World Bank Presentation
3rd October 2005
Iain Richards, MFM
Introduction
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By way of introduction I should note that I am neither an accountant by
training nor by profession.
In the way of these things, the views I am proposing to outline should be
taken as reflecting personal views rather than, necessarily those of my
organisation.
Today's talk is intended to provide a view of the broader context in which the
three papers about aspects of audit, which were circulated as handouts, are
set.
Discussions about financial reporting and auditing often become circular, debating
the respective interests of a variety of users of accounts, the capital markets,
regulators and the profession, as well as their respective time horizons and biases.
The view I propose to outline today is un-ashamedly derived from a long-term
shareholder perspective on audits and the financial reporting framework around
which they are based.
Our interest in, and the importance we attach to audits goes directly back to the
reasons for their introduction. In our view, the audit exists to address information
asymmetries and the agency problems that exist between property owners (the
shareholders) and those charged with the stewardship of that property (company
directors and management).
Its introduction reflected a need made painfully clear by financial reporting failures
and corporate fiascos, as was the introduction of the related accountability
framework.1 The aim was to ensure effective, reliable and meaningful reporting that
safeguarded against the inherent self-interest bias that could affect the presentation
of a company’s performance and directors' stewardship.
In this context the UK model is based on owners’ “right to have” effective and
meaningful reporting. This contrasts with the US model which is sometimes
characterised as being regulatory assurance about information users are deemed to
“need to know”. The distinction is an important one.1
The differences and the reasons for them have been extensively explored in papers
written in both the UK and Australia, which I would be happy to share with those who
are interested.
The divergence that arises out of these differences is, however, at the root of the
material issues of concern and debate that exists around the race towards
international convergence and, potentially, harmonisation (if such a thing is even
possible).
1
: see Addendum 1
As long term investors, we have a fundamental interest in monitoring and assessing
the performance and stewardship of the companies we own – not in looking for
regular forecasting exercises as market trading catalysts.
For different reasons we have the same ultimate interest in emerging markets. In
say, Asian emerging markets, there is a fundamental issue arising from lack of
liquidity that is exacerbated by poor shareholder rights, weak regulatory framework
and (often) ‘cultural norms’ / local market practice.
Whether as a long-term investor or an investor in riskier more illiquid stocks, the
stewardship/substance-over-form model of financial reporting and auditing has great
value for us – you could even say is vital to us.
While the investor voice may now be getting more vocal, publicly, the issues that are
being flagged are not new. Our organisation has been trying to flag them, to little
effect, since 2003 (Hence becoming more vocal about what we see happening).
The catalysts for this investor concern have been threefold:
(i)
(ii)
(iii)
The direction and effects of the international convergence campaign
The quality and effectiveness issues around audit
Accounting firms' continual & continuing manoeuvring for ever more liability
protection.
Each one exacerbates the others.
In the context of what I have said I would hope it is apparent that we attach (or
perhaps I should now say, attached) considerable value to the role of traditional
accounting and to receiving relevant and reliable information that gave a true and fair
view of the company’s performance and the stewardship of our assets, or, if you
prefer, capital. Its focus on providing objective and prudent information on the
sources, uses and changes in capital and on the protection of that capital was pretty
close to our hearts.
In comparison the US model and, increasingly, the international model focus on an
asset-liability approach. An approach which focuses on, effectively, forecasting
future cash flows on the basis of assumptions and judgement. These are based on
management’s views of its ability to deliver and on its views about external factors
outside its control.
If anyone is interested in exploring the nature and implications of this in detail I would
be happy to provide a couple of papers which analyse this further. It is, partly, on the
back of this that changes to audits are being excused as inevitable (that is once you
get to an admission that there is a change).
It is not that shareholders can't see benefits in aspects of fair value accounting,
because we can in some respects. What we do not accept is the extreme to which it
is being taken to the exclusion of all else.
It is beginning to appear that accountability and, indeed, stability are being
surrendered and made hostage to the vagaries of the international capital markets.
Now there is a frightening thought!
