Select Committee on Treasury Minutes of Evidence

Memorandum submitted by the New Economics Foundation

  "You have a great brew of greed, and hubris, and excesses, and financial wishful thinking, and that adds up to a weakening of the auditing processes. They've been infected."

Paul Volker.


  The New Economics Foundation (NEF) investigated the role of the global accountancy firms in its report The Five Brothers: the rise and nemesis of the big bean counters, published in March 2002. The report was a continuation of our critical analysis of economic globalisation, corporate governance and how economic activity is measured.

  In particular we were concerned that the big five accountancy firms, now reduced to four, had in recent years dramatically increased their influence in the world of business without there being a concomitant increase in their accountability.

  From academia to the business press they were now described variously as: "the back office of the global markets" (The Economist); "Management's private police force" (Professor Prem Sikka); and that they "in effect run corporate Britain" (Aston & Warwick Business School).

  Considering the threat posed by the audit failures to the long-term public interest NEF believes that there is a deep historical irony in the current situation. The advent of Limited Liability companies effectively brought the accountancy profession into existence. In order to create confidence and raise funds for major public infrastructure works, this category of company was created. The relative immunity it offered failed entrepeneurs was seen at the time as a significant concession. The balancing element was that these new companies had to present scrupulously audited accounts to their shareholders. The historial irony now is that a system designed to encourage good public works, is now so flawed that it threatens to do more public harm than good.

Summary of initial concerns

  Growing irrelevance of the orthodox audit: History is passing by orthodox accounting, leaving it almost redundant. Though still a legal requirement it is increasingly meaningless. So-called "intangibles" now make up at least 70 per cent of the value of the FTSE 350 companies. Yet there is no meaningful measure for many of them such as trust, reputation, human capital or innovative capacity. Where intagibles are measured, their accounting lacks transparency and consistency. Additionally, new public expectations of social, ethical and environmental corporate performance have undermined the fuction and usefulness of the audit in aiding investment decisions and informing shareholders.

  Role in the global economy: The major accountancy firms are actively facilitating the consolidation and concentration of corporate power in the global economy, and in a context where there is no global regulation in the form of competition authorities to temper the trend.

  A further concern is that even according to research by the accountancy firms themselves 83 per cent of mergers and acquisitions (M&As) were unsuccessful in terms of enhancing shareholder value. Even worse, over half of deals actually destroyed shareholder value. Yet, ironically, and a disturbing demonstration of the capacity for self-deception with the sector, 82 of people involved in negotiating deals thought that their own went well.

  Conflict of interest are still not properly addressed: The major accountancy firms have expanded to the extent that their relationship both as service providers and auditors to their clients represent a dangerous and inefficient conflict of interests.

  The problem of "revolving doors": The close relationship between the major accountancy firms and their corporate and public sector clients means that they can slip into a "spin doctor" role, compromising the integrity of audits. This situation may be more likely to conceal information that could damage confidence or that could reflect badly on a clients' social or environmental accountability.

  That the combination of political contribution from the major accountancy firms and a revolving door linking them to government departments can lead to collusion and cronyism between the professional services and the state.

  Aggressive tax minimisation: Through their intimate knowledge of, and ability to work the international financial system, the big accountancy firms are aiding forms of aggressive tax minimisation that ultimately undermines democratic government; and implicity supporting dubious financial regimes and other forms of sleaze. Speaking to the New Economics Foundation, one director of a big four accountancy firm told us that where money laundering, bribery and other forms of dubious and illegal practice were concerned, that the, "Only question is whether it happens in 30-40 or 50 affiliated country offices around the world".

Summary of initial recommendations:

    —  Fresh air factor: NEF strongly supports compulsory auditor rotation. Companies should be forced to change auditors regularly to avoid "over cosy" relationships. The FSA has recommended a five-year rotation, but an even shorter rotation might be more appropriate.

    —  Revolving doors: There should be a minimum three year cool-off period between auditors taking jobs in government or firms (or vice versa) where there is a perceived conflict of interest.

    —  No buying influence—a ban on political donations: Because of their unique role in the economy the major auditors should stop making political donations. It would be a first step to rebuilding public trust in the profession.

    —  Conflicts of interest: The separation between auditing and consultancy work should be thorough, and made permanent and mandatory. Regulators should guard against future backsliding.

