Select Committee on Treasury Appendices to the Minutes of Evidence


APPENDIX 21

Memorandum submitted by The Institute of Chartered Accountants of Scotland

  Having received its Royal Charter in 1854, The Institute of Chartered Accountants of Scotland is the oldest professional body of accountants in the world. It has over 15,000 members worldwide, with around two thirds of its active membership working in business and one third in practice.

  The Institute's objective is to uphold the integrity and standing of the profession of chartered accountancy in the interests of society and the membership, through excellence in education and the development of accountancy and through services to members and the enforcement of professional standards.

  The Institute has been active in the corporate governance debate in the UK and internationally ever since it was instrumental in initiating the debate that led to the setting up of the Cadbury Committee in the early 1990s. As its members work inter alia as finance directors, analysts, auditors and regulators, the Institute's Council is well-placed to comment on all aspects of the corporate governance framework.

SUMMARY OF RECOMMENDATIONS

  We recommend that:

    —  the boards of UK plcs be reminded of their statutory responsibilities and that guidance be developed for them; we also recommend that consideration be given to introducing for UK plcs specific guidance relating to the responsibilities of the non-executive directors on the board. (Paragraph 7)

    —  shareholders should be assisted in their understanding of the true nature and potential economic cost of management incentivisation schemes; this should be achieved through (1) the continued development by the Department of Trade and Industry of proposals to enhance Boards' disclosure of policy on directors' remuneration and (2) the development by the International Accounting Standards Board of internationally accepted measurement and disclosure rules. (Paragraph 8)

    —  a review of (1) the provision of non-audit services to audit clients and (2) rotation of auditors should take place under the auspices of the Accountancy Foundation, the body charged with overarching responsibility for the success of the independent regulation of the accountancy profession in the UK. (Paragraphs 14 and 16)

    —  consideration should be given to reviewing the range of acceptable non-audit services that an auditor could provide to an audit client. (Paragraph 13)

    —  the existing ethical guidance for auditors should be supplemented by a requirement on the directors of plcs (the non-executive directors in the case of listed companies) to undertake a positive re-evaluation of the auditors every five to seven years. (Paragraph 19)

    —  the Treasury Committee should support the UK accountancy bodies in urging that the IASB should reject the approach to accounting standard-setting currently taken in the US and instead adopt an approach that results in transparent financial reporting and in the reflection of economic reality rather than mere compliance with rules. (Paragraph 23)

INTRODUCTION

  1.  It will be many months (and perhaps years) before all the reasons are discovered for the collapse of Enron. What is clear already is that concern over the effectiveness of the corporate governance framework in the United States has shaken confidence in the financial regulation of public limited companies around the world. We recognise, however, that there are significant differences between the corporate governance systems in the UK and US and so we must be careful when making recommendations in a UK context.

  2.  We fully support the objectives of this Inquiry and have sought to identify ways in which confidence in the UK corporate governance framework can be restored. In order to do this, we have identified a few key issues and have addressed the perception of these issues rather than merely considering the views of those most closely involved in corporate governance in the UK.

  3.  The scope of this Inquiry is UK public limited companies (plcs) as opposed to UK listed companies. We recognise that a higher level of financial regulation and investor protection is required for listed companies and for companies holding other people's money, than for plcs. We anticipate that the other reviews being undertaken in the UK, for instance by the DTI, FSA and Accountancy Foundation, will address listed companies as well as plcs. We intend to make written submissions to these other bodies.

  4.  We will, of course, continue to evaluate the implications of the Enron affair as more facts emerge. We may wish to present further written evidence to the Committee in due course.

MANAGEMENT FAILURE

  5.  In a market economy such as that in the UK, conducting business is about making judgements and taking risks. The corporate governance framework must therefore contain structures and processes to control and challenge those making these judgements so that the shareholders' interests are protected. However, putting in place a corporate governance system and regulatory structure that eliminates risk is impossible and, indeed, counterproductive. An appropriate balance needs to be struck between regulation and commercial opportunism.

