Memorandum submitted by Mike Rake, UK Senior Partner, KPMG
Thank you for your letter dated 25 March 2002 inviting KPMG to make a written submission to the Treasury Committee as part of its inquiry into the financial regulation of public limited companies. We welcome this opportunity, and set out below our position on these issues. In addition, I would be very happy to appear before the Committee and answer any questions that MPs might have.
Over recent weeks, I and many other KPMG partners have fielded questions on the issues raised by the Enron bankruptcy. Chief Executives, Audit Committees and Boards of Directors are seeking reassurance on the integrity of financial information, the transparency of disclosures, and the professional service firms reporting on them, and have broader questions on many aspects of the capital market framework. For accountants it is the biggest crisis that the profession globally has faced. In this document we outline some of the issues and possible changes that we believe are important for the future of the accounting profession.
However, there is increasing evidence both in the US and across Europe that the issues thrown up by Enron are broader in scope than the role of the auditor. There is considerable concern over, inter-alia, US accounting rules in relation to off-balance sheet finance and other items; the role and remuneration of non-executive directors; in particular the role and responsibility of Audit Committees; the position and responsibility of external lawyers; regulators; credit rating agencies, and the role of investment banks in presenting complex schemes to clients. The whole question of the effectiveness of financial analysis provided by institutions based on the disclosures and detailed public account filing is also coming under scrutiny.
These issues need to be addressed recognising that the UK situation is different from that in the US. We need also to take into account that the Office of Fair Trading (OFT) recently examined the competitiveness of the UK accounting profession, and their conclusions pointed to a competitive profession. Moreover, it is important that any changes are carefully considered because we face a complex situation that has no easy solutions. We therefore welcome the inquiry of the Treasury Committee, and the further reviews announced by the Secretary of State for Trade & Industry, Rt Hon Patricia Hewitt MP (into the role of non-executive directors and the UK's arrangements for financial reporting and auditing). We at KPMG look forward to participating fully in these reviews.
FOCUS OF KPMG'S COMMENTS
For the purposes of this submission, I believe it will be most productive to concentrate on some of the key areas of potential change which might be considered as a means of further improving the regime for regulation of public listed companies, and for restoring confidence in the capital markets and the accounting profession. My assumption is that the various professional bodies will give you considerable detail regarding the development of the accounting, auditing and regulatory structure in the UK, so I do not propose to cover that ground.
As a prelude to that I think it is valuable to set out some of the things which KPMG has put in place already since we recognise that the large professional firms have an important role to play in enhancing the current standing of the accounting and auditing profession.
We believe that KPMG's continuing success is linked with that of its stakeholders and it is appropriate that we report on progress in such relationships.
Since 1995 we have published an annual report including public company style financial statements, which since 1996 have been audited by independent external auditors. We think this development was important as a way of making the workings of the firm open and transparent.
We also published a stakeholder report as part of our annual report in 2001. Stakeholders are both direct, as in clients, employees and suppliers, but also no less importantly, indirect, as in local communities, government, non-governmental organisations, regulators and the media. KPMG also recognises wider society (of which we are part) and the environment (for the same reason) as important stakeholders.
We believe the large professional firms should be required to publish audited financial statements and to be accountable for their activities to their stakeholders.
Other key developments in some of these areas over the past few years have included:
Work on promoting diversity within the firmwe need to attract the best people and recognise the different experiences, mindsets and skills that people of different backgrounds bring to the firm, hence our active support of initiatives like New Deal.
Continued investment in our community programmes which have five themesmentoring, leadership, enterprise, employability and team buildingwith the over-riding issue being education. We were one of the leading corporate givers last year, investing £4.3 million in 2001. We also have set up the KPMG Foundation to help tackle educational disadvantage.
Working with clients and suppliers to assist them in improving their own environmental impact, as well as ourselves introducing environmental measures which have improved the environment and saved money.
All of these matters are important for the reputation and performance of KPMG, and represent our commitment to a leadership position within the profession.
In all areas of our operations, we are looking at ways of further increasing effectiveness, openness and transparency. In particular, in the area of ethics and independence, we already fully comply with the guidance and requirements of the various regulators (including the Financial Services Authority (FSA), the Institute of Chartered Accountants in England and Wales (ICAEW), and the Joint Monitoring Unit (JMU)). We will also be complying fully with the new EU and IFAC rules. Beyond this, we have our own national and international ethics and independence rules, and peer review processes. Moreover, we are currently considering the merit of appointing an independent "ombudsman" for the firm.
