Round table: Fixing a broken system

Enron and subsequent corporate scandals have destroyed public confidence in the business world, in capital markets and in the reliability of financial reporting. How that confidence can best be rebuilt is a matter of fierce debate. But what is beyond argument is that the system is broken and it needs fixing – fast. No industry has come under greater fire than the accounting profession in the wake of the business scandals. Global Agenda asked senior executives at the Big Four firms – Deloitte Touche Tohmatsu, Ernst & Young, KPMG and PricewaterhouseCoopers – for their views on how confidence in corporate and financial reporting, and in their own profession, can be rebuilt

GLOBAL AGENDA How can confidence in the accounting profession be restored?

NICK LAND The issue, first and foremost, is to restore confidence in corporate and financial reporting, particularly in the US and other developed countries.

This includes, of course, the role and regulation of auditors, but also the underlying basis for US GAAP [Generally Accepted Accounting Principles], regulation of investment banks, better disclosure of directors’ compensation and better corporate governance worldwide.

In the US and the UK, we hope a series of corporate reform efforts will begin to repair the public’s shaken faith in our financial markets and in the business environment.

Despite everyone’s desire for a quick fix, there are no silver bullets. Trust and confidence will only return through a commitment by all market participants to high quality, uncompromising integrity and sustained performance excellence.

In the longer term, we hope that there will be a rapid move to a position where global standards – accounting, auditing and ethical – prevail.

But professional bodies in the world’s major capital markets need to begin a long-term campaign to help explain to investors, the media and other stakeholders the role of auditors and what audits can and cannot achieve.

JIM COPELAND The passage of tough new laws may give the investing public an initial sense of security around reform, but true confidence in the accounting profession won’t be restored until everyone involved – management, audit committees, boards of directors, and accounting professionals – performs by consistently doing what they know is right each and every day.

When everyone who is actively involved in the process of accounting and auditing discharges responsibilities with the highest levels of integrity, the quality of financial reporting will improve and confidence in our profession will be bolstered.

There is a real need to educate the investing public on the role of the auditor, which is to reduce risk, not eliminate it. Certainly, greater transparency and communication of the roles and responsibilities of management, boards, audit committees, and accounting professionals will help in this process.

In addition, we advocate creating a board to investigate impartially and report publicly on the cause of financial “crashes” – something similar to the role played by the US National Transportation Safety Board in investigating transportation disasters.

SAM DIPIAZZA There is no question that we have work to do to regain the confidence of the investing public. We are eager to start working with the new Public Company Accounting Oversight Board, established by the Sarbanes-Oxley legislation, to improve investor confidence through a more effective inspection and disciplinary process. We also believe that better corporate transparency is the key to regaining public trust and we will continue to advocate more thorough and meaningful disclosure of information by companies.

MIKE RAKE We must not be complacent. Confidence has been dented. It will take time for confidence to be restored. For that to happen the profession must embrace sensible reform – an enhanced role for audit committees, independent oversight, greater transparency in the operation of accounting firms and more frequent rotation of audit partners.

To promote and deliver the highest standards of assurance we need to move as quickly as possible to one global set of accountancy protocols. These should be firmly rooted in a principles-based approach, underpinned by a more consistent model of corporate governance across the world.

GA How have you changed your practice in the wake of the recent corporate scandals?

DIPIAZZA We are confident of the integrity and quality of our audits as well as the other advisory services we provide clients. However, we are always reviewing and improving all of our practices. We have also taken a number of concrete steps to address the perception of conflict of interest in our industry in light of the corporate scandals.

Most importantly, we completed the sale of our consulting business to IBM in October last year – finalizing a process of separating our consulting business from our audit business that began two years ago. In the US we also sold our business recovery services, corporate value consulting, and human resources outsourcing businesses in order to get back to our core competencies – providing assurance, tax advisory and other advisory services related or complementary to the audit. In addition, we have taken steps to improve disclosure within our own organization. This year we published our first Global Annual Review, a 40-page report on our global quality, risk management and independence programmes. Our US firm has begun disclosing partner compensation and evaluation policies to audit committees.