  6.  Corporate governance is not just about structures. It is also about people and thus about behaviour. In recognising this, we must be aware that no rules will work if the individuals charged with observing them are not committed to the principles that underlie them. Good corporate governance therefore requires the highest standards of professionalism and integrity among those concerned in the management of companies and the preparation and presentation of financial information.

  7.  It would appear that the top management within Enron were not working to these high standards of professionalism and integrity and that the control and challenge aspects of the corporate governance structure within Enron were not effective. We recommend that the boards of UK plcs be reminded of their statutory responsibilities and that guidance be developed for them; we also recommend that consideration be given to introducing for UK plcs specific guidance relating to the responsibilities of the non-executive directors on the board.

  8.  We are also concerned about the use of schemes for the incentivisation of management. For example, share options can create a significant incentive for the artificial inflation of a company's share price in the short-term to the ultimate detriment of the shareholders' long-term interests. Such incentivisation schemes tend to institutionalise a conflict of interest that may undermine the most assiduous audit. We consider it important that shareholders should be assisted in their understanding of the true nature and potential economic cost of management incentivisation schemes; this should be achieved through (1) the continued development by the Department of Trade and Industry of proposals to enhance Boards' disclosure of policy on directors' remuneration and (2) the development by the International Accounting Standards Board of internationally accepted measurement and disclosure rules.

THE STATUTORY AUDIT

  9.  All plcs are required under legislation to have their annual financial statements audited by a Registered Auditor. The purpose of the audit is to provide the shareholders with an independent opinion as to the truth and fairness of the financial statements produced by the board of directors. Registered Auditors must be independent, carry out their work with integrity, be fit and proper, keep to technical standards, be competent and continue to be competent and be able to meet claims against them that may arise from audit work.

The Provision of Non-Audit Services

  10.  To date, it has been considered economic, in terms of skill and effort, to allow audit firms to provide non-audit services to audit clients. (The benefit for the quality of the audit, it is argued, is that the auditor can draw on the knowledge and experience of colleagues' expert in areas, such as taxation and treasury operations, which impact on the audit work.) Thus currently services such as internal audit services, tax planning advice, corporate finance and strategy etc can be provided to audit clients provided certain ethical safeguards are maintained. In particular, Registered Auditors must review whether the provision of such services is a threat to their objectivity in relation to each audit engagement.

  11.  Over recent years, increasingly complex business practices have increased companies' awareness of the need to ensure that their procedures are effective and properly implemented throughout their organisation. As a consequence, larger firms have responded by increasing significantly the range of non-audit services they offer to their audit clients, with the result that a larger proportion of their profitability now stems from services other than audit. Although we understand that there is no evidence of a causal link between the provision of non-audit services to an audit client and audit failure, the public perception is different. However, there would appear to be no distinction in the public mind between non-audit services that are complementary to the audit role and services that could be inconsistent with that role.

  12.  We believe that these perceptions need to be addressed. Others will take the view that there is no need to address the perception issues since they are not demonstrably causative of the Enron affair or generically the cause of other major failures.

  13.  In our view, audit should be recognised as a quality service that is an essential part of the corporate governance framework. We recommend that consideration should therefore be given to reviewing the range of acceptable non-audit services that an auditor could provide to an audit client. Our initial thoughts are that services such as work done in connection with stock exchange circulars, tax compliance work, due diligence work on acquisitions, assistance in the completion of regulatory returns etc, would almost certainly be acceptable. Equally, providing internal and external audit to the same client is unacceptable. Auditors should not be making management decisions or auditing their own work.

  14.  There is clearly a need to debate these issues fully. We therefore believe that a review of the provision of non-audit services to audit clients should take place under the auspices of the Accountancy Foundation, the body charged with overarching responsibility for the success of the independent regulation of the accountancy profession in the UK.

Rotation of Auditors

  15.  A threat also exists to auditor independence from over-familiarity with a client. The accountancy profession's ethical rules recognise this and require that review processes (including an annual review) should be put in place by audit firms in order to satisfy themselves that each audit engagement may be properly accepted or continued. (For listed companies, there is a requirement that audit firms ensure that no audit engagement partner remains in charge of such an audit for a period exceeding seven consecutive years.)

