Managerial Auditing Journal Crunch time for bank audits? Questions of practice and the scope for dialogue Margaret Woods, Christopher Humphrey, Kevin Dowd, Yu‐Lin Liu, Downloaded by JOHANNES KEPLER UNIVERSITAET LINZ At 04:23 06 April 2017 (PT) Article information: To cite this document: Margaret Woods, Christopher Humphrey, Kevin Dowd, Yu‐Lin Liu, (2009) "Crunch time for bank audits? Questions of practice and the scope for dialogue", Managerial Auditing Journal, Vol. 24 Issue: 2,pp. 114-134, doi: 10.1108/02686900910924545 Permanent link to this document: http://dx.doi.org/10.1108/02686900910924545 Downloaded on: 06 April 2017, At: 04:23 (PT) References: this document contains references to 63 other documents. 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About Emerald www.emeraldinsight.com Emerald is a global publisher linking research and practice to the benefit of society. The company manages a portfolio of more than 290 journals and over 2,350 books and book series volumes, as well as providing an extensive range of online products and additional customer resources and services. Emerald is both COUNTER 4 and TRANSFER compliant. The organization is a partner of the Committee on Publication Ethics (COPE) and also works with Portico and the LOCKSS initiative for digital archive preservation. *Related content and download information correct at time of download. The current issue and full text archive of this journal is available at www.emeraldinsight.com/0268-6902.htm MAJ 24,2 114 Crunch time for bank audits? Questions of practice and the scope for dialogue Margaret Woods Nottingham University Business School, Nottingham, UK Downloaded by JOHANNES KEPLER UNIVERSITAET LINZ At 04:23 06 April 2017 (PT) Christopher Humphrey Manchester Business School, University of Manchester, Manchester, UK Kevin Dowd Nottingham University Business School, Nottingham, UK, and Yu-Lin Liu Manchester Business School, University of Manchester, Manchester, UK Abstract Purpose – The purpose of this paper is to review the way in which auditing issues have been raised and addressed during the credit crunch and developing global financial crisis. Design/methodology/approach – Analysis is based on a review of the academic auditing literature, regulatory and audit reports, together with papers from the financial press. Findings – After highlighting the relative lack of media attention devoted to the external auditing function in the light of major corporate collapses, the paper considers what, contrastingly, is an active and ongoing series of responses to the current crisis on the part of auditing firms and the profession more generally. Through such analysis the paper explores a number of implications of the credit crunch for both auditing practice and research. Research limitations/implications – The paper is constrained in part by the rapidly unfolding nature of events, with important policy developments arising almost on a daily basis. The paper draws primarily on events up to the beginning of October 2008. Practical implications – The paper has important messages for audit practice and research, including the technical capacities of external audits in the banking sector, the contributions of standard setting bodies and regulatory oversight, and the scope for enhanced dialogue between such parties and audit researchers. Originality/value – The paper serves both to focus and stimulate analysis of the credit crunch on the audit profession. It demonstrates the complexity of contemporary practice and highlights the importance, especially from an educational perspective, of developing understanding of banking audit practice and associated regulatory interactions – including the presented possibilities both for research and enhanced academic-practitioner dialogue. Keywords Auditors, Banks, Auditing, World economy, Recession Paper type Research paper Managerial Auditing Journal Vol. 24 No. 2, 2009 pp. 114-134 q Emerald Group Publishing Limited 0268-6902 DOI 10.1108/02686900910924545 1. Introduction The global credit crunch, which began with the drying up of wholesale credit markets, has proved traumatic for the international financial system as many institutions have reported huge write downs in asset values and some have been pushed into forced sale to prevent bankruptcy. Since the US sub-prime problems began to bite in August 2007, Downloaded by JOHANNES KEPLER UNIVERSITAET LINZ At 04:23 06 April 2017 (PT) one major US institution – Lehman Brothers – has gone bankrupt, and other key mortgage providers in both the USA (Fannie Mae and Freddie Mac) and UK (Northern Rock and Bradford and Bingley) have become dependent upon central government support for their survival. In addition, a number of other institutions have survived only through an arranged take-over. In early September 2008, UK, the Derbyshire Building Society and the Cheshire Building Society faced substantial problems as a result of exposure to the US sub-prime market, and have been taken over by the Nationwide, a much larger mortgage lender with a stronger capital base. Similarly, in the USA, the bank Bear Stearns was the subject of a forced sale in March 2008, and in September 2008 Merrill Lynch announced that it was to be sold to Bank of America in a share exchange deal for $50 billion, following the group’s overall loss of $18.7 billion in the year to August 2008. During late September 2008 and early October 2008, events have continued on an unprecedented scale, with bank collapses and/or rescues in numerous countries (including the wholesale collapse of the Icelandic banking sector) and the launching of enormous government financial bail-out schemes for the banking sector, the nationalisation of leading international banks, and the issuing of governmental guarantees to deposit holders. It has been suggested that “the global financial economy has never in recent years been tested by quite such a combination of accidents and jolts to confidence” (Peston, 2008). In relation to accounting practice, some commentators have argued that the credit crunch crisis has been exacerbated by the use of fair value accounting. Sir David Tweedie, Chairman of the IASB, has responded by arguing that: “accounting has to reflect facts, not assume stability when it does not exist” (IASB, 2008a, p. 2). His view is echoed within the audit profession, with Richard Sexton, head of assurance at PricewaterhouseCoopers (PwC) in UK, for example, arguing that: [. . .] accounting doesn’t create reality, it reflects it. Here (fair value) it has clarified where there are some issues and has illuminated them. In the criticism there is an element of “we don’t like the answer” (Hughes, 2008b, p. 5). The concerns with fair value have, nevertheless, continued to grow in prominence in the financial press, leading to stock exchange regulators and politicians around the world calling for its suspension, accompanied by vociferous counter-arguments from those supporting fair value accounting and challenging what they see as undue political interference. In contrast to earlier corporate crises, such as Enron, WorldCom, or Barings, the role of auditors in the credit crunch appears to have received relatively limited media coverage. More evident focal points have been the banking institutions themselves, the strength of their business models, associated remuneration structures and incentive based cultures and the problems being generated by the rise of increasingly complex financial instruments. Press comment on auditors has been largely confined to instances where audit reports have been modified, or valuations challenged (for some exceptions, Sikka, 2008a,b). The material presented in this paper demonstrates that the limited press comment on auditing issues belies what has been, and continues to be, a hive of international activity, action and reaction, both in terms of the responses of auditing firms and the auditing profession more generally. The paper’s analysis is constrained in part by the rapidly unfolding nature of events (drawing primarily on events up to early October 2008) Crunch time for bank audits? 