Why do auditors and regulators continue to turn a blind eye to the dodgy accounting practices widely used by Britain’s banks to disguise the true level of their assets and liabilities?

The answer is probably that the banks have simply become too powerful. For example, it is impossible to get a credible law firm to sue a bank, because all the major solicitors’ firms are so dependent on banks as clients. I believe the main reason no-one dares question the smoke and mirrors at the heart of most banks’ balance sheets is that regulators including the Financial Reporting Council and the audit firms are effectively “captured” – either in the banks’ pockets or simply running scared.

One example comes when a big four firm such as Deloitte, Ernst & Young, KPMG or PwC become so dependent on retaining or winning non-audit work from a big bank they will wave through fanciful numbers as auditors since they don’t want to bite the hand that feeds.

To find out more about this worrisome state of affairs, it’s well worth reading a “gentle” polemic written by Prem Sikka, professor of accounting at Essex University, and published on the Guardian’s Comment is Free website. This is pasted below but can also be accessed here.

Although it skates over the efforts of Cadbury, Greenbury, Hampel, Higgs and Smith to address matters, Prem’s article is required reading for anyone with an interest in standards of corporate governance in the UK. It exposes some systemic failures which can and do lead to corruption in both banking and in business. I have also published two revealing comments from Comment is Free site, written by auditors with a conscience, at the end of Professor Sikka’s article.

The banks’ balancing act

In the wake of the recent subprime crisis and the accompanying credit crunch, Gordon Brown is concerned about economic turbulence ahead. There is no denying the depth of the unfolding crisis. Banks have been queuing up for financial support from taxpayers. The European Central Bank is providing nearly £250bn to alleviate the crisis. The UK taxpayer has poured nearly £50bn into Northern Rock alone and central banks are also busy pouring money into the banking system. Yet broader questions about the systemic failures are not being addressed.

All of the troubled banks boasted good governance. They had executive directors, unitary boards, independent non-executive directors, ethics committees, audit committees, auditors and risk assessment processes. Yet none of these alerted the stakeholders, or the regulators, of the dangers of their business model to themselves and the financial system.

Off balance sheet accounting – that is, the practice of not fully reporting corporate assets and liabilities – was highlighted as a major vehicle for cooking the books by the Enron scandal. Banks excelled at such practices during the 1980s Latin American debt crisis, a forerunner of the current subprime crisis. Yet the same practices have continued unabated.

Bank directors admit that they have been very economical with information about their company’s assets and liabilities. Banks created structured investment vehicles (SIVs) and other structures to keep troubled items off their balance sheets and report higher profits. Auditors were happy to approve such accounts. None of the credit rating agencies objected. Profit forecasts were met and stock markets were appeased.

This also made some directors rich as their salaries, bonuses and share options are linked to reported profits. The linking of director remuneration to profits is an open invitation to massage profits. The same directors are now asking the taxpayers to bail them out. None have been forced to return their gains. None have been held personally responsible and prosecuted for publishing misleading financial statements. The banking industry has not been investigated for its practices.

Belatedly, the corporate-dominated Financial Services Authority is calling for reforms of accounting practices, but it has failed to explain why it continued to accept poor practices. Can it really claim to have scrutinised the accounting practices of banks? It should be prosecuting directors for publishing misleading financial information, especially as they made financial gains from inflated profits, but it can’t seem to get off its bended knees.

Chancellor Alistair Darling also wants to clamp down on dodgy accounting practices, but has failed to explain why he did not address these issues during his tenure at the Department of Trade and Industry. The UK accounting regulator, the Financial Reporting Council (FRC) states that during 2008-2009 it plans to examine a sample of the accounts of banks and financial services companies. Even though SIVs have been freely used by banks for many years, none of the FRC’s accounting standards make any mention of such practices. By any measure, there has been a major regulatory failure that should be independently investigated.

Enron, WorldCom, Tyco, Parmalat, iSoft, Barings, Farepak and other companies implicated in headline-making scandals had non-executive directors. Banks also boasted audit committees and non-executive directors. In theory, non-execs are independent of the executive board and provide independent voices within companies.

The reality is that they are often friends of executive directors and therefore cannot bite the hand that feeds them. They hold multiple appointments and sit on the boards of a number of companies.

Due to multiple directorships they are unable to devote sufficient time to the affairs of all companies and are in no position to offer informed, independent advice. They are not elected by bank depositors, employees or other parties who bear substantial risks and thus lack an independent accountability base.

Those on the non-exec gravy train can earn around £30,000-£60,000 for attending board meetings 12 or so days a year.

Audit committees staffed by non-executive directors are supposed to evaluate risks, internal checks and balances and quality of published accounts. Yet none made any effective assessment of the risks, or alerted shareholders, savers, regulators, or the general public of the risks. None blew the whistle on banking practices. None have been hauled in by any regulator for failings in their duty to invigilate the main board.

Despite recurring scandals, under the weight of corporate power successive UK governments have shied away from effective reforms to the governance of large corporations. The mantra has been that executive directors, non-executive directors and external auditors can check corporate excesses.

The subprime crisis once again exposes the fiction of such claims.

Without a thorough investigation of the way banks are governed, structure of company boards, effectiveness of regulators, rights of savers, methods of director remuneration, quality of financial information and silence of auditors, meaningful reforms cannot be introduced. Yet none of this is on the government agenda.

And here are two interesting reponses to Prem’s article:

1) From sombody calling themselves GoodAccountant

The difficulty with accounting standards is that they now serve no purpose – maybe David Tweedie and his friends are doing some academic experiments but they serve no purpose even though the accounts are getting longer.

Bank auditors could have used the “true and fair” override to object to the accounts, but did not. I guess they were more concerned about their fees.

What is the FRC’s response? It has taken its cue from big firms and now wants to abolish the “true and fair” override. That means that if the accounts comply with the rules then they are okay even though they are nonsensical. There are so many areas in which there are no rules and accountants are supposed to use their judgement, but none of that will matter in the future.

Companies will get a clean bill of health from auditors, auditors will collect fat fees. Neither can be sued for producing rubbish accounts and the public will pick up the tab for all these follies. The FRC has totally failed and the sooner people realise that the better.

2) From someone calling themselves MaiLing, who says they are “currently working on a bank audit at a Big Four accountancy firm”

I am part of a team that has just started the audit of a bank. Just before the audit, the partner in-charge of the audit and the technical department (it is a Big Four firm) briefed us on SIVs, CDOs and the subprime crisis. So what should we be doing at the audit? The answer – check the figures that the management supplies.

In other words, take the bank directors’ word and then see that the figures that claim to have used are actually used. One member of our team said, “as the market value of financial instruments depends on the present value of future cash flows and markets themselves are in turmoil, how can we out guess the markets and decide that the figures are reasonable”.

Our audit partner told us that we do not have to worry about that and only need to confine ourselves to checking what the directors provide. So they could give us any figure.

The “true and fair view” override and common sense that GoodAccountant mentions is just ignored. We have been asked to be mechanical about our audit. If the directors’ figures are good enough, then what is the point of doing the audit? This kind of audit does not do any good and unless a bank goes bust no one will question what goes on an audit. If they do, the Institute will then discipline the firm and I am not aware of any Big Four partners ever being thrown out or any big firm closed down.

I fear for the future of our profession. Only independent regulation can save it.

THis blog post was published on 3 January 2008