Select Committee on Treasury Appendices to the Minutes of Evidence



APPENDIX 10

Memorandum submitted by Mr Jonathan Hayward, Hayward & Partners LLP

  My credentials in this regard are that until recently I was an audit partner in one of the Big Five firms, where I was the European leader of a small research and development group responsible for innovation in auditing. Consequently, I have had some years of observing audits in practice in the UK, North America and Continental Europe, and have formed a number of views which are contrary to the received wisdom in the profession. I am no longer associated with any established audit firm and the views expressed below are my own personal opinions.

  Independence of auditors will not be achieved by restricting the provision of non-audit services. In my experience, a high level of non-audit services is a symptom of an underlying cause, rather than the cause itself.

  The underlying cause is that auditors see company management as their client, rather than the investors or any other stakeholders. Although audit committees may recommend appointment and approve fees, and annual general meetings must approve the auditor's appointment or reappointment, these recommendations and approvals almost invariably follow management's preferences. In the case of fees, this is formalised to the extent that the AGM merely authorises management to fix the audit fees.

  The practical consequence of this is that competition between audit firms has had two principal effects. The first of these is that price competition, together with the influence of process-based Auditing Standards, has contributed to a gradual but significant process of commoditisation of the audit, to the extent that it is difficult to distinguish between the audits of the different firms and there is no expectation that audit appointments will be influenced in any meaningful sense by the proposals relating to the audit process itself. The second effect is that the firms seek to differentiate themselves by the quality of the service they offer to management. In a competitive tender, this is where most of the attention is given.

  A successful auditor is therefore one who manages to remain balanced on the very fine line between helping management achieve its objectives and ensuring that the company remains within legal and professional limits. Seen in this light, it is perhaps surprising that there have not been more cases where auditors have over a period of time strayed off that fine line.

  It should be said that most public company auditors are highly aware of this dilemma and are extremely conscientious in trying to achieve a balance. Given the pressures and complexities involved, however, we should not be surprised if occasionally some fail.

  Although there is a place for additional regulation, it is unlikely to be effective on its own. Measures should be taken to redefine the client so that the auditor is not subject to the degree of tension described above, and to change the basis of competition between firms so that they are competing on quality of assurance rather than on service to management. Institutional investors generally feel unable to exert much influence on the appointment of auditors and the work that they do. It should be possible to improve this situation by giving statutory backing to the independence and responsibility of audit committees. Corporate governance reports should specifically cover the role and the effectiveness of the audit committee, and these reports should be subject to independent attestation (not by the auditors).

  Although the reduction in the number of large audit firms from five to four will reduce competition, this will actually have negligible impact on the quality of audit, given that they already do not compete in this respect. (On the contrary: the drama of the Andersen disintegration will undoubtedly have had a chastening and beneficial impact. Unfortunately, it will wear off over time.) The interests of society and of shareholders would be served by the emergence of specialist independent audit firms who would compete on quality. The principal barrier to entry of such firms is the conservatism in the markets. Government has a role to play in helping to open minds to the desirability of new entrants and the need for the markets to judge the value of an audit by something more discriminating than merely looking for a long-established brand.

  Compulsory rotation of auditors would undoubtedly make auditors more conservative and reduce the likelihood of unpleasant surprises. Excessive conservatism, however, is just as bad as excessive optimism, even if it might be more acceptable to many since the consequence of erring on the side of excessive conservatism is an indefinable loss of value, rather than periodic spectacular collapses. There is also the problem that as business becomes more complex it becomes ever more important for auditors to have a detailed understanding of their clients, which takes time to build up. (This sounds like special pleading by auditors but in my experience is an entirely valid concern.) Given the uncertainty over whether the net effect of rotation would actually be beneficial, an alternative should be offered. Independent assessors should periodically monitor an audit as it proceeds, including observation of meetings, and issue a report on the effectiveness of the audit. The report should, amongst other things, include matters such as the depth of experience and expertise in the audit team, and the effectiveness of the audit firm's procedures for ensuring proper consultation in significant areas of judgement. (This is quite different from the profession's existing quality processes, which are after-the-event reviews of documented compliance with procedures.)

  Finally, reporting and audit requirements should be amended to reflect the fact that the interests of both long-term investors and society as a whole are best served if factors relating to the long-term sustainability of a business are clearly explained. Financial reporting is inherently backward-looking and is therefore of restricted usefulness in assessing the future prospects of a company. Companies have developed many measurements for internal use which are indicative of future value, but there is no obligation to report any of these, practices vary widely and there is no body with clear responsibility for standard-setting.

  Furthermore, many business models—Enron being an extreme case in point—produce short-term results but the sustainability of these results is dependent on a number of assumptions (for example, in Enron's case, that the share price would keep rising). Although no company or auditor can be expected to attest to long-term prospects, it would be possible for assumptions of this sort to be made explicit so that the risks inherent in a company's business model could be better understood.

  I should be pleased to provide further evidence either orally or in writing if this would be helpful.

 


 
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