MG4A9 a member of Big 4, gave HBOS, British

 

 

 

MG4A9
Summative Essay

 

 

 

 

“KPMG’s
audit of HBOS shows why the public expects much more” (Financial Times,
20/09/2017)

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Course
Code:
MG4A9

Candidate
Number:
81336

Word
Count Part 1:1567

Word
Count Part 2: 489

Seminar
Teacher:
Dr Juan Lopez-Cotarelo

 

 

 

 

 

Part One: Critical
Analysis

 

Introduction

 

In
recent years scandals in the financial sector of partly all industries have
been increasingly affected the economy of virtually all developed countries.
One of the most explicit examples of this is the scandal that occurred in
Britain after one of the well-known consulting firms audited financial reports
of the British bank.

 

At the
end of the February 2008, well-known consulting company KMPG, a member of Big
4, gave HBOS, British investment bank, healthy clean audit opinion after their
inspection. HBOS reported in its annual report for the year ending 31 December
2007 a profit before taxation of £5.5 bn (The Guardian, 19/09/2017). After eight months, the bank collapsed
because of the bad property loan made it unable to receive funding (FT,
01/12/2017). It became the second significant fiasco in the banking history of
Britain (The Guardian, 19/09/2017).

 

After heavy political pressure
from Treasury committee, the UK accounting watchdog, the Financial Reporting
Council finally accepted to open an official investigation to look into whether
auditors committed a serious “misconduct”, or they were “reasonable threated”
(FT, 01/12/2017). At the beginning of December 2017, the FRC closed the
investigation and published its decision about this situation highlighting that
KPMG financial statement “was not unreasonable at the time” and there is no
evidence of misconduct (FT, 30/11/2017).

 

This scandal is a clear
illustration of the principal-agent theory, where the principal and agent come
into confrontation. Thus, this essay will comment on the expectations that were
entrusted to auditors by shareholders, the actions of executives that were involved
in the process, and will give some recommendation to strengthen the auditing
system in order to prevent such severe downfalls.

 

“Principal-Agent”

 

According to “principal-agent”
theory, a principal is an owner of a resource who is usually in a higher
hierarchical position and delegate the guidance of the firm to another person
or a company – agent, who is able to make a decision on behalf. In this case,
it seems that shareholders of HBOS are principals, and agents, in
turn, are executive directors of HBOS who set short-term objectives, make
decisions and coordinate the development and expansion of the bank.

 

To see how the theory work and what is its potential
problem it is necessary to study some details in depth. HBOS was led by James
Crosby from 2001 to 2006 at the time of its aggressive expansion, and after
that, in 2006 it was handed to Andy Hornby, and Lord Dennis Stevenson as a
chairman (FT, 20/09/2017). The expansion into commercial real estate lending of
HBOS consisted of aggressive sales culture and growth trajectory with weak risk
controls that built up over many years (FT, 26/01/2016). According to Paul Moore,
who is the former head of regulatory risk at HBOS between 2002 and 2005, he was
fired by James Crosby following his warning to the Board about HBOS’s risk
sales strategies. After that in 2009 Moore presented this evidence to the UK
House of Commons Treasury Select Committee and, as a result, James Crosby
resigned as Deputy Chairman of the Financial Services Authority (FT,
26/01/2016). Moreover, Peter Cummings, the former head of corporate lending at
HBOS, was also fined and banned for life from working in financial services
(FT, 20/09/2017). Following this, it can clearly be seen that shareholders
(principal) could not have controlled the greedy, risk-taking executives
(agent), who, in terms, had more information and could
manage HBOS to their advantages, reducing the efficiency of the bank, and the
shareholders’ investments, that led to HBOS collapse.