    —  Reasonable suspicion: To strengthen the auditor's hand they should be able to report "reasonable suspicion of fraud" to officials without compromising client confidentiality.


    —  Because of the special circumstances surrounding the collapse of Andersen and the further consolidation of the auditing sector, NEF recommends the establishment of a one-off ad-hoc global competition commission to audit major accountancy firms and investigate the implications of their global domination of the accountancy industry.

    —  Assessing stakeholder not shareholder value and redefining corporate value in the public interest: new models are needed to assess the social and environmental well-being and impact of corporations. Increasingly, orthodox accounting will need to be complemented by other assessments that highlight essential information to investors and stakeholders, such as political, social and environmental risks. The Global Reporting Initiative (GRI) presents a new global framework for corporate reporting. It is only a voluntary initiative but provides a model for stakeholder engagement that could mature into a regulatory framework. New tools—such as the Local Multiplier Effect, which measures the catalytic effect of companies on local economies—can be adopted to create an audit for the real world.

    —  Measuring the unmeasurable: while the stated value of modern corporations tends to greatly exceed their market capitalisation and hard assets, the basis on which such estimates are made is rarely clear. Up to 75 per cent of corporate value is now represented by "intangibles", such as reputation, innovative capacity, trust and human capital. Valuation of a company should be based on a company's real value including its intangible asset base. The formulae accountants use to determine a company's "true"value therefore need to be based on clear, standard and transparent measures.

    —  Highest common denominator transparency: To lead by example auditors should at least meet the highest standard of transparency practiced by the publicly listed companies they audit.

    —  Setting up stakeholder councils: Only by opening up the ossified rituals of the boardroom can real change happen in the world of corporate governance. NEF proposes new bodies such as the stakeholder council, that represent the interests of all stakeholders—employees, customers, suppliers and anyone else affected by the firm—rather than just the interests of partners, directors and shareholders.

Since Enron—the state of play

  According to Sir Howard Davies, Chair of the FSA, the British system could not "stop an audit firm becoming too close to a client and misleading investors".

  On 15 June 2002, the federal jury hearing the Andersen/Enron case finally delivered its decision after 10 days of deliberation. Andersen was found guilty of obstruction of justice, although the company was let off on the potentially more serious charge of deliberately destroying evidence in the document-shredding that followed Enron's collapse. Pending appeal, the decision means that Andersen will be banned from auditing publicly listed companies for a period of up to five years, and has left an indelible stain on the companies reputation.

  Andersen offices in dozens of cities worldwide have been bidding to merge with rival professional services firms. The Financial Times remarked at the "astonishing speed" with which Andersen's global empire has been carved up. As of early May, the "scramble for Andersen" had seen all but a handful of the company's 84 country practices announce their intentions to merge with another firm—most of them Big Four branches.

  NEF's major concern is that there is no guarantee that what has happened to Andersen could not happen again. The problems exposed by Enron and previous, less publicised scandals, have not fundamentally been addressed. If anything, things have become more unstable due to the increased concentration of power into the hands of just four companies following the Andersen land-grab.

Continuing concerns

  Conflict on interest: We are concerned that very real conflicts of interest concerning the professional services firms are still not taken sufficiently seriously within the remaining big four firms. This was illustrated by the reticence shown by James Copeland, the director of Deloitte Touche Tohmatsu, who stated that the company's decision to devolve its consultancy arm had been taken "very, very reluctantly", and that in his eyes, "the independence issue related to providing both auditing and consulting services is one of perception only."

  Deloitte has not left the consultancy business at all. While Deloitte Consulting, the by-product of DTT's disaggregation, has taken many of the parent company's clients in the US, reportedly the same has not happended in the UK. In Britain, and in Europe as a whole, DTT continues to perform consultancy work through its Management Solutions division, which is fully owned and controlled by the parent company. In 2000, Management Solutions reportedly brought in 68 per cent of DTT's consulting revenue in the EU. In fact, far from making a clean break from consulting, DTT's role is set to increase. Management Solutions has recently incorporated 600 new staff, cannibalised from the carve-up of Andersen's UK business consulting division. Similarly, Ernst & Young undertakes numerous consultancy-related activities, including tax consulting and "tax risk management", as well as advising on information systems and corporate finance strategy.

