mr Fleck) There are pluses and minuses for that, one of which is, the person needs a certain amount of time to become familiar and to be effective, and if you set too short a period of time then you are out, just as soon as you have really got your feet firmly under the table; then you get into rather complex issues about the interrelation between the lead partner and the other partners on the team. It is a fine call, as to whether it would be better if it were five years or seven years, the New York Stock Exchange has just advocated five years, and certainly that is something that will be looked at very carefully.

  202. Will you be forming a view on that issue yourselves, at some stage?
  (Mr Fleck) Yes.

  203. When will that be?
  (Mr Fleck) I think we are already consulting and discussing it, as we sit here.

  204. You do not want to do it now?
  (Mr Fleck) I do not think so, if you do not mind.

  205. And what about the retendering of audit work on a mandatory basis; would that make any sense?
  (Mr Fleck) Our own view, Sir, is no; that is already the potential of rotation by another means. For what it is worth, we believe that there is a discipline that needs to be injected which requires the audit committee to report on a regular basis, we would actually say annually, as an audit committee, to the shareholders, with an explanation of what it has done, why it has done it, and not just limited, if I may say, to the audit, but also to the criteria by which it has allowed, if it has, non-audit services to be done. We would advocate a full report on the nature and depth of the relationship between the audit committee and the audit firm.

  206. Is there a problem here though, because the first thing that Sir John said, when I asked why the auditors had failed in the Enron case, was that they had got too close to the client, it was too cosy, but the only thing that you have mentioned, very fundamentally, which might change that, so far, is, Sir John appeared to suggest, that that might mean actually that you would have a situation where you would make it more difficult for people to cross from the audit teams into the companies. That seemed to be the major implication of your comment, Sir John?
  (Sir John Bourn) There are other things as well that I think should happen. Following on Mr Fleck's point, I think the non-executive directors should report on their own discussions with the external auditor, they should report on the remuneration of the external auditor, they should report on the whole range of services the external auditor has provided for the firm, they should show what has been paid for them, and they should show why any extra work beyond the audit has been given to this firm rather than to somebody else. So I think you should have the non-executive directors having a more public face, being identified, being a contributor to their section of the annual report, which commented on all these issues about the discussions they had had with the external auditor, their concerns about him, why they had wanted to change him, why they had not wanted to change him, and have all this up front. But there should be these features, and that the external auditor should know that this discussion with the non-executive directors is an important part of his work, and that his ability to satisfy the non-executive directors is crucial in the determination of whether he stays the external auditor.
  (Dr Reeves) Could I make just a quick point, because, Chairman, we talk about auditor rotation, I think it is important to differentiate auditor firm rotation and an auditor partner rotation, and certainly all our studies to date suggest that audit firm rotation does not work, certainly international experience suggests that it does not work, in countries like Italy and Brazil, and it has not worked in countries like Spain, Turkey and Slovakia.

  207. Why did it not work?
  (Dr Reeves) Again, we are looking into that, and again there have been other studies done, in fact, in the UK; the Cadbury Committee, in 1992, came out against audit firm rotation, the Republic of Ireland has just produced its review group on auditing, in Australia the Ramsay Report met, and, of course, recently, the SEC and the Senate Banking Committee, and, of course, Paul Sarbanes also suggested there were conceptual problems and empirical problems about the whole process of firm rotation. I think the biggest one is, there is a huge learning curve, probably in years one and two, to gain knowledge of the business, particularly in the complex global environment. And the views are, I think, two-fold. One is that the learning curve, obviously, is quite costly, and, secondly, where there is audit failure it tends to occur in the first two years; and there is a very useful empirical study, done by John Burton, the ex-Chief Accountant of the SEC, which suggests that a huge proportion of audit failures do occur in years one and two. So I think we are moving towards the view, at this stage, where audit firm rotation probably is not a favoured option; having said that, we do believe that it is important in terms of flexibility, and we think audit partner rotation is an important issue. And, I suppose, Chairman, in terms of our deliberations, the two areas, or the two pertinent questions, relate to duration and seniority, is seven years the right time period, or should it be five years. I think the ABI, in their evidence to yourselves, suggest five years, the Senate Banking Committee have suggested five years. I think there is an issue in terms of proper succession planning; that, to me, is the criterion for determining whether it should be five or seven years. The other, final, problem would be the seniority, and we talk about audit partners, moving above audit partners, there is also an issue around rotation of the team members underneath the audit engagement partner, and, if we changed the rotation cycles between all the various players, including the directors, maybe we would ensure that cosy relationships would not exist in the future.

  208. There are a lot of issues there, which, unfortunately, we have not got time to follow up in this session; but can I ask just one final question of you, to close off this bit, for me, anyway. What view does the Board take on whether there is any cross-subsidy between audit work and other work that auditors do? You will probably know that Lord Sharman has criticised the fact that some auditors in this country do not publish very fulsome statements of their financial positions, and he said in a recent speech, I think in the House of Lords, that "Proper financial disclosure and segmental reporting would once and for all resolve the issue of whether auditing is" being used, in some cases, as a loss leader?
  (Dr Reeves) I think that is changing, Chairman. I understand that, certainly in terms of the big four companies, by the end of this year, I would imagine all will have taken on limited liability partnership.