We are increasingly concerned that the super tanker of convergence is going offcourse and we can only hope policy makers realise and appreciate the implications
before its too late. From 2 years' bitter experience we see little prospect of
addressing it through UK channels. Keeping to the super tanker analogy, its been
about effective as sailing a dinghy in front of a super tanker under full steam hoping it
will change course for us. It has been both a revelatory & bruising experience.
The latest phase of the international dimension of the debate is already underway in
the form of the IASB-FASB project on the conceptual framework.
While cast as a pause for thought and review of the conceptual framework to be
used, once you read the project summary and explanation it appears that its clear
purpose is harmonisation of the existing IASB-FASB models, with little more than
token acknowledgement of the wider interests/options.
For example, this already appears to be going down the route of an entity reporting
concept for a wide range of users (although that might be a recognition of the fact the
focus is no longer fully meeting shareholders' needs but rather those of market
analysts and trading).
There is a hierarchy of users of financial reports that ranges from the share owners,
through creditors, potential investors and on to wider elements of society. It is
however the shareholders who are the ultimate owners of a company and if their
performance, stewardship and accountability needs are met, all those who rank
ahead of them should be satisfied too. Equally, if information does not satisfy
creditors needs it won't ultimately meet shareholders – hence the long standing focus
on the share owners as the clear focus of reporting.
The wider needs of different groups are often specialised and are often best met by
developing specific reporting to meet those needs. Sundry ad hoc additions and
amalgamations of such requirements are riddled with risk. Such a trend together
with a dilution of the focus as to who financial statements are prepared for will further
undermine and distort the process of reporting and accountability to the owners.
Reasserting and securing this core focus of financial reporting would help clarify
related aspects of their focus. This includes the risks of moving away from the
‘parent’ view to an 'entity' view, which combines the interests of shareholders with
those of underlying ‘minority’ non-controlling interests.
Quite aside from being confusing to shareholders and others, it is probably
meaningless to the underlying minorities. In addition, the accounting consequences
could prove odd. How would transactions in the equity of a subsidiary be accounted
for? Presumably as transactions with owners and, hence, not taken through the P&L
income statement. Would earnings really be an aggregation of shareholders &
minorities’ income?
I hope this sense of a need for clarity and focus highlights the importance of reestablishing the accountability and stewardship model, with the useful additions - not
replacements - that can be drawn from the asset-liability methodologies.
So what is the consequential divergence that has been seen in the audit? It focuses
around the questions of rules-vs-principles and form over substance.
There has always been scope in accounting to game the numbers but the need for
an unencumbered opinion from the auditor on whether the financial statements give
a True & Fair View of the state of affairs of the business has been the safety net
shareholder hope to rely on.
Sadly convergence towards the US accounting and auditing model and the reliance
on asset-liability forecasting has led the UK to get a brutal wake up call from such
things as:
(i)
The proposed adoption of ISA (e.g. ISA 700 which, amongst other things,
redefines the True & Fair View as meaning 'fairly presents, in material
respects, in accordance with the standards’)
(ii)
The attempt by standard setters to get the legislative framework changed in a
way that matches standards and effectively delegates the key principles to the
standards.
Giving auditing standards a quasi-legislative basis can have some potentially
perverse consequences, as those of you read the Australian Auditor General’s
comments in the handout “Undermining the Statutory Audit …” will know.
At present, under the UK’s principle based approach, auditors duties are not
presently limited to compliance with standards but rather are still subject to the courts
and legal precedence based on the overarching legislative principles and
requirements. The pressure to change this by the profession is however slowly
working, with increasing acceptance apparent amongst standard setters.
It’s worth emphasising the current nature and purpose of the audit in the UK which
was articulated in the Caparo-vs-Dickman case. It is the auditor's function to ensure
that so far as possible the financial statements accurately reflect the company’s
position:
(i)
To protect the company itself from the consequences of undetected errors
(including omissions) or, possibly, wrongdoing.
And
(ii)
To provide shareholders with reliable intelligence for the purposes pf enabling
them to scrutinise the managements affairs and to exercise their collective
powers.
Simple & clear!
[There is additional explanation of the purpose of the audit handed down by the Law
Lords in the case, which is worth being aware of.]
