Oireachtas Joint and Select Committees

Wednesday, 20 May 2015

Committee of Inquiry into the Banking Crisis

Nexus Phase

PricewaterhouseCoopers - Mr. Ronan Murphy and Mr. John McDonnell

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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As we've a quorum, the Joint Committee of Inquiry into the Banking Crisis is now in public session, is that agreed? Agreed. Can I ask members and those in the public Gallery to ensure that their mobile devices are switched off? We now commence session 1 today which is a public hearing discussion with Mr. Ronan Murphy, senior partner, PwC, and Mr. John McDonnell, partner, PwC.

In doing so we would like to welcome everyone to the 27th public hearing of the Joint Committee of Inquiry into the Banking Crisis. Today we continue our hearings with senior auditors who had roles before and during the crisis. At this morning's session we will hear from witnesses from PwC, Mr. Ronan Murphy, senior partner, and Mr. John McDonnell, partner.

Ronan Murphy joined PwC in 1980 and was admitted to the partnership in 1992. He has been a senior partner at PwC since 2007.

Mr. John McDonnell is a partner in PwC's banking and capital markets group. He is the Bank of Ireland audit partner in PwC. Mr. Murphy and Mr. McDonnell, you're both very welcome before the committee this morning.

Mr. Ronan Murphy:

Thank you, Chairman.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Before I hear from the witnesses, I wish to advise the witnesses that by virtue of section 17(2)(l) of the Defamation Act 2009, witnesses are protected by absolute privilege in respect of their evidence to this committee. If you're directed by the Chairman to cease giving evidence in relation to a particular matter and you continue to do so, you're entitled thereafter only to a qualified privilege in respect of your evidence. You are directed that only evidence connected with the subject matter of these proceedings is to be given. I would remind members and those present that there are currently criminal proceedings ongoing and further criminal proceedings are scheduled during the lifetime of the inquiry, which overlap with the subject matter of the inquiry. Therefore, the utmost caution should be taken not to prejudice those proceedings. Members of the public are reminded that photography is prohibited in the committee room. To assist a smooth running of the inquiry, we will display certain documents on the screens here in the committee room. For those sitting in the Gallery, these documents will be displayed on the screens to your left and right. Members of the public and journalists are reminded that these documents are confidential and they should not publish any of the documents so displayed.

The witnesses have been directed to attend this meeting of the Joint Committee of Inquiry into the Banking Crisis. You have been furnished with booklets of core documents. These are before the committee, will be relied upon in questioning and form part of the evidence of the inquiry. So, if I can now ask the clerk to administer the oath to both Mr. McDonnell and Mr. Murphy.

The following witnesses were sworn in by the Clerk to the Committee:

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Thank you again, Mr. McDonnell and Mr. Murphy, and I believe, Mr. Murphy, you'll be going first with your opening statement this morning ... yes?

Mr. Ronan Murphy:

That's correct, Chair.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay. So, if I can invite you to make your opening statement please.

Mr. Ronan Murphy:

Yes, thank you, Chairman, good morning and good morning also to the members of the committee of inquiry. Can I firstly say that I and my colleague here on my right, John McDonnell, welcome this opportunity on behalf of PwC to meet with the committee this morning and to assist you in your work. Chairman, in your letter to me of 6 May you allocated a time period for me to read my opening statement. I don't anticipate that I will require all of that time but I would nonetheless like to make some opening remarks.

Chairman, in your introductory remarks you outlined a brief biography of my career and I won't repeat this. However, I would like to make some comments around my role and function as senior partner of PwC. My main role is to act as the CEO of the firm on behalf of the partners. This is a role I've held since 1 July 2007, as you've mentioned, and from which I will step down on 30 June next. We currently have 95 partners in the Republic of Ireland firm, over 2,000 staff and revenue in the Republic of Ireland of €230 million for the year ended 31 December 2014. In terms of clients, my principal role is to ensure we have appropriate systems in place to make sure that we deploy suitably experienced and senior partners to carry out specific client assignments. On the risk and quality side, the senior partner has a very key role to ensure we have effective client acceptance and retention controls in place and also that there is adequate support in place for partners dealing with higher risk situations and making critical professional judgments.

PwC Ireland is a member of the PwC global network and in that context the senior partner's role is to ensure that new practices and procedures-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Sorry, Mr. Murphy, if I could just slightly disrupt you, I think you may have a box on the speaker there that's actually-----

Mr. Ronan Murphy:

Oh, I'm sorry. I'll take it off.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Thank you very much.

Mr. Ronan Murphy:

Sorry. Will I continue Chairman or-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Please ... yes.

Mr. Ronan Murphy:

PwC Ireland is a member of the PwC global network and in that context the senior partner's role is to ensure that new practices and procedures developed in centres of excellence in other parts of our network are effectively rolled out in the Irish firm.

Chairman, I was directed by you on 12 March to attend this meeting of the committee this morning. I responded to you on 27 March and I think it's appropriate that I read out a paragraph from that letter as follows:

Further to your letter of 12 March ... directing me to attend before the Joint Committee, I would like to point out to the Joint Committee that I have not practiced as an auditor since my appointment as Senior Partner on 1 July 2007 and, furthermore, prior to that date, I acted [almost entirely] on non-financial services entities. Accordingly, as I have never been an auditor to a bank, I request that I be granted the option of being accompanied by one of my financial services partners so that I can fully respond to the key themes and lines of inquiry when I attend before the Joint Committee on 20 May.

Chairman, the firm appreciates your consent to this and accordingly I'm accompanied by John McDonnell this morning and I will shortly pass over to him to permit him to make his opening remarks.

As requested, Chairman, I submitted my written statement on behalf of the firm on 22 April. The statement addresses the five key themes which I was directed by the committee to cover. In summary, these themes are: integrity of financial reporting; appropriateness of property-related lending strategies and risk appetite; the liquidity versus solvency debate; the adequacy of the assessment and communication of both solvency and liquidity risks in banking situations, institutions and sectors; and capital structure and loss absorption capacity. Chairman, I'm happy that if you wish, that this statement can be taken as read. However I think it's appropriate that I read the short conclusion included in the statement. Our conclusion is that audits in the period from the start of the financial crisis were clearly challenging due to the inherent uncertainty facing the Irish and global economies and the particular issues faced by Irish banks. The loan loss provisions were clearly a material estimate in the overall set of financial statements on which we expressed an opinion. We stand over the quality of the audits of the financial statements of Bank of Ireland and the robustness of the audit opinions issued on the respective reporting dates.

Chairman, my colleague John McDonnell and I would be happy to answer questions from the committee and to explain to the committee how we arrived at this conclusion and why we believe this conclusion was appropriate.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Thank you very much Mr. Murphy ... sorry -----

Mr. Ronan Murphy:

I'm just almost there, Chairman.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Sure yes, take your time.

Mr. Ronan Murphy:

We would also be happy to explore with the committee how bank accounting and bank auditing could be enhanced so as to help avoid a similar financial crisis recurring. Before I conclude, Chairman, could I say that in relation to Bank of Ireland, that it has been and continues to be a significant client of the Irish firm of PwC. We were joint auditors to Bank of Ireland along with Deloitte of London up to 1990 and since then have been the sole auditors. We believe we had, and continue to have, a very strong working relationship with the executives, the audit committee and the court of the bank and provided appropriate challenge and support to the bank in an unprecedented period of turmoil starting in the middle of the last decade. Can I also say Chairman that, in accordance with the new rules currently being introduced on mandatory auditor rotation, we will step down as the bank's auditors no later than the required date of 2020.

In conclusion Chairman, our objective today is to assist the committee as best we can. As you'll be aware we have already provided the committee over 5,300 pages documenting our work over the period and this highlights the extensive communication we had with Bank of Ireland throughout this critical period. Thank you Chairman.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Thank you, Mr. Murphy. Your opening statement, which you provide to the committee will be published as well this morning in full, just so it's put into the record. And also just in terms of notification that was given to both yourself and Mr. McDonnell, you would be here representing yourself, along with the activities of your firm. So Mr. McDonnell, if I can invite you to make your opening statement please.

Mr. John McDonnell:

Thank you Chairman, thank you Ronan. Good morning Chairman and members of the committee of inquiry. Like Ronan, I welcome the opportunity on behalf of PwC to meet with the committee this morning and to assist you in your work. I am here today in my capacity as lead audit partner on Bank of Ireland from 2010 to date. Whilst not directly involved in the Bank of Ireland audits from 2001 to 2009, I am familiar with the audit procedures adopted by PwC in the audits of banks in the period in question and like Ronan, I will do my best to answer the committee's questions.

Chairman, I submitted my written statement on 6 May 2015. I'm happy to take the statement as read but I would like to make a few introductory remarks on two aspects: (a) the role of audit, what it is and what it is not, and (b), the impact of prevailing accounting standards in recognising risks. So moving to the role of the audit, there is and has been a lot of discussion about the role of an audit, including what it is, what people think it is and what they might like it to be. So I think it's important at the outset to set out what the role of an audit is, where it begins and ends, and what it is not. In doing this I'm drawing from the requirements of company law in Ireland and auditing standards. The objective of an audit of financial statements is to enable the auditor to express an opinion whether the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework, that's IFRS in the case of Irish banks for 2005. Although an auditor's opinion enhances the credibility of financial statements, the user cannot assume that the audit opinion is an assurance as to the future viability of the entity nor the efficiency or effectiveness with which management has conducted the affairs of the entity.

In other words, the primary purpose of an audit is to provide independent assurance to the shareholders that the directors have prepared the financial statements properly in accordance with the rules of IFRS. An audit does not exist to provide comment or opinion on a company's business model. That is not the purpose of an audit, nor is there any means for an auditor to express such views in the audit opinion. The prescribed format and somewhat binary nature of an audit opinion does not allow for commentary on an entity's business model. In fact, the content and set of financial ... the content of a set of financial statements is prescribed by the accounting and regulatory framework. There is nothing in this framework which allows an auditor an avenue to express a view in the financial statements on a company's business model. In the context of regulatory returns, there is no requirement for auditors to audit or review, and nor did we audit or review, any regulatory turn of the bank, be it solvency, liquidity or otherwise.

I move on to the second item - impact of prevailing accounting standards and recognising risks. The objective of financial statements is to provide information about the financial position, the performance and changes in financial position of an entity. Accounting standards set the rules for the preparation of financial statements and, as I said, IFRS are the accounting standards that applied to listed entities in Ireland, including the banks, from 2005 or March 2006 in the context of Bank of Ireland.

Financial statements portray the effects of past transactions or events. They're not intended to provide all the information that users need to make economic decisions. The aim of accounting standards is to faithfully represent past transactions or events in financial statements. Matters such as stability, capital adequacy and future prospects are outside the remit of accounting standards. The requirement to focus on past transactions and events means that IFRS prohibits the recognition of future events. By way of example:

1) There is a general rule in IAS 39, which deals with accounting for financial instruments and impairment, that losses expected as a result of future events, no matter how likely, are not recognised as impairment on loans and receivables - this is called the incurred loss approach.

By way of example, the date a borrower became unemployed would be an impairment trigger in many retail books. What I mean by an impairment trigger is the first point at which impairment is allowed to be recognised. But banks cannot take into account an ... expected increase in unemployment in the following year, say 2016, in their year-end, say 2015, assessment of impairment, no matter how likely, because this unemployment has not yet happened. There is a second example. There's a general rule in IAS 37 and that deals with provisions contingent liabilities and contingent assets, that provisions cannot be recognised for future operating losses. And my third example deals with events after the balance sheet period, IAS 10, and this standard does not allow an entity to recognise the financial impact of events that arise after the balance sheet date concerning conditions which did not exist at the balance sheet date.

IFRS set the rules which had to be applied in financial statements of Irish banks during the financial crisis. The financial crisis tested some of these rules and found some of them wanting. Changes have now been made but, nonetheless, they were the prevailing rules. Therefore, they were required to be applied. The accounting rules of the time did not allow for the recognition of future events or risks. There have been changes since the crisis to accounting auditing and corporate governance standards. We've engaged heavily in the process and welcome the opportunity to engage further with the various stakeholders in the overall debate on improving financial reporting. Thank you, Chairman.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Thank you very much, Mr. McDonnell, and thank you again, Mr. Murphy. We'll commence this morning's opening questions with Senator Susan O'Keeffe. Senator, you've 25 minutes.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Thank you, Chair. Good morning. Mr. Murphy, in the seven years between 2004 and 2010, your firm would have earned a total of €66 million for the work that you did at Bank of Ireland. Obviously, that is split between the audit and the other work.

So while I appreciate we're here largely to talk about the audit, I'd just ... I'd like some clarity, maybe, on ... because the other work appears to have earned quite a lot of income, and given that you are the chief executive of the company, you might be able to throw some light on that.

Mr. Ronan Murphy:

Okay. Senator, included in the figure you've quoted there are the audit fees.

Mr. Ronan Murphy:

There are a significant amount of non ... of audit-related fees, and that would be where we supported the bank in terms of IFRS transition. We supported the bank in terms of providing accountant's report where there was capital raising. We were involved in Sarb-Ox implementation. And then there's an element of non-audit fees, which would be for tax and some consulting fees.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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For clarity, Mr. Murphy, would the people concerned in the non-audit activity be completely separate to the audit team or would there be a crossover?

Mr. Ronan Murphy:

They would be completely separate, Senator. So the ... we have three divisions in our practice - audit, tax and consulting. John McDonnell works in the audit practice. Those working on the audit were solely in the audit practice. Anyone providing tax advice would work in the tax practice, and those providing consulting advice would be in the consulting practice. They're three separate divisions.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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In any way, would the people involved ever have had a conversation or been invited to have a conversation with the bank where, if you like, there'd be a joined-up presentation by PwC to the bank, you know, saying, "Well, we found all of this and here you go, here's a clear picture"?

Mr. Ronan Murphy:

Yes, I think where that would most happen, Senator, would be where our tax colleagues were preparing tax returns or looking at certain tax planning aspects, and they would link in with the auditors as part of that. That's where it would mostly happen.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Okay. So they weren't ... there wasn't a Chinese wall environment going on.

Mr. Ronan Murphy:

There wasn't a total Chinese wall, but, as I say, it wouldn't be the norm that you would have discussions. It would mainly happen around the tax and audit linkages to make sure that the auditors were fully aware of the consequences of tax planning and tax returns.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Given the scale of the earning, was Bank of Ireland one of your biggest or, indeed, perhaps your biggest - perhaps you could tell us - client?

Mr. Ronan Murphy:

Certainly, Senator. The Bank of Ireland is ... was and is our largest financial services client and throughout the period it would have been one of our largest ... three largest clients.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Did I hear you correctly to say that you'd been auditing Bank of Ireland since 1990? Is that correct?

Mr. Ronan Murphy:

Correct. Sorry ... yes, what I said was that we were joint auditors up to 1990 with another firm and then we became sole auditors in 1990 and we've been sole auditors since that date.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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And I think you talked about the quality of the relationship between yourselves and the bank being a good one.

Mr. Ronan Murphy:

It was a very good professional working relationship and, as I say, we provided appropriate challenge and support to the executives on the board in what was a very difficult period.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Do you believe that the longevity of your relationship could be perceived to have an implication of closeness? Do you see why people might observe that and say, "They've been the auditors for such a long time; they must know each other very well"?

Mr. Ronan Murphy:

I think that's a reasonable question to ask, Senator. We were auditors, as I say, solely for 25 years, but there are some very key safeguards in place to make sure that we don't become any less independent than we should be and that we don't provide appropriate challenge and robustness and rigour and, I mean, just to very quickly enumerate those, Senator ... I mean, John McDonnell said he has been partner on the Bank of Ireland for the last five years. We've a new partner taking over. His predecessor did five audits, as did his predecessor. So every five years we're required to rotate the partner. We also have, in the case of Bank of Ireland, a quality review partner. He's not involved in the relationship but he does review the planning documentation. He reviews the papers and, critically, he reviews all of the judgments. So he, again, would be making sure that we applied appropriate rigour and independence and we arrived at the right decision. And I think, thirdly, Senator, it's important to realise that in our engagement with the audit committee of the Bank of Ireland, every number of years they would do a formal review of the quality of our service, and that would have happened on every, probably, third anniversary, where they would look to make sure that we were providing the services that they thought were appropriate. So those safeguards would ensure that we have, and we continue to apply, the right level of independence.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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In your view, did the firm's audit team have sufficient banking and, particularly, I suppose, property experience, given what we saw in the growth of property-related investments by the bank over that period of time?

Mr. Ronan Murphy:

Senator, we're happy that we had the absolute level of experience we needed. John can explain that we have within the firm a banking group where the ... in our audit practice, a banking group where all of the staff are almost exclusively working on bank clients. There's about 100 people in that group. We have five partners. The core team supporting ... auditing the Bank of Ireland would have been drawn from that. John ... if that's okay?

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Sure, of course, yes. Mr. McDonnell?

Mr. John McDonnell:

Senator, we're the only firm in Ireland that have a dedicated banking practice as opposed to a dedicated financial services practice. So when you arrive into PwC on day 1 and you join the banking practice, you only work on banking audits, so the full audit team that we would have directed to Bank of Ireland was from our banking practice and they would have all had banking experience commensurate with the period of time they were in the firm.

Secondly, we were very conscious that Bank of Ireland is organised on a divisional basis, so we would have taken our retail banking specialists to audit the retail part of Bank of Ireland, we would have taken our corporate banking specialists to audit the corporate side of Bank of Ireland and our treasury specialist to audit the treasury side of Bank of Ireland. In terms of mobilising for the audit, we would have had specific Bank of Ireland structured training at the start of every year where we would look at the key risks and significant risks with Bank of Ireland and ensure the team were up to speed on those.

But also, as a banking practice, we would have detailed, banking-specific training over and above the training everybody else in the firm gets before we enter into a cycle of banking audits. That training would deal with three aspects. The first aspect would be accounting training: any changes in the accounting that has particular relevance to banking and that would have been very heavily focused on accounting for financial instruments and impairment. Two, any auditing training and that would have had two focuses, Senator. The first is any changes in auditing standards that we need to take into account but also re-emphasising aspects of auditing standards that maybe ... that we need to focus in on as the business environment changes and particularly in that aspect, it would have been how one audits impairment and how one audits an incurred loss model on impairment, and thirdly, particular training around the current business environment in which the financial institutions are operating. And that would have been, as you would expect, a heavy focus on training around credit, accounting for credit, the auditing of credit and as part of that training, we would have been discussing the impact of the credit crisis on the property markets and we would have had auctioneers coming into us to give us their perspectives on the property crisis etc.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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You might ... because there is such, I think, a mixed perception of what auditors do, could you just indicate what size of a team you might have had in place over the average year and whether or not that team was working constantly or for a period of time, you know, very hard and then there is a gap, or how does it function and how often are they in and out of the bank, the actual physical bank?

Mr. Ronan Murphy:

Maybe, Senator, I will just give an overall perspective on the audit team and ask John then to comment in relation to the bank. Is that okay?

Mr. Ronan Murphy:

In terms of the audit teams, it has been a very consistent model over many years and it is applied consistently throughout the profession. There are really four levels. There is the partner and as I say, in our firm we have 95 partners. Their job is to make the critical judgments. They consult as widely as they need internally, they have the support of the quality review partner, but they are the ones who can commit the firm. The next level below the partner are the directors, senior managers and managers, who are very experienced accountants who are in charge of the project management of the audit. Below them are the qualified seniors. These would generally be qualified chartered accountants. They would be on-site on clients throughout the period of the audit and they would be supported by unqualified staff. These would be trainees, who are training to become chartered accountants.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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What is the period of the audit, Mr. Murphy? When you say, "for the period of the audit", what is the period of the audit?

Mr. Ronan Murphy:

You say how long would the audit take?

Mr. Ronan Murphy:

The audit of the Bank of Ireland would generally have taken about four or five months. John, do you want to-----

Mr. John McDonnell:

Just to answer, the audit cycle of Bank of Ireland, Senator, would operate throughout the full year. We wouldn't be with the bank throughout the full year but would operate throughout the full year. We would be engaged in a degree of planning and conversation with the bank - if I take it December-December, it's probably easiest - in the early part of the year, discussing with the bank key matters that are impacting their financial statements, discussing changes in accounting standards, changes in auditing standards and they would always seek our views on accounting for particular matters. That would happen, if you like, throughout the first half of the year. We would then enter into our review of the half-year financial statements, and that would take place, if it was a December year-end, generally we would plan for that in June and we would be operating in July and into August. Then we move into the planning of our audit and we would determine our audit plan and present that to the audit committee, generally in September time, and then we would start full-scale on the audit in October and that would run through until we sign the financial statements, which would be usually the end of February in a December year-end, then we would move into signing and finalising the form 20-F, which is the equivalent of financial statements we would have filed with the SEC. We'd finish that in March and we'd start the cycle again. The main bulk of our time would be probably, it changes every year but October to February, coming into March. In terms of the resources that we would have mobilised at the peak of the crisis, probably in and around 200 people, of which 25%, give or take, would be the senior management team, which would be partners and senior managers.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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So in the previous year, for 2008, you would complete and sign off the audit in March 2009?

Mr. John McDonnell:

Yes, 2008 was a March year-end, apologies, but for December it's similar-----

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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It's usually after three months the actual end of the ... year-end

Mr. John McDonnell:

Yes, usually two months after the end of the period, and then the 20-F follows a month after that, usually. That's usually the way it works.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Now, you've talked a little bit about, and I'm sure other colleagues will talk about, the changes and some of the things that have happened in terms of the changing of rules for auditors and for auditing in the future. But did your firm ever call for a change of rules prior to 2008? Were you out there banging the drum saying, "Audit rules are not strong enough", or were you satisfied up until then that the audit rules were strong enough and robust enough for the work that you were doing?

Mr. John McDonnell:

I think, Senator, in the context of the audit rules and the rules that were applicable to allow us to formulate an opinion, I think the rules that were in place were appropriate for the time, and I think the substance of those rules is still in place in the canon of accounting standards. I would say that we stand over the audit opinions on Bank of Ireland, we did a very robust and thorough audit, and we are satisfied that those opinions were appropriate.

The main changes, though, in auditing standards since the crisis have been predominantly focused in on the role of the auditor and the role of management, and trying to strengthen an understanding in the marketplace as to what an auditor does and what an auditor doesn't do, and what management do and what management do not do, and the interaction between the two. And what we've seen is, we have seen a development - for an example, Senator - we've seen a development in the audit report, whereas the audit report previously would have been a two-page report, now it's about a six-page report. Previously we would've just, effectively, said what our responsibility is and what our opinion was; now we will specify how we, how we determined the focus of our audit, so, in other words, what entities were in scope and what were not in scope, what was the materiality that we would have applied to our audit, and what were the key areas of audit focus, so, in other words, the significant risk and, clearly, impairment would have been one of them, and what tests we undertook to audit those areas of focus, and then how that brought us to our opinion. So it's much more discursive around the opinion, and the second part of the change was that management through ... the directors, through the auspices of the audit committee, would outline what they considered were the significant issues that they took into account in the context of the finalisation of the financial statements, and how they interacted with the auditors in that regard. And, lastly, the directors would then say why they believed the accounts were fair, balanced and understandable. All that was being done in the past; it is just now more, it is communicated in a more detailed manner to the marketplace.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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But you weren't calling for that change, you weren't, among your colleagues and your international partners and so on, you weren't saying to each other or to yourselves, "Do you know, guys, we need to change, we need to make these rules more robust"?

Mr. John McDonnell:

We would have always been involved in debate in the markets around auditing standards, we would be constantly in debate with the body who sets auditing standards, the body who set accounting standards, we would always have been involved in the debate about good corporate reporting and, I don't have examples, but I'm sure that we were involved in saying that, you know, we would always be promoters and supporters of better communication to the marketplace. And we would have always been supporters in, since well before the banking crisis, about, you know, auditors looking at a better way to communicate what they do because there has always been an expectation gap between what we do and what people perceive that we do. But I can't pinpoint a specific and say that as a result of the crisis we did X, Y and Z; we would have been constantly involved in that debate.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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No, actually, I was asking particularly, prior to the crisis, in fact, but-----

Mr. John McDonnell:

Well, we would have been involved in the debate prior to the crisis. There was a number of, and this is going back a long way, there was a number of documents and debates done in the Institute of Chartered Accountants. I think one of our partners, Niall Deasy, was involved around the expectation gap, so we would have been involved in that debate, but it's been a long-standing debate, Senator.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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When the loans, when you would examine ... the auditing team would examine loans that the bank had, would the bank provide the sample of loans, or would you go in and seek a sample of loans?

Mr. John McDonnell:

No, Senator, the bank would not provide the sample of loans, we would select the sample of loans; we would not notify the bank as to what our sample was until we went in to seek that sample, and we would select that sample ourselves.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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And would you seek the sample from across all loans, or would you concentrate more on the top end or the bigger loans, or did you give equal parity to-----

Mr. John McDonnell:

We would seek ... we would apply two types of testing. We would apply targeted-type testing and then we would test the balance that ... the remaining balance. We would focus our audit approach on the risks inherent in the book so while we wouldn't necessarily go for big loans but we would focus our sample, if we're testing for impairment, on loans that are more likely to have risk factors, thereby they could be impaired, but we would also look at other loans. So, it would be across the whole, the whole population, focused in on where we perceive the more material risk. And the reason we do this is because the purpose of an audit is to focus in on risks and material misstatements, so all our auditing focus is always focused on where there is more likely to be a risk of material misstatement.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Would you know, for example, if the bank had interest free loans being given to any body or any organisation? Would that be something a bank ... an auditor would know or would that just simply not arise?

Mr. John McDonnell:

I'm not sure it would be something that I could say an auditor would know. It would be a focus of our work to look at whether the, whether an institution gave interest free loans for a number of reasons, and I'll articulate. The first reason is if a loan is issued at an interest-free rate. Then that loan would need to be fair valued under IAS 39, and at day 1, to determine what the actual interest is. So if you issue a loan of €100 at an interest-free rate, in reality what that would be booked at in the accounts would be €95 and then the interest would be accumulated. IFRS always assumes there's an interest in it. Secondly and more importantly, the reason we would look at interest-free loans would be in the context of our requirements to consider related party transactions and there would be a risk that if an institution gave a loan at an interest-free rate that there may be a related party aspect to it. It's not necessarily saying that the loan would not be appropriate, but there would be disclosures that would need to follow from that and our audit would heavily focus in on that.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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When you're ... when the auditors for AIB were here with us, they said that they had had a meeting in 2000 ... early 2008 with the Financial Regulator. It was a meeting of the four firms with the regulator. And this arose in the context of contingency for ... for the going concern for AIB. I appreciate you're the auditors for Bank of Ireland, you can't speak for AIB, but I'm wondering whether you're aware and attended this meeting that AIB refers to with the regulator.

Mr. John McDonnell:

Senator, yes, I am aware of the meeting. I personally didn't attend. We did attend the meeting, but I think the meeting ... I think the meeting that KPMG referred to last week was the meeting that the accounting firms had with the regulator in the context of accounting for financial instruments as a result of the liquidity crisis. And what happened at the time was that we had the subprime crisis in late 2007 and, as a result of that, there was a number of issues around how one would value securitisation vehicles, but, in particular, the credit aspect of financial ... of financial instruments. And we, indeed, and it's in the book of evidence, would have written to Bank of Ireland in that context in September 2007, highlighting the issues that people were considering. And that was the meeting that the four firms had along with the institute with the Central Bank I believe, and it was really to discuss valuation-type aspects of ... arising from the subprime crisis and liquidity crunch resulting from then.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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But was there any questioning on the part of the auditors for Bank of Ireland at that point yourselves, at that point with the bank in relation to the bank as a going concern and whether you would ... whether there was any concern on the part of the auditors about the bank as a going concern?

Mr. John McDonnell:

Us questioning the bank as a going concern ... oh, yes, there was-----

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Can you tell me about that please?

Mr. John McDonnell:

Oh yes. Our ... we always have responsibility to consider and audit the going concern concept and we would do that every year.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Yes. I'm specifically concentrating now on your observations at the end of 2007.

Mr. John McDonnell:

Yes. We would always have a, as I said, a responsibility and, in 2007, Bank of Ireland was still on the March year-end, so our year was 31 March 2008. And maybe just before I just get into it what we did there, I might just stand back and say what-----

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Sorry, I'm just conscious of the time, Mr. McDonnell.

Mr. John McDonnell:

Okay, sorry. Fine.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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I'm sorry, it's just if you can concentrate just on what you-----

Mr. John McDonnell:

We focused in on going concern considerably with Bank of Ireland in March 2008 as a result of the effective freezing of the securitisation market. That had a knock-on impact on liquidity in the marketplace. Bank of Ireland were a small player in the securitisation market and they didn’t have any of the valuation issues I discussed earlier on, or a very small number of them. We would’ve focused very heavily with Bank of Ireland and they would have increased the amount of work they would have done themselves to assess the going concern aspect. And we would have considerably ramped up the work we did in terms of going concern.

And we would’ve particularly focused in on liquidity and we particularly focused in on a number of things. And we took reliance from a number of things. One, Bank of Ireland’s deposit base had grown by 19% that year. They were still growing deposits. Two, they had access to the wholesale money markets and they had considerable access to the wholesale money markets and they had no issues accessing those markets, albeit that the cost of funds was a little higher. And, three - and this, we had taken considerable comfort from this - they had a huge amount of liquid assets, about €30 billion, which they had not sought to access the ECB with. So that's ... we would have focused on that and done a lot of work around that.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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And Mr. Boucher in his document, exhibit B3, said that, "Many aspects of normal financial market operations-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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What reference?

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Exhibit B3:

Many aspects of normal financial market operations have ceased or been curtailed or else done under radically different conditions. Liquidity conditions were very difficult in the period leading up to 31 December 2007, with a brief rally in January-February-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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I just need you to clarify that document, Senator.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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-----a rally, however, that was not sustained.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Sorry, Senator, I need you-----

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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I don’t know what else to tell you except it’s exhibit B3, RB001 - B0I.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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It’s a Bank of Ireland document, is it?

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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It is. Mr. Boucher ... I said at the start.

Basically Mr. Boucher was saying that things ... it was very difficult and liquidity conditions were very difficult. And I’m just trying to establish what ... were the auditors ... the auditors were clearly aware that they were very difficult is what he’s saying. I’m just wondering did you agree or-----

Mr. John McDonnell:

Liquidity issues were difficult, were very difficult, were difficult at that point in time and the difficulty was caused as a result of the liquidity crunch which had come from the subprime market.

Mr. John McDonnell:

What had actually happened was that the wholesale money markets had become more expensive to raise funds. We would have had detailed conversations with Bank of Ireland as to their ability to access those markets. They were able to access the markets and they continued to access those liquidity markets, albeit at a higher cost of funds. Secondly, and this is the very important thing we would have looked at is were Bank of Ireland still being able to draw funds from depositors and they were. Their deposit base grew by 19% up to March 2008.

But the most important focus of our audit and the most important focus of management’s audit was the level of collateral that they had that they were not using at that aspect. They had about €30 billion in liquid assets which they could have repoed with the ECB. My recollection is that they had not drawn down any ECB funds at that point in time. And at that point in time, liquidity markets were a lot tougher than they had been heretofore but they were not as tough as they became when Lehman's collapsed.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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If I can move you to the going concern position for the end of 2008. And again, KPMG referred to ... that this was a completely different experience. They had to consult with the regulator, with the Department of Finance, with the Central Bank, with everybody. That it was an "unprecedented" was the word they used. And that's pages 125 to 126 of KPMG’s evidence from last week.

And, again, I want to know whether that was a similar experience with Bank of Ireland. Was it unprecedented? Was there any change in the way that you signed off on the going concern issues in relation to Bank of Ireland for 2008?

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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The witness may not be familiar now with the evidence of last week, okay, just to flag that.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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No, but he'll be familiar, I hope, with what happened in Bank of Ireland.

Mr. John McDonnell:

Chairman, I think I can answer the question.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Sure, indeed. You’ve plenty of time.

Mr. John McDonnell:

Bank of Ireland’s year-end was 31 March 2009. We would have been very heavily focused in on the audit of going concern in Bank of Ireland. Bank of Ireland were in a slightly different position than AIB because it was three months later. At that point in time, the bank had been recapitalised through the preference shares from the State. The bank had ... the Government guarantee was in place. And, lastly, the Bank had had a number of conversations with the Central Bank with regard to the availability of emergency liquidity, although I will say that the bank had not drawn down any emergency liquidity at that point in time. The bank, I believe, although I’m not certain, had started ... may have started to use some of its securities to repo them with the ECB in terms of raising money from the ECB.

We would have focused very heavily in on capital. The capital was in place. The Government undertakings were in place. Liquidity - the bank had detailed conversations with the Central Bank as to the availability of funds.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay, final question and supplementary then.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Was it unprecedented at the time?

