Select Committee on Treasury Appendices to the Minutes of Evidence



APPENDIX 1

Memorandum submitted by Mr Hugh Aldous

  The following observations are not on behalf of my firm but are entirely personal views.

  May I suggest that there are two issues in the furtherance of better corporate reporting and governance: the independence and standards of the professions (not just auditing, but investment analyst and actuarial opinion) and the role of directors. There is also some debate about accounting standards.

  The integrity of the opinions of the "reporting professions" is critical because others rely on them. Auditors, research analysts, actuaries and maybe even investment managers all produce opinions on which others rely. Sadly, what we still see in corporate reporting (from Maxwell to Enron to Split-Capital Funds) is professional opinion which tends to serve the professional's own continuing fee relationship and which consequently lacks integrity and independence.

  For the accountancy profession the Enron saga seems to be an extreme example of one aspect of lack of independence: the identification of the auditors with management. Independent professional opinion requires an independence of mind—independent of financial or competitive advantage to your own firm and your natural desire for money. The large firms of auditors effectively undermined an independent profession 20 to 30 years ago when a free-standing profession faded and five (soon to be four) large firms emerged. Professionalism now requires some regulation, I fear.

  The auditors' judgement is supposed to be exercised on behalf of those who rely on professional opinion: the shareholders, not the management. It should not be varied so as to appease management, or to keep the audit or gain other professional appointments. Professionalism means that an auditors' judgement may require him or her to confront management at the expense of the audit contract. Commercialising the profession and focusing reward on personal achievement has made that much tougher. Most partners in most audit firms will be influenced to some extent if personal reward comes from achieving billing targets. Many firms of accountants also have a fixation with growth.

  Only a strong, even eccentric, mind would not be affected by opportunities to sell corporate advice on top of the audit and so enhance their firm's billing, or maybe find a way round technical objections in order to please the management and retain the appointment. It can be tempting to see the management, not the shareholders, as the paymasters and please the management in order to ease the route to growth and reward.

  Because the integrity of assessing true value added in corporate reporting is absolutely fundamental to our economic well being (and our pensions and our society) it must be ensured. Standards of common practice within a group of practitioners is not a sufficient benchmark and does not ensure a sufficient pace of change or ensure integrity. If professionals no longer feel answerable to their profession, that is another reason why they may need a different regulator.

  I would not be averse to an independent body which published observations on the standards of corporate reporting and the standards and practices of auditing. Such an independent body might be much more approachable and less defensive than the Auditing Practices Board. Auditors should listen to public comment about corporate reporting, the interpretation of financial statements and the reliance placed on independent professional opinions issued by auditors, actuaries, analysts and whoever else.

  Meanwhile it has been tempting for auditing firms to try to narrow the definition of an audit to a set of propositions which limits risks and avoids plain speaking. If you listen to a defence by auditors, their defence is compliance with standards, not meeting the reasonable expectation that reporting profit might have something to do with enhanced value and positive cashflow. Although the Auditing Practices Board has done a commendable job it has narrowed the definition of audit in focusing and limiting the liabilities of auditors. Actuaries seem to have followed the same path.

  One niche in the UK which does have an alternative way of ensuring independence in auditing and consulting is the Audit Commission for local government work. The Audit Commission rules are clear: we will inspect you and appraise your standards; you can audit or consult, but not both for the same client. That may, or may not, be a model rule for the listed private sector but, whatever happens, some regulation looks to inevitable.

  Rotation of auditor firms is culturally interesting. It should not be dismissed. The objections to rotation raised by the big five, and the expression of that objection sent out in the name of the forthcoming President of the ICAEW (who just happens to be a PwC partner), do not suggest very much "open mind". Rotation done properly would mean that auditors would know that they had a limited tenure, as they do in the public sector. Those of a professional mind would know that it was their duty to do a good job and to assist their successors. That would require auditors to keep careful explanatory records, perhaps up to the standard of due diligence notes, and pass them on to their successors. Cultures might change. Auditors would have to demonstrate their understanding of the business they audited and know that others would inevitably review their work. They might quickly see that their interest and reputation would lie in being professionals first, rising to standards which their successors would review, and profit sharers in their own firms second. Interestingly enough, if you look at how the firms auditing under the Auditing Commission rules co-operate and share technical knowledge you would see some of the last vestiges of professionalism at work. Rotation may or may not be practical, but it is being dismissed too quickly out of self-interest.

  Although I have emphasised auditing, some of the same principles apply to all those whose opinions are relied on by others. It really isn't good enough to march our pensions up the hill of stock market euphoria and then down again on research analyst's work which is designed to boost broking and investment banking incomes.

 

CORPORATE GOVERNANCE

  The parallel running issue is corporate governance. What is the role of non-executive directors? Do they understand what makes a business sustainably better and adds value in a way which will enable the business to grow in future value as well as apparent bottom line profit? What should they seek to know, how should they be informed, how open should they be in their relationship with the auditors, and vice-versa?

  The insurance market is beginning to detect a tide of potential actions against directors. The role, competence, strength and independence of the director is now top priority as well as the state of the auditing profession. The view of Hermes and PIRC may be uncomfortable but they set a discipline and I do hope that the Committee is taking evidence from them.

  The DTI could do more to emphasise the responsibilities of directors and could publicise more what could happen to directors whose behaviour has become irresponsible.

  A change in behaviour tends to change culture. Corporate governance might change if non-executive directors spent some time with shareholders and analysts. Auditing and corporate governance might improve if the non-executives and the auditors spend some time each year, in addition to formal audit committees, understanding some of the issues in the business and making sure that each fully understands what concerns the other.

  I regret to add that the purgatory of section 432 inquiries and of litigation against auditors and directors at least focuses the mind.

ACCOUNTING STANDARDS UK AND US

  The meaning of "true and fair" (the UK opinion on company accounts) has been an interesting debate for over 50 years. It is a judgement. It is difficult to reduce judgement to either a science or a process. Possibly the US "present fairly" is more rule bound, but a common objective needs to be set both sides of the Atlantic: profit is an increase in value which can be realised in cash. What is a true and fair view of the state of a company's affairs will never be exact, but we could get it more nearly right by applying that simple principle.

  I do hope the Committee is taking evidence from Sir David Tweedie. It's my impression (but I have done no research) that in "boom" years the interpretation of accounting standards allows the overestimation of profits which gets more aggressively adjusted, or corrected, in less good stockmarket years. (It is not helpful of me to say that someone has done some recent research on that, but I have forgotten who.)

THE OLIGOPOLY OF THE ACCOUNTANCY PROFESSION

  As to the inevitable reduction of the number of really big auditing and accounting firms to just four (or four brand associations of national firms), a UK solution might lie with a further investigation into market concentration by the OFT and a possible referral to the Competition Commission for remedies which might oblige firms to divest themselves where they have more than a reasonable percentage of a defined market. That would at least increase the number of competitive groupings. It wouldn't necessarily recreate a profession, but it might well be a jolt for the better.

8 April 2002

 


 
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