Audit

• cap that!
• tax clamp down
• shelling out
• banking crisis

cap that!

The Big Four have been disappointed by the UK Office of Fair Trading's rejection of their argument that capping auditors' liabilities is necessary to ensure a competitive and sustainable market for auditing large companies.

Potential liabilities arising from company audits are not a serious barrier to market entry, concluded the OFT. Other factors - reputation, third party perceptions, economies of scale, global networks and regulation - were far more significant in disadvantaging medium sized firms. Moreover, all the Big Four have similar exposure to potential liabilities, so a cap would not affect their relative competitive positions.

Unlimited liability has not so far caused firms to withdraw from the audit market, pointed out the OFT. Audits, and non-audit services sold to audit clients, remain 'valuable businesses that the Big Four firms appear keen to retain,' said the report. Andersen's collapse was brought about by reputational damage, not auditor liability.

Mary Francis, director-general of the Association of British Insurers, had been one of those urging the OFT to reject capping. She argued that capping would assist major firms to use audit as a 'loss leader' for the sale of consultancy services. The ABI claimed that greater competition was needed in the supply of audits, but capping liabilities was not the means to achieve this.

Yet the risks attached to the Big Four were emphasised by Ernst & Young's continuing problems arising from the collapse of audit client Equitable Life. The Joint Disciplinary Scheme has decided to investigate E&Y's role, without waiting for the outcome of civil litigation brought by Equitable.

The JDS is reported to have written to E&Y making specific allegations and awaits the firm's response before deciding whether to instigate formal proceedings. The JDS does not comment on cases prior to their conclusion, but its executive counsel, Christopher Dickson, said: 'We hope to make up our mind, one way or another, very soon.' Negative outcomes of both the JDS and court cases could bring serious damage to E&Y.

Peter Wyman, a partner at PricewaterhouseCoopers, said the OFT report was not entirely unhelpful. 'There is one conclusion within the OFT report that we welcome - that capping would not be anti-competitive,' he said. But he believed the OFT had 'completely under-estimated the pro-competitive aspects of capping'. Added to which, Wyman claimed, the OFT had made a major mistake in 'their claim that there is adequate insurance'. Rather, he said, 'there is no insurance available to all the Big Four - one phone call by the OFT to Lloyds would have confirmed that.'

Mike Rake, chairman of KPMG International, added that a cap on liabilities could persuade insurers to provide policies to the Big Four 'within five years'. At present, the firms have to set aside approaching 5% of their revenues for self-insurance. Rake added that without capping, audit fees may have to rise significantly.

But there is evidence that the market for auditing large companies in the United States is opening up - either because of reputational damage to the Big Four following major Securities and Exchange Commission investigations, or because the firms are refusing to audit high risk companies.

Inevitably, E&Y is the biggest net loser of clients in figures produced by Audit Analytic, having been barred by the SEC for six months from taking on new clients following an investigation of its relationship with audit client PeopleSoft. PwC lost the highest amount in audit fees and almost as many clients as E&Y, resulting from imposing tighter criteria over whom it will audit, said PwC.

BDO and other medium sized firms have won many of the Big Four's former clients. But Grant Thornton International has lost more clients than it has gained, at a time when its reputation in the US has suffered from its role as an auditor of Parmalat and MCA Financial Corporation, a now bankrupt mortgage lender.

tax clamp down

New disclosure requirements for tax avoidance schemes are now in place, designed says the Inland Revenue to 'deter the creation of contrived and artificial schemes whose main purpose is to avoid tax'.

The control framework is accompanied by noticeably tougher enforcement action. The Revenue is sending letters to 13,000 contractors and 44,000 sub-contractors in the construction sector, questioning self-employed status. In many cases, says Ernst & Young, this will be followed-up by compliance reviews. Some contractors can expect penalties doubling their tax and national insurance liabilities.

A similar warning was issued by Chas Roy-Chowdhury, ACCA's head of taxation, who said that many contractors could face tax bills going back six years. He added that contractors' profits could be further damaged if forced by the Revenue's action to treat sub-contractors as employees, taking on their National Insurance, holiday and sick pay costs.

Meanwhile, the use of gifts of shares and securities to charities via offshore trusts in order to reduce income tax liability has been blocked. This was welcomed by the Charities' Tax Reform Group, which felt this practice had abused measures designed to assist charities and tarnished the reputation of the charitable sector. Other avoidance measures banned have been the artificial treatment of rent from leased equipment - excluding it from income - and the use of manufactured payments to reduce corporation tax liability.