Mr. John McDonnell:

Was it? Sorry, no I ... sorry, Senator. It was wholly unprecedented. There was absolutely no expectation in the marketplace that someone of the size of Lehmans would collapse. There was no ... the market was stunned with the actual immediacy of the impact of that on wholesale markets and the interbank markets closed down at that point in time, so there was ... and therefore there was a heavy dependency on funding from the ECB and the banks were aware of that and the discussions ... they would have had ongoing discussions with the Central Bank and we were well aware of that. We would have been heavily involved in that and, as part of our audit procedures, we would have sought to have detailed discussions with the banks. We would have overlooked the collateral, over the full period, now, because this runs on into 2010 and 2011. We would have had detailed debates with our head of risk. When I got involved, I would have been discussing with our global head of risk how other banks were looking at going concern. We would have detailed conversations with the directors, the head of treasury, the person responsible for ensuring the collateral is in place, the head of deposits, the audit committee, the court. We would have discussions with ... We would have had a technical panel and that technical panel ... so, in terms of, for the audit partner to make a decision, because the serious in this, we would have had a technical panel so we would have had a conversation with our peers and that would have included our head of risk, our head of audit, some senior partners who are very good and versed in business risks, our head of accounting technical. I would have met with the Financial Regulator, the NTMA, the Department of Finance, the Central Bank. So we took this very, very seriously as did the bank, took it very, very seriously.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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You were very involved.

Mr. John McDonnell:

Very.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay, thank you very much. I just want to stay with one aspect of that, Senator, before I bring in Senator Barrett. If I can bring up core document page 55, group audit findings report, year ended 31 March 2008 and what this is is an audit findings carried out by your firm, Mr. Murphy and Mr. McDonnell, with significant audit risks and other areas of focus. Maybe if I can draw your attention to the very last section of the page, which relates to your dialogue with Senator O'Keeffe:

Assessment of ongoing concern.

The directors of a listed company are formally required to assess the company's going concern position annually. B[ank of Ireland] has continued to trade very profitably. However, in common with other banks [and I will return to this line in a moment, in common with other banks], there has been a significant increase in liquidity risk. Management's formal assessment of [on]going concern and in particular liquidity risk has only just been finalised. Accordingly, we will update the Group Audit Committee on our review of this assessment at the meeting [of the] 16 May 2008.

Now, Mr. McDonnell and Mr. Murphy, this is about five months before the guarantee, when Bank of Ireland, from earlier evidence here, were in a very crisis position. The comment there, "in common with other banks", can you please explain to me what that actually means? Is this or is it not a suggestion that there was some open dialogue amongst those in the wider financial community as to a general liquidity concern right across the financial sector?

Mr. John McDonnell:

There was at that point in time, Chairman. As I mentioned earlier on, there had been impacts on liquidity as a result of the US subprime market and the securitisation market had effectively frozen and liquidity was becoming, I suppose ... wholesale liquidity was becoming more short term and was becoming more expensive and it was recognised in the global markets that liquidity had become more difficult. That is what we meant by "in common with other banks". It wasn't just Irish banks. It was right across-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Maybe you could elaborate upon that dialogue so that was taking place in terms of the "in common with other banks".

Mr. John McDonnell:

In terms of-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Was there a discussion taking place in your firm at the time that there is a potential for a significant liquidity crisis coming down the tracks here?

Mr. John McDonnell:

There was discussion in our firm at the time around the impact of what had happened in the subprime market on liquidity. We would, as a regular ... regularly, Chairman, we would discuss, banking partners, both in Ireland and across the firm, would discuss the impacts on markets of various things happening and we would have discussed within our firm, and as I am sure the other firms were discussing, the impacts of the matters I just discussed earlier on liquidity in the marketplace and we would have had those detailed conversations within our firm and we would have had conversations with Bank of Ireland in that regard.

And also, as I mentioned, I believe the meeting in February with the ... with the institute and the Central Bank was around ... was around the impacts of that crisis.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay, and you advised the group audit committee. What was the advice you gave them? You said, "Accordingly, we will update the Group Audit Committee ..." - that's the Bank of Ireland group audit committee, I presume, you're talking about there.

Mr. John McDonnell:

Yes, well, what happened was that the Bank of Ireland had considerably ramped up their approach to going concern and the going concern detail paper was not available ... was only just made available to us at the time of writing that audit committee report. So, what we did at ... verbally at the audit committee was bring, with management ... bring the audit committee through what the bank did to ensure itself that the going concern concept was appropriate to be applied in the bank. And the work that we did and we would've articulated - and I think it's in the minutes ... and management would have said why they were satisfied with the going concern concept ... we would've brought the audit committee through the work that we did, which I've mentioned to the Senator, and lastly, management would have concluded that they felt it was appropriate for the bank to continue as a going concern. We would've said that we were comfortable with that and the audit committee would've recommended to the board that they adopt the going concern concept.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Earlier in your engagement, I think it was Mr. Murphy or it could have been yourself, Mr. McDonnell, when Senator O'Keeffe was speaking to you about the banking experience held within your firm ... what was the extent of the property experience?

Mr. John McDonnell:

Our banking partners and staff are banking experts, what I mean by that is we're experts in the auditing of banks, we're experts in accounting for banks. We are not property experts but we would have ensured that our staff got appropriate training in what they needed to understand in the context of the auditing standards and the accounting standards and what they would need to understand to audit impairment of financial instruments. It's audit impairment as opposed to credit risk.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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But isn't it a case that, at the time ... that there was significant loan concentrations in the bank into the property sector and that that was going to ... that that had a relationship with the liquidity difficulties that the bank may actually encounter into the future? Would that have been seen, or even seen now, on reflection, as a necessary skillset or a deficit of skills, given the situation that was going to arise, or did it not?

Mr. John McDonnell:

Chairman, the concentration of credit risk is as a consequence of the bank's business model. The bank's business model is the responsibility of the bank's management and directors. Our responsibility, as auditors, is to consider material misstatement in the financial statements ... the risks of material misstatement in financial statements and that's the boundary of what we do. So, the fact that the bank had a concentration credit risk, we would've been aware of that, we would've discussed concentration and credit risk, we would've discussed property prices with the bank over various stages but in the context of their impairments models. And we would have identified to the bank that it was very important to keep their impairment models up to date. We would've also discussed with the bank the difficulties of keeping those impairment models up to date when property prices are under stress. We would've also discussed the growing loan book ... and the growing loan book in the context of impairment models. But, Chairman, our focus of our work, as prescribed by the rules, was on the approach that the bank took to determine impairment in accordance with IAS 39.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Just to clarify for the committee, before I bring in Senator Barrett, did your firm have the relevant property experience or are you saying to the committee this morning that property experience wasn't a required prerequisite of the skillset of your audit team?

Mr. John McDonnell:

We had the appropriate ... appropriate experience in property-related matters to conduct our audit and to be able to determine the appropriateness of the bank's impairment charges. I can say that.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Thank you. Senator Barrett.

Photo of Sean BarrettSean Barrett (Independent)
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Thank you, Chairman, and welcome to our visitors this morning. Could I start with the PwC document on page 25, if I may, please?

It deals with the transfers to NAMA which, from the Bank of Ireland, went at a 43% discount. Was that a surprise to the auditors?

Mr. John McDonnell:

No, Senator, it wasn't. That there was a difference between what NAMA paid for the assets and what the ... and the nominal amount of the loans that were issued ... it wasn't.

I'll just make a couple of comments around that, Senator. The first is that there was always going to be a difference between what NAMA paid for the loans and what the banks carry the loans at because they're calculated in two very different ways. Second point I'd make is that the 43% discount is a haircut against the amount that was lent. It is not a haircut against the carrying value in Bank of Ireland because the carrying value in Bank of Ireland would've included impairment provisions. Impairment provisions, as I indicated, are accounted for in accordance with the incurred loss model. And that means that you need, first off, an impairment indicator, so you need to have objective evidence of impairment. When you have objective evidence of impairment, you can book an impairment loss. Secondly, how you book an impairment loss is you take the expected cash flows from the loan, not taking into account future impairment indicators, and you discount them at the interest rate implicit in the loan. What was-----

Photo of Sean BarrettSean Barrett (Independent)
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Could I refer-----

Mr. John McDonnell:

The amount that was sold to NAMA was at effectively fair value, and that's a very different value. And as we know now that, when the loans were sold to NAMA, it was at the effective ... it was at the bottom end of the cycle, so therefore the fair value of those loans was a very different amount to the impaired value of those loans. They're calculated very differently.

And lastly, under IAS 39, the bank were not allowed to account for these loans at fair value, so they couldn't write them down to fair value and they could only book the additional loss when the loans were transferred to NAMA. Bank of Ireland were very aware of that and, in their December 2009 accounts, disclosed that they expected to take quite a substantial additional losses on the loans transferred to NAMA as a result of this calculation difference.

Photo of Sean BarrettSean Barrett (Independent)
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Thank you. Could I have core document BOI - RBU & LCR at page 14 displayed, please?

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Is it a Bank of Ireland document now you're talking about here?

Photo of Sean BarrettSean Barrett (Independent)
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It's a Bank of Ireland document, Chairman, and-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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That hasn't been provided with the witness. And I've said this to members already, if they're going to be introducing other questions that are outside the core book ... the core documents we have this morning, they need to be notifying the secretariat and the witnesses beforehand. Okay? Now, the witness may be ... I'll give you a bit of latitude here, Senator. The witness may or may not be familiar with it, but if they're not familiar with it, you're not going to press a question on it, but you can address generally to the theme. Go on.

Photo of Sean BarrettSean Barrett (Independent)
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Thank you, Chairman. The statement was made by Mr. Laurence Crowley, the governor of the Bank of Ireland, and his successor endorsed it - Richard Burrows - that, on both of their times as governor, "In particular, I do not recall any issues of imprudent lending being brought to a Board by the Executives of the Bank, the internal auditors or the external auditors."

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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On that.

Photo of Sean BarrettSean Barrett (Independent)
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Does that tally with your own experience? Did you ever have these discussions with governor Burrows or governor Crowley?

Mr. John McDonnell:

I personally didn't because I only came on in 2010, but I am conscious of the reporting that we gave to the bank. We would have discussed, as I said earlier, discussed the bank's business strategy only in the context of impairment of loans in the context of our audit work, so I'm not surprised that we wouldn't have had a detailed discussion about the bank's strategy to lending, because the bank's strategy of lending is for the role of management, the role of directors. Our role is bounded by the risk of material misstatement in the financial statements, and we would've had detailed conversations with the audit committee around the impact of their lending on their impairment and the controls over impairment, and that's where the focus of our work was. I can't discuss as to what the audit committee would've said to the court or not.

Photo of Sean BarrettSean Barrett (Independent)
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There is a statement in the Financial Timesof 27 February this year by Caroline Binham. In the UK, critics "of the big four accountancy firms will point to the fact that they gave [the] banks a clean bill of health only months before the onset of the worst financial crisis in a generation." It looks like Mr. Burrows and Mr. Crowley were given the same complacency from their auditors.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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You can't ask that question, okay? That's a leading question. Could you care to comment upon that as a proposition, that the advice that was given to Bank of Ireland would have maybe given a more benign position to what the true health of the situation was?

Mr. John McDonnell:

I think, Chairman, you have to look at what our role is. Our role ... and I know I'm repeating myself, but it's really important. Our role is to give an opinion on the financial statements. The financial statements ... the purpose of financial statements is to faithfully represent the past. A set of financial statements ... the bank enter into transactions, those transactions have an impact on the balance sheet, we give an opinion as to whether those transactions have been properly accounted for. It is not our role ... and there's been a lot of debate about this through the crisis and after the crisis. It's accepted that it was not our role at that point in time to give an opinion on the business model of the bank. That's the role of management. And very importantly here, our role as auditors are governed by the independence rules, and the independence rules say that we cannot get involved in management activities. So, we're not ... we can't get involved in the setting of the bank's business strategy. We can't get involved in the determination of whether it's right or wrong. That's for the purpose of management. Even the monitoring of the lending strategy is a management role. We have to be very, very careful that we don't cross that line or we cease to be independent. So thereby we focus in on what we were asked to do, and what we were asked to do under legislation and our letter of engagement with Bank of Ireland was to talk about whether transactions had been properly accounted for in the financial statements and whether impairment on those transactions were properly reflected in the accounting statement.

The impact of business model on future risks and the impact of business model on the future profitability of the bank is something for management, and I think ... that expectation gap I know is there, but that's what we did.

Photo of Sean BarrettSean Barrett (Independent)
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You were also auditing Northern Rock. Wasn't that correct?

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Hold on a second, now. We're drifting outside the terms of reference of this morning. Unless you've something germane and that's relevant to this morning's line of inquiry, Senator, I just have to ask you to move on.

Photo of Sean BarrettSean Barrett (Independent)
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Would the collapse of Northern Rock in 2007, including an Irish branch it had here in Dublin ... would that have been the topic of discussion between you and Mr. Burrows and Mr. Crowley?

Mr. John McDonnell:

I can't answer that because I wasn't there. I can say, as a firm, we would've discussed the collapse of Northern Rock. It was in the public domain. People were talking about it. People were talking about why it happened, but I just ... I don't know.

Photo of Sean BarrettSean Barrett (Independent)
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But PwC weren't just people. They were the auditors of Northern Rock.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Sorry, sorry. Senator, I'm going to have to ask you to kind of ... you're moving into a leading line of questioning, now, this morning. So, if you can ask questions rather than just make a series of statements, or else I'll have to move on because we've a particular line of questioning we do have to pursue this morning and I don't want to be taking up members' time by taking the questions myself, so I would ask them to-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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-----concentrate now on the programme of work that we have ahead of us.

Photo of Sean BarrettSean Barrett (Independent)
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Thank you, Chairman. The core document pages 59 and 60. No. That states on page 60, "No circumstances have come to our attention, in our capacities described in the schedule attached to this letter, that give rise to a statutory duty on us to report to you under section [s.]47 of the Central Bank Act, 1989." And that document is dated 18 June 2008. Now, under section 47 of the Central Bank Act, if I might quote it:

If the auditor of [the] holder of a licence [that's the bank]--(a)has reason to believe that there exist circumstances which are likely to affect materially the holder's ability to fulfil his obligations to persons maintaining deposits with him or meet any of his financial obligations ... or

(b) has reason to believe that there are material defects in the financial systems and controls or accounting records of the holder ...he shall report the matter to the Bank [that's the Central Bank] in writing without delay.

Was that how you found the bank on ... in June 2008, I think, as the Chairman has said earlier, within months of requiring rescue ... that there was nothing to report under section 47 of the Central Bank Act ... that you found in the audit?

Mr. John McDonnell:

Senator, under our obligations under law ... we have an obligation to report certain matters to the Financial Regulator. We do not have the right to report any other matters to the Financial Regulator. We just have an obligation to report some things ... certain matters. And that obligation arises solely out of our work as auditors. So it's only if something comes to our attention as ... when we are completing our work as auditors and, as I explained, our work on auditors looking at risks of material misstatement in the financial statements. Our audit approach is not about considering the bank's business model. And nothing arose from our audit that gave us an obligation to report to the regulator. We are required to, when nothing comes from our work that gives us an obligation to report to the regulator ... to give a negative ... a ... a ... statement that nothing has come to our attention and that is what we included in our annual report to our Financial Regulator at that point in time. And we would have also included with that annual report, a copy of our audit findings document for that point in time. And that audit findings document would have when into ... into detail about our identification of significant risks, our commentary on those significant risks and our commentary on the audit procedures we adopted to conclude our opinion on financial statements.

Photo of Sean BarrettSean Barrett (Independent)
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And is it a matter of any regret at this stage that you didn't send a report to the Central Bank under that section 47? Or do you still think that the deposits were entirely safe in June 2008?

Mr. John McDonnell:

No-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Just ask the ... Mr. McDonnell for his opinion. Whether it's a matter of regret or not, Mr. opinion ... or Mr. McDonnell will inform us.

Mr. John McDonnell:

Pardon, Chairman?

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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I'm encouraging the Senator just to ask the question. Whether it is a matter of regret or not is something that you ... you can disclose, Mr. McDonnell.

Mr. John McDonnell:

I stand ... we, as a firm stand, over our report to the Central Bank. It was an appropriate report to the Central Bank under the terms of our requirements under ... under the ... section 47 of the Central Bank Act. And it was an appropriate report to the Central Bank under that and PN 19. And it ... it was appropriate.

Photo of Sean BarrettSean Barrett (Independent)
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Would describing the bank at that stage ... and having the dialogue with the regulator, have improved our understanding of what was going on in Irish banking at that time?

Mr. John McDonnell:

We always welcome engagement with the regulator but, as I said, we hadn't ... we did not have the right to raise matters with the regulator. We would have met with the regulator where the regulator asked us to meet ... to meet ... asked to meet with us. We had interaction with the staff of the regulator but we did not meet the regulator himself over that period. I don't believe the staff of the regulator sought to meet with us in the context of our audit of Bank of Ireland.

Subsequent to the financial crisis there is a ... now an auditor protocol and we would meet with the regulator on a very ... a very regular basis - at the start of our audit, during the ... during the execution of our audit and at the end of our audit. And we welcome that engagement with the regulator and it's working very well. And also, the regulator has now started to ask us to ... to do specific work for them current ... around GL44 and that work allows the regulator to direct us to do certain work which might be of benefit to their role. The one thing I would say is the regulator is a very different role to the audit firms'. The regulator's role is about the safety and soundness of the banks, whereas a set of financial statements is around whether the financial statements give a true and fair view of past transactions and events. As I said in my opening remarks ... you know ... financial ... a set of financial statements are not about stability, they're not about capital adequacy and they're ... they're the primary concerns of the regulator. So they ... we've different objectives. But I do think it's good that we have engagement.

Photo of Sean BarrettSean Barrett (Independent)
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Yes, but could you expand on that engagement which we have now? Because the committee has to look at what we do going forward. So we'd be most interested-----

Mr. John McDonnell:

Under the-----

Photo of Sean BarrettSean Barrett (Independent)
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Do you meet? How frequently and what do you discuss?

Mr. John McDonnell:

Under the auditor protocol the auditors have engagement with the Central Bank and in the context of Bank of Ireland, that's all I can talk ... what .... what would happen is at the start of our ... our audit, the Central Bank would ask us to come in and for us to bring them through our audit plan ... which we would present to the audit committee. And I would go through that plan in detail with the Central Bank. I would bring them through what we consider to be the significant audit risks, why we consider them to be the significant ... significant audit risks and the type of testing we plan to undertake.

Secondly, we would bring them through our ... our assessment of materiality. And lastly, we would bring them through the ... our timetable and our ... our expected communications with management and the audit committee. We would discuss that in a degree of detail and we'd take comment from the regulator. Secondly, then, probably it could be early December, early January, we would have a meeting with the regulator where they ... that ... where we would bring them through where we are in the context of our work and anything that has arisen from that. And lastly, then we would have a meeting with the regulator after we had concluded our work and that might ... would probably be after we signed the financial statements ... whereby we would discuss with the regulator the final ... the final outcome of our work. But as I ... as I would point out, the regulator would ... would also get access to our audit plan documents and our audit findings documents.

Photo of Sean BarrettSean Barrett (Independent)
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Chairman, could I ask for BOI B1 to be displayed please?

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Bank of Ireland booklet ... you'd have to give notification prior to the ... if it's just a statement from it you want to use Senator Barrett, I can allow you to read it out and maybe ask Mr. Murphy or Mr. McDonnell to comment upon it.

Photo of Sean BarrettSean Barrett (Independent)
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Thank you, Chairman. I'm just wondering - and thank you very much, Mr. McDonnell - if these are the kinds of discussed ... it's from a Bank of Ireland document at that ... "ANALYSIS OF THE REASONS WHY THE INSTITUTION RAN INTO DIFFICULTY", and it lists the following items at the end of page 17:

[The B of I] issues ... revolved around the:-
  • the absolute quantum of property lending ...
  • ... greater dependence on-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Senator, I'm going to have to .... you need to reference the document in full for me. But I would advise members very, very strongly that if they are going to be introducing documents that are not on the core listing for this that there is plenty of notification to be given to witnesses in advance because the full context of what is actually being delivered is not being given to the witness. So, can you just reference the document for me in case I have to go and find this and produce this to the witness?

Photo of Sean BarrettSean Barrett (Independent)
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It ... it lists issues that are felt to be important in discussing the Bank of Ireland in relation to its rescue - property lending, wholesale markets for funding, greater reliance on securitisation and going into some businesses that they weren't equipped to ... were ... are property lending and wholesale funding ... are they part of the discussions you have with the regulator under the new dispensation?

Mr. John McDonnell:

The discussions we have with the regulator would be on our approach to the audit of impairment and we would articulate where we would see risks ... where we would see risk in the context of our audit of impairment and how we plan to execute our work to address those risks. Again, I have to say that our audit work is purely around the risk of material misstatement. It's not around the business model. So that's what we discuss. We discuss our approach of the audit of Bank of Ireland.

Photo of Sean BarrettSean Barrett (Independent)
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But would risk include the risk of excessive concentration of lending into the property sector, for example?

Mr. John McDonnell:

The risk would take into account the impact of what the bank has done on its loan book, its loan stock, and its loan provisions. And we would consider that in the context of how the bank goes about determining its provisioning and in the context of the audit procedures we need to adopt to audit that provisioning. That's where it begins and ends. We're concentrated on what has happened in the past, we're concentrated on how that is reflected in the financial statements and we're concentrated on the risk that it may not be properly reflected in the financial statements. And that's what we do. It is ... you know, business model, sustainability, capital adequacy - all that is a matter for management and a matter for the regulator in the context of their work on safety and soundness. Our work is to give an audit opinion in accordance with the rules on which we are guided by.

Photo of Sean BarrettSean Barrett (Independent)
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O02300 type: 1 -->

Does risk include reliance unduly on wholesale funding rather than deposits?

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay ... if that's when your ... we're moving in now to an operational matter ... for the bank as opposed to what are actually operational procedures and auditing measures for the firm that's actually before us. Mr. McDonnell is already on record as saying that he ... clearing ... making a clear distinction between what are bank operations and what are auditing operations. So, Senator, I'll have to push you back into that space or else I'll just take the questions myself.

Photo of Sean BarrettSean Barrett (Independent)
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Thank you Chairman. The signing of the documents by the names PricewaterhouseCoopers, is that anachronism these days? We have had people saying that, perhaps, the individual partners and auditors should be the people responsible. I suppose we don't sign ourselves as Seanad Éireann or Dáil Éireann or Trinity College Dublin. I mean, are we moving towards an area where auditors will be expected to take responsibility for the work that they conduct rather than the corporation?

Mr. Ronan Murphy:

Maybe, Senator, I might just answer that. The historical background is that as partners in the firm you're signing the firm's name so you are committing the firm, so therefore, it is being signed on behalf of all of the partners in the firm. The practice nowadays is that partners do sign in their own name but John can give you more details in terms of when that came into play but it is ... it has been always the practice in the past that you are committing the firm and the firm is standing behind the opinion.

Mr. John McDonnell:

Yes, and Ronan is correct. I think that from 2013 you now sign in your name so that the market now knows the partner personally who signed the opinion but it is also for and on behalf of PricewaterhouseCoopers, so when I sign a set of accounts for Bank of Ireland I'm signing on behalf of myself and I'm signing on behalf of the firm. And I would take that ... I'd take the signing of that opinion very very seriously because it has significant impact on the firm and it also has significant impact on me personally.

Photo of Sean BarrettSean Barrett (Independent)
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Should there be a disciplinary action against individual auditors?

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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On the basis of what, Senator?

Photo of Sean BarrettSean Barrett (Independent)
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On the basis that they are taking more responsibility rather than signing in as PricewaterhouseCoopers, for example.

Mr. John McDonnell:

I don't think there's any distinction between signing as PricewaterhouseCoopers or signing as John McDonnell on behalf of PricewaterhouseCoopers, Senator, because as I explained when I sign an opinion or when a partner signs an opinion it binds the firm. It is the firm's opinion signed by a partner acting on behalf of the firm but that partner is the partner who has done the work and that partner takes that role very very seriously.

Mr. Ronan Murphy:

And we are subject, Senator, to the investigation and disciplinary procedures of the Chartered Accountants Regulatory Body and that has not changed given the change in protocols regarding the signing of opinion. So, we are still subject to those very intense regulatory and investigative procedures.

Photo of Sean BarrettSean Barrett (Independent)
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Is the regulation of accountants less strict in Ireland than in the United Kingdom or the United States, where fines have certainly been substantially larger in both jurisdictions?

Mr. Ronan Murphy:

I don't believe so, Senator. As I say, we are subject to CARB, which is the short name for the Chartered Accountants Regulatory Body. They are subject to oversight by IAASA, so we have a very proactive regulatory regime, which would be similar to the situation in the UK and the US.

Photo of Sean BarrettSean Barrett (Independent)
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And has that proactive regime been-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Final question Senator.

Photo of Sean BarrettSean Barrett (Independent)
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Yes. Has it reacted appropriately to what is a bigger bank collapse in Ireland than in the other two countries?

Mr. Ronan Murphy:

Senator, it's hard ... I mean, has it reacted appropriately? It has reacted to circumstances, not only in terms of the financial crisis but also previous circumstances. It is a very proactive regulatory regime that we operate under.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay. Thank you very much. I want to turn to one matter there, please, before I bring in Deputy O'Donnell and that's in regard to the NAMA-acquired loan portfolios from Bank of Ireland. This is in the core document, page 25 - annual report and financial statement. So, in there when NAMA acquired the loan portfolios from Bank of Ireland, NAMA imposed a haircut of over 43% on the nominal loan on the value of assets at that particular time and Senator Barrett touched upon this with you. Can I maybe just ask, were you satisfied with the valuation methodology used by Bank of Ireland assessing the value of Bank of Ireland's land and development loan book and the potential impact upon the subsequent provisioning?

Mr. John McDonnell:

Sorry, Chairman, just so I understand ... the valuation in the context of what NAMA paid or in the-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Yes, the 43% haircut.

Mr. John McDonnell:

What NAMA paid, Chairman-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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I'll take you to the acquired loans asset document that's in front of you there.

Mr. John McDonnell:

I can see ... yes.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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If you look at it ... on table 3 on the right-hand top corner of it, there is the Bank of Ireland loan balance transferred, a €9.9, I presume these are billions, consideration paid €5.6 billion, discount 43%.

Mr. John McDonnell:

Yes, okay. So, is it the calculation of the €5.6-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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I'm asking you were you satisfied with the valuation methodology used by Bank of Ireland in assessing the value of their land and development loan book before it went into the haircut?

Mr. John McDonnell:

First off, the amount that NAMA paid was a matter that was driven by the legislation which brought in NAMA. The bank had no ability to impact that at all. NAMA just paid them what they paid them. That amount was a close to a fair value-type calculation. The nominal value is before provisions so that's not the carrying value at Bank of Ireland at the time that it was transferred, it's the amount that was actually lent and Bank of Ireland would have determined the carrying value of that, taking into account that loan balance and appropriate impairment provision, calculated in accordance with the incurred loss approach. And, as I said, Chairman, as part of our audit work, we would have focused very heavily in on the audit of impairment and we were satisfied to give a clean audit opinion at that point in time. So, we had no issue in terms of the calculation of the carrying amount of the loans at the balance sheet date prior to when they were sold to NAMA and, as I said, the bank couldn't influence the amount that NAMA paid because that was set by legislation. They're two very different calculations. They will always be different.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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But, can you provide any explanation to the committee this morning as to why the NAMA high cut, rather than NAMA haircut, was so high, Mr. McDonnell?

Mr. John McDonnell:

Yes, because the NAMA haircut was a close to a current fair value for the loan and given the very depressed state of property prices, fair values were always going to be lower than in an incurred loss value. And, as I said earlier on, Chairman, the bank had no ability to fair-value its loans in its financial statements. It was required to account for them at amortised cost, which is basically what you lent less your incurred loss impairment. The two numbers are calculated differently and because we were at, as we now know, the bottom of the cycle, fair value was always going to be below the amortised cost amounts, so it was always going to be different. And, as I said, Bank of Ireland were critically aware of that and that's why they disclosed in the financial statements 31 December 2009 that they were going to make substantial losses on the disposal of loans to NAMA and they also would have, I believe, explained why those losses could not be recorded in accounting standards until the loans actually transferred to NAMA.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay, so can I just check for the record so Mr. McDonnell, were PwC aware of the fair value of these loans when signing off on the account?

Mr. John McDonnell:

We would not have audited the fair value of those loans because the bank were not allowed ... the bank had accounted for these as loans in receivables, they were not allowed to fair-value them. That's the first point. Secondly, when we audited the 2010 accounts we would have had to audit the gain or loss on the disposal to NAMA and as part of that audit procedures, we would have looked at the amount of which NAMA paid the bank for the transfer. But, as I said, NAMA dictated that. The bank did not have any real influence in determining what that price was. It was set by legislation. So, in this instance NAMA would say we're paying €5.6 billion for the loans and that's what NAMA paid and we would have ensured that that's what NAMA paid. We wouldn't have audited the NAMA calculation because there was no ... we didn't have the basis first off for the NAMA calculation, that was what NAMA did and, secondly, it wasn't particularly relevant because NAMA was going to pay what NAMA was going to pay and they paid €5.6 billion. And, we would have ensured they paid €5.6 billion.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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So, what was the difference between the fair value and the IAS 39 valuation when it all panned out?

Mr. John McDonnell:

I don't have the numbers ... I don't have the numbers, Chairman, but it was-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Was there a difference?

Mr. John McDonnell:

Oh, yes there was ... it would've been disclosed in the accounts. I can give you the December '10 number if that's of help.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Yes.

Mr. John McDonnell:

It wouldn't be the total amount. I think it was ... I think the bank would have booked a loss on the disposal to NAMA of about €2.2 billion but I just need to check it ... yes, loss on sale of assets to NAMA and associated costs, €2.2.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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€2.2. Thank you very much. Deputy Kieran O'Donnell.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Thanks, Chairman. Mr. McDonnell, for a layman, we have a lot of technical terms here ... how would you define true and fair ... "true and fair view"?

Mr. John McDonnell:

That the accounts had been properly prepared in accordance with the appropriate accounting framework, which is IFRS.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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What about reflecting the actual financial position of the state of the bank at that particular moment in time?

Mr. John McDonnell:

The purpose of the set of financial statements is to faithfully represent the past transactions and events ... the accounting standards are brought in to direct management as to how to do ... how to measure their assets and liabilities in the context of reflecting past transactions and events. And, where a financial statement ... sorry, where an accounting standard is prescriptive in how one must measure and recognise an asset or liability and it is specifically directed at the measurement or recognition of an asset or liability, you must apply that accounting standard to that measurement and recognition, otherwise the accounts will not give a true and fair view.

Once an accounting standard says this is what you do, you have to follow that otherwise you could not say the accounts give a true and fair view. That's the way it works. The accounting standards come in, they set the rules and they set the boundary, if you like, on true and fair.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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The 2000 ... year ... the year end for Bank of Ireland is 31 March every year ... was back then. So the year 31 March 2007 and the year 31 March 2008, you would've audited the company's accounts and you gave technically ... which was an unqualified audit opinion ... an independent audit opinion. In layman's terms ... someone reading the accounts, you did not criticise the accounts in any way. So the question, I suppose, I want to ask is in light of the fact ... you signed your audit report for 31 March '08 accounts on 20 May '08 and within literally four months of that date a bank guarantee had to be brought in to effectively secure the deposits and liabilities of Bank of Ireland, which was from the taxpayer. And within a short period of time of that again, within another what ... four months, the taxpayer had put €3.5 billion of their money into Bank of Ireland. Now looking at that in hindsight, did the accounts show a true and fair view or not?

Mr. John McDonnell:

Yes, the accounts did throw ... show a true and fair view. As I said-----

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Why?

Mr. John McDonnell:

-----financial statements are a point in time representation of the assets and liabilities in accordance with accounting standards.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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But, Mr. McDonnell, you have said here that there was a liquidity crisis from late 2007 onwards. You had discussions with the regulator amongst the four big firms in Ireland, including PricewaterhouseCoopers, on 10 January 2008, around the whole area about how you'd value securities. That was once again around liquidity. So the question I'm asking here is, to the layman looking in, how did you not in any way criticise the accounts? You wrote to the regulator on ... document Vol. 1 PwC, Chairman, page 59 and 63 ... and you were required to report to the Financial Regulator ... and once again you drew reference to nothing to do with liquidity, not one mention of solvency-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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You have to give time to respond because otherwise you'll run out of time for your questions.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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The question I am asking once again, Mr. McDonnell, to the ordinary person looking in ... how could you give a report that was in no way critical of '07 or '08 accounts in respect of Bank of Ireland?

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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The question's made. Mr. McDonnell and Mr. Murphy, whichever.

Mr. John McDonnell:

As I said in my opening remarks, financial statements are about giving a faithful representation of past transactions and events. No, that's important-----

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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I know that-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Sorry, Deputy, now I will have to interject. If you are going to take a couple of minutes asking a question, you at least have to accommodate the same amount of time for a response. Mr. McDonnell, please, without interruption now.

Mr. John McDonnell:

-----and the auditor's job is to give an opinion as to whether those accounts give a true and fair view in accordance with the requirements of accounting standards. That's what we did. We did that work very thoroughly, very robustly and we stand over our opinion. As I said in my opening remarks, there is no ... avenue in either the wording ... the prescribed wording of an audit opinion, or indeed in the accounting and regulatory framework which sets out what goes into a set of financial statements to allow an auditor to give a subjective view on an entity's business model. That is not what we were asked to do, it is not ... there is no ... we are not allowed to-----

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Yes, but Mr.-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Deputy, I'll bring you back in when Mr. McDonnell is finished, yes?