As Halsbury Law puts it (e.g. on the balance sheet).
“It is the duty of an auditor to verify not merely the arithmetical accuracy of the
balance sheet, but its substantial accuracy and to see that it includes the
particulars required by the articles and by statue and contains a correct
representation of the state of affairs of the business”.
“That doesn’t mean it is his duty to consider whether a business is prudently
run, but whether the balance sheet shows the company’s true financial
position”.
“To do that, an auditor is expected to examine the books and take care to see
that their contents are substantially accurate”.
“He must place before the shareholders the necessary information as to the
company’s true financial position and not merely the means of acquiring it”.
Put another way by Lord Denning in Fomento vs. Selsdon Fountain Pen Co.:
“An auditor is not to be confined to the mechanics [these days we would say
processes] of checking vouchers and making arithmetical computations, he is
not to be written off as a professional 'adder-upper and subtractor'. His vital
task is to take care to see that errors are not made, be they errors of
computation, or errors of omission or commission or downright untruths."
A similar sense used to be apparent in the US system. The most obvious example
being the Continental Vending Case (United States vs. Simon 1969) where it was
deemed that the critical test was whether the financial statements as a whole fairly
presented the financial position of continental. Compliance with standards was
evidence of this but was not necessarily concluding. The resulting conviction and the
principle were upheld on appeal.
While this view held good in subsequent cases in the 1970s, more recently in the re:
Calpine Corp. Securities Litigation in 2003, the Court found racy accounting to hide
the Company’s true financial results could not be held improper as the case failed to
allege how the practices adopted violated any accounting standard. Is this really the
route policy makers and standard setters want to go down post-Enron? [a mix of the
liability limitation agenda, supported by the perceived nature of increasingly rules
based framework that encompasses increasingly subjective, assumption based
accounting?]
In addition, to have credibility, accounting and auditing have to address creative
compliance something it is nigh on impossible to do with a rules based process
driven framework.
As one leading accountant put it:
“It is a brave standard setter indeed who can be certain to have covered
every possible situation, both current and potential, and to have provided a
detailed rule for it. A set of principles can cover every situation whether
foreseen or unforeseen – rules encourage avoidance, principles encourage
compliance”.
[Will we ultimately be left with a framework that takes us down a similar route to the
one that has given us the Tax avoidance industry?]
In the early 1970’s the SEC became concerned about a proposal in a draft auditing
standard that defined “fairness” in terms of conformity with GAAP. They got it
removed. In the UK we appear to be seeing a similar trend/issue within ISA 700.
This issue, which emanates from IFAC and the profession, goes to the heart of many
corporate debacles and the actual audit failures that enabled them to reach critical
stage [again there is a strong liability limitation agenda apparent - 'righteous by
process'.]
A recent example is probably the UK’s Equitable Life failure. The investigation by
Lord Penrose noted problems with both this and the limitations created by the
drafting of standards. While reaffirming that judging audit practice/failure was not
within the scope of his investigation at the end of his conclusions he noted – rather
tartly perhaps – that at all material times and auditors could assert that they had
acted in accordance with the applicable standards.
The initial investigation by the profession’s Joint Disciplinary Scheme
(www.castigator.org.uk) led to the counsel filing complaints against the auditors that:
(i)
For 1990 to 1993 the audit did not comply with the statutory requirements
(ii)
For 1994 to 2000 the audit failed as a true & fair view was not shown
(as well as on failings in terms of the depth of the audit re: understanding, and over
inadequate objectivity and independence.)
The UK has seen its key safeguards eroded already despite recommendations to the
contrary by Parliament. Let me explain:
In 2002 the UK’s Treasury Select Committee undertook an inquiry into Enron and the
lessons for the UK framework. The Bank of England confirmed that the UK’s True &
Fair View principle would have caught Enron. On questioning the Auditing Practices
Board confirmed this and the role of FRS 5, on the substance of transactions, which
underpinned it in the given context. The Auditing Practices Board also
acknowledged that this would be weakened by the adoption of international
standards unless they were improved – (guess what, they were not).
