Examination of Witnesses (Questions 1-19)
MR MICHAEL GROOM, MR PETER WYMAN, MR DAVID BISHOP, MR ROGER ADAMS, MR BRUCE EPSLEY AND MR RICHARD MALLETT
WEDNESDAY 10 APRIL 2002
1. Good afternoon, gentlemen. Welcome to the Committee's first inquiry session into The Financial Regulation of Public Limited Companies. For the sake of the shorthand-writer, could you introduce yourselves and your affiliations, please?
(Mr Wyman) I am Peter Wyman. I am the Deputy President of the Institute of Chartered Accountants in England and Wales. I am also a partner in PricewaterhouseCoopers.
(Mr Groom) Michael Groom. President of the Institute of Chartered Accountants in England and Wales, and also Chairman of the Consultative Committee of Accounting Bodies.
(Mr Epsley) Bruce Epsley. President of the Chartered Institute of Management Accountants.
(Mr Mallett) Richard Mallett. Technical Director of the Chartered Institute of Management Accountants.
(Mr Bishop) David Bishop. Council Member of the ACCA; ex-President. Ex-partner of KPMG; still an adviser, for bad behaviour, to KPMG. Vice-President of the Federation des Experts Comptables Europeens; and still on the Financial Reporting Council.
(Mr Adams) Roger Adams. Technical Director of the Association of Chartered Certified Accountants.
2. In the light of what we are inquiring into today, David, we will take that "bad behaviour" comment as flippant.
(Mr Bishop) Thank you very much.
3. In the light of Enron, we decided to hold this inquiry regarding the implications of Enron for the financial institutions in the United Kingdom. Now there is a view that the USA and the UK accounting systems are different, that the US accounting system is not based on the values that the UK one is based on, and therefore we really do not have much to worry about, here, in the United Kingdom. How much do you share that view; what are your comments on that?
(Mr Wyman) I think you are entirely right in saying that there is a significant difference between the US and the UK, in as much as US accounting standards are entirely rule-driven; and, as we know from, say, tax, if you have rules, people tend to push right up to the limit of those rules. What we have in the UK, and under David Tweedie's guidance throughout the 1990s, the UK Accounting Standards Board developed accounting standards which rely very heavily on rules, but, beyond that, then say you have to have a look at the substance of the underlying transaction, and if the rules do not produce the right answer then you have to look at the substance and put that answer in, in its place. So, if you look at Enron, from what we read in the newspapers and hear from the Congressional Hearings, and so on, one of the major problems with Enron was all this off balance-sheet debt, which results from a straight following of rules without being able, because the accounting standards did not allow you, to stand back and say does this produce the right answer. So there is a very fundamental difference between the US and the UK. That is not to say that we should sit here complacently, in the UK, and say we have no lessons to learn and we should not worry about what has happened in Enron.
4. So what are the implications?
(Mr Wyman) I think we need to look at corporate governance. I think that there should be an enhanced role for the audit committee; a very fundamental part for the external auditors is the way they can rely on support from the non-executive, the independent directors that comprise the audit committee. I think there needs to be greater transparency, fuller disclosure of work that is done, for example, by the auditors on non-audit work, so that external stakeholders can judge for themselves whether that work is appropriate. And I think we need to look at the reporting of risk. One of the things that my Institute has been working on for several years is a much greater reporting of risk, for companies to say, in their annual report, "Inherent in our business inevitably are risks," any business has risks in there, and for there to be greater disclosure, so that investors and other stakeholders can understand better exactly what it is that they are investing in. One of the things we have been very supportive of, as a profession, has been the Company Law Review which the DTI has undertaken, and in that Company Law Review one of the proposals is for a mandatory operating and finance review, which, in a discursive way, would take people through, amongst other things, the risks that are in the business. So we think that there is a lot that we were looking at in the UK before Enron, but obviously Enron gives it a greater urgency. I think we have to look at auditor independence, we have to reassure ourselves and all users of accounts that auditors are independent; and we have to make sure that we have done everything we possibly could have done to have the highest possible quality in auditing and financial reporting, to make sure that anything we do to create greater auditor independence does not reduce auditor quality, which would be obviously a damaging and retrograde step. But we have to recognise there was a loss of confidence, and that confidence needs to be restored.
