Examination of Witnesses (Questions 20-39)
MR MICHAEL GROOM, MR PETER WYMAN, MR DAVID BISHOP, MR ROGER ADAMS, MR BRUCE EPSLEY AND MR RICHARD MALLETT
WEDNESDAY 10 APRIL 2002
20. Thank you. Can I just move on to something that is central to Enron, which is this question of off balance-sheet accounting, or special entities, or what has been referred to already as leasing. Now, as is eloquently said, in a Paul Volcker article, in Accountancy Age, this is the author: "I can't be alone in thinking that use of the phrases "off balance-sheet" and "special purpose entity" state the users' intention to mislead". Well, I would tend to go along with that; that is what Enron tends to reinforce. So what is being done about this? Why are we persisting with these sorts of devices that mean that accounts are no longer a true and fair account of the financial status of a company, because there are so many things in the cellar that are called "special entities"?
(Mr Groom) I think this is where we need to keep re-emphasising the difference between the UK and the US. For a considerable number of years, the bodies represented here have argued very strongly for a global approach, in a whole range of areas but particularly accounting standards, that I think you are talking about, and the Enron issue has more closely brought the Americans to the table. And what we need is an approach which says global accounting standards must be the way forward, but not global standards as long as they are the ones that we have got in our country. Now what we have got in the UK is a set of standards that, in the area you are talking about, does not allow those items to be left off the balance-sheet, and international standards, almost certainly, will go in that direction. The American standard in that area is quite fundamentally different.
21. And are you saying that that is the case now, or that will be the case?
(Mr Groom) That is the case now.
22. Are you also saying that, in the light of Enron, there needs to be no change to the present position in the United Kingdom?
(Mr Groom) No. I think what we have said consistently is that all of these areas need to be looked at on a continuous improvement basis; and so, with the setting up of the International Accounting Standards Board and the strength it now has, every single standard needs to be held up to the light. And what they are doing at the moment is they are looking at areas where there is the greatest divergence around the world and they are putting significant amounts of work into making sure that those particular standards are taken forward; but that again will be a continuous process over a number of years.
(Mr Wyman) May I just pick up on something you said, which is terribly important; you said accounts no longer show a true and fair view. In the United States, it is not, and never has been, a requirement for accounts to show a true and fair view; that is one of the fundamental differences between the UK, and indeed all of Europe, and the US.
23. But they do not show a true and fair view either here, if you have got stuff off balance-sheet in the cellar which nobody knows about?
(Mr Adams) Can I just make an observation, on this issue of balance-sheets. Clearly, we do have an accounting standard in this area, but also, I think, the Seventh European Directive looked at consolidation issues, and broadly embodied the notion of control or significant influence as the way of identifying when another entity should be consolidated. And it is noticeable that in the fallout from Enron the concern of the European Commission has been primarily about looking at the auditor independence issues, perhaps with the Committee on Auditing, much rather than the accounting standard area, or the off balance-sheet area, where I would tend to agree with Peter and Michael that our accounting standards focus on issues of control, voting control, or significant influence over the operating policies of other vehicles. And I think that that is a world away from the rules-based approach of where you can have a 3 per cent, independent, third party holding in a special purpose entity, with 97 per cent of the rest guaranteed by a second party, i.e. a bank, which seems to have been at the root of many of the Enron vehicles but, in fact, much of the control over operating policies actually exercised by Enron and Enron staff. There is a kind of big philosophical thing here, in accounting terms, about have we crossed the Rubicon, in terms of accounting, over here.
24. I think we will move on to another section; but what I am inferring from this is that you are getting very close to saying that an Enron could not happen in the United Kingdom, and you are just putting it down to off balance-sheets and maybe own shares. And I would like to confront Harvey Pitt and others with a view that United States accounts are not a true and fair view; and I wonder what Mr Pitt's answer to that would be?
(Mr Groom) I think, interestingly, Peter and I met with him about a month, or so, ago, and his meeting of mind with us, on a whole range of issues
25. Does he agree it is not a true view?
(Mr Groom) Specifically, on that area, I cannot recall, unless Peter can, that particular bit of it.
26. I do not really think so, to be honest?
(Mr Groom) But if we look at the underlying issues of substance over form, of global accounting standards, all those things we have talked about, he was very much in line with the approach that we have taken in the UK. And, indeed, a week or two earlier of that, I was a participant in a World Economic Forum in New York, and, without people in the audience knowing I was there, prominent Americans were standing up, saying publicly, "We, in America, need to look at the UK, at the lessons they have learned over these ten years."
Chairman: You would make a good politician, Mr Groom; you never answered the main question. However, we move on to Jim Cousins.