115 MAJ 24,2 Downloaded by JOHANNES KEPLER UNIVERSITAET LINZ At 04:23 06 April 2017 (PT) 116 and the confidential, behind-the-scenes, form of regulatory negotiations. Nevertheless, collectively the paper serves to raise a number of important questions and implications for audit practice and research, including the technical capacities of external audits in the banking sector, the contributions of standard setting bodies and regulatory oversight, and the scope for enhanced dialogue between such parties and academic audit researchers. It certainly reinforces the observations by Power (2003) and Humphrey (2001, 2008) that key dimensions of the practice of audit and its institutional settings are under-documented, under-researched and worthy of constructive, but challenging debate. The next section of the paper provides a brief historical summary of the credit crunch and emerging audit practice issues/problems. This is followed by a section outlining and reviewing the subsequent responses of both the audit profession and financial regulators/oversight bodies to the crunch – which have involved the publication of numerous practice statements, discussion papers and guidance notes. The paper closes by reflecting on such activities and developments, arguing that, collectively, they reflect a more active arena than that suggested by general financial media coverage – raising, in the process, important questions about the nature and capacities of bank auditing, its regulation and the scope for enhanced academic-practitioner dialogue. 2. The credit crunch, bank crises and the audit profession 2.1 The credit crunch and bank crises The credit crunch began in summer 2007, when accumulating losses on US sub-prime mortgages triggered widespread disruption to the global financial system. The problems originated in the growing practice by banks and other mortgage providers of using special purpose entities or collateralised mortgage obligations (CMOs)[1] to “slice and dice” their credit risk exposures. For non housing loans, collateralised debt obligations (CDOs)[2] provided similar opportunities for institutions to pass on their risks via the sale of special bond issues. The market for CMOs, CDOs and other similar forms of financial instruments has grown rapidly in recent years as they provide a useful tool for financial institutions which use them for the management of both their capital asset ratios and their credit risk exposure[3]. The credit crunch is a direct consequence of the scale of exposure of financial institutions to this market in so-called “complex financial instruments”. A key factor in the crunch is illiquidity in the market for sub-prime mortgage based CMOs due to increasing uncertainty about the value of the underlying collateral. The value of a bond purchased from a CDO or CMO is usually model based, and dependent upon a set of assumptions about the risk of the underlying collateral, but such assumptions are both subjective and uncertain. Most importantly, the perceived risk at the time of purchase of such bonds may change over time, leading to a change in their value. The lower the assumed risk, the higher the value of the bond and vice versa, and so issuers may be tempted to overprice bonds whilst investors lack the full information required to make an independent judgement of the risk. Market liquidity is thus dependent upon buyers being confident that prices reasonably reflect the risk-return trade-off, and the credit crunch originated (and still continues) because this confidence evaporated. Buyers rightly began to suspect that their bonds would collapse in value as the sub-prime mortgage default rates increased. Downloaded by JOHANNES KEPLER UNIVERSITAET LINZ At 04:23 06 April 2017 (PT) As a result of the falling prices, many institutions incurred large losses on complex structured securities, resulting in an increased demand for liquid assets. Unfortunately, as the lack of confidence further reduced liquidity in many of the credit markets, the problems only worsened. Consequently, financial institutions have experienced periods where they have suffered major falls in the value of assets combined with vanishing market liquidity. By April 2008, the five largest UK banks: (1) HSBC. (2) Royal Bank of Scotland. (3) Lloyds TSB. (4) Barclays. (5) HBOS. had recorded write downs and asset impairments totalling approximately £22 billion (Smith, 2008). The level of exposure to the crunch varies between institutions, however, and it is accepted that both HSBC and Lloyds TSB have limited their activities in the CDO and sub prime markets (Smith, 2008). Nonetheless, HSBC reported that its profits fell by 28 per cent in the first six months of 2008, as it recorded over US $10 billion of impairments on US mortgages and a further US $3.9 billion of write-downs on credit crunch related securities within its trading operations. HBOS, the UK bank most exposed to the crunch, saw profits fall by more than two thirds over the same period, and loan write offs and trading debt write downs amounted to £2.4 billion. Commenting on stock market reaction to the collapse of Lehman Brothers, Simon Pilkington, a bank analyst at Cazenove, warned that the forced sale of assets by the liquidator of Lehman would drive write-offs by other banks: We expect additional valuation write-downs from all the UK banks and particularly Barclays, Royal Bank of Scotland and HBOS. The size of write-downs is unknown at this stage. We are particularly cautious on HBOS, given its exposures and funding structures (Lindsay, 2008). Very soon after this comment, and following further falls in its share price, HBOS agreed to a £12 billion take-over by Lloyds TSB, a deal that had to be renegotiated in early October 2008 as market prices continued to fall. In UK, such falls subsequently also triggered the nationalisation of the Royal Bank of Scotland and the launching of a £37 billion governmental rescue package for UK’s biggest banks – which followed on from a $700 billion bail-out plan in the US, notable not just for its sheer scale but the battle engaged by the US President and Treasury Secretary to secure the approval of Congress. An additional development in response to the accounting impact of the credit crunch has been a series of class action law suits in the USA against institutions involved in trading, issuing and underwriting CDOs. Cases have already been filed against Citigroup and Merrill Lynch arguing that investors were inadequately informed about their exposure to risks in these markets, and a number of local councils in Australia were threatening to sue a subsidiary of Lehman Brothers over the sale of CDOs (McDermid, 2007), but the bank’s demise has made such an action close to worthless. Rating agencies have also come under fire from both politicians and investors for their role in generating supposedly inaccurate risk classifications for such securities (Graybow, 2008). Additionally, by late 2007 the Securities and Exchange Commission in the USA were Crunch time for bank audits? 117 MAJ 24,2 conducting more than twenty investigations into the CDO market, including one into the arrangements banks entered into with hedge funds that may have been designed to hide or delay mark-to-market losses (The Economist, 2007). Further SEC investigations have also been initiated in 2008, including one into the Swiss bank UBS, to assess whether they misled investors by reporting inflated values for mortgage-backed securities held as assets, despite knowing that those valuations had eroded (Reuters, 2008). Downloaded by JOHANNES KEPLER UNIVERSITAET LINZ At 04:23 06 April 2017 (PT) 118 2.2 Auditors and the credit crunch A key problem for auditors is the verification of the valuation of illiquid assets, bearing in mind the consequential impact that such valuations can have on the reported profits (or losses) of major banking institutions. The auditor’s role is to attest that the published financial statements give a “true and fair” view of the reporting entity’s financial position and performance but in volatile markets, significant adjustments to opinions on valuation may be required within a very short time frame, and for companies highly exposed to collateralised debt markets, valuing these elements of their balance sheets is not straightforward. When preparers and auditors have access to liquid markets that serve as a reference point for a valuation, reaching agreement on security values may be relatively simple, but when market liquidity dissolves, problems begin to surface. As credit markets have seized up, it has become very hard to obtain genuine “trading prices” and alternative methods of reaching a valuation have been adopted. Many of the mortgage linked securities on the books of the largest banks are valued at quasi market prices, which are based not upon the price of the security itself, but an extrapolated value taken from associated derivatives’ indices such as ABX, even though these indices are open to criticism because they are relatively new and also highly volatile (Hughes and Tett, 2008). As a result, according to Tony Clifford, Head of Financial Services Audit at Ernst Young in London: [. . .] there is a real debate as to whether we (auditors) should calibrate credit prices from credit indices if there are no market prices. Some of these indices are very thinly traded and can be manipulated and they are only one indicator among many (Hughes, 2008a). In semi-liquid markets, another possibility is for auditors to use so-called “distress” prices, or the prices realised in a fire sale as the reference point, but the definition is open to interpretation. The IASB’s Expert Panel has recently recommended a narrow definition in order to avoid a problem reported privately by auditors – that clients have attempted to widen the definition in order to record higher prices than the last traded fire-sale price (Hughes, 2008b). In the absence of even quasi market prices, so-called level three assets and liabilities are valued using mark-to-model, in which mathematical models based upon a set of assumptions about future events predict forecast cash flows as a basis for security valuation. The resulting values may, however, be highly sensitive to changes in the underlying assumptions. A report in the Financial Times indicates that recent calculations by the Bank of England, for example, show that if tiny changes are made to the type of model typically used by banks to value mortgage-linked debt, the implied price of supposedly “safe” assets can suddenly change by as much as 35 per cent (Tett and Davies, 2007). The use of model-based valuations also raises two other potential problems for auditors. The first is the need to audit the internal controls used by the client in Downloaded by JOHANNES KEPLER UNIVERSITAET LINZ At 04:23 06 April 2017 (PT) arriving at its model based valuations. The second relates to the expertise of the audit team, with the PCAOB Chairman, Mark Olsen, expressing concern that auditors “may not have the extensive training in valuation techniques necessary to verify companies made the right choices” (Johnson, 2007). Under such circumstances, the audit partner needs to not only recognise the need to use experts, but also decide on how to make use of their inputs in the audit. Validation of the price estimates prepared internally requires both understanding and verification of the assumptions which underpin the company’s internal valuation models, as well as an audit of the internal controls over the valuation process itself. A number of valuation disputes have been reported in the media, illustrating the difficulties surrounding audit judgements and the potential for disagreements with auditees. The case of Bradford and Bingley’s write-down of its synthetic CDOs in closing its accounts for 2007 is one such example. The auditors, KPMG, found itself in “tough talks” (Smith, 2008) with management over the valuation of these financial instruments – the critical nature of which was reinforced by subsequent events which saw the “nationalisation” of the mortgage arm of Bradford and Bingley[4] in September 2008. Another example where auditors challenged the approach to accounting for assets within financial institutions is in relation to the valuations of certain assets held by two hedge funds managed by failed investment bank, Bear Stearns. Writing in The Business Week, Goldstein and Henry (2007), on the basis of access to confidential financial statements for two of Bear Stearns’ hedge funds, revealed that Deloitte & Touche, the funds’ auditor, warned that the majority of the funds’ net assets had been estimated by its own managers “in the absence of readily ascertainable market values”. According to Goldstein and Henry (2007): Deloitte went on to caution: “These values may differ from the values that would have been used had a ready market for these investments existed, and the differences could be material”. In the case of the High Grade, 70 per cent of its net assets, or $616 million, were being valued in such a manner, up from 25 per cent in 2004. For the Enhanced fund, 63 per cent of net assets, or $589 million, were “fair valued”. Investors appear, however, to have been unable to make use of the warning, because Bear Stearns reportedly did not release the 2006 audited financials until mid-May 2007, only two weeks before the firm suspended redemptions in the Enhanced Fund with Goldstein and Henry reporting that many investors claim that they never received the particular financial statements. Subsequently, in April 2008, the liquidators of the two hedge funds filed a lawsuit against both the company and its auditors Deloitte Touche, seeking to recover over $1 billion in losses. The suit is said to accuse Bear Stearns, the managers of the hedge fund, and Deloitte, of not living up to assurances that the funds were relatively safe and conservative investment vehicles (Chasan, 2008). Looking at internal control issues rather than valuation problems, in its 2007 audit report for AIG, the world’s largest insurer, PwC noted “a material weakness in internal control over financial reporting related to the AIGFP super senior credit default swap portfolio valuation process and oversight thereof” (AIG, 2007, p. 129). The auditor’s comments impacted on the market, with AIG’s share price falling 11.7 per cent in one day as analysts began to question the company’s level of exposure to the US housing market (Betts and Hughes, 2008). In mid-September 2008, following substantial write-downs of its credit default holdings, AIG granted an $85 billion dollar loan by the US Federal Reserve in order to prevent its disorderly failure and further crises in the financial markets. KPMG Crunch time for bank audits? 119 MAJ 24,2 Downloaded by JOHANNES KEPLER UNIVERSITAET LINZ At 04:23 06 April 2017 (PT) 120 generated similar waves in the stock market early in 2008 when it reported a material weakness “in the valuation processes for asset backed securities positions in the collateralized debt obligations trading business” of Credit Suisse (2007, p. 284). A problem had been identified in the course of valuing assets in preparation for a $2 billion bond issue by the bank. The series of pricing errors found by KPMG resulted in the suspension of a number of traders and the global head of Credit Suisse’s CDO operations (Hughes and Davies, 2008). As a result, Credit Suisse reduced the value of a portion of its mortgage backed securities by a total of US $2.85 billion. One interesting aspect of the Credit Suisse problem is that the full details of the nature of the control weakness were not published in the bank’s annual report, but only reported in an SEC filing. The audit comment in the annual report merely stated that there was a material weakness, but did not detail its nature. Not all of the media coverage of auditors in the credit crunch has been positive for the profession, however, as evidenced by the US government’s report on the role of KPMG as the auditor of the now bankrupt sub-prime lender New Century Financial Corporation. The Justice Department’s Report concluded that KPMG had contributed to certain “accounting and financial reporting deficiencies by enabling them to persist and, in some instances, precipitating the Company’s departures from applicable accounting standards” (US Bankruptcy Court, 2008, p. 2). More muted criticism of auditors emerged from UK’s Treasury Committee report into the failure of Northern Rock. Whilst not suggesting that the auditors PwC had acted improperly, the committee nonetheless criticised what it regarded as a backward looking approach to audit in recommending that: [. . .] the accounting bodies consider what further assurance auditors should give to shareholders in respect of the risk management processes of a company, particularly where a company is regarded as an outlier. The committee also expressed concern “that there appears to be a particular conflict of interest between the statutory role of the auditor, and the other work it may undertake for a financial institution” (Treasury Committee, 2007, Summary & Conclusions, para. 59). Most recently, at the 7 October 2008 hearing of the US Congressional Committee on Oversight and Government Reform focused on the causes and effects of the AIG bailout, Lynn Turner, former chief accountant of the Securities and Exchange Commission, expressed concern that PwC had failed to catch and report the errors that had led to a 2005 restatement of AIG earnings (correcting for a $3.9 billion overstatement for the accounting periods 2000-2004 inclusive). While concluding that PwC had appropriately challenged management and highlighted (subsequent) shortcomings, Turner did wonder if the auditors have “been consistently behind the curve in surfacing problems. I believe the board would have enhanced shareholder confidence by bringing in a ‘fresh set of eyes’ and a new independent auditors” (http://oversight.house.gov/documents/20081007101007.pdf, p. 9). The examples outlined above suggest that the credit crunch is providing significant challenges for auditors, particularly in the area of valuation of illiquid financial instruments – but that the market is also sensitive to the work being undertaken by auditors and their comments on valuation processes, whether through the standard