(Mr Bishop) I think, on that last point, of confidence, and coming back to your first question, of much to worry about, I think we have got a lot, because I think the confidence in the capital markets has been seriously damaged, and also the confidence in the process of audit has also been put under question, again, and that does concern me, and I think we have a mutuality of interests here to restore that, in the public interest. So that a cold, hard look at where we are now, and perhaps starting at where we were, because we have moved quite a lot, and I think this is in all our evidence to you, from where we were ten years ago, with the Polly Pecks and BCCIs, and so on, to where we are now, in the UK, is quite different, in terms of transparency, in terms of our reporting standards, the quality of reporting now has been enhanced considerably. But, where we go from here, we could say, and I think it would be wrong to say, that "if it ain't broke, don't fix it;" but we have not regarded that as something to stop us trying to raise the game, over the past ten years, with the various initiatives taken by the Financial Reporting Council, and looking at corporate governance with Cadbury, then Greenbury, then Hampel, and coming out with the Combined Code, which started to set some standard practice, of best practice. But all the time best practice is getting better, and we have got to get better. So this is why I welcome the various reviews which are going on, and we should be a very positive part of that review.
5. We seem to have overdosed on corporate governance, over the past 10, 12 years, and how far have we advanced?
(Mr Groom) I think it is a question of looking at the various aspects of corporate governance; and one of the DTI reviews, as you well know, is aimed in that direction. There are undoubtedly things there that can be looked at: should we have restrictions on non-executive directors, how many directorships they can take, do they spend enough time, are they paid enough money, how strong is the audit committee process, etc. And I think my only concern is that the Enron thing does not cause us, here or elsewhere in the world, to have knee-jerk reactions, but that we go through the processes, such as this Select Committee, such as those reviews, look at the facts and then see whether we need incrementally to improve what we have got in this country, which is world standard, frankly.
6. But David has said there is a lot to worry about, and if there is a lot to worry about it would appear that it is axiomatic that fundamental change is required. So what we are looking for, as a Committee, is your views and the propositions you have as to what fundamentally needs to change?
(Mr Bishop) Let me come back on "there is a lot to worry about". It is public perception, and public perception is, to me, reality; and what we actually have done and achieved, yes, we have overdosed on corporate governance, in the last ten years, but what has happened is, behaviour is now more transparent through the way we report, in terms of the amount of information you now get in annual reports, on pay, for instance, that is very significant. And some people would argue, on the one hand, that "That has created a free market in executive pay, and that is why pay has risen;" others will say, "No, no; it's the same individuals just ramping up their pay." But those are two extreme views. And what we need is a cold, hard look at what the reality is, at what the effect has been, in terms of behaviour and in terms of risk. The Turnbull Report, which was, I think, a lot of work was done by the ICAEW, initially, and the Turnbull Report and the analysis of risk and the reporting of risk, as Peter says, is something we should look at, because, I think, more information should be given to shareholders, and also for the general public, on risk. Because it is not a risk-free society we live in, business is not risk-less, it is a very risky operation.
(Mr Wyman) Chairman, might I pick up your point. You said, if there is a lot to worry about, we need fundamental change, and I think my position is that we have had the fundamental change in the UK, and that is the distinction with the US; the US has not learned the lessons from the late 1980s, the early 1990s, and I think we have had the fundamental change in the UK in both financial reporting, corporate governance, and in auditing. What we need now is to build on that, and it is quite a lot of, but it is incremental change rather than fundamental change.
7. So what you are saying then, Peter, is that you have undergone that change, therefore, from the professional point of view, there is not much to worry about; but there is the public and you have got to assuage their concerns?
(Mr Wyman) No. I think we are in continuous improvement, we have been for a long time, but I would not wish to undo the changes that have been put in place. I think, in this country, we have world-class financial reporting systems, our accounting standards are better than anybody else's. As we move towards international accounting standards, it is very important that the international accounting standards build on the qualities that are in UK standards and do not go down this rule-driven approach, which risks ending up with the wrong answer. Interestingly, one of the very few good things that have come out of Enron is a growing recognition in the United States that their accounting standards, and indeed other things in the United States, are not as good as they thought they were previously. So I think we do need to build on what we have got, that is why I say it is not fundamental change, but I would not want to underestimate the incremental change that needs to take place.