27. First of all, Chair, I would like also to acknowledge the work of Sir David Tweedie, as he now is, and the work of the Accounting Standards Board in the earlier 1990s. But the Committee has had one piece of evidence from somebody suggesting that 70 per cent of the value of British companies, assessed under British standards, is represented by goodwill and branding and reputation, which, of course, were precisely the focus of some of the most important reforms that Sir David Tweedie was responsible for. Now do you agree with that sort of ballpark figure, that 70 per cent of the value of British companies is represented by these intangible items; does that seem to you to be a fair account?
(Mr Wyman) Speaking personally, I have never seen any calculation or basis for arriving at 70 per cent, but it does not feel inherently wrong to me, from what I know about where the value is, in businesses. So I would not disagree with it, but I could not say it is the right number; it does not feel wrong.
(Mr Adams) It would vary, on a sectoral basis, clearly.
28. Yes, of course; of course. One might find that, software, telecommunications, it was different from, let us say, Railtrack?
(Mr Adams) Due to a negative value.
29. Sure. Now that means that if a large proportion of the value of companies is locked into intangibles, with all the inherent difficulties of measuring intangibles, which was Sir David Tweedie's great project, that means that this suggestion of yours, which is in the Company Law Review, of an operating and financial review that would measure risk, has got some difficulties about it?
(Mr Wyman) You have touched on really the central difficulty in financial reporting, which is the judgements that have to go in, whether the rules, and so on; at the end of the day, this is not a science, it is an art, and there is a lot of judgement. And my wish for the risk to be better displayed is to enable users of the accounts to form their own judgements, and that is not in any way to take away the responsibility from the directors and the auditors, obviously, that is where the real responsibility is. For example, if you spent a lot of money buying 3G licences, and you think this is the future, and you bet your company on that being the case, that gives you a value for the investment you have made; everybody can have a judgement on the future of 3G, and the directors obviously will have a value, auditors can have an opinion, but it may be different from anybody else. But, I think, if we can display better the judgements that have gone into the formulation of these very big accounting treatments, that would actually help everybody, investors and other stakeholders. As you rightly say, it is very hard, and you cannot be precise, and so it is a judgement.
(Mr Groom) Can I add to what Peter has just said. At the end of the day, when you are talking about listed companies, which is what your inquiry is addressed to, it is market forces that determines value, because it determines the share price; and our line, very clearly, is that shareholders, potential investors, must have as much informed information as possible, and, therefore, in this area, there must be maximum transparency. Our Institute has done a number of projects, as have, again, the other bodies. As an example, one of the things we have been working on is a thing called "Prospective Financial Information", which is a way of looking forward at what is likely to happen in the company; there have been other studies in relation to intangibles, into valuing market factors, etc., etc. But I do not think, at the end of the day, you can have a valuation technique that comes away from market forces, that is what drives the capital markets.
30. Just for one moment to clarify your view about listed companies and the operating and financial review, which was a subject that the Company Law Review explored, I am drawing the conclusion, from what you have just said, that you would like the operating and financial review requirement to be a requirement on all listed companies; that is correct?
(Mr Groom) Yes.
31. Now the operating and financial review would be expressed in law, it would carry legal force; and what sanctions do you think should apply to the enforcement of an accurate, or reasonably accurate, operating and financial review, and where should those sanctions lie?
(Mr Wyman) The enforcement of standards generally is a very big issue, which we have given a lot of thought to, and it is currently the subject of much discussion across Europe, and there are different models in different countries. The main policeman in this, if I can describe it in that way, is the Financial Reporting Review Panel, which is a panel that sits beneath the Financial Reporting Council, and its remit is to investigate any complaint about accounts, and if the accounting standards have not been followed then it has sanctions to go to the courts to require a restatement of those accounts. And that is a very, very effective concentration of minds, of both directors and auditors; there is no doubt in my mind that it has had a huge impact in improving the quality of financial reporting. Part of the debate is, should it move from a reactive, it waits for a complaint, it is a complaints-driven system, should it move into a proactive, on a sample basis, calling in accounts and reviewing them without waiting for a complaint, and whether the costs, and they are not insubstantial costs, would merit the benefits, needs to be something that is an ongoing discussion. So I think that is where I would be looking for the policeman. The sanction, first of all, it is to restate, so you have not got away with it, you have got to tell the world how it was, and huge damage, potentially, anyway, to the reputation of both the company and the auditor; and we have seen in recent months just how quickly reputations can get damaged, which is why it has been so effective.