LAND We have reviewed in detail our risk management policies and processes and are regularly reviewing and developing our audit methodologies and will continue to do so. We have also reviewed the nature and focus of our learning and development programme.

We will, however, be re-emphasizing the importance of integrity and objectivity as a cornerstone of our culture and also re-emphasizing our commitment to quality.

RAKE For a long time now KPMG has had a programme of robust global risk management. Well before Enron we had rolled out an update of this whole programme to all our partners. The need for consistent international standards has become clear and so we have been implementing the new IFAC code on auditor independence – which we strongly support – and we will be even tougher in ensuring and policing consistent high standards across the globe. This underlines the core of the KPMG way – which is the primacy of technical excellence and sound professional judgement, backed up by strong consultation as well as rigorous inter-office and independent reviews.

COPELAND When you see the pain associated with any audit failure, it is clear that we all must do better – and we will. We have to raise the bar – for our own performance and for our profession. It’s important to note, however, that most recent scandals have been first and foremost business failures, but that doesn’t mean we can’t initiate a process of continual improvements in the quality of audits.

To get there, Deloitte is engaged in an intensive self-examination, which has already resulted in effective change. We want to ensure that we are doing everything we can to affirm and enhance our commitment to ethical and competent performance.

For many years, we have built ethics into our professional education curriculum, but we’re taking a fresh look at our course content to assure ourselves that ethics and integrity are sufficiently emphasized – and our expectations properly communicated. We are also placing new emphasis on this aspect of the recruitment and performance evaluation tools we have in place. We need our people to be constantly vigilant and alert to situations that we should be concerned about – whether in a client organization or our own.

GA What do you feel most ashamed and/or proud about?

RAKE I am extremely proud of the robust and independent way in which our people have dealt with many difficult client situations – which never hit the headlines. Across the globe I am proud of our 100,000 people who are highly trained, professional and responsible, providing a range of essential business services to organizations as diverse as major multinationals and local councils – adding huge value to our clients, their local communities and to their country’s economy.

I am disturbed and embarrassed by the vilification that our profession has had in recent times. It has clearly had an adverse impact on our people’s morale. It was a tragedy that the actions of some individuals have not only contributed to a loss of confidence in the capital markets but have led to ordinary people losing their jobs, savings and livelihoods. We need to do everything in our power to restore the reputation of audit, which is at the core of the effective working of the world’s capital markets.

DIPIAZZA I am most proud of the people of PricewaterhouseCoopers who come to work every day and enthusiastically serve their clients. It is their strength of character and dedication to integrity that will ultimately repair the reputation of the profession.

LAND I do not feel ashamed about anything to do with E&Y;’s business. Like all leading businesses, we work hard continually to improve what we do.

I am proud of many things, particularly our culture, which is based on openness, transparency and consultation and our ability to harness the power of our global capabilities without being centralized and bureaucratic.

Globally we’re pleased and proud that Andersen firms in 57 out of 83 countries chose to join E&Y; in 2002. Also, more former Andersen clients around the world chose E&Y; than any other Big Four firm. We’re very proud of that.

COPELAND We are extraordinarily proud of our people in the US who worked through adversity and personal inconvenience following the attack on the World Trade Center in New York. Deloitte was the only Big Four firm that had a major presence in the WTC district and we were knocked out of our World Financial Center offices for 11 months. It took extraordinary courage and dedication of our 3,000 people who were affected to think of their clients first, and carry on working in a number of different locations.

As to any regrets, we have not succeeded in helping the investing public understand both the benefits and the limitations of the audit services we provide. Too often the discussion takes place following the relatively rare, but nonetheless painful, failure that impacts investors and other stakeholders. That is not the time to educate the public, and we need to find a more effective means of helping investors understand the benefits and limitations of financial statement audits.

GA Do you support the introduction of International Accounting Standards?

