Select Committee on Treasury Minutes of Evidence


Memorandum submitted by The Review Board, the Auditing Practices Board and the Ethics Standards Board of the Accountancy Foundation

INTRODUCTION

  1.1  This evidence is presented as a contribution towards the Treasury Committee's inquiry, in the light of the collapse of the Enron corporation in the United States of America, into the arrangements for financial regulation of public limited companies in the United Kingdom. It is submitted jointly by the Chairmen of the Review Board, the Auditing Practices Board and the Ethics Standards Board of the Accountancy Foundation.

  1.2  This paper:

    —  explains the role of the Accountancy Foundation and its subsidiary bodies within the framework of regulation of accountants in the UK;

    —  comments on the issues arising from the Enron collapse; and

    —  describes the principal actions currently being taken or planned by the Auditing Practices Board, the Ethics Standards Board and the Review Board on matters relevant to the Committee's inquiry.

THE ACCOUNTANCY FOUNDATION AND ITS SUBSIDIARY BODIES

  2.1  The Accountancy Foundation represents a new system of non-statutory independent regulation of the accountancy profession. The key feature of the new system is its independence from control or undue influence by the accountancy profession. Its aim is to ensure that the public interest in the way that the profession operates is fully met and thus to secure public confidence in the impartiality and effectiveness of the profession's systems of investigation and discipline, professional conduct and regulation.

  2.2  The new framework consists of five bodies; the Accountancy Foundation, the three "associated bodies"—the Auditing Practices Board (APB), the Ethics Standards Board (ESB) and the Investigation and Discipline Board (IDB)—and the Review Board.

  2.3  All of the new bodies are constituted as companies limited by guarantee. The Review Board, APB, ESB and IDB are subsidiaries of the Accountancy Foundation, but the constitutions of these bodies are such as to ensure that in fulfilling their respective remits they are fully independent.

  2.4  The most significant features of the bodies are described briefly below. The relationship between the bodies is illustrated by the diagram in the Annex to this paper[1].

Accountancy Foundation

  2.5  The Accountancy Foundation was established in 2001. It has the overarching responsibility for the success of the new system and is the key point of contact with the Government and others to this end. In addition, it appoints the members of the Boards of each of the subsidiary bodies, most of whom are lay members, and ensures that the new system is adequately funded. The members and directors of the Accountancy Foundation are nominated by the bodies specified in its constitution, which do not include any professional accountancy bodies or any accounting firms.

Review Board

  2.6  The Review Board is a major innovation in the system of regulation. Its role is to review the self-regulatory activities of the six members of Consultative Committee of Accountancy Bodies (CCAB) [2]and the activities of the three associated bodies of the Accountancy Foundation, with a view to ascertaining whether these activities serve the public interest in maintaining and enhancing the standards of work and of conduct of accountants.

  2.7  The Review Board will make recommendations; in any circumstances where a Review Board recommendation is not accepted by the body concerned there will be an obligation on that body to give reasons for the position it has taken. Both the Review Board's recommendations and the responses of the bodies concerned to them will be made public. In addition the Review Board will publish a report annually on the overall operation of the new system.

  2.8  The Review Board has eight members of whom none may be accountants in public practice or accountants involved in any way in the governance of any accountancy body. There s no bar to membership by accountants who do not fall into one or other of these categories. However, it is of the essence of the new system that the Review Board should, to the maximum extent possible, be independent of the accountancy profession and only two of its present members hold an accountancy qualification.

Auditing Practices Board

  2.9  APB is responsible for leading the establishment of standards of auditing so as to enhance public confidence in the auditing process and the quality and relevance of auditing services in the public interest. Commencing operation in April 2002, it replaces the former Auditing Practices Board (``old APB''), which operated from 1991 under the aegis of the CCAB. APB has 15 members, of whom not more than 40 per cent may be accountants eligible for appointment as company auditors. The remaining 60 per cent may include accountants provided they are not eligible for appointment as company auditors.

Ethics Standards Board

  2.10  ESB is responsible for securing the establishment, on a profession-wide basis, of ethical standards for all accountants and setting the agenda for the preparation of ethical standards by the accountancy bodies. Unlike APB, it is a new body and has been in operation only since September 2001. ESB has 10 members, of whom not more than 40 per cent may be professionally qualified as accountants.