The TSC conclusions and recommendations were that no dilution of standards
should be allowed; the True & Fair View should be retained; and the UK’s interests
should be maintained in the development of a common EU approach.
So what happened? Looking into it, it seems apparent that the governance of
standard setting is another important issue that can not be overlooked.
In the context of the IAASB, we believe it is essential that the independence and
perceived conflicts of key individuals and groups involved needs careful scrutiny in
the deliberations that take place.
[IAASB: 14 out of 18 members seen as Big4 / Global Firm representatives; IFAC
chairman still appointing members; members terms and stated roles call into
question its focus and independence]
With accounting standards we saw the global firms reinvent their role through IFAD,
to drive the convergence debate. That same risk of underlying control of the agenda
around ISA must be borne in mind.
I’ve barely touched on the question of further propagation of the standards to
emerging markets. It’s not a particular area of expertise for me, but I’d like to
highlight some themes from discussions we have had about it.
I’ve already mentioned the importance we would like to attach to financial reporting in
the emerging markets. Do auditors and ISA’s have a role to play? I’ve highlighted
just some of the concerns we have about ISA’s in the context of current international
convergence and our view as shareholders.
Stepping back though, in emerging markets any improvements in the rigour of
auditing would be welcome. But there are still issues that people should be aware of.
I haven’t touched on the question if competition which is reaching a critical point.
Whatever the perceived merits of the recent KPMG settlement in the US, the issues
and near-panic about the potential loss of another so called Global Firm is telling
about the problem we face.
Is helping to open the emerging markets in a way that benefits the Big 4 really
desirable? It may be inevitable, but at some point policy makers are going to have to
address the complex monopoly that exists?
That monopoly hardly operates in the public interest when considered in the context
of the purpose of the audit. The US PCAOB report on KPMG highlighted that 1 in 4
audit reviews raised significant issues. How many would it have been if you dropped
the significance test?
In the UK the POBA's Audit Inspection Unit review of the Big 4 highlighted numerous
worrying practices and shortcomings. Most notable were indications that audit
quality had been replaced by revenue generation in appraisal systems and as the
criteria for partnership promotions. So before promulgating a framework that plays to
the Big 4 approach, policy makers may want to consider the long-term role and clarity
of purpose around audits on a back to basics basis.
However, that said there is a sense that in emerging markets the Global Firms often
bring a more rigorous approach with a lower tolerance of abusive practice and lower
thresholds for audit qualification. This appears to be generally supported by
academic work I have seen highlighting the greater effectiveness of these firms in
controlling gaming that breaches the rules, although there is little evidence that says
that the level of earnings management within the technical constraints of the rules is
any different.
Cases like the recent Reichi Precision Co. (Taiwan) one don’t create certainty and
clarity, so while audit is valued, the sense is that investors are still working out what
to make of the changes being seen.
Conclusions
Building on the context of the themes I have discussed, what might shareholders
ideally hope to see?
 To be truly effective the conceptual frameworks for financial reporting and
auditing must be clear, meaningful and effective. We have a rare opportunity to
step back appraise and reconsider the international agenda - Yes to effective
convergence – No to shoe-horning the whole thing into a theoretical model that
fails to meet the needs of accountability and stability.
 Retain the core elements of traditional accounting with assets-liability additions,
not replacements. So, for example in a statement of comprehensive income, we
might see, say, three columns along the lines of: (i) actual tangible performance
in the year (ii) the additional 'fair value' forecast elements and (iii) adjustments
made to previous fair value forecasts.
 A return to the True & Fair View basis of accounting and focus in unencumbered
audit opinions that are not captured and/or redefined by standards.
 However, given the way practice and standards have developed, this may no
longer be enough and greater clarity in the overarching and overriding principles
is probably needed, e.g. on audits:
(i)
The purpose of the audit must be clearly recognised [ref: the Caparo-vsDickman case referred to earlier].
(ii)
The application of skill, care and diligence [Its worth highlighting that one of
the failings we see in the audit is a fixation on building in the dangerous
concept of “reasonable assurance” effectively ISAs imply that “giving people
reasonable” is a bottom approach built into every level of the audit. If you
build something on, say, 90% assurance, you end up with 65% assurance.
