Excesses in the Financial System - Essay Example

EC Proposals and the Sta y Audit 0 Introduction Financial crisis has historically been related to excesses in the financial system and the crisis of 2007 to 2009 has been no different. In fact, Taylor (2008, p. 1) indicates that the crisis which started in 2007 was a result of a housing boom which later went bust and led to a turmoil in major countries across the world. The housing boom led to the creation of various derivatives such as credit default swaps (CDS) which attempted to spread the risks of sub-prime lending. The financial crisis crippled the international financial system leading to a major recession which still threatens to be a double dip. Blame was levied at rating agencies, directors of companies in the financial system and their regulatory agencies, as well as accounting and auditing professionals. This led to a number of regulatory responses that were aimed at strengthening controls over the operations of financial institutions and enhancing financial reporting. These responses have not only been limited to governments in the countries affected but to various bodies including standard setters for the accounting and auditing profession. Te European Commission (EC) which gives directives to 27 countries, made two proposals that could result in major changes in the auditing statutory audits and the audit of PIEs. They are aimed at the professionals whose opinion adds credibility to financial statements as well as supervisors of PIEs. Additionally, there was the Basle lll Accord which amended the capital requirements for financial institutions. Since then auditors have been required to provide more comfort to investors by carrying out additional procedures that would enhance financial reporting. Audit committees have also been challenged to provide the necessary support to ensure compliance. This paper provides information on the background to the financial crisis and the audited accounts of financial institutions. It also looks at the background to the EC’s proposals and discusses the reasons behind the EC’s concerns in relation to the statutory audit. A discussion is provided on the proposals made by the EC as well as a critical evaluation of them. The main proposals in relation to audit quality are also explained. 2.0 Background to the financial crisis Several factors worked together to generate the crisis in the financial markets across the world since 2007. Jickling (2010) points out that there were multiple causes to the crisis as reflected in the policy responses taken in the US. One of these was the existing and anticipated credit losses on mortgages in the United States (Ellis 2010). These mortgages were made available to persons who would not have been able to obtain them under normal circumstances. The lowering of standards allowed them to obtain mortgages at relatively low rates so that they could own their own homes. However, one drawback was that the rates were adjustable. Therefore, persons who might have been able to repay in the initial stages soon found out that they could no longer service their mortgages. This coupled with the oversupply of houses on the market resulted in a reduction in their house values and therefore the values of the security for mortgage loans. In some cases the value of the houses was worth less than the loan balance and so homeowners ended up with negative equity. Therefore, there were no tangible benefits to be gained from holding on to properties that were not worth the amounts owed. A large number of homeowners defaulted on their mortgages and so it had a ripple effect which impacted the global financial system. Murphy (2008) referred to this as imprudent mortgage lending which caused a terrible shock to the financial system. Murphy (2008) also indicated that although imprudent lending paid a role, its role was not very significant. Another factor blamed for the crisis was global imbalances. Smaghi (2008) indicates that this is characterised by some countries like China and Germany having large surpluses while some like the US and UK have deficits. Although, conceding that excessive debt and the mispricing of risk was the root cause of the crisis, the buyers and sellers in the market have contributed in some way. Only when this issue of global imbalances has been addressed will there be a resolution of the problem. Acharya and Schnabl (2010) indicate that it was the investment in Asset Backed Commercial Paper (ABCP) denominated in US dollars that triggered the crisis. Large commercial banks in both deficit and surplus countries created ‘risk free assets’ by setting up ABCP conduits. This is a form of securitization where off balance sheet vehicles are used to purchase long-term assets using short term debts. In this case the banks retained the credit risk associated with these assets. Most ABCP were issued in US dollars and sold to money market fund investors. A large proportion of the proceeds were invested in the long-term financial assets in the UK and US which are both deficit countries. The commercial banks that sponsored these transactions were located in both deficit and surplus countries. As information relating to the deterioration in the quality of US subprime assets became news in 2007 all major banks in Europe were affected. In fact, two German banks were the first to require support from government (Acharya and Schnabl 2009). The foundation for this problem was considered to be the housing boom. 3.0 The housing boom Unrealistic