RAKE Absolutely. We live in a global economy dominated by major global corporates and they should report their financial position and be audited in a consistent way from country to country and continent to continent. I support the adoption of International Accounting Standards [IAS] and I applaud the EU for agreeing to implement them by 2005 – it is a challenge for others to follow. I am very pleased that many in the US now see the benefits of moving towards a principles-based approach.

DIPIAZZA Absolutely. And we applaud the European Commission for mandating all EU member states to adopt International Accounting Standards by 2005 as well as steps currently being taken to converge US GAAP with international accounting standards. However, we would like to see an entirely new set of standards emerge that are truly global in nature – we call this “Global GAAP” – and that would allow investors to compare the performance of any company in any industry with any other in any country in the world.

It has always been my view that US GAAP relies too heavily on rules rather than substantive principles and a rules-based system leads more easily to financial engineering, which, in my opinion, is in part to blame for the accounting and corporate crisis we now find ourselves in.

COPELAND We support convergence around high-quality accounting standards. Investors and issuers will need to have a say on what form they eventually take, but if the standards eventually adopted are high enough, convergence will speed the emergence of larger, more integrated and more efficient capital markets.

The EU’s decision to move toward IAS by 2005 will give an early indication if this is correct. It’s important to remember that, whatever the eventual course, a huge investment in education and infrastructure will be required. Having common, high-quality standards is a good idea, but we need the people and the tools to apply them wherever they may be adopted around the world. It is, at best, a long-term project.

LAND Absolutely. The prize is, of course, global accounting standards – in other words, that national GAAP is subsumed by global standards. The recent corporate scandals have given much more impetus to this goal.

GA Do audit committees have enough power?

RAKE No. In some significant jurisdictions there is still no requirement for listed companies to have audit committees. And even where they operate, in many instances they are not really effective and sufficiently independent of management. However, many audit committees have begun to assert themselves since Enron and WorldCom and this is absolutely right.

An effective audit committee, with clear responsibilities and reporting to shareholders, can play a key role in reviewing the quality of the audit, auditor independence and ensure that management are acting in the interests of the shareholders. Periodic reviews of the audit appointment and pre-approval of non-audit services would, in our view, be more effective than other proposals such as mandatory rotation of the audit appointment and the prohibition of certain categories of non-audit services.

Audit committees should comprise wholly, or largely, non-executive directors with enough time and resources to effectively carry out their role. We must get to a situation where there are effective audit committees in every jurisdiction and that they consist of high-calibre people who are well trained and have the time to do a good job. In our view this would support our long-held proposition that auditors work with the management but for the audit committee representing the shareholders.

LAND There is no doubt in the UK and elsewhere that audit committees will increasingly take an “active” rather than a “passive” role, including monitoring auditor independence. The people who sit on audit committees know they must guard their own independence, and be vigilant about protecting investors’ interests.

COPELAND There is a difference between the powers conferred in a contract or charter for an audit committee and the power they exert through their activism and knowledge of finance and accounting. We have been working over the years to guide businesses on deploying both kinds of power on behalf of their shareholders and stakeholders. Even before the recent scandals, our Corporate Performance project with the World Economic Forum was identifying best practices in this area for boards and audit committees.

DIPIAZZA There are significant differences in corporate governance around the globe but audit committees in the US now have appropriate authority in part because of Sarbanes-Oxley.

Ineffective audit committees often haven’t sought the information needed on the company’s industry, business, accounting and financial reporting issues, and relevant information about the internal control and audit processes from management, the external auditor and internal auditor, and haven’t probed deeply enough to be positioned to know what problems might exist in financial reporting. Without relevant information, the audit committee can’t be positioned to do what it might need to do, regardless of the authority it has.

But the real question is whether audit committee members have enough knowledge, experience and integrity to fulfil their fiduciary role. Do members understand their responsibilities and the time and commitment needed to carry out those responsibilities effectively? While some audit committees are still in denial – believing what they’ve been doing all along is just fine – most are taking the new law seriously and are concerned enough to modify their behaviour. How much is changed remains to be seen.