(Mr Adams) Can I just draw a parallel, also, Peter, perhaps with the directors' report, to say that currently the directors' report is a legal requirement and yet it is not covered, the auditors' report, as far as I understand it, does not cover specifically the directors' report. The auditor is under a requirement to review the disclosure and statements made within the directors' report and to raise anything that is inconsistent with the auditors' understanding, flowing from their audit of the financial statements. Now, it seems to be, when you come to a mandatory OFR, you are going to be in very much the same position there, that you must be looking for inconsistencies between the statements that directors are making, regarding the issues that drive value, and the procedures that they have taken to protect value, on the other hand; because, both from the corporate governance perspective and from the intangible assets perspective, there will be things that are potentially, I am not going to say unauditable, but difficult to provide assurance on.
(Mr Wyman) Can I just add, I think the real problem is not to legislate for there to be an OFR, that can be done by a Standards Board or by Government.
32. But you want it though, or business is in favour?
(Mr Wyman) Totally in favour.
(Mr Adams) But, Peter, is not the FSA looking at the listing rules, and this will come under the listing rules?
33. I sincerely hope so?
(Mr Wyman) What I was going to say was, I do not think there is a difficulty in legislating for there to be an OFR, whoever that legislator is, Government, FSA, Accounting Standards; the problem, the difficulty, is then to make sure that there is quality reporting of risk. And, on the one hand, there is a worry that you end up with something, which we see frequently in the States, I am sorry to go back to the States, where, in order to make sure nobody can say, "Well, you didn't tell us about that risk," we will have another 400 pages of every company's accounts, with every risk that anybody could possibly imagine being reported, and that is not going to help anybody. So we have to find a mechanism, as to what are the key risks, those risks that, fundamentally, if you have made the wrong judgements, fundamentally will change the value, and possibly even bankrupt our company, and it is a quality rather than a sort of quantity discussion. And that is hard, and that is very hard to legislate for.
(Mr Adams) We are discussing this slightly in the abstract. I think, if you look at an OFR statement, or even a proposed OFR statement, there will be a tendency for it to be written, I suspect, in quite high-level language. If you look at an MD&A (management discussion and analysis) statement, filed for the SEC, you may well find some of Peter's very specific risks spelled out in great detail, over many pages. And the UK standard-setting system has tried to avoid that sort of "death by disclosure" type approach. I think, part of the reviews that are going on at the moment is to determine whether that is a correct approach, is fuller disclosure of risk, are the markets prepared to pay for it, are the companies themselves capable of making the statements, capable of identifying and communicating them.
34. That raises some very broad issues, which it would be interesting to come back to. But just to pursue this for one moment, you do want, and I am here addressing the Institute of Chartered Accountants, the operating and financial review statement to be mandatory, but not to have any legal force to back up their failure to perform properly to prepare one?
(Mr Wyman) Sorry, I was not trying to say that.
35. You did refer us to the financial reporting review system?
(Mr Wyman) I am sorry, and I was assuming that if it was introduced by Company Law then there would be enforcement procedures for the Company Law, as there is with any other Company Law.
36. But the responsibility for the operating and financial review would lie with the directors?
(Mr Wyman) Yes.
37. What duties would lie with the accountants?
(Mr Wyman) As has already been said, at present I think it would fall outside the scope of the audit, and that troubles me, I do not believe that is right, I think the scope of the audit should be extended; but that takes us into another big issue, which is an issue of liability and the need for some liability reform, if we are going to be able to get auditors to take on these extra responsibilities. That is perhaps something to come on to.
38. Do you think the standards which are used as the basis for the preparation of these future operating and financial reviews, the risk-focused reporting, should have the force of law, that they should be subject to mandatory sanctions?
(Mr Wyman) I am not sure that I have a deep-rooted objection to there being legal sanctions on non-compliance with accounting standards. I have to confess, it is not something I have given huge thought to. I am very concerned, which is a slightly different point, that we avoid, forgive me for saying this here, the politicisation of standard-setting. I think that is another problem that has happened in other parts of the world. That does not mean necessarily you cannot have legal sanctions for enforcement, enforcement is separate, I accept, from standard-setting, but the point I was trying to make was that I think we have in place effective sanctions, effective policing and effective sanctions, and I am not sure that legal sanctions take you very much further. But I am open-minded on that.
39. Just to digress, for one moment, onto the ground covered by my colleague Mr Beard, of course, Sir David Tweedie's inspired system of trying to deal with intangibles has not yet been put to the test of a serious recession, which is, of course, what brought about the Sir David Tweedie reforms; so we cannot be absolutely confident that a serious downturn in the economy, if one were to occur, would not show up some difficulties with the Sir David Tweedie system, can we?
(Mr Wyman) No, we cannot, and that is why I keep coming back to this reporting of the key risks; because if the value of a company changes because of a downturn, obviously share prices come down, but if the underlying value of a company changes significantly, if its business and its assets depend on the state of the economy, to an extent that is greater than just any other company, then that is a key risk that would need to be identified, and that would be something which investors and stakeholders could understand. That was what was wrong, as I understand it, with Enron, nobody understood what the business was.