On 1 August 2019 the Senate referred an inquiry into the regulation of auditing in Australia to the Parliamentary Joint Committee on Corporations and Financial Services for report by 1 March 2020.
Submissions close on 28 October 2019. DFA has made a submission.
Introduction.
We welcome the current inquiry and note the similar initiatives underway in several other jurisdictions. This is an important issue.
We believe there is a need to refocus the auditing practices which are currently deployed by the “big four” firms in particular and the industry more widely. We reach these conclusions, having analysed the financial sector for more than 30 years, as a consultant, financial firm employee and a partner within Arthur Andersen before its dissolution.
There are many threads to the argument, but, these large audit firms are in our opinion too close to management of large companies, as they both advise them on strategy and tax minimisation, and separately provide audit services. In addition, these big four firms are responsible for the evolution of accounting standards, including off-balance sheet minimisation, as well as providing advisory services to companies and Government, and they also offer auditing capabilities. Conflicts abound.
Whilst in theory audit practices should be separated from other commercial and advisory operations of the big four, I have seen examples when company account planning sessions have included cross discipline discussions, from advisory, consulting, services AND audit, to craft strategies to maximise the commercial benefits to the audit and consulting firm. This happened regularly at AA.
In addition, the audit of large companies are executed in a formulaic and superficial way, where the main test is the need to meet relevant accounting standards, not separately confirming independently that the business is functioning as advertised from a financial and compliance perspective. Who audits the auditors?
Remember that in 2008 several banks failed, despite having been given an unqualified audit in the months prior. Others required substantial Government bail-out or were absorbed by other industry players. Nothing has changed (other than the quantum of debt and other exposures have increased substantially) since then.
A Financial Services Example.
To illustrate the limitations of audit, I will highlight four areas, where from my research and experience current banking sector audits are deficient.
Financial Derivatives Exposure.
According to recent RBA data Australian banks have some $48 trillion of gross derivatives exposures. This will include services to client, but also position taking on a trading basis within the bank’s treasury operations. Recent BIS research highlighted that in a low interest rate environment, banks will tend to lend less and trade more to try to bolster profits[i]. Plus, some window-dress their books for quarter end.[ii]
Derivatives gross exposures dwarf the capital and assets held within banks. This gross exposure is not reported clearly within the accounts, because most is held off balance sheet. Moreover, the true net-exposure which a bank may face will be determined by market movements and relative trading positions. But even net exposures are not adequately reported. We only get a glimpse of the true positions (and risks) when capital is applied under the Basel rules, but this does not tell the full story, yet are within current accounting standards, and off-balance sheet rules. We see no evidence of auditors picking through the derivatives book and validating or reporting these gross exposures. In a crisis this may well hit the financial position of an individual bank, and trigger the need for a restructure, bail-in or bail-out. Current audit rules and approaches are designed to minimise disclosure and obscure the true risks. APRA does not provide an alternative route to disclose such risks.
Internal Risk Models
Major banks can use their own “internal risk models” to estimate the amount of capital applied to the business, under the Basel rules. These models are complex and “tuned” by the institutions to enables institutions’ to maximise their use of capital. However, we are not convinced these models are functioning as intended, and they are not subject to regular audit, either by external auditors, or APRA. Thus, the data is taken as accurate from the “black-box” and this may lead to higher risks in the business than are disclosed. Again, the true position will not be exposed until a crisis hits.
Property Portfolio Revaluations
Large financial companies hold significant portfolios of mortgages backed by residential property. An initial valuation is used in the underwriting process. However, unless there is a material refinancing event, subsequent portfolio adjustments, (because for example property prices move down) are applied only at an aggregate level (for example state level). As a result, there is a significant risk the property portfolio is overstating the real current value of the underlying security, and this may translate to bigger risks in a downturn. In addition, the amount of capital held under Basel rules could well be understated. There may be offsetting benefits in a rising market, but the standard portfolio analysis is not very accurate. But once again external auditors will be not examining the operation practices of portfolio valuations yet will sign off on the accounts as true and accurate.
Household versus Loan Risks
Households often hold multiple loans across a lender or lenders. APRA only considers the status of individual loans. Reporting for audit purposes will be at a loan, not household level. Indeed, there are cases when loans are deliberately split to reduce the overall loan to value results. Once again this is an area where auditors will not tread, but the risks in the system are higher than those reported in the accounts. Again, the true position will not be exposed until a crisis hits.
These are just examples of pain points which the current audit processes will not adequately examine. There are many others.
Final Observations
The role of an auditor should be more than just checking with the accounting standards and signing off. They should be seeking out material issues, independently from management. But in the four cases above the results are wanting.
The solution would be to create an independent audit function, perhaps within the Auditor General’s domain, to provide accurate and independent analysis of large financial players. In addition, we believe that the audit functions of major firms should operate as separate service businesses and should NOT be also be allowed to offer creative accounting and off-balance sheet techniques as part of their service suite. The conflicts and limitations are obvious and concerning.
However, the true impact of such deficiencies would only be revealed in a crisis, mirroring 2008, by which time it is too late. Changing management and audit practices as suggested would place our important financial sector companies on a firming footing. Such changes could well benefit other industry sectors as well.
Changes to audit practice and structure are essential!
Martin North
Principal Digital Finance Analytics[iii]
October 2019
[i] The Real Problem With Low Interest Rates – https://youtu.be/LLUfzna5iys
[ii] https://digitalfinanceanalytics.com/blog/bis-confirms-banks-use-lehman-style-trick-to-disguise-debt-engage-in-window-dressing/
[iii] Digital Finance Analytics is a boutique research and advisory firm. More details are available via our Blog. https://digitalfinanceanalytics.com/blog/
