Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 180-199)



  180. But that is not what the Bank of England has told this Committee, the Bank of England has told this Committee, the problem may be less acute, nicely worded, the problem may be less acute because of the true and fair override. I ask you, can you give me an example of where the true and fair override has, in fact, referred to any of these issues; you cannot give me one?
  (Mr Fleck) Not in relation to Special Purpose Vehicles, no, and I think I might have phrased the proposition slightly differently from the Bank of England. And I am happy, if it would help you, Sir, to give you a brief note on the point. [5]

  181. That would indeed be helpful. Now, coming to another point, in your own Review Board paper to us, you refer to, Sir John has just referred to the issue of fraud and the difficulty of detecting it, and in your paper to us you have referred to a review you are making of the adequacy of existing auditing standards and guidelines with reference to fraud. Have you, in fact, issued any new guidance or auditing standards on this issue of fraud?
  (Mr Fleck) The Auditing Practices Board was the first body in the world to provide a standard on fraud, and it did so roughly in the middle of the nineties; and that, in the light of subsequent events, we are learning how effective that has been and reviewing that standard for republication in the early times of this new Board.
  (Mr Grant) Could I also add to that question, we have been looking carefully at published experiences, in relation to fraud, during the last few years, in particular, looking at the reports from the Joint Disciplinary Scheme; and, in analysing the issues there, many of the points fit into the work that we have done on quality control systems within firms, because we saw that it was not, in many ways, the standards that were at fault, it was the implementation of those standards. And so that led us very quickly to the belief that therefore quality control within firms was critical, and about two years ago we issued a revised SAS 240, which is the strongest standard on quality control in the world, and I say with pride that it is being used as the basis for developments in international auditing standards at this very day; and I hope that very soon the IAASB will produce a standard which is based on the work that we did in the UK.

  182. Can we take those two issues separately. You have referred rightly to the issue of quality control, and you said you have a very tough standard about that, and I believe that to be the case. If the Committee asked you for some evidence of what setting those new guidelines on quality control had actually meant, in terms of changes in practice, that would be a perfectly reasonable thing to do, and no doubt you would be able to send us some information?
  (Mr Grant) If I could just say, the APB writes the standards, we rely on the Accountancy Bodies to monitor the implementation of those standards. The Joint Monitoring Unit, which works for three of the Accountancy Bodies is doing that work, and they are looking particularly at the implementation of SAS 240; it came into effect only a year ago, and so their findings have not yet come through, although I am told informally that there has been a positive reaction to our standards. Some of the work that the Review Board will be doing, that has already been referred to, is looking at the activities of the JMU, to see how their monitoring is progressing, and they are doing the work later this year. So I expect, by the end of the year, we will have some information in that regard.

  183. You are giving me a sense of diffusion of responsibility; you say there is a standard and then you say, "Well, we're not the body that monitors the implementation of that standard, but the people who are, well, they're reacting very favourably to it." There has got to be more to it than that?
  (Dr Reeves) I think, Chairman, this reflects the comprehensiveness and the co-ordination of the Foundation, because it is an iterative process, the standards are set by the Auditing Practices Board, the Review Board has the responsibility to monitor the performance of the auditing firms, through the medium of the Joint Monitoring Unit. And if there are concerns, in terms of the standards not being supported, in terms of those standards being bridged, then there is an onus on the Review Board to report back and to talk and discuss with the Auditing Practices Board how something could be done to improve that standard. So this is part of a dual, two-way process that exists, with ourselves and the APB; and, of course, it also reflects in terms of our dealings with the Ethics Standards Board, and will do in terms of the Investigation and Discipline Board in the future. So this starts with the 23 regulatory bodies, it is important to have a body like the Foundation, as the overseeing body, with these other operational support bodies, so there can be this process of communication, for the betterment of the profession.

  184. Fine; but Mr Grant has just made it very clear to the Committee he does not regard your Review Board as being responsible for monitoring the implementation of the standards you produce. That is not a very satisfactory situation, is it?
  (Sir John Bourn) We are not in charge of the Joint Monitoring Unit, but we are interested in its activities and we shall report, and report publicly, on the effectiveness of its work, as part of the Review Board's activities.

  185. I wonder if I could ask either Sir John or Mr Fleck, in evidence to the Committee, you have indicated, I think you have indicated, your support for a mandatory Operating and Financial Review, which was one of the outcomes of the Company Law Review?
  (Mr Fleck) That is correct.

