Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 100-119)



100.  In the case of New York, the analysts were recommended to buy a company whereas the private remarks were hugely disparaging to the companies concerned so that it seemed they were in somebody's pocket and that is the same thing that happened here.

  (Mr Brandt) That is the allegation; we will have to see if it is actually correct. But that could happen here. It is a pressure because all these things are pressures on analysts to deliver and it is a pressure on the directors to deliver et cetera.
  (Professor Sikka) First of all, let me perhaps congratulate journalists for the coverage of Enron and other things because frequently it appears to an outsider that corporations and auditors and regulators are more interested in covering things. We need to have things investigated in order that we can learn from them. It is shameful that to this day in Britain there has been no official investigation of real or alleged fraud and audit failures at Polly Peck, Levitt, BCCI and Resort Hotels just to name a few and, if it were not for the journalists, we would hardly know anything about these things. Putting that to one side, I think there are real problems with corporate governance and involving the role of analysts and so on. Analysts can have private meetings with directors and get inside information. So they have a better idea of what is going on though, for business reasons, they may issue different kinds of recommendations. We also find that public limited companies in Britain have seven months after the year end to publish information, which means that most of the information is out of date by the time it is published. No self-respecting director would make decisions about the future by using information that is more than a year old. When companies first come to the market, they publish profit forecasts. When they are engaged in mergers and take-overs, they publish profit forecasts. All major companies have budgets and plans and forecasts. What exactly is wrong with providing that kind of forward looking information to stakeholders? If we believe that published accounts form part of a technology which enables people to manage their risks and to manage their investments, then we should be considering publication of future orientated information. We know that accountants can report on them because they report on prospectuses. We know that accountants can report on them because, whenever there is a contested take-over bid, they report on them. However, it appears that frequently the system is designed to disadvantage the ordinary stakeholders because institutional investors—and you referred to them—can appoint directors. They can have inside information. Analysts have regular meetings, bankers have regular meetings with company management to get their finger on the pulse but, in the US, companies are required to publish information after 90 days and we should be able to do the same here. I note that in the company law review, the proposal at the moment is not to hit 90 days, though they are trying to reduce it to six months, but really 90 days should be quite reasonable. Also, you were talking about the general role of the institutional shareholders. I am afraid that major pension funds and institutional investors are subject to the same constraints as anybody else, that is that their performance is measured by profits, market share, number of clients, income and their performance is measured in a very, very short way, a short time-span. The same happens in companies. The average time-span of a chief executive in any company is about three to four months. So, it is very difficult for people to concentrate on the long term. So many calls have been made for the institutional shareholders to be more vigilant but it does not appear to work and I think that we should be looking at alternative mechanisms.

  Chairman: I think we have had a fair shot at the introductory question and I will now hand over to one of my colleagues.

Mr Beard

101.  The anxiety that is arising comes because we have had, as has been said, not just Enron on which attention is focused at the moment, but a whole sequence of these events: BCCI, Polly Peck, Resort Hotels and recently Equitable. We have had the view from the accounting profession that the lessons from all these have been learnt and are being applied and so on but, if that is the case, why did we get Equitable? Equitable is only quite recent. In each of these cases, the worrying thing is that an audit had been carried out only months before the balloon went up when they were all revealed to be in a sad state of affairs. So sad in fact that you wonder how on earth anybody who had looked in detail at these companies could have missed it. That is the worrying feature in all this. One of the difficulties in it is to get to where the actual problem lies because it is not just accountancy, it is too wide an issue to talk just in terms of accountancy. Is the problem with the original board of directors that they are really compiling accounts that are not intended to be transparent but are actually intended to mislead? Is the problem that the rules on things like offshore accounting and offshore companies are wrong or is it that the rules on off balance sheet financings are wrong? Is it in fact governance, that the external directors, the non-executive directors, have not actually watched adequately over the animal spirits of the executives? Is it that, when we get to the audits, the auditors become parti pris to the company in one way or another because they have other interests or because they are looking for jobs or whatever? Where is the weakness in all these cases? You have all studied these matters. Can you point to where we should be looking to find out where the weakness is and what should be done.