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Chairman-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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No, and keep your questions short, Deputy, if you want plenty of time. Mr. McDonnell.

Mr. John McDonnell:

From an independence perspective, we have to be very careful that we don't get into the role of what management do. What we were asked to do was say whether the accounts gave a true and fair view at that point in time. We conducted our work appropriately, we conducted our work with the proper due diligence and we were satisfied that our opinions were appropriate.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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But the question I have, Mr. McDonnell, is based on the fact that €3.5 billion of taxpayers' money went in to Bank of Ireland within a relatively short few months, in hindsight now do you believe the accounts showed a true and fair view at 31 March '08?

Mr. John McDonnell:

Yes I do.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Okay. Can I move on from that? In terms of your analysis of risk, the issue in terms of auditing is materiality. So how do you define "materiality" Mr. McDonnell?

Mr. John McDonnell:

Materiality is both a qualitative and quantitative aspect, we would look at a number of things when we're talking about it. Quantitatively, we'd look at key drivers in the financial statements. They would be the net banking revenue line, we'd look at PBT, etc., and maybe to cut-----

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Mr. McDonnell, in the limited time I have, what-----

Mr. John McDonnell:

Okay. Our materiality would-----

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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-----what would be the percentage of materiality based on ... give a benchmark, what ... did you change-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Question today, Deputy, so please don't be using up your time.

Mr. John McDonnell:

Our materiality over that period would have been in and around ... in and around maybe €70 million to €50 million, depending.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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€70 million to €50 million?

Mr. John McDonnell:

Depending.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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On a particular item?

Mr. John McDonnell:

Yes, depending on a number of items and our-----

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Did you adjust that materiality when the crisis hit in '07 and '08, to take account of risk?

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Question is made.

Mr. John McDonnell:

We would set our materiality the same way taking into account the likely ... taking into account the result ... the expected results of a bank.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Did you change your materiality when the risk period came?

Mr. John McDonnell:

We did not change our approach to materiality.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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At all?

Mr. John McDonnell:

No, but-----

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Why not, considering the risks?

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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The question was made, a bit of time to respond.

Mr. John McDonnell:

Materiality is looking at the disclosed performance in a set of financial statements so if a bank loses, let's say ... a large number of ... let's say a bank loses €10 billion, let's say they do - your materiality is prescribed around that number. So it's not driven by ... necessarily by the risk, it's driven by the performance in the financial statements and the numbers in the financial statements.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Can I move on to the item? The level of audit fees that you would have earned from the audit, Mr. McDonnell ... was the ... in 2008 you got €4.9 million and overall you got €10.8 million from Bank of Ireland. Was that your highest audit fee?

Mr. Ronan Murphy:

Senator ... or Deputy, I don't recognise that figure. Could you just quote it again please?

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Where is it coming from please?

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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In 2008 PwC received €10.8 million-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Deputy, if you are referencing it you can just give the inquiry ... inform the inquiry-----

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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It's the external auditors' fees by institution 2004 to 2010.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay. What's the reference?

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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We were provided with it by ... it's a sheet given to us by the secretariat, Chairman.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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So the question really I have is twofold. Number one - in 2008 the €10.8 million, which was the total fee - €4.9 million for the audit and €5.9 for the non-audit - was that your highest single fee? And, secondly, from a ten-year period up to 2009 it's reported that, between audit and non-audit income, you got over €100 million for Bank of Ireland and about ... you could take it that €56 million of that was non-audit and about €50 million of it was audit. Did that in any way conflict you ... to have that level of fees coming in from one single client?

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Or not.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Or not.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Please, Deputy. I'll be calling members in when we go to recess to actually have a private meeting with you when we go to a break at the recess please.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Or not.

Mr. Ronan Murphy:

Chairman, can I answer that question just in relation to the fees and ... the schedule which we have here is extracted from the statutory accounts-----

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Yes.

Mr. Ronan Murphy:

-----and the period you are talking about Deputy is the year to 31 March 2008.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Correct.

Mr. Ronan Murphy:

Fees in that year were €9 million, of which €8.1 million were audit and audit related and €900,000 were non-audit fees. So in relation to your question regarding independence, the non-audit fees were just about 10% of the total fees. So, therefore, it would be wrong to say there was any potential impairment of our independence given that small percentage.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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How does this relate to being-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Final question, Deputy.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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---being the ... was it your largest fee, combined?

Mr. Ronan Murphy:

In that year it was certainly one of our three largest fees. I can't be certain whether it was the largest fee in that year. Some years the Bank of Ireland fees were the largest but throughout that period it was one of our three largest fees.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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How did you ensure that couldn't be-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Sorry, the question's made and I'm moving on.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Final question, Chairman, just one final question. How did you ensure that there wasn't conflict of interest where you had one client, Bank of Ireland, having ... commanding such a large level of fee?

Mr. Ronan Murphy:

Well, I think, when you look at that figure of €9 million in terms of total fees ... the fees for Ireland in that year were €6.7 million. Chairman, our revenue is not in the public domain ... sorry, it is now because of the requirement on transparency reports, but I will disclose that our revenue in that year, the total firm fees was €231 million.

So the quantum of fees that we received from Bank of Ireland was less than 3% of our total fee income. There's a requirement under the Auditing Practices Board ethical standards that no client should pay you more than 10%. We were well short of that in terms of the quantum of fees.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay, thank you very much. I'm now proposing that we take a break. We'll return at 11.30 a.m. but I would ask the committee just to remain in the committee room for a couple of moments before we suspend. During the suspension, I'd like to remind the witnesses ... remind them that once they begin giving evidence to the committee, they should not confer with any other person other than their legal team in relation to their evidence or matters that're been discussed before the committee. With that in mind, I now suspend the meeting until 11.30 a.m. and remind the witnesses that they are still under oath until we resume.

Sitting suspended at 11.11 a.m. and resumed at 11.43 a.m.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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I am going returning to public session, is that agreed? And just to thank Mr. McDonnell and Mr. Murphy for joining us again this morning, and, in doing so, I invite Deputy Joe Higgins. Deputy, you've ten minutes.

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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Yes ... Mr. McDonnell, you've said that the audit process goes on over the year and you said about 200 employees would be involved in the Bank of Ireland audit, but just very, very briefly, for people out there and ourselves, could you just physically tell us how is the audit done? Like, does a small army of 200 leave Spencer Dock, march to the headquarters, or do they fan out around the country, or how does it work? How do you get the information and so on?

Mr. John McDonnell:

We start off, Deputy, at the start we design our audit plan, and, as part of that audit plan, we determine what we would consider to be the significant risks of material misstatement, and then we also would look at the other risks of material misstatement. Then we would design the tests that we need to apply to get appropriate audit evidence for each of those. We have a detailed audit methodology designed by the firm and we would apply that. We would sit down at the start and have a mobilisation meeting with our team, bring our team through where we want them to focus and what we want them to do, and, as I said earlier on, Deputy, we would have a retail team for the retail audit, we'd have an insurance team for the insurance audit, a treasury team for the treasury audit, a UK banking team for the UK banking audit. I would issue instructions to all of the teams. We would then mobilise the teams and the teams would then set about testing the various transactions in line with the instructions issued by the audit partner and in line with our audit methodology. We apply a consistent approach across the patch so that-----

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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Yes, but how do they do that? Do they go into all the branches or to the headquarters, or-----

Mr. John McDonnell:

They would go into the ... they would go into various headquarters of the group, so various buildings, the insurance building, the treasury building, the head office building, etc.

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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And Bank of Ireland will have compiled what happens in a range of branches-----

Mr. John McDonnell:

Bank of Ireland would have detailed systems and controls over all the processes and transactions which arise in the various branches and arise in the various operations.

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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And then they have access, what, to computers, to information networks or to paper, or-----

Mr. John McDonnell:

Our teams would have access to the Bank of Ireland systems, their computers, their controls, their books and documents, and we would also have our own computer processes that we bring with us to allow us to audit, so we'd audit both physically and we'd also audit by computer, computer auditing.

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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Okay. Now Bank of Ireland was organised along divisional lines and different divisions had separate management information systems. And there was issues arising with difficult-to-manage credit and risk groupwide ... in the Oliver Wyman report, 20 May 2015, it says, summarises, that in relation to information available to the board on the credit risk, and I quote "Incomplete heterogeneous'-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Page 9 and 10, Joe, is it? Page 9 and 10?

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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Page 10, yes - "incomplete, heterogeneous and difficult to collate". Now, were you satisfied that you had full access to the, and accurate information to discern the full financial position of Bank of Ireland, considering these issues?

Mr. John McDonnell:

Yes, we were satisfied that we had access to the bank's systems and their operations and the books and records to allow us to formulate our opinion. Two things I would say, in the context of their having a load of disparate systems, that's not unusual in the audit of a financial institution, or, indeed, any entity. Any entity would have a lot of different computer systems. The important thing is is that there are controls over how those computer systems talk to each other, and also there are controls over any manual interventions. So while it would be ideal to have one platform, you'll rarely see that platform; so it wasn't unusual that Bank of Ireland would have a disparate set of systems in their divisions, but what was important is they had appropriate controls over how those systems rolled up together. In the context of the Oliver Wyman report, the Oliver Wyman report was around credit governance, whereas, as I said, our role is solely on the focus on material misstatement in the financial statements, so, in that regard, our role was around the audit of impairment, and impairment is a small subset of the overall credit risk methodologies.

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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And when it comes to risk, what is the legal role of the auditor? For example, as you know there have been issues with concentration in property and construction, and then there has been the concentration around a small number of developers in the case of some banks. Do you have a role in advising on the wisdom of lending, let's say, tens of millions to buy a field just for speculative reasons? Do you have a role in that?

Mr. John McDonnell:

No, Deputy, we do not have a role in that. Our ... the beginning and ending of what we look at, in terms of risk, is the risk of material misstatement in the financial statements, that is, that impairment is properly calculated in accordance with accounting standards. We do not have a role in determining the bank's lending strategy, or in the appropriateness of lending strategy, and, as I mentioned earlier on, we have very strict independence rules, which means that we cannot stray into management decisions or management responsibility. So we are actually prohibited from being involved in the decisions of how an entity sets its business model or how it runs its business; that's for management. What our role in ... is, is to report at the end of the year on the transactions which fell out of that business model, that they were properly accounted for. That is where our role ends.

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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So if PwC representatives came across in a situation where they saw a €50 million loan for a few fields west of Mullingar, and €40 million for a few more fields in west Cork, which is on the basis of value to be realised, on the basis of speculation that the property that will be built on those will go up, etc., etc., the auditor might think, "This really is unwise". Would the auditor, you, tell me, or do you, that has no role in that?

Mr. John McDonnell:

We have no role in determining the ... in advising management on the wisdom of their business model or, indeed, of the wisdom of entering into particular lending strategies. What we do do is we select a sample of loans and we, on foot of our audit work on those loans, we would look at the collateral supporting those loans, but only in the context of the determination of impairment.

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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So you do have a role in examining the security that would be put up to guarantee those loans, is that correct?

Mr. John McDonnell:

In terms of when we would select a sample of loans to do our audit work, as part of that sample we would look at the collateral supporting those loans, yes.

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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Yes, then, I notice Mr. McDonnell, in your PwC half-year review, which is in the documents, page 19, there is grave concern expressed here in relation to that very point, the valuation of loans, of financial instruments. For example, in the middle of page 19, your people say, "In cases where prices are obtained in the market, but these prices are not based on actual trades, consideration needs to be given to the appropriateness of the prices." In the middle or to the latter end of 2007, isn't that raising a very, very serious question? And is there an implication here that there is a fear that there isn't adequate collateral for large loans?

Mr. John McDonnell:

This part of this document, and as I would have referred to Senator O'Keeffe, this was the document we issued in response to the impact, the first impact on the liquidity crisis as a result of the subprime in the US. We would have issued this to all of our banking, and, indeed, non-banking, clients. But this paragraph, this is the first page, on page 19, is around financial instruments accounted for fair value and loans and audit account for fair value and it is really around how one values holdings in securitisation vehicles, how one values credit derivatives, because the level of trade in the securitisation market had decreased quite substantially and, therefore, it was difficult. Markets were thin and it was difficult to determine whether a trade in the market was actually a fair price or whether there was no trades in an active market. And that is what this is focusing on. It is not focusing ... page 19 is not focusing on impairment of assets which are not carried at fair value, which are normal loans and advances.

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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But, in general, did you ever perform a review on the valuations received for assets offered as security?

Mr. John McDonnell:

We would have selected a sample of loans. As part of the testing of the sample of loans, we would have looked at the security and we would have looked at the valuations of the banking-----

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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And was PwC satisfied with the valuation policy in Bank of Ireland?

Mr. John McDonnell:

The bank ... the policy for valuation in Bank of Ireland was appropriate policy for the determination of impairment and we would've looked at that. We would've looked at the valuations that Bank of Ireland would've had for its collateral in our sample of loans.

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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How do you explain then that the bank was left so disastrously exposed in the crash a few months after this document, for example?

Mr. John McDonnell:

The bank would have had a strategy to lend in certain sectors and as a result of that strategy, they would've built up exposure in certain centres, certain sectors, and as we moved into the credit crisis, the property values collapsed and as a result of property values collapsing, they would've experienced impairment, which is consistent with what we would've seen in the ... elsewhere in the marketplace and consistent with what we would've seen across the globe. The actual impact of the credit crisis is that stock markets, property markets, all sort of other markets collapse in the prices. And people did not expect such an unprecedented collapse.

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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Yes, but Mr. McDonnell, the evidence given by NAMA chairman and chief executive here was damning, I would say, by ... in what they wrote in relation to issues of the security and the non-examination of security for very large loans who were left out. You didn't come across this in your audits in Bank of Ireland?

Mr. John McDonnell:

Sorry, Chairman, in the context of Bank of Ireland ... I am not sure what-----

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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No, I didn't say this. They didn't specifically refer to Bank of Ireland. They were speaking in general in relation to the banks whose loans finished up in NAMA.

Mr. John McDonnell:

I can't comment for any of the banks that we obviously didn't audit. In terms of Bank of Ireland, Bank of Ireland would've had very detailed procedures around the perfection of the security. We would've looked at those procedures and they would've had very detailed controls around ensuring that they perfected security, and we looked at those controls. And, certainly, when a loan moved into an impaired category, the level of control and the level of scrutiny would've increased quite substantially.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Thank you Deputy Higgins. Deputy Doherty.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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Go raibh maith agat, a Chathaoirligh, agus fáilte roimh an bheirt agaibh chuig an coiste fiosrúcháin. Can I ask you by asking you first of all, can you recall any issue which may have warranted a qualified report, which was discussed with the bank but did not feature in the management letter, the final year-end report?

Mr. John McDonnell:

No, I am not aware of any such matter.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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So, is it the case or not that for the years PwC audited the bank, no issue arose during the audit that necessitated a qualified report?

Mr. John McDonnell:

No, no such issues arose.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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No such issues arose. Mr. Murphy, on page 10 of your opening statement, you referred to the practice note 19(1), and this can be answered by either of you, and you state and I quote: "...there may be circumstances where the auditor concludes that a matter does not give rise to a statutory duty to report but nevertheless feels that in the public interest it should be brought to the attention of the Financial Regulator". To your knowledge, were there any cases where this happened?

Mr. Ronan Murphy:

Deputy, in the case of Bank of Ireland, there were no cases.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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There were cases?

Mr. Ronan Murphy:

There were no cases.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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There were no cases?

Mr. Ronan Murphy:

Correct.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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So, to your knowledge, there were no cases when the auditor came across something on the book of the bank that, while within the rules, was, nevertheless, a cause of concern?

Mr. Ronan Murphy:

Deputy, what we're saying here is that in the context of our requirements to report to the regulator, and John covered it in the earlier part of the ... of our evidence, nothing came to our attention under the requirements from the Financial Regulator to report to them on any matters.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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Yes. The question that I am asking is not in relation to what you're required to report, which is in ... again, in your opening statement, you talk about the statutory duty to report, but you go on to say but "nevertheless feels that in the public interest it should be brought to the attention of the Financial Regulator," that it allows an auditor ... and I will read it again: "where the auditor concludes that a matter does not give rise to a statutory duty to report but nevertheless feels that in the public interest it should be brought to the attention of the Financial Regulator". So there was, and correct me if I am wrong, but from your statement, my reading is that there was an ability to report issues that were not statutory and an obligation on you to report, if you felt it was in the public interest?

Mr. Ronan Murphy:

Correct.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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Correct. So, again, back to my question, were there any cases where the auditor came across something on the books of the bank that, while within the rules were, nevertheless, a cause of concern for the auditor?

Mr. Ronan Murphy:

No.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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No. So ... okay. So during the auditing process of Bank of Ireland, you have never identified any issue that was a cause of concern?

Mr. Ronan Murphy:

No, that it was a cause of such public concern that we should bring to the attention of the regulator. That's correct. We haven't.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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Okay. How do you ... where is the tipping point in terms of such a concern that it was of the public interest?

Mr. Ronan Murphy:

I mean, Deputy, that's a question of professional judgment. It would be very much a decision reached by the audit partner, being John in the case of the last five years, supported by the quality review partner and our internal processes. So it would not be a decision that we would arrive at lightly.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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Okay.

Mr. John McDonnell:

And, you know, our right to report is prescribed in PN 19 and prescribed by law. So while we would be able to report matters, as Ronan said, if we believe they're appropriate under common law, it is only in the context of the output of our audit procedures that that arises too. So it's only in the boundaries of our audit.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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Okay. But it did go beyond the statutory requirement to report certain matters; it allowed you to report additional issues that you observed during the audits.

Mr. Ronan Murphy:

Correct, yes.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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Okay. When Brian Goggin, the former group chief executive of Bank of Ireland gave evidence before the committee, he said in relation to commercial property exposure, and I quote him: "€13 billion was in land and development and even again I think you'd need to look behind that, €5.4 billion of that €13 billion was in land bank. I think that is where the real problem was, in land bank." I want to refer you to page 16 of the PwC group audit findings report on 31 March 2008. This page is not in the core booklets, but it has been given to you and the reference number for the screen is PwC 00047-016. There is a brief mention of commercial property and land bank and I am going to quote that. It says: "BB UK [which is Business Banking UK] has exposure to some higher risk areas, such as land bank, commercial property and other less secure types of lending and as a result the risk of latent bad debt is on an upward curve." Can I ask you: did PwC observe a similar exposure with regard to the Irish operation of Bank of Ireland?

Mr. John McDonnell:

This is I believe our reporting on the UK operations. We would have looked at impairment on all of the property books and we would’ve seen and would’ve reported to the audit committees in various stages. We would have seen the increase in property across Bank of Ireland and we would have also discussed with the audit committee the impact of the growing loan book and the impact of that on their impairment models. We would have also discussed at various stages the impact of the falling of property prices on and, particularly the speed which with, with which, apologies, property prices fell at certain stages and we would’ve reported that to the audit committee. And the last thing we would have reported to the audit committee was around how incurred loss was reported and how there was a market, how there was a lag between ... in the reporting of incurred loss and expected loss. We would’ve discussed all of that with the audit committee and with management out of the process of our work.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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Okay. Can you explain to me why, in relation to the audit of the UK division of Bank of Ireland, that you felt it necessary to make that point in terms of commercial property and less secure types of lending and the result of the risk of latent bad debt is on an upward curve but that same type of statement did not find its way into the audit of the Irish division of that bank?

Mr. John McDonnell:

I’d need to look at our audit findings report for the Irish division. I’m sure we made comments on property in the Irish division. I can look, I have it here.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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Okay.

Mr. John McDonnell:

It might take me a minute to find that.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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Okay. Well. If you want to-----

Mr. John McDonnell:

In May 2008, retail, which is Ireland, key concerns centre on residential, developmental, landbank, finance ... distressed activity has resulted in a number of mid-tier developers coming under pressure to service a debt and result in significant increase in provisions within the business lending book. Reduction in activity in the construction sector is also implied on personal lending to those involved in construction and construction-related activities.

Mr. Ronan Murphy:

That is page 14 of the report.

Mr. John McDonnell:

That is page 14 of the group audit findings report on 12 May 2008. And that retail is the Irish operations.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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Okay, and that covered a range of areas. It didn’t specifically identify commercial property as an individual area as ... which was identified in the UK division.

Mr. John McDonnell:

Well, it ... yes, but it did mention landbank property.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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Okay. Okay.

Can I ask you in relation to financial reporting, the same report and this is on page 29, section B, the reference on the screen is PWC00047–029. It makes the following observation with regard to:

The high level of aggregation in the choice of loan types used to disclose credit risk information. Only 3 classes of loan exposure are disclosed being mortgages, personal and commercial. This choice assumes that loans in each class share sufficiently common credit risk characteristics. In particular this could be open to challenge in the single “commercial" class. Management note that their approach is generally consistent with market practice.

So, the managers made the point that this was market practice yet PwC still felt the need to highlight this issue. Why would PwC have seen the aggregation of commercial loans into one class as an issue?

Mr. John McDonnell:

This, if my recollection is correct, was around the time IFRS 7 first came out. IFRS 7 was around the disclosure of financial ... of risks of financial instruments. This was particularly directed around the disclosure of credit risk. IFRS 7 said that banks were required to disclose credit risk in the context of what it calls "through the eyes of management" and at that point in time, Bank of Ireland would have looked at their loans in line with these categories. And the thing that was being raised is to whether Bank of Ireland should consider, when they move forward, disclosing a greater breakdown in their loans in advance, if you like. But the bank would’ve come back to us and they would’ve said that they disclosed their ... all their sectorial and geographic disclosures in another disclosure in the IFRS 7 notes, which you will see in the financial statements.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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The Nyberg report on page 6 referred to the auditors as the silent observers. On page 51 of the Nyberg report, he asked a direct question, "why did the banks require State support in 2008 so soon after all of them had received unqualified audit reports from various auditing firms?" Can I ask you, could you answer that question and do you believe that the categorisation or the portrayal of auditors as the silent observers in the Nyberg report is a fair one or an unfair comment?

Mr. John McDonnell:

I think Nyberg found that the auditors, and I quote from page 5 of the executive summary, "The auditors clearly fulfilled this narrow function [in accordance with] existing rules and regulations." As I've said, our role ... the role of an audit is very prescribed in accounting standards and in law and we conducted our audits and the auditors conducted their audits in line with those rules and regulations. That is what an audit does. We fulfilled our function appropriately under those rules. And Nyberg agreed with that. They’re the rules that are applied and we have to operate within those rules.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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Okay. Final question is this here. You mention in the opening statement the changes that have taken place and the changes that are about to kick in in 2018. Bearing in mind those changes with all of them in place, including the one that will come in in 2018, if those were applied at the point of your audit of 2008, would the bank have still received the same type of audit? Or, what in your view would have been the difference to the type of audit that you would have provided Bank of Ireland at that time?

Mr. John McDonnell:

The bank would have received in substance the exact same type of audit in terms of our methodology. The one thing you cannot say the change in 2018 is the change from moving from an incurred loss model to an expected loss model. So that comparison isn’t relevant. You had to apply an incurred loss model at the periods in which we conducted our audit and we stand and still stand over our opinions.

The last thing I’d say is that in terms of disclosure, in terms of corporate governance and in terms of auditing standards, all the debate after the credit crisis has really come down to two things. Is a better disclosure from management and the directors as to what their role is in the set of financial statements and better disclosure from auditors as to what their role is in the audit of a set of financial statements? Through all of that, nothing has changed the role of the auditor, which is to give an opinion on whether the financial statements have been properly prepared in accordance with the rules of IFRS. And the disclosure has been around getting better communication on the interaction between management and the audit firms.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Thank you. Deputy Phelan.

Photo of John Paul PhelanJohn Paul Phelan (Carlow-Kilkenny, Fine Gael)
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Thank you Chairman. You caught me a bit by surprise there. I thought there was somebody before me.

Can I ask actually at the start ... Mr. McDonnell ... I think you referenced shareholders in several of your answers and, indeed, in your opening comments. And you said that the responsibility of an auditor is primarily to the shareholders to ensure that the accounts of the company being audited are correct. In light of the fact that in Bank of Ireland, so many of those shareholders have virtually lost everything, do you believe you fulfilled your duty completely to those shareholders in the carrying out of the audit of Bank of Ireland?

Mr. John McDonnell:

Yes, we fulfilled our duty completely to those shareholders in the audit of Bank of Ireland because the role of the auditor in Bank of Ireland is to give an opinion on the financial statements. And our opinion stated that those financial statements were properly prepared in accordance with IFRS. That is where our role starts and where our role ends. We don’t give investment advice or anything to shareholders. It’s just around the historical information. It’s not about the business model etc.

Photo of John Paul PhelanJohn Paul Phelan (Carlow-Kilkenny, Fine Gael)
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Is it your view or not that shareholders when they make investment decisions tend, or not, to study the audited accounts of the companies that they’re thinking of investing in? Or, do you think that audited accounts really should be part of the decision-making process of shareholders before they make an investment?

Mr. John McDonnell:

I am not an expert in investment advice but I would assume that shareholders would look at financial statements and people would look at financial statements because they are available in the marketplace. I would assume they are looked at.

Photo of John Paul PhelanJohn Paul Phelan (Carlow-Kilkenny, Fine Gael)
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To touch on what my colleague Deputy O’Donnell was asking earlier, how do you reconcile the signing off of the 2007 accounts for Bank of Ireland in May 2008 with the fact that in January-February 2009, €3.5 billion worth of taxpayers’ money had to be invested into the bank to rescue it?

How do you reconcile the fact that the audited accounts from PwC gave Bank of Ireland a clean bill of health, that it was a true and fair view and that it was a going concern, and the going concern prospect, I suppose, is the one that I am really focusing on, and the fact that eight months later it really wasn't a going concern to the extent, at least, that €3.5 billion at the time, and subsequently somewhat more, had to be invested by the taxpayers of the country, some of whom were shareholders who lost virtually everything, into Bank of Ireland?

Mr. John McDonnell:

The financial statements, as I've said, are ... the role of, say, the financial statements is to faithfully represent the past, represent the transactions and the financial statements at that period appropriately represented the transactions which the bank had entered into at that period. In the context of going concern, "going concern" is an accounting concept which is around the measurement basis and at, when we signed those financial statements, it was appropriate for the bank to apply a going concern ... to apply the going concern concept, because it was not in liquidation nor was liquidation expected. And that's the only reason that you do not apply the going concern. There is a misapprehension is that you can have a choice between going concern and non-going concern. Under accounting standards, you must apply the going concern concept unless the company is about to be liquidated and that was not the case. The last point I would make is, when those financial statements were signed, no one had ... no one expected that Lehmans were going to go bust and no one expected a knock-on impact on the liquidity markets and, indeed, then the knock-on impact on the credit market.

Photo of John Paul PhelanJohn Paul Phelan (Carlow-Kilkenny, Fine Gael)
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Was ... sorry, five minutes? Yeah, sorry, I don't ... I can't ... Was a post-balance sheet review conducted just prior to the signing off the accounts in May 2008 and did that indicate any of the difficulties that Bank of Ireland was about to enter into?

Mr. John McDonnell:

In terms of our audit of that period, we would have taken into account all developments right up to the date on which we signed the financial statements and you will find that the audit committee meeting, I would say but I just can't recall, was probably two or three days before the financial statements were signed and at that meeting there was a very fulsome discussion around the going concern, a very detailed paper produced by management, a very fulsome discussion between ourselves, management, the audit committee around the appropriateness of the going concern concept.

Photo of John Paul PhelanJohn Paul Phelan (Carlow-Kilkenny, Fine Gael)
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And didn't ... when you say fulsome discussion, like, what did it throw up or are you at liberty to it?

Mr. John McDonnell:

At that ... well, as I've said earlier, earlier on, at that point in time, a number of things were discussed, was the bank's success in raising, in increasing its deposits by 19%, the bank's continued access to the wholesale funding markets albeit that those markets were more short term and albeit that it was more expensive. Thirdly, the fact that the bank had considerable amounts of liquid assets and also the bank had considerable amounts of other assets which it had not repoed in the ECB funding, which we'd also looked at, the fact that the bank had not got involved in using the ECB for funding. So, all in all, there was no indications at that point in time that the bank could not access the retail funding market and there was no discussion around a Lehman-type event because it was not, not expected.

Photo of John Paul PhelanJohn Paul Phelan (Carlow-Kilkenny, Fine Gael)
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Can I turn to page 31 of the core document? It's a group audit committee minute from Bank of Ireland and in the minutes, it's at the bottom of page 31, I think it is under the heading "Non Audit Fees", it is noted that approximately, and this is a quote, "approximately €6 [million] has been paid in Statutory Audit fees, including SOx, and €15.2 [million] on Non-Audit work". In the financial statement for the year ending 2009, the amount accounted for under auditors' remuneration comes in at €8.2 million. Can you reconcile the €8.4 million figure stated in the financial statement against the €21 million as per the minutes of the group audit committee?

Mr. Ronan Murphy:

I'd get onto that, if I may. The fees for the period we are talking about here, which is 31 March 2009, as disclosed in the statutory accounts, are €8.4 million. That is the correct figure. The figure that is included here includes a number of fees that were not directly related to our audit of Bank of Ireland and there were two major elements there and I'll just take a moment to explain it if I may.

In situations where the bank is a participant in bank syndicates, there is sometimes a requirement, if the loan is impaired or if there is issues around the loan, to carry out independent business reviews. That is a decision for the syndicate. It is not a decision for the Bank of Ireland. It is a decision for the syndicate or it may well be a decision for the directors. Approximately €7.2 million of that €15.2 million was in respect of these independent business reviews. They were not contingent, they were not part of our audit fees and they were not ... it was not dependent on us being auditors to Bank of Ireland. They are entirely independent and separate.

There is a second element of it, Deputy, which is €4.4 million of fees, where the Bank of Ireland acted as asset manager for some very big international funds. Examples would be Guggenheim; BIAM. Those fees were paid by those funds to PwC but they were not dependent on a relationship with the Bank of Ireland. The decision to appoint PwC was a decision for the boards and the trustees of those funds. So, the vast majority of that €15.2 million is not ... is totally unrelated to our role as Bank of Ireland auditors. The correct fee for non-audit fees is as disclosed in the accounts, which is €700,000, which is €400,000 for tax fees in Ireland and €300,000 for tax fees in ... outside of Ireland, which was mainly in the UK.

Photo of John Paul PhelanJohn Paul Phelan (Carlow-Kilkenny, Fine Gael)
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Okay, okay. I want to turn briefly before I finish to ... Chair ... to the issue-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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This is coming to the final question now, Senator, or Deputy.

Photo of John Paul PhelanJohn Paul Phelan (Carlow-Kilkenny, Fine Gael)
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----- yes, of necessary professional scepticism from the Nyberg report, which I am sure you are familiar with. It has been quoted several times at hearings to other auditors and other witnesses. Mr. Nyberg, at paragraph 3.6.2, stated, "Commission would have expected a bank auditor exercising necessary professional scepticism to have concerns where they were growing property and funding exposures combined with material governance failings." Do you accept, gentlemen, the findings of the Nyberg report in relation to PwC's auditing of Bank of Ireland?

Mr. John McDonnell:

The first thing I will say in response to your question is that we showed appropriate and detailed professional scepticism. We carried out a very robust audit of Bank of Ireland and we gave an appropriate opinion and we still stand over those opinions and I would say, as I said earlier on, Nyberg's clearly said the auditors clearly fulfilled this narrow function in accordance with the existing rules and regulations. We're a set of ... we're an audit firm. There are a set of rules. Those rules dictate what we do. We applied by those rules in giving, in giving, the opinion.

Photo of John Paul PhelanJohn Paul Phelan (Carlow-Kilkenny, Fine Gael)
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In your view, what was he ... what was he expressing when he said that, you know, he would have expected a bank auditor exercising necessary professional scepticism to have concerns where they were growing property and funding exposure? I mean, is that not a direct statement about all auditors of all Irish banks, including PwC of Bank of Ireland?

Mr. John McDonnell:

I can ... I can read it. I didn't have a detailed conversation with Nyberg. I could assume what was in his mind when he read it but I can only really comment in the context of the work we did at Bank of Ireland and I can assure you we took our role very, very seriously. We did a very robust audit and we applied appropriate scepticism and we came to an opinion in accordance with the rules which we stand over. That's all I can say to that, Deputy.

Photo of John Paul PhelanJohn Paul Phelan (Carlow-Kilkenny, Fine Gael)
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Very good.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Deputy Eoghan Murphy. Deputy, you have ten minutes.

Photo of Eoghan MurphyEoghan Murphy (Dublin South East, Fine Gael)
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Thank you, Chairman, and thank you to both the witnesses. The reference for my question, Chairman, is at pages 37 to 40 in the core booklet. But before I come to that I just wanted to go back, Mr. McDonnell, to something you were speaking about earlier in relation to PwC and the dedicated banking unit that you have. Was this unique amongst audit firms at the time?

