The Treasury Committee has agreed to the following Report:
THE FINANCIAL REGULATION OF PUBLIC LIMITED COMPANIES
- The collapse of Enron Corporation in the United States, its largest corporate failure ever, sent shockwaves through the financial systems of the world. The regulatory framework in the United States, arguably one of the most rigorous in the world, had failed in large measure to predict this financial catastrophe until it became inevitable, and all the regulatory checks and balances had failed to prevent it. Although the precise reasons for Enron's failure are not yet fully established, there is a clear view that both accounting failures and corporate governance failures have played a significant part. It is therefore no surprise that confidence has been shaken in the whole framework of company accounts in the United States, and in how directors run their companies there.
- Inevitably, the question has been asked 'Could an Enron happen here?'. The Chairman of the Financial Services Authority, Sir Howard Davies, speaking at the World Economic Forum in New York earlier this year, was in no doubt that "the only wholly honest answer to that question, if one means - could there be a large and unpredicted corporate failure in the UK - is yes". The Enron collapse has therefore provided a renewed stimulus to debate within the United Kingdom on matters such as the role of the auditors; their independence; the regulatory framework of the accountancy profession; the robustness of accounting standards; and ways of improving standards of corporate governance, particularly through strengthening the role of non-executive directors.
- We therefore launched our inquiry in 5 February 2002, with the following terms of reference:
"To examine, in the light of the Enron collapse, the arrangements for financial regulation of public limited companies in the United Kingdom".
We have taken evidence on four occasions. In addition, a large number of individuals and organisations have submitted written evidence. We are most grateful to all who have contributed to the body of evidence on which this report is based. We believe that this evidence would repay careful analysis and assessment in the context of the Government's response to the events of Enron. We therefore commend it to the relevant bodies.
- The Government recognises that the Enron collapse has also dented public confidence in the system of financial regulation of companies operating in the United Kingdom. It therefore set up in February the Coordinating Group on Audit and Accounting Issues (CGAA), jointly chaired by Ruth Kelly MP, Financial Secretary to the Treasury and Miss Melanie Johnson MP, Parliamentary Under-Secretary of State for Competition, Consumers and Markets, Department of Trade and Industry, to coordinate the response of key regulators to the issues for accounting, auditing and aspects of corporate governance raised in the aftermath of Enron. The group has so far met twice and the Chancellor announced on 15 July that it would produce its interim report the following week. The Government has also appointed Mr Derek Higgs to lead an independent Review into the role and effectiveness of non-executive directors. Through the Review, announced at the same time as the CGAA, the Government intends to focus primarily on what can be achieved through best practice.
- A recurrent theme of the evidence we have taken is the difference between the United Kingdom's accounting and corporate governance requirements, and those in the United States. It has been argued that reforms made following earlier corporate failures in the United Kingdom, coupled with the overriding requirement for accounts to show a 'true and fair view', mean that an Enron-type failure is inherently less likely here. Although we recognise that we have rather different arrangements from the United States for the oversight of the accounting profession and for financial regulation, we believe that it would be dangerously complacent to assume this. What has happened in the United States has shaken confidence worldwide in matters such as the independence of auditors from company management. We agree with the Government that it is important to restore this confidence.
- It is, however, unrealistic to expect the accountancy profession and its regulatory framework to provide a panacea. Professor Higgs of the London Business School recently commented that "The whole financial community has become terribly negligent". As Lord Sharman pointed out, many other kinds of professionals are also involved in running major companies. Mary Keegan, Chairman of the Accounting Standards Board (ASB) expressed similar sentiments. It is also up to all concerned to work to ensure that the company is run properly. Even greater responsibility rests on the directors of the company, executive and non-executive, to conduct its business in accordance with the law, and with integrity. It is upon this bedrock that public confidence in companies and their accounts ultimately depends.
- As our evidence demonstrates, a lot of work by Government, regulatory bodies, professional bodies and others, is currently in progress. This report therefore necessarily has something of an interim character to it. We shall continue to keep developments under review and will return to this matter in due course.
- The Enron collapse caused particular attention to be given to a number of accounting matters. Questions have been asked about the quality of accounting standards, and the rigour with which they are applied. Questions have also been asked about the quality of accountants' performance, particularly in relation to the auditing of public limited companies. Areas where concerns have been expressed include whether auditors have in reality an adequate degree of independence from the management of client companies; whether accounting standards are adequate; and whether the present regulatory framework is effective. In the following sections, we look closely in more detail at each of these areas.