  (Professor Beattie) The answer is that these are not mutually exclusive possibilities that you raise. These are all potential problem areas. There is not going to be one single solution towards this. Indeed, there is no solution that can prevent these sorts of things ever happening. What one can do is try to put in place a system that minimises the possibility of these happening with a view to cost benefit issues. We have to look at that. All of these are areas to address: the management of the company, the corporate governance, the accounting, the law, all of them are areas to address. They are constantly being addressed although the pattern tends to rise and fall. Sometimes everybody is looking in a more concentrated manner at these issues and then we have periods where interest is rather less. About 10 years ago, we had a lot of changes in this area and I think things improved a great deal. But, in the 10 years since then of course, the world moves on. The business world today is quite a different world from even 10 years ago.

102.  Are you saying there is a different sort of source of difficulty now than there was 10 years ago?

  (Professor Beattie) I am saying that, yes, new issues do arise constantly because sometimes the nature, the way in which business is being conducted, the kind of markets we have are constantly changing and evolving.

103.  What specifically are the new issues compared with the issues, say, in BCCI?

  (Professor Beattie) I suppose that one major change that we have had in the last 10 years is the nature of and the importance of what you might call intangible assets to a business. That could be one thing you could point to.

104.  Could you say that again, please.

  (Professor Beattie) The importance of intangible assets to a company's business has come much, much more to the fore in the last 10 years. Ten years ago, most of companies' value was in the form of bricks of mortar and now people talk about clicks rather than bricks: everything is electronic, everything is intellectual capital and things of this nature.

105.  That is not the case for either Enron or Equitable, is it?

  (Professor Beattie) It is not the case in all of these.

106.  Enron cannot be in this position because it could not value its assets properly and nor is Equitable.

  (Mrs Fearnley) Can I make one or two comments on this. A number of the failures associated with Enron were to do with valuations of assets and contracts. The accounting there was very complex and it was not just an issue of putting losses into these sort of subsidiary or sort of special purpose entities. So, there were issues of valuation there. If we look at most of the cases where things have gone wrong, there has not been a lot that has gone wrong since 1991. We cannot be complacent about that because the economy has been booming since 1991 and of course what happens in a booming economy is that you get less corporate collapses. I think it is really quite dangerous to look at the Equitable case as typical because there are so many unusual aspects of that particular case. We have another regulator, the Financial Services Authority, that was responsible for the financial solvency of the insurance company, so it is not just simply a matter of an auditor having . . . I am not going to comment on whether the auditors did something wrong or not because that has not been decided.

107.  It is surely similar to Enron and similar to some of these other cases we have been quoting where the company had been audited only months before it was in virtual collapse.

  (Mrs Fearnley) May I just make a comment about Equitable as well because another issue associated with Equitable was that there was a very complex issue of litigation and cases going to the House of Lords. So, although there has been a large problem there, I think that the issues associated with that particular case are immensely complicated. It is not just a normal corporate collapse in that sense because you have too many other parties involved and, until it all comes out as to actually what did happen, I would not like to say who was responsible and how it actually came about. Certainly, as Professor Beattie says, you have to look at the whole surrounding area, and of course Equitable was a mutual, not a company, and that puts it into a completely different oversight mechanism than what we have in company law and in the normal practices for companies. I think that is a very difficult case to take as typical. I am not making excuses for anything—

108.  It does not change its accounting standards because it is a mutual rather than a limited company.

  (Mrs Fearnley) It changes the oversight mechanisms and I think that is what is equally important.


109.  The integrity of the company's accounts and whatever.

  (Mrs Fearnley) Yes.

  Mr Plaskitt: I have one supplementary point on the Equitable affair. We have the announcement this morning that Equitable is going to sue its accountants by £2.6 billion.

  Chairman: Its auditors.

  Mr Plaskitt: How do you interpret that and what is going to be the outcome in terms of the relationships with companies and their accountants as a result of that action?