expectations about future house prices added a lot of fuel to the housing boom (Case and Shiller 2003). Housing prices rose by approximately 50% in real terms during the period from 1996 to 2006 and fell by 19% in real terms between 2006 and 2009 (Glaeser et al 20110. In fact, up to the last quarter ending December 31, 2011, house prices fell by another 11% in real terms (Glaeser et al 2011). Easy credit was given as an explanation by some writers (Himmelberg et al 2005; Mayer and Sinai 2009; Taylor 2009). Thus Glaeser et al (2011, p. 1) points out that the ease with which credit could be accessed spurned on by low interest rates, high loan to value ratios and ‘permissive mortgage approvals’ is one of the explanation given. Khandani et al (2009) indicates that approval rates and the reduction in the down payment required was a factor which provided yet another explanation. However, Glaeser indicates that no data was found to support that hypothesis. Favilukis et al (2010) suggests that it is a combination of a reduction in the relevant costs associated with the transaction and the relaxing of credit. Taylor (2008) supports this view and points out that monetary policy was too lax during this period and therefore allowances were made in such a way that people who under normal circumstances would not receive a loan for a home based on their income were allowed to do so based on other factors which are normally secondary when assessing eligibility for loans. This resulted from a lowering of standards so that individuals in the low income groups could own their own homes (Ellis 2010). Interest rates were well below the normal levels in various countries but this was more pronounced in the US. The inability to repay mortgage loans because of the loan agreements which allowed for interest rates to be adjusted meant that as interest rates increased mortgagors began to default. Financial institutions were therefore exposed to huge losses on their mortgage loans or various derivatives such as mortgage backed securities (MBS) and collaterised debt obligations (CDO’s) which they owned in conjunction with the spreading of risks by the originators of these mortgage loans. Glaeser et al (2011) points out that the impact of the rate of interest on prices suggests that interest rates only accounted for one-fifth of the increase in house prices during those years. There was also no evidence to substantiate the claim that changes in approval rates or loan to value ratios provide the necessary explanation for much of the increase seen in the price of houses during the period. Ellis (2010) points out that although the boom in the construction generally and in the housing market specifically was a worldwide phenomenon, it was the US market that seemed to have been greatly affected. The problems in the US financial system triggered problems for financial institutions all over the world, especially in Europe due to globalised nature of the financial market. The boom in the housing market was followed by a slump and a credit crunch which affected the global financial system. Labonte (2007) describes it as the housing bubble that burst. Labonte (2007) also indicated that a bubble is hard to identify until it burst. Therefore, it was difficult for the authorities to foresee this crisis. The factors blamed for the crisis may be analysed under the following headings: Predatory lending Attempts to spread the risks associated with sub-prime lending; and Lack of regulatory control over the derivatives aspect of the banking business; 3.1 Predatory lending Predatory lending is the practice of making loans to borrowers whose ability to pay is questionable. According to Gramlich (2000) it involves all or one of the following. i. Making loans that are not affordable based on income but rather on the assets of the borrower; ii. Encouraging borrowers to refinance loans in order to obtain fees as well as high points whenever refinancing takes place; iii. Concealing the true nature of loan obligations from borrowers who are not very sophisticated and do not understand what they are getting into. Predatory lending is described as fraud in some circles since ability to pay is one of the main decision factors when granting loans. In fact, Gramlich (2000) indicate that predatory lending is fraud and involves the abuse of complex mortgage provisions. He added that they are normally desirable and presents advantages to borrowers but only in cases where the borrower understands. Predatory lenders normally see consumers who are desperate and who cannot qualify for traditional bank loans. These people normally have bad credit records. These lenders often encourage borrowers to refinance their loans into longer term loans at higher interest rates and with additional commitment fees when they are unable to pay. Predatory lending also led to foreclosures and a number of borrowers lost their homes when they defaulted on loan repayments. Predatory lenders were also non-depository lenders and so they were not required to report data under the Home Mortgage Disclosure Act (Gramlich 2000). The housing boom in the United States led to a credit crunch as some mortgagees were unable to pay when interest rates changed. The high levels of default led to a credit crunch as the securities were worth less than the mortgage loan. These loans were packaged into various derivatives such as mortgage backed securities in order to spread the risk attached. Some of these derivatives were rated highly by rating agencies such as Standard & Poor’s and Moody’s. Institutions that held mortgage backed securities were not able to recover their full investments as the values on which they were based were falling. In essence most of these securities were bad and so their assets were either non-existent or did not value what their values were deemed to be. Financial institutions were unwilling to lend and banks were failing all over the world as they were all engaged in what appeared to be a booming financial sector. 