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FSA challenges audit profession to sharpen up its act

Audit reports | FSA challenges audit profession to sharpen up its act Ian Fraser

Do auditors tend to be so close to the management of the companies whose financial results they’re supposed to be auditing that they are predisposed to take whatever they’re told by their paymasters at face value? And if auditors are failing adequately to challenge management on book-keeping and audit methodology, what is the value of the audit reports they produce?

I’ve been mulling this over these questions for some time (it probably has something to do with the fact I used to work as accountancy correspondent for a UK newspaper!) and I've been erring towards answering “yes” and “very little/less than zero.”

My inclination to respond in this way has been reinforced by the clear audit failures shown up by the banking crisis, and discoveries made during my research for a BBC documentary about Sir Fred Goodwin’s reign as chief executive of Royal Bank of Scotland.

Last week, the Financial Services Authority stepped in with a surprisingly forthright attack on the audit profession. In a discussion paper [PDF, 537 KB], jointly published with the Financial Reporting Council, the regulator, which is to be disbanded and merged in with the Bank of England by the UK government, identified a “worrying lack of scepticism" among auditors.

The FSA as good as accused auditors of cozying up to corporate management and becoming their poodles. The result? An "inadequate level of challenge" and auditors who take their lead from management on certain critical assumptions—such as the point at which delinquent loans should be written off as bad debts.

In a statement, FSA director Paul Sharma said:

"Our experience has indicated that, at times, auditors have focused too much on gathering and accepting evidence to support firms' assertions, rather than exercising sufficient professional scepticism in their approach. This falls far short of what the FSA—and society at large—expects from auditors."

This confirms what cannier investors have been telling me for years. They began to question banks' financial statements in 2006-07, suspecting the valuations placed on many of their assets were, to say the least, far-fetched. Most of these cannier investors did not want to pollute their portfolios with any bank holdings.

In its 82-page paper mentioned above, the FSA implied that the audit profession's acquiescence had enabled banks and other financial institutions to be "systemically aggressive" in their accounting policies and presumably therefore to dupe their investors (Ernst & Young's Lehman Brothers audit is a case in point). It said it had found one (unnamed) bank that "had incorrectly netted down derivatives in the balance sheet leading to a misstatement of c. £900 billion" (see page 49 of discussion paper PDF).

The FSA said there was "a general deficiency" among banks when distinguishing between clients' money and assets, and their own money and assets. The FSA indicated that some of these findings will form the basis for future enforcement action. It has already fined JP Morgan £33.3m—a record fine from the UK regulator—for failing to protect up to $23bn of client money by keeping it safe in segregated accounts.

One of the problems that the FSA alludes to is the conflict of interest within the accountancy profession. The audit firms sell a variety of other services to their banking and financial clients—including restructuring and insolvency work, and a wide range of consultancy services. Since this non-audit work is often more profitable than auditing itself, the 'Big Four' accountancy firms—PriceWaterhouseCoopers, Deloitte, KPMG and Ernst & Young—have traditionally used audit as a loss leader to secure other more lucrative assignments from the same customers. Within such a framework, they are more or less guaranteed to be a soft touch.

The FSA's discussion paper, which invites interested parties to submit responses by September 29, 2010, also raises the prospect greater regulatory supervision of the audit profession. It seems the FSA would also like to persuade auditors to act as whistleblowers in cases where they identify questionable activity at client firms. That, however, might be expecting to have its cake and eat it.

Further reading on the future of audit

Tags: accountancy , audit , banking , Financial Services Authority (FSA) , fund management , regulation
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