Mr. John McDonnell:

I believe we were the only firm in Ireland that had a dedicated banking practice. That's my belief.

Photo of Eoghan MurphyEoghan Murphy (Dublin South East, Fine Gael)
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Is that still the case?

Mr. John McDonnell:

That would be my belief, yes.

Photo of Eoghan MurphyEoghan Murphy (Dublin South East, Fine Gael)
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Okay. And within that unit you had, you said, the specialist banking, retail banking, treasury teams. But did you ever consider a specialist property lending team?

Mr. John McDonnell:

We would have had specialist credit teams and those specialist credit teams in, if you like, if you take our corporate team, for want of a better word, we would have had specialist credits ... credit specialists, who would be used to auditing corporate credits, and we would have had retail credit experience in our retail teams.

Photo of Eoghan MurphyEoghan Murphy (Dublin South East, Fine Gael)
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But no one with a particular focus on, say, property?

Mr. John McDonnell:

X02400 type: 1 -->

Property would have been a component of those----

Photo of Eoghan MurphyEoghan Murphy (Dublin South East, Fine Gael)
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Component.

Mr. John McDonnell:

----- and they would have had a specialism, they would have had an expertise in the audit of credit arising from the types of exposures that fall in those and property would be one of those exposures but it would not be the only exposure, but we are looking ... we are talking about the expertise to audit credit because that's what our job is.

Photo of Eoghan MurphyEoghan Murphy (Dublin South East, Fine Gael)
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Okay. And when the bank began to change its internal structures at the beginning of 2001, specialist property financing units, and then in 2004, a dedicated property unit, was there a discussion in PwC about changing how you might audit the bank's activities?

Mr. John McDonnell:

I ... I don't know, to be honest, but what ... what I would, what I do know is is, and the reason I don't ... I wasn't involved in Bank of Ireland in 2000.

What I do know is is that we would always and we do always at the start of any audit sit down and talk about the risk that apply to that audit, so, therefore, when a bank starts to build up as Bank of Ireland started to build up considerable exposures in various areas, we would have ensured that our banking expertise was appropriate to audit the bits that we were required to audit arising from that, and that would have been impairment.

Photo of Eoghan MurphyEoghan Murphy (Dublin South East, Fine Gael)
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So your concern would have been that you have the necessary expertise to audit what the bank was doing - not necessarily a concern with the additional risk the bank may or may not been taking on?

Mr. John McDonnell:

No, I have said before, it's not our job to comment on the risk that the bank is taking on. It's our job to complete our audit to ensure that we appropriately audit risks of material misstatement in the financial statement which we look back rather than looking forward.

Photo of Eoghan MurphyEoghan Murphy (Dublin South East, Fine Gael)
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So it wouldn't have been your responsibility to comment to the bank itself but would people ... in your ... inside your expert team looking at banks and looking at Bank of Ireland, would they have been commenting to themselves or to senior partners about what was happening in the bank ... and the changes that were happening, the increases in ... say ... concentration in property lending?

Mr. John McDonnell:

I can't comment on what people were thinking in themselves ... I mean ... all I can really comment here is on the audit of Bank of Ireland and on the audit of Bank of Ireland we would have discussed at the start of every year, we set our audit plan, we would have discussed the risks in the context of what we were required to do and that's what we would have done.

Photo of Eoghan MurphyEoghan Murphy (Dublin South East, Fine Gael)
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Okay but in terms of ... have you looked at documentation from the time internal to PwC?

Mr. John McDonnell:

Yes I have, yes-----

Photo of Eoghan MurphyEoghan Murphy (Dublin South East, Fine Gael)
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And would there be documentation, e-mails for example, of people on the bank team discussing their own concerns as to strategies being pursued by the banks, separate to their role as an auditor to the bank and the risk that they might be concerned with in terms of auditing?

Mr. John McDonnell:

I haven't looked at all the documents over the period. I have looked at documents on the file. Basically what is on the Bank of Ireland audit file is work directed towards the audit of Bank of Ireland and that work is directed towards the risks and it's directed towards the audit of those material risks. We don't have a role in determining the bank's business model and we do not do a critique on our audit file of those business models. And the reason I say this, and this is important, we're an independent set of auditors, it's not our job to get involved in the management of the running of the bank and, therefore, we need to be very careful that we look at what we are required to look at and that's what we do and that's what our staff would be trying to do and that's what we would see on our files.

Photo of Eoghan MurphyEoghan Murphy (Dublin South East, Fine Gael)
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Okay. The document I cited is a document from the group risk office to the group risk policy committee on 13 December 2007 and it's talking about property concentration in the group's loan book. So as part of your audit, does it concern itself with these types of documents?

Mr. John McDonnell:

This is the ... I think it's a GRPC minute, we would have seen the minutes of the GRPC ... GRPC is a very important risk committee within Bank of Ireland and as part of our audit of Bank of Ireland, we would consider the governance in place and the context of the financial statements. One of the key risk committee, as I said, is the GRPC, so we would look at the minutes of GRPC, yes.

Photo of Eoghan MurphyEoghan Murphy (Dublin South East, Fine Gael)
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Right, but to what purpose did you look at the minutes, say, for example, in these minutes, where it expresses a number of concerns about exposures?

Mr. John McDonnell:

We would look at the minutes in the context ... in two contexts: one, to ensure that there was appropriate governance, and it's governance in the context of the audit of set of financial statements, to ensure that there are appropriate committees and those committees are looking at aspects of the accounting statements and, secondly, and another prime focus of our look, would be to consider any impacts that these have on impairment. So where these minutes have detailed application to the calculation of impairment, then we would look at them and they would direct our work.

Photo of Eoghan MurphyEoghan Murphy (Dublin South East, Fine Gael)
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Impairment at that point in time, not in future impairment risks?

Mr. John McDonnell:

Yes ... we're not ... we're in an incurred loss model and an incurred loss model is the loss event has to happen and then it is of consequence for the accounts. Sorry, if it hasn't happened, it's not of consequence for the accounts because we're not in an expected loss model, so we ... we're doing an audit and we have to focus on what we're asked do and what we're asked to do is look at impairment from an incurred loss perspective.

Photo of Eoghan MurphyEoghan Murphy (Dublin South East, Fine Gael)
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Okay. This document then from the group risk policy committee or to the group risk policy committee, it's the end of 2007, and it's noting that 44% of all non-mortgage lending is to property. And when you combine mortgage lending with property construction lending, it's 70% of the bank's entire loans. So did PwC ever analyse the risk level associated with the percentage share of the property-related lending?

Mr. John McDonnell:

I think the 70% includes both property and mortgage, if I am correct-----

Photo of Eoghan MurphyEoghan Murphy (Dublin South East, Fine Gael)
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Yes ... it's the two figures together.

Mr. John McDonnell:

-----so there two ... so they'd be two separate risk factors. What we would look at is the risk of material statement. What we would look at is the impairment calculations from the bank and ensure that the impairment calculation of the bank are appropriate to give them their impairment charge and are appropriate to allow us to give a clean opinion on the bank's financial statements and that's very important. But our reporting in the context of property concentration, in the context of property prices, in the context of an expectation gap between incurred loss and expected loss, we would have reported on that to the audit committee, quite regularly during this period, but always in the context of the calculation of impairment because that's what we were asked to do. So when we look at ... our pure focus is "What does that mean in the context of the calculation of a loss, an incurred loss for the period that we are asked to cite our audited opinion?" That's what we look at it.

Photo of Eoghan MurphyEoghan Murphy (Dublin South East, Fine Gael)
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What about the wider concern, though, that's been expressed internally about this exposure ... this concentration exposure? I mean, if you go to page 40, half-way down the page it states, "If the GRPC [Group Risk Policy Committee] is of the view that the level of property exposure in the Group's balance sheet is too high, there are relatively few realistic options that could be considered", and it points out a few. That's a warning from one part of the bank to the other over its concentration exposure.

Mr. John McDonnell:

What it is is it's a minute from a risk committee documenting the risk that exists as a result of the bank's lending strategy. What we have to do is audit the balance sheet that arose as a result of the strategy. So the balance sheet is there, we audit the transactions and we audit the transactions in the context of whether they've been properly measured and recognised in the balance sheet. So we are always looking in the context of an impaired loss calculation.

Photo of Eoghan MurphyEoghan Murphy (Dublin South East, Fine Gael)
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But as it says here, if the exposure is too high and there are relatively few realistic options that could be considered. You as PwC cannot take a view on that in terms of your assessment of the bank's position.

Mr. John McDonnell:

No, because it's not our assessment, as I said, it's not our role to talk about what the bank's strategy was, what its policies were, what options are available to the management if it's a business. What our job is "What loans have they entered into at the year end?", "Are those loans properly accounted for?" In the context of are they are properly accounted for, "Has impairment on those loans, as they exist at the balance sheet, has that been properly calculated?" That is our role - that's where it begins and ends, Deputy.

Photo of Eoghan MurphyEoghan Murphy (Dublin South East, Fine Gael)
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In finalising your accounts, then, for 2007 and this report came in December 2007, you could make no regard to this particular risk being identified and you could have no concern for the future, based on this risk?

Mr. John McDonnell:

What I would say is, is that we considered all risk documents, we consider all evidence available to us in the context of formulating an opinion on the financial statements. Secondly, we would have considered all these documents in terms of the required disclosures and we look in the financial statement, the sector risk was properly disclosed in the bank's financial sectors ... in the bank's financial statements and indeed, the funding model to fund those sector risks was also disclosed in the bank's financial statements. That's where our role begins and ends, Deputy.

Photo of Eoghan MurphyEoghan Murphy (Dublin South East, Fine Gael)
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Okay, thank you. Thank you, Chairman.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Thanks very much, Deputy. Just before I move on to the next member, if I can just ... one of our lines of inquiry is the integrity of financial reporting, Mr. McDonnell and Mr. Murphy. In around 2005, most banks adopted the IAS 39 in relation to the calculation of the provision of bad debts. Within the industry, was there any discussion or opinion about this standard and particular in regard to the adoption of the standard as to how it would relate to profit and loss in accounts and the provision for bad debt?

Mr. John McDonnell:

There was considerable discussion around, even prior to that, if you just look at who the ISB are, the ISB are an independent objective standard setter, that's why people apply their rules because they're independent and objective. When the ISB set IAS 39, they would have a very long consultation period and as part of that consultation period, they would have got a lot of comments back from users of the financial statements around what was right or wrong. Sorry, what they believed was appropriate or not appropriate ... sorry, that's the right way to say it ... and they would have taken that into account and then they made their deliberation. And it's important to understand where the ISB are coming from with this. They were concerned at that point in time because a lot of market participants were concerned that people were making what was called "big bath provisions" or as Deputy Levitt in the SEC "cookie jar provisions". There was concern that people were making provisions when times were good and then they were releasing those provisions when times were bad and smoothing their profits to ensure that they had an appropriate trend. That was the concern ... so that was at the forepoint of the ISB's mind. So the ISB's intention on IAS 39, would be that it was pro-cyclical, their intention was that when there was a significant downturn, you would have greater losses than in benign times. That was the intention to meet that obligation. So clearly, when financial institutions and people were moving from old GAAP ... what we called old Irish GAAP (IFRS), there was a lot of debate about what would IAS 39 mean in the context of provisions.

And it would generally mean that provisions would be lower. There was some debate about the appropriateness or not ... the appropriateness or not of that, but it kind of all became a little bit irrelevant because, when the EU adopted IAS 39, it had to be applied. So, once personal views as to whether it was right ... once personal views as to whether you felt it was the most appropriate standard became not of a consequence, it was the standard, it was the rules and, therefore, you needed to apply ... apply those rules. And that's what financial institutions and, indeed, other financial institutions did. They just moved on and they applied the rules and they kept going.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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So, upon the commencement then, Mr. McDonnell, of the adoption of the international auditing standard, IAS 39, did this mean that the audited financial statements no longer had to comply with the true and fair standard that ... of the previously accepted standard?

Mr. John McDonnell:

Chairman, I'd actually say the opposite. Once IAS 39 was adopted by EU law, it became part of the financial framework which had to be applied. If you have material lending transactions, you must apply the incurred loss approach, and I would believe if you did not apply the incurred loss approach, you could not say the financial statements gave a true and fair view. If you did comply the incurred loss approach, then you could give such a view. And the true and fair view, as it applies to accounting standards, where, as I said earlier on ... where an accounting standard specifically deals with a matter and deals with it in the level of detail which IAS 39 dealt with it and deals with its eyes open, knowing that it's going ... with a view that it should be pro-cyclical, then they're the rules as set down. When those rules are in law, you must apply those rules to give a true and fair view. If you don't apply them, you cannot say the accounts give a true and fair view.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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And in your firm-----

Mr. John McDonnell:

That would be my view.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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In your opinion, Mr. McDonnell, do you believe that ... did you feel that it was right for the firm to adopt the standard?

Mr. John McDonnell:

The firm being-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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In your opinion, did the firm feel it was right to adopt the standard?

Mr. John McDonnell:

PwC would've been involved in all of the consultation periods on all financial accounting standards. We give our views. In some instances, we agree. In some instances, we disagree but, as I said, once the standard becomes part of IFRS, we, as a firm, are required to apply it as are our clients are required to apply it. So, it became GAAP and, therefore, we had to apply it. So, we ensured that we were proficient, expert and that we could apply it appropriately.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay. And-----

Mr. John McDonnell:

And that's all we can say we do.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Yes, and we accept that the rule had to be applied, but, I suppose, the question I'm putting to you this morning is ... during PwC's interaction with the bank, did either party express concerns regarding the adoption of IAS 39?

Mr. John McDonnell:

We had very detailed debate with the bank about the impact of IAS 39 across a whole range of assets and liabilities, particularly impairment. We would've discussed with the bank the impact of IAS 39 and how it compared and contrast with the previous accounting framework. We would've also looked at it in the context of US GAAP. Directors and management would've had views. We would've discussed all of those views. But at the end of the day, the rules were the rules and we would ... and Bank of Ireland needed to apply those rules. They ensured that they'd the appropriate controls to apply the rules and we ensured that our audit and our accounting expertise was appropriate so we could actually audit those rules.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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But in a general capacity, Mr. McDonnell, when a rule is being applied, I'm sure you, as the auditor, and the firm that you're auditing would talk about how the rule gets rolled out and all the rest. But what I'm asking you here is, was there concerns being expressed by either your firm or by the bank or were you in discussions that there were going to be concerns with regard to how this rule was going to be adopted and the implications of adopting it?

Mr. John McDonnell:

The primary debates we would have had, Chairman, were around the differences between this GAAP ... IFRS and where we previously came from and how those differences might manifest themselves and to ensure that the employees and the directors and management staff understood the rules of IFRS, because they were the new rules of the game, and to understand that they were being properly prepared. Because personal views were not particularly relevant. The accounting standard was what it was and it was designed to do something and it had to be applied.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Thank you.

Mr. John McDonnell:

And, therefore, the focus of the management and directors of Bank of Ireland was, "We have to apply this properly. Let's get on and make sure that we do apply it properly and we understand it in all its minutiae." And our primary concern was to ensure that our staff, our managers and our directors understood it in all its minutiae so, therefore, it could be applied properly. So, we could stand back at the end of the day and say, "We understand IAS 39 and we understand it's been properly applied", because that's our role in this.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay. I understand that and I'm going to move on now to the next questioner, but I just want to ask that question again to you. I understand what you're saying with regard to any new accountancy rule that comes down, people have to be trained up, people have to be familiarised with it and so forth, but, specifically in regard to IAS 39, was there any concern held by either your firm or by the bank or was there at any time an engagement between you and the bank that there was a concern as to how this rule would roll out? I'm not asking about the operational aspects of it-----

Mr. John McDonnell:

I-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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-----I'm asking was there a concern.

Mr. John McDonnell:

Chairman, I can only answer the way I've answered the question. I've tried to answer the question. We would've had a detailed debate about how it was applied.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Yes.

Mr. John McDonnell:

It was the rule. We would've engaged in the consultative process to get to the rule. We would've engaged in the consultative process to get to the rule, but once the rule was made, personal views were irrelevant. It needed to be applied.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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I'm sorry, Mr. McDonnell, but I'm going to have to press this with you. I understand how rules get applied, but in the ... what I'm asking you was, in all of that process, was there a concern about the rule? Now, I'm not asking for a "Yes" or "No" question, I'm just asking you was there a concern about the rule.

Mr. John McDonnell:

I think there was an understand ... Chairman, the way I can answer this, there was an understanding of how the rule operated. There was an understanding of how and what it might mean to financial reporting,-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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I-----

Mr. John McDonnell:

-----but I can't say we-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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I can go into legislation that I have here now that would've forced you to answer a question if I wished, but I'm asking you was there concern about the rule in your firm or in the bank or were there discussions with regard to a concern around it?

Mr. John McDonnell:

I don't believe there was a concern about the impact IAS 39 would've had on a financial crisis. I don't believe there was a concern discussed in that manner. I think what we were trying to ascertain was how the accounting standard worked, the basis for which the accounting standard was brought in, which was to address other issues in the marketplace, and ... and that's what we looked at.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay. Thank you. Deputy Michael D'Arcy.

Photo of Michael D'ArcyMichael D'Arcy (Fine Gael)
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Thanks for the upgrade, Chairman. You're welcome, gentlemen. Can I ask you, in relation to the policy exceptions, did PwC ever review the loans that were outside of the policy exceptions? And the booklet is the PwC booklet, Vol. 1, page 43 to 48. The policy exceptions place.

Mr. John McDonnell:

Yes. I mean, we would've reviewed a sample of loans and I'm sure that the sample of loans ... we would've identified a number of these policy exceptions. The way the policy worked in Bank of Ireland was that the credit policy was drawn very tightly. And, therefore, if there was an exception to that credit policy, it went up to the next level-----

Mr. John McDonnell:

-----and if the next level approved it, then it was approved, and we would've ensured that that happened when we went through our ... our ... our review of loan samples.

Photo of Michael D'ArcyMichael D'Arcy (Fine Gael)
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And each year there was a number of exceptions to the policy. And would you have reviewed a sample batch on each?

Mr. John McDonnell:

No. We would've reviewed a sample of loans and, coming from that sample, I'm sure there would've been exceptions to the policy as expressed in those papers, and then we would've ensured that the next layer of approval was in place. And if the next ... the way it worked is if there was to be a tight policy drawn, if it came to an individual discretion level, the person had the discretion to approve it if it was in that policy. If it wasn't, it went up to the next level and the next level could approve it. And then once it was approved, it was within the total policy.

Photo of Michael D'ArcyMichael D'Arcy (Fine Gael)
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Sorry. What I'm trying to get at is, the following year there's another ... percentage of exceptions. When exceptions went through the process and were sanctioned by the bank, did PwC pursue another sample each calendar year as there were exceptions flowing?

Mr. John McDonnell:

We would have reviewed a sample of loans every year and-----

Mr. John McDonnell:

-----I would've ... I haven't looked at all the samples, but I would assume that there would've been these type of exceptions in each of the samples. I would've assumed, yes.

Photo of Michael D'ArcyMichael D'Arcy (Fine Gael)
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Okay. Page 47 of the ... of your booklet: "Bank of Ireland transferred 191 connections to NAMA with [an] aggregate ... value of [€9.76 billion] ... Cases including policy exceptions [were] identified [of] 139 out of 191 ... [or] ... (73%) with aggregated exposure of [€8.78 billion]". That seems like a very, very high figure for exceptions ... for a huge quantum of money. Were any of those cases reviewed to your knowledge?

Mr. John McDonnell:

I honestly don't know. As I said, we would have reviewed a sample of loans and there was a fair chance that ... that some of those loans ... those loans would have been in the sample. But I can't be conclusive to that. But we would have reviewed them and there would have been ... I'm sure those exceptions would have arose.

Photo of Michael D'ArcyMichael D'Arcy (Fine Gael)
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And can you comment on the level of exceptions, 72%, please?

Mr. John McDonnell:

No. I mean it was the bank's policy and I understand this from speaking to the bank, you know, when I got involved, their policy was to draw their loan policy very, very tight and if there was an exception to that policy, it went to the next level. And part of the reason they would have said to me they had a tight policy is they wanted full ... they wanted greater transparency around individual loans and exceptions. And what really ... what they wanted was a ''two eye'' principle. So you've got a discretion within a tight policy ... you've got a discretion, it goes up to the next level. So two people looked at it - the person at that discretion level and the next discretion level and they wanted ... one of the things that they did say to me ... and this was just after the fact ... they thought about widening the policy but they felt that that wasn't an appropriate decision. This is a better rule. And that's why they would say they got a lot of exceptions at the first level. But, therefore ... but it's not an overall exception because it can be approved at the next level.

Photo of Michael D'ArcyMichael D'Arcy (Fine Gael)
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The ... we know the NAMA numbers were ... people who were transferred were people with €20 million plus. I just want to take the comparison between that and the policy exceptions for owner-occupiers and the policy exceptions for buy-to-let mortgages. The policy ... on page 47 ... on ... in 2005 we have the policy exceptions for owner-occupiers at 10% and for buy-to-lets at 20% ... at 19%; 2006, 9% for mortgage, buy-to-lets, 17%; 2007, 7% versus buy-to-lets, 16%; and then, finally, in 2008, 5% owner-occupier exceptions and 13% mortgage buy-to-lets. The difference, Mr. McDonnell, is two times and three times owner-occupier versus mortgage buy-to-lets. And then the only percentage figure that we have for NAMA is 73%. Can I ask you did the exception become the rule and the rule become the exception?

Mr. John McDonnell:

No, the policy was that if a loan had an exception, it went up to the next level and it could be approved. That was the policy-----

Photo of Michael D'ArcyMichael D'Arcy (Fine Gael)
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I understand that.

Mr. John McDonnell:

That policy was applied. That was the rule, if you like. A number of these exceptions could be for ... for technical-type breaches or .. or exceptions. Maybe one of the ... an example would be where you needed to have an income statement for a company and the company had only started trading so there was no income statement. There was all sorts of reasons for the exceptions. A whole plethora of them ... but I would have ... I ... this is the first time I ... when we got the evidence ... this is the first time I've seen this so we wouldn't have been doing comparisons between the exceptions ... between various categories of loans. We wouldn't have seen this before.

Photo of Michael D'ArcyMichael D'Arcy (Fine Gael)
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And can you comment on the ... on the percentage difference between owner-occupier exceptions and the buy-to-let exceptions? -----

Mr. John McDonnell:

Without -----

Photo of Michael D'ArcyMichael D'Arcy (Fine Gael)
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-----two times or three times the difference.

Mr. John McDonnell:

Without having the detailed analysis as to why the exceptions arose, I don't know. I mean I could ... it would only be supposition as to why one is ... is different to another. I mean, I haven't seen the make up of it .... I ... I really ... I don't know.

Photo of Michael D'ArcyMichael D'Arcy (Fine Gael)
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Could you offer an opinion, please?

Mr. John McDonnell:

I don't ... maybe there was more technical-type breaches in the buy-to-let but I don't know. It's only supposition. I honestly don't know. I don't have the ... the material. If I had the material backing it up, I could tell you because I'd have all the material; I just don't have it.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Are you finished? Okay. Just a ... further on Deputy or Senator D'Arcy's questions there. Did PwC have any concerns with the exceptions to the lending policies and the level of exceptions?

Mr. John McDonnell:

We understood the policy in detail and we would have .... we would have identified ... that we would have seen exceptions of policies that we weren't sure ... our detailed testing. In the context of the ... you know, our opinion on the financial statements and whether the financial statements gave a true and fair view, we wouldn't have had a concern as to the impact on our opinion on the financial statements.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay, and were these concerns sent along then and addressed?

Mr. John McDonnell:

No, we would ... we wouldn't have ... we would have ... they would have arose ... the policy was in place. We understood the operation of the policy, Chairman. And where there was an exception to one ... one part of the policy, we would have ensured that it was approved at the next level. If it was approved at the next level we wouldn't have raised that ... that higher because it was in line with the rules of Bank of Ireland at that point in time.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay, thank you. Deputy Michael McGrath.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Thank you very much, Chair. You are very welcome Mr. McDonnell and Mr. Murphy. If I can start by asking if PwC performed any stress testing as part of the external audit of Bank of Ireland to take into account the correlation between different types of property being financed- residential, commercial, development land and speculative land banks - and if you did, what conclusions were drawn? And if not, why not?

Mr. John McDonnell:

We didn't produce our own stress tests around those concentrations. The bank would have produced detailed stress tests as part of their processes. And the bank, I think, the bank would have got Oliver Wyman to help them, to assist them in terms of their impairment analysis. We would have reviewed those stress tests and we would have considered the outcome of those stress tests. But the one thing I will say is under IAS 39, you need to look at each individual loan separately or groups of similar loans separately. You can't, when you are looking at impairment, mix a land loan with a business loan. They have got a different risk profile. You consider impairment on those separately. That's the way IAS 39 works. So, the bank would have done stress tests, we would have looked at the stress tests as part of the overall bank's governance but we would not have done our own stress tests.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Okay. Are you happy enough to take some questions on the financial statements prior to the years-----

Mr. John McDonnell:

Oh yes ------

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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-----that you became the auditor in charge,

Mr. John McDonnell:

I am but ------

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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-----which was a -----

Mr. John McDonnell:

Oh, I am. That's why I am here -----

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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-----2005, 06, 07? Okay.

Mr. John McDonnell:

That's why I am here.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Can I ask why the financial statements for Bank of Ireland for 2005, 2006 and 2007, for example, would not have provided a breakdown by sector of the loans owed to the bank by customers? So I'm talking about the notes to the accounts, the disclosures by the bank in the financial statements for 2005, 6 and 7, for example, there is no breakdown by sector whereas we have looked at the accounts of other banks for example, AIB and Ulster Bank, and they would have been providing a breakdown by sector.

Mr. John McDonnell:

The Bank of Ireland IFRS 7 came in for financial periods ending 31 December 2007, which for Bank of Ireland was 2008. And IFRS 7 was the accounting standard for which prescribed the disclosure of sectoral concentrations and disclosures around credit risk and they .... considerably increased the required disclosures of credit risk. I haven't actually done an analysis of what was there -----

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Sure, yes-----

Mr. John McDonnell:

-----before '08 but I suspect that that's why you see from March 2008 onwards, you see much greater disclosure around market risk, credit risk, etc., because that's was driven by IFRS 7, which is the accounting standard that came in to promote and require greater disclosure and require greater-----

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Okay-----

Mr. John McDonnell:

----- disclosure and that------

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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And that came into effect-----

Mr. John McDonnell:

-----I suspect ..... I suspect that's the reason-----

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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-----at the end of '07 is it?

Mr. John McDonnell:

I suspect that's why you will ... you will see a difference-----

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Yes -----

Mr. John McDonnell:

------between the March '07 accounts and the March '08. It hit everybody else for December because Bank of Ireland is March ... they were ... March ... March '08. All the other banks were December '07. So if you're comparing the December '07 for, let's say, AIB and Ulster Bank, you would need to compare it with the March '08 because that's ... there is the comparator-----

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Okay. And prior to then, the level of disclosure was dictated by what?

Mr. John McDonnell:

It was dictated by IAS 39.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Okay. And did that set a minimum standard? Was it open to the directors of the bank, for example, to go beyond that and provide additional disclosure in the notes to the accounts?

Mr. John McDonnell:

It's always open to the director of financial statements to provide additional disclosures to the extent that I think that disclosure is reasonable and to the extent that that disclosure accords with financial ... with accounting standards. Now, you -----

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Yes -----

Mr. John McDonnell:

-----you have to ... the disclosure has to be sensible in the context of the accounting framework, if you know what I mean. And has to be in the context of the historical numbers.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Okay. For example, the account to the end of March 2005 in the relevant note, which was 15, dealing with loans and advances to customers, subsection C, there was a reference of concentration of exposure to credit risk. It said: ''Group's exposure to credit risk from its lending activities does not exceed 10% of loans and advances to customers after provision in any individual sector or industry with the exception of residential mortgages''. Now that was repeated again then in 2006. But at that point, property and construction was added into residential mortgages as being an exception to the ... to the 10% rule. But it wasn't until 2008 that you had a specific note on credit risk exposures and you're saying that arose from-----

Mr. John McDonnell:

That arose from-----

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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-----the new IFRS-----

Mr. John McDonnell:

----the new IFRS 7. I think there would have been market disclosures around ... and I just can't recall whether that 10%, whether you have to disclose, whether you have something over and above 10%. I don't recall where that comes from-----

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Yes.

Mr. John McDonnell:

-----it may have been a market standard or it may have come from one of the accounting standards; I just can't remember that.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Okay. I suppose, the point I am getting at is that it wasn't until the financial statements for the year ended 31 March 2008 were published, which was May 2008, that a reader of the Bank of Ireland financial statements would have realised the extent of that bank's dependence on the property and construction sector. None of the accounts prior to that gave any information on the bank's reliance and the concentration of risk in property and construction.

Mr. John McDonnell:

They don't ... I mean, I just don't have the 2007 accounts ... the March 2007 accounts to hand so I just don't ... can't do a comparison as such.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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But, as you said, the '07 was not prepared in accordance with the IFRS.

Mr. John McDonnell:

Well, I-----

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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-----though the directors could have made additional disclosures if they had so wished.

Mr. John McDonnell:

They're ... in the bank's form 20F there was a requirement, which is called the guide 3 requirements, and in the March '07 accounts for the guide 3 accounts, the accounts disclosed property and construction of property for 2007, 2006 and 2005.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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And that is published, is it?

Mr. John McDonnell:

That's publish, yes. And, it says property and construction: €16 billion, '07; €10.7 billion, '06; and €8 billion, '05 under IFRS.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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And that's published by the bank.

Mr. John McDonnell:

That's published by the bank, yes. Just bear with me a second.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Sure, yes.

Mr. John McDonnell:

Yes.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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What we're dealing with here essentially is the financial statements which were audited by PwC and it wasn't until the 2008 financial statements that somebody would have seen, for example, that Bank of Ireland had lent over €35 billion to property and construction, which accounted for 26% of all loans made by the bank. Anyone relying on the financial statements prior to 2008 would not have had any sense of the level of dependence that the bank was placing on property and construction. That's what I'm putting to you.

Mr. John McDonnell:

Property and construction lending in 2007 was €16 billion. The requirements of the financial-----

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Where are you taking that from?

Mr. John McDonnell:

I'm taking that form the form 20F.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Okay but that's not the financial statements.

Mr. John McDonnell:

That says ... sorry, Ireland €10 billion and the UK €26 billion.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Yes, but I'm talking about the financial statements which are prepared by the directors and audited by yourselves.

Mr. John McDonnell:

We do audit the 20F. The financial statements prepared by the directors need to be prepared in accordance with relevant accounting standards and the 2007 financial statements would have accorded with the relevant accounting standards. The accounting standards were changed and IFRS 7 came in in 2007. So, if you look at the financial ... if you look at the financial statements of any financial institution between ... in 2007 or in the context of the bank's accounts in 2008, you will see substantial increase in disclosure because IFRS 7 came in and IFRS 7 required the banks to give substantial disclosure. Prior to the adoption of IFRS 7 that ... other standards applied and Bank of Ireland's accounts prior to that accorded with those financial ... those accounting standards and that's why we could give an opinion on those financial statements.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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But would it have been open to the directors prior to that new IFRS coming into play in 2007 to disclose in the financial statements the information which was in form 20F, sectoral concentration, essentially? Could the directors have included that information in the notes to the financial statements prior to the 31 March 2008?

Mr. John McDonnell:

The directors ... yes, the directors could put that disclosure in the financial statements.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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And to your knowledge was there any discussion between the PwC team and the bank about providing that additional disclosure above and beyond the minimum level required in the standards, but in the interests of giving the reader of the financial statements the maximum amount of possible information?

Mr. John McDonnell:

We would've always discussed with the bank their approach to disclosures in the financial statements but I don't know what was actually discussed at that point. We would always discuss ... we would've always ensured that the bank ... and the bank would've always themselves ensured that they complied with appropriate accounting standards and they did apply with appropriate accounting standards. There was a big move, as I said, in the marketplace to increase disclosure and that arose from IFRS 7. The banks had just come through the adoption of ... the Bank of Ireland had just adopted IAS 39 in 2006 ... in 2005 and IFRS 7 came in as part of that accounting standard so people were still getting to grips with the overall requirements of IFRS. That's the only way I can answer it.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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I think you said earlier on, Mr. Murphy, that PwC became the sole auditor in 1990-----

Mr. Ronan Murphy:

That's right.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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-----of Bank of Ireland.

Mr. Ronan Murphy:

Yes, that's right.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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And under the mandatory rotation rules you have to depart that job as such by 2020, is it?

Mr. Ronan Murphy:

That's correct, yes.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Can you clarify what those rules state at the moment?

Mr. Ronan Murphy:

There are new rules coming in for public interest entities, which are large corporations regulated ... regulated entities that require us ... the auditors to retire after a period of ten years.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Ten years. And, prior to that rule coming into play, was there any rule about-----

Mr. Ronan Murphy:

There was no requirement.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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No term limit.

Mr. Ronan Murphy:

There was no term limit.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Whatsoever.