3.2 Attempts to spread the risk associated with sub-prime lending Sub-prime lending refers to is offering loans at interest rates above the prime rate in order to account for risk and to facilitate borrowers who would not normally be able to receive loans. This was encouraged and led to a boom in the housing market. Predatory lenders use this as a basis to grant loans to borrowers who just did not meet the requirements. Gramlich (2000) indicates that much of this type of lending facilitated the development of the subprime mortgage market. In fact, Gramlich (2000) indicates that the number of subprime equity loans increased from 80,000 in 1993 to 790,000 in 1998 – an 880% increase. This helped them to attain the American dream of owning their own homes. 3.3 Lack of regulatory control over the derivative aspect of the banking business There is a lack of understanding with regards to the derivative aspect of the banking system. A number of innovations occurred with the repeal of the Glass-Steagall Act in the US. This set the stage for several events. The differences between commercial and investment banks were becoming non-existent. Bad loans were packaged into CDO’s in order to minimise their risks. In order to protect the originators of these loans and other securities they were packaged into other securities such as credit default swaps. The market values for most of the derivatives were several times lower than their notional values. Stiglitz (2010) indicates that notional values depend on the value of the underlying assets. The regulatory authorities in the US and the UK as well as other countries failed in carrying out their obligations because they did not have adequate knowledge of the securities market. This lack of knowledge meant that there was little or no regulation. Therefore they were left to carry on their innovative but reckless practices. Most of the transactions were off balance sheet and so they did not show up in the financial statements. Culp and Mackay (1994) indicate that derivatives are no riskier than other financial activities and so any attempt to apply too much regulation would not be useful and would therefore add too much burden. The auditors were missing in action as they were either incompetent or they did not approach their work with objectivity, independence and professional skepticism. Those who invested in securities not only depended on the audit report which provides an opinion on whether the financial statements provide a true and fair view of the operations of the entity at a particular point in time but also credit rating agencies. Credit rating agencies (CRAs) such as Moody’s, Fitch and Standard and Poor’s carry out research on the issuers of bonds and other forms of securities. Based on the information they gather, they make public their views. Analyst, investors and advisers depend on this information for obvious reasons. Triple A (AAA) ratings suggest that the security is of a very high quality. Stakeholders depend on this and so it was devastating for them to realise later that their were conflicts of interest as some of these rating agencies provide services for some of these organisations including public interest entities (PIEs). The collapse of the financial system brought into question the credibility, independence and other professional ethics that auditors ought to display in carrying out their work. With respect to the financial crisis, Lou and Wang (2009) assessed the likelihood of fraudulent financial reporting. They found that fraudulent reporting positively correlated with one or more of the following situations: higher levels of financial pressures of a firm or supervisor of a firm; higher percentages of complex transactions of a firm; more questionable integrity of a firm’s managers; and more deterioration in the relationship between a firm and its auditor. All these were present in some PIEs during the crisis. These factors played a role in allowing the crisis to get out of control. 4.0 The Audited Accounts of Financial Institutions According to the EC (2011a) many banks made huge losses on both on and off balance sheet transactions during the period 2007 to 2009. Therefore, some stakeholders were at pains to determine how the audit reports were not qualified. An audit report gives its users comfort on the correctness of financial statements. However, there are certain items that the auditors cannot possibly verify and therefore depend on representations made by management. This does not mean that off balance sheet transactions should not be verified. In exercise of the code of ethics of the profession all audit firms and auditors should display certain characteristics. They include: independence, objectivity, integrity and professional skepticism. These codes of conduct are common to auditors globally. In terms of the performance of their duties they are expected to have the necessary qualifications and experience based on the nature of the audit. The nature of work done is dependent on the size of the organisation, the