Accountancy lost sight of its primary role to the detriment of us all
By Ian Fraser
Date: July 11th, 2011
“There seems to be no limit to the optimism of businessmen… which the growing complexity of the market opens up. The first line of defence of investors and creditors is the vigilance of the practicing accountant. [Accountants] are cautious men, and their caution is expressed in the concept of conservatism.”
The quote, which I found in the report of the Future of Banking Commission, speaks volumes about how accountants behaved at the time and their value to the capitalist system.
Chris Fletcher, who retired as head of retail sales at asset management group Baillie Gifford in April but formerly worked as audit partner at KPMG, once told me how, in the early 1980s, senior auditors struck the “fear of God” into corporate boards. Directors were quaking when the auditors came to visit and one auditor in particular spoke to the directors of client firms as an old-fashioned headmaster might address errant schoolboys, sternly telling them what was and was not acceptable practice.
As I explained in an earlier blog post, this started to change in the 1980s. As they sought to boost revenues and profits, the large accountancy firms diversified into a wide range of associated areas, triggering a commercial land grab that was hugely successful for the likes of PWC, Deloitte, KPMG and Ernst & Young.
But the diversification, which included the “lowballing” of audit fees, and the use of audit as a “loss leader” to secure other more lucrative work from corporate clients, also gave rise to conflicts of interest, making it harder for auditors to exercise their professional scepticism. Many started to see their role as protecting management, not protecting the interests of investors and creditors.
In short, the ‘Big Four’ firms became so focused on their own commercial success they started to neglect their primary role of keeping financial markets honest. (For further information on this you should look at the findings of the House of Lords inquiry into the audit profession and the views of Berkshire Hathaway vice-chairman Charlie Munger).
Few lessons were learnt from the Andersen collapse of 2002 and the “Big Four” audit firms helped stoke up the global financial crisis with their unquestioning acceptance of the often wildly optimistic valuations placed on bank assets by bank boards, and their failure to ask difficult questions about excessive leverage and excessive concentrations of risk in the financial sector.
Yet the accountancy profession still seems incapable of recognizing the need for reform. During the House of Lords inquiry last November, the “Big Four” chiefs seemed to suggest they considered it perfectly acceptable to deceive investors by fudging “going concern” statements on behalf of banking clients. And as the Future of Banking Commission report points out, the International Accounting Standards Board now wants to remove references to the need for ‘conservatism’ and ‘prudence’ from its own rule book! Here’s another excerpt from the FoBC report:
“The International Accounting Standards Board (IASB) has proposed that the references to ‘prudence’ or ‘conservatism’ as desirable qualities of financial reporting information be removed, as these were said to be incompatible with the principle of ‘neutrality’.”
The FoBC report added that the attempts to harmonize accounting standards globally are having some dangerous spin-off effects:
“Accounting standards also need to be reviewed. We recognise that, for good reason, the accounting standard setters have focused on drawing up accounting standards which can be applied globally. While we recognise the value of this exercise, we are concerned that the baby may be thrown out with the bathwater. “We note Martin Taylor’s observation to the Commission that ‘sometimes the accounting bodies argue in a quasi-theological manner between two alternatives which can both be supported intellectually. It might be a good idea if they chose the one with the better social consequences sometimes’.
“Mr Taylor added that during his time at Barclays, ‘The accounting standards require you to recognise [losses] only when they occur, and that means that banks have overstated profitability in the up phase of the cycle, and understated profitability in the down phase of the cycle’.”
The report added:
“Unless the auditor can be trusted to be independent, then the integrity of the capital markets will be compromised. There need to be fundamental questions asked about the purpose of the audit. The auditor should be required to report all significant risk factors which come to their attention as part of the audit. The FSA should extend its current trend of encouraging much more dialogue with auditors and the FSA should require further work from the auditor of any areas of a bank’s activities where they have concern …”
These are just a few of the eminently sensible suggestions for reform included in the report. Rather than list them all here, I recommend reading the full report, published in June 2010 (or at least to read the section on accounting and auditing on pages 69 -74).
Members of the Future of Banking Commission included author Philip Augar, Martin Taylor, ex-chief executive of Barclays and David Pitt-Watson, chairman of Hermes Focus Asset Management. The commission interviewed heavyweights from the banking world including Sir Brian Pitman, the late former chairman and chief executive of Lloyds TSB.
This blog post was first published in QFINANCE on July 7th, 2011
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