Mr. Ronan Murphy:

No, Deputy, there was no term limit.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Okay. If I can finally raise the issue of ... of practice note 19, which Deputy Doherty raised as well. So, this is where it goes beyond the statutory requirement laid down in the Central Bank Act 1989 but where the auditor may in circumstances where it concludes that the matter doesn't give rise to a statutory duty to report but nevertheless feels that in the public interest it should be brought to the attention of the regulator, to use your own words, Mr. Murphy. The group risk policy committee that Deputy Eoghan Murphy referred to on 13 December 2007, which is on page 37 of the core booklet, highlighted in pretty stark terms the concentration risk that Bank of Ireland was facing at that time. Was any consideration given by PwC to making a disclosure to the Financial Regulator under practice note 19, an additional voluntary disclosure about the level of concentration risk that Bank of Ireland was facing at that time in respect of lending to property and construction?

Mr. Ronan Murphy:

Deputy, I don't believe so.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Not considered at all or-----

Mr. Ronan Murphy:

Not considered ... not considered in terms of reporting to the Financial Regulator.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Was there any consideration to the fact that it may be an issue of interest to the regulator that one of the main banks in Ireland had, for example, 44% of its non-mortgage related lending in the basket of property and construction?

Mr. Ronan Murphy:

There may have been discussion but I'm not aware of it.

Mr. John McDonnell:

Our ability to report to the regulator, as I said, is set out by obligations to report and we can, in certain circumstances, report over and above those obligations but it's only in the context of the work we do from ... arising from our audit work. That's the first point I'd say. The second point I'd say is that the regulator has its own regular ... returns which the bank need to issue to the regulator and those returns deal with various concentrations risk. So, the regulator has its own mechanism to be well aware of the what the bank do and they had their own reporting regime. So, the fact that we see something in our work which as part of our audit doesn't lead us to report per seto a regulator in that situation because the regulator has its own framework-----

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Sure, but you could've decided to.

Mr. John McDonnell:

I'm not sure that we would have the ability just to say that we saw a report and report that to the regulator. I'm not sure of the basis on which you would be reporting to the regulator.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Well, if you felt it was in the public interest to bring a matter to the attention of the Financial Regulator ... you could argue that it was in the public interest, and certainly of interest to the regulator, to know that at that time Bank of Ireland's exposure to property and construction was so high. That could, at least, have been considered.

Mr. John McDonnell:

I think what's in the public interest is around the continuing functioning of the financial institution and that's where-----

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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That's what's laid out in the Act. They're your mandatory requirements.

Mr. John McDonnell:

It is in the context ... our ability to report in that really flows from what we look at as part of our audit. We don't ... I don't believe we really have the ability to report to the regulator on various things that we see. It would have to be something which we would consider, arising from our audit, that we should report in and around that type of thing.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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This was a key element of your audit ... looking at the loan exposures, looking at the adequacy of the provisions being made, the application of the accounting standards and their impact on the true and fair view of the financial statements. I mean, that's the very essence of the audit that you were doing.

Mr. John McDonnell:

As I explained, we looked at that report in the context of our overall governance and looked at risk management and the governance over risk, the GRPC being a key risk committee. We reviewed that report solely in the context of how it impacts on our calculations ... on the bank's calculation of impairment and our audit of that calculation of impairment. We would've looked at that. I don't believe we had any obligation, be it under the rules of section 47 of the bank or indeed any other way to report to the bank ... I don't think we had any obligation to report that at all.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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I never suggested it was an obligation. It is a "may". So, the question I put was, was it open to the auditors to bring those matters to the attention of the regulator?

Mr. John McDonnell:

Yes.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Yes it was. Thank you.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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I'm going to move to wrap up. I'm going to invite both leads in for five minutes. Before I do, if maybe I could just put a general question to both Mr. Murphy and Mr. McDonnell. In the firm's opinion, did the external audit fulfil its role or not?

Mr. John McDonnell:

Chairman, could you repeat that, sorry?

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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In the firm's opinion, did the external audit fulfil its role or not?

Mr. John McDonnell:

Yes it did.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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It did indeed. In that regard, if I can maybe just move things towards a wrap-up, can you explain, in layperson's terms, if the auditors did their job properly according to the rules why did every bank in the Republic of Ireland fail without warning?

Mr. John McDonnell:

As I said Chairman, an audit is a set of financial statements, is a representation of what happened in the past, past transactions and events. It is not a representation of stability, capital adequacy or future prospects of an entity and we gave our opinion on the ... on the transactions that occurred in the past in the financial statements and we stand over those opinions.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Mr. Murphy?

Mr. Ronan Murphy:

I agree with what Mr. McDonnell has said. We carried out our work. I think we've spent the last three and a half hours here outlining in detail the work we did, how it was in line with auditing practice accounting standards and we believe we did the best possible professional job in the context of the Bank of Ireland audits.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Was the bank failure, to both of you, a surprise or not?

Mr. Ronan Murphy:

Yes, when you say the bank failure, I think what happened and what transpired was a huge surprise. Nobody could have anticipated ... I mean, we spoke about a period of unprecedented turmoil, nobody could have anticipated what happened. Chairman, I've been in public accounting for 35 years. I've seen recessions, I've seen economic cycles, I've seen the downturns in the '80s and the '90s - nothing prepared us for what we saw from September 2008 onwards.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Mr. McDonnell?

Mr. John McDonnell:

I would agree with that. It was totally unprecedented and ... I share exactly what Ronan said. I've been through other downturns but I've never experienced anything like the one we've gone through.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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In view of that, can bank audited accounts predict a risk of a bank failure, in your opinion, into the future?

Mr. John McDonnell:

I think the accounting standards have been developed to allow ... if you look at impairment, we're moving from an incurred loss to an expected loss model. That will mean that accounting standards will recognise loss quicker than in the past. I think that the disclosures and likely future disclosure ... there's much better disclosure around risk, etc., so I think there's a better chance that financial statements will alert to crisis moving into the future. But I would say that a set of financial statements are always going to be about a representation of the past and the past is not always going to be representative of future shocks, and a set of financial statements will never capture ... they might capture expected loss and that's the new model we're going to, but they won't capture unexpected loss. And even if a full set of financial statements were accounted for at fair value, if the market ... if there's a sudden shock in the markets, fair values can drop and they can drop very, very quickly and that can have a ... that can have a very difficult effect on a set of financial statements. Financial statements are always looking backwards, they are not looking forwards and they need to be viewed in that context. But there's been a couple of changes around going concern and the directors in ... the change around going concern is the going concern concept still remains but there's going to be a directors' viability statement into a set of financial statements going forward where the directors will have to give some disclosure around the viability of the business model over an horizon greater than ... greater than one year. And that obviously will have some impact.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Mr. Murphy?

Mr. Ronan Murphy:

Chairman, could you repeat the question?

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Can I ask you, in terms of audited accounts, can they predict the bank failure or a risk of a bank failure going into the future?

Mr. Ronan Murphy:

I think the changes that have been brought in that we've spoken about this morning will certainly help in terms of being able to predict, but at the end of the day we're talking about a set of historical information so it is limited in terms of what it can do.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Thank you. Deputy ... or Senator Susan O'Keeffe, five minutes, and then I will move on to Senator Barrett.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Thanks Chair, I have a couple of shorter questions and then a longer one. When you were saying there to Deputy McGrath that it was ... it would have been open to you potentially to disclose the level of property concentration at any time, did the bank ever ask you not to make such a disclosure?

Mr. Ronan Murphy:

No Senator.

Mr. John McDonnell:

No.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Did the Financial Regulator or the Central Bank ever ask you not to?

Mr. John McDonnell:

No Senator.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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In terms of the dealings, did you have any dealings with the Minister for Finance, the Department of Finance, the Taoiseach or the Taoiseach's office prior to 2008?

Mr. Ronan Murphy:

When you say dealings Senator, could you just-----

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Phone calls, conversations, meetings.

Mr. Ronan Murphy:

In relation to the Bank of Ireland, no.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Yes, in relation to your role here as Bank of Ireland auditor.

Mr. Ronan Murphy:

No, in relation to the Bank of Ireland, the answer is no.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Were you involved with Bank of Ireland on the night of the guarantee, were you standing by or taking phone calls?

Mr. Ronan Murphy:

No, Senator, we were not ... we did some work in advance of the guarantee. That work was completed on the Friday evening - Saturday morning, where we reported in relation to the liquidity concerns on three of the institutions that subsequently became covered institutions but our work effectively ceased that weekend. So we never advised nor were we asked to give any advice on nor did we give any view on, the options being considered by the Government at that point in time.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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So can you just give me some clarity about the work that you did do that you've just explained, the kind of timeline for that?

Mr. Ronan Murphy:

I can Senator. I can give some high-level comments in relation to ... and I know you're talking about Project Atlas ... and I can give some -----

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Sorry, I didn't realise ... I wasn't trying to go in to that.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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No, we are not talking about Project Atlas.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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No, I wasn't trying to go there. I am sorry, I didn't mean to.

Mr. Ronan Murphy:

Okay, well that was the approach, the work we did in advance of the guarantee is Project Atlas phase one, Senator so-----

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Okay, there was no ... sorry Chair, I wasn't asking.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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We'll deal with Project Atlas at another entirely different time.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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No that's fine, I was trying to establish whether there was any other work that you might have done, with your Bank of Ireland-only hat on?

Mr. Ronan Murphy:

No, Senator, there wasn't, no.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Thank you, that's what I mean to say, I beg your pardon. In terms of your team of 200 people that worked with you, did you have to ... did you go abroad to recruit or were all those people recruited in Ireland or did you have a mix of people?

Mr. John McDonnell:

I haven't looked but it's a mix of people we would recruit. Predominantly we recruit in Ireland but we would recruit across Europe and we'd recruit across the world. We'd also have, if you like, a PwC secondment-type programme where we take people in from other PwC offices and we'd give people to other PwC offices. And when we get engaged in recruitment or in the secondment programme, we're always focused in on people with banking-type expertise to fulfil what we need in our banking group.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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So for some of them, they would have needed training about the Irish property market, about Ireland, about the way in which we ... you know the businesses day to day, if they were coming from abroad?

Mr. John McDonnell:

Everyone needs training and we'd always ensure that people get the appropriate type training. As I said earlier on Senator, we have a very detailed training programme both in the context of the Bank of Ireland audit and in the context of the banking group.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Did you ... did your audit team audit Bank of Ireland understanding that the bank was too big to fail?

Mr. John McDonnell:

That was not a concept that we would have ... been discussed in terms of the audit of Bank of Ireland. We would have audited Bank of Ireland in the context of the auditing standards and in the context of the risks that we saw and the context of our requirements. And we would also review it in the context of the ... the environment in which it operated in, the regulatory environment in which it operated in, the Central Bank environment it operated in and the business environment in which it operated.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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So it was never discussed with the bank management, you know, look we're-----

Mr. John McDonnell:

No, we never would have had a discussion with bank management at Bank of Ireland to ... too big to fail. What we did is we looked at the risks. We looked at them in the context of our requirements and we ensured that they were properly audited and we never would have taken that into account.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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On several occasions you have referred to the idea of financial statements faithfully representing the past at a particular time, you've talked about never getting involved in the running of the bank. Can you then clarify for me the role that you did have prior ... I'm sorry, post-September 2008, when it was all, as you said yourselves, in a completely unprecedented situation, you were now talking to the Financial Regulator much more, the Central Bank, and all kinds of ... you were now, I would say if it's fair to say, you were now involved much more. So how did that square, that involvement directly with having meetings with people who were not the bank, outside your audit, I don't understand that?

Mr. John McDonnell:

We were seeking to ... at that point in time we had come through the Lehman collapse and we were seek ... and the Government guarantee ... we were seeking to ensure that the bank would be able to continue in ... in operating in existence and as part of that we had to ensure that (a), the bank had proper access to liquidity and (b), the bank had proper access to capital.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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But that wasn't part of your audit function.

Mr. John McDonnell:

It's part of ... part of our audit is we have to look at ... we have to consider the applicability of the going concern concept over the next 12 months and as part of that, as I said, we would have very heavily looked at liquidity. And when we got into the credit crisis and then the sovereign debt crisis, we would have been looking at liquidity and at that point in time the bank, and indeed all the banks, were very heavily dependent on the EU in the terms of their liquidity, and we had conversations with the Central Bank in the context of the Central Bank's policies to provide liquidity to the ... to the sector. And we would have had conversations with the Department in the context of the systemic importance of Bank of Ireland and the Department's support for Bank of Ireland in the context of both capital and-----

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Just to clarify, Chair.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Supplementary now.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Absolutely. So you were ... would you use the word negotiating or assisting ... what is the word that you would use there?

Mr. John McDonnell:

No, no. We were not negotiating, we were seeking to understand the level of support which the Central Bank were giving Bank of Ireland in the context of liquidity. We were seeking to understand the level of support which the Department of Finance and the Government were giving the bank in the context of capital.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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But you were allowed to talk at the meetings that you attended. You were allowed to be participants in them. You weren't sitting passively at the-----

Mr. John McDonnell:

No, we ... we were seeking to get audit evidence. So, we're sitting doing audit opinion on a set of financial statements and we are looking at the applicability, the going concern concept, we are looking at disclosure in the financial statements and we're looking at the bank's ability to have appropriate liquidity. The bank was very, very dependent on the ECB and we needed to ensure that that dependency ... that the ECB would provide liquidity to the bank over the horizon that we were meant to look at for going concern, which is a year. And, therefore, we asked the ECB would ... would they confirm that and they confirmed that to us. It was us gathering audit evidence. That was our role.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay, thank you very much. Senator Barrett.

Photo of Sean BarrettSean Barrett (Independent)
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Thank you very much, Chairman, and thank you, gentlemen. Did the bank's management and board structure impede the provision of good governance within the banks or what impact, if any, did it have?

Mr. John McDonnell:

No, Senator, the bank ... the bank's management and governance structure ... the bank were always very open with us. They always shared things with us very early. They always took our counsel and they always reflected our counsel in the preparation of the financial statements, so we'd a very open relationship with them. But look at their governance ... the banks ... the bank had to apply Sarbanes-Oxley and Sarbanes-Oxley arose as a result of a corporate failure in the US, and it is taken as probably one of the best-in-class corporate governance-type arrangements for the production of financial statements. And the bank would have very detailed processes around the governance ... its governance over financial statements and around detailed controls around the production of financial statements. The bank would test those controls and we'd test those controls. So we took considerable comfort from the fact that the bank applied a Sarbanes-Oxley model.

Photo of Sean BarrettSean Barrett (Independent)
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Just that ... it has 20 years imprisonment and criminal penalties of $5 million. Is that a model that this committee might look at, Sarbanes-Oxley?

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Sarbanes-Oxley?

Mr. John McDonnell:

Sarbanes-Oxley is a model which is applied in the US.

Mr. John McDonnell:

It's a model which entities apply for reporting on financial controls. The ... the ... the CEO and chief executive report under Sarbanes-Oxley and the auditors have to give an opinion under Sarbanes-Oxley.

Photo of Sean BarrettSean Barrett (Independent)
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You were talking about the regulator now. Have you any observations on the regulator in the period 2003 to 2008 and in the period leading up to the crisis?

Mr. John McDonnell:

I ... we've had a ... Senator, as I said earlier, we had very limited engagement with the regulator and we would've reported the regulatory requirements in accordance with our requirements under PN 19. And, you know, that engagement would've been quite limited. We now have much greater engagement with the regulator.

Photo of Sean BarrettSean Barrett (Independent)
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Did you encounter, in doing the sample of loans, any problems of income verification?

Mr. John McDonnell:

What do you mean by income verification? Sorry.

Photo of Sean BarrettSean Barrett (Independent)
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Verifying the income of the borrower.

Mr. John McDonnell:

The bank would have had detailed procedures around its collateral and around the information that it gets from its loans. It would've detailed controls in place and we would've looked at a sample of loans. We looked at the operation of those controls. I can't say in all the sample loans that we see ... what we would've seen. But anything that we would've seen, we would've reported up. But I can say the bank had very, very detailed checklists and controls over collateral.

Photo of Sean BarrettSean Barrett (Independent)
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Were there concerns ... just two, if I may, in the wrap-up, Chairman ... were there concerns about Bank of Ireland's loss of market share? Were there concerns when you were doing the audits that a lot of power had been moved from local branches and regions to the centre?

Mr. John McDonnell:

They were ... they were ... the bank had a business model where it was trying to co-ordinate its ... its ... its ... the operation of its controls so it would get a much better effective control and it would get consistency and control across its models. So the banks would always change and verify ... change their business models and we would have discussions with the banks about those business models solely in the context of how it impacts on our audit or the financial statements. I don't ... I don't ... that's where it would begin and end in terms of our interaction with that.

Photo of Sean BarrettSean Barrett (Independent)
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Thank you, gentlemen. Thank you, Chairman.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Thanks very much. Okay, that brings me to wrapping matters up. And, in doing so, I would like to thank Mr. Murphy and Mr. McDonnell for their participation today and for their engagement with the inquiry. The witnesses are now excused and I just want to take a brief suspension because there's some lines of inquiry, notification stuff that ... we just need to have a quick sit-down before we go to lunch. So with that said, I'll just suspend for two or three minutes to excuse the witnesses and we'll just resume in private session to deal with those matters promptly then. So Mr. McDonnell and Mr. Murphy, you are excused.

Mr. John McDonnell:

Thank you, Chairman.

Sitting suspended at 1.15 p.m., resumed in private session at 1.17 p.m. and suspended again at 1.30 p.m. until 2.30 p.m.

Ernst and Young - Mr. Paul Smith and Mr. Dargan Fitzgerald

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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I now propose that we go back into public session for this afternoon's engagement, is that agreed? Okay, and the committee is now back in public session for session 2. This is a public hearing with Mr. Paul Smith, former managing partner at Ernst and Young, and Mr. Dargan Fitzgerald, audit partner, Ernst and Young. The Committee of Inquiry into the Banking Crisis is now resuming in public session and can I ask members and those in the public Gallery to ensure that their mobile devices are switched off.

Today we continue our hearings with senior auditors who had roles during and after the crisis. This afternoon we will hear from witnesses from Ernst and Young, Mr. Paul Smith, former managing partner, and Mr. Dargan Fitzgerald, audit partner. Mr. Paul Smith is a former managing partner with Ernst and Young. He held this position from 2000 to July 2009, having been re-elected on three consecutive occasions.

Dargan Fitzgerald is head of Ernst and Young's insurance and audit practice in Ireland. He is a partner in Ernst and Young since 2000, and within Ernst and Young is the EBS's auditing partner. Mr. Smith and Mr. Fitzgerald are both very welcome here this afternoon.

Before I start hearing from the witnesses, I wish to advise the witnesses that by virtue of section 17(2)(l) of the Defamation Act 2009, witnesses are protected by absolute privilege in respect of their evidence to this committee. If you are directed by the Chairman to cease giving evidence in relation to a particular matter and you continue to do so, you are entitled thereafter only to a qualified privilege in respect of your evidence. You are directed that only evidence connected with the subject matter in these proceedings is to be given.

I would remind members and those present that there are currently criminal proceedings ongoing, and further criminal proceedings are scheduled during the lifetime of the inquiry, which overlap with the subject matter of the inquiry. Therefore, the utmost caution should be taken not to prejudice those proceedings, and in this regard, I remind members and those present, that Mr. Paul Smith and Mr. Dargan Fitzgerald are here today to discuss their roles as auditors with Ernst and Young of EBS. While Ernst and Young also acted as auditor to Anglo Irish Bank, due to the current criminal proceedings before the courts, Ernst and Young's role as auditor of Anglo will not be examined by the joint committee at today's hearing, so as not to prejudice those particular proceedings.

So with that said, members of the public are reminded that photography is prohibited in the committee room. To assist the smooth running of the inquiry, we will also display certain documents on the screens here in the committee room. For those sitting in the Gallery, these documents will be displayed on screens to your left and right, and members of the public and journalists are reminded that the documents are confidential and they should not publish any of the documents so displayed.

The witnesses have been directed to attend this meeting of the Joint Committee of Inquiry into the Banking Crisis and you have been furnished with booklets of core documents. These are before the committee and will be relied upon in questioning and form part of the evidence of the inquiry. So with that said, I now ask the clerk to administer the oath.

Clerk:

The following witnesses were sworn in by the Clerk to the Committee:

Mr. Paul Smith, former Managing Partner, Ernst and Young.

Mr. Dargan Fitzgerald, Audit Partner, Ernst and Young.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Thank you again, Mr. Fitzgerald and Mr. Smith, and in whichever sequence you choose, if I can ask and call on you to make your opening statements to the inquiry, please.

Mr. Paul Smith:

Thank you very much. Good afternoon. My name is Paul Smith. I joined Ernst and Young in 1973, specialising in tax, and became a partner in 1982. I was based in the firm's Irish tax desk in New York between 1994 and 1996, before returning to Ireland. I was managing partner from 2000 until 2009, when I retired from the firm.

I hope my remarks today can assist the committee with its inquiry. I will briefly outline my role and responsibilities as managing partner before and during the banking crisis. I will explain how we undertook our audits of EBS, the role auditors played generally, and my reflections on lessons learned from the banking crisis.

As I outline in my written evidence, I was responsible for the strategy, management and leadership of the firm, working with my colleagues in the firm's management committee. I was also responsible for dealing with specific issues referred to me as managing partner, from time to time. An important part of my role was to represent the partnership externally, and within the EY network internationally.

EY Ireland has several divisions and practice areas, covering various professional disciplines and sectors. One of these is our financial services group, and the partners in this group carried out the audits of banks and other financial institutions. The partners and staff of this group were specialists, highly experienced and conferred regularly. They had available to them the depth of resources and expertise, both in Ireland and internationally, that were required to operate to the highest professional standards when providing services to large and complex financial institutions. The partner in charge of the financial services group kept me and my colleagues in the management committee up to date on significant developments in the sector and on matters relating to individual clients, where necessary.

While I was not involved in the planning and execution of individual audits, I understood the fundamental principles underpinning the firm's approach. Significant issues would be referred to me if they required my attention. The management committee and I engaged particularly closely with the financial services group as the banking crisis unfolded. We knew that our colleagues were responding to the challenging environment, increasing the extent of their audit work, and that significant additional resources were allocated.

While I was aware of the increasing challenges facing Irish banks, no issues were referred to me as managing partner at any time with respect to our audit of EBS. Nor, as far as I am aware, did we ever receive any complaint from EBS. I appreciate that the committee may have questions about our audit. As I am not an auditor, and as no issues were referred to me with respect to the audits, I have proposed that my colleague, Dargan Fitzgerald, should appear alongside me, and the committee has invited him to do so. He was the audit partner of EBS for 2007 and 2008. Dargan is EY's audit compliance principal, and an audit partner specialising in the audit of financial institutions, and is better placed to answer detailed questions on the EBS audits, and on audit procedure generally, than I am. I have read the evidence Dargan has supplied to the committee, and I agree with it to the extent of my own expertise.

I have also discussed this opening statement with Dargan and my former colleagues in EY Ireland.

While I don't claim to be an auditing expert or to have reviewed the EBS audit files, I am confident that the EY audit team properly performed its responsibilities as statutory auditors of the financial statements of EBS. I believe that EY undertook its duties as statutory auditor professionally and diligently, in accordance with international auditing standards. The audit opinion on the EBS financial statements reflected the applicable statutory requirements. In accordance with normal practice, the audit team also reported in greater detail to the audit committee and to the board of EBS, drawing their attention to any management and control issues identified during the course of the audit. Finally, the audit team also communicated with the Financial Regulator as required.

Our audit reports offered all stakeholders reasonable assurance about the state of EBS at a particular point in time. In particular, the financial statements presented by the directors were true and fair. The presentation complied with accounting standards. It is worth noting that our audit opinions have not been subsequently challenged. EBS has not restated its accounts for 2007 or 2008. Statutory audits are not designed to provide advice on future business models, or commercial decision making. Neither is it the auditor's role to advise on risks to the business, particularly business risks, which are market wide and not confined to a single entity or job review. During ... dealing with these risks, it is the responsibility of the management, their advisers and regulators. It is inappropriate for auditors to advise on these questions. To do so would compromise their independence. It is fundamental that auditors do not audit their own advice.

But I do understand why people ask why auditors didn't warn the banks of the risks of their decisions. The first thing to say is that it is now clear that the combined risks were underestimated by all stakeholders at the crucial time, that is, the period leading up to the peak of the boom. Second, it is important to view this question in the light of the statutory role of an auditor and the parameters and limitations of that role. The focus of auditors was on the risk that previous years' financial statements had been materially misstated. Therefore, at the start of an audit, we're looking back at the decisions that have already been made and the income and expenditure of the company of the year that has passed. Third, it was the responsibility of each bank's board, under the supervision of the prudential regulator, to run its business and to determine its commercial strategy and its appetite for risk. If we had issues about a particular commercial strategy, then our role would be to ensure that those charged with the governance of the client were aware of those issues and that the impact of the financial statements at the year end was correctly reflected.

In terms of our role at the time, however, the auditor's primary function was to carry out a statutory audit of the company's financial statements and to express an independent opinion on them. I believe that the statutory audit does play an important role. It provides an independent, professional opinion, based on an audit conducted in accordance with international auditing standards. It records the auditor's opinion as to whether the financial statements conform to international accounting standards and whether they provide a true and fair view of the company's position and results over a particular period. Financial statements are inherently historic, reflecting the position up to the previous year end. Of necessity, decisions by a company and the regulator are based on more current, but non-audited information, such as the company's own management information, the books and records which the company is legally required to keep and the detailed returns supplied by the company to the Financial Regulator.

It is important for me to acknowledge that the banking crisis has had devastating consequences for individuals and families all over Ireland. The effects have been humbling for anyone involved in financial services and I understand the loss and the anger of people who have suffered. Everyone connected to the financial services industry at the time has reflected on their own role in the crisis and how the regulatory environment can be improved. It is important that this reflection happens and EY and the audit firms generally are no exception to that. As I have explained, auditors perform the role required of them but that is no cause for complacency. We believe that many users of financial statements generally understood the purpose and limitations of an audit but we accept that many observers expected more from the audit process than a statutory audit was actually designed to deliver.

Since the crisis, EY Ireland, our international colleagues and various authorities have considered how audit can be made more useful. Changes have been made in several areas and Dargan will refer to these in his opening statement. But more can be done. I'd like to use my remaining few minutes to suggest areas where some changes could be made in the future to improve the usefulness of audit. I understand that auditors are now better able to communicate to the regulator. This communication with the regulator, in my opinion, should be in both directions. Specifically, the regulator should be permitted and encouraged to exchange information with auditors. That is my first recommendation.

I am sure my colleagues will continue to support strengthening the role of audit committees and internal audit functions within companies. I understand that progress has been made on this point, but that it's a continual process, and Dargan can answer questions on that subject. And that is my second recommendation. My third and final recommendation is based on discussions I have had with former colleagues since being invited to appear before this committee. Insurance companies are required to provide detailed information to regulators in their regulatory returns and to ask an external auditor to provide an opinion on those returns. It seems logical to me that banks and other financial institutions could be subject to the same requirements. Their returns could be independently audited as well. That would improve the transparency of the system and increase regulators' confidence in the information that financial institutions provide. It would also ensure ... it would also serve to ensure that auditors were aware of current trends in the Financial Regulator. That is my third recommendation.

So, to sum up, I believe that EY performed its statutory duties, in accordance with auditing standards, and carried out high quality audits on the EBS financial statements and that those financial statements provided transparency and reasonable assurance to investors, regulators and policy makers in respect of the company's financial performance during the period covered by the financial statements. I understand the distress and anger of people who have suffered as a result of the banking crisis and I've reflected on the causes of the crisis. And I've also commented on improvements since the crisis and suggested some further possible improvements. I welcome the opportunity to speak to the committee and I look forward to your questions.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Thank you very much, Mr. Smith. Mr. Fitzgerald.

Mr. Dargan Fitzgerald:

Thank you, Chairman. Good afternoon. My name is Dargan Fitzgerald, I am an audit partner, specialising in the audit of financial institutions, and EY Ireland's audit compliance partner. I was the audit partner for EBS for the years ending 31 December 2007 and 2008. I am happy to endorse the comments made by Paul and I would like to add some detail regarding our audit of EBS.

Paul has addressed a long-standing question on the role of audit and the apparent misapprehension that it was the role of auditors to advise on banks' prospective commercial lending strategies, strategies which proved extremely successful for some banks for some years, but which ultimately left the banks exposed in the global recession. As Paul mentioned, auditors do not advise on the business models which our clients adopt. We do not advise clients on the wisdom or prudence of their commercial decisions. Stakeholders do not and should not look to audits to provide commentary on business risks. Auditor independence is a fundamental principle and we could not provide an independent audit while simultaneously advising management.

When considering the impact of the banking crisis on EBS and the commercial strategies it adopted, the turning point as identified by various investigations into the crisis appears to have been the board's decision in 2005 to follow the example of its competitors by increasing its exposure to development property lending. While the board of EBS has since described that commercial strategy as, I quote, "a mistake", I have no reason to doubt that it was adopted in good faith by the EBS board at that time. I know that the board was satisfied that such a commercial strategy was in the best interests of EBS. As far as I am aware, the Financial Regulator did not raise an objection at the time. EY Ireland was not consulted on the decision to adopt this strategy. Our firm had no role in the EBS decision to adopt that commercial strategy in 2005. On the contrary, as statutory auditors, it was important that we were independent of this commercial decision making.

Nevertheless, if, during our audit work, we became aware of control weaknesses or of issues which gave rise to a significant risk of misstatement of the financial statements, then we would draw these matters to the attention of those charged with governance. There were various issues that we identified and raised with management over the years, as can be seen from the core documents which are before the committee.

However, future commercial decision making and its associated risks and financial consequences were matters for the board. It was the auditors' role to express our view as to whether the financial statements fairly presented the institution’s financial performance for the particular period. In our opinion, the EBS financial statements did so. For example, the 2008 annual report presented by the directors, which accompanied the financial statements, acknowledged the unsuccessful commercial strategy and the resulting losses and impairment provisions as at 31 December 2008. The 2008 annual report, presented by the directors, also disclosed that those provisions and losses were likely to increase in subsequent periods.

Now with hindsight, the banks’ business models and lending practices have attracted universal criticism. I agree that, in the light of what transpired from 2008 onwards, many of the banks’ earlier commercial decisions have proven extremely damaging. The exposure of individual institutions in Ireland and elsewhere became increasingly obvious as the credit crisis developed. By the time Lehman Brothers collapsed, it was evident that the banks were in serious difficulty. By that time, far less development lending was taking place in Ireland in any event. The board of EBS had taken the decision to stop development property lending by April 2008. However, by then the damage had been done before the frailties of the system had been laid bare when global liquidity abruptly dried up.

The need for foresight on the part of those responsible was greatest at the time at which the banks embarked on development lending at what, with hindsight, we now know was the height of the boom. I cannot say that the auditing profession foresaw these developments any more than any other stakeholders did. However, unlike the directors and the prudential regulator, our primary responsibility was to provide an opinion on the past year’s financial statements and to consider the risk that those historic financial statements were misstated. A statutory audit is not designed to anticipate future trading risk. That would be akin to a corporate finance role, a very different function. The auditors did not make any assessment prior to the 2008 audit that EBS’s business strategy left them unacceptably exposed in the event of a future financial crisis, nor, as I have outlined, was it the auditors’ responsibility to do so. We were aware, as auditors, that EBS had changed its commercial strategy, increasing its development lending. This was following a strategy which was widely viewed as being successfully pursued by other Irish banks. Our approach to the audit of the last year’s financial statements reflected our understanding of the strategy being pursued. It was not our role as auditor to advise on the mix of commercial and residential lending which EBS should adopt in the future. Nevertheless, if the auditors had been concerned about the wisdom of EBS increasing its development property lending, what could or should they have done? Disagreement with the bank’s commercial decisions would not have been a basis to resign or to qualify the previous years’ financial statements, unless, for example, those financial statements were misstated or there were corporate governance issues which had led the auditors to doubt the integrity of management. Furthermore, the auditors were constrained by client confidentiality and could only have divulged confidential information to the Financial Regulator in limited circumstances, such as where there had been a regulatory breach. None of these three scenarios had occurred in the case of EBS. Accordingly, the auditors’ only option would have been to ensure that the directors were fully aware of management’s actions. In this case, as is clear from their annual reports, the directors of EBS were aware of and had endorsed the increase in development lending.

I agree with Paul that we carried out high-quality audits of EBS’s financial statements throughout the period. In preparing for the session, I discussed the changes that have taken place since the financial crisis with Paul and also the changes that could happen in future. I will briefly outline the changes that have been implemented already.

First, dialogue with regulators is an important consideration. At the time, auditors did not have an open channel of communication with the Financial Regulator. Bound by client confidentiality, auditors were limited in the information they could divulge, except in exceptional circumstances such as a suspected regulatory contravention. I should be clear that, as audit partner, I had no particular concerns or no particular information in respect of EBS which I felt should be divulged to the Financial Regulator. That said, the desirability of a more open and two-way dialogue with prudential regulators is a clear lesson from the crisis. Progress has indeed been made on this point. The Central Bank’s auditor protocol provides a framework for auditors to raise issues about financial institutions with the prudential regulator, now the Central Bank of Ireland. This is welcome and consideration should be given to placing this on a formal basis and to enabling communication in both directions. The Financial Regulator, who has greater market-wide visibility, may well be able to inform the auditor's approach to the audit, ensuring that the auditor can take account of the regulator’s concerns during their audit work.