  16.  The perception is now, we believe, that these requirements need to be reassessed. We recommend that the Accountancy Foundation should undertake a careful review of the arguments for and against audit rotation.

  17.  There has been considerable debate about introducing mandatory rotation of audit firms. The main arguments against rotation of audit firms are that:

    —  longer-serving auditors have a greater knowledge of the client and the business and thus are able to make a better assessment of audit risk;

    —  non-productive time is needed for new auditors to familiarise themselves with the client company: this will lead to greater cost for the company;

    —  research undertaken in the late 1970s[1] indicated that the risk of audit failure is apparently higher in the early years of an audit appointment than in later years, due to incoming auditors' lack of familiarity with the company and its business; and

    —  mandatory rotation would remove from the non-executive directors of plcs an important element of judgement in the assessment of the shareholders' interest and leave no element of flexibility.

  18.  The main argument in favour of rotation is that the knowledge that the relationship is not permanent must change the auditor's mindset substantially in favour of greater objectivity. We also question whether the research cited in paragraph 17 reflects the nature of audit failure in the UK since 1980. It would be useful to review current research in this area.

  19.  On balance, we believe that the corporate governance framework for plcs would not be enhanced by the introduction of mandatory rotation of audit firms. Instead, we recommend that the existing ethical guidance for auditors should be supplemented by a requirement on the directors of plcs (the non-executive directors in the case of listed companies) to undertake a positive re-evaluation of the auditors every five to seven years. The requirement to undertake this re-evaluation and deal appropriately with the outcome could be reported in the proposed Statement of Directors' Duties that is envisaged in the DTI's Company Law Review proposals.

ACCOUNTING PRINCIPLES VERSUS RULES

  20.  A key element of corporate governance is to have the directors prepare for shareholders financial statements that reflect the economic reality of the company's activities over the year and its financial position at the year end.

  21.  The Enron case has raised concerns over the approach taken in the US to accounting standard-setting. In the US, there is a requirement to prepare financial statements that "present fairly" the financial position of the group and its results for the year in accordance with the detailed accounting rules specified under US Generally Accepted Accounting Practice (US GAAP). If an accountant does not consider that following US GAAP results in the financial statements "presenting fairly" the financial position of the group and its results for the year, that accountant has no right to override the detailed accounting rules. The public perception may now have moved to viewing this approach to accounting standard-setting as failing to produce an acceptable level of transparency in financial reporting. We agree with this view.

  22.  In contrast, the European Union's Fourth Company Law Directive requires companies within the EU to prepare financial statements that give a "true and fair view" of the company's activities during the year and its financial position at the year end. This requirement, which was introduced in the Directive as a direct result of lobbying by the UK and the Netherlands, recognises that the inherent complexity of companies' operations and the uncertainties implicit in management decision-making defeat any attempts to develop a set of financial statements that all informed observers would regard as "right". In view of the many judgements that must be made when preparing the annual financial statements, a range of possible outcomes—all coming within the bounds of accepted practice—is to be expected. The financial statements are also prepared in accordance with Financial Reporting Standards (FRSs) produced by the UK's Accounting Standards Board. The FRSs adopt a principles-based approach rather than a rules-based approach, recognising that the prescriptive rules approach is unable to address all possible situations that might arise. In addition, use of the concept of "substance over form" in the UK means that the underlying economic reality of the transaction or a series of transactions will be reflected in the financial statements, rather than merely showing their legal form. Indeed, the Companies Act explicitly overrides the requirement to follow UK GAAP, if doing so would not result in a "true and fair view" being shown.

  23.  Increasingly, developments in accounting standard-setting nationally are being influenced by international developments. Global capital markets are moving towards acceptance of the International Accounting Standards produced by the International Accounting Standards Board (IASB). We therefore, recommend that the Committee should support the UK accountancy bodies in urging that the IASB should reject the approach to accounting standard-setting currently taken in the US and instead adopt an approach that results in transparent financial reporting and in the reflection of economic reality rather than mere compliance with rules.

24 April 2002



1   "A critical look at professionalism and scope of services" Professor John C Burton, Journal of Accountancy, April 1980. Back


 
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