  Ernst and Young and other big four companies employ a series of satellite firms providing other consultancy and legal services. Through these associated businesses, each of the big four can essentially provide all of the same services as they did before breaking up. Dr Chris McKenna, whose study of the management consultancy industry is due out next year, observed "The questions people ask their accountants almost inevitably lead to business advice, and it's hard to draw a distinct line between the two". McKenna predicts that unless regulation bans it, in 10 years' time the accountancy/consultancy conglomerates could well be back.

  Concentration of Power: The amalgamation of Andersen offices around the world by its big four rivals reveals the continuing trend within the industry for becoming ever-larger and more powerful. Ernst & Young and Deloitte Touche Tohmatsu have, to date, grabbed the largest shares of the Andersen pie. Both companies gained offices reportedly worth approximately $2 billion in combined annual revenue, as well as 15,000 staff each, swelling their ranks to around 100,000 and 110,000, respectively. As the number of leading players in the industry shrinks, an already dangerously oligopolistic sector has become even more concentrated.

What has been done to address the situation so far?

  As a direct result of the Enron collapse, major changes are in store in the regulatory environment. Among the steps that have already been taken are:


    —  The Securities and Exchange Commission (SEC) has already announced plans to create new organisations outside the structure of the American Institute of CPAs (AICPA) to oversee auditors of publicly held companies. A disciplinary board would be created to accelerate the investigation of alleged audit failures and provide more transparency, and the current program of firm-on-firm triennial peer reviews for auditors of publicly traded companies would be replaced by an annual quality monitoring process for the largest firms, administered by a new organisation. This new body would have expanded authority to monitor compliance with SEC practice standards and to refer instances of non-compliance to the disciplinary board. Both new entities would have a majority of public members and operate outside the profession's self-regulatory structure.

    —  Following from this, the Senate Banking, Housing and Urban Affairs Committee will mark up a draft bill that would establish a new organisation to monitor the accounting profession (to be overseen by the SEC). Unlike the House Accounting Bill (HR 3763), the legislation would fund the new oversight board mostly through fees assessed on accounting firms and their corporate clients, and would give it "full authority" to obtain documents or testimony in the course of investigations.

    —  In response to these proposals by the Chairman of the SEC, the member of the Public Oversight Board (POB) announced their intention to terminate the board's existence no later than 31 March 2002. Currently, the POB oversees the peer review, quality control inquiry, and other activities of the SECPS and the standard setting efforts of the Auditing Standards Board.

    —  Reversing a longstanding position, the AICPA has announced it will not oppose limits on providing certain non-audit services to pubic company audit clients.


    —  The Government is looking at the role of non-executive directors and on the way financial reporting and auditing is undertaken. The Financial Services Authority is in talks to take over financing of the profession's watchdog—the Accountancy Foundation. The intention is to improve the profession's image by switching the fundng of existing regulatory structure from the six accountancy institutes to the FSA. The FSA is also examining the possibility of compulsory rotation of auditors.

    —  Furthermore, the Treasury, Financial Services Authority and the Accountancy Foundation have been pulled together to form a special group to address the role of auditors in the UK. The first meeting of the group was held on 11 April 2002. The members are: Melanie Johnson MP, Minister for Competition, Consumers and Markets; Ruth Kelly MP, Economic Secretary to the Treasury; Sir John Bourn, Chairman, Accountancy Foundation Review Board; Michael Foot, Managing Director, Deposit takers and markets directorate, FSA; Mary Keegan, Chairman, Acocunting Standards Board; Professor Ian Percy, formerly Chairman, Accounts Commission for Scotland and Rosemary Radcliffe, Economist, and Complaints Commissioner at the FSA. The first meeting focused on work the regulators have in hand to address; including the quality of audit (particularly with regards to strengthening the independence of auditors), financial reporting and corporate governance, in particular the role of the Audit Committee. The group are working to ensure that there is a comprehensive and coordinated work programme to be taken forward by regulators over the coming months. It will provide a progress report by the summer, with a final report at a later stage. NEF is concerned, however, that this process is heavily dominated by technical experts and not wider stakeholder representatives.

