Should the auditors have known the banks weren’t a going concern?

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There's quite a debate going on regarding concerns Francine McKenna and I have raised regarding the problems of banks failing after Big 4 auditors issued unqualified audit reports on their accounts, implying that they thought them going concerns for the coming year.

So, let's get some facts straight. For example, Lloyds TSB plc issued its 31.12.07 accounts on 21.2.08, unqualified. HBOS issued its accounts for the same year end on 26.2.08. The director's report (page 148) included the statement:

Going Concern
The Directors are satisfied that the Group has adequate resources to continue in business for the foreseeable future and consequently the going concern basis continues to be appropriate in preparing the accounts.

The auditors said:

In our opinion:
the Consolidated financial statements - give a true and fair view, in accordance with IFRSs as adopted by the EU, of the state of the Group's affairs as at 31 December 2007 and of its profit for the year then ended;
- the Parent Company financial statements give a true and fair view, in accordance with IFRSs as adopted by the EU as applied in accordance with the provisions of the Companies Act 1985, of the state of the parent Company's affairs as at 31 December 2007;
- the financial statements and the part of the Directors' Remuneration Report to be audited have been properly prepared in accordance with the Companies Act 1985 and, as regards the Group financial statements, Article 4 of the IAS Regulation; and
- the information given in the Directors' Report is consistent with the financial statements.

KPMG Audit Plc

Note that last confirmation: irrespective of IFRS (and that's pretty key right here) they think that the going concern basis continued to be an appropriate for preparing the accounts.

So, what is the going concern basis? I'll refer to latest international guidance on this issue. It says:

Going Concern Assumption
Under the going concern assumption, an entity is viewed as continuing in business for the foreseeable future. General purpose financial statements are prepared on a going concern basis, unless management either intends to liquidate the entity or to cease operations, or has no realistic alternative but to do so. Special purpose financial statements may or may not be prepared in accordance with a financial reporting framework for which the going concern basis is relevant (e.g., the going concern basis is not relevant for some financial statements prepared on a tax basis in particular jurisdictions). When the use of the going concern assumption is appropriate, assets and liabilities are recorded on the basis that the entity will be able to realize its assets and discharge its liabilities in the normal course of business.

It then makes clear that assessment of this issue is the responsibility of management, as HBOS indicated, but of course an auditor has to concur. And in doing this authoritative guidance notes:

5. Management's assessment of the entity's ability to continue as a going concern involves making a judgment, at a particular point in time, about inherently uncertain future outcomes of events or conditions. The following factors are relevant to that judgment:

• The degree of uncertainty associated with the outcome of an event or condition increases significantly the further into the future an event or condition or the outcome occurs. For that reason, most financial reporting frameworks that require an explicit management assessment specify the period for which management is required to take into account all available information.

• The size and complexity of the entity, the nature and condition of its business and the degree to which it is affected by external factors affect the judgment regarding the outcome of events or conditions.

• Any judgment about the future is based on information available at the time at which the judgment is made. Subsequent events may result in outcomes that are inconsistent with judgments that were reasonable at the time they were made.

The last point is important and has been heavily relied upon by those who argue that the auditors had no duty to consider going concern qualifications on all those banks that have needed to raise extra capital to ensure their liquidity this year. But let me be clear: no one, anywhere in banking had any doubt that these securitisation market failed in August 2007. Let's also be in no doubt that any reasonably informed observer knew that HBOS suffered early exposure to the resulting issues. I mentioned it in September 2007 on this blog. HBOS's securitisation vehicle, Grampian, was already in trouble then.

Now if I knew that, why didn't the auditors and directors? Everything said by February 2008, when Northern Rock had collapsed, its debt was unsaleable, the securitisation market had failed and people were already talking of worse to come that to make the claim that the bank was a going concern when securities in issue exceeded member's capital tenfold that this was an ambitious situation to be in - especially so when £57 billion of these were issued as mortgage securitised loans - the precise product that the market had been rejecting for almost six months by then.

In view of those facts it is my opinion (nothing more, but an informed one) that irrespective of the absurd rules on valuation that IFRS allows (where the underlying value of assets can be ignored so long as there was a market in the security itself on the balance sheet date) a 'true and fair' over ride situation prevailed with regard to going concern in this case because the 'size and complexity of the entity, the nature and condition of its business and the degree to which it is affected by external factors [required] the judgment regarding the outcome of events or conditions' to be materially modified with regard to events already known by then, or predictable to such degree that allowance should have been made for them, and a cautionary note at the very least explaining the basis of assumption for use of a going concern basis should have been included in HBOS's accounts, and I have little doubt those of the other companies in question as well. This, I stress, is not hind-sight. It seems to me self evidently true given what was known by then and what we should have expected of those both with greater knowledge, and greater ability to ask question (i.e, the auditors).

But that begs the question 'did the auditors want to ask?' This, I think is crucial. I suspect that they either did not want to ask, or did not want to know the answer. A going concern qualification on any bank would have been disastrous. It could have precipitated a crisis, a crisis that was simply delayed a few months as a result. And so I suspect that the auditors knew the situation, and chose to ignore it, and are now seeking to justify their position with the benefit of hindsight. It is not those of us who are criticising that are using that advantage, but them. And yet, this still represents a failure of their duty. If the risk existed they had to report it. If they did not report it because they thought they would increase the risk then the system of audit is, in any event, invalidated. An audit system that cannot result in an honest audit report is of no benefit to anyone.

Either way we have an enormous problem. First, the modern audit is not about creation of a true and fair view, it is about reporting compliance with what might be a wholly inappropriate accounting standard i.e. IFRS. Second, because of that reluctance to create a true and fair view the awareness of the obligation to use a true and fair over ride is very limited, and therefore there is a marked reluctance to use a going concern qualification, which is almost unknown. Third, that creates systemic risk which undervalues the whole audit process to the point that it is meaningless. Whichever way you look at it, since the Big 4 fundamentally created this situation they are responsible for the outcome, whether individually for the particular accounts on which they failed to express what I believe to have been an appropriate opinion, or collectively on a systemic basis for providing what they claim to be a service which they are incapable of delivering.

It is a damning indictment however you look at it.