  2.11  Whereas APB has responsibility for setting auditing standards itself, ESB's role is to "set the agenda" for the ethical standard setting processes of accountancy bodies by specifying the standards that are needed and the issues that need to be covered. It will be for the accountancy bodies to prepare the necessary standards: if they fail to do so to ESB's satisfaction, ESB has the power to develop and issue such standards itself.

Investigation and Discipline Board

  2.12  When it becomes operational, IDB will take over the functions of the present Joint Disciplinary Scheme operated by ICAEW and ICAS and this role will be extended to cover all the accountancy bodies (with the exception of ICAI). The focus will be on cases of "public interest", investigating and disciplining those members who have displayed misconduct; other cases will continue to be dealt with by the individual accountancy bodies concerned.

THE ENRON COLLAPSE

  3.1  The sudden collapse of Enron, formerly the seventh largest company in the United States of America, precipitated a major crisis of public confidence in the governance of US publicly quoted companies and raised deep concerns about the quality of their published financial information and the credibility of their reported earnings. The questions about the role of Enron's auditors, exacerbated by allegations concerning the destruction of documents, led to serious misgivings about the ethical standards of auditors and the integrity of the audit process. These events have given rise not only to enquiries and investigations in the US but also to questions across the world about the systems and regulatory arrangements which underpin the operation of the capital markets.

  3.2  The facts behind this case will not become clear until all the relevant enquiries and investigations have been concluded, and this may take some time. As new facts emerge, consideration should be given to whether changes are needed in the UK. In the meantime, it is important to assess whether the regulatory arrangements in the UK are sufficiently comprehensive and sufficiently robust to safeguard, at a reasonable cost, against a major unexpected collapse of comparable dimensions. Present knowledge of the Enron collapse, albeit incomplete, suggests that there are three areas of concern: financial reporting, corporate governance and audit quality.

  3.3  Although there are a number of significant differences between the US and UK regimes of corporate governance, regulation and accounting and auditing standards, any assertion that a corporate failure comparable to that of Enron could not occur in the UK should be rigorously tested. The issues raised by Enron merit careful analysis and possible regulatory action.

Financial reporting

  3.4  Accounting standards differ between the US and UK and it is thought likely that some of the accounting practices adopted by Enron would have been prohibited in the UK. In addition to specific UK accounting standards[3] that seem to address directly issues that were relevant to Enron, there is the overall UK requirement for directors to present financial statements that present a "true and fair view". There is no US requirement that financial statements should present a true and fair view; rather, the underlying principle is that financial statements have to be "fairly presented" in accordance with US generally accepted accounting practice. The requirement placed on UK company directors to prepare accounts that present a true and fair view is considered by many to be a more demanding test as to whether the financial statements reflect the underlying financial reality of the company.

  3.5  An important aspect of financial reporting is that it involves a considerable amount of judgement and estimation and it is unrealistic to expect accounting standards to eliminate this completely. The need for judgement and estimation means that there will always be an element of imprecision in financial reporting; it also means that there will be an opportunity for management to "manage earnings".

  3.6  In June 2001, APB published a consultation paper entitled "Aggressive earnings management". The paper was developed because of APB's concerns that, despite the progress made during the last decade in corporate governance, accounting standards and auditing standards, the quality and reliability of financial reporting may be undermined by increasing commercial pressures on those responsible for preparing financial statements.

  The consultation paper was warmly welcomed by commentators; it was perceived as dealing with a topic of current relevance and importance.

  3.7  Significantly, commentators recognised that aggressive earnings management cannot be countered by auditors alone: good corporate governance and appropriate accounting standards are essential prerequisites. In addition to the work already being undertaken by APB, which is described in paragraph 4.2 et seq, actions suggested by commentators included:

    —  the Department of Trade and Industry (DTI) accelerating the implementation of relevant proposals in the recent study of company law reform, in particular, the proposals for a mandatory Operating and Financial Review (OFR) and widening the responsibilities of directors, employees and third parties to provide information to auditors;

    —  the Financial Services Authority (FSA) reminding directors of listed companies of the relationship between the OFR and their responsibilities under the Combined Code to present a balanced and understandable assessment of the company's position and prospects;

    —  institutional investors alerting remuneration committees and audit committees to the potential conflict of interest arising between the opportunities presented to directors to obtain large financial rewards from reporting a certain level of earnings and their duty to prepare financial statements that present a true and fair view; and

    —  the Accounting Standards Board (ASB) publishing an accounting standard on revenue recognition.