audit reporting channels or other, more informal, filtering mechanisms. The scale of the challenges is also reflected in the nature of the professional response beyond the level of the individual audit firm and the next section of the paper reviews the formal guidance and recommendations that have been issued since 2007 on auditing in financial services. Downloaded by JOHANNES KEPLER UNIVERSITAET LINZ At 04:23 06 April 2017 (PT) 3. The response of the audit profession and the regulators In June 2007, shortly before the credit bubble burst in the USA, Mark Olsen, at the PCAOB, expressed a view that the expanding use of fair value accounting could “put reliable auditing of financial reporting at risk” (Johnson, 2007). His view mirrored concerns expressed earlier the same month by the Chief Economist at the SEC. The International Auditing and Assurance Standards Board’s (IAASB, 2007) consultation paper on its proposed strategy for 2009-2011 acknowledged an increasing demand for implementation guidance on fair value accounting from a number of constituencies, including regulators, and the paper raised the possibility that the IAASB might develop guidance for auditors on the audit of complex valuation models. Subsequent developments in the financial markets, and particularly a growing lack of market liquidity, resulted in the Financial Stability Forum (FSF) reporting that it would “welcome the adoption of common guidelines for valuation, particularly for complex illiquid products” as a way of helping to restore confidence in valuations of credit instruments and in assessments of counterparty creditworthiness (BIS, 2007)[5]. The following month, the US based Center for Audit Quality published three short papers addressing key accounting issues arising from the illiquid market conditions, viewed from the perspective of existing US Generally Accepted Accounting Principles (GAAP). The papers were, respectively, titled: “Measurements of fair value in illiquid (or less liquid) markets”, “Consolidation of commercial paper conduits” and “Accounting for underwriting and loan commitments” (Center for Audit Quality, 2007a,b,c). Concurrently, the large international accounting firms, in the name of the Global Public Policy Committee (GPPC, 2007) were drafting a paper summarising the requirements, under existing International Financial Reporting Standard (IFRS), in respect of the valuation and disclosure requirements for financial instruments, which was duly published in December 2007[6]. The paper emphasised that it was only seeking to clarify the existing international accounting rules, without explicitly providing guidance on their implementation. In the words of a PwC partner Pauline Wallace, “We don’t see ourselves as the right people to provide guidance, but we can provide the context, that’s our role” (Accountancy Age, 2007). The GPPC sent copies of its paper to a range of regulatory bodies including the International Accounting Standards Board, the Accounting Task Force of the Basel Committee on Banking Supervision, the FSF and the International Organisation of Securities Commissions (IOSCO). In UK it was also reported that the large accounting firms had met with officials from the Financial Services Authority in December 2007, to seek regulatory support for the GPPC line on valuation (Accountancy Age, 2007). Just prior to the publication of the GPPC paper, the PCAOB (2007) published a staff audit practice alert covering the audit of fair value under US GAAP. It sought to “remind auditors of their responsibilities for auditing fair value measurements of financial instruments and when using the work of specialists under the existing standards of the PCAOB” (PCAOB, 2007, p. 1). In so doing, the alert described, but did not interpret or establish US GAAP and drew particular attention to Statement of Financial Accounting Standard (SFAS) No. 157, Fair Value Measurements. Financial Accounting Standards Board (FASB) (2006) which became effective for financial statements issued for fiscal years beginning after 15 November 2007[7]. In addition, it referenced extant auditing standards in detailing some considerations for the auditor Crunch time for bank audits? 121 MAJ 24,2 Downloaded by JOHANNES KEPLER UNIVERSITAET LINZ At 04:23 06 April 2017 (PT) 122 in determining whether a specialist is needed and noting that the auditor should evaluate assumptions used in fair value measurements developed by a company’s specialist in accordance with the PCAOB standard on auditing fair value measurements. The paper also highlighted the auditor’s responsibility to evaluate the appropriateness of using the specialist’s work for the purpose of financial statements prepared in conformity with GAAP. Before the year was over, the IAASB confirmed its willingness to look at the audit problems associated with complex financial instruments by establishing a Task Force to consider how best to approach the development of possible further fair value auditing guidance (IFAC, 2007). The remit of the Task Force was to begin consultations with relevant parties on aspects of the audit of fair value measurements, and to make recommendations to the IAASB for matters that require priority attention. In UK, the Audit Practices Board issued a bulletin at the start of 2008 (Audit Practices Board, 2008) which provided guidance on audit issues that extended beyond valuation problems. The bulletin discussed audit risk assessment, the possibility of limited access to credit markets leading to going concern issues relating to the audit client, and the audit of directors’ comments upon the risks and uncertainties facing an entity as a result of the credit crunch. The intention of the bulletin was to provide an indicator of good practice rather than prescriptive guidance, but it also served to highlight the range of audit issues arising out of the credit crunch. At an international level, guidance on the audit of accounting estimates, including fair values, and the related disclosures – International Standard on Auditing (ISA) 540 – was initially published as an exposure draft in 2004 but in response to comments a revised “close off” version was drafted in 2006. Some expression of concern over this version of the standard led to the IAASB agreeing at its meeting in September 2007, to develop draft Terms of Reference for a task force on fair value audit guidance. There were subsequent further revisions to ISA 540 in accordance with the clarity drafting conventions agreed by the IAASB, and a further revised version was approved by the IAASB in December 2007 and issued in February 2008 (IAASB, 2008a,b). The standard adopts a risk based approach to the audit of accounting estimates, including fair values and the related disclosures, and although it only becomes effective for audits of financial periods commencing on or after 15 December 2009, the board hopes that it will be applied earlier. ISA 540 also includes requirements and guidance on misstatements of individual accounting estimates and indicators of possible management bias. Representatives from the major audit firms were invited to give a presentation to the February 2008 meeting of the European Group of Auditors’ Oversight Bodies (EGAOB). The presentations, on the impact of the sub-prime market crisis on audit methodology and practice (EGAOB, 2008) indicated that audit firms had been able to react quickly to the liquidity crisis of August 2007, and that there were no major differences in audit practice between the US and the EU because of the use of a global methodology based on ISAs. However, it was stressed that the problem of bankruptcy and going concern issues were real, meaning that auditors’ judgment would be important. Being either over- or under-cautious were both said to be potentially damaging for investors. The same month an open meeting was organised by the IAASB to gather information from a broad range of individuals familiar with the area of fair value on issues such as the type of guidance that might be needed for the auditing profession, how such guidance might be used, and the fair value topics that Downloaded by JOHANNES KEPLER UNIVERSITAET LINZ At 04:23 06 April 2017 (PT) warranted priority attention (IFAC, 2008a,b). The meeting concluded that there was no clear consensus on whether there was a distinct need for additional audit guidance at the time, and views were also mixed on whether it is appropriate for a standards setter to develop implementation guidance, in light of the aim to develop principles-based standards. Nevertheless, a further call for additional guidance was issued in April 2008 in a report to G7 Ministers and governors of the central banks from FSF (2008). The report recommended that the IAASB should “enhance the guidance for audits of valuations of complex or illiquid