Credit crunch effect on audit

The credit crunch explained

The ‘credit crunch’ refers to the increasing cost of borrowing money (‘debt’), sparked by rising interest rates, and the situation that ensued. When interest rates rose (even slightly), many people could no longer afford the repayments on their mortgages, and had to default. This affected the American ‘sub-prime’ market, where money is lent to potentially risky debtors. Banks have exacerbated this problem by over lending, in some cases offering up to 125% mortgages, where in the case of a default and repossession, they can only recover 100% ( the value of the property), leaving them 25% out of pocket.

Ultimately the cause was over-optimistic lending, without considering the risks and recoverability.

Why interest rates were increased

Interest rates are used to control inflation as part of a government’s monetary policy. Increasing interest rates reduce inflation and slow down spending. It is considered that a steady inflation rate of around 2% is healthy for an economy.

Victims of the credit crunch

Everybody is a victim, either directly or indirectly, including companies and individuals. However, two banks have suffered seriously: Northern Rock and Bear Stearns.

Northern Rock

Northern Rock was bailed out by the UK government, effectively nationalising it and making the UK government the UK’s largest mortgage lender.

Watch this interview with Liberal Democrats' deputy leader and main economic spokesperson Vince Cable, to find out more about the Northern Rock crisis.

Bear Stearns

Bear Stearns, a famous 80-year old investment bank, was purchased at 1/20th its value by JPMorgan Chase, in a swift move to prevent a bankruptcy filing. The Central Bank (the US equivalent of the Bank of England) lent Bear Stearns emergency funding to help keep it running, which the new owners will eventually have to repay.

How the credit crunch affects the audit industry

The credit crunch has increased the audit risk. The most significant impact has been to the audit of banks. Auditors will now need to look much more closely at a bank’s lending situation to determine if it can reasonably recover the money it has lent. This is particularly important as audit firms must give an audit opinion as to whether the bank is a going concern. In the cases of Northern Rock and Bear Stearns, the audit opinion proved incorrect, and the auditors could be held accountable for not identifying that the company was at risk (see article .)

There is also an increased risk to all companies with significant borrowings. As interest rates rise, if a business can no longer afford its loan repayments, it may be forced to file for bankruptcy. Audit firms will take extra care when reviewing the debt of any company to ensure that they are not exposed to substantial risk, and that any matters of risk are reflected in their audit opinion.

Further Information

This bulletin by the Financial Reporting Council (FRC) is a useful guide to the issues that affect audit during a credit crunch situation - see bulletin.

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