(Mr Adams) I think I would agree with Peter, that it would be incremental rather than fundamental, on accounting standards. I think a lot of energy has gone into upgrading and reshaping the way in which we look at accounting standards, since the Dearing Committee Report in 1990. The embedding of "substance over form" argument throughout standards has been exceptionally good for disclosure and transparency in this country, but I think there are still areas, and I think leasing is one of the areas, where we still have a rules-based standard, which Sir David Tweedie and now Mary Keegan are anxious to try to shift the rules there, so that, with regard to just the difference between an operating and a finance lease, we stop the legal game that goes on around that. So I am quite sure that there are some incremental issues that need to be dealt with; and when they come through into financial accounts people may look at them and say, "My goodness, this is the same as FRS 17; this is horrific," or something. But we get to each of those in turn, I think. Clearly, in the 1990s, dealing with financial instruments has been a major issue for standard-setters, and the resources allocated to standard-setting are another issue that, I think, if you look at Harvey Pitt's submission to Congress, at the beginning of this month, it indicates that far more resources on the US side are going to be required. I would go along with the incremental rather than the fundamental, on the accounting standards. It may be that in the corporate governance area we have built a corporate governance structure piece by piece through a very bullish 1990s, and it is only when the economy changes that these new rules and structures face the test of the market. And we are finding that, in some cases, which may be the role of audit committees, it may be the fact that a pool of non-executive directors, etc., we could cast blame, I think, in a lot of directions, and I think it is unfair to do that, I think possibly one has to step back from corporate governance and say, "We're looking at it through a new lens, at the moment, and let's find out whether all of it is fragile, or whether there are just particular parts that need to be looked at again."
8. So we are unanimously agreed on the incremental approach?
(Mr Adams) Yes.
(Mr Wyman) Yes.
9. We are getting into the abstractions of corporate governance, but, I think, before we get there, there is a question of financial reporting. Mr Wyman said earlier that Enron was not really the beginning of this, there were a number of other cases; and there were. There were, as he has mentioned, Polly Peck, BCCI, Levitt, Resource Hotels; all those. The DTI then referred to the profession to see what should be changed, as a result of those instances. So, what happened; because there are still some other questions that arise about the United Kingdom, and we should not get away either with the idea that all of this Enron stuff was the Americans and we are quite different from them, because I do not believe that is true?
(Mr Wyman) If I may, if you go back to the late 1980s, when a lot of the financial scandals that you have referred to happened, some of them only became visible in the early 1990s, if we set that as the starting-point, and I fully accept there have been other scandals since, but if you take that as the starting-point, we had this complete review of corporate governance, I will not go through every step again, but that is when Cadbury started, that is when we started to
10. But I am talking about financial reporting now, Mr Wyman?
(Mr Wyman) Alright; well, financial reporting specifically at that point, when David Tweedie took over at the Accounting Standards Board, which, incidentally, is independent from any of the accounting bodies, and drove through, with quite a lot of opposition from all kinds of quarters, including business, a radical, new approach to accounting; and, as we have already said, for example, this "substance over form" that is embedded into our financial standards is completely different from what they have in the United States. So I do think we have come a very long way in financial reporting, we have come a very long way in governance, which is a part of reporting, we have come a very long way in auditing, since the early 1990s; not perfect.
11. But not far enough to have avoided an Equitable, for instance, which was much more recent than the cases that you quoted previously?
(Mr Wyman) I am certainly not saying, and I hope this was clear earlier, there is nothing left to do, everything is perfect; we go on and on improving, and I think Enron and other cases just underline the necessity to carry on improving. But I do think there has been very, very significant change from the early 1990s, change that did not take place in the United States.
(Mr Bishop) And I think that there is one other thing we should perhaps emphasise, and that is that you cannot stop criminals, you cannot stop collusion, as auditors; auditing, it is not an adversarial process, it is a question and answer process, and there must be some trust, unless you have got reason to distrust. And, some of the cases you have mentioned, there is criminal activity there; and if we are going to be bloodhounds, rather than watchdogs, it is going to be a very, very different game.
12. But auditing is supposed to find that out?
(Mr Bishop) Major errors and criminal activity, yes, but not minor.
13. But BCCI was not minor?
(Mr Adams) It is collusion.