    —  The Accountancy Foundation is also considering whether to establish an independent appointments board that would select the auditors for Britain's publicly listed companies. That would follow the system already used in the public sector, where the Audit Commission appoints firms to hospitals, local authorities and other private bodies. Under current rules, shareholders have to vote on the appointment and dismissal of auditors, but they are normally selected by the board.

Corporate Responsibility Bill

  The new Corporate Responsibility Bill, sponsored by Linda Perham MP and supported by the New Economics Foundation and other groups, makes provision for companies with an annual turnover of £5 million or more to:

    —  Produce and publish annual reports on environmental, social, economic and financial matters—both for the preceding year, and to outline the above impacts of proposed activities.

    —  To consult on proposed operations of the company and the impacts these will have on employees. This includes relationships with Governments and donations to any political parties.

    —  To specify certain duties and liabilities of directors.

    —  To establish a Corporate Responsibility Board made up of as wide a section of stakeholders as possible.

  The Bill has been introduced in response to some of the issues raised by the recent Company Law Review Steering Group and the fall-out from recent corporate and accountancy failures. It is hoped that the Bill will make companies more accountable for their activities by:

    —  Expanding directors duties beyond financial considerations.

    —  Establishing an environmental and social standards board to develop guidance for and ensure the compliance of reporting on environemtal, social, economic impacts.

    —  Making background documents on company practice more widely available to the public.

    —  Consulting a wide section of stakeholders before embarking on major new projects.

  The Bill is supported by a wide cross-section of NGOs and stakeholders, including the New Economics Foundation, Friends of the Earth, Save the Children Fund, Traidcraft, CAFOD and Amnesty International.

What still needs doing?

    —  Regular rotation of auditors is essential to encourage transparency and guard against cronyism. At the very least, companies should be compelled to put their audit out for tender on a regular basis.

    —  Comprenhensive reporting on non-financial matters should be part of a transparent auditing procedure. The production of social and environmental reports would enable shareholders and others to gauge potential risks that wouldn't be shown through a standard auditor's report.

    —  Two of the big four, PwC and DTT, still do not publish annual financial reports. Auditors for publicly quoted companies need to practice what they preach and publish their own annual reports. In a market as big as the UK, revenues should also be broken down to country-level.

    —  The National Audit Office currently cannot audit nor investigate private companies that have received central government money. The Sharman report published last year advocated widening the NAO's powers so that it could do so—but to date the government has so far remained silent. The Sharman report's recommendations should be implemented forthwith.

    —  Stakeholder governance: "In the 1920s, the chairman of General Electric, Owen Young, pushed the idea of stakeholder boards." In order to ensure that conflicts of interest do not interfere with the integrity of financial, social and environmental reporting, the Big Four should open up their governance to a wider group of stakeholders. This recommendation is also consistent with those of the Turnbull report, published by the Institute of Chartered Accountants, to devise ways of company boards to implement a "sound system of internal controls" to safeguard shareholder and investor interests.

    —  Jam the revolving doors between accountancy firms and their corporate clients. Auditors who work for one of the Big Four firms should be barred from working for any of the companies they have audited for a period of at least three years to prevent conflicts of interest from arising.

    —  Closer scrutiny of political ties and donations, particularly when the big four are subsequently bidding for contracts with public service providers and government departments.

    —  Different accounting rules are needed for countries whose domestic economic situations are very different, for example in the size and importance of capital markets. Great caution is required in the evolution of international standards to avoid imposing inappropriate accounting practices on countries.

Summary—the causes of current corporate failure are systemic

  The current crises are not chance aberrations: To suggest that the Andersen case was a one-off example of weak management and poor business practice is to ignore the systemic causes that contributed to the company's downfall. The fact that warning signs from previous accounting scandals involving Andersen—as well as other Big Five companies—had been ignored was a lost opportunity to make meaningful changes to the way the professional services sector is regulated and monitored.

  Don't let them slip: Now, as the fallout from Enron begins to recede from the public eye, only to be replaced by scandals involving other large corporations, accountancy's trade associations appear to be trying to ride out the storm of unrest without conceding the need for major changes to the regulation of accountancy. NEF believes that losing momentum for reform, as it was lost after the Asian financial crises of 1997-98, will miss their best opportunity to date to intervene in an industry that has become dangerously unstable—threatening not just shareholders interests but the livelihoods of millions of people.

4 July 2002

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