  186. Why do you give your support to this mandatory Operating and Financial Review; what are its benefits?
  (Mr Fleck) There are two parts to that answer. The first is that the whole concept of audited accounts dates back to the 19th century and is in the context of an historic look back at what has happened in the past. In the modern day and age, in the way in which the financial markets have developed and the way in which the support and information people require, both in making available funds, investing, selling, doing business with the company, they need to know more about how the company's future looks than how it looked historically. And the only way in which that can be done is to provide to the community at large, through the OFR, information about the key risks and the key factors affecting the business, its future and how it is likely to perform, I suppose one of the key factors that could adversely or positively affect its performance. The OFR is a vehicle for doing that, and we believe that that will make the financial statements more meaningful, more relevant, in the modern business community.

  187. So what you are saying is, present audits look backwards, you want a review which can look forwards as well?
  (Mr Fleck) We want to be able to contribute to the investors' and the markets' understanding of the business prospects of the entity.

  188. Now, in your own evidence to this Committee, you have referred to some guidance, well it was not guidance, it was a consultation on the problem of aggressive earnings management, and you drew the Committee's attention to the fact that this Operating and Financial Review would contribute to solving the problem of any difficulties of aggressive earnings management.
  (Mr Fleck) It is a contributor to the fabric that enables these things to be addressed.

  189. What is your own contribution to solving the problem of aggressive earnings management?
  (Mr Fleck) That is a large question, Sir.

  190. It is an obvious one?
  (Mr Fleck) We start from the fact that we have issued the Auditors Code, which sets the standards that we expect audits to be conducted by, by reference to integrity, to rigour, to professionalism, and the like. Secondly, we establish guidelines, standards, that address particular issues and the way in which auditors should look at them, and the criteria by which they should look at them, and give guidance as to how they might comply with those criteria. That covers a whole range of different areas, and there are 30 standards, give or take, and all of them, in different respects, affect the way in which the accounts come up with a true and fair view; and aggressive earnings management is a mental approach that can apply to any part of the business activities. So I cannot say to you there is a standard that addresses aggressive earnings management, because you are trying to deal with something which is a conduct issue, that is throughout the way management may be trying to address matters, it may range from looking at an estimate of some prospective liability of litigation, on an ultra-positive basis, it may be taking a very positive view of a long-term contract, which is unduly optimistic. So there is a whole range of ways in which aggressive earnings management can manifest itself, and all we can do, and I hope we are doing it increasingly effectively, is by coming up with principles and rules and guidance that are addressing, or helping, auditors achieve the principles in the Auditors Code.

  191. Have you issued new guidance on aggressive earnings management?
  (Mr Fleck) Since we issued our paper last summer, no, we have not, Sir; we have been in discussion with a variety of people, including the FSA, the DTI, and, I might say, we have been encouraging movement on the Company Law Review which Mr Grant referred to, because there are a number of key elements in the Company Law Review recommendations which are fundamental to addressing these issues. We can only use the tools that are available to us; we were the people who stimulated this debate, we identified issues that needed to be addressed, we identified the people who ought to be involved in them, and we are working with them in moving forward on that front, and it ranges from tightening up on certain existing standards to addressing certain new issues.

  192. When do you expect to issue guidance on aggressive earnings management?
  (Mr Fleck) Well, Sir, I hope I have made it clear that it is not a question of issuing guidance on aggressive earnings management itself, it is a question of taking the components and addressing them individually; and we do not have the ability to deal with all those issues.
  (Mr Grant) Could I add just one further dimension, and that is the international one. Auditing, as you will be aware, is an international activity, there is considerable interest and support for the idea that auditing standards themselves should become international. One of the things the APB has done is promote the importance of aggressive earnings management internationally, and support for that has grown in relation to developments in the US. We have close links with the international standard-setting body, which is called IAASB, and we are working with them on three particularly important areas that are relevant to aggressive earnings management; one is in relation to the standard on fraud, another one is on the standard on materiality, and the third one is in relation to accounting estimates. The UK is leading international projects in improving auditing standards in two of those three areas, and we are heavily involved in the third. This is relevant, if I could just say, because the likelihood is, in my view, that by 2005 auditing standards will become international, and that the European Community will require, alongside international accounting standards, international auditing standards; so we have positioned ourselves, to contribute our knowledge and experience to getting international standards right when that happens.

  193. We cannot rely on you, you are relying on