Memorandum submitted by the Institute of Chartered Accountants of England and Wales
Thank you for your letter of 22 March inviting the Institute of Chartered Accountants in England and Wales (the Institute) to submit evidence to the Treasury Committee's inquiry into the financial regulation of public limited companies. I attach our submission, which is briefly summarised in this letter.
The Institute is the United Kingdom's largest professional accountancy body, with over 122,000 members. We have some 52,000 members working outside practice including the Finance Directors of 56 of the FTSE 100 companies. As a Recognised Supervisory Body under the 1989 Companies Act we are responsible for the regulation of virtually all the Registered Auditors of some 2,800 companies listed on the United Kingdom stock exchanges.
The Institute is incorporated by Royal Charter, and is required to operate in the public interest.
While the collapse of Enron took place in the United States, the Institute believes that confidence in the United Kingdom and other capital markets has also been affected. Such confidence is essential, and we therefore welcome the opportunity to discuss with the Treasury Committee what can be done to rebuild this confidence.
The circumstances leading to the failure of Enron are still the subject of detailed investigations, and the Institute therefore makes no comment on the business issues raised. However, the Institute is well placed to provide informed and expert commentary on the broader issues raised in relation to financial reporting, corporate governance and audit.
Since the late 1980s there have been continuing efforts in the United Kingdom to limit the scope for excluding from the balance sheet assets and liabilities which could substantially affect the overall financial position of companies. A key development was the move by the Accounting Standards Board (ASB) in the mid 1990s to standards that focused on the underlying substance of the transactions.
United States standards have not yet moved so far in this direction, although we note that the US Financial Accounting Standards Board (FASB) is now considering such a move.
Although the Enron affair has not so far brought to light any substantive issues that raise new threats to United Kingdom financial reporting standards, there is always a need to develop standards to take account of new business practices, reasonable shareholder expectations, and other developments. The leading role in this will now be played by the International Accounting Standards Board (IASB), and the Institute will contribute actively to its work.
A financial reporting regime will enjoy credibility only if high quality standards are implemented on a consistent and rigorous basis. The United Kingdom Financial Reporting Review Panel (FRRP) is now being considered as a potential model for enforcement of accounting standards at a European level.
We believe that traditional financial statements, however well constructed, will rarely provide sufficient information for analysts and investors. We have therefore recommended that a wide-ranging operating and financial review (OFR) with due emphasis on risk-related information should be a key component of companies' annual reports. In addition, we will continue to stimulate discussion and produce guidance on improving information for shareholders and investors.
The key element in corporate governance is the way companies are directed and controlled to protect the interests of shareholders. Effective corporate governance requires clear delineation of responsibilities, transparent reporting and principled directors.
United Kingdom corporate governance has been comprehensively reviewed since the early 1990s through a series of influential reports. The ICAEW has played a leading part in this process of continuous review and development, and is committed to building on this programme.
Audit committees and non-executive directors on other committees play a key role in corporate governance through their active independent contribution to the running of businesses.
The link between companies' objectives, internal control and risk management in the Turnbull Report, which requires directors to re-examine their control of the company on a regular basis, is a further important strengthening of corporate governance.
More generally, the combination of United Kingdom Company Law (specifically the ten per cent rule for the calling of an extraordinary general meeting that can dismiss directors) and the concentration of share ownership in the hands of the leading City institutions has meant that United Kingdom shareholders have greater leverage in discussions and disagreements with management than shareholders in the United States. A leading United States shareholder activist and fund manager was recently quoted as saying:
"In truth, US corporate governance should be called `apparent' while in the UK it can be considered `real'." (Financial Times, 18 March 2002)
No one could guarantee that "another Enron" could not happen here, but we believe that United Kingdom corporate governance practices are strong and improving, and will greatly mitigate the risk.
Nonetheless, there are several areas where we believe that consideration could be given to further developing United Kingdom corporate governance. Above all, there is the continuing need to remind board members of their role and responsibilities and to ensure that they fully understand their fiduciary duty. Other areas for consideration include:
additional guidance on criteria for independence of non-executive directors;
improved communications between non-executive directors and shareholders;
increased time and resources for audit committee members.