In theory they have enough power. The issue is how they exercise that power and – to some extent – the shortage of independent directors with requisite skills.

GA Is compulsory rotation of auditors a good idea?

DIPIAZZA If the goal is to limit the knowledge and expertise of accountants performing a company’s audit, then audit rotation is an excellent way to accomplish just that.

But if the goal is to have quality audits that are based on in-depth knowledge of a company and its complexities, then the mandatory rotation of audit firms is a mistake. If a company must rotate its audit firm every five years, the new auditors take a year or two to get up to speed on the company.

They do not have the benefit of staggered rotation of personnel or prior year auditor documentation to identify important risk factors that must be considered in determining audit scope. The Sarbanes-Oxley legislation requires rotation of audit partners within a firm, not firms – a decision made after much debate. We believe that this is a much more workable approach.

LAND From an audit quality perspective, many people view compulsory rotation as high risk, low reward, and I agree. It’s worth noting that the European Commission and US Congress considered mandatory rotation as part of Sarbanes-Oxley, but rejected it.

Mandatory rotation of an entire audit firm would be quite a draconian measure, and could lead to the risk of bad audits for two key reasons. First, a change of auditor could be automatically triggered at the wrong time in a company’s cycle – for instance, during a major management upheaval, a significant restructuring or a major transaction when auditor continuity across a couple of years is highly desirable.

Second, for large and complex corporate groups the learning curve for new auditors is very significant and inevitably it takes a couple of years before the auditor has a full knowledge and understanding of the group, its culture, people and processes.

RAKE No – company audit committees should have the duty to review auditors on a regular basis but have the freedom to reappoint the existing auditors where they are very satisfied they are providing a high-quality, robust and independent service. Where they do reappoint there is a strong case, as the UK Treasury Select Committee has suggested for instance, that they should have to justify their reasons to shareholders. Mandatory rotation has been tried and dropped in Ireland and Spain and it has been rejected by the EU. As the independent study in Italy found, it reduces competition and audit quality, increases costs to the business and can lead to corporates having a convenient excuse to see off a particularly challenging auditor.

COPELAND Multiple studies show that the incidence of audit failures rises when audit firm changes increase.

Within Deloitte we have established guidelines on rotating individual partners and teams on client engagements, even though this poses challenges when it comes to geographic mobility and timing of availability for our professionals. Establishing rules that result in up to one quarter of all public audits changing hands in any given year in the future would create an unworkable system. I believe it’s an example of a reform whose unintended consequences would be worse than the problems it’s trying to address.

GA Should auditing be a government activity paid for by the public?

DIPIAZZA No I don’t think that would be effective at all. Such an idea would completely ignore a practical reality – the world’s largest and most significant corporations are multinational and have operations that need to be audited all over the world. Given the talents needed to respond to a dynamic changing environment, the markets are best served by having auditing continue to reside in the private sector. Any independence concerns that arise as a result of having auditing in the private sector have been addressed through a multitude of safeguards including prohibitions on ownership and allowable services.

LAND This is a theoretical option. However, I believe that quality would suffer and I do not understand how a government-run public company auditor would be able to audit international/multinational groups without the overseas capability.

COPELAND The question of whether our current system of engaging a professional services firm to perform audits or whether a system of government audits is better can be examined as a matter of law. Most recently, the US Congress performed a comprehensive review of issues associated with corporate audits and determined that the reforms set out in the Sarbanes-Oxley Act of 2002 were appropriate responses to the corporate failures that gave rise to congressional review. During the hearings and other elements of the legislative process, there were no serious proposals to replace the current system with one of government audits. Thus, the most comprehensive review of corporate audits in 25 years resulted in continuation of the private audit model by Congress.

As to the cost of audits, it could be said that the public pays for audits under either system. The reliability of financial information on which investment decisions are based is fundamental and could be viewed as an issuing company’s cost of capital that, ultimately, impacts investment returns.