The second area where progress has been made is on accounting standards. Accounting standards provide a common international approach to the presentation of financial statements, just as auditing standards promote consistency in approaches to audit. Changes have been made to accounting standards to allow financial institutions to report unexpected losses in their loan book, as well as reporting actual incurred losses. The need for this change was recognised internationally in the wake of the banking crisis. The standard setters have worked hard to engage with all stakeholders following the crisis, including EY, and I welcome this change.

Thirdly, I support strengthening the role of audit committees. I believe that audit committees should be strong, dedicated and fully engaged in carrying out their functions. They are there to represent shareholders and to challenge management. Strong audit committees ensure financial reporting is scrutinised and challenged. Again, this is an area where progress has been made but more could be done.

Finally, and perhaps most significantly, changes have been made in prudential regulation and in capital requirements for banks through Basel III and other regulatory initiatives. The committee will be well aware of the scope of these changes and of their impact. Prudential regulation and international capital requirements, the responsibilities of the board, especially non-executive directors and management, all play their own roles. However, it is important to emphasise that audit forms only one part of the wider system of assurance available to stakeholders. It is important that audit, as part of this system of assurance, continually improves and becomes more useful to all stakeholders. Therefore, as we look to the future, I’m happy to endorse Paul Smith’s three recommendations.

That concludes my statement and I welcome any questions the committee might have.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Thank you very much, Mr. Fitzgerald, and I also thank you for your earlier contribution, Mr. Smith. If I can now invite Deputy Joe Higgins. Deputy, you have 25 minutes.

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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Yes. Gentleman, and just to reiterate that you were also auditors for Anglo Irish Bank but due to current criminal proceedings before the courts and to avoid any danger of prejudice to those proceedings, it's not for today ... in relation to Anglo, it's for another day.

So, Mr. Fitzgerald, if I could ask you, when you audited EBS in 2007 and 2008, you provided an unqualified independent audit opinion.

Could you just say, in a nutshell, what that means technically?

Mr. Dargan Fitzgerald:

Certainly. So the audit opinion spans typically two pages and "in a nutshell" is possibly slightly challenging, as it actually covers a number of different statutory and legal requirements. The principle of those is that it confirms that the financial statements have been prepared, in our opinion, fully in compliance with international financial reporting standards. It also complies ... it also confirms that the financial statements are reported in a framework fully in compliance with relevant company law. In this ... in this case, relevant law may include building societies Acts, given that it was a building society.

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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And in view of what happened subsequently to EBS and some of its loans and with hindsight, would you now provide those same opinion that the accounts gave a true and fair view?

Mr. Dargan Fitzgerald:

Yes, I would provide the same opinions, in my view, and, in making that overall comment to you, I would comment that the ... you mentioned subsequent events after that and you mentioned the effect and benefit of hindsight and I think even with the benefit of hindsight, the important reference point, as I mentioned, is the applicable financial reporting framework of the time and the fact that the accounts are drawn up to a particular point in time, in this case ... in the case of the 2008 financial statements, 31 December 2008.

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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And, Mr. Fitzgerald, when NAMA acquired EBS loans, NAMA imposed a 57% haircut on the nominal value of those loans. I think it was from something like €900 million to €400 million. Why was this cut so drastically high?

Mr. Dargan Fitzgerald:

Well, Deputy, first of all, I am not sure I can really comment as I wasn't involved in that process and, you know, the approaches taken by NAMA in relation to the banks and the actions it carried out resulted, I understand, in different levels of discount, depending on the nature of the portfolios taken over. So, I actually can't speculate as to how exactly those numbers were arrived at. It's probably important to bear in mind that ... that two calendar years, I think, at least, had elapsed by the time that process took place with NAMA and so I think the importance of the phase of the economic cycle, with reference to audited financial statements, is very crucial. And, again, the point I'd refer to is that the financial statements for 2008 are drawn up to a point of time and that the audit opinion confirms that they give a true and fair view in accordance with the applicable accounting standards relevant at that time.

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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And when you were auditing EBS, were you satisfied with the valuation methodology used by EBS in assessing the value of land and development loans and the potential impact on the subsequent provisioning? And you may be aware of heavy criticism by NAMA's chief executive and chair, when they were in here, in a general comment on the banks in relation to the valuation and the type of securities, etc. Were you satisfied?

Mr. Dargan Fitzgerald:

In broad terms, I must say the answer to your question is "Yes" and, if I just give a little bit of background, in terms of our review of the loan book generally, we, as you would expect, take a view based on a sample weighted towards higher value and more risky loans and our audit work comprises a number of tests of those loans. It also rests on tests we have carried out during our audit of the systems and processes that lead to the booking and recording of the loans. And, in that context, when we come to the year end or balance sheet part of our audit, as it's called, we also examine the loan files and review further documentation and obtain appropriate explanations from management in relation to the status of the loan as of the balance sheet date. And, in doing that work, we also review any property valuations that have been carried out. Sometimes these are formally required by the bank and they are third-party valuations from external valuers. In some cases, they're values derived internally from either analysis of cash flows or updating of previous valuations. In any of the work we carried out, generally, I must say, the work was very satisfactory. We had few, if any, occasions where we were unable to obtain a satisfactory explanations for management for the decisions they had taken in relation to any valuation for impairments on loans and that's ... given the fact that the market at the time was showing the beginnings of considerable uncertainty in relation to the values of collateral in cases where loans were already stressed.

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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Okay, thank you. Mr. Fitzgerald, the Financial Regulator reviewed EBS residential mortgages lending in 2007 and found that 7.35% of home loans were outside policy; 24.3% of home loans-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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To reference that document there for you, Deputy, it's pages 17 to 18-----

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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Yes, that's page 17-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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-----of the Financial Regulator-----

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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-----of the core documents. 24.31% of home loans approvals exceeded affordability; and buy-to-let cases ... 15.82% were outside policy. And in a further letter from the regulator, which is page 21, in relation to the level of exceptions to policy ... "The level of exceptions to the Credit Policy for the eleven months to 30 November 2007, was 29.2%" but in 2006 it had been 42.1%. Is that an inordinate exception level and was Ernst and Young concerned about the extent of loans that fell outside policy?

Mr. Dargan Fitzgerald:

Thank you. So, a couple of comments. First of all ... and I'm familiar with the references that you gave in those two documents, thank you. First of all, I just need to distinguish between the role of the Financial Regulator in issuing such letters and our role as external auditors and you'll appreciate that the Financial Regulator's role as a supervisor is based on its detailed programme of work which has a very different scope and aim compared with the ambit and role of the external auditor. So, I would say, firstly, as a general comment to the committee, that one may not be comparing like with like in asking for external auditor comment on such things. We have a very clearly defined role in relation to what we do with such regulatory correspondence when we ask for it and, of course, come across it. This is governed by one of the auditing standards - compliance with laws and regulations. And we are required to understand the content of such reports and then assess how they impact our ... our audit. And, as I mentioned in some of my previous comments, our audit is ... the possible effect on our audit is in relation to the risk of misstatement of the reported balance sheet or income statement amounts. So, I just want to make the point that such comments by the Financial Regulator do not directly impact or correspond with or feed into external auditor assessment other than they may ... they may inform our risk assessment as to where we should focus our effort of our audit. So you-----

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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I know, Mr. Fitzgerald, that you're the fourth cohort of auditors that have come before the inquiry and all have been extremely insistent on emphasising the narrowness, perhaps, if I put it like that, or the narrow parameters of the audit role. But do you say that the auditor has no role in reviewing loans, such as I quoted from the regulator, that fall outside of policy?

Mr. Dargan Fitzgerald:

I would say they don't necessarily have a role in reviewing them in the same way and from the same perspective as the Financial Regulator does. The Financial Regulator may be more concerned with aspects of adherence to procedures and they may be more concerned with aspects of documentation of procedures, whereas the external auditor's role is, as I mentioned, to assess whether any of the items highlighted by the regulator do, and I must say it is in a background way ... whether they affect the risk assessment of the auditor in carrying out the auditor's tests.

So that is not to say that if there was something that alarmed the auditor, it should not be taken into account. If it had a pervasive effect on financial reporting, it absolutely would be taken into account. I think it's important, in relation to the items you've highlighted, to understand that as when we, as auditors, take samples of loan files, we do look for characteristics relating to both the administration and the credit approval of the loan and we carry out tests of the underlying data. Exceptions to policies may be relevant, although sometimes those exceptions just show that there's been a particular activity level in a particular sector. They may not indicate that anything is wrong with the financial reporting; they're more internally procedural. So, in summary, my answer, Deputy, is we take it into account or we may take it into account but we don't necessarily actually retest it or factor it directly into our work. I hope that's helpful.

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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Mr. Fitzgerald, not just ... your ... as you said, I think, or it's a fact anyhow, that EBS turned to property and development loans to achieve growth and profits and that this was a characteristic of all the financial institutions in the bubble, some, to what has been referred to, as an excessive degree - what one of the witnesses here, Mr. Black, a regulator ... a former regulator from the United States, called "crazy growth". Would a person of your experience and your firm's experience, notwithstanding the narrowness of the parameters of audit as you see it, would that not have set alarms bell ringing in, say, 2005, 2006, as the bubble expanded?

Mr. Dargan Fitzgerald:

Well, to answer your question and your comments, first of all, just to highlight that I mentioned that in public record in their annual reports, the reference to development property lending is explained as having taken ... decisions having been taken place in 2005. I think, as a matter of fact, the substantial, or relatively substantial, development property lending, the bulk of it, took place, I think, in 2006 and 2007, a relatively short period before in, as I think I mentioned and it's in the public record, in April 2008, that development lending was ceased. So, it's actually a relatively short period for any problems to emerge with loans or, indeed, the extent of the exposure to be reassessed. And I would just say in that context that development property lending was disclosed in the various footnotes to the financial statements, as you are aware, and I also would comment that my view is that it was not a ... I'm sure it did not seem at the time to be a very large proportion of the balance sheet of the building society.

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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Yes. Did you have any occasion in relation to any concern about exceptions to lending policy to report that in any formal way? As you said, it's in the accounts, but did you have ... was attention drawn to this in any formal way as a result of any concerns Ernst and Young had?

Mr. Dargan Fitzgerald:

I think the short answer is "No" and if I just explain, that's because in the course of our work, we were not ourselves coming across any of the exceptions in the way in which, I think, your comments are referring to the Financial Regulator's comments. We may not have been testing for what in testing terms we call "that attribute" in our testing. We would have been, perhaps, concerned with the set-up of the loan, the overall approval of the loan and that particular aspect may not have, as I mentioned previously, been a particular item for which we were testing at that time or in that case. And, as a general matter, and as you can see in the core documents that are before the committee, while we brought various matters to the attention of the audit committee, which we found during our audits, of a control compliance nature or of financial reporting or judgmental nature, credit exceptions were not one of those which we came across and, therefore, they did not fall to be reported.

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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Okay. Mr. Fitzgerald, in 2008, Ernst and Young identified a "going concern" problem with EBS in relation to an outflow of funds, a fall in share prices, and then you have the guarantee-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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I'll just reference the document there as well, Deputy Higgins, while you're getting the ... page 25 to 28 of the core documents.

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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Yes. Did you consider a review of the assessment of going concern in any previous year, in 2006 or 2007, for example?

Mr. Dargan Fitzgerald:

Yes, I can confirm that in each year there is a formal assessment of going concern, typically both by the directors of actually, of all entities subject to external audit and that going concern assessment is initially carried out by the directors and, in fact, it's part of the representations which auditors annually receive that the directors have satisfied themselves that the going concern basis continues to be appropriate. So, yes, to answer your question, in each year, there's a formal assessment of going concern, both by the directors and by the auditors.

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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But you expressed concern in the 2008 ... was there any form of concern in relation to that issue in any of the previous years?

Mr. Dargan Fitzgerald:

Only as I mentioned ... well, my direct knowledge is only of 2007 and it would have been in the context of what our mandatory audit procedures to assess going concern and from my recollection of that year, there would have been a formal going concern assessment from the directors. If I could just highlight in the documents and I'm referring to document 25 and if I could just highlight that the words used in the document are, "We have identified from our market knowledge that there is a potential going concern problem for EBS and for all Irish credit institutions". So I just would like to highlight that it's "potential" and really what that is saying is we are. ... [and the note is dated 14 February, within a few weeks of the approval by the directors of the financial statements] ... we're confirming that, as a matter of ... as a matter of logic and one might say common-sense in the circumstances of their time, there would fall to be a greater focus on going concern for all banks, given that they were then, in the case of domestic institutions, availing of the Government guarantee scheme. So by definition, there was a potential going concern issue for all banks which all auditors, I'm sure, considered very carefully at the time.

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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Mr. Smith, if I could turn to yourself, just in conclusion, and in a more general way. I think you hinted yourself and certainly your counterparts in the other three major auditing firms are adamant that no one, as it was put today, could have foreseen the collapse in the banking system and the crisis and the crash that resulted from the bubble, but could I just put it to you: Ernst and Young is a massive international organisation, you are in 150 countries, you have 190,000 employees, your income gross in 2014 was €27.4 billion, I guess ... or dollars ... so you're a huge organisation with huge resources and expertise. Now, Mr. Smith, considering, for example, the history of your company in the United States, which would have seen the loans and savings debacle in the '80s and the '90s and the huge crash that happened there and then in the Scandinavian countries in the late' 80s and the '90s, Sweden for example, a modern capitalist, industrialised society with a huge bank ... banking crisis, all as a result of speculative lending and of excessive rates of growth, would it be reasonable or not to say to a company like yourselves, you should have seen that was happening in Ireland was really a replica of what caused all these previous bubbles and disasters? And, indeed, others did see in advance. I just put it to you for comment, if you like.

Mr. Paul Smith:

Thank you for your question. Undoubtedly, these cycles of boom and bust come all the time and in many, many jurisdictions, but I have to say, as a matter of fact, we, notwithstanding our large international network, did not feel any different from, I would say, almost the unanimous view of the commentators in Ireland on the economic situation in Ireland that the two events which occurred, the liquidity crisis and the crash in property values, we did not anticipate that.

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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Yet we had a witness in front of this, an economic commentator, David McWilliams, who said: "I think the Irish property crash and the banking crash were both incredibly predictable and absolutely preventable." And then he made reference to statements he made in 2003 in relation to the bubble and the banks and the huge extension of loans we had. Another witness, Alan Ahearne, referred to a 2005 report that was published by the US Fed, a study of dozens of booms and busts. And, finally, we had Professor Morgan Kelly in late 2006 and again in 2007 similarly, studies of international boom and bust, and drawing the conclusions that it was inevitable. We had all the same features in Ireland. It was, therefore, inevitable that it would end in a disaster. Why ... that was their conclusion. Why did an organisation like yours, as I said, with resources and expertise not draw the same conclusion?

Mr. Paul Smith:

Well, Deputy, those were individual points of view, but I have to say they wouldn't correspond in my recollection ... and remember, it's six years ago now and further. In my recollection, that didn't correspond with the widely held view by the vast majority of commentators that what Ireland was experiencing - the growth that Ireland was experiencing - would slow down and that there would be a soft landing. That was by far the most widely-held view. So, I agree that there were individual people who spoke out at various times, but if you look over the whole broad level of commentary around the financial crisis, those were very few views in the overall crowd.

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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Could I ask you, finally perhaps, Mr. Smith, would you see any ... would you agree in any way with some assertions that have been made in evidence here that, in the course of the bubble, you had institutions making inordinate, or massive by any scale, profits? You had senior executives in financial institutions and perhaps in related professions reaping extensive bonuses and huge material rewards linked to the rapid expansion. Would you say in any sense that that might have blinded people or not to the dangers and left people carry on even if they had some inkling that perhaps this could end in tears?

Mr. Paul Smith:

Well, I can't speak for people in other institutions, but I can say that the auditors in Ernst and Young were not blinded by those circumstances and carried out their duties as sceptical auditors independently and I believe arrived at the correct conclusions in terms of providing an audit opinion on the accounts of EBS.

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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Thank you.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Thank you very much. Next questioner is Deputy Kieran O'Donnell. Deputy, you've 25 minutes.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Thanks, Chairman. I want to welcome Mr. Smith and Mr. Fitzgerald.

Mr. Paul Smith:

Thank you.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Can you recall any issue, which may have warranted qualified report, which was discussed with the bank but did not feature in a management letter?

Mr. Dargan Fitzgerald:

No, I cannot, Deputy.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Did the adoption of IAS 39 mean that the audited financial statements no longer had to comply with true and fair standard, the previously ... that was previously accepted?

Mr. Dargan Fitzgerald:

I might just make some comments on that. I'm aware that that topic has come up, both in this room and elsewhere, and the short answer is, no, I don't feel that there is any conflict between international financial reporting standards and the true and fair view. And in particular in relation to the EBS audit in 2008, I'm quite satisfied that the appropriate accounting framework was employed and therefore that, as auditors, we were entitled to report in true and fair terms, as it's called.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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If IAS 39 came into being from accounting years from 1 January 2005 onwards, if IAS ... which appears to, you know, by way of fair comment, have coincided with the massive growth in loans - development loans - in the banks. If IAS 39 had not been introduced, would there've been a difference in the way you reported and would there've been a difference in the way losses were reported in the accounts of EBS?

Mr. Dargan Fitzgerald:

Well, I must say that's a difficult question to answer because one would have to rework the historical fact patterns to arrive at a conclusion. I must say my sense of it is I doubt if there would've been much difference, but that would have to be tested by a very rigorous analysis. In ... conceptually, the regime prior to IFRS was not fundamentally different and it ... while I can't speak for any of the EBS report results-----

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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But you would've provided expected losses, as well as incurred losses, under the old regime prior to ... IAS 39 purely restricted it to incurred losses, but you would've been ... effectively, as an auditor, you would've looked to have losses provided on an expected losses basis prior to IAS 39. Correct?

Mr. Dargan Fitzgerald:

I'm not sure that the position is quite as simple as that and quite as clear cut as that. And as I wasn't the auditor to any particular bank, actually, at the transition date to IFRS, I can't comment in a sort of live environment, so I'm not sure I could really speculate as to that. My overall sense is that, as a general matter, that the statement is ... needs to be qualified by careful analysis of any differences between pre-existing GAAP, as it's called - generally accepted accounting practice - and IFRS. I think the key point ... I mean, I can only speak for the audits that I was involved in, 2007 and 2008. You're absolutely correct and, as I referred to in my opening comments, they employ ... in applying IFRS and particularly international accounting standards relating to loan loss provisions, they employ the incurred loss model. I think, and I think it's now been widely debated ... I think it's clear that that does comply with reporting requirements requiring a true and fair view as the applicable reporting requirement of the time.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Did ye have an issue with the introduction of ISA 39 as an accountancy organisation? Did you make your views known to various bodies, your own institute and so forth? How did you feel about IAS 39 being introduced?

Mr. Dargan Fitzgerald:

Well, actually, I can't speak for the generality of the firm or the management of the firm that time. My feeling is that there was no particular issue, inasmuch as accounting standards do constantly evolve. In all GAAP frameworks, generally accepted accounting practice, and in all IFRS, international financial reporting standards, governed by the International Accounting Standards Board's frameworks, there are, as I'm sure you know, annual improvements projects. These often involve significant updating or rewriting of standards. This is typically in response to consultation with stakeholders and they typically involve very large groups which give expert opinion and the opinion of stakeholders as to how standards should best evolve.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Can I go to EY - Vol. 1, page 31, which is basically your reporting requirements to the regulator in respect of 31 December 2008 accounts? And I want to reference this document back to your own internal memo, page 25 of the same document ... on page 27, paragraph 3. And you reference in it that - the paragraph I'm doing is paragraph 4 on page 31, "EBS internal reports indicate that it ha[s] not been compliant with this requirement on certain dates during March, November and December 2008". And you said, "Under Requirement 6.3, certain limits [as] prescribed for two separate time bands. In the second time band prescribed, cash [flows] are required to equal at least 90% of [the] cash outflows." And in your own internal memo on page 27, you say that "In a Big 4 meeting with the Central Bank on Friday 21 November ['08] the Central Bank representative twice stressed that [the] non-compliance with these tests did not mean a bank was insolvent." So, first of all, were you surprised with that comment from - or not from - the regulator and how did that feed into your review in terms of going concern for EBS for the 31 December '08 accounts?

Mr. Dargan Fitzgerald:

Thank you. First of all, in relation to any concern or reaction to the regulator's comment as reported, I am not surprised reading that account. I feel that the regulator was likely anxious to emphasise that, in times of liquidity stress in the financial system, there would from time to time be breaches of what may have been quite stringent regulatory requirements around future expected cash flows.

And in essence, I feel the Financial Regulator was emphasising that these might be catered for by, as it turned out, Government support in terms of the Government guarantee, or, indeed, other measures that the banks might be able to take. Then in terms of your reference to ... and I hope I have the same reference ... 31 ... our letter of 6 March and you referred to the ... to our making of a report of these items. There was no latitude for us to fail to report these, as they were required under those regulatory instruments.

I think the last part of your question was whether they were ... these were factored into the question of going concern. And I can confirm, absolutely, liquidity was one of the key aspects of going concern considered, of course, by the directors initially in their papers and consideration, and, secondly, by us as external auditors. We ... we would have been aware of matters of this nature. In fact, it's exactly as you highlighted in your comments. I don't think they were particularly serious, but they were absolutely required to be reported to the regulator when we were aware of them, which we duly did.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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And were ... were you ... did ... were you aware at any stage in the '06 and '07 audits that there was liquidity issues?

Mr. Dargan Fitzgerald:

I don't believe we were required in either of those years to make any similar reports.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Okay. And what would have been your interaction with the Financial Regulator between '03 and '08? And how do you feel their role ... how did you feel their role, I suppose, was? And I can take it ... because KPMG were here before us and they confirmed that a meeting took place on 10 January 2008 with the Financial Regulator involving the big four-----

Mr. Dargan Fitzgerald:

Yes-----

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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-----practices, including yourselves.

Mr. Dargan Fitzgerald:

Yes.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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So you might just give us a general overview of your general dealings with the regulator.

Mr. Dargan Fitzgerald:

Certainly. Well, as I say, I was involved in 2007 and 2008. There may have been dealings with the regulator in previous years but I actually can't speak to that. I would be happy to check that and come back to the committee, if that was required. In 2007 and in 2008, I think ... my recollection is that the dealings with the regulator were exactly as you mentioned and as, I think, other testimony confirmed. In terms of a joint meeting between the regulator and meeting or meetings between the regulator between representatives of the big four firm, possibly in one case under the aegis of the Institute of Chartered Accountants in Ireland. I feel those meetings were very fruitful, in a broad sense, very informative. From the account of those meetings - I don't think I was at either of those meetings personally, but colleagues reported to me in writing and verbally about them, of course, as they were very important matters - and I feel that the regulator was anxious to listen to any of the commentaries on the ... what, even in the earlier of those dates, was an involving credit crisis - it was called a credit crunch at that time - and was also able to give the firms some high level briefing without, of course, dealing with matters relating to any individual institution, to give a high level briefing, in terms of the stance of the regulator in relation to any aspects, and in any ... in later meetings to confirm the effect and intention of the Government guarantee, in other words, to stand behind the Irish domestic banks. That was a very important matter for the later consideration of going concern, as my previous comments mentioned.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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And in terms of what you quoted in your own internal report on going concern, page 27, and also your reference to the regulator, do you feel that it was in order to take the evidence or to take the assurance of the regulator in terms of that there wasn't an issue with solvency with the bank in terms of the breaches of the zero to eight days category?

Mr. Dargan Fitzgerald:

Well ... well, I'd comment in relation to that that the views of the ... of the directors at the time ... I should start by saying the going concern assessment would have considered a number of different factors. And the consideration of those was made formally by the directors in a separate paper, which I don't think is a part of the core papers but would have been available to us at during our audit, and it would have formally considered aspects such as solvency and in that particular ... in relation to that in the case of EBS, the particular aspect for consideration was the extent of loan losses, as the loan losses directly reduced solvency, if you like, on a one-for-one basis, notwithstanding that a significant impairment was proposed and eventually adopted by the society in its books. And that caused the first ever loss of the building society in its history, if I recall.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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That was ... that was 31 December 2008.

Mr. Dargan Fitzgerald:

2008. And in relation to ... in relation to your question around solvency-----

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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And did you adjust their accounts ... the provision they made, that based on post-year audit, did you look for a higher impairment provision?

Mr. Dargan Fitzgerald:

Well, to answer that question ... just to make a couple of comments. The work we carry out in relation to impairments, sort of, starts with planning as I mentioned, selection of a sample of files to see if loans have been appropriately recorded. These are called systems tests, tests of internal control and they are ... they then are the basis upon which we ... we take those ... the results of those tests into account in our year-end work. When we come to our year-end work, we look at a variety of indicators of potential impairment of the loans. We discuss these with management. These may be documentary matters; they may be background environmental or macroeconomic matters; they may be the condition of the borrower; they might be collateral values ... that collateral values of themselves might not cause impairment-----

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Well, I suppose, two things then might feed into that. Would you have carried out, independently, stress tests on the loans for EBS? And, secondly, what did you set the level of materiality ... which is obviously the benchmark at which you look at making adjustments ... if it's below a certain figure, an adjustment isn't required ... what was the level of materiality for the EBS audit and did you adjust it, we'll say, from '07, '08 on to take account of the increased risks in the ... both the domestic and the financial markets and the international markets?

Mr. Dargan Fitzgerald:

Yes, well as a matter of fact, and I just brought the figures with me, as a matter of fact, in the 2007 year, our materiality was calculated at €7.3 million. And, in 2008, we reduced it very explicitly and deliberately to €2.7 million.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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And can I ask ... you might just explain to people looking in how you ... because that means that you dropped it by not too far off €5 million. That's a significant drop of €7.3 to €2.7 million. Will you explain how that would operate in practice in terms of carrying out the audit and how it was dealt with loans?

Mr. Dargan Fitzgerald:

Yes, certainly. So the effect of the lower materiality is, I mean, in very simple terms: the lower the materiality, the more significant will be any individual error that is present in the financial statements. So if an error were greater ... a single error were greater than that materiality amount, we would propose adjustment as a matter of course.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Why did you feel it necessary to drop your materiality level from €7.3 million to €2.7 million in one year?

Mr. Dargan Fitzgerald:

Because we ... and I think you ... I think your previous question actually referred to this. We took into account the macroeconomic factors, the stress in the system generally, the potential decline in collateral values and our clear desire was to carry out an increased scope of audit testing. And this materiality amount is linked to another amount we call a testing threshold and that means that the sample sizes is in simple terms would have been considerably bigger in the 2008 year.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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And did it give rise to you requesting that EBS make a larger provision in terms of an impairment provision ... in terms of loans ... than they had provided based on the accounts that were provided to you to be audited?

Mr. Dargan Fitzgerald:

Well, I wouldn't put it in terms of our requesting a provision-----

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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What did it result in?

Mr. Dargan Fitzgerald:

Understood. But again, the materiality that the auditors choose does not of itself, in principle, effect the provision. The provisioning is entirely carried out in the first instance by the society. And I must say in EBS case, there was a very structured methodology and a very structured approach to calculating all the relevant provisions.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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I suppose, in simple terms, Mr. Fitzgerald, did your audit result in an increased impairment charge or not?

Mr. Dargan Fitzgerald:

Well, I don't think I could answer the question quite in those terms because I ... thank you-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Continue.

Mr. Dargan Fitzgerald:

Just, I don't think I can answer the question in quite those terms. There's a degree of iteration between a company being audited and its auditors in terms of whether the auditors are satisfied with the provision.

I must say, in times of increasing uncertainty, there's an element of ... an increasing element of judgment in terms of settling on the final provision amount. I mean, we would have, as management was, encouraging of ... of taking a particularly careful review of all the provisioning inputs in arriving at the final figure.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Okay. Is it in order, Chairman, for me to quote from the Nyberg report?

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Yes, if ... Are you familiar with the Nyberg report, Mr. Fitzgerald?

Mr. Dargan Fitzgerald:

As a general matter.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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You're familiar with it, okay. Can I ... I want to quote from page 51 and, I suppose, it's the question that people ask. It says, and I quote:

All of the covered banks received unqualified audit reports throughout the Period. An obvious question is: why did the banks require State support in 2008 so soon after all of them had received unqualified audit reports from various auditing firms?

How would you both comment on that statement from Nyberg?

Mr. Dargan Fitzgerald:

Well, I'd make a couple of comments. The first comment I'd make is I do think the statement valuably highlights that at the time audit reports were what's sometimes called "binary" in nature. They either qualified and said there was a major problem or they were unqualified and suggested, perhaps, to a reader unfamiliar with financial reporting, that there was no problem. And, in that regard, I think that developments since then have been very helpful in terms of allowing audit reports ... or, I should say, requiring audit reports of certain public interest entities to now contain a detailed commentary on the nature of financial reporting risks encountered by the auditor during the audit and the nature of key judgments made by audit committees, directors and management. And, those items were not present in audit reports of the time so-----

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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But emphasis of matter was always available, Mr. Fitzgerald.

Mr. Dargan Fitzgerald:

Understood. And an emphasis of matter arises when a matter so serious as to be necessary for the reader to be aware of it to, in simple terms, make sense of the accounts has, as you say, always been available. It does, under auditing standards, only arise in a particular set of circumstances and so I think it ... in reality, in terms of the critique of financial reporting in the crisis, I think emphasis of matter has probably had a limited application and, indeed, factually has had very limited use. I think that's because of the constraints around its use and the intention for which it was designed.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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And, I suppose, the final question I have is that Nyberg, in his report ... he basically headed up the issue on external auditing. He said: "The Silent Observers: External Auditors". How would you ... what would be your reaction to that statement?

Mr. Dargan Fitzgerald:

Well, I'm not sure I should make any particular reaction. It's a ... it's a ... it's essentially a personal observation and it's ... it's ... it's ... it's-----

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Well, I suppose, let me put the question another way.

Mr. Dargan Fitzgerald:

Thank you.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Do you believe that the role of the auditor is too limited in terms of dealing with the audit of organisations in terms of expressing a true and fair view? Do you think it was too limited?

Mr. Dargan Fitzgerald:

Well, I'm not sure it was too limited in terms of the ... in terms of the requirements on audit at the time. However, I mean, I do understand that ... that ... that the crisis has caused a re-evaluation of the benefits of external auditing and I do feel that external auditing, as an activity - and that the profession of those who are involved with it - has responded, at least to some extent, since the crisis, particularly in terms, as I just mentioned, of ... of ... through new auditing standards for audit reports for public interest entities making qualitative commentary on the risks and judgments that are included and involved in the financial reporting of public interest entities. So, I think that ... I think that the commentary in relation to possible shortcomings of both financial reporting and auditing need to be very carefully taken on board and I think many of those have already been acted on in terms of the financial reporting and auditing profession.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Thank you, Chairman.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Thank you very much, Deputy O'Donnell. Just a couple of matters before I move on to Senator MacSharry. In regard to the Financial Regulator, do you believe that the reports issued to the Financial Regulator provided them with enough information to enable them to discern the full regulatory position of the society?

Mr. Dargan Fitzgerald:

Chairman, could I just clarify the reports that you mentioned. What reports have you in mind?

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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They ... in going back to Deputy ... earlier, when Deputy O'Donnell was talking to you, he was talking to you briefly about the firm's interaction with the Financial Regulator-----

Mr. Dargan Fitzgerald:

Yes.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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-----during the 2003 to 2004 period and the role that the Financial Regulator played during that period as well. So, I'm just asking you do you feel that the reports issued to the Financial Regulator provided them with enough information to enable them to discern the full regulatory position of the building society?

Mr. Dargan Fitzgerald:

Thank you. Well, I'll just comment ... I think the question is in relation to reports that we may have made and, as I think I've mentioned, we made one - and only one - report of a regulatory breach which we discussed and which forms part of our papers, our letter of 6 March 2009. Just to highlight that the building society, as a regulated banking entity, made its own quarterly unaudited annual returns to the Financial Regulator and those are very key components of the regulatory supervision, as I understand it, and so the vast majority of the information relevant to the regulator would be contained in those documents, which are not subject to external involvement.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay, thank you. During Ernst and Young's interaction with the society, did either party express concerns rather than just talk about the issues ... but specific concerns in regards to the adaptation of IAS 39?

Mr. Dargan Fitzgerald:

Not to my knowledge.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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There was no concerns, either at Ernst and Young's side or at EBS's side?

Mr. Dargan Fitzgerald:

Not to my knowledge.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay, thank you. Senator Marc MacSharry.

Photo of Marc MacSharryMarc MacSharry (Fianna Fail)
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Thanks very much and welcome, gentlemen.

Mr. Dargan Fitzgerald:

Thank you.

Photo of Marc MacSharryMarc MacSharry (Fianna Fail)
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Can I ask, with regards to the preparation of the firm's annual audit plan and the risk assessment underpinning it, did the risk assessment approach adopt a change to meet the prevailing environment?