- A number of witnesses, including Lord Sharman, Sir Howard Davies, Mrs Fearnley and the professional institutes, were opposed to the idea of mandatory auditor rotation. The EU Committee on Auditing has a clear majority against mandatory external rotation. Lord Sharman did not think it had worked anywhere in the world, as did Dr Reeves and Mr Brandt commented that it would be ineffective if, as apparently happened in one jurisdiction, the auditing team moved on with the job. It would also be a substantial exercise: we received evidence that auditor rotation on a five year cycle would force 352 listed companies within the United Kingdom, which would not otherwise have done so, to change their auditors. Lord Sharman, and others, were also concerned at the prevalence of audit failures in the early years, and the possible impact on price quality. On the other hand, Lord Borrie, Chairman of the Accountancy Foundation, recently criticised the Big Four firms for rejecting mandatory rotation ahead of the report of the CGAA, saying that the accountancy profession must address "a very serious lack of confidence in auditing practices and in accounts".
- Sir Howard Davies, Chairman of the FSA, had "an open mind" on the question of auditor rotation, and was not wholly persuaded of the argument against that incoming auditors' unfamiliarity led to most audit failures coming in the first year or two of the appointment. He favoured a regime where the audit committee needed to make a positive decision on reappointing the auditors, and explain why they were doing so "and then maybe some backstop provision for auditor rotation of 15 years or something". Sir John Bourn supported the case for "a considered rotation rather than an automatic one". Mr Richard Fleck, Vice-Chairman of the Auditing Practices Board was opposed to mandatory re-tendering, describing it as "the potential of rotation by another means".
- We note the array of arguments against auditor rotation. There would undoubtedly be additional costs and some potential risks. Nevertheless, the absence of any kind of rotation requirement leaves a perception - and almost certainly the reality - of an undesirable cosiness between some firms and their auditors. This poses even greater risks. We accept the need for auditor or audit firm rotation in principle, and we want the Government to produce proposals to implement it.
- We note that re-tendering is a regular feature of many public sector appointments, and we have received no evidence that this operates to the detriment of the quality of work carried out. We consider that there is a good case for requiring audit committees to look explicitly at rotation of audit firms every five years. We believe that the audit committee should be obliged to make a statement to shareholders on those occasions when they decide to retain the existing auditor after conducting such a five yearly review.
- There was general agreement, though, on the need to ensure adequate rotation of lead audit partners, and staff, an area where the professional bodies already have extensive rules. We recommend that the Ethics Standards Board considers urgently, in the light of the evidence we have received, whether the existing provisions are adequate. We believe that there is a good case for requiring rotation of the audit partner/manager on an audit every five years, rather than the present seven years. We also believe that there should be a time limit preventing auditors from being employed by a firm which they have audited. This should be at least one year.
- Sir Howard Davies saw the relationship between the auditors and the company as "a kind of culture issue ... as much as a rules issue". It was Sir John Bourn's view that the auditors failed in the case of Enron because they were too close to the client. It was important that the auditors did not see themselves as part of, or adjunct to, the management team.
- Professor Sikka took a much stronger line, arguing that the scale of provision of ancillary services fatally compromised the position of the auditors as independent of company management. He maintained that there was considerable evidence that accounting firms used audits as 'loss leaders', because of the access the audit appointment could be expected to offer to other, more profitable, work for the same client.
- The professional institutes, and others, argued that a complete separation was unnecessary, and that adequate restrictions were in place to prevent unacceptable conflicts of interest. They also took the view that the arrangements to police these restrictions were adequate.
- Confidence in the independence of the auditor is central to the integrity of the audit. Independence is clearly open to question when auditors also perform a significant consultancy role - especially when the audit contract may have served as a loss-leader to acquire this more lucrative business. We therefore believe that there is a strong case for disclosure in relation to non-audit work. We believe that the Audit Committee should be required to assess the extent of non-audit work and should be required to notify shareholders of any potential conflicts of auditor interest. We recommend that the audit committees of listed companies be required to publish details of audit and non-audit contracts, giving a detailed justification of the arrangements to shareholders.
- On the question of auditors carrying out ancilliary work for their clients, Sir Howard Davies commented "The key really is how to determine, if you are the audit committee, that your auditors are really properly independent ... A simple auditing yes, consulting no, is a bit difficult because there is a spectrum of services and some of them may be audit related and may be quite reasonable, some not. I think that what we need is to look for some guidance to audit committees. Some things are easy. Internal audit and external audit together is a pretty easy one to determine that is not a sensible thing to do. Some tax advice is easy to determine is not a sensible thing. Auditors should not put in the risk management system which they are then auditing to see whether it works. You could fairly reasonably produce a codification of the kinds of services which you think might well compromise auditor independence and where an audit committee, all other things being equal, would not want to have their auditors doing those things and if they were doing any of them they would want to explain very clearly in the accounts why they did not ... I suspect that amplified guidance to audit committees on a sort of code of auditor independence might well be a sensible compromise".