  209. All of them will have done?
  (Dr Reeves) I would imagine, certainly two have already, and two have indicated they would like to by the end of this year.

  210. Have you had any signs from them that they are going to do that, PricewaterhouseCoopers and the other one?
  (Dr Reeves) Only from the statements they have been making themselves to the press; but certainly Ernst & Young, who took it on very early on, and KPMG, who recently did that, suggest there are very clear advantages with taking on limited liability partnership, transparency being, I think, a very important factor.

  211. And is there evidence of cross-subsidy at all?
  (Dr Reeves) Just going on, I think transparency is needed, both financially and managerially. Coming back to the point about cross-subsidisation, I presume you are meaning, by this, the cross-subsidisation from the audit fee and the audit assignment across to the possibly more lucrative non-audit services. There have been various studies done on this, Chairman, using the Americanism, it is called "low-balling"; but what we have done, so far, in terms of looking at these past studies, is suggest, in terms of the attitudinal surveys undertaken, that it is issues rather about the quality of the audit work, based on the firms' thinking about possible litigation, based on the possibility of loss of reputation, that seems to far outweigh any short-term profitability criteria. So that was one study done in 1995, which said very clearly it is quality rather than price that counts. There have been other studies done, in fact, we ourselves are doing one, in terms of auditor switching and the reasons for that over the last ten years, and hopefully that, again, will tell the reasons why the audit client, or indeed the auditor and the audit client have decided to part company. Again, a study done by Beattie and Fearnley, who I think gave evidence to this Committee, suggests that switching is due much more to a change in the company's policy, and also the auditor's professionalism, as opposed to the price of the contract. So, I suppose, in economic terms, that audit services tend to have an inelastic demand. It is very difficult, having said that, in terms of analysing these studies, to demonstrate, if there are lower prices, in terms of the audit, whether that is done for the purpose of gaining business in the non-audit service market; and no empirical studies, to date, have actually shown that.

Mr Plaskitt

  212. Sir John, generally speaking, who would you say is defining the rules of auditing in the United Kingdom, who are the people doing it?
  (Sir John Bourn) The Auditing Practices Board.

  213. Who are professionally, what?
  (Sir John Bourn) The members of the Board cover a number of professions. There are, of course, accountants, but it is not confined to accountants.
  (Mr Fleck) It is 60 per cent non-accountants, non-practitioners.

  214. And, generally speaking, when a complaint comes forward about the matter of audit, who in this country is investigating?
  (Sir John Bourn) If a complaint is made about the audit, it is made to the institute of which that auditor is a member.

  215. The people who carry out an investigation of a complaint, what is their profession?
  (Sir John Bourn) This is a study which is about to happen, but one in which we are actually engaged at the moment; it tends to vary between the six institutes, but the investigation is made by professional people, some of whom are accountants, some of whom tend to be lawyers, in some cases some of whom are not of any of those professions. But the attempt is made, and I do not say "attempt" as if that was not a serious attempt, by all the six institutes to have lay elements in the administration of investigation complaints.

  216. And who is ultimately funding the people who are writing the rules of audit and carrying out the investigations of audit; who is paying for it?
  (Sir John Bourn) It is paid for by the institutes, but a lot of the people who give their time to it are not doing it on a paid basis but do it voluntarily.

  217. So, finally, is it not the case that, it is, in fact, true to say that, in terms of the people defining auditing rules, investigating auditing conduct and funding all of this, essentially, are themselves auditors and accountants?
  (Mr Fleck) It is not true in relation to the setting of the standards, Sir; 60 per cent of them are not auditors, they are lawyers, they are from all parts of the community, they are businessmen, 60 per cent of the Auditing Practices Board is not.

  218. But you would say it was true in the case of investigation and the ultimate funding?
  (Mr Fleck) Those are funded through the profession. Can I add just one thing to what Sir John said, only just out of completeness, and that is that one of the key investigators actually is a former investigator at the Serious Fraud Office, who has come across to the institute.

  219. But, given what you say, can you not appreciate why we think there is a problem of perception, to use the word you have used a few times this morning?
  (Sir John Bourn) There is a problem of perception, it is a problem of perception about professions generally in this country, and about the way in which can you actually trust professional people, because they may talk of the public interest; but Jeremy Bentham said, in the 18th century, "What are professions; organised conspiracies against the public interest." And there are people today who would repeat those words. And I have done it, because, you are right, there is this concern right across the board; and, certainly, the task of myself and my colleagues, who, on a voluntary basis, have said we will do the best we can to see to what extent those suspicions are justified, and to the extent they are to make recommendations to improve it and overcome it.

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