financial products and related disclosures” (FSF, 2008, p. 33). The report also emphasised the role played by the audit function in maintaining market confidence and suggested that the six largest audit firms should: [. . .] share with the IAASB the audit approaches that they have brought to bear in addressing the auditing and financial reporting issues resulting from the current market conditions and which could be used for enhancing auditing guidance. The IAASB, national audit standard setters and relevant regulators could benefit from these approaches and recommendations (FSF, 2008, p. 34). The FSF report also suggested that the IASB could create an expert advisory panel, on which auditors should be represented, and this panel was subsequently formed in June 2008. The call for guidance issued by the FSF was echoed, in June 2008, by the Basel Committee in its paper on the lessons learned from stressed markets about fair value measurement (BIS, 2008). The committee noted that: [. . .] auditors have a critical role to play in improving consistency in the application of fair value accounting standards. Papers published during the market turmoil by the Center for Audit Quality and Global Public Policy Committee were welcome and useful in this regard. Nevertheless, greater clarity in how auditors interpret and how banks apply standards will help to improve consistency across banks (BIS, 2008, p. 12). The committee also pledged to “work with accounting and auditing standard setters and auditors to promote standards and practices that enhance the reliability, verifiability and transparency of fair value estimates” (BIS, 2008, p. 13). Further pressure on accounting regulators came in July 2008 from the Committee of European Banking Supervisors (CEBS) in their statement that: [. . .] accounting standard setters should consider the need for further guidance on measuring fair values when there is little market activity in the instruments concerned (or other instruments relevant to pricing) (CEBS, 2008). More specifically, in relation to audit, the committee suggested that “auditing standard setters should pursue their efforts to enhance the guidance for the audit of fair value estimates” (CEBS, 2008, p. 2). CEBS also noted that they would be closely following the progress of the standard setters in addressing the relevant issues, and liaising closely with the Committee of European Securities Regulators (CESR) in such monitoring. Contemporaneous with the CEBS publication was a consultation paper published by CESR (2008). This paper addressed the issue of measurement and related disclosures of financial instruments in illiquid markets. Comments posted to date on the CESR web site suggest that there is very little support from any of UK professional bodies (ICAEW, ACCA or CIMA) or the big audit firms for the issuance of application Crunch time for bank audits? 123 MAJ 24,2 Downloaded by JOHANNES KEPLER UNIVERSITAET LINZ At 04:23 06 April 2017 (PT) 124 guidance on fair value accounting from a body such as CESR. Responses such as that from KPMG state that whilst the CESR’s ideas contribute to the broad debate, they strongly believe that the CESR should not provide its own guidance but instead provide input to the IASB’s expert advisory panel. The comments indicate that the profession seeks to support and pursue the search for international consistency in the approach to fair value measurements, disclosures and their audit via the IASB rather than through either banking or securities’ regulators. The IASB expert advisory panel’s draft report was published in mid-September 2008 and, in common with other regulatory publications issued during the credit crunch, the panel document specifically states that it “does not establish new requirements for entities applying International Financial Reporting Standards (IFRSs) or any other Generally Accepted Accounting Principles (GAAP)” (IASB, 2008b, p. 1). The view presented is one in which the existing international accounting standards on accounting for financial instruments (IAS 39) and the accompanying disclosures (IFRS 7) provide a principles based background open to interpretation by practitioners – a stance reflecting the IASBs avowed support for a “principles-based” approach to standard setting. Interestingly, and in some contrast to the FSF report that initiated the creation of the panel, the report contains minimal reference to the role of audit. Instead, the emphasis is on the underlying accounting standards, which are subject to interpretation via the implementation and audit processes. The panel’s report does, however, emphasise the need for detailed disclosures in relation to fair value, whilst re-iterating that those disclosures reflect management’s judgement of what is important to “help users of financial statements understand the techniques used and the judgements made in measuring fair value” (IASB, 2008b, p. 20). The role of auditors, however, came back into focus at the meeting of the Independent Forum of Independent Audit Regulators in Cape Town at the end of September 2008. Issues considered at the meeting included the adequacy of audit evidence to support fair values and going concern assessments and the reliance placed by auditors on specialists (Sukhraj, 2008). IFIAR, chaired by Paul Boyle, the chief executive of UK’s Financial Reporting Council, also met with delegations led by the CEOs of BDO, Deloitte Touche Tohmatsu and KPMG to consider global quality monitoring arrangements – IFIAR’s previous meeting (in Oslo, April 2008) had held similar discussions with delegations from Grant Thornton, PwC and Ernst & Young[8]. At the end of September a joint FASB and SEC press release (SEC, 2008) recognised a need for immediate additional guidance. The FASB committed to publish, following a one week comment period, additional interpretative guidance on fair value measurement under US GAAP and these were duly issued on 10 October (FASB, 2008). Demands for more guidance, however, have been tempered by a desire to retain a principles-based approach to audit. Other events at the beginning of October 2008 (and the final ones addressed in this section of the paper in what has been a fascinatingly busy time for regulatory action) do reflect ongoing professional efforts in this regard, whilst simultaneously facilitating the sharing of practitioner experience. For example, the IAASB’s (2008b) staff audit practice alert entitled “The challenges in auditing fair value accounting estimates in the current market environment” draws attention to the ISAs that are particularly relevant in the audit of fair value accounting estimates in times of market uncertainty. These encompass those dealing with understanding the entity and its environment and assessing the risks of material Downloaded by JOHANNES KEPLER UNIVERSITAET LINZ At 04:23 06 April 2017 (PT) misstatement, responding to assessed risks, using the work of an expert, obtaining management representations, and communicating with those charged with governance. Again, the alert was very careful to note that it did not amend or override the ISAs that are currently effective. The IAASB did declare a willingness on the part of the task force and staff to consider the need for additional information or guidance concerning auditing fair value although it was suggested that any such work would probably involve coordination with others, including IFAC member bodies, firms, regulators, audit oversight bodies and national auditing standard setters. The support for international co-operation is also highlighted in the symposium on the audit of financial institutions organised by the Forum of Firms and held on 9th October. According to David Maxwell, chair of the Forum of Firms (IFAC, 2008b), the Forum of Firms is an association of networks of international accounting firms that perform transnational audits, and the symposium was “designed to disseminate good practice in an area of critical importance in today’s environment and to support the Forum’s members in providing the highest quality audit services to their clients and the public”. The symposium was reported as having been attended by over sixty partners from twenty one international networks of accounting firms, where they shared their experiences, industry insights and current practices for audits of financial institutions. The symposium concluded with a discussion of specific auditing responses appropriate in audits of financial statements of financial institutions, which were stated as including the importance of strong risk management and transparent disclosure for restoring market confidence as well as heightened sensitivity to going concern issues (IFAC, 2008b). 