Corporate governance

  3.8  The UK system of corporate governance has been substantially strenghthened over the past decade as a result of the Cadbury Committee, followed by the Greenbury, Hampel and Turnbull Committees. The Combined Code also offers important guidance in this area.

  3.9  Enron raises concerns not only about the actions of individual executive directors but also more generally the role of audit committees and the independence and role of non-executive directors; it is therefore timely that the DTI has announced a review of the role of non-executive directors.

  3.10  Aspects of the role of audit committees which are particularly relevant to the work of the Accountancy Foundation bodies are the extent to which the audit committee takes responsibility for the appointment and remuneration of the external auditors and the nature and extent of their periodic communications with the auditors. We hope that the DTI review will address these areas.

  3.11  A key aspect of corporate governance relates to the way in which auditors are appointed and remunerated. At present, the board of directors recommends to the shareholders an accounting firm for appointment as auditor and this recommendation is usually endorsed. As a consequence, auditors are, in effect, appointed and remunerated by the persons who, inter alia, are responsible for preparing the financial statements on which auditors are required to report. This, clearly, gives rise to a threat to the independence of the auditors.

  3.12  This threat to auditors' independence has been the subject of discussion for many years. APB has, as set out in its discussion paper "The Future Development of Auditing"[4] suggested that one way to overcome the issue would be for a "shareholder panel" to be appointed by the shareholders, one of whose responsibilities would be to appoint and remunerate the auditors. This suggestion was not well received. An alternative might be for the audit committee itself to be appointed directly by the shareholders and for it to make a recommendation to the shareholders for the appointment of the auditor. We believe that the DTI review of the role of non-executive directors should consider further these questions. We would, of course, be pleased to help in any way we can.

  3.13  Clarification as to the nature and extent of the audit committee's periodic communications with the auditors may be a helpful means of increasing the effectiveness of both the audit committee and the auditors. In 2001 the APB significantly strengthened auditing standards to require auditors to communicate certain matters to audit committees (SAS 610 (Revised)). But, for these new standards to be fully effective, directors need to know what to expect from auditors and to actively participate in discussion with them. APB has also been in discussion with a number of organisations with a view to developing guidance for directors on a joint basis.

  3.14  Other areas that the DTI review may wish to consider include:

    —  how audit committees are appointed (directly by shareholders or by the Board of Directors as a whole);

    —  the effectiveness of existing audit committees (time spent by audit committee members, skills and knowledge, initial and on-going training received, support provided, etc);

    —  whether it is possible, given time availability and concerns regarding liability, to require more of audit committees;

    —  whether a "monitoring" role for audit committees is consistent with a unitary board of directors; and

    —  whether audit committees should be required to meet periodically with significant shareholders.

Audit quality

  3.15  Audit quality is the result of a combination of auditor independence and technical competence.

  3.16  Much of the attention post-Enron has been on whether more should be done to ensure that auditors are independent of the audit client, both in fact and in appearance. The issue of auditor independence has been raised so strongly in relation to Enron that it must be carefully addressed.

  3.17  There is a need for the consolidation of experience to determine whether auditor independence is impaired by:

    —  the potential loss of an audit assignment; and/or

    —  the provision of non-audit services, particularly in relation to the size of the office or region; and/or

    —  the closeness of the relationship between auditor and auditee.