110.  Professor Sikka, would you answer that for us, please.

  (Professor Sikka) There are many points and perhaps I will just pick up on the last one. First of all, I think it should be noted that auditors, following the House of Lords judgment in the 1990 Caparo case, only owe a duty of care to the company as a legal person. They do not owe a duty of care to any individual shareholder, creditor, employee or other stakeholder. People refer to accountancy firms as professional firms, but let us strip that word away. Essentially, they are profit making organisations. Like every other organisation, their performance, success and failure within is measured by the profits fees income and very little else. If the implication is that the auditors should be serving the public interest, there is no such requirement in the Companies Act and it does not form any part of the business equation at all. We only found out about Equitable Life and other cases because something went wrong and it came to light. As long as a company survives, we do not know anything about the quality of the audit at all. In this case, the auditors are being sued. Research shows that, in a large number of cases, the actual settlements made by accountancy firms are a very tiny fraction of what the law suit originally is for. I produced a paper which estimated that the average liability costs including insurance and meeting the law suits—and this is based on 1990's figures—was 2.67 per cent of the income of major accountancy firms. This is a very low figure. The average dentist or doctor has a much, much higher liability cost.

Mr Beard

111.  What does that tell us?

  (Professor Sikka) What that actually tells us is that we have reduced the incentives for good audit. Anyone producing sweets and packets of crisps has to owe a duty of care to the current and potential consumers but, when you dilute the economic incentives for delivering good audits, this is what you are going to get. The research that I submitted to you shows that in many accountancy firms, audit work is actually falsified because accountancy firms impose tight time budgets and they expect trainees to do the work within that time. It cannot be done. That is noted in the DTI Inspector's report in Barlow Clowes that, due to tight time budgets, the audit staff did not complete the audit because they did not have time to do it. It also noted that the audit firm shredded documents, yet very little questions have been raised about the internal culture and the value of the accountancy firms which continue to produce these kind of episodes for us. So, if you want good audits, you have to create a good economic incentive. That means firms must be held liable for their accounts. Yet, following the Limited Liability Partnership Act, 2001, more liability concessions have been given to accountancy firms. That raises questions. What kind of audit will they deliver as a result? When you look at the disciplinary side, Polly Peck auditors, some 10 years after the event, have been fined £75,000. The firm made about £25 million from the Polly Peck audits. Most of the blame is conveniently placed on a partner who had already died. When we look at the Maxwell auditors, the firm was fined, which worked out at about £6,000 per partner and, 10 years after the event, the blame is placed on a partner who has died. So, you have very, very weak regulatory and legal environment.

112.  Are you saying that the auditors are at fault in not finding out more of the facts of the company and, if that is the case, is it the auditor's fault or is it the company misleading them in the information that is available?

  (Professor Sikka) I think the primary duty for preparing financial statements as far as the law is concerned is with the directors.

113.  Yes.

  (Professor Sikka) Auditors are always there to quote Lord Denning's words, paraphrasing them, in a case known as Fomento Ltd v Selsdon Fountain Pen and Ink Company, 1958, where he was saying that the audit should always be done with an inquiring mind believing that errors and omissions and misleading statements may have been made. So, when auditors are relying for a large part of their income on the companies they are auditing, in many cases the finance director is a former partner of an audit firm now being audited by former junior colleagues. You have numerous problems on the independence side. In 1976, the DTI Inspectors report on Roadships Limited, which is mentioned in the evidence that I submitted, raised a question and they argued that the auditor's independence was comprised in that particular episode because the auditors had created the very transactions on which they were reporting, yet nothing happened. 1979, the DTI inspector's report on Burnholme and Forder, the same episode. The US Senate Report on BCCI, they are making the same allegations. Very little seems to change because the Department of Trade and Industry has too many conflicting roles. It is trying to—

114.  Why are we concentrating on the auditors as the policemen when what you are implying is that the original accounts are not a true and fair statement of the position of the company? If that is the case, then the implication is that it is the directors of the companies who are playing games with the accounts to mislead. Is that what you are saying?