4. Discussion and conclusion The current credit crunch is one that is increasingly witnessing the drawing of parallels or comparisons with past financial crises, most notably whether it is on a scale that may ultimately match that of the 1929 Wall Street Crash. It was a consideration of such prior crises that initially stimulated our interest in the area of bank auditing. Put simply, we were intrigued as to why the recent banking collapses and the massive downgrading of bank share prices had not generated the frequently asked, high profile question from the media as to “where were the auditors?” We were intrigued as to whether, beneath the banner headlines, there was a different story to be told and whether the current financial crisis was potentially reflective of a different attitude to the external audit function (and the respective responsibilities of corporate management). We also considered it important to reflect on the developmental implications for auditing of whatever position it was currently found to be occupying. The relative lack of media discussion of the role of audit in the credit crunch may be seen by some as an evident success story. People not asking “where were the auditors” must mean that the profession has managed the credit crisis well to date and responded effectively to societal expectations. A more sceptical interpretation might claim that the profession has simply been trying to keep its head down, emphasising the responsibilities of others, pushing management to tighten their disclosure policies, and drawing clear dividing lines between the responsibilities of international accounting and auditing standard setting bodies and the interests of the profession. A third perspective could suggest that the external audit has lost social significance or that the lack of debate implies that questions are storing up for the profession, a number of which might not be easily answered. Crunch time for bank audits? 125 MAJ 24,2 Downloaded by JOHANNES KEPLER UNIVERSITAET LINZ At 04:23 06 April 2017 (PT) 126 Analysis of the headline media coverage of the credit crunch is suggestive of various explanations for the apparent lack of attention to the bank audit function. In some cases, events triggering corporate collapses have been portrayed as mid-year trading events and, implicitly, presumed not to have any connections with previously reported, and audited, financial data. Accordingly, if trading positions had got out of control since the publication of the last year’s accounts, this was not an audit problem. There are also indications that the post-Enron, Sarbanes-Oxley arena is such that stakeholders are now expecting more of management and not seeking to use auditors as scapegoats for management failings. If corporate lending had become excessively risky and speculative, this was a consequence of poor management strategy and direction. If executive remuneration and incentive structures had been wrongly aligned, or if rogue traders had been allowed to run amok within a bank, this was a management control error not an audit failing. If disclosures and explanatory notes detailing asset valuations and risk exposures were overly complex or subjective this was primarily a consequence of inadequate reporting standards and procedures or market movements post the audit opinion. It is also possible, however – and especially on the basis of the activity reported in this paper – to argue that the audit profession has been very active in this crisis. The market has responded to signals contained in annual audit reports, reports to regulators and expressions of concern emanating from auditor-auditee discussions over valuation issues and the underlying strength of banking business. Institutionally, there have also been a series of public interventions by the auditing profession. National and international auditing standard setters have issued practice recommendations and revised standards. The big audit firms collectively have published documents reminding auditors of key issues to consider when conducting audits of financial institutions in troubled times. Presentations have been made to, and dialogue pursued, with key regulatory and public oversight bodies. The profession has been spreading a message that it has a role to play. Indeed, when the FSF issues a report on the current financial crisis and makes explicit reference to the need for standard setters to draw on the expertise and collective audit methodological experiences of the global audit firms and the importance of audit in maintaining market confidence, it does become more difficult to claim that this is a crisis that has by-passed auditing. That said, the frequency with which fair value is represented as an accounting, rather than also an auditing, issue does lend additional support to this latter view. Taken collectively, opposing interpretations of the role of audit in the credit crunch reflect that the situation is a more complex one than first impressions would suggest but one that is also demanding of serious attention. Indeed, our experiences of studying auditing and the responses of the auditing profession in the context of the current financial crisis point to a number of matters that go to the heart of the contemporary audit function. In closing, we therefore wish to represent these as both questions of audit practice and the institutional, standard setting and regulatory, framework within which auditing is practised. Critical commentaries on the auditing profession (Sikka, 2008a,b) have emphasised the mismatch between the scale of fees earned by auditors and the speed at which some banks have collapsed after the issuance of an unqualified audit report[9]. Such pieces regard the problems with auditing as being an institutionalised consequence of a commercially-driven audit industry and place faith in structural reform, including the establishment of alternative assurance providers, such as a nationalised audit body, Downloaded by JOHANNES KEPLER UNIVERSITAET LINZ At 04:23 06 April 2017 (PT) to conduct external (bank) audits. The auditing profession has withstood similar challenges in the past and one can readily find in the auditing literature analyses of how the profession has survived relatively comfortably over many decades with an auditing expectations gap – lobbying to maintain the status quo and even using the gap to nurture an aspirational image of the profession positively seeking to meet “new” expectations (for more discussion, Humphrey, 1997; Fogarty et al., 1991). The current situation is certainly witnessing a good deal of “behind the scenes” activity on the part of the profession and, as we have seen, a host of public statements and practice guidance. However, the reality of the current crisis is that the audit issues run much deeper than the standard environment associated with notions of an expectations gap. Nor, arguably, is their resolution just requiring the establishment of a body of alternative audit providers. External auditors, especially in the banking sector, nowadays appear to inhabit a world of few absolutes and few positions of comfort. From the perspective of the accounts being audited, there is growing talk of the downward spiralling consequences of fair value accounting, with downgrades in asset values putting even more pressure on banks as markets react negatively and capital adequacy positions deteriorate further. Audit firms have potentially significant institutional factors limiting what they can say and do in such circumstances. Can they insist on the application of mark-to-market valuations when it is being argued that the market is no longer acting rationally, nor processing information sophisticatedly? Do they have the technical expertise to challenge management valuation models? Do they have the economic incentives to disturb the fair value regime give that some accounting firms are now amongst the biggest promoters of the IFRSs? There is also the risk that undermining current accounting standards not only undermines the strength of the current standard setting regime but also the value placed in audit. The discomfort faced by auditors is evident in some of the public statements by leading representative of the profession and its biggest firms. There have been appeals to the fact that contemporary practice is only reflecting business and economic realities and not creating it. In short, if market values are volatile, then accounting valuations will reflect that. Such statements go against large parts of the accounting research literature which has consistently demonstrated that accounting has both constitutive and reflective powers – that it creates a reality as well as merely reflecting it (Hopwood, 1987). In instances where assets are being marked to model, fair value accounting is very much creating a reality. It is a value (an approximate market value) that did not exist until the accounting regulation allowed/required it. The above demands to mark to market under fair value accounting regimes, coupled with the sheer volatility of stock markets and the complexity of financial instruments and debt securitisation, all suggest that external auditors are operating in increasingly risky and pressurised circumstances. There are evident questions to ask as to the processes by which auditors rely on valuation and risk estimation models operated by their banking clients, the degree of reliance that they place on the work of independent valuers and experts and the considerations that declining market prices generate in terms of both going concern issues and post balance sheet events. How durable are audit opinions and how easy is it to defend the issuance of a clean audit opinion on a bank that subsequently collapses in the face of deteriorating market conditions? Regulatory documents have been issued reminding companies of the need for prompt disclosure of price sensitive information, and the desirability of informing Crunch time for bank audits? 