Select Committee on Treasury Appendices to the Minutes of Evidence


APPENDIX 24

Memorandum submitted by PricewaterhouseCoopers

  1.  As a member of the world's largest professional services organisation, with more than 150,000 people in 150 countries. PricewaterhouseCoopers welcomes the opportunity to respond to the Treasury Committee's inquiry into the financial regulation of listed companies. As the largest firm of auditors in the UK, we have substantial practical experience of the areas into which the Committee will be inquiring.

  2.  We support the memorandum that has been submitted to the Treasury Committee by the Institute of Chartered Accountants in England and Wales (ICAEW). We therefore do not attempt to cover all the ground in that submission. Rather we bring out some key points from our practical experience, particularly regarding audit.

  3.  While we naturally concentrate on the UK, the Committee might also find helpful the attached paper "Accounting for the World"[2] which we have distributed to our clients and others, which summarises PricewaterhouseCoopers' position on the issues as we see them globally.

CORPORATE GOVERNANCE

The importance of good corporate governance

  4.  We begin with the subject of corporate governance because that must be the starting point for considering issues of this kind. It is corporate governance that has the crucial role in driving the creation of the nation's wealth as well as protecting investors and other stakeholders in companies. Good corporate governance secures good management and bad corporate governance tolerates bad management. Good corporate governance also secures good accountability and transparency in companies' affairs. Good corporate governance needs to be encouraged by many parties in our financial system: institutional shareholders, bankers, professional advisers and, not least, auditors.

  5.  Good corporate governance in turn is essential to an effective audit. The audit of a larger public company requires many judgements. These require a responsible dialogue with the directors, not least the independent directors; a great practical value of audit is the cross-examination of the auditor by the board and its audit committee of independent directors. There will usually be a substantial number of items on the audit "scoresheet", that are as much concerned with the quality of the profit as with its mathematical quantity; these will range from loss provisions and the value of assets to the effect of unusual events on the underlying earnings. This dialogue cannot be replicated with thousands of shareholders of a public company and therefore depends on strong independent directors.

  6.  The auditor's statutory duty is to the shareholders, but there is a practical need for the auditor's support and advice to be available to the directors, particularly the independent directors, on the shareholders' behalf. Indeed in practice the directors will seek the auditor's independent advice on a range of issues covering the company's, often far flung, operations—from the quality of the internal controls to the quality of management.

  7.  It has been suggested that shareholders might elect their own audit committee, but that is precisely what they should, in effect, already be doing in electing the independent directors.

Improvements in corporate governance

  8.  Our experience is of a substantial improvement in British corporate governance, and business management, over the last decade. The role and calibre of the independent directors in the unitary board have been greatly strengthened. Audit committees are generally taking their responsibilities seriously within the unitary board. Many of the reforms now being suggested in the US were implemented in the UK in the 1990s. The UK's governance code has also been emulated by a great many countries outside the US.

Company Law Review

  9.  Nonetheless, the improvements have not been reflected in every company and the need for continuing vigilance by all concerned is important to the nation's competitiveness. We therefore welcome the DTI's Company Law Review. This seeks better to define, to a high standard, the responsibilities of directors, institutional shareholders and auditors in corporate governance. Combined with the proposed Company Law and Reporting Commission to keep a continuing watch on corporate governance, the proposals should do much to maintain a climate, which is conducive to good governance. We urge legislation to implement the proposals.

ACCOUNTING

  10.  Our judgement, which is based on substantial current experience, is that concern about any general malaise in the quality of UK financial reporting is misplaced. Great improvements have been brought about over the last 10 or more years, through the Accounting Standards Board, the Financial Reporting Panel and, not least, we believe, the accounting firms.

  11.  All our experience leads us to support whose who advocate the continuance in the UK of an accounting regime which is based on principles rather than legalistic rules. The presentation of the overall quality of profit and financial position is as important as its mathematical accuracy determined by compliance with set piece rules. In addition, the importance of the UK's "true and fair view override" is fundamental to the substance over form culture of accounting and auditing in this country.

  12.  We also support the move to international accounting standards (IAS) with the proviso that the global standard should be a principles-based one. The fact that the world's financial system has sustained a shock surely adds urgency to the implementation of IAS. The European Commission is aiming to adopt IAS by 2005; we are urging the US to do likewise although we do not underestimate the political and cultural barriers to be surmounted. The PricewaterhouseCoopers' publication "Accounting for the World", attached,[3] further explains our position on these and related matters.

  13.  We also support the Company Law Review's proposal for a reasonably controlled framework (the Operating and Financial Review) for a company's narrative reporting on the drivers of shareholder and stakeholder value, given the limitations of the present historical accounting model—and for explicit auditor association with this. Indeed PricewaterhouseCoopers has been promoting for some time a model ("ValueReporting") which recognises that the value of a company is increasingly represented in its less tangible assets, such as market position and investment laid for the future.

AUDITING

  14.  We recognise the crucial role that audit plays in the UK's financial system through the underpinning of confidence it provides to the capital markets.

Integrity of professionals

  15.  Overwhelmingly, the quality of auditing depends on the calibre of audit partners and staff in particular their integrity, ability, experience and personal courage under adversity (for example against hostile management).

  16.  The UK profession has long been fortunate in attracting those high quality people. We believe that the integrity and ability of our professionals remains second to none in the professional and business communities. In the current debate on the regulation of the profession, nothing should be done which would reduce its attraction to people of this calibre.

Professional regulation

  17.  We welcome the new independent regulatory regime for the profession in the UK—which goes further than that for other professions—because we realise the importance of public confidence in what we do.

  18.  However, unlike some other regulated industries, the interests of our regulators—and our own interests—precisely coincide in a single objective: audit quality. For our part, it is difficult to over-estimate the consequences of quality failure to the reputation of the firm, the careers of individuals and the cost and management time of litigation. However, ill or well founded an allegation of negligence, a partner will spend his time substantially dealing with the litigation rather than developing his or her career.

  19.  Our own quality procedures include:

    —  Independent review partners, who have little or no contact with the client, in order to preserve complete objectivity.

    —  Special review panels of senior partners in cases where audit judgement are particularly difficult.

    —  Post-audit quality reviews by independent partners.

    —  Rotation of audit partners every seven years, in accordance with professional guidance.

    —  Continuous personal appraisal of partners and staff.

Audit independence

  20.  The considerable interest in audit independence is entirely understandable. If we believed there was a systematic problem, we would in our own interests take management action to do something about it. But all our experience is that threats to audit independence are human rather than structural, for example occasional lack of personal resolve by the partners to stand up to "bullying" management or insufficient scepticism of what he or she is being told. We address those threats by the procedures referred to in paragraph 19 above.

  21.  We firmly believe that a "principles-based" approach to independence, such as that already in place in the UK and now recommended by the European Commission, is to be preferred to a rule-driven regime. This is because, as with accounting, principles will result in a more objective approach to the subject.

  22.  We accept there are some honestly held views that the provision of other services to audit clients is such a threat to independence that, in varying degrees, regulations might prohibit them. We honestly believe otherwise. Others have explained to the Committee the reasons why further restrictions would be misplaced, reasons which we support. Suffice it to say that we believe they would in time reduce rather than enhance the quality of auditing. This is because of the importance of variety in the firm to attracting and retaining good people in a very competitive employment market. Variety is also very important to the skills and experience they bring to the audit which need constantly to broaden as business techniques and transactions become more complex (eg treasury, IT). We believe that an "audit only" service to audit clients could ultimately lead to an "audit only" firm because too many choices of which service to provide would have to be made.

  23.  The following example illustrates these points well. PricewaterhouseCoopers is in the process of disposing of our management consulting practice. This was a management, not a regulatory, decision driven by the needs of the consultancy sector increasingly to establish business alliances with other companies, some of whom would be audit clients, and equity-based payment from audit clients, based on results. PricewaterhouseCoopers judged that the potential threat to audit independence was insurmountable. Too many immediate choices needed to be made, between retaining the audit or a consultancy joint venture to make the combined business a continuing viable proposition.

  24.  Another proposition being put forward is that audit firms should be "rotated" every few years. There are many practical arguments against this which have been made by others, with whom we agree. Our comment focuses on why we think rotation would reduce audit quality. Our experience is that it takes time to understand the complexities of a large company and, put colloquially, to find "buried bodies".

  25.  Audit committees are excellently placed to make the judgement on what matters overwhelmingly in practice, the personal demeanour of the partners and senior staff. It would be strange, to say the least, not to trust them to make that judgement, but to require the very same people to conduct "beauty parades" when, for just those companies minded to pursue "aggressive accounting", acceptability of accounting policies could become a competitive factor. Rotation of audit partners, rather than firms, best addresses the "familiarity" threats in practice.

Liability reform

  26.  Finally, we refer to auditor liability. A professional should be responsible and pay for his mistakes. But the present system of joint and several liability means in practice that litigants naturally sue the "deepest pocket", usually the auditor. This distorts the incentives of others for good corporate governance and such is the potential scale of litigation—often the amounts claimed are upwards of one hundred times the annual audit fee—that the profession has become increasingly risk averse in the kind of client it will accept and the scope of the audit. We do not believe that the public interest is served by defensive auditing. On the contrary, the Enron experience shows the need for auditors to be fearless in the discharge of their professional responsibility.

  27.  PricewaterhouseCoopers believes that a system of liability proportional to blame is the logical solution. However, we have reluctantly accepted the conclusions of the Company Law Review that this is not practicable and so therefore support its recommendation for auditors to be able to contract reasonably to limit their liability as a proxy for proportionality.

The need for continuing vigilance

  28.  Increasing pressures of the capital markets, and of results-based directors' compensation, for "performance" strain the resolve for objective financial reporting. PricewaterhouseCoopers takes these threats very seriously, through continual enhancement of the quality procedures we have described above. The resources that we devote to risk management are several times greater than what they were only a few years ago; we accept that as a necessary price for ensuring the highest standards of professional practice.

CONCLUSION

  29.  We believe that the Committee should focus on the responsibilities of all concerned in our financial system to encourage and sustain good corporate governance. For our part, we will continue our increasing vigilance as an essential part of that system. As we have explained, our own interests and the public interest are precisely aligned.

  30.  We are happy to help the Committee in any other way to help advance those mutual objectives.

18 April 2002



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