  3.18  The effectiveness of a potential regulatory solution (or set of solutions) to the issue of auditor independence will depend on the nature of the threat:

    —  for instance, it is claimed that concerns about losing an audit assignment could be mitigated by the following regulatory solutions:

    —  compulsory audit firm rotation;

    —  audit clients have to explicitly state why they have not changed auditors after a period of time;

    —  compulsory competitive tendering for audit services;

    —  limits on the fee income generated by an auditor from individual clients (on a partner/regional office/firm basis); and

    —  external appointment of auditors;

    —  for instance, it is claimed that concerns about the provision of non-audit services by auditors could be mitigated by:

    —  further disclosures regarding the composition of audit and non-audit fees under the Companies Act 1985;

    —  auditors being prevented from providing material non-audit services or those services not closely related to the audit; and

    —  compulsory competitive tendering for non-audit services unrelated to the audit;

    —  for instance, it is claimed that concerns about the closeness of the relationship between auditor and client could be mitigated by:

    —  a compulsory delay (``cooling-off period'') between an auditor leaving a firm and taking up employment at a client company;

    —  appointment of the auditor by the audit committee or an audit review panel;

    —  further disclosures in the annual report by the audit committee (or audit review panel, as appropriate) in respect of the audit and the relationship with the auditor; and

    —  external appointment of auditors.

  All of these factors have to be considered in the context of an essential need for an adequately close relationship between auditor and audited to enable the auditor to do his job effectively.

  3.19  But concerns about audit quality go beyond the issue of auditor independence: some argue that there is also a need to address the technical competence of auditors and the rigour of the audit process and to address issues such as:

    —  do the training requirements of the profession fully develop the knowledge and skills required of accountants?

    —  do accountants maintain their level of knowledge and skills throughout their professional careers by continuous professional development (CPD)?

    —  how effective are the systems for monitoring audit work as client business models and audits become increasingly complex?

    —  is there adequate emphasis on quality within audit firms?

    —  is the balance right between the amount of audit work required by current auditing standards and the risk of fraud or error?

    —  should audit committees be more actively involved in evaluating the effectiveness of audit (as is to be required by legislation being introduced in the Republic of Ireland)?

CURRENT ACTION BY THE ACCOUNTANCY FOUNDATION

  4.1  The following paragraphs summarise the principal actions currently being taken or proposed to be taken by APB, ESB and the Review Board on matters which have a bearing on the issues raised by the collapse of Enron and which are relevant to the Committee's inquiry.

Auditing Practices Board

  4.2  APB intends to continue the work already commenced on aggressive earnings management and, in 2002, undertake work in the following areas:

International activity

  4.3  Aggressive earnings management is an international problem and solutions to it will also need to be international. APB has been actively encouraging international auditoring standards setters and the International Auditing and Assurance Standards Board (IAASB) to address the issue. APB also believes measures to prevent aggressive earnings management should be high on the International Accounting Standards Board's agenda.

Auditing standards

  4.4  APB will, in conjunction with IAASB, consider the adequacy of existing auditing standards and guidelines on:

    —  "Fraud and error", on matters that should alert auditors to the risk of aggressive earnings management;

    —  "Materiality and the audit", on the auditors' consideration of unadjusted misstatements and the qualitative aspects of materiality; and

    —  "Audit of accounting estimates", to reflect FRS 18 and to address the relationship between statements made in the auditors' report and the disclosures made in the financial statements on the use of significant estimation techniques.

Professional scepticism

  4.5  An attitude of professional scepticism is vital to enable auditors to identify and deal with circumstances that may be indicative of aggressive earnings management. Although professional scepticism can be reinforced by auditing standards, APB believes that attitudes are principally influenced by the cultures that exist within audit firms and by the training the firms provide their partners and staff. APB believes that the accountancy bodies should review how their education and training programmes provide the foundation for scepticism and that audit firms should consider how to strengthen working environments to ensure that audit teams apply an appropriate level of professional scepticism. APB will consider how best it can contribute to this process.

Guidance for directors

  4.6  As noted in paragraph 3.12 above, the APB believes that it will be helpful for members of audit committees to be aware of the new requirements of SAS 610 (Revised) and will consider how best it can contribute in this regard. APB has been in discussion with a number of organisations with a view to developing guidance for directors on a joint basis.

Ethics Standards Board

  4.7  After the first six months of its existence, ESB is planning to issue a consultation paper "Setting the agenda for ethics" in May 2002, in order to help it gain a better understanding of public opinion on the ethical issues involved in the work of accountants. The results of this consultation exercise will help ESB to set the agenda for the development of ethical standards for the accountancy profession.

