ENRON: COMMENTS FROM ACCA
1.1 Rarely, if ever, have the newspapers carried so much coverageboth in reports and commentaryon accounting issues, both technical and political, than in the immediate aftermath of the Enron casethe filing, in the US Bankruptcy Court, of voluntary petitions for Chapter 11 reorganisation of Enron Corporation and certain of its subsidiaries. The problems exposed by the largest bankruptcy in US history go much deeper than a possible breakdown in auditor performance. It has been the catalyst for a number of other companies, on both sides of the Atlantic, to come under scrutiny. In many instances, share values have been significantly affected. There are questions about the credibility of reported earnings and a significant number of corporate earnings restatements. In the case of telecoms, the results of virtually a whole sector have been called into question. As a result, the Enron affair has triggered an enormously wide-ranging debate and has raised questions about many aspects of the operation of capital markets as well as concerns about financial reporting and auditing standards, regulatory arrangements and the quality of the corporate governance in major corporations.
1.2 It will, of course, take many years for all the facts to emerge. Nevertheless, a sea change has already taken place in public perception which demands some immediate action. And it is clear that the agenda for this action must address a number of themes, regardless of whether, and in what proportions, they prove to have been at issue in the Enron case. Action should not, however, be hasty but should be based on a careful analysis of the issues. There must be considered solutions to the range of problems which have been identified in relation to the ways in which companies and markets operate, to the pressures onand inbusiness and to the general pace of change. Great care must be taken neither to exacerbate the initial problems nor to create new onesor both.
1.3 The questions which have been raised about accounting and auditing principles and practice suggest a wavering of trust in the market and its regulators. If the issues are not addressed in an appropriate manner, this scepticism ofor even antagonism tothe ability of business to make the market serve the common interest could spread. It is, therefore, imperative that the response is one which accepts that there are shortcomings in the present arrangements, identifies those shortcomings and finds reasoned and reasonable ways of dealing with them.
1.4 There has already been no shortage of opinionsfrom governments, regulators, professional bodies, corporations, investors and the media. ACCA offers its contribution from a unique global viewpoint and experience. It is the largest worldwide professional accountancy body, with nearly 300,000 members and students in 160 countries and with 32 staffed offices and 35 active centres. ACCA's members hold senior positions throughout the corporate sector and, although ACCA is strongly identified with the smaller practitioner, it also has a significant presence at partner level in the Big 5 firms around the world. It is, therefore, well placed to comment on the problems exposed by Enron.
1.5 In this paper, we reflect first on the nature of modern capital markets, and then set out a number of suggestions relating to each of the core areas where capital markets, reporting entities, their management teams and the professionals who provide them with assurance services have come under scrutiny since the collapse of Enron. We suggest a range of possible developments in the areas of financial reporting, auditing and corporate governance. It should be noted that our stance on many of the issues discussed pre-dates the collapse of Enron.
ACCA has supported the global acceptance of international accounting and auditing standards for some years. Indeed, its core educational programme has been heavily influenced by them (over 40,000 ACCA students are taking examinations set in accordance with international standards) and it already provides an international diploma on them. Implicit in its support for these principles-based standards is a rejection of the rules-based approach which may have been a contributory factor in the Enron collapse.
In the belief that independent monitoring will always achieve a higher level of objectivity and public trust, ACCA's approach to audit monitoring has always rejected the peer review approach.
Through its annual sustainability reporting awards and its close involvement in the development of the Global Reporting Initiative (GRI) guidelines, ACCA has pioneered wider reporting developments and championed the cause of increased corporate accountability and transparency.
ACCA's diploma in corporate governance is offered internationally to candidates from both the private and public sectors.
1.6 The key suggestions which we make are that:
global financial markets need a global set of principles-based financial reporting standards and a global code of corporate governance; legalistic, rules-based standards encourage creative, loophole-based practice.
while the necessary new solutions to global market problems and issues of auditor independence will have to be introduced and controlled at individual national level, they should be based on principles which are agreed and co-ordinated at the global level.
the objectives of financial reporting practice should be expanded to recognise the growing level of concern arising from the globalisation of business.
the participants in capital marketsboth major corporations and institutional investorsshould provide the resources to ensure that the markets function properly through an externally administered levy which confers no influence at the regulatory level.
auditor independence issues should be revisited and the relationship between a reporting entity and its professional advisers should become more transparent.
there should be a review of the regimes for monitoring practice in auditing, financial reporting and corporate governance.