Mr. Dargan Fitzgerald:

Yes. Thank you. As I mentioned, the risk assessment starts with an updating of our understanding of the circumstances of the entity being audited. So, in this case, the building society. This is carried out through meetings and discussions with management and review of relevant papers, such as board reports. As a result of our assessment of the ... what are called "entity level controls", controls within the company ... or within the building society and consideration of external factors, such as stress within the financial system and other macroeconomic factors. As I previously referred to, one of the planning tools is to select what's called planning materiality ... and, these are the comments I made earlier. That materiality is set at a level which results in a particular set of sample sizes, which govern the extent of detailed testing we carry out, both of internal controls and of balance sheet amounts. So, if I put that in, sort of, more plain English, we update our understanding through discussion with management of the state of play within the building society. We set out a plan of testing of internal procedures and controls - called internal control testing - and then at the year end we select a sample, which in the case of 2008 was statistically quite a large sample, of loan files and other items to test substantively. And, in simple terms, that substantive testing means discussing with management the circumstances of each individual loan, as I previously mentioned.

Photo of Marc MacSharryMarc MacSharry (Fianna Fail)
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Is that process gone through every year or just, say, in the context of '07-'08?

Mr. Dargan Fitzgerald:

It's an ... it's an annual process of assessing the financial reporting risks and annually we update our understanding of the business and the internal control environment and we plan our various tests, both of internal controls and of balance sheet and income statement transactions and balances, accordingly.

Photo of Marc MacSharryMarc MacSharry (Fianna Fail)
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And for 2008, I mean, was there a marked difference in the preparation and planning for that because of the environment?

Mr. Dargan Fitzgerald:

I must say there was. The planning for the 2008, 31 December year-end audit would have begun ... it's really part of a year-end ... all-year process but, in practical terms, it would have taken place in August, September, October of 2008. And you'll appreciate that, particularly in September and October of 2008 the ... actually the global financial system was showing enormous stress and strain and so we had to consider whether financial reporting risks were likely to arise and be heightened in our audit of EBS and we responded accordingly.

Photo of Marc MacSharryMarc MacSharry (Fianna Fail)
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Can I ask did the firm conduct their own independent assessment of EBS's credit risk methodology to satisfy themselves that the principles-based process adopted by the society were appropriate?

Mr. Dargan Fitzgerald:

In simple terms, yes. We reviewed the various methodologies for setting loan impairment provisions. Just for clarity, some of those would be methodologies relating to the calculation of what is called individual provisions - where it's on a loan-by-loan basis - and then some of the methodologies, and I think this may be the thrust of your question, relate to the calculation of what's called collective provisions. And this is where, for a portfolio of loans as a whole, an additional provision is made for what's sometimes called the latent incurred losses in the portfolio - on the basis that these losses may not always be evident from examination of individual loan files.

So the methodology adopted by the society, in common with other banks, was to model the incidence of incurred but not reported losses as they're called and the subsequent derivation of the collective impairment provision. So we reviewed that and we reviewed, therefore, the methodology itself, the inputs, the outputs for sense check and carry out overall analytical review procedures. And in that way we satisfy ourselves that the methodology adopted and the results appear reasonable.

Photo of Marc MacSharryMarc MacSharry (Fianna Fail)
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In 2005 Ernst and Young sent a management letter, it's on page ten of the evidence book, to EBS and it looked at the maintenance of credit quality and the appropriateness of loan provisioning. It said there should be-----

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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What page?

Photo of Marc MacSharryMarc MacSharry (Fianna Fail)
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Ten. It is only a short reference and I'll be quoting it directly but I'm just mentioning it for you. "Should there be a default on a loan, there is an additional risk that the collateral securing the loan is insufficient." It later says in the same letter, "Our controls testing focused on the credit review process and the role of the Credit Risk Committee in assessing asset quality and approving impairment provision." Further, it later says, "We concluded that the credit review process is robust and that there are suitable controls around the processes."

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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I just need a small bit of clarity on that, Senator, I'll give you a bit of time. I just need a bit of clarity in finding it. The reference page may not be the actual page in the core booklet.

Photo of Marc MacSharryMarc MacSharry (Fianna Fail)
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Page ten is blank so it's the one beside it.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay, it's page 11.

Photo of Marc MacSharryMarc MacSharry (Fianna Fail)
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But it starts on the page before that again, so sorry. But I've quoted the relevant points precisely so it's only for the Chairman's benefit. How significant did Ernst and Young at the time believe that the risk of insufficient collateral to EBS?

Mr. Dargan Fitzgerald:

To answer that question, just to highlight that for each loan selected in our sample we discuss with management the situation of the borrower, the extent to which the loans are fully paid up to date. We also examine the question of whether there is any objective evidence of impairment of the loan. In technical terms that starts with the question of default. Also, if there has been a default there may be a requirement for management to carry out a discounted cash flow analysis and part of the consideration of the residual value of the loan will involve consideration of collateral value. So collateral value is absolutely assessed as part of that set of procedures which assess each loan individually, to assess whether it is impaired or not.

Photo of Marc MacSharryMarc MacSharry (Fianna Fail)
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So I mean if ... in that management letter, if you believe there was insufficient collateral potentially, why would the firm state that the credit review process is robust and there are suitable controls around the process?

Mr. Dargan Fitzgerald:

Because the latter conclusion is of a more general nature whereas some of the specific items that we have highlighted are for the benefit of management to understand items that we may have come across during our testing work. So for clarity, the second conclusion that you read is of a more general nature and rests on the body of work that we have carried out, of which we may find some individual instances, as I think I previously referred to, where we need to report to management that we have come across those matters but they typically will not prevent us from making the overall conclusion in a satisfactory way.

Photo of Marc MacSharryMarc MacSharry (Fianna Fail)
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Can you confirm that CARB and IAASA regulate your firm?

Mr. Dargan Fitzgerald:

Yes I can.

Photo of Marc MacSharryMarc MacSharry (Fianna Fail)
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Has your audit activity of financial institutions been reviewed by them?

Mr. Dargan Fitzgerald:

Absolutely, from time to time, and if I just ... explain your reference to CARB and IAASA. So CARB is the Chartered Accountants Regulatory Board and it carries out the on-site routine inspections-----

Photo of Marc MacSharryMarc MacSharry (Fianna Fail)
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We know. With respect, it's just that I have a minute left.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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I can afford a bit of time.

Mr. Dargan Fitzgerald:

I beg your pardon.

Photo of Marc MacSharryMarc MacSharry (Fianna Fail)
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No bother, it's just we have gone through this with all of the others. No disrespect but we know the organisations.

Mr. Dargan Fitzgerald:

Not at all, I understand.

Photo of Marc MacSharryMarc MacSharry (Fianna Fail)
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So if ... you've had reviews of your audit work in that regard. Has there been any adverse findings?

Mr. Dargan Fitzgerald:

Not to my knowledge although, I'd have to go through individual findings and I don't believe that any findings were what would be described as adverse in the context of your question.

Photo of Marc MacSharryMarc MacSharry (Fianna Fail)
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Ever asked by a client that you're auditing, from a financial services perspective, to alter or remove a member of the audit team?

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay, just tell me where you are within the terms of reference here now Senator and then I'll bring Mr. Fitzgerald in?

Photo of Marc MacSharryMarc MacSharry (Fianna Fail)
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It's consistent with questioning of the other auditors from the other ... a very specific line was dealt with, with other auditing firms.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay, I'll give a bit of space there but just be mindful of any reputational damage of people that are not inside the room here.

Photo of Marc MacSharryMarc MacSharry (Fianna Fail)
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But I'm not mentioning any names and I presume you won't.

Mr. Dargan Fitzgerald:

Could I ask you to repeat the question?

Photo of Marc MacSharryMarc MacSharry (Fianna Fail)
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Were you ever asked by a client firm to alter or remove the auditor or member of an audit team?

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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If I go back to that now, when we were dealing with that last week ... the firm itself - I didn't allow that question and they didn't respond to it.

Photo of Marc MacSharryMarc MacSharry (Fianna Fail)
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No, they did, and what you didn't allow, Chairman, with respect, and you can check the record, was the naming of the institution. The question was answered. Where there was a delay in a question was very specifically to do with me asking was it a particular company and at that point you intervened.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay, give us the specific issue, coming back to Mr. Fitzgerald.

Photo of Marc MacSharryMarc MacSharry (Fianna Fail)
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I am not mentioning any financial institution, I'm asking were there ever financial institutions who may, in the course of your work, have made an approach to you to say, "Could you remove part of the team for being over enthusiastic in their questioning or efforts"?

Mr. Dargan Fitzgerald:

My reply is firstly to say I can only confidently speak in relation to the work I have carried as auditor of EBS in 2007 and 2008. In relation to EBS as audit partner I can confirm to my knowledge the question is "No". I have no other knowledge of any such thing but I could not be definitive.

Photo of Marc MacSharryMarc MacSharry (Fianna Fail)
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Just very finally then, there's ... I think it's the very first page in the evidence book, would it be page 3, it's a note ... a file note by Kieran Kelly following a meeting with the CEO of the society and it mentions a number of things. One of the things it mentions, as a concern, is a credit shock. Obviously, this would have been a lot earlier than the ... it would have been 7 February 2007. I'm just interested to know ... an external market shock such as a credit shock was identified clearly by Mr. McGovern in discussions with Kieran Kelly and that is certainly his note on it, as we can see there from page 3. Can you give us any other information on that? Was it articulated as a result of fears that the society had at the time or indeed Kieran Kelly your own personnel, and what if any actions were determined as a result?

Mr. Dargan Fitzgerald:

Well, I'm sorry to say that my knowledge is limited as I wasn't at that meeting, and that was in relation to the year preceding the year in which I took up the position as audit partner for the society. So I actually just can't make any additional comment that might help you in that regard.

Photo of Marc MacSharryMarc MacSharry (Fianna Fail)
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It certainly didn't form the basis of any discussion, or did it, from that date to your knowledge, up until the credit crisis with the collapse of Lehman's in September 2008?

Mr. Dargan Fitzgerald:

Well, I think I can comment because shortly after this time I would have become involved, as you would expect, in the planning for the following year.

I can say that as soon as the evidence of shortage of liquidity in the banking markets began to present itself, which, from memory, was towards the latter half of 2007 ... I can confirm that the audit team was aware of that and factored into its assessments for year-end 2007, an appropriate audit response.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay, thank you very much. With that now said, I propose that we take a break. The witnesses are reminded that once they begin giving evidence that they should not confer with any person other than their legal team in relation to their evidence on matters that are being discussed before this committee. With that in mind, I now suspend the meeting until 4.35 p.m. and remind the witnesses that they're still under oath until we resume. So I now propose we suspend until then. Is that agreed?

Sitting suspended at 4.21 p.m and resumed at 4.40 p.m.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Mr. Smith and Mr. Fitzgerald, are you okay? So we go back into public session to continue this afternoon's proceedings, is that agreed? I now invite Deputy Michael McGrath to question.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Thank you very much. I would like to welcome Mr. Smith and Mr. Fitzgerald here today. Can I just start by asking Mr. Fitzgerald to outline the structure of a typical audit team that you would have led in respect of EBS, and to give us some insight into the level of skill and experience within this group ... and to state your opinion, whether you believe that there was sufficient banking and property experience, and people with the right balance of qualifications, in the teams that you would have managed for the two years that you led the audit?

Mr. Dargan Fitzgerald:

Certainly, thank you. So, as a general matter, the teams are - which carry out the audits - are, we call them multidisciplinary teams. The key disciplines involved are core auditors, but also tax specialists and information technology specialists, being the two other specialisms that are typically brought in, and I'll come back to the matter of property valuations in just a moment. So, the two years that I was involved in, I think I mentioned previously that, the team was considerably larger in the 2008 year than in the 2007 year. The reason for that is the increased focus and increased ... we had on the lending portfolio and the question of impairment, based on our risk assessment. In that context, we expanded the team, as I say, from the 2007 team.

Just to give you some contextual background to that, the total numbers involved in the audit team would have been in the region of 30, from memory, in 2007, and 40 in 2008, with a corresponding increase in the audit hours. I should also mention that in 2008 the ... because of our general understanding of the presence of risk within the financial system, we made a designation of the audit which we call "close monitoring", which means we heighten its risk in terms of our register of the risk of the potential misstatement in relation to the audit. So I was assisted by what's called an independent partner, who acts as a sounding board and a peer reviewer of any key decisions that I make. There are other partners involved in the team, such as a tax partner and an information technology partner, and then, as you can imagine, the balance of the team of some 40, from memory in 2008, is made up of directors, managers, senior managers and core staff, coming from those various disciplines.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Thank you. Can I ask, when did EY secure the audit of EBS? When was the first year?

Mr. Dargan Fitzgerald:

I actually don't know. I have a feeling I read somewhere that we were in place as auditors for some considerable period and I certainly don't remember a time when we weren't, but then I joined EY in 1999.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Mr. Smith, are you aware?

Mr. Paul Smith:

I think we have been auditors right since the very beginning of the foundation of the society.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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And when was that?

Mr. Dargan Fitzgerald:

So probably 50 or 60 years, possibly longer.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Okay. Right up to and including 2008?

Mr. Paul Smith:

Yes.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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And given that EY had the audit for that length of time, do you think it creates any difficulty in terms of the closeness of relationships, the knowledge that you would have and the fact that working so closely with the same people over a long period of time would have an impact on your independence for example or on the quality of the work being carried out?

Mr. Dargan Fitzgerald:

No I don't feel so, Deputy. You, I am sure, are aware from other testimony that there is a very formal system of audit partner rotation. And there is also a system of rotation of what is called "key audit personnel", which means that the senior personnel with extended periods of tenure on the audit team are also rotated. So, I feel that the audit partner rotation, which is precisely the reason I took up as audit partner in 2007, rotating in, as we call it, for the preceding audit partner after his five-year period in place. There is, actually, a balance to be struck between familiarity and closeness to the client. And it is precisely for that reason that our ethical standards require the mandatory partner rotation.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Okay. The final taxpayer bill, as such, for EBS was in the region of €1 billion. Given your knowledge of the accounts of EBS and the business model pursued, can you give us your view on how those losses arose? Were they substantially related to the property and development loan book which was grown considerably since 2005 or how much of it do you believe was mortgage related? Can you give us your sense of why the bill was about €1 billion for EBS?

Mr. Dargan Fitzgerald:

I'll do my best, Deputy. Since I didn't have an involvement with any of the financial reporting of the society in 2009, 2010, 2011 or subsequently, I must say I am not qualified to comment on those years specifically. And I must say, as a matter of fact, you will be aware that the vast majority of the loan losses were recognised in those later periods. I feel that the work that I did have connection with in 2007, and particularly 2008, probably gives me some insight and I think it's probably a matter of fact, although I could be corrected, that a large proportion of the ultimate loan losses arose from commercial property, including development property and buy-to-lets. My understanding of that is purely from brief review of the NAMA documentation that forms part of the core packs. So, I do feel that the facts of which I am aware show that commercial property and, as one would expect, buy-to-let property and of course development finance, which was the first to show evidence of stress and strain, as I mentioned, were probably the prime reasons for the losses.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Okay. The 2008 financial statements, in note 11, do break down the loans and advances to customers and as far as I am aware, that was the first time that there was such a breakdown. For example, the figures that are provided for commercial development finance, home loans, retail, buy-to-let, commercial buy-to-let. I don't see a corresponding breakdown in the 2007 accounts. Would that be correct?

Mr. Dargan Fitzgerald:

I'd have to check, but I think you are correct. And I think I recall that in view of the loan losses which were being recognised in 2008, and as I previously mentioned, I think this caused the first ever loss in ... overall loss for the building society, which was regarded as a very major matter. I believe that the categories and detail of the loan note disclosures in 2008 were expanded to include that additional detail, so that there could be, for the user and reader, a clear relationship between the provisions and the loan portfolios.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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So, just to clarify that, additional disclosure in the 2008 financial statements didn't arise from any change in accounting standards, for example. It was a decision made by the directors and supported by the auditors. It wasn’t as a result of any change in accounting practice.

Mr. Dargan Fitzgerald:

I’m actually not sure. I’d have to check those facts but I’m happy to do so and revert to the committee.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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If you could, please-----

Mr. Dargan Fitzgerald:

Absolutely.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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-----that would be helpful.

Just to look at the issue of the losses that did arise. There is a breakdown, as I say. The total loans and advances to customers was about €17 billion across the group at the end of 2008. Home loans, €13 billion. Retail buy-to-let, €1.5 billion. Commercial buy-to-let, €600 million. What’s the difference, just to clarify, between retail buy-to-let and commercial buy-to-let?

Mr. Dargan Fitzgerald:

Two things. Firstly, commercial may relate to non-residential and will be designated commercial. And I think within the accounting policies, buy-to-let over a certain size - I think from memory it was €1.5 million - was classified as commercial.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Okay. And then under, let’s say, property development, commercial is listed at about €1.2 billion and development finance at about €500 million. So, at the peak, EBS’s loan exposure to commercial and development finance was in the region of €1.7 billion to €1.8 billion.

Mr. Dargan Fitzgerald:

Those figures are correct.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Is it of that order, as you understand it. And so, then the overall bill for recapitalising EBS is accounted for by heavy losses on the commercial and development finance book but also buy-to-let mortgages, both retail and commercial.

Mr. Dargan Fitzgerald:

I’d have to emphasise I don’t have granular connection with any of the later years’ figures. So, I’m afraid I cannot assist with specifying exactly where the losses arose, as they were in subsequent periods.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Okay. And were you involved in the decision to make additional disclosure in the 2008 financial statements as regards the exposure of EBS to development and property for example? There is disclosure there, significantly above and beyond what was there in 2007. Was that a decision of the directors? Or, was it a decision that you encouraged or advised would be made in the course of the audit in 2008?

Mr. Dargan Fitzgerald:

Again, you will have to forgive me. I’d have to check the facts. I’d have to compare the 2007 and 2008 disclosures to give you a definitive answer and I’d have to check our files. My overall recollection is that, as I mentioned, the disclosures in 2008, which may in the case of certain components of the loan book have been expanded, were to give additional information given that the loan losses were being recognised into a very significant degree. It may, subject to checking, have been because of ... practice was then dictating that additional disclosure, although I must say I don’t remember that. It would in any event, just to conclude, it would in any event have been the case that in 2007, we as auditors would’ve checked that full disclosure was made in accordance with whatever the disclosure rules were at that time. And similarly for 2008. There is a certain latitude that management teams may give additional helpful disclosures over and above specific required disclosures if they feel that it gives a fuller picture and we, of course, encourage that from time to time.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Okay. Just a final area I’d like to touch on, Mr. Fitzgerald, is IAS 39, which has come up time and time again in terms of impairment provisioning. It is to tease out the wriggle room, if any, that you would have as an auditor in advising directors how to make provisions in accordance with IAS 39. My question for you is whether the application of IAS 39 is absolutist as such or whether, if you believe in the interests of making a true and fair view override as such and if you have the evidence to back it up, that a departure from IAS 39 would be warranted and could result in additional provisioning, provided you could stand over it and have the evidence? Can you explain the absolutist nature of IAS 39? And to what extent an auditor has discretion to depart from IAS 39 in making provisions for potential bad debts where he or she believes the evidence points in that direction.

Mr. Dargan Fitzgerald:

Certainly, I’ll do my best. First of all, I would say I’d ... I probably wouldn’t describe any of the accounting requirements of IAS 39 as absolutist. I would say that in terms of the way in which they prescribe the recognition of loan losses, they are certainly relatively tightly defined.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Yes.

Mr. Dargan Fitzgerald:

And I feel that the accounting profession and then, by extension, the auditing profession, was rightly very careful to interpret appropriately the precise wordings within international accounting standard 39 and the relevant guidance notes and ... and I think it touches on some of the points in your question. It is ... it is absolutely the case, in my professional opinion, that there ... there was not very great latitude in terms of recognition of loan losses and when I say not great latitude, I mean that ... that tests of the existence of objective evidence of impairment of the loans had to be passed before impairments could be made. And my ... my clear understanding from the work of ... of our own audit teams in this case is that we very carefully assessed whether ... whether management had appropriately implemented those specific definitional requirements of objective evidence of impairment. And where judgments were made, that for example, additional provisions were required, that those were justified in all the circumstances. There were some elements of a judgment, particularly in larger loans, and particularly in cases where there was perhaps some repayment capacity but repayments had perhaps slowed and perhaps where collateral values had declined but were still substantial. And all of those things had to be taken into ... in the round in making an individual assessment of impairment.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Okay. What the regulations state, as I read them, is "In the extremely rare circumstances in which management concludes that compliance with a requirement in a standard or an interpretation would be so misleading that it would conflict with the objective of financial statements set out in the Framework, the entity shall depart from that requirement in the manner set out in paragraph 18 if the relevant regulatory framework requires, or otherwise does not prohibit, such a departure." So it is narrow, but the question is, are there some circumstances in which the strict application of IAS 39 was not required ... where there are some circumstances in which an auditor could depart from IAS 39 and seek additional provisioning and still remain within accounting standards and the regulations that underpin them?

Mr. Dargan Fitzgerald:

I must say that ... in relation to the 2006, '7 and '8 audits of EBS, I don't believe there was any question of any such circumstances arising and I'm not sure if, conceptually, I can actually imagine such circumstances. I mean ... perhaps, conceptually, as a ... in a hypothetical way, that could be argued and I am aware there is testimony-----

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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It is provided for in the regulations.

Mr. Dargan Fitzgerald:

Well-----

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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It does say "extremely rare circumstances". My question is ... is really asking you to confirm ... it isn't necessarily specific to the audits you did, but that, and you mentioned it earlier on, the IAS 39, no more than any other accounting standard, is not absolutist in nature and that, while the discretion is extremely narrow, the auditor does have some discretion to depart from a standard in the event that rigidly sticking to it would be misleading in that it would conflict with the objective of the financial statements set out in the framework. So I am just asking you to confirm that ... that that is correct. Is that the case?

Mr. Dargan Fitzgerald:

Well, absolutely. I can certainly confirm that, in the case of the audits that I was involved in, there was no question of any conflict arising between the true and fair view and the implementation of the accounting standard, absolutely.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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But in certain circumstances, an auditor could interpret that requirement as giving him or her scope to depart from the strict interpretation of an accounting standard, if they felt that was necessary for the financial statements to give a true and fair view.

Mr. Dargan Fitzgerald:

Well, you're absolutely correct that the concept of true and fair override involves exactly such a thing. There can always be that potential. I just would stress that ... that, in terms of the specifics of the audits I was involved in, I don't feel that that was-----

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Didn't arise.

Mr. Dargan Fitzgerald:

-----a relevant consideration.

Photo of Michael McGrathMichael McGrath (Cork South Central, Fianna Fail)
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Thank you, Mr. Fitzgerald.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay, thank you very much. Just two matters, I just want to ... before I bring in the next questioner ... in earlier questioning there with Deputy McGrath, Mr. Fitzgerald, you said you would return to the issue of the property experience and we didn't get around to it, so maybe if you could now.

Mr. Dargan Fitzgerald:

Yes, by all means.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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And that's in regard to the firm's audit team and the sufficient property experience that you might have.

Mr. Dargan Fitzgerald:

Yes, thank you, Chairman, and happy to do so. And, as I think other testimony to the ... from other auditing firms may have confirmed, it is not the typical practice among the auditing firms to employ within their own teams estate agents or valuers.

And so the ... in accordance with auditing ... international auditing standards, the appropriate approach is for the entity being audited to obtain and to arrange to be carried out the appropriate valuations of properties where they are needed or where they are appropriate and the auditor carries out tests, referred to as reliance on the work of an external expert, where they assess the qualifications and the experience of the valuer and they may then, for their audit purposes, rely appropriately on the valuations obtained.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay, and, I suppose, a general question then following on from that, Mr. Fitzgerald: were you satisfied or were there sufficient qualified staff in Ireland in that regard?

Mr. Dargan Fitzgerald:

Well, absolutely, in the context that I've just outlined, absolutely, I feel that our staff were appropriately qualified.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay, thank you very much. Deputy John Paul Phelan.

Photo of John Paul PhelanJohn Paul Phelan (Carlow-Kilkenny, Fine Gael)
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Thank you, Chairman. Good afternoon, gentlemen. First of all, I want to start with the core documents, pages 4 and 9. First, on page 4 - it's a minute of a meeting between a Mr. Kieran Kelly from Ernst and Young and the chief executive of EBS, Mr. McGovern, and it's from February 2007 - on page 4 in the third paragraph, I want to reference a quote, the second half of the third paragraph beginning with "He" ... "He also commented [he being Mr. McGovern] that whilst his confidence in the financial reporting function is improving he is still finding that there is imprecision in figures and that people are being forced into taking actions which are in turn imprecise and slightly unfocused." And again, on page 9, it's the management letter of 2005 under the heading "Risk", I want to reference it also:

There is a risk that the Society may fail to identify errors or [misposition] mispostings arising from uncontrolled changes to formulae or data in key spreadsheets. As a consequence, the financial statements of the Society may be misstated.

Mr. Fitzgerald, were you satisfied that you and the audit team from Ernst and Young had access to complete and accurate information from EBS in order to conduct your audit properly?

Mr. Dargan Fitzgerald:

Thank you. Well, first of all, for the 2007 and '8 audits that I supervised and, ultimately, signed as auditor, yes, I am so satisfied. Looking back and to your question in relation to both of those comments and if I could take the management letter from 2005 and without necessarily ... this was wasn't my own audit team, rather I wasn't supervising the audit team that carried this out and subject to that, nonetheless, if I just explain the purpose of this communication. So, as auditing standards require, that's auditing standard 260, reporting to those charged with governance, as I previously mentioned, where we come across an issue or an improvement point that needs to be brought to the attention of management of the audit committee, our management letter typically contains it and it typically contains it in the sort of format that one sees there. So the topic, in other words, what, sort of, part of the financial reporting is involved, the observation, what we found, and then the risk and the comment that you quoted from the two comments under the heading, "Risk", their purpose is to illustrate - we sometimes call them "what could go wrong", they illustrate, if you like, the worst case, if this control point is not acted on, of what could happen. So, where we write appropriately, "As a consequence, monthly management finance reports may be inaccurate", just to highlight that those would not necessarily mean that there would be pervasive error in management accounts but that arising from, and in the context of euro bank account reconciliations, there might be misreporting. The key point is that is highlighting the risk of what might go wrong and then our recommendation and the response of management ... we highlight in our recommendation what we feel should be done to, if you like, fix the problem and then management under the column "EBS response" identifies how they intend to resolve the issue, assuming they agree with it. It would typically be our practice, just for your additional understanding, then in the following year to follow up to see that such items had been cleared and then they may be replaced, of course, with new comments but that that item would be closed in the following year-----

Photo of John Paul PhelanJohn Paul Phelan (Carlow-Kilkenny, Fine Gael)
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Was it cleared in the following ... was it resolved in the following year, do you know?

Mr. Dargan Fitzgerald:

I'm actually not sure because I think it's not in the 2006 management letter.

Photo of John Paul PhelanJohn Paul Phelan (Carlow-Kilkenny, Fine Gael)
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Yes, it's not there either.

Mr. Dargan Fitzgerald:

It may be in the papers ... it may not be in the papers. My understanding is it would typically be closed, and I think even the comment in the EBS response reads: "This recommendation was implemented in November 2005". And on that basis, assuming that is factual, I assume the point would be closed.

Photo of John Paul PhelanJohn Paul Phelan (Carlow-Kilkenny, Fine Gael)
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Okay. In reference to the first quote from the meeting with Mr. Kelly and Mr. McGovern and the reporting function and the statement that's included in that minute where Mr. Kelly spoke about imprecision in figures again ... this is 2007. It's a kind of a repetition, although it might not be directly related to the quote off of page 9. But do you feel that that matter was addressed subsequently or have you any comment on it?

Mr. Dargan Fitzgerald:

Well, you'll forgive me saying, not being present at the meeting, I'm not sure in quite what context it was made, and it feels like a very high-level comment where the chief executive is commenting to the audit partner to give the audit partner a flavour for his level of confidence in using the financial information generated internally to make management decisions, in other words, an operational and business focus. not strictly the domain of the audit in terms of the external auditor's assessment of risk of financial reporting misstatement. But, having said that, one which, as I think you can probably take from the fact that the note is reproduced so, if I may say so, comprehensively and included on our audit files, one that I'm sure would've been taken into account in the subsequent audit work.

Photo of John Paul PhelanJohn Paul Phelan (Carlow-Kilkenny, Fine Gael)
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Okay. Can I briefly ... I want to put a couple of questions to you in relation to some matters that I raised with other audit firms. In particular, I want to address the issue of necessary professional scepticism, which I've raised with all the others. And Mr. Nyberg in his report ... and it's a quote that I put to other ... your colleagues from other audit firms and I want to put it to you in relation to your auditing of EBS. And I quote from page 56 of the Nyberg report, paragraph 3.6.2: "The Commission would have expected a bank auditor, exercising necessary professional scepticism, to have concerns where there were growing property and funding exposures, combined with material governance failings." Do you feel that that applies to your auditing of EBS, that finding of the Nyberg report?

Mr. Dargan Fitzgerald:

Well, I have a couple of reactions to the commentary. First of all, I suppose it is very much a summarised reaction and, I might say, a personal reaction in terms of the quality of the comment, and I think, in terms of the role of external auditor, it's probably not something I would immediately move to agree or disagree with. I kind of feel it's that person's opinion, and, you know, they're absolutely entitled to have that. I do know that the role of professional scepticism has come into some particular focus since the financial crisis and, in the context of the work of this committee and of similar work groups across the world reacting to the financial crisis, there has been a very explicit move to increase both the exercise of scepticism, which has always been an important and, you might say, necessary attitude of mind of external auditors and of auditing firms, but to improve both the rigour of challenge to management and management's judgment. And in that context, I would mention a project in the external auditing world called clarified ISAs, international standards on auditing. They were, after the financial crisis, updated to improve the level of specificity of some of their required audit procedures, and some of those related to exactly that point - scepticism. So I feel the general matter of challenge and scepticism is integral to external auditing and always has been, and I do feel there have been improvements in enabling those challenges to management judgment and the exercise of scepticism being deployed more fully.

Photo of John Paul PhelanJohn Paul Phelan (Carlow-Kilkenny, Fine Gael)
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I understand. Briefly, though, to return to my initial question, his comment from the Nyberg report ... does it apply to Ernst and Young's auditing of EBS, yes or no?

Mr. Dargan Fitzgerald:

Well, I'm-----

Photo of John Paul PhelanJohn Paul Phelan (Carlow-Kilkenny, Fine Gael)
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It's a criticism, if you like, and it's not my words.

Mr. Dargan Fitzgerald:

Understood.

Photo of John Paul PhelanJohn Paul Phelan (Carlow-Kilkenny, Fine Gael)
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I'm not making any value judgment on it, but he said that he would've expected a bank auditor exercising that scepticism to have had some ... identified some of these failings. That's basically what he's saying.

Mr. Dargan Fitzgerald:

I understand that, and I just would ask you to appreciate that it's, I think, a generalised comment about the sector as a whole.

In terms of the audits that I was personally responsible for on behalf of Ernst and Young, I don't feel that scepticism was lacking, far from it. In fact, I feel it was robustly exercised. I hope that answers your question.

Photo of John Paul PhelanJohn Paul Phelan (Carlow-Kilkenny, Fine Gael)
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That's fair enough. Finally, Mr. Smith, I just want to ... at the ... in your opening statement you referred to three proposals, if you like, for the auditing profession I suppose really, going forward ... recommendations I think you did call them. Can you outline briefly in the, in the minute or so that is left, the nature of the changes that would be required to bring them about? You know, would it require legislation, regulation, European regulation, is it something that can be instituted from the audit community themselves, from auditors internally or is it something that the Oireachtas would have to act upon?

Mr. Paul Smith:

Yes. I am happy, I am happy to respond to that, albeit with a big caveat, which is that I am no expert. You know, I am out of the business six years and before that I wasn't an auditor, per se. But the three recommendations were, one: that there would be more effective two-way communication between the regulator and the audit firms. I think I would have to refer to Dargan on this in terms on what the technicalities are around that because there's obviously a framework, a legislative framework around that. And since it involves issues of client confidentiality or at least, potential client confidentiality issues, I could see how some legislation might be required there. The second was in the strengthening the role of audit committees and the role of internal audit. I think that's not really a legislative matter. I suppose legislators will always want to participate but I think that that's more an internal matter, probably falling more within the codes of governance for companies generally. The third is around the audit of the returns that are made by financial institutions other than insurance companies and these are the quarterly returns to the Financial Regulator. I simply don't know whether that would require a legislative adjustment or not.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Thank you very much. Deputy Doherty.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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Thank you very much agus fáilte roimh an beirt. In the EBS building society 2008 audited reports under the heading: ''Significant Accounting and Auditing Issues'', Ernst and Young states and I quote:

Given [the] current market conditions, there is an increased likelihood that borrowers will be unable to repay loans. Should there be a default on a loan, there is an additional risk that the collateral securing the loan is insufficient. Provisioning [in this area - sorry provisioning] is an area of judgement and estimation ...