  4.8  The consultation paper is intended to promote serious thought and debate across the entire spectrum of ethical topics faced by accountants, whether they are employed in industry, commerce or the public sector or engaged in public practice.

  4.9  An important component of the paper will deal with a number of fundamental questions concerning the independence of auditors. ESB is currently considering whether revision of the existing ethical standards of the members of CCAB along the lines of the recently revised IFAC Code of Ethics (November 2001)—which was developed before the collapse of Enron—would be appropriate and, in particular, whether it would be a sufficient response to reasonable public expectations at the present time.

  4.10  Areas being considered by ESB include:

    —  the concept of independence, including questions of who should appoint auditors, the scope of the role of audit committees and the relationship between auditor independence and corporate governance;

    —  the principle-based approach to independence with underlines the IFAC Code and the need for sufficient guidance to enable auditors to make sound and consistent judgements, especially in the more subjective areas; and

    —  the degree to which the issues, including those outlined in paragraph 3.17, result in threats to auditor independence.

Review Board

  4.11  The Review Board set out its overall proposed work programme in its publication "Protecting the Public Interest" (February 2002) and invited comments by 24 May 2002. (Copies were sent to Members of the Treasury Committee at that time.) Although the proposed work programme was prepared pre-Enron, the studies are relevant to the issues raised by the collapse of Enron.

Review of professional regulation

  4.12  The Review Board has a specific remit to review both the self-regulatory activities of the six members of CCAB and the activities of the three associated bodies of the Accountancy Foundation.

  4.13  With regard to the members of CCAB, the Review Board's priorities for 2002 will be to review the self-regulatory activities in respect of:

    —  complaints and discipline; and

    —  registration and monitoring the performance of auditing firms.

  This will be followed in 2003 by a review of the bodies' approaches to:

    —  training; and

    —  continuous professional development (CPD).

  4.14  With regard to the associated bodies, the Review Board will review the work undertaken by the Auditing Practices Board and the Ethics Standards Board during 2002. This will include any work undertaken in respect of:

    —  auditor independence;

    —  recent developments in the audit risk methodologies of the largest accounting firms; and

    —  improvements in communications between auditors and audit committees.

  4.15  In addition, the Review Board will consider undertaking a study of completed Joint Disciplinary Scheme cases and DTI Inspectors' reports to understand the extent to which the lessons of high profile cases in the UK (Barings, Maxwell and Polly Peck) are embraced in current regulatory arrangements regarding both accountants and auditors and whether they have shown any consistent causes of company or audit failure.

Consolidation of studies on auditor independence

  4.16  during 2002, the Review Board intends to draw together and assemble evidence on the issues surrounding auditor independence both in the UK and, where relevant, overseas. This may include, but is not limited to, consideration of the following issues:

    —  provision of non-audit services by auditors clarification of the definition of non-audit services, the criteria that determine the extent to which they are audit-related and the analysis of non-audit fees paid by companies;

    —  compulsory audit firm rotation and competitive tendering consideration of the extent to which the regular rotation of audit firms adds costs and/or delivers quality to the audit process;

    —  appointment and external accountability of auditors potential solutions to improve external accountability and auditor independence such as the appointment of auditors by an independent body and/or an audit review panel.

  From this evidence base and the work of the other Accountancy Foundation bodies, the Review Board will consider potential solutions to the issues raised and make recommendations as appropriate.

  4.17  All evidence gathered will be passed to the other Accountancy Foundation bodies, as appropriate, for further consideration as part of their work programmes.


19 April 2002




1   Ev. 104. Back

2   CCAB comprises the Association of Chartered Certified Accountants (ACCA), the Chartered Institute of Management Accountants (CIMA), the Chartered Institute of Public Finance and Accountancy (CIPFA), the Institute of Chartered Accountants in England and Wales (ICAEW), the Institute of Chartered Accountants in Ireland (ICAI) and the Institute of Chartered Accountants of Scotland (ICAS). Back

3   FRS 5 "Reporting the substance of transactions" and FRS 8 "Related party disclosures". Back

4   Not printed. Back


 
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