 

It is not the only issue that attracts the attention
of the Financial Conduct Authority. The FCA is also investigating from 2010 a £245m fraud at HBOS’s Reading
branch (FT, 20/09/2017). This scam was organized by Lynden Scourfield, the lead
director of HBOS’s impaired-assets division in Reading, according to presiding
judge (FT, 07/04/2017). The investigation led to the conviction of fraudulent
trading, money laundering and corruption of six people: two former HBOS managers,
including Scourfield and four associates (FT, 07/04/2017; FT, 20/09/2017). In
addition to this, former top executives at HBOS are already under investigation
of the FCA over the lender’s collapse (FT, 07/04/2017). Thus, top-managers of
HBOS were likely be informed about the scam while, according to an internal
Lloyd’s report, several HBOS executives emailed about this issue and did not
want to disclose the fraud to shareholders (FT, 07/04/2017).

 

Furthermore, HBOS top managers
kept the information about the state of affair of the bank not only from their
shareholders, but also from Lloyd’s shareholders in 2009 when they were
encouraged to buy HBOS by the government, relieving it of the burden of
nationalizing HBOS, according to Richard Hill, lawyer (Bloomberg, 18/10/2017). “The
information that would have disclosed that HBOS was a bust bank was
deliberately withheld” (Richard Hill, Bloomberg, 18/10/2017). Lloyd’s lost from
“collapse” of HBOS at 9.3 billion pounds (Bloomberg, 18/10/2017). In the course
of various tricks and information hiding, therefore, the executives managed
HBOS at their advantages, and, besides, sold the bank without any risks and difficulties,
which proves that HBOS self-delusion model of management fail not because of
external market and crisis, but because of failure of bank’s shareholders to
create an appropriate culture and provide the challenge to the executives, who
in terms, abuse their power (FT, 19/09/2017).

 

KPMG audit and FRC investigation

 

Relationships between auditors KPMG and shareholders HBOS also can be seen
as an example of principal-agent theory. The problem in this relationship that
expectations, which was expected from auditors, was not fulfilled that led to more
serious consequences, such as the downfall of the bank and loss of trust from
the society.

 

What did shareholders of HBOS expect from KPMG audit?

 

It is known that the primary auditor’s obligations are to test management
competence, spot worsening credit marketing conditions, check assets on the
balance shit, inspect the accounting record, calculate loan-loss provisions and
other risks, check access to wholesale money markets. Although it seems to be a
clear statement, these expectations could not be fulfilled. It might occur for
several reasons: lack of available data, lack of an appropriate degree of
professional scepticism and disinterest of customers in the opening of problems
(FT, 01/12/2017; FT, 19/09/2017). As shown by this situation, the audit cannot
be considered a reliable method of identification of fraud and/ or
deterioration in the financial condition of a company. Shareholders expected
that audit would provide a certain level of reliability, but in reality, it was
much lower. However, the auditors generally benefit from this discrepancy that
set high fees, which meet the high expectations. In the end, the auditors received
pay for less work, than was announced, because they gave low-quality financial
statement that is neither credible nor objective. In terms of inappropriate
data and information, KPMG analysts has relied on analyst research, that was
“notoriously upbeat”; however, they denied this information, noting that
auditors used a wide range of material, including public domains (FT,
01/12/2017). Thus, it would be right to assume that KPMG either were interested
in such an invalid report, which reveals no doubt that the bank would be able
to exist next year, or abusing their position, the auditors simply did not want
or were not able to prove this information. 

 

However,
there is the Financial Reporting Council, which under the political pressure
started the investigation and were not be able to find somewhat unreasonable in
KPMG’s audit. Although FRC is an independent actor, according to Mr Moore and
Dr Shah, who were members of a group of accounting specialists, Paul George,
the FRC’s executive director for conduct, spent 14 years at KPMG where was a
partner.  Consequently,
the investigation under KPMG’s audit might not be impartial, as it was expected.

 

Recommendations

 

It
would be fair to give some potential suggestions to shareholders to avoid or
predict an abuse of power by executive directors, and, in addition to this,
some possible steps that auditors should take to avoid further growth of gap between what society wants and needs
from audit, and what it provides (FT, 25/09/2017). First of all,
shareholders (principal) might rethink the system of rewards and control of
executives, for example, pay for performance. Secondly, shareholders may be
interested in creating a strategy for the bank with challenging tasks to the
executives that can be shown after a year. Thirdly, a principal might need to
request to legislate more power to an auditor, as well as FRC to prevent future
frauds. Regarding action that auditors should take, they might ensure all
regulatory and market risks are captured, audit teams apply an appropriate
degree of challenge and professional scepticism in the audit of loan loss
provision, rather than confirm management’s view.