- We believe that, as a general principle, auditors should not be permitted to audit work done by themselves. We recommend that certain non-audit-related services should not be provided by a company's auditors and we want the Government to produce proposals to enforce this, including a strict definition of such services.
- We took evidence from both the Accounting Standards (ASB) which is responsible for setting accounting standards for the United Kingdom, and from the International Accounting Standards Board (IASB), which is responsible for setting international standards.
- The ASB is responsible for the making, amending and withdrawal of accounting standards relevant to all UK companies. The Chairman, Mary Keegan, outlined the process of setting standards, and pointed out that the United Kingdom has had a standard since the mid-1990s which ensured that most special purpose entries were included in UK accounts. There was, in her view, no need for a "knee jerk reaction" in this area in response to events at Enron.
- She did, however, identify another area where the ASB had issued an exposure draft, on fair values. She said that she could not implement it as a standard in the United Kingdom until amendments had been made to the law both at European level and in the United Kingdom. She also described the progress of the ASB's work on the question of 'revenue recognition'. We believe that an Accounting Standard on revenue recognition and to control aggressive earnings management should be introduced, on a national or an international basis, at an early date.
- The recent EU decision that quoted companies will be required to use International Accounting Standards by 2005 may change the emphasis of the work of the ASB. Mary Keegan told us that "at the moment at the Accounting Standards Board we are working on the view that we will continue to have UK accounting standards and that in almost every respect these should be identical with the international accounting standards. She also saw an increasing role for national boards in working with the IASB, and in ensuring that its standards can be used properly in the varying business environments of different countries.
- The recently published White Paper on Modernising Company Law proposes that the ASB would be replaced by a Standards Board with a rather broader remit, as part of an overhaul of the institutional arrangements. It also proposes that the Standards Board should be responsible for drawing up detailed rules for the compilation of the Operating and Financial Review (OFR). A number of witnesses strongly supported making OFRs mandatory for larger companies. The company's auditors will be required to report on the OFR, essentially concerning the adequacy of the process of preparation rather than the detailed content. They will, however, be required to report on compliance with applicable rules and if the OFR is inconsistent with the financial statements or other information arising from their audit.
- The Financial Reporting Council is the umbrella body for the ASB and for the Financial Reporting Review Panel. It is funded one third by the accountancy profession, through the institutes, one third by Government, through the Department of Trade and Industry and one third by business, for the most part from a levy administered by the Financial Services Authority. The Chairman of the ASB was "entirely satisfied" that its objectivity was not compromised by the fact that some of its funding came from what might be construed as interested parties. Her view was that "the mechanism which was brought in in the early 1990s, which is effectively a partnership between business, the accountancy profession and Government in supervising the setting of standards in the UK is a very satisfactory situation and allows no one group to dominate the process".
- We asked the ASB about the implications of insufficient international standards being in place by 2005. Its Chairman expressed the view that there was a risk that the price of agreed international standards might be that they were of lower quality than apply in the United Kingdom. She added "We at the ASB have as our number one priority ... to work with [the] IASB to try to minimise that risk and to make sure that the financial reporting solutions for UK companies come 2005 will be every bit as strong...".
- We were disappointed at the leisurely approach of the ASB. We believe that there are issues for the Board that require action before 2005.
- Sir David Tweedie, Chairman of the International Accounting Standards Board (IASB) told us that the International Accounting Standards Committee Foundation, its parent body, was funded by a combination of accounting firms, financial institutions and public companies. Although he did not think that the source of the Board's funding compromised its independence, as the trustees had no say on the technical side and the Board had no say on the financial side, Sir David expressed concern that the current method of funding could lead to indirect pressure, through withdrawal of funding. He cited an example of a threatened withdrawal of cash when American industrialists expressed disagreements with IASB thinking on accounting for share options and other areas where there are, or were likely to be, differences of view between the Board and American interests. He considered that "ideally the best way of funding us...would be to put a levy on registrations around the world". We strongly support Sir David Tweedie's robust stance in resisting such pressures.
- Sir David recognised that developing international standards could involve reconciling sharply conflicting viewpoints. He alluded to the difficulties in getting them accepted in the United States. In this context, we note recent press reports that three quarters of North American institutions surveyed recently wanted the single global standard to be the American GAAP.
- Sir David Tweedie particularly mentioned accounting for share options as an area where the United States was vehemently opposed to IASB proposals. Both Lord Sharman and Sir David pointed out that the practice of issuing share options was far less widespread in the United Kingdom with the United States, where people could get most of their remuneration in share payments "and even pay suppliers in share options".
- We are generally opposed to the use of share options as a significant source of remuneration in public companies. We shall wish to take evidence on this later. We agree with Sir David Tweedie that an International Accounting Standard that properly reflects the value of such options should be agreed. We believe that share options used for executive and other remuneration and payment should be prudently accounted for as future negative net income on a company's profit and loss account.