Other reforms we are considering to strengthen our own rules include:
Prohibition on audit partners from joining their audit clients in an executive position for say a period after their last involvement with the client.
Further tightening of the rules regarding rotation of audit partners.
There has been much adverse commentary about the continued consolidation of the global accountancy profession. Much of this resistance comes from public limited companies and regulators, and was evident at the time of the merger between Price Waterhouse and Coopers and Lybrand. Whilst the Anderson situation is clearly different, the reality of the situation is that there are now only four large firms. This clearly raises concerns about a further reduction in choice.
THE AGENDA FOR CHANGE
Beyond the steps which we can take as a firm to restore confidence in our profession and in the capital markets, there are a variety of suggestions for change on a wider scale which have emerged.
A number of possible reforms should be relatively uncontentious in the UK and we would support their implementation. We believe that these changes taken together would represent a significant enhancement to the current regulatory framework and corporate governance. These include:
Expanding the authority of Audit Committees. There are already many good and effective audit committees. However, because of the increasing complexity of their role there is a need to consider further guidance for non-executive directors on their roles and responsibilities, and ensuring that audit committee members have appropriate time and resources to fulfil their duties. This further guidance would extend to the qualifications and remuneration of audit committee members. In addition we believe that there should be a limit on the number of non-executive appointments that any one individual can hold on the boards of public limited companies. Further, the Audit Committee should publish a report on its stewardship of the audit relationship. Specifically, it should explain why it has or has not changed auditors. In the case where the auditors have resigned, the auditors should make a public statement outlining the reasons for resignation, with appropriate privilege for such statements.
A fully empowered and effective Audit Committee is a vital component of corporate governance and is the forum in which questions of auditor independence, quality and non-audit service provision should be properly dealt with.
Improved and more wide-ranging Operating and Financial Reviews (OFRs) for companies' annual reports, to supplement existing financial statements with better information for analysts, shareholders and investors. In particular this would include information on risk and how the Board of Directors have discharged their responsibilities in this regard.
Improved disclosure of non-audit fees. The UK's rule on disclosure of fees paid to auditors are already more comprehensive than in other EU countries, and the US has only recently introduced rules similar to our own. However, the current debate indicates that the level of disclosure even in the UK is not sufficient to enable shareholders to have a reasonable understanding of how the fees are analysed between audit, audit-related and other services. Accordingly, given the degree of public interest in this matter, we would support a move to require further analysis of non-audit fees.
Further strengthening of the independence of the current regulatory structure by the government taking over the cost from the accountancy profession. In any event, the government should have the right to appoint or nominate the Chairman of the Accountancy Foundation.
Further development of International Standards for both Accounting and Auditing. This would include working to ensure that EU positions on quality assurance, auditor independence, accounting standards and auditing standards are in line with international standards as these continue to develop. This would also include helping to promote the existing UK "substance over form" and "principles over rules" model internationally (which we note the US Financial Accounting Standards Board (FASB) is now considering).
It is worth noting that whilst business is increasingly global, we do not yet have an agreed global legal, regulatory or accounting framework.
Beyond these, there are some other changes which some commentators have called for and where it is less clear that real benefit would follow. All would involve substantive change and would therefore need considerable consultation, particularly with the user community, to ensure that any changes are measured and have real benefit and address any concerns which have real substance. We are focussing on the three principal reforms which have been suggested.
For each of these changes we will set out the main advantages and disadvantages (as advocated by proponents and detractors), as a means of aiding understanding and promoting further informed debate. In summary these potential change areas are:
Rotation of audit firms.
Regular re-tendering of audit work.
Limitation on provision of non-audit services by the auditor to audit clients.
ROTATION OF AUDIT FIRMS
What is it?
Requirement for rotation of audit firms at a defined interval.
Some commentators believe that rotation heightens independence by limiting the danger of "cosy" client-auditor relationships
Works well in the public sector under the guidance of the Audit Commission.
Can be implemented without primary legislation.
Heightened inherent risk in early years of appointment due to the lack of detailed knowledge of the client, its business and the key issues in the financial statements.
New auditors necessarily invest more learning time in the early years of the audit relationship which obviously has an attendant cost both to the auditor and the company.
Cumulative knowledge and experience within the audit firm is lost when rotation is mandated and this can be especially important in cases of greater complexity.
Mandatory rotation could be a convenient solution for companies wishing to remove their auditors without attracting public comment.