The picture regarding VAT avoidance and fraud is more mixed. Analysis conducted by KPMG Forensic shows that while the number of fraud prosecutions reaching court has risen, the value attached to those cases has halved. 'The main reason for the fall in the figures over the last two years is that the work HM Customs & Excise has been doing on cracking down on 'carousel fraud' is really paying dividends,' said David Alexander, KPMG's fraud investigation partner. Carousel fraud involves a person importing goods from a zero rate country, selling the goods on with VAT included and then disappearing without forwarding the VAT payment.

Yet a new report from the House of Commons Public Accounts Committee presents a more negative picture of continued VAT fraud. The committee calculates that Customs loses £11bn annually from frauds and errors, but argues that the department fails to address the problem seriously enough because it does not put its own figure on the losses. Data matching with the Inland Revenue - made easier with the merger of the two departments - is an important step to tackle the fraud, says the committee of MPs. 'I urge Customs to consider tougher penalties for evasion and under-declaring VAT, as a greater deterrent,' added committee chairman, Edward Leigh MP.

Mike Warburton, senior tax partner at Grant Thornton, said that the Government's tax avoidance clampdown reflects the squeeze between commitments not to raise the basic rate of income tax, yet to increase public expenditure. 'They tried various forms of stealth tax, like National Insurance and stamp duty increases, but another approach is to stop leakage through tax avoidance,' he explained.

Warburton suggested, though, that a simpler tax system might be a preferable alternative to the constant issuing of new anti-avoidance rules. 'The Labour Party in opposition, in 1994, said that tax avoidance flourished because of complex tax legislation,' recalled Warburton. 'Now they are in government they say they have to introduce complex tax legislation to tackle tax avoidance. But every time they introduce new tax avoidance controls they open up doors to new tax avoidance opportunities. So they have gone for the blanket requirement to obtain approval for schemes, but that will be a hell of a task to police.'

shelling out

Shell has agreed settlements of $120m with the Securities and Exchange Commission and £17m with the Financial Services Authority, resolving investigations by the regulators into the misleading reserves declarations by the oil giant.

Shell's settlement with the FSA agrees to an FSA entry of a final notice finding that the company breached market abuse provisions under the Financial Services and Markets Act and its Listing Rules, but does not involve Shell admitting the allegation. Similarly, Shell will consent to an administrative order from the SEC finding a violation of US Federal security laws, while not admitting a breach.

However, this may not be the end of the affair for Shell's auditors - PricewaterhouseCoopers and KPMG. Allegations published by the Wall Street Journal suggested that an internal reserves auditor warned the external auditors of possible reserves irregularities two years before the company publicly admitted the 20% overstatement.

Shell is playing down any potential impact on the two firms. A Shell spokeswoman said: 'We are not engaging in a blame game here. There are no excuses and none of this should have happened. It is important to remember that the core of these issues relates to the process of preparing for standardised SEC reserves reports. The auditors have been hugely helpful in the investigation and their participation in the process has been invaluable.'

As an indirect effect of the reserves-induced crisis, Shell is now poised for a fundamental change in its corporate governance arrangements. Under pressure from institutional shareholders, there is to be a merger of the boards of the UK Shell company and the Royal Dutch holding company, which may lead to a full merger of the two companies.

Other high value settlements appear to illustrate a tougher line being taken by the SEC. Bristol-Myers Squibb has agreed to pay the SEC $150m to settle fraud allegations. According to charges laid before a district court, this involved over-supplying drugs to wholesalers and improperly recognising related revenue to the extent of $1.5bn. Bristol-Myers Squibb neither admits nor denies liability under its SEC settlement and the SEC is continuing to investigate the role of senior executives in the alleged fraud.

The SEC's other high profile case is the most politically sensitive, involving energy company Halliburton - US Vice President, Dick Cheney, was its chief executive until 2000. Halliburton has now been charged along with two of its former financial executives for allegedly failing to notify changes in its accounting practices in 1998, when Cheney was running the company. Cheney is not personally facing any allegations. But Halliburton is further accused by the SEC of failing to notify promptly its potential liability to claims from asbestos exposure at its subsidiary Dresser Industries, acquired in 1998.

Halliburton subsidiary Kellogg, Brown & Root is also exposed to massive asbestos liabilities. KBR faces more difficulties as a result of a class action lawsuit brought by Connecticut law firm Scott & Scott, alleging accounting malpractice even more severe than that investigated by the SEC.

At present, much of Halliburton's focus is on Iraq, where it has won major infrastructural repair and development contracts. Ironically, US expenditure in Iraq has itself been disrupted by a critical audit from KPMG for the United Nations' agency, the International Advisory and Monitoring Board for Iraq (IAMB).

Various control weaknesses, including an absence of metering of oil extraction, caused KPMG to qualify its opinion on the Development Fund for Iraq's statement of receipts and payments. The Coalition Provisional Authority believes that the failure to meter has allowed large quantities of petroleum products to be smuggled out of Iraq.

KPMG reportedly also criticised the awarding of contracts - the largest to Halliburton, worth $1.6bn - without competitive bidding. The US Pentagon considered withholding 15% of its fees to Halliburton on some contract work in Iraq and Kuwait as a result of the Pentagon's auditors' criticism of Halliburton's accounting systems used on the contracts.

banking crisis

A six-year investigation by Ireland's High Court Inspectors has found that the National Irish Bank systematically assisted customers to evade tax by opening bogus non-resident accounts and by opening other accounts in fictitious names. Blame resided with the bank and senior executives, not branch managers, said the Inspectors.

It would be 'inappropriate to find individual [branch] managers responsible' as the practices were the result of a culture in which ethical standards were not regarded as part of the bank's core values, said the report. 'Responsibility for the practices lay at a higher level in the Bank.'

Auditor, KPMG, was criticised for its conduct after evidence of malpractice emerged, for being 'remiss in not requesting that management quantify the potential retrospective liability to the Revenue Commissioners'. Internal auditors had reported to KPMG and the bank's audit committee in 1994 the high level of non-compliance with statutory tax duties.

Although internal auditors had warned of the risk of high material liability arising from the tax non-compliance, KPMG failed to act on this. The Inspectors suggested that if KPMG had done so, the board would have been prompted to address the issue properly - which, in fact, it failed to do.

However, KPMG was absolved from all other responsibility. The Inspectors decided that the tax evasion malpractice committed by the bank had been properly addressed and reported by the internal auditors, who were accordingly not at fault. KPMG was correct in relying on the action taken by the internal auditors and on what should have been appropriate responses taken by the bank's audit committee and board.

Interviews conducted by the Inspectors reveal that many bank customers were offered bogus accounts by bank staff, for example if they indicated they were considering opening accounts with other banks offering higher rates of interest. Many customers, though, were not paid the rates of interest they were entitled to.

NIB will now be making almost 1,500 fee and interest reimbursements, valued at a total of 1.19m euros, with a further 10.6m euros set aside for a subsequent reimbursement programme and another 10.8m euros offered to investors in offshore products. So far, 6.7m euros has been paid by the bank to the Revenue Commissioners in settlement of the tax lost through the tax evasion practices. NIB will also have to meet the full costs of the Inspectors' investigation. It has now stopped selling offshore accounts. Total costs to the bank of the scandal are expected to exceed 75m euros.

This may not be the end of the affair. Ireland's Tanaiste - deputy prime minister - Mary Harney, who instigated the investigation after a revelatory television programme, condemned the bank and its senior officials. She accused the bank of an 'astonishing catalogue of systematic over-charging and tax evasion'. Harney called for criminal prosecutions of the bank and its former senior executives.

NIB issued a forthright apology for its past behaviour. It said it was fully addressing all the causes of the problems exposed by the Inspectors and would fully reimburse affected customers. It added that all the senior officials responsible for the wrongdoing had left the bank.

NIB is Ireland's fourth largest bank and unconnected to the Allied Irish Bank, which was recently revealed to have conducted systematic overcharging of customers over a prolonged period. (See 'AIB admits 'unacceptable' practices', accounting & business, July/August, p6.)

NIB's owners, the National Australia Bank, is disillusioned with its experience in Ireland and wish to sell the bank, according to reports in Australia. It is suggested this may lead NAB to also sell its other European investments, the UK's Clydesdale, Northern and Yorkshire banks. KPMG has now been replaced by NAB as its group auditor, following an SEC investigation into allegations that KPMG broke independence rules by assisting NAB to assess corporate loans.