127 MAJ 24,2 Downloaded by JOHANNES KEPLER UNIVERSITAET LINZ At 04:23 06 April 2017 (PT) 128 investors about special purpose vehicles, but when markets are shifting rapidly in the middle of the external audit cycle, maintaining up to date information remains problematic. As Samuel de Piazza, Chief Executive of PwC commented, “Now that the markets are moving rapidly, the trading in the securities is thin and the collateral . . . is fragile, that makes for a tough audit,” (Guerrara and Hughes, 2008). Tough audits mean that auditors also need to be aware of the possibility of a management “threat” which might jeopardise their independence and objectivity. Although De Piazza went on to suggest that auditors were equipped to deal with such problems, he did not elaborate on the detail of how this would be achieved. The circumstances of financial crisis can also serve to heighten expectations of auditors – not least because when things are increasingly uncomfortable, people look to rely most on “comfort providers”. The danger in such contexts is that the profession’s traditional lines of defence run the risk of emphasising the irrelevance of audit. In a situation where everyone is concerned with declining stock market prices, the disintegration of asset and equity values and revelations of the toxic nature of debt, how effective is it for auditors to respond that the fair values in the bank’s balance sheet are true and fair but cannot be taken as reflecting “current” market values? In other words, the auditors confirmed values at the balance sheet date, and so cannot be blamed if they have subsequently changed. Technically true but leaving the profession vulnerable to questions as to the point of paying substantial audit fees for opinions that almost immediately become out-of-date. Raising questions about the quality and sustainability of the external audit function has a sense of irony attached to it given that recent years has seen such professional, regulatory and governmental attention devoted to notions of audit quality including work undertaken by bodies such as IOSCO, the Financial Reporting Council, the Audit Quality Forum, the US Center for Audit Quality, US Treasury Committee, UK’s House of Commons Treasury Committee on Transparency and the US Treasury’s Advisory Committee on the Auditing Profession. There are also some clear signs that the push for quality has been successful – for instance, 78 per cent of respondents to a survey of public company audit committee members by the Center for Audit Quality rating overall audit quality as either “very good” or “excellent”, with 83 per cent indicating that it had improved significantly in recent years (Ernst & Young, 2008). Even so, there are important indications that caution and careful reflection is needed here. The audit profession is certainly keen to emphasise the importance of global adoption of proportionate liability regimes for external auditors and the need to avoid the post-Enron, Arthur Andersen-like disintegration of any large audit firm – with talk of such possibilities in the aftermath of a major bank collapse seemingly becoming more evident (Accountancy Age, 9 October 2008)[10]. In this context, it is worth reflecting on the comments of one of the audit profession’s senior members, Michael Cook (retired Chairman and CEO, Deloitte & Touche), at an IOSCO roundtable event on audit quality: I believe it is irrefutable that audit quality has significantly improved over the past years [. . .] To use a sports analogy, the “defence” part of financial reporting has grown stronger. This part includes all the factors designed to protect the reliability and credibility of financial information, such as internal control, auditing, certification, and whistleblowing. However, the reason our defence is currently very strong, is that we have played nothing but defence for a long time. As a result, I believe the value, relevance, and usefulness of the financial information that we are working so hard to protect is rapidly declining (Audit Committee Chair, IOSCO, 2007, p. 8, emphasis added). Downloaded by JOHANNES KEPLER UNIVERSITAET LINZ At 04:23 06 April 2017 (PT) The beauty of Cook’s analysis is that it points directly to current dilemmas being faced by the auditing profession – that it can respond in one way to regulatory pressure but in the process become vulnerable to other developments. What value is improved auditing quality if the value and significance of audited financial statements is significantly declining? From an auditing perspective, if anything needs to emerge from the current financial crisis, it is the capacity for more in-depth, balanced and mature discussion on the contemporary world of auditing in the financial services sector. A useful way of illustrating the potential for discussion is to consider what was being said ten years ago at a time when the audit liability regime was said to be excessive and encouraging auditors to resolve audit issues orally rather than document them for fear that such documentation could come back to haunt the firm in any subsequent litigation (IFAC, 1998). Nowadays, the criticisms of today’s audit regulatory regimes suggest that contemporary notions of audit quality are rooted in notions of auditability and, as noted earlier, place too much emphasis on documentation procedures and making the audit more of a compliance, check-list completion function (Khalifa et al., 2007). The middle ground, one presumably occupied by carefully considered and documented professional judgement, is one that can only exist these days if it is accompanied by a public oversight regime committed to the promotion of audit quality and transparency – as self-regulation no longer has the requisite levels of trust and credibility. A significant question in all of this, however, is the extent to which such public oversight regimes are generating deep insights into audit processes. Regulatory inspection reports by bodies such as the PCAOB are welcomed by the large audit firms but increasingly challenged in terms of the strength of their judgements on identified audit problems. The percentage of such reports that is kept out of the public domain (audit firm failings will only be revealed publicly by inspectors if they are not rectified within 12 months) makes it difficult to assess the respective validity of competing viewpoints. There is a real associated danger that the whole public oversight regime is making audit firms much less willing to open up their processes and procedures to external, independent, research examination – which sits uneasily with the commitments to public interest and transparency. The lack of visibility attached to the day-to-day dilemmas of audit practice is arguably further reinforced by the desire on the part of international standard setters to be seen to be principles-based and not get bogged down with the nitty-gritty details of practice for fear that this would transfer them into rules-based organisations. The consequence of all of this is that we are left with an audit function of which we know relatively little either in terms of the nature of its practice and its capacity to meet a potentially ever-expanding set of challenges. In a highly politicised environment, it can look naı̈ve to call for more open dialogue but this is what serious commitments to the global public interest and thought leadership should entail. It would be fascinating to see more public debate and engagement on the private discussions and interactions that are currently taking place between, and across, senior representatives from audit firms, professional bodies, regulators and standard setters. It would certainly help to ensure that an important debating arena is not left polarised between those talking up auditing quality without much supporting detail and those who see the audit profession as structurally flawed and failing to meet its requisite responsibilities. As the auditing literature makes very clear, there “is a big set of research possibilities Crunch time for bank audits? 