 

Conclusion

 

An
analysis of the financial press shows that extreme economic conditions became
the starting point of opening the whole range of HBOS incentive problems.  Fraudulent trading, money laundering and corruption made HBOS unprepared for
market conditions. As a result, the UK government provided £25bn of emergency
funding to Lloyds Banking Group to prevent its collapse (FT, 19/09/2017). In terms of KPMG,
it may be complicated for them to return public trust and refresh some crucial
part of an audit, giving shareholders the information needed. FRC also needs to
be more impartial in their investigations. To conclude, the principal need to
focus its effort on further improvement of legislation in the field of finance,
while there
are many doubts about the existing.

Part Two: Timeline

 

 

Date

Newspaper

Headline

Summary

1

11/02/2009

FT

FSA:
s’ok, KPMG said HBOS was fine

Was
KPMG HBOS’s official auditor?

2

06/12/2015

FT

Review:
“Crash bank wallop” by Paul Moore

Paul
Moore has some evidence about HBOS crisis.

3

14/12/2015

FT

HBOS
review offers the chance to expose the flaws in our accounting system

Examination
of the reason for HBOS’s failure. Is it the inappropriate KMPG’s audit or
defective accounting standards?

4

14/12/2015

FT

Treasury
committee wants KMPG probed over HBOS audits

Investigation
over the audit, conducted by KMPG, is vital to restore public confidence to
the audit process.

5

21/01/2016

FT

KPMG
to face preliminary enquiries into HBOS audit

FRC
started the first stage of a process that can lead to a formal investigation
– asked preliminary enquiries. It took seven years after HBOS’s collapse to
start the case.

6

26/01/2016

FT

An
influential group of Accounting experts seek independent probe into KPMG’s
audit of HBOS

A
group suggest engaging impartial auditors as independent oversees to make inspection
clearer.

7

07/04/2017

FT

UK
watchdog restart probe into HBOS fraud case

Results
of the investigation a £245m fraud at HBOS’s Reading branch.

8

13/04/2017

FT

KPMG
scandal highlights problem of auditing’s resolving door

KPMG
fired six employees because they provide incorrect advanced information. KMPG
need to think carefully about regulatory processes.

9

19/09/2017

The
Guardian

Why
were HBOS auditors cleared? We need a full explanation

FRC
investigation was entirely fair and proper, but explanations are required.

10

19/09/2017

FT

KPMG
cleared over audit of HBOS before collapse

FRC
reported that KMPG could not have predicted the extreme economic situation and
that is why the statement was not unreasonable.

11

19/09/2017

FT

KPMG’s
audit of HBOS shows why the public expects so much more

In
2014 KMPG and other consulting firm identified additional steps that might be
useful to prevent mistakes in an audit of loan risk.

12

20/09/2017

FT

HBOS
blame game fails to find a victim in KPMG

After
closure the KPMG investigation, a parliamentary committee paid attention to
Bank of England and led to 6 convictions. Three former senior managers of
HBOS were under scrutiny.

13

25/09/2017

FT

Strengthen
the auditing process to avoid more scandals

Who
should be held accountable: executives or auditors? The demand for
improvement the process of audit and overcoming the expectation gap.

14

18/10/2017

Bloomberg

Lloyds
“mugged” shareholders into 2009 HBOS deal, lawyer says

The
explanation of unclear Lloyd’s purchase of HBOS.

15

30/11/2017

FT

Watchdog
admits it was slow to investigate HBOS audit

FRC
has registered that the government legislate to give similar power them over
accountants.

16

01/12/2017

FT

KPMG’s
bank audit might as well have been done in the pub

KPMG
audit was based on analyst research, which was notoriously upbeat (HBOS rated
either a “buy” or a “hold”) and that, in turn, was based on auditors’
financial reports. During FRC investigation, this information had not been
confirmed.