nature of its operations and the environment in which it operates. This helps to determine the level of risk involved and the level of audit work that needs to be done in order to arrive at an opinion. Auditors are required to perform risk assessments that will enable them to determine the scope of their work. However, the methodologies used in arriving at an opinion differ among them. Additionally, the materiality levels used to obtain samples for testing are different. The methods applied in valuing securities differ in some respects. In order to ensure the independence and integrity of auditors, the code of ethics emphasizes the importance of the audit fees not being determined by the level of profit or revenue that the company makes but by the amount of work to be done and the level of competence required. Additionally, the fees from one client should not exceed a certain percentage of the total audit fee of the audit firm. As it relates to conflict of interest, auditors should not be allowed to hold investments or office in the entity subject to an audit. According to the EC (2011b) the crisis in the financial sector has shown up the weak areas in statutory audits, especially as it relates to public interest entities. These are entities which the public has high levels of interest in for a number of reasons. These reasons may include but are not limited to their size, the number of employees they have, or their corporate status in relation to the types of stakeholders they have. This has led to a proposal in relation to how the audit of their financial statements should be done. However, some of these changes appear to be nothing new or unheard of in the profession. 5.0 Background to EC Proposals The EC has outlined its proposals in the form of a directive and a regulation. The purpose of the directive is to seek amendments to the directive on statutory audits. The regulation relates only to PIEs and the performance of their statutory audits. If the directive is accepted then it would require changes to the laws of Member States. However, the regulations would apply to all Member States without the need for a change in their laws. These proposals came about as a result of the crisis in the global financial system. This crisis called into question the role of the auditor in the performance of statutory audits especially those in which the public and other stakeholders are interested - PIEs. Financial institutions that were profitable and whose securities were highly rated collapsed and led to billions of taxpayer funds being paid out in bailouts. These bailouts were done in order to prevent a total collapse of the world financial system. 6.0 The EC’s Concern in Relation to the Statutory Audit The turmoil in the global financial system brought into question the role of the auditor and their independence. In order to improve the competitiveness of the audit market it was important to give small and medium sized audit firm a fair chance. This is important as some of the shortcomings observed relates to large entities that were audited by the ‘Big Four’ firms. The competence of auditors were brought into question and in terms of auditors who wanted to perform audits in another Member state (cross-border audits) the proposal requires either the passing of an aptitude test or three years experience working under the appropriate supervision. 7.0 Critical Evaluation of the Proposal A number of changes were proposed in order to reduce the audit expectation gap, strengthen audit independence, objectivity and professional skepticism; enhance integrity and avoid conflict of interest. These it is suggested would improve the quality of the audit. They include: Mandatory rotation of auditors; Mandatory tendering of the audit; Provision of related audit services only; Audit only firms; Ownership of audit firms; Composition of audit committee; An extension of the work to be performed during the performance of a the statutory audit; A special extended version of the audit report for the audit committee; Supervision of the audit sector within guidelines of the European Securities Markets Authority; Single market for statutory audits in the EU that would allow for cross-border audit services; Compliance with International Standards on Auditing (ISA); Nullifying contractual clauses the limit choice of auditor; Transitional agreements; The real issue is how these proposals would enhance independence, objectivity and professional skepticism and therefore audit quality. While some are welcomed improvements in enhancing audit quality there are others that have received the wrath of audit practitioners. The change in the composition of ownership of audit firm will provide additional capital that would help facilitate effective competition in the industry. However, it may not lead to the necessary independence and objectivity required as the owners are not all bound by the need to adopt professional code of ethics but may still exhibit undue influence. Investors in this sector will need a worthwhile return on their investment and some of the other proposals like the audit only firms and near audit services would not allow some of the current auditors to remain in the profession much less those who have not gone through the task of acquiring the necessary qualification. Mandatory rotation of auditors and tendering after a minimum of two years could result in auditors or audit firms not getting the necessary experience that is normally gained with relatively long tenures. It