- We support the concept of international standards, a view apparently shared by a large majority of institutional investors worldwide. We believe that Sir David Tweedie's evidence indicates that there may be real difficulties in securing their acceptance in some major areas, although we are heartened by Sir David's view that all the core international standards should be in place by 2005. Pressures to agree a comprehensive range of Standards by 2005 must not dilute standards applicable in the United Kingdom, particularly in relation to a 'true and fair' view.
Regulation of the Accountancy Profession
- Professor Sikka criticised what he saw as an over-complex regulatory structure for the profession. Sir John Bourn, appearing as Chairman of the Review Board, agreed that 23 bodies altogether have a hand in different aspects of regulation, but considered that for the main thrust of the work, the two main elements were the Financial Reporting Council, concerned in particular with accountancy standards, and the Accountancy Foundation, particularly concerned with ethics, investigation and auditing. Sir John saw the Accountancy Foundation, established with professional and government support, but with a majority of non-accountants in its constituent bodies, as well placed to oversee the profession.
- Sir Howard Davies described the regulatory arrangements as "a halfway house between statutory and self-regulation". He described it as "more independent and more objective than the United States system", but added that initiatives in the United States in the light of Enron go beyond United Kingdom arrangements in some respects. This might point to a need to go further, if the United Kingdom wanted to ensure that companies could, without further qualification, by listed on US exchanges. He added "one of the blunt realities...is that you need to satisfy the American authorities that you have a set of procedures which are equivalent to theirs".
- A number of witnesses commented on the funding of the regulatory body, the Accountancy Foundation in particular. This is entirely funded by the profession. Sir Howard Davies, Chairman of the Financial Services Authority, did not consider that the source of financing was the problem, but there was an issue as to whether the level of funding should be discretionary. Sir John Bourn thought that the question of the source of finance for the Foundation might be an issue when it is reviewed after five years' existence. He commented that "I think in the modern world questions do arise as can a body really be independent if it is financed by the profession itself and I think it is harder and harder to convince the world at large that that is the case". He also noted that the Financial Reporting Council already had some Government funding.
- The regulatory structure of the accountancy profession raises questions about rigour and independence. These arise as a result of the regulatory process being funded by the industry itself, and, in particular, in the way these funds are collected. We welcome the efforts being made by the Accountancy Foundation to improve the industry's regulatory regime. We recommend that the Government give this issue urgent examination, and that it considers the introduction of industry funding arrangements similar to those which operate in the case of the Financial Services Authority.
- We believe, though, that the existing regulatory framework of the accountancy profession is cumbersome and excessively complicated. We consider that there is a strong case for a single, independent, regulator, which is not only independent but seen to be independent.
1 A list of witnesses who gave oral evidence may be found at p.26 Back
2 As at 2 July 2002 (Q424) Back
3 Official Report, 15 July 2002, Vol. 385, Col. 24w. Back
4 See DTI Press Notice P/2002/234 (15 April 2002). Mr Higgs expects to publish his report around the end of the year (Official Report, 18 July 2002, Vol. 389, Col.440w). Back
5 Official Report, 10 July 2002, Vol. 388, Col. 936w. Back
6 Financial Times, 10 July 2002 Back
7 HC 758-iv Back
8 Q324 Back
9 Q407. See also Q409 Back
10 QQ296-7 Back
11 Q283 Back
12 Memo /02/96 (16 May 2002) Back
13 Q206 Back
14 Q152 Back
15 Ev 56 Back
16 Q283 Back
17 Financial Times, 8 July 2002 Back
18 Q152 Back
19 Q198 Back
20 Q206 Back
21 Appendix 26 Back
22 Q407 Back
23 Q195 Back
24 Q113-4 Back
25 Q410 Back
26 Q301 Back
27 Q302 Back
28 FRS 5 Back
29 Q303 Back
30 Q303 Back
31 Q305 Back
32 QQ311-7 Back
33 Q319 Back
34 Cm. 5553-I, paras 5.5-6 Back
35 Cm. 5553-I, paras 4.34 Back
36 Q307 Back
37 Q310 Back
38 Q308 Back
39 Q320 Back
40 QQ329-337. See also QQ348-356 Back
41 QQ227-9 Back
42 QQ343-4 Back
43 Q332 Back
44 Q346 Back
45 Financial Times, 8 July 2002 Back
46 QQ337-8; QQ348-358 Back
47 QQ289-91 Back
48 Q363 Back
49 Financial Times, 8 July 2002 Back
50 Q379 Back
51 See, for example, Ev 91 Back
52 Q156 Back
53 Q390 Back
54 Q391 Back
55 Q393 Back
56 Q156 Back
57 Q389 Back
58 Q156 Back