And it goes on. So, with that in mind, did Ernst and Young ever perform a review of the valuations received for assets offered as security? And were E and Y satisfied with the valuation policy?

Mr. Dargan Fitzgerald:

Thank you. So my first point to mention is that the work we carried out is both at an overall level, and as I think as I previously mentioned, is in relation to individual loans. And where we are carrying out audit work in relation to individual loans, we are considering the collateral values if it is appropriate in considering the carrying value of the loan and any relevant impairment. As I previously mentioned, typically the society would have engaged external valuers to value the collateral. At the time of carrying out the audit from ... in some circumstances, updated valuations were obtained. Perhaps for the more significant loan collateral values and in other cases, they were proving difficult to obtain and management made its own estimates and we evaluated the estimates that management had made. So in summary, I must say that collateral values were a focus of audit attention and in terms of external valuers, as I mentioned, those valuations were commissioned by the entity, as was normal and appropriate and reviewed by us where appropriate.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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So, when appropriate. So, the question was: did you review the valuations received for assets offered as securities? Is that a yes, where appropriate?

Mr. Dargan Fitzgerald:

It's in relation to the samples in which we chose, some of those may have been cases where collateral was important to the evaluation of the loan and in some of those we would have reviewed and inspected the actual third party valuations.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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And the second part of my question: were you satisfied with the valuation policy within EBS?

Mr. Dargan Fitzgerald:

Yes, absolutely. All of the-----

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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You've given comment on it but the ... if you are satisfied with it that's fine because you've mentioned earlier on-----

Mr. Dargan Fitzgerald:

Yes. Overall, we were satisfied.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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Did Ernst and Young ever review EBS's process of registration of mortgage security and, if so, what was your opinion on the process and controls the bank adopted?

Mr. Dargan Fitzgerald:

Yes, again as part of controls testing in various years, to my knowledge, and particularly in the two years in which I was audit partner, one of the aspects which was tested in our testing of procedures and controls related to either safe keeping of deeds or the registration of title of ... in deeds. While, as a general matter, we were satisfied with the ... with the procedures that the society employed, I'm sure you'll be aware that there was a pervasive issue throughout the conveyancing industry with the length of time that deeds were sometimes held with solicitors and, as I think you can see in the papers in the core documents, we did, on occasion, draw to the attention of management the importance of following up with tracking letters and phones calls and so on, the location of deeds and the perfection of the security. So, yes, it was something that we took note of and communicated, as required, to management.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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Okay. Mr. Smith, I'd like to refer to core booklet, page No. 4 ... this is a minute of a meeting between Kieran Kelly of Ernst and Young and Ted McGovern, chief executive of the EBS, which took place on 7 February 2007 and which was written and signed by Kieran Kelly. He says, and I quote, He goes:

I asked [Ted McGovern] how there focus on commercial lending fits into the ethos of the society as a retail ... service provider. [It goes on to say] He sees the business as having the potential to generate returns which can be fed back into the rest of the business and the possibility that they may be creating a franchise that is attractive for the future.

Can I ask you, first of all, why would the auditor be questioning the chief executive on the business model of the bank, if that, we're led to believe, isn't the role of an auditing firm in relation to questioning the business model of a bank?

Mr. Paul Smith:

I'll answer briefly. Remember, I'm not an expert on auditing. But my understanding is that it would be normal for the auditor to have a conversation with, not only the chief executive but other members of the management team in the client, to try and understand what was going on in the business. And the reason for trying to understand what was going on in the business is so that the audit approach which is then taken by the auditor in examining the financial statements for the year fully understands the nature of the risks that are inherent in the business. That's the purpose. The purpose is not to advise or to criticise or to critique the business practice of the client.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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You need to help me on this one here because like ... is an auditor's role not just to look at the figures and statements and, regardless of what the institution are doing, just to look at the figures? If it is - and correct me if I'm wrong in that ... if it is, then why would you be asking the chief executive why they're going into commercial lending and how it fits in with the ethos of the building society? Maybe, Mr. Fitzgerald, if you-----

Mr. Dargan Fitzgerald:

Perhaps I might have more connection with this item and I hope these comments will be helpful. You're quite right in your comment that it's not the domain of the auditor to question management on their commercial strategy and I think I mentioned that in my opening comment ... in my opening remarks. However, to be an effective auditor, an understanding of the financial reporting risks involves understanding the business risks. So, an understanding of the business risks can be obtained, typically, through a conversation with senior management and other procedures such as reviewing board minutes, which is also carried out. I think, in practical terms ... I can understand the thrust of your question ... in practical terms, an audit partner is often dealing with a finance director in terms of understanding the financial reporting details. However, it's absolutely appropriate that in terms of understanding the commercial strategy that the audit partner would have a conversation with the chief executive and, as you can see from this note, it touches on a number of background factors. I'd more characterise it as a background briefing rather than one central to the actual conduct of the audit.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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Okay. There was mention earlier on to the evidence in the core booklet ... it's on page 21 and it's a letter from the Financial Regulator to the EBS dated 3 March 2008 and it relates to the inspection of EBS's commercial property loan book that was carried out by the regulator's office in January 2008 in relation to exceptions to policy.

The letter states the level of exceptions to the credit policy for the 11 months to the 30 November 2007 was 29.2%, for 2006 it was 42.1%. I believe that you gave evidence saying that the credit ... the exceptions wasn't something you audited. Would that be correct?

Mr. Dargan Fitzgerald:

Well, I just, I suppose, want to just nuance my answer slightly. We may have ... as we picked individual transactions or balances on a sample basis, we may have come across exceptions to credit policy if we were looking to see the approval history of a particular loan. However, it may not have been central to our audit assessment of whether it was reported financially correctly as to whether the ... it had been an exception or not. That would be more internal to the society and would be less relevant for the external financial reporting.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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Okay. Would it be relevant to an auditor and financial reporting, if an institution gave out loans and 100% of the loans were outside the credit policy?

Mr. Dargan Fitzgerald:

Well, I think, if the auditor became so aware, and that awareness would typically be in exactly this way by reviewing regulatory correspondence, because it would be the domain of internal audit or the regulator to highlight such a thing ... I think that would probably highlight that the actual limit of approval for the policy needed to be revised. And sometimes the presence of exceptions to policies simply indicated that the throughput and the value, and the value of the loans being approved, was higher than originally intended and I think that actually runs through the Financial Regulator's letter - that they recommend that the limits be revised to cater for the throughput.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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We understand that the regulator had picked up on this because we see it from the letter. My ... what I'm trying to figure out with the 200 - I think - staff that went in ... or I'm not sure how many staff went in to this institution ... but the staff that went in to this institution and the samples ... on average, if you were taking any sample in 2006, 42% of them would show that there was exceptions to the credit policy. Does the audit team look at not just the financial accounting but also the controls and processes? And for a financial institution isn't the lending policy a core area, or not, of the institution? And if you have four out of every ten loans being issued that is outside of the lending policy of the institution, is it or is it not an issue that an auditing team should be picking up that there is so much lending taking place that is outside of the credit policy of the institution?

Mr. Dargan Fitzgerald:

Understood. And so ... it might be. I must say in EBS's case it was not an issue that particularly manifest itself in the samples we selected and in the approach that we took. So, for example, if we were seeing that a loan had been appropriately approved it could well be that these ... that either it happened in periods when these exceptions did not take place, or the exceptions - as they are described by the Financial Regulator and highlighted appropriately by the Financial Regulator - they may not have been relevant to the financial reporting. They may not have actually influenced the amount that was recorded as a loan and our audit procedures would have been designed to ensure that the financial reporting of the loan was appropriate.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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The final question I have here is in relation to IAS 39, which this committee has heard a lot of over the last number of days. I want to deal with IAS 39, paragraph 43, which allows for the ... I'll just quote it just for the reference: "When a financial asset or financial liability is recognised initially, an entity shall measure it at its fair value plus, in the case of a financial asset or financial liability not at fair value through profit or loss, transaction costs that are directly attributable to the acquisition or issue of the financial asset or financial liability." That paragraph states that when you recognise a loan that was issued by a financial institution that you would have to recognise it at market value on the first recognition of the loan. Am I correct so far in my interpretation of that? I take your nodding as ... that I'm reading this properly because I'll just go on to the next bit then if that's the case.

Mr. Dargan Fitzgerald:

Certainly.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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So, on that basis, was there many loans that you audited, or your firm audited, in relation to EBS, that were written down to market value and was ... when they were originally audited by ... recognised by your firm, when they were originally audited?

Mr. Dargan Fitzgerald:

Certainly. I'll probably have to come back to the first part of that question. I'll have to ask to refer to the specific accounting policy - the ... the loans under international financial reporting standards are not, in some sense, reported at a market value in the sense that you mention.

The sequence is, they're recorded at cost, there's an ... a derivation of an effective interest rate but, crucially, the impairment provision is what does exactly what you refer to. If an impairment provision is required, it reduces the carrying value of the loan, which, in simple terms, is typically close to its nominal value ... the amount that was loaned to the borrower. It's the operation of the impairment provision, if any, that brings, in simple terms, that to the realisable value of the loan, which you may have referred to as market value.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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Maybe to just clarify where I'm trying to get-----

Mr. Dargan Fitzgerald:

Please.

Photo of Pearse DohertyPearse Doherty (Donegal South West, Sinn Fein)
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-----and I'll use a ... just an example from my own head. If an institution provided a loan for €500 million to an individual to do X, Y or Z, and on the day that you went into the audit you believed that that lending was, maybe, inappropriate, the assets weren't there to secure it, so on and so forth, and the market value - the fair value, which is the value to be reached with ... between two parties that aren't connected in the free open market - was half of that, is the accounting standard that I mentioned, IAS 39, paragraph 43 - which requires you not to recognise that loan in an incurred loss basis but actually on a fair market basis, which means that you would have to have that loan written down to €250 million instead of what was the book value of €500 million - would that be a fair assessment of what you would be required to do?

Mr. Dargan Fitzgerald:

Well, I think, again, I'd have to play it back. I think you'd have to refer to the specific accounting policy which is absolutely in compliance with the standard for valuing the loans in the books of the society and because of the different types of loans, it can be a little bit more complicated than the outline description. There are two stages to assessing the value for reporting in the financial statements. One is whether there is objective evidence of impairment, that is, typically, if there is evidence of, in simple terms, stress and strain in the borrower's repayment of the loans. That absolutely depends on whether the borrower is up to date in those payments or not in similar analysis. And then, as a second stage, if there is objective evidence of impairment, the institution - the bank or building society - will typically carry out a discounted cash-flow analysis. That fulfils the requirements of the standard. The discounted cash-flow analysis will produce a value, which will be the value that would be booked if, but only if, there is the first factor present ... the objective evidence of impairment. And in that way, and using the principle of incurred losses, which simply means that only losses which have actually occurred up to the balance sheet date, are to be recognised, then the resulting provision and write-down that you referred to is incorporated in the financial statements.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay. Thank you very much, Deputy. Just on a related matter, before I bring in Senator O'Keeffe, I just want to ... when we spoke about the property experience in the audit team ... moving beyond estate agents and others that you indicated as being part of the audit team, Mr. Fitzgerald, did a team at any stage include a person who understood the concepts of commercial loan underwriting?

Mr. Dargan Fitzgerald:

Oh, absolutely. I feel that the team had several senior personnel, myself included, who fully ... were fully experienced and very briefed in all of those relevant factors.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay, thank you. Senator O'Keeffe.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Thank you, Chair.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Your phone.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Please turn off the phones. Like, it's not possible-----

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Guilty, as charged.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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I think this ... this is probably best directed at you, Mr. Fitzgerald, but I may be wrong. I'm just trying to find out whether the society's management and board structure ... did it impede the provision of good governance within the society at all or what impact might it have had?

Mr. Dargan Fitzgerald:

Well, I don't feel that the ... that the structure of the society impeded good governance. I never reached any such conclusion as a result of our work. I must say I was impressed in the society by the rigour of the operation of the various sub-committees of the board. I personally spoke, of course, with many senior members of the management of the society but I also reviewed the minutes of the meetings of those board sub-committees, and I'm referring, for example, not only to audit committees but to asset and liability management committees, risk committees and investment committees. And I felt, given that the society was in ... in relative terms not a giant organisation - it was one of the smallest of the Irish-covered institutions in the end of course - I actually felt its ... it had a very elaborate system of governance and control generally and I was very impressed by it.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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In 2011, the corporate watchdog, Paul Appleby, was ... and, again, you may not be familiar with this quote, so if you're not, of course, you may not have to comment on it. He said that there were grounds for questioning the consistency and quality of audit work within the profession, and he said that, "auditors report surprisingly few types of company law [offices] offences to us", with the so-called big four auditing firms reporting the least often to his office, at just 5% of all reports. So I'm just wondering if that's a quote that you're familiar with and if you have any view. If you're not, of course you don't have to.

Mr. Dargan Fitzgerald:

I'm afraid I'm not familiar with the quote.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay, thank you very much.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Were you at all aware in any of the auditing that you did of any ... whether EBS itself invested equity in any of the property transactions for which it also provided debt financing?

Mr. Dargan Fitzgerald:

I'd have to check the files and check my understanding. My recollection is either no or little, but I could be corrected. I'd have to check the detail of the files, but I don't feel that was a feature of their arrangements.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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When Professor Ed Kane was here ... and, again, this testimony, you may not have seen. On page 233, he said, "One may know that the firm is in grave trouble but the auditors may not have sufficient information to allow them to determine that." Would you have a view on that? And, again, that's obviously a broad statement. He was referring broadly, not specifically.

Mr. Dargan Fitzgerald:

Well, I don't know the background or the context of that statement particularly, I'm afraid, so I probably shouldn't comment. I don't really know where that statement is coming from in terms of its context.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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He was just talking generally about the practice of auditing, but I respect that. In 2011, the Revenue Commissioners - and, again, Minister Fitzgerald, you may not be familiar with this - said that audits said little about the business model of firms or their liquidity position, and:

Audit reports are primarily addressed to shareholders. However, as recent events have shown, others, including the general public, have an interest in the results of some large companies. There is a need to better set out the societal role of the audit.

Would you have a view on that?

Mr. Dargan Fitzgerald:

Yes. I must say I agree with those comments, and I just might say that, as it happens, I'm a member of the council of the Institute of Chartered Accountants in Ireland, and one of the initiatives that the institute undertook in the wake of the financial crisis was to convene a working group which considered and reported with a publication called "Statutory Audit: What the Future Holds", and in that we discussed exactly some of those challenges to the usefulness of auditing in terms of external financial reporting. And the ... some of the themes that we considered and reported on were in relation to the quality of communication that is included in the external audit report. And I think it has become clear that an external audit report in the hands of a reader, particularly a reader not particularly versed in financial matters ... in its ... in previous eras at the time that I was carrying out these audits, those audit reports restricted themselves to talking about the accounting framework and the law and certain other statements that nothing had come to their attention in relation to statutory disclosures that had not been made. Now, for public interest entities, the audit report is much longer, much more rich in content in terms of commentary on key judgment issues that have been the concern of the auditor and, by extension, the concern of management and the audit committee. And I think that these ... this has been a significant improvement, I'm sure not perfect. I'm sure there'll always be what's sometimes called "an expectation gap" between the users, particularly non-financial users of financial statements, and the current state, but I do feel that the advances that have been made potentially improve the usefulness for society as a whole.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Others who've given evidence, and I mean this in the broadest sense, have referred to that period of time, I suppose, between the beginning ... probably 2008 and specifically obviously around the time of the guarantee, as being unprecedented and as being very difficult. So I just wonder what your observation might be of that time, if, indeed, you have one.

Mr. Dargan Fitzgerald:

Of the time of the financial crisis?

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Yes, of that particular time. Do you have an observation to make? Either of you.

Mr. Dargan Fitzgerald:

Well, just, I'll make the general observation that I'm quite certain that in my own professional career, spanning over 30 years, they were unprecedented conditions.

And I think, as ... between Paul Smith and I, we mentioned in our opening statements ... I mean, one cannot underestimate the adverse financial effects throughout all of society, and that was one of the reasons that in the institute working group that I mentioned, we were so concerned to make some public statements that would, hopefully, contribute to an improved environment for external auditing, because of some of the issues that you raise in terms of the usefulness of the external audit. But in summary, and to answer your question, I absolutely feel that the financial crisis was almost overwhelming.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Mr. Smith, do you ... would you care to make an observation?

Mr. Paul Smith:

Only to echo what Dargan has already said and to say that in my own experience of 36 years in the profession, but not in auditing, this was absolutely unprecedented. I might just add one further comment was ... which is that, notwithstanding that it was unprecedented, I felt that the response of my colleagues in terms of carrying out their audits in a very difficult and constantly changing environment ... I thought the response was excellent and they produced very good audit reports.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Can I just finish by going back, perhaps, to the letter that my colleague, Deputy Doherty, referred to ... the letter between ... the Kieran Kelly file note in relation to Ted McGovern ... I beg your pardon, that's the core document, page 3 ... page 3 and 47, actually, on page 4. So, he goes on to say that Mr. McGovern raised various things like the reliance on a few numbers of very key people is a risk - he was talking about in the institution - that there is imprecision in figures and that people are being forced into taking actions which are, in turn, imprecise and slightly unfocused. In respect of control breakdowns in the year, he said that there would appear to be fewer than in previous years, which he took as being a positive outcome from some changes and actions which had been taken. He said that there were, and I quote, "a couple of fraud instances and behavioural instances" which caused him concern. So ... and then he goes on to say, "I asked [him about the] focus on commercial lending [as a fit in] the ethos of the society as a retail financial services provider", and he said "this is a business line that they feel they can make return commensurate with their risk and for which they have skills and opportunities to capitalize on". So again, largely, those comments feel again to people not familiar ... and we've listened a lot to auditors saying that it is a faithful statement and that it looks at the figures in a time and that you don't have anything to do with the running or the influence of the management. I appreciate you've observed that it is a ... that it was a background briefing, but it does seem as if there were very specific observations being made about problems at the society, albeit it's in, you know, in this context, so I'm just wondering how ... there was clearly an exchange here. How ... I don't know how that fits into the audit process.

Mr. Dargan Fitzgerald:

Yes, thank you. I think I appreciate the thrust of your question. I would just say that, while it is a high-level and a background briefing note, it does inform the conduct of the audit and, I mean, I actually can't say this without checking, but if I had been in the room and was carrying out the audit based upon this as a high-level briefing, absolutely we would circle back to check matters reported as frauds. There would be a process inside the society to record frauds that have been identified and we would look to see whether they had any impact on the financial reporting. Typically, they don't, or they have already been reported and they're more internal control issues, but, nonetheless, we do take into account ... and a typical way of dealing with it on an audit would be to take a file note such as this and tick off each of the points and cross-reference them to another piece of our work where we had satisfied ourselves exactly to your question that there was nothing that was being referred to which should give us concern in carrying out our work. So I would say, yes, it was a background briefing, but we would not ignore any of the comments if we thought they would affect the financial reporting. I hope that helps.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Quickly.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Just to clarify, he ... Mr. Kelly does ask about how commercial lending fits into the ethos of the society.

Mr. Dargan Fitzgerald:

Yes.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Is that not a direct question about management style or an approach or an adopting of a, you know, maybe concentrating more on commercial lending than had hitherto been the case?

Mr. Dargan Fitzgerald:

Well ... it's ... I feel it just evidences a dialogue in terms of understanding the business risks and the business motivation and, again, I feel that's quite appropriate and it doesn't stray into advising management or any of those things. I think that's obtaining and understanding appropriately by asking as to the rationale.

Photo of Susan O'KeeffeSusan O'Keeffe (Labour)
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Thank you, Chair.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Thank you very much. Senator Barrett, ten minutes.

Photo of Sean BarrettSean Barrett (Independent)
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Thank you, Chairman, and welcome along this afternoon. Could I ask did you perform stress testing as part of the external audit of the society?

Mr. Dargan Fitzgerald:

Well, if by stress testing you mean did we analyse different scenarios in which the reported results might fall, given different scenarios of loan losses, and I'm not sure that is your question, but certainly, in terms of what's commonly called stress testing, we evaluated different scenarios which the society produced in terms of the loan loss provisions, to ensure that the scenario and judgments ultimately made, in relation to the impairment provisions adopted and incorporated in the financial statements, were reasonable.

Photo of Sean BarrettSean Barrett (Independent)
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Because, if I may, page 17 of the core document, Chairman, the regulator is concerned at the "high level of approvals that exceeded the affordability guidelines, particularly as this criterion is the one which incorporates stress testing of loan repayments", and it says "see also finding M1", which we don't have. So, was it the wrong kind of stress-testing or why did the regulator bring up the issue in relation to the EBS in his letter, which is dated 10 June 2007?

Mr. Dargan Fitzgerald:

Thank you. Well, first of all, to understand that the purpose of the regulator in bringing up such items is, as I previously mentioned, quite different from the external auditor's role and they very much approach their work from different angles. The regulator, as I understand it, carries out a very detailed body of work to check that the detailed operation of procedures, which they, as regulator, feel are important in relation to the functioning of the regulated entity, that those are carried out appropriately, and these recommendations are, therefore, very very detailed in that regard. When you mention stress testing, I think now that I see your reference, I imagine that's in relation to the stress testing of the repayment capacity of an individual borrower, I think that's probably what's referred to. The answer I gave was at a level of the totality of loans and please excuse me if I misunderstood your question. So I would think in relation to that comment on stress testing, that will not have a direct correspondence with any external audit tests as such, except to the following extent: that as I previously mentioned, we always, investigating ... in reviewing a loan and discussing it with management, we look to see whether there is evidence of impairment of the loan, including any financial distress of the borrower, and so that may have been relevant.

Photo of Sean BarrettSean Barrett (Independent)
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But would it have come to the auditor's notice that there was a high level of approvals not within normal guidelines and a quarter, virtually, of the home loans exceeded affordability guidelines? Having in mind what Mr. Smith was saying earlier about a new dialogue between the regulator and the auditors, would these not be things that, going forward, we should actually be discussing to say, "these are the warning signals we see here", and here is more that the regulator has brought in? Otherwise, we could lose another €100 billion, if we take into account the losses to two sets of taxpayers and the shareholders being wiped out.

Mr. Dargan Fitzgerald:

Understood. Well, I would comment as follows: I think that the comments you've made do highlight the benefits of one initiative that I feel is very important that I mentioned in my opening remarks, which is the introduction of an auditor protocol, between the then Financial Regulator, and now the Central Bank of Ireland, and external auditors. And that edict was updated in 2013, and it provides explicitly for bilateral or in some cases trilateral meetings - bilateral meaning the entity being audited ... that meaning the Financial Regulator, on the one hand, and the auditor to an institution, on the other, and those meetings specifically allow the Financial Regulator, if they so wish, to communicate a concern around an item just like the one you mentioned. It also means that the auditor can communicate to the regulator items that the auditor may feel the regulator should have knowledge of, and, frankly, it allows for an informal discussion of such matters.

And in my own experience, and I have sat in on many dozens of such meetings under this protocol, it is very helpful in a mutual understanding in the regulator's department and in the auditor as to what the significance of such matters really is.

Photo of Sean BarrettSean Barrett (Independent)
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I liked your earlier point about improvement points, control points and this kind of dialogue and Mr. Smith's points, but we better move on or our mutual admiration will use up too much of the time.

You say on page 11, it's in the fourth paragraph on the right hand side: "We noted that there is a strong risk consciousness in general throughout the Society". But does that not contrast with the 57% discount? I was thinking that, you know, our new man in drapery buys really good suits, but we can only sell them at 57% discount, so that he hasn't got a great cost consciousness.

Mr. Dargan Fitzgerald:

Well, I would just repeat that the ... and the comment we've made that you refer to is at the, I might say, the highest possible level. It looks at and comments on our general understanding of whether processes of internal control are operating effectively. In the work that we carried out, we found that internal control environment to be relatively strong. And when I say that, we would be comparing to the experience we had had of other similar institutions and to other institutions generally. I do feel there was a strong control consciousness.

Now, notwithstanding that, banking involves dealings with an enormous number of individual customers and the Financial Regulator's brief, I believe, in carrying out reviews like this is to highlight procedural matters that would not have the same significance for us as for the regulator.

Photo of Sean BarrettSean Barrett (Independent)
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How do the groups of accountants operate? Again, the dreaded word, does EY Ireland operate as a "silo" or would you have contacts with the other EYs around the world?

Mr. Dargan Fitzgerald:

Well, we certainly don't operate as a silo. We describe ourselves as a global firm and we are integrated in a number of ways with other practices. We would work, as you might expect, closely with the practice in the United Kingdom, but also with other financial services centres overseas, such as New York and-----

Photo of Sean BarrettSean Barrett (Independent)
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So it's more than a franchise, is it?

Mr. Dargan Fitzgerald:

Yes, but I wouldn't have described it as a franchise.

Photo of Sean BarrettSean Barrett (Independent)
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When Lehman Brothers collapsed, would you have been speaking with your opposite numbers in New York about what did they feel went wrong in the audit? Because it's been crucial throughout these hearings, the collapse of Lehman Brothers. I'm just wondering if you had any insights into ... from your colleagues in EY New York?

Mr. Dargan Fitzgerald:

Well, I'd say two things. First, no, I personally had no such conversations, but I wouldn't have expected to particularly and ... but I would also say that both internal EY commentary of the risks facing financial institutions was disseminated regularly, which assisted teams like my own significantly in their understanding of the nature of the financial crisis that was then unfolding and of the financial reporting and auditing risks that resulted.

Photo of Sean BarrettSean Barrett (Independent)
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As I understand Sarbanes-Oxley, there are two things that I might like to ask you about. Individual responsibility, I think, it's as high as 20 years imprisonment for malpractice in auditing and $5 million fines, and separation of auditing from consultancy work. Could you tell us a little bit about those in the little time remaining, please?

Mr. Dargan Fitzgerald:

Certainly ... well, certainly happy to comment on the latter. In relation to the former, I would just comment that the attitude of legislators in each jurisdiction, in each country, does vary greatly. And I'm sure there's broad consensus that in the United States there's a very great focus on that. I'm sure that lessons can be learned in other countries and territories. And I might mention that, for example, in Irish legislation, there has increasingly, and will increasingly be, certification of financial statements amounts by directors, rather than just a sort of general responsibility. So, I do think that has evolved.

In terms of the question you asked about the separation of consulting or advisory work from auditing work, in practice, it is rigidly separated, due to the operation of ethical standards. And so, I must say the profession is extremely conscious of the perils of self-audit or of conflict of interest.

I know in our own firm, as I'm quite sure in the other firms, enormous lengths are gone to to ensure conflicts of interest are either not present or are handled appropriately.

Photo of Sean BarrettSean Barrett (Independent)
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Thank you very much. Thank you, Chair.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Senator D’Arcy.

Photo of Michael D'ArcyMichael D'Arcy (Fine Gael)
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Thank you, Chair. Mr. Fitzgerald, what changes, if any, to the auditing process should be taken in to improve the current structures?

Mr. Dargan Fitzgerald:

Well, some of them we’ve probably touched on in some of the discussions. I think the move to make ... to update audit reports so that in the case of public interest entities they give more detail about the judgments, are an important development. I feel that the role of audit committees in terms of the robust challenge that they can bring to board operation is an important additional improvement that is being and can continue to be made across the piece.

Photo of Michael D'ArcyMichael D'Arcy (Fine Gael)
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And in terms of ... what’s your opinion in relation to audit firms to further improve the supervisory and the regulatory process of banks and financial institutions?

Mr. Dargan Fitzgerald:

Well, I’ll probably confine my comments to the perspectives that deal with auditor-specific matters and the interaction with the Financial Regulator that auditors have. As I mentioned, an updated auditor protocol enables both meetings and other communication between the auditor and the Financial Regulator. I feel this is very helpful to the conduct of external auditing. I presume it is helpful to the regulator.

I had mentioned in my ... both my opening remarks and in our written statement that it possibly could be improved by being underpinned in a statutory way. At the moment, it’s a protocol issued by the Central Bank of Ireland and there is some thought that if it were underpinned by a statutory basis, it might be more reliable. And there is always the possibility that external auditors should have a right to report rather than the duty to report which they currently have.

Photo of Michael D'ArcyMichael D'Arcy (Fine Gael)
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Outside of the move to codify those protocols, those non-statutory provisions, anything else you could think of that should be incorporated that haven’t been to date?

Mr. Dargan Fitzgerald:

Nothing springs to mind.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay. Thank you. I’ll just move towards a wrap-up so, Mr. Fitzgerald and Mr. Smith, in inviting both Deputies in.

Can I just come back and deal with just one matter relating to the Financial Regulator and the matter of loan exceptions? Following the Financial Regulator’s findings, did Ernst and Young alter their sampling approach when reviewing loan exceptions?

Mr. Dargan Fitzgerald:

I probably would have to check the detail of the files. My recollection is that it was not felt that we needed to do so. And the reason I say that is that, as I previously mentioned, the sample sizes that we were contemplating in the and then executed in the 2008 year were significantly increased in number and scope on the 2007 year so there was already a considerable increase in the amount that we were testing.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Thank you. Deputy Higgins.

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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Gentlemen, I’ve just one question to sum up. We’re just coming to a conclusion of just north of 14 hours of testimony and questions from the four that are considered the giant auditing firms in this State, and giants internationally as well in the auditing world, who audited in this State the giants of the financial institutions. Up to the end of 2007 and reporting in the first six months of 2008, there were no qualified reports whatsoever. A clean bill of health was given. You were happy with the loan books. You were happy with the security for the loans. You were happy with the large concentrations of loans in land and property. Happy with loans-to-deposit ratio and happy that all the banks were going concerns. Yet, just a few short months later at September’s end, the self-same financial institutions were in a state of chassis, down banging on Government Buildings, desperately looking for a bailout and a guarantee, leading to a process that eventually cost our people €64 billion and years of austerity and pain and dislocation.

Can you try to explain that to our aggrieved people?

Mr. Dargan Fitzgerald:

Well, perhaps I can lead off and just say I think your comments, which absolutely, in me personally, provoked the reaction that as we previously mentioned, the effects of the financial crisis have been, I would say, cataclysmic and there is no attempt, Deputy, to underplay, in any of my, and I think our, testimony those effects. I mean, they are fully appreciated and I think some of ... some of the comments I've made in terms of improvements to auditing practice since the financial crisis began I hope go some way to improving the situation going forward but I am cognisant that they are only small steps and ... and that greater steps must be taken in a whole plethora of different arenas such as regulation generally, governance generally and so on.

I think your comments highlight the precipitous fall in certain markets, particularly for property assets, in a very short number of years, and I just would reflect on the fact that, in the 2007 report to the audit committee, we wrote then specifically highlighting that the credit loss provisioning represents one of the most significant challenges for banks and building societies in complying with the requirements of International Accounting Standard 39. So, I just would highlight, I think in our ... certainly in my own case, I can say, I think the audit team was alert to the possibility of financial reporting being under stress and strain but I think that it's important to remember the respective roles of the various participants in the crisis.

Photo of Joe HigginsJoe Higgins (Dublin West, Socialist Party)
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Mr. Smith, you were the senior person in Ernst and Young. Your comment, please.

Mr. Paul Smith:

I really don't think that I've got anything specifically more to add to what my colleague has already said.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay, just on that note, can I just turn to, in respect of the booklet, page 11. I now bring in Deputy O'Donnell. And this just develops on from Deputy Higgins's comment there. It's the second panel of conclusions and it's the second paragraph:

We reviewed the Society's Credit Impairment Policy to understand and consider the Society's methodology [to determine] specific and collective provisions. We are satisfied that the methodology complies with the requirements of IAS 39.

That was in 2007; in around the time that you wrote that correspondence. I just need to just kind of measure how I frame this. By satisfying the methodology compliancies and requirements of IAS 39, was that sufficient in providing a true and fair view of the banks, in effect?

Mr. Dargan Fitzgerald:

Thank you. Yes, I do feel it was and, if I can perhaps put some of my comments in a slightly different and summarised way, which I hope will be helpful, the ... those readers of the financial statements prepared in accordance with that accounting standard, assuming they had knowledge of the way in which the standard prescribed the recognition of incurred losses, in terms of impairment of loans, would have been in a position to appreciate from the financial reporting that ... that there was ... that there was weakness in the bank's situation and the ... the principle of our giving a true and fair view is that, because it references a specific reporting framework, if the reader can appreciate the, and I appreciate that's not always easy, but if the reader can appreciate the actual formal basis for the framework, well then it is important that the auditor carries out their role in reporting within that framework, and I think the true and fair view is to be understood in that context.

Photo of Ciarán LynchCiarán Lynch (Cork South Central, Labour)
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Okay. Thank you very much, Mr. Fitzgerald. Deputy O'Donnell.

Photo of Kieran O'DonnellKieran O'Donnell (Limerick City, Fine Gael)
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Can I just take up the true and fair view, just to get clarity? You're required to audit obviously under company law but, in here case, it was built inside the Act 1989 for a true and fair view.

The question, I suppose, I want to ask is, with the change in ISI 39 in terms of recognising losses from 1 January 2009, did it bring about a delayed recognition of losses after the horse had bolted or did IA 39 have an