is argued that tenures which are of a short term nature tend to have higher risks for audit failure due to the fact that the new auditor may lack or have insufficient knowledge of the clients business and would therefore be more likely to place reliance on estimates and management representations (PricewaterhouseCoopers 2002; Gul et al 2007). Gul et al (2009) found that shorter tenure has negative implications for both earnings quality and industry expertise. Expertise in audit is normally attained after been engaged on the audit for a relatively long period of time, which in some cases requires more than five years. It can therefore be argued that some firms especially the smaller ones will not be able to gain the expertise required in some industry to become specialists. Therefore, this level playing field which is envisioned may place them at a disadvantage. While, regular tendering and rotation may allow them the opportunity to get a chance to enter a particular industry to gain experience, it may not give them the opportunity to become specialist. Additionally, small and medium-sized audit firms may not have the required staff internationally to satisfy the needs of multinational corporations. In relation to the proposal for the provision of related audit services only, this should help to enhance independence. When an audit firm provides other services such as tax advice and other consultancy services unrelated to the audit, it presents a conflict of interest. This is so because the audit firm becomes dependent on the client firm for not only income from the audit but also supplemental income. This can impact objectivity in carrying out their role as auditors. However, there are measures that can be taken to avoid this and most of the larger audit firms have separated their firms into several practices to avoid this. Deloitte (2012) insists that the non-audit service aspect represents an insignificant proportion of audit firms business. However, this may not be so for small to medium-sized audit firms. The proposal for audit only services further complicates the matter. Deloitte (2012) contends that this would have an adverse effect on audit firms as they would be more dependent on the entities for which they provide audit services. The dependence on one type of fee with no supplemental income especially in slack periods which audit firms are known to have would mean that audit firms may have to consider employing staff on contract. This would have further negative implications on audit quality. 8.0 Proposal in relation to Audit Quality In relation to audit quality, the strengthening of the role of the audit committee is welcomed. The need to provide them with extended reports is long overdue. In fact, Deloitte (2012) points out that the EC proposals in relation to their role and composition will definitely make them more independent, objective and allow for a greater level of professional skepticism in how auditors carry out their work. This would therefore facilitate an improvement in the quality of audits. Additional disclosures in the financial reports are needed as it will provide stakeholders, especially investors with more information on the audit process. This would help to bridge the audit expectation gap by enhancing transparency. According to PricewaterhouseCoopers (2012) mandatory rotation does not enhance audit quality. Auditor or audit firm rotation is nothing new to the profession; neither does it impact objectivity, independence and professional skepticism in any profound way. It was considered in the US but was not adopted (PricewaterhouseCoopers 2012). It would have a negative impact on the quality of the audit rendering financial reports unreliable while increasing cost for the investing public (PricewaterhouseCoopers 2012). In fact, Deloitte (2012) indicates that it would be severely detrimental for financial institutions that have the more challenging audits and therefore require specialists. Deloitte (2012) also points to the problems that this would pose for multinational corporations (MNCs) which would experience difficulties in rotating their external auditors. This concern is based on the need for such entities to select auditors who are capable of putting in place teams in all of their market locations to carry out audits that meets high standards of quality. This concern not only applies to mandatory rotation but also to mandatory tendering. However, EC (2011a) points out that the audit committee would make justified recommendations to shareholders. They would also provide reasons for their recommendation to the competent authorities. It is therefore hoped that they will take some of these points into consideration. The proposal on the mandatory inclusion of at least one person with experience in auditing on the audit committee is therefore a step in the right direction. 9.0 Conclusion and Recommendation Some of the changes proposed have merits and will surely enhance audit quality. The debate on mandatory rotation, mandatory tendering, audit or related services only continues. These proposals would definitely result in hardships for some audit firms. However, splitting their businesses into completely separate practices may be a point for serious consideration if the audit only proposal becomes law. However, care should be taken to ensure that whatever is made law does not negatively impact the competiveness of the audit market. Compliance with ISA’s is important. 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