  (Professor Sikka) I think that directors are at fault but that the whole reason for hiring auditors is to have a second opinion and if the independence of the person giving the second opinion, if you like the umpire, is compromised, then the whole number of problems multiply.

115.  It does not make them guilty though, does it?

  (Professor Sikka) I think we then have to ask ourselves what kind of checks and balances we wish to impose. Within companies, the minute we say we are going to measure directors' performance by profits or earnings, we are immediately creating incentives to massage the accounts. If we are saying that directors' salaries are linked to profits and earnings, we are immediately creating incentives to massage the accounts.

116.  If that is the source of the problem, why are we letting them get away with it?

  (Professor Sikka) What I am saying is that directors have problems as well. This is why the Department of Trade and Industry takes action against directors. It recognises and it disqualifies a number of directors from misbehaving, but the similar sort of pressure and scrutinies are not there for auditors. The whole reason for having auditors is to provide a second opinion.
  (Professor Beattie) Just to pick up on a couple of points that Professor Sikka raised. There is the issue of what would we expect the auditors to do and one of the first things that I was taught is that the auditor is a watchdog and not a bloodhound. That is the system we have in place in this country. The auditor does not go in to seek out fraud first and foremost. The second point you made was about the economic incentives of auditors. The auditors do have economic incentives to do a good quality audit. If they do not, they risk reputation loss and reputation damage and they take that exceptionally seriously because, if they do not maintain a high reputation, they will not get business in the future. So, they do have economic incentives to do high quality audits.

Mr Laws

117.  I want to ask the same question first to Mr Brandt and then to Professor Sikka in order that we can get the opposite ends of the table, as it were. It is a rather general question which is to ask you what your definition is of the present purpose and scope of the audit function and to ask you how well you feel that it is serving particularly stakeholders such as directors and shareholders and perhaps, although you might not like doing this, in order to aid comparison, you might give us a mark out of ten for the way in which it is working at the moment in the UK.

  (Mr Brandt) That is not one question, that is several but I will try and answer. The purpose of the audit is to comment, give an opinion on, the published financial statements for the shareholders and, through them, for the market. Any idea that they are there to help the directors as one of their main objectives should, I think, be firmly rejected and is one which has taken root, I would say, in the last 10 to 15 years particularly in the States and I think that has led the accounting profession there and to some extent here down a blind alley. We deal with this in our submission; we make this point. How are we doing on that? The number of really big scandals which have happened in the last ten years—and again I do not wish to appear complacent—is quite small in regard to the fact that there are 2,200 listed public companies and of course we never hear about the things which go right, do we? Human nature being what it is and, as I said before—

Mr Beard

118.  It could be the tip of the iceberg too.

  (Mr Brandt) Yes. On the other hand, I would hesitate to describe the accounting profession as an iceberg; there is no evidence that there is nine-tenths under water, absolutely none. I would say that it is much more like—and you asked for a score out of ten—nine out of ten generally, but some glaring and horrible failures. If I may come back to what Mr Beard said, it is the directors who are responsible primarily and when you have a regulator as you do in Equitable Life—and this may come out in the litigation which is happening—who is concerned with the valuations et cetera which are being made use of in the insurance world—and I am not an insurance specialist—the auditors may actually say, "Well, it was dicey but, if the Regulator is happy, are we second-guessing the Regulator?" because the Regulator gets returns from insurance companies, I think on a quarterly basis like banks.

Mr Laws

119.  Mr Brandt, before I ask Professor Sikka for his views on this issue, you mentioned that one of the key roles is to provide information to the shareholders. Do you think the accountability of the auditors to the shareholders in terms of financial accountability, if things go wrong and they do a bad job, needs to be strengthened?

  (Mr Brandt) You have that situation in the States, do you not? There is no Caparo rule in the States. Therefore, the auditor is open to class actions and is in the middle of quite a lot of them at the moment. I do not like the idea, I have to say, because I do not like increasing my liability, thank you, without any corresponding benefit on the other side. I do not wish to be the insurer of last resort to the great British capital market.

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