However, the concept of the unitary board should not be weakened. The board as a whole is responsible for the control and direction of the company.
The regulation of audit in the United Kingdom differ in many respects from the system currently in place in the United States. In particular:
The independence code is a principles-based approach which insists that the reality of independence, not merely the requirements of a set of rules, must be observed.
The inspection regime is in the hands of full-time professionally qualified inspectors, employed by the professional bodies, whose work programme is approved by the government.
Supervision of the professions's regulatory and disciplinary arrangements to ensure that they are in the public interest is undertaken by the Accountancy Foundation, an independent body established in co-operation with the government.
Many of these differences between United Kingdom and United States practices resulted directly from the changes prompted by the major corporate collapses of the last 1980s and early 1990s in the United Kingdom.
The Institute constantly monitors the performance of the United Kingdom regime and developments elsewhere to ensure the continued effective operation of the United Kingdom model.
The major corporate failures of the late 1980s and early 1990sin particular Maxwell, BCCI, and Polly Peckwere a wake-up call for the business and regulatory communities and the accountancy profession in the United Kingdom. Fundamental changes were introduced in financial reporting, corporate governance and audit, and work continues in a constant search for improvements.
Among the many lessons learned, three key themes emerged: substance over form, transparency, and the management of risk.
The principle of substance over form is deeply embedded in the United Kingdom:
in our accounting standards, which bring "quasi-subsidiaries" into the consolidated financial statements whatever their formal status
in our ethical codes, which require auditors to be independent in fact, not merely to appear to adhere to rules
in the fundamental requirement for the annual accounts prepared by the directors to present a "true and fair" view, even if that means over-riding a rule which would tend to distort the picture.
The principle of transparency is now pervasive. Examples include:
wide-ranging requirements to disclose information in companies' annual reports
external monitoring of audit firms by teams of independent professional inspectors
the establishment of the Accountancy Foundation to provide external oversight of every aspect of the profession's regulatory and disciplinary arrangements.
The emphasis on internal control and risk management has emerged from the recognition that, however effective safeguards against misrepresentation and abuse may be, they will never be sufficient to eliminate all possibility of failure. In the modern rapidly evolving global economy the pattern of threats (and opportunities) can change over a very short period. The challenge is now to respond to this by embedding effective internal controls and risk management as an integral part of companies' way of doing business, with a particular focus on the effectiveness of these procedures by those charged with governance.
In the United States, many of the questions that were asked in the United Kingdom a decade ago are being raised again in the wake of the Enron collapse. Similar conclusions to those, which were reached and acted upon here are being reached now in the USAin particular in relation to the primacy of substance over form on which there is now a developing international consensus.
We would not claim that the United Kingdom system needs no further action. Change in the business world is constant. New entities, new products and new processes emerge all the time and we must be constantly alert to the new threats they may pose. In addition, there is still more to do through refinement and evolution of our existing structures, for example by extending disclosure requirements and reinforcing the role of non-executive directors. However, the lessons of the 1980s and 1990s have been hard-won and must not be forgotten in the understandable desire to find "a solution" to Enron. In particular, any proposal to substitute form for substance through the imposition of rule-based compliance requirements must be viewed with great scepticism.
We believe that the accountancy profession and others involved in corporate governance in the United Kingdom have learned the hard lessons of the past. The search for improvements continues and many constructive initiatives are in progress to modernise company law and improve standards worldwide (see Appendix 3 to our submission). It would be unfortunate if these carefully considered initiatives, which will be of long-term benefit, were blown off course. In particular, we strongly urge the Government not to be diverted from implementing the proposals for company law reform, which, if the final report of the Company Law Review Steering Group is followed, include important recommendations on matters such as corporate governance.
The issues surrounding the collapse of Enron are wide-ranging, complex and arose in a legal and regulatory environment which is different from that of the United Kingdom. It is important that any proposals made by the Committee are based on a thorough examination and sound appreciation of all factors and we would be pleased to assist the Committee in any way we can to achieve this goal.