129 MAJ 24,2 Downloaded by JOHANNES KEPLER UNIVERSITAET LINZ At 04:23 06 April 2017 (PT) 130 between determining and advocating an ‘ideal’ or ‘optimal’ auditing system and rejecting the existing system” (Humphrey, 2008, p. 184). For instance, is auditing becoming increasingly more difficult to undertake? Is there a decline in the degrees of professional freedom available to auditors in undertaking their work or are audit firms benefiting from a greater willingness to discuss and share ideas on what comprise the best audit approaches? How well in practice are auditors managing the growing complexity of asset and liability identification and valuation; demands for measurement and recognition of such assets and liabilities; and volatility of “mark-to-market” valuations in periods of market turmoil? What audit problems are presented by the integration of accounting numbers in capital adequacy requirements, debt covenants and remuneration contracts? What do auditors think of the expanding nature of corporate disclosures and the voluminous nature of corporate annual reports? How threatening is the current financial crisis to the long-term sustainability of audit firms and the audit discipline/market more generally[11]? Does external auditing need to expand to become a continuous assessment function or has it already assumed such a status? Is the value placed on external audit by financial analysts, fund managers and other key stakeholders increasing or declining? Is there a growing relative importance being attached to internal audit or to other forms of assurance? Does the focus of external audit assurance statements need to change? Is there any role for external audit in assisting with regulatory initiatives that may seek to bolster the reliability of ratings provided by credit ratings agencies? In what ways are public oversight and principles-based standard setting regimes improving audit quality? What are the educational priorities for external auditors, especially those specialising in the banking and financial services arena? Constructive, challenging and important debating issues are clearly plentiful – but they need addressing – and addressing in a mature and open fashion, that is respectful of, and sensitive to, both practical auditing experience and alternative understandings, constructions and theorisations of practice. If this does not happen, and the financial crisis continues to deepen, one question will come to dominate – namely “where were the auditors” – and who can say whether that will be followed by an even more poignant one for the auditing profession, namely “do you remember something that we used to call external auditing”? As the last couple of papers we looked at before completing this paper asked: “The harder they fall: Will the Big Four survive the credit crunch?”[12] and: So what does the future hold for the auditing profession? Will the “Big 4” survive? Will the function be nationalised? Anthony Hilton, of the London Evening Standard, who has a reputation for thinking outside the box, has even questioned whether audit itself will survive. That’s a difficult one, but it may not be beyond the realms of possibility[13]. Notes 1. A CMO is a special purpose entity which is the legal owner of a pool of mortgages. The entity issues tranches of bonds which are secured against the mortgage pool. Buyers of the bonds include banks, hedge funds and other institutional investors, but the value of the bonds is dependent upon the security provided by the underlying mortgage collateral. If there is uncertainty about the mortgage repayments then the bonds are likely to fall in value very quickly. 2. A CDO, like a CMO is a special purpose entity that issues debt against credit based collateral, but instead of specializing in mortgage debt, CDOs combine various types of debt. A CDO splits the different types of debt into tranches which represent different levels of risk ranging from AAA Downloaded by JOHANNES KEPLER UNIVERSITAET LINZ At 04:23 06 April 2017 (PT) 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. rated through to the lowest grade known as “toxic waste”. The tranches are then used as collateral against a bond issue which pays interest in accordance with the level of collateral risk. Higher grade tranches therefore earn lower returns than the junior lower grade tranches. The Basel II regulatory framework requires that banks hold minimum levels of capital to support their credit risk exposure. The amount of capital to be held is intended to reflect the level of counterparty risk, which is estimated by calculating a net exposure at default. By the creation of special entity vehicles (SEV), banks can transfer credit risk across to the SEV and through securitisation and the issue of collaterized bonds, they can re-configure their institutional exposure to risks from existing counterparties. Similarly, via the purchase of such bonds, the banks can take on a different mix of risk and engage in what is commonly termed structural financial planning. Bradford and Bingley’s assets have been nationalised and its retail deposits sold to Spain’s Banco Santander. The FSF brings together senior representatives of national financial authorities (e.g. central banks, supervisory authorities and treasury departments), international financial institutions, international regulatory and supervisory groupings, committees of central bank experts and the European Central Bank. The GPPC is made up of representatives of the six largest international accounting firms – BDO International, Deloitte, Ernst &Young, Grant Thornton International, KPMG and PwC. SFAS 157 uses a three tier hierarchy to classify the assumptions required to derive a fair value for an asset or liability. It gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. Level three inputs are unobservable inputs for the asset or liability. Unobservable inputs are those that reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. www.frc.org.uk/images/uploaded/documents/Press%20Release%207.pdf See www.guardian.co.uk/commentisfree/2008/mar/14/watchingthedetectives and www. guardian.co.uk/commentisfree/2008/sep/18/marketturmoil.economics for the blogs that succeeded these papers. www.accountancyage.com/accountancyage/news/2227862/analyst-warns-run-audit-firm4270841 For a review of such discussion at the 2008 meeting of the American Accounting Association, www.jamesrpeterson.com/home/2008/08/the-accounting-professors-ask-arethe-audit-firms-sustainable.html www.accountingweb.co.uk/cgi-bin/item.cgi?id ¼ 189048&d ¼ 526&h ¼ 524&f ¼ 525 http://jamesmendelssohn.typepad.com/ References Accountancy Age (2007), “Big ‘Six’ draw up bank audit blueprint”, Accountancy Age, 26 November. 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(2008b), “Watching the detectives-the subprime crisis should teach us to keep a much closer eye on company auditors from now on”, The Guardian, available at: www.guardian. co.uk/commentisfree/2008/mar/14/watchingthedetectives (accessed 2 October). Smith, P. (2008), “Gauging the pressure”, Accountancy Magazine.com, pp. 26-9. Sukhraj, P. (2008), “IFIAR considers audits during credit crunch”, Accountancy Age, 25 September. Tett, G. and Davies, P.J. (2007), “What’s the damage?”, Financial Times, 5 November. Treasury Committee (2007), The Run on the Rock, Fifth Report of Session 2007-08, House of Commons Treasury Committee, London. US Bankruptcy Court (2008), “Final Report of Michael J. Missal Bankruptcy Court Examiner”, Unites States Bankruptcy Court for the District Delaware In re: New Century TRS Holdings Inc., A Delaware Corporation et al., available at: http://graphics8.nytimes.com/ packages/pdf/business/Final_Report_New_Century.pdf (accessed 10 October 2008). Further reading CIMA (2008), “Deloitte & Touche warned of Bear Stearns problems”, Insight, March. Davies, P.J., Hughes, J. and Tett, G. (2007), “So what is it worth? Decomposition is agony in a moribund market?”, Financial Times, 13 September. Lex (2008), “BofA/Merrill Lynch”, Financial Times, Lex Column, 15 September. Power, M. (1996), “Making things auditable”, Accounting, Organizations and Society, Vol. 21 Nos 2/3, pp. 289-315. Woods, M. and Humphrey, C. (2008), “Monitoring of the risk management system and the role of internal and external audit”, in Woods, M., Kajuter, P. and Linsley, P. (Eds), International Risk Management – Systems, Internal Control and Corporate Governance, Elsevier, Oxford, pp. 123-41. 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