RAKE Definitely not. I still believe that the investing public, business owners, employees and governments are better served by a high-quality and sensibly regulated market. However, if we are to continue with a US-led litigious environment, with ongoing extreme pressures on the risk-reward balance, then we could end up with a state audit business by default. That would be a terrible outcome for business.

GA Does the whole basis of financial reporting need to change?

DIPIAZZA Yes it does. We’ve been saying it for years and have even written two books on the topic – Building Public Trust. The Future of Corporate Reporting and The Value Reporting Revolution.

But the issue isn’t simply one of pure financial reporting. While accurate financial statements are essential, they are not enough to give investors an accurate and complete picture of a company’s financial health. Other items – non-financial and intangible – need to be reported like customer retention and research and development. Furthermore, the format in which this information is presented needs to be dramatically improved. We need to get beyond the paper-based formats and onto internet-based formats like XBRL, which facilitate analysis and overall clarity when looking at a company’s financials.

LAND I do not think the basis needs to change. But it will evolve. The fundamentals of good financial reporting are global accounting standards based on clear rules but with an override based on principles (substance over form), the maximum transparency through disclosure and a realization that financial reporting will always have its limitations as a measure of performance.

RAKE I think it must evolve. At the moment it tends to be the validation of an historical record. Shareholders and other stakeholders rightly require more validation about trends and future intentions to give greater transparency about possible risks or uncertainties that could affect the company in the future. As I said before, we also need a substance-over-form international standard by 2005 – which is consistently applied and globally understood. There should be no slippage in this timetable – if anything it should be accelerated.

In addition there are some really contentious issues which need to be reported in a consistent way across the world – such as pension fund deficits, share options and post-retirement medical care.

COPELAND Our system of financial reporting is sound. What needs to be reinforced is the commitment of everyone involved in producing publicly reported financial information to act consistently with the highest levels of integrity of quality. We encourage discussion and debate about the evolution of financial reporting and the challenges presented by new forms of global, cutting-edge organizations, and increasing business pace. In the end, however, financial reporting systems are only as good as the integrity of those who use them.

GA Did Andersen deserve to go under? Were they any different from you?

LAND I think that Andersen paid a very high price for their “misdeeds” in the US and it is unhelpful to both customers and our industry that there are only four large multinational firms. Clearly, some aspects of Andersen’s culture and risk management in the US appear to have been misguided, and some of the actions they took reflected poor judgement.

Ultimately, culture is of paramount importance in our type of professional services organization as is the system of checks and balances around professional judgements and the management of risk. We believe strongly within E&Y; that we have the right culture, right strategic priorities, the right risk management processes and an unshakeable commitment to quality. However, we also recognize that we have to be vigilant and continue to develop our approaches and our processes.

Last year we were pleased to welcome 25,000 former Andersen staff and partners, in 57 countries, to our firm, and we look forward to working with these valuable people to deliver quality services.

COPELAND The collapse of Andersen was a tragedy, and was an unfortunate example of many people suffering because of the actions of a few. The client corporate failures, job-losses, investment and retirement savings losses were tragedies also. Finally, the damage to the integrity of the accounting profession has been a tragedy. Of the tens of thousands of audits performed each year in the US by more than 300,000 honest, hard-working men and women, only a tiny fraction of these audits involve restatements or are challenged in any way. The over 100,000 people who work for Deloitte around the world – and many thousands of people who work faithfully and hard in our profession – are among the finest people I know.

RAKE Andersen had a strong reputation and many high quality people. I do question whether it was really in the interests of the capital market for the whole firm to be destroyed so quickly as a result of the actions of a few when others in the capital markets were merely fined. As we learn more of what happened we see that there need to be widespread reforms to remuneration committee policies, non-executives, credit rating agencies, investment banks practices, strategy consultants, lawyers and regulators. All of this must be addressed to restore investor confidence.

DIPIAZZA What happened to Andersen is a tragedy. There were, and are, a lot of good people at Andersen who have paid a dear price, although they had nothing to do with Enron or any of Andersen’s other problems. The real issue is to determine what caused the series of audit failures at Andersen and how to ensure that it will not happen to another firm.