Rotation in practice
In addition to the points above, at present of the OECD countries, only Italy has mandatory auditor rotation. Brazil and Singapore have recently introduced it (for financial institutions and banks respectively). On the other hand, Turkey, Slovakia and Spain which previously operated such a system, have subsequently reversed their position after the rotation regime was seen to create more problems than it solved. Some other countries, most notably Ireland, have recently considered rotation and rejected it. The Chairman of the Securities and Exchange Commission (SEC), Harvey Pitt, has recently spoken out against the concept.
It is already a requirement for the lead partner on an audit client to rotate every seven years. Moreover, research and considered opinion from academia, regulators and the profession all point towards rotation of audit firms not being an effective means of improving independence or audit quality.
This is a reform where the disadvantages far outweigh the advantages. There is no clear evidence from those countries that have, or have had, rotation that there has been any improvement in audit quality. UK company law already requires shareholders to appoint auditors annually and the Combined Code requires the audit committee to keep under constant review the independence of the auditor. The Audit Committee (suitably empowered and effectivesee previous comments) is the right forum to provide the necessary corporate safeguards regarding the independence of auditors.
REGULAR RE -TENDERINg Of AUDIt WORk
What is it?
Requirement for regular re-tendering of audit work, but not to rule out the possibility that the current auditor would be reappointed.
Less intrusive than rotation because it keeps the decision with the plc and allows them to reappoint if they wish
Breaks assumption that auditors will be reappointed and forces audit committee to ask themselves direct questions about audit performance
Gives other firms the opportunity to set out the case for a fresh pair of eyes
Can be implemented without primary legislation
Cost and inconvenience to client and auditor
Companies may sometimes put their audit out to tender in order to reduce fees rather than to improve quality or independence
Regular re-tendering could be a convenient solution for companies wishing to remove their auditors without attracting public comment.
If Audit Committees are reformed in the ways suggested above, they should be able to deal effectively with issues around auditor independence without the need to enforce such drastic change. We believe there is not a strong enough case for mandatory regular re-tendering of audit work.
LIMITATION ON PROVISION OF NON-AUDIT SERVICES BY THE AUDITOR TO AUDIT CLIENTS
What is it?
To impose limits on the amount or type of non-audit work which an auditor can do for an audit client. This would most likely involve imposing specific service prohibitions which would significantly modify or completely replace the existing conceptual frameworks for auditor independence (supplemented by detailed guidance) as recently adopted by the International Federation of Accountants and reviewed, post Enron, by the European Commission.
Might serve to heighten perception of independence
Can be implemented without primary legislation
Many non-audit services provided by audit firms equip the auditor to perform the audit more effectively and the skills involved are an integral part of auditing a modern, complex and sophisticated global business.
Prohibition or fixed limits would encourage a narrow mindset of adherence to rules which would most likely undermine the existing frameworks which require the auditor to identify independence threats and then consider how, if at all, those threats can be managed through safeguards.
Prohibition restricts the freedom of companies, and their audit committees to choose their advisors.
The key worry has been the provision of high value implementation consulting services by the auditor. All of the larger firms either have or soon will have sold their consulting businesses.
Prohibition would undermine the Multi-Disciplinary Partnership model which has been the cornerstone of the appeal of the sector to the graduate market and has been consistently endorsed by various bodiesmost recently the OFT.
It is perfectly appropriate that the Audit Committee should have a significant role to play in bolstering shareholders' confidence in the independence of its auditors. The UK auditor is now required under auditing standards to engage in a constructive dialogue with the Audit Committee over matters of independence and to make an annual confirmation of independence to the Audit Committee. Any cases of uncertainty will be discussed with the Audit Committee before any engagement is accepted. We are already seeing Audit Committees demonstrating their active consideration of these issues. Moreover, we believe the Audit Committee should determine the scope and level of non-audit fees.
These views are of course being considered outside the UK and it is again notable that Harvey Pitt has also spoken out against limitation on provision of non-audit services by the auditor to audit clients.
The Enron situation has clearly highlighted a range of concerns about the current operations of the capital markets and the need for improvements at many levels. This requires actions by standard setters, auditors, regulators, audit committees and other participants, to restore investor confidence. We at KPMG are committed to doing our part to see that the necessary and appropriate improvements are made.
This paper sets out where we believe firms should act to make themselves more open, more accountable, and more committed to active community engagement. We commend to the Committee certain key reforms as discussed above:
Expanding the authority of Audit Committees
Improved and more wide-ranging Operating and Financial Reviews (OFRs)
Improved disclosure of non-audit fees
Further strengthening of the independence of the current regulatory structure
Further development of International Standards for both Accounting and Auditing.
We believeparticularly in relation to the strengthening of the Audit Committeethat these would ensure that the UK has an enhanced robust framework for the effective governance of public limited companies.
8 April 2002