Rarely, if ever, have the newspapers carried so much coverage – both in reports and commentary – on accounting issues, both technical and political, than in the immediate aftermath of the Enron case.
Despite the emphasis that has been given to the role of Andersen in the Enron affair, the problems exposed by the largest bankruptcy in US history go much deeper than a possible breakdown in auditor performance. Enron 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. This article sets out ACCA’s views on each of these issues.
Capital market regulation
The collapse of Enron 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. ACCA considers that there should be a mechanism which requires both major corporations and institutional investors to provide the resources needed to ensure that the markets function properly – perhaps via an externally administered levy which confers no influence at the regulatory level.
And 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 ACCA argues, however, that local solutions should be based on principles which are agreed at the global level. National regulators and others will need to be prepared to give up a measure of control over their domestic activities in return for influence over global developments.
Financial reporting
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.
By specifying precisely where the line is to be drawn, legalistic, rules-based standards encourage those who wish to operate as close to the line as possible, or even to test the limits. They enable the exploitation of loopholes and devalue professional judgment.
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 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 .
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.
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 years – from railroads to dot.coms – have 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.
Auditor independence
Enron, and all the other cases which have attracted attention, have demonstrated the need for greater transparency and trust The global financial community should address this as a matter of urgency 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, 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 audit staff have moved to senior executive roles in client companies – this could take the form of a moratorium prohibiting auditors from moving to audit clients for an appropriate period after they have been personally involved with the audit.
There is also the issue of the size of the audit fee relative to the local office which is providing the service and the fee generation target(s) set for the engagement partner. While this cannot be dealt with by prescriptive regulation, audit monitoring should focus on the culture within audit practices and the pressures on individual engagement partners.
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 fulfill the role of appointing auditors but for multinational companies a global, not national, approach would be necessary. This approach would require the full backing of regulatory authorities worldwide. An alternative approach would be for non-executive directors and corporate audit committees to have a much higher profile role in the auditor appointment process.
Audit monitoring
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.
The UK system of quality control 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».
Non-executives and the risk management process
ACCA believes that the ultimate responsibility for ensuring effective corporate governance – including the implementation of robust internal control and internal audit mechanisms – rests 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
The concept of payment for performance is 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.
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.
Non-executive directors
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.
The independence of non-executives is another critical issue – much 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.
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 behavior, 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. ACCA believes that 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-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 regulators – such as IOSCO – and other global organisations – such as the International Federation of Accountants – to develop and promote compliance with a global governance code.
Wider disclosure and accountability
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: investors, who are right to demand plain language 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 entitles to know how a business responds to the wide range of risks facing it.
Our key suggestions
In summary, therefore, ACCA suggests that:
- global financial markets need a global set of principles-based financial reporting standards and a global code of corporate governance;
- 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 markets – both major corporations and institutional investors – should 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.
Enron should be the catalyst for improvements in a range of areas affecting company reporting and governance.
The article «Enron – next steps» was published in April’s issue of ACCA newspaper Accounting & Business. ACCA Russia Representative Office can be contacted for local queries by telephone: (095) 737 5542 or e-mail: ilya.yuferev@accaglobal.com.