14. Neither was Equitable all that minor either?
(Mr Bishop) It is collusion; it is the difficult one. If the management collude against you, it is very, very difficult to discover it. We have got some of the best people undertaking that work. But it comes back toI have worked in Europe, as a representative of the UK accountancy profession, on the FEE (that is the Federation des Experts Comptables Europeens) review of the role, responsibilities and independence of auditors, and we came up with the word "independence", and we said, "Independence of what; what does it mean to us, the word `independence'?" Independence is a state of mind, and that has been used, I think, in CIMA's presentation to you, a state of mind; what is that? That is objectivity. Alright, objectivity; what is the sort of temptation which can lead you to lose that objectivity, as an auditor, as an executive; and some of it would be financial interest, a large financial interest, self-interest, self-review, conflict of interest. Now how do you stop it; and the Germans and the French were only convinced that this was a reasonable definition when we said, "Can you produce a rule which will ban sin, can you define sin?" And they said, "No, but we will go on a principle that we recognise, if those temptations are there." What do you do about it?
15. We will come to theology in a minute; let us stick to financial reporting, for the present. And there are things in the financial reporting that are not so abstract as defining sin?
(Mr Adams) I have already mentioned, in one area, let us say, of leasing, that it is quite clear that we do need to move the UK approach to the standard that we have. Peter has already mentioned the issue about reporting of risk through company financial statements; first of all, the assessment of risk, where the risk arises, and then the way in which it is reported. Because risk is not going to be a double-entry issue that you can put in the profit and loss account and the balance sheet, necessarily, but there has to be a part of the financial statements, a part of the annual report and accounts, through which risk can be communicated, possibly in a narrative form. And I think actually we are at a very early stage in developing our thoughts on how risk should be reported, even through the operating and financial review statement, or some other mechanism, on which I think the English Institute has done quite a lot of work, background research.
16. On that point, the Institute of Chartered Accountants in England and Wales recommended that statutory accounts should be complemented by a wide-ranging operating and financial review, with due emphasis on risk, which I think Mr Wyman has touched on. How has that proceeded; has that recommendation been well received, has it progressed very far, and what is being done about implementing it?
(Mr Groom) It has been backed up very strongly by the Company Law Review, in which all of our respective Institutes have played a big part.
17. Where does it stand now, in relation to being implemented?
(Mr Groom) Where it stands at the moment is that the DTI is very keen to find legislative time; we are keen that they do so, and Government, hopefully, will move that forward. And there are some very good things in there that will help this whole process; the operating review is one part of it, but there are many other issues which
18. But why does it need legislation, why cannot it be the Accounting Standards Board just make the changes?
(Mr Adams) The ASB, the Accounting Standards Board, has had a working party, since just before Christmas, revising the operating and financial review statement, which was originally issued as a "best practice" statement for listed companies in 1993; that working party has had two meetings. Graham Ward, the immediate past President of ICAEW, and myself were both on that working party; there will be an exposure draft published next month. What comes out will be, I think, a halfway-house, it will be an upgrading of the existing operating and financial review guidance. But ASB decided to approach it incrementally, to go back to that word, because of what is coming out of the Company Law Review, which represents a much more fundamental change; so you will find much more emphasis on the principles in this document. Previously, it was rather a checklist of values-based, forward-looking type issues that companies might or might not feel like disclosing; now we have constructed a principles-based approach for the operating and financial review, which hopefully will result in the disclosure of, I am not saying more commercially-sensitive information, because part of the-standard-setting process is always a battle between the forces of greater disclosure and those who wish to retain their commercial sensitivity, or confidentiality, but I think that the new statement that comes out will go some way towards identifying particularly the value drivers that underpin accounts. I think the risk issues will come more through the Company Law Review.
19. But this incremental approach is beginning to make manana sound urgent?
(Mr Wyman) I think that is to underestimate how much has happened; and I said earlier, and I am happy to repeat, that I think Enron has given a new urgency to a lot of things that we have been talking about for a long time. Company Law Review, I think, was a first-class exercise conducted by the DTI over a period of time, involving business and all the professions, and has come up with a recommendation to modernise completely Company Law in this country; the OFR is a part of that. And I would merely echo what has just been said, I think we will get on faster if we can have a Companies Bill that legislates for the Company Law Review recommendations, rather than dealing with it piecemeal. But we are not sitting here, waiting for a Companies Bill and doing nothing in the meantime; we have been doing several things. One is, as has already been said, developing, through standards, an approach to an OFR; and, secondly, my Institute has been doing a lot of work to persuade companies that it is possible to make much greater disclosure of risk without giving away competitive advantage. And I think that is a very important ingredient in this, because we have to have not just a mandatory statement of risk but something which is useful and contributes to an understanding of what the company's business is.