Audit is a far more complex aggregation. Reasonable assurance is what
users will choose to varying degrees to attach to the audit not something
that should be made into an integral part of the building blocks of an audit].
(iii) avoiding standards the focus on compliance with rules & essential process
based standards that, not least, are seen as a liability limitation mechanism.
 See also the handout "Audit Reform a focus on purpose and transparency"
We work with and greatly value many members of the auditing profession including
those at the coal face. Their good advice and insights have been welcome and
helpful and we want to re-empower these people to act effectively on our behalf.
On that note I will wrap up and I hope this was helpful in providing a flavour of the
shareholder perspective and the reasons why there is increasing concern about what
is happening in terms of financial reporting and the audit.
END.
ADDENDUM 1
A potted history of UK Audits and their purpose
The UK the statutory corporate audit was first introduced in 1844, abandoned (for most
sectors) in 1856 and reintroduced by the Companies Act, 1900. Following the City Equitable
Fire Insurance Co. Ltd debacle (a massive fraud that destroyed the business, where the
auditors were found to be repeatedly negligent but absolved from liability as a result of the
limitations that had been adopted - a familiar concern in the current context) the current
liability framework was introduced in the Companies Act 1929. This is now reflected in
sections 310 and 727 of the Companies Act 1985.
The Statutory Audit in the UK has been explained in Parliament as being required in the
interests and protection of the public and, in that context, the duty owed by auditors
formulated as one owed to the shareholders of the company as a group.
The purpose of the audit was to act as a safeguard and check on agency problems and costs
that arise from the separation of ownership and control in companies. These relate to the fact
that the agent, as ‘utility maximizer’, may not act in the interest of the principal (striving rather
to obtain what is in their bests interest) and the existence of information asymmetries that can
aggravate this and the effectiveness of (in particular financial) reporting to shareholders.
A potted history of US Audits and their purpose
There is often a lack of recognition of the critical differences between the financial reporting
and accountability frameworks of boards and auditors in the UK compared to the US. US
audits were introduced as part of the introduction of financial reporting requirements in the
1930s.
For historical and competitive reasons, Company Law in most US States did not require
financial reporting and offered little in the way of shareholder rights. Attempts to address this
had little success until, following the Wall Street Crash in 1929, the Federal Government was
forced to intervene. In doing so, however, the Federal authorities were forced to take a
divergent and fundamentally different approach to the UK’s.
This difference of approach reflected the limitations of Federal Law in its interaction with State
Law. The US approach had to be based in Securities Law (under the 1933 Securities Act),
which deals with the sale of securities, rather than in incorporation law (as in the UK) which is
the preserve of State Law.
Unlike in the UK therefore, the US system is not concerned with laws of property and rights
but, rather, is primarily concerned with market pricing, a ‘general-purpose’ function. As a
result the US system does not have the same governance and stewardship function, or
system of accountability, as the UK’s. The associated development of US audits (see below)
took place in this context.
Differences in the Audits
US - audits appear in practice to be a process based, technical compliance check, which is
intended to provide reasonable assurance that accounts being filed with the SEC (note unlike
the UK they are not presented to shareholders) are ‘fairly presented, in material respects’ with
US GAAP (i.e. what is deemed the 'need to know'). Seen from another angle, as put by one
part of the accounting profession: "US-influenced audit standards are heavily influenced by
the ‘tick box’ approach which has the aim of demonstrating that the auditor has not been
negligent. In our view, this reduces the essential technical quality of an audit." (Extract from
an Association of Chartered Certified Accountants (ACCA) submission to the UK's
Department of Trade and Industry, March 2004).
UK - audits are a public interest safeguard, offering shareholders a report containing an
opinion on whether the accounts provide a true and fair view of the state of affairs of the
business. This has the purpose of, first, protecting the company itself from the consequences
of undetected errors, omissions or, possibly, wrongdoing and, secondly, to provide
shareholders (as owners) with reliable intelligence for the purpose of enabling them to
scrutinise the conduct of the company's affairs and to exercise their collective powers (a 'right
to know').