TUESDAY 4 DECEMBER 2007

MR RICHARD SEXTON AND MR JOHN HITCHINS

  Q1320  Mr Love: As I understand it, as reported that takes a very tough line on the use of market prices for making that valuation. We have just heard from four of the large institutions. Do market prices exist for the particular vehicles we are talking about?

  Mr Sexton: We have not gone through the audit period of 31 December 2007 which will undoubtedly be a challenging period in relation to obtaining appropriate evidence. The market values would have been looked at as at 31 December 2006. That market did exist. The models to which you refer and the nature of the paper refer to the fact that the first port of call ought to be market value. When market value does not exist or there is no reasonable liquid market one needs to look to models to establish what if any value can be placed on the assets.

  Mr Hitchins: The paper was intended to be a companion to a similar paper produced in the US under USGAAP. Basically, it put together into one paper all the references in the accounting literature on how to prepare fair value accounts for financial instruments. It therefore goes through the fair value hierarchy. If you do not have a quoted market price what do you then do? What other sources of evidence do you obtain?

  Q1321  Mr Love: One of your colleagues, Pauline Wallace of PwC, who is leading the production of this report has said that it was there not to provide guidance but context. What does she mean by that?

  Mr Sexton: Pauline Wallis is one of our technical specialists in that area in PwC. The intent of her comment is that it is there to alert the market as a whole to this being a significant issue and to reinforce the need for people to consider the valuations very carefully.

  Mr Hitchins: It is not intended to provide new interpretations of accounting standards because that is not the job of the big accounting firms. If that is needed it should be done by those who set accounting standards.

  Q1322  Mr Love: I am interested in the view expressed about the so-called model-based calculations. If you were here earlier and listened to the discussion you would have heard that there are obviously very different models, assumptions and calculations. To what extent will this paper bring consistency to that?

  Mr Sexton: We cannot dictate to the market or those who prepare those models what assumptions they should make. Our job is to make sure they have gone through a very thorough process and that their assumptions are reasonable and based on supportable information wherever available.

  Q1323  Mr Love: The obvious question to arise from that is whether you can find yourself auditing two different large financial institutions with very similar vehicles which have used very different assumptions and models and therefore have arrived at very different valuations and you then agree with their decisions on these matters?

  Mr Sexton: Whether or not we would agree with them is a matter for the future, but we can certainly come across the circumstance where different institutions use different models, as they do. That is absolutely the case.

  Q1324  Mr Love: How confident are you that by the use of this report we will get more confidence and trust in the marketplace? There is a lot of concern that there is not just a lack of transparency about the valuations but where there are valuations they differ so much that nobody can have any confidence in them. Do you think this will make a contribution towards restoring confidence?

  Mr Sexton: I think that if financial institutions ensure they provide appropriate and detailed disclosures where they use those models it will provide greater transparency so everybody can understand exactly what is going on.

  Q1325  Mr Love: You mentioned earlier in response to Mr Fallon that a lot of the work you do is not concerned with just standard auditing procedures; you are brought in by companies for a whole variety of interim auditing purposes. Why has there not been a large-scale move among financial institutions to bring in auditors to look at the valuations? There is a great deal of talk among all of them about the need for transparency but a total lack of preparedness to be transparent themselves. Why is that happening?

  Mr Sexton: The only way I can answer that is to refer to the amount of disclosure that is mandated under international financial reporting standards IAS 39 and IFRS 7 as recently reissued which are required to be put into the financial statements. The banks of their own accord will go about their valuations and employ a lot of people to do them.

  Q1326  Mr Love: I am minded to ask you for a value judgment about international financial accounting standards because that seems to be the response to all of these questions but I shall not do so. Have you been advising your clients on the need for transparency and suggesting to them that they might wish to undertake some interim auditing procedure in order to get out into the marketplace the best estimated true valuation of some of their vehicles?

  Mr Sexton: We have encouraged all of our audit teams to talk to their clients over the period about the need to look at the valuations of their assets and liabilities, be that in the banking or corporate environment.

  Q1327  Mr Love: As I understand it, for most firms the accounting year will end either at the end of this year or early next year. That means you will not get fully audited accounts for some considerable period. Are you giving your firms any advice on bringing forward valuations in order to get them into the marketplace?

  Mr Sexton: Perhaps I may answer that in two parts. First, you are absolutely correct that the tradition in the financial services world is to have a 31 December year end. Typically, they would issue preliminary results reasonably early in January through the month of January. Indeed, if one uses Northern Rock as an example its interim announcement in relation to 2006 was on 24 January and for most financial institutions the audited financial statements followed approximately a month later. There are also continuing obligations under regulation in the UK for all listed institutions to keep the market informed of material developments. That is outside the scope of the work of auditors, but it is a continuing obligation on those companies.

  Q1328  Jim Cousins: How much do you charge for writing a comfort letter?

  Mr Sexton: That depends very much on the nature and volume of the information required.

  Q1329  Jim Cousins: You appear to have received fees of £500,000 for auditing Northern Rock and £700,000 for writing comfort letters. How much per comfort letter did you charge?

  Mr Sexton: As I have explained, that depends entirely on the scope of the specific comfort letter.

  Q1330  Jim Cousins: How many comfort letters did you write?

  Mr Sexton: There were a number of comfort letters in 2007.

  Q1331  Jim Cousins: How many?

  Mr Sexton: No more than 10.

  Q1332  Jim Cousins: You charged £70,000 for a comfort letter. Therefore, there is more money in writing comfort letters than in auditing the company?

  Mr Sexton: When we are requested and required to provide things like comfort letters we provide that service to our clients. I am not sure we would look at it on the basis that there is more money in providing comfort letters to the client. That depends entirely on their level of activity in relation to those particular matters.

  Q1333  Jim Cousins: You have to agree that in the wider world it would seem pretty extraordinary that your fee for auditing the company was £500,000 and your fee for writing 10 comfort letters was £700,000.

  Mr Sexton: As I have explained, the £500,000 is for a statutory disclosure in connection with the fee for auditing the company Northern Rock Plc. There are additional subsidiary companies within Northern Rock that are subject to audit and regulatory responsibilities that fall on the company that must be fulfilled. If you take those numbers together what you see is that we charged fees of £1.1 million as statutory auditors to Northern Rock and £700,000 in connection with comfort letters and securitisation.

  Q1334  Jim Cousins: In your discussions with the FSA about Northern Rock what did you tell them that was material to your function as auditor?

  Mr Sexton: I do not have a transcript of the precise comments made to the FSA by the audit partner at the tripartite meeting.

  Q1335  Jim Cousins: Just give us the general flavour. When you talked to the FSA what sorts of things did you tell them?

  Mr Hitchins: The first point here is that which I referred to earlier in terms of our duty to report when we become aware of something that is material to the FSA. I am not aware of when or how we had those discussions with the FSA.

  Q1336  Jim Cousins: Did you report anything to the FSA about Northern Rock?

  Mr Sexton: We would have had normal conversations as part of tripartite meetings with the FSA, with Northern Rock management and the regulator.

  Q1337  Jim Cousins: Could you charge £300,000 for that?

  Mr Sexton: The work that we provide to the regulator as statutory auditor is mandated by the FSA and subject to the very competitive marketplace to which you have referred.

  Q1338  Jim Cousins: In the tripartite discussions that you had with the FSA, about which you have not really been able to tell us anything, where did your duties lie?

  Mr Hitchins: I do not know whether there was a tripartite meeting. They do not happen every year but only at the FSA's request.

  Q1339  Jim Cousins: Did any happen?

  Mr Hitchins: I do not know.