2. THE PRICE OF FAILURE
2.1 Capital markets, such as that on which the stock of Enron was principally traded, exist to bring together investors seeking returns and corporations in need of capital. The allocation of capital to those corporations which provide the greatest return is made more efficient by the disclosure of timely, relevant and accurate financial information. This apparently simple principle gives rise to the development of financial reporting practice, auditing standards and the regulation of capital markets.
2.2 The processes which bring investors and corporations together and which, thereby, allocate funds to the most efficient and successful enterprises should ensure the effectiveness of capital markets. But, if they are to work smoothly, the mechanisms must be free of distortions. This requires the information which is available to all the parties in the exchanges to be reliable and trustworthy so that the markets can function efficiently, with a well-oiled engine. If they do not, the friction becomes too great because trust in the information which is available is lost and the risks imposed on participants become too high. Thus, corporate failuresof which the Enron debacle has been a spectacular exampledo not just manifest distortions in the market but risk undermining the balance between cost and benefit and the acceptable level of risk which makes the whole market mechanism sustainable. It is, therefore, imperative that measures should be taken to re-establish the system as a whole and, consequently, confidence in its stability.
2.3 The Enron group has been involved in businesses as diverse as the supply of water and dealing in complex derivative products based on weather patterns. Its operations have spanned the globe and affected many countries and capital markets. The collapse has, however, occurred in the capital market which is not only the largest in the world but which considers itself to be the best regulated. As a result, all capital markets are in future likely to have to devote more resources to maintaining the integrity of their investor-orientated information.
3. THE CONTINUING MODERNISATION OF CAPITAL MARKETS
3.1 The last few years have seen many improvements in the provision of investor information. Ironically, the timing of the Enron collapse is such that some of the most significant recent developments have not had time to take effect.
For example, following the 1999 Blue Ribbon Committee report, the US Securities and Exchange Commission (SEC) approved changes to the Audit Committee rules of the New York Stock Exchange, the American Stock Exchange and the NASDAQ market so as to require a minimum of three independent directors on audit committees. Full implementation, however, was only required by mid-2001.
Significant changes have also been made in SEC auditor independence rules and, following the publication of a revised Code of Ethics by the International Federation of Accountants (IFAC), similar provisions will be implemented worldwidebut not until the start of 2005.
3.2 Important though they are, changes such as thesedesigned to strengthen capital marketsmust be examined against the economic and other changes occurring in the markets themselves. Alongside an accelerating trend in the last few years towards globalisation and cross-border capital flows, the world economy has experienced turbulence.
The East Asian financial crisis in the late 1990s was followed by a general slow-down, with Argentina being the most obvious current example of an economy in crisis.
The volume of market trading has expanded considerably, both in existing and emerging centres. Markets now include traded derivatives, and other complex financial products are commonly employed by business.
The explosive growth in the Internet gave birth to new business processes and transformed the delivery of information to investors.
Although individual share ownership has grown, investorsonce typically individuals of high net worthare now predominantly institutional, such as insurance companies, providers of retirement benefits and other professional investment managers. All investors are now faced with understanding financial statements of increasing complexity.
3.3 Taken together, ACCA believes that these changes in the capital markets have outstripped the initiatives aimed at strengthening control of their operation. As a result, there must now be a significant acceleration in the regulation of capital markets and their supporting mechanisms.
4. THINK GLOBAL: ACT LOCAL
4.1 The operation and regulation of capital markets is diverse and complex.
Markets in different countries are subject to different laws.
Regulators necessarily oversee only those markets where they have authority.
Markets differ widely in the total capitalisation of their listed corporations.
It is clear that new solutions must be found to global market problems. These will have to be introduced and controlled at individual national level. However, it requires the will of investors to drive change and increasingly investorsparticularly institutional investorsoperate on a global basis. ACCA argues that it is necessary for local solutions to be based on principles which are agreed and co-ordinated at the global level. This will mean that national regulators and others must rise above national concerns. Difficult as it may be, they must be prepared to give up a measure of control over their domestic activities in return for influence over global developments.
4.2 Some global initiatives are already under way. Financial reportingoutside the US, at any rateis being driven by the International Accounting Standards Board. The International Federation of Accountants is responding to pressure from the International Organisation of Securities Organisations (IOSCO) and the European Union to accelerate the modernisation of international auditing standards. Similarly, the OECD has issued what can be argued to be the first global code of corporate governance, although this lacks the detail which is normally associated with national codes.
4.3 The resources allocated to existing global regulation and standard setting are a microscopic proportion of the total resources which are available to capital markets. There is little doubt that the pace of change could be accelerated significantly if more funding was made available. There is then the issue of who should provide that funding. Some commentators take the view that there is an inherent conflict in regulation being funded by those who are subject to it. Attention has even been drawn to the fact that the International Accounting Standards Board approached Enron (along with most other large corporations) for funding.
4.4 In ACCA's view, this is an oversimplification. Any arrangements which enable "he who pays the piper" to call the tune are, of course, flawed. On the other hand, an externally administered levy which confers no influence ought to be acceptable. ACCA considers that there should be a mechanism which requires the participants in capital marketsboth major corporations and institutional investorsto provide the resources needed to ensure that the markets function properly.
5. FINANCIAL REPORTING
5.1 It remains the case that financial reporting standards are drawn up with the needs of the investor foremost in the minds of the standard setter. When large companies crash, however, it is not just the investors who lose outcreditors, employees, families and communities all suffer. ACCA believes that accounting standard setters must be seen to be operating in the public interest. This will require much wider participation from those representing the investment and stakeholder communities. The standard setting process should be more inclusive and fully open to public scrutiny. There should be no barriers to access to standards.
5.2 Although the full facts of the Enron collapse will not emerge for a long time, it is already evident that investors were not properly informed about the significance of off balance sheet finance arrangements. US accounting rules may well have contributed to this, in that they are concerned with the strict legal ownership of investment vehicles rather than with their control. By contrast, International Accounting Standards follow the principle of "substance over form" and their use would have resulted in the details of the special purpose entities being reported in a transparent way.
5.3 The difficulty with legalistic, rules-based standards is thatby specifying precisely where the line is to be drawnthey encourage those who wish to operate as close to the line as possible, or even to test the limits. They encourage the exploitation of loopholes and devalue professional judgement. This is less of an issue in a system which is based on principles and, therefore, judgement. In ACCA's view, standards and rules which are based on principles are greatly preferable. ACCA strongly supports European Union moves to adopt International Financial Reporting and Auditing Standards in the next few years and believes that those accounting standard setters and capital markets worldwide which are not yet committed to these should now address the issue urgently. This will, for example, require the US capital markets to commit to the adoption of international standards in preference to established US GAAP and GAAS.
5.4 Where a rules-based approach is used, however, standard setters must act firmly and quickly on controversial subjects. The Enron collapse has called into question the speed of response of the US financial reporting standard setting body. Lobbying, either direct or through government, by those with vested interests in avoiding change is a danger to all national standard setters. There are some indications that, in the Enron case, active lobbying may have contributed to delays in issuing standards to govern the treatment of the special purpose entities used in off balance sheet financing transactions.
5.5 It is also clear that the inappropriate recognition of revenue remains a major challenge for accounting standard setters. Many of the most celebrated corporate collapses of the last 30 yearsfrom railroads to dotcomshave their origins in the mis-statement of reported revenues. Standard setters and auditors alike need to focus on the principles of revenue recognition not just when bull markets turn sour but at all times.
6. AUDITOR INDEPENDENCE AND COMPETENCE
6.1 Media comment in the wake of Enron has focused heavily on the issue of auditor independence. Some national regulators have announced that they are considering options such as placing a limit on the time for which auditors may hold appointment or banning them from undertaking consulting work. These reactions raise two issues.
First, leaving aside the substantive merits or otherwise of these proposals, ACCA is concerned that such national developments will lead to a fragmentation of rules. Instead, a global solution should be pursued. The global adoption of the independence provisions of the IFAC Code of Ethics will be a major milestone in promoting consistency.
Secondly, however, it is not clear that the two measures which have been most widely reported are the appropriate responses. The general issue of "auditor independence" covers a number of separate matters including:
over-dependence of an auditor on a particular client, either because of the size of fee income relative to the total fees of the firm's region or office, or because of the existence of fees from non-audit work such as consultancy;
the employment of staff recruited from the audit firm;
the process of appointing and re-appointing auditors;
the rotation of audit partners; and
the process of monitoring and regulating auditors.
6.2 It is not clear that all, or indeed any, of these were major factors in the Enron case and there is a danger that a knee-jerk reaction which misses the target may do more harm than good. Nevertheless, it is the case that public perceptions have shifted as a result of the Enron collapse and the issue of independence does require further consideration. This consideration must take account of all the different aspects of the matter and indicate a careful consideration of the potential benefits and possible costs of any changes.
6.3 Enron, and all the other cases which have attracted attention, have demonstrated the need for greater transparency and trust. This needs to be addressed as a matter of urgency by the global financial community. No single measure is likely to deal with the questions which have been raised and a range of ideas must be considered. These could include:
making the appointment of the external auditors less dependent on the executive directors and involving the non-executive directors, the audit committee and institutional shareholders; in turn, this would have far-reaching implications for the corporate governance mechanism.
limitations on the ability of audit firms to offer consulting services to listed company audit clients (although not necessarily a ban on the provision of such services to non-audit clients)
fuller disclosure of audit and consulting fees in the annual report and accounts
a mandatory review by a company's audit committee of the independent status of the external auditors and the publication of a statement that it is satisfied with the results
a prohibition on audit firms providing audit services in instances where senior audit staff have moved to senior executive roles in client companies: this could take the form of a moratorium prohibiting audit staff from moving to audit clients for an appropriate period after they have been personally involved with the audit.
6.4 One matter which is not easily addressed by prescriptive regulation but which requires sensitivity on the part of auditors themselves is the issue of the size of the audit fee relative to the local office providing the service and the fee generation target(s) imposed on the engagement partner. When assessing the independence and objectivity of those tasked with providing the assurance activity, it is not appropriate simply to look at individual audit fees relative to gross partnership income. They need to be considered in the context of the income of the office in which the partner concerned works and the expectations which the firm has of him or her. It follows that audit monitoring should focus on the culture within audit practices and the pressures on individual engagement partners.
6.5 ACCA also believes that the process of audit appointment should be reviewed. Although in theory this is a matter for shareholders, in practice the appointment is controlled by management. It may be time to see if this can be changed. One possibility is that private sector or even governmental bodies might fulfil the role of appointing auditors but for multi-national companies a global, not national, approach would be necessary. This approach would require the full backing of regulatory authorities worldwide. An alternative strategy, which we fully support, would be for non-executive directors and corporate audit committees to have a much higher profile role in the auditor appointment process. This would be part of the wider consideration of better corporate governance discussed at section 8 below.
7. THE REGULATION OF AUDITORS
7.1 In a speech on 17 January 2002, the Chairman of the SEC said of the regulation of the accounting profession:
We cannot afford a system, like the present one, that facilitates failure rather than success. Accounting firms have important public responsibilities.
He went on to set out his vision:
. . . this system must at heart be a tough, no-nonsense, fully transparent disciplinary system, subject to independent leadership and governance. In addition, there must be regular monitoring of the ways in which accounting firms perform their responsibilities, and the area in which either individual firms or the profession as a whole, can improve.
7.2 ACCA shares this view. Indeed, as an organisation which is domiciled in the United Kingdom, it has actively participated in the setting up of an oversight body, which is dominated by public membership, and is involved in a system of quality control which avoids firm-on-firm review and instead utilises, through professional bodies, permanent monitoring staff who are not connected with individual accounting firms. This sort of system, which can both operate on a national basis and cover transnational audit firms, is demonstrably more effective and independent than the widely used and much criticised system of "peer review".
7.3 Professional bodies must have independent investigation and disciplinary procedures and be seen to act in the public interest. This enables them to take firm and transparent action against members who fail in their fundamental responsibilities, whether as executives or as auditors.
8. CORPORATE GOVERNANCE
Non-executives and the risk management process
8.1 ACCA believes that the ultimate responsibility for ensuring effective corporate governanceincluding the implementation of robust internal control and internal audit mechanismsrests with the Board as a whole. In line with the recommendations of the Turnbull Report, Boards of listed companies should ensure that appropriate mechanisms are in place for identifying and managing risk, and should report publicly on these matters. As independent agents, however, non-executive directors have a particular responsibility to investors to ensure that corporate governance processes are appropriate and effective. We believe that there is a case for reviewing the effectiveness of non-executive directors in fulfilling this responsibility and, if necessary, for providing them with an enhanced role in the communication process.
Executive remuneration and sustainable wealth creation
8.2 Despite growing public criticism, capital markets have encouraged as best practice the system of linking the pay of executive directors to corporate performance, through share options and similar devices. The concept of payment for performance continues to be widely accepted. When, however, it is applied to the remuneration of senior executives, it may do more than simply encourage good performance. It may also incentivise short-term and self-motivated decisions, which are not in the long-term interests of investors. The risks inherent in the system have not hitherto been acknowledged. And it has been exacerbated by the short-term perspective of fund managers who are themselves concerned with their own performance relative to market benchmarks.
8.3 ACCA suggests that investors will be better served if performance-related compensation is linked to the longer term generation of corporate wealth. There is an obvious conflict between, on the one hand, the pressures of increasingly frequent interim reporting and one year service contracts and, on the other, the need to deliver sustainable investor returns. This might be addressed by the introduction of remuneration schemes, which reward sustainable year-on-year growth in profitability and shareholder value. The trend towards shorter contractual arrangements may also need to be reviewed and executives should be remunerated in a more transparent way (perhaps necessitating greater disclosure).
Independent non-executives and audit committees
8.4 The Enron audit committee has been criticised for failing to control the apparent exploitation of US accounting rules to present a better picture of performance than was the actual case. Consideration needs to be given to the time commitment and effort which is required from non-executive directors whose role is to look after the interests of the investors and other shareholders they are there to represent. They should bring to their role a balance of experience and new thinking, some real understanding of the sector in which a company is operating and the ability to make a strategic contribution. And this requires that they are available for meaningful amounts of time.
8.5 Many have argued that a minimal level of involvement militates against their ability to fulfil a realistic role in promoting accountability. Companies without an "open culture", where directors have relatively little awareness of what other directors are doing, will be particularly weak. Greater attention should, therefore, be paid to effective board self-evaluation and evaluation of individual directors, including the question of whether members of the audit committee devote sufficient time to this part of their duties.
8.6 The independence of non-executive directors is another issuemuch commented on by corporate governance lobby organisations. There are obvious weaknesses in a system where former executive directors can become non-executive directors and so in the position of exercising an accountability function in relation to former colleagues. Even where a person holds more than one non-executive director office, the remuneration for such work will mean that the ideal of non-executive director independence, on which the oversight role is based, is far from easy to demonstrate.
8.7 The development of mechanisms for monitoring and regulating the operation of audit committees also needs to be considered. Such mechanisms should be independent of auditors, who are not appropriate parties to examine aspects of corporate behaviour, which directly affect their own work. The fuller involvement of investors would add greatly to the credibility attaching to governance mechanisms and ACCA considers that it is necessary for investors, particularly institutional investors, to take an active role in monitoring the activities of audit committees.
8.8 What is needed urgently is a code of corporate governance which is capable of global acceptance. Such a code should build on initiatives, which have occurred in several jurisdictions. Examples of such initiatives include the OECD Principles of Corporate Governance and the World Bank-driven Global corporate Governance Forum. We strongly urge the promoters of such initiatives to join forces with market regulatorssuch as IOSCOand other global organisationsuch as IFACto develop and promote compliance with a global governance code.
8.9 At another level, market mechanisms are also beginning to appear. We note with approval the Company Governance Scores being developed and piloted by Standard & Poor's . Linking good governance to capital market accessibility is a powerful tool in motivating companies to improve their governance structures and their overall transparency. Likewise, the market-based nature of this assessment tool will have an immediate impact on poor performers.
8.10 Despite all that has been written and done in recent years, ACCA believes that there is still considerable room for further development of corporate governance practice and reporting. Indeed, there is a need for investor information beyond the narrow confines of the financial statements. Disclosure of corporate governance performance is increasingly relevant to investors, who are right to demand plain English reporting of matters of significance. ACCA champions the extension of corporate reporting to the wider economic, social and environmental aspects of a business; investors and other stakeholders are entitled to know how a business responds to the wide range of risks facing it.
9.1 Three sets of issues arise from the Enron affair.
whether there has been fraud or the law has been broken
questions about the adequacy and enforcement of accounting and auditing standards and procedures, and
matters of corporate governance, which include, in particular, the points that, while company value should be a long-term goal, management reward has a much shorter time horizon and that, while auditors should act on behalf of shareholders, they are appointed by, and can become too close to, management.
9.2 The first of these is a matter for the relevant authorities. ACCA is, however, concerned with the other two sets of questions. They are directly relevant to its role as a professional body and its responsibility to act in the public interest. ACCA's comments are not just formal responses to immediate questions. They arise from and reflect ACCA's core values, its commitment to the highest standards of ethics and integrity and the fact that it operates on a global basis. The combination of these factors means that ACCA can make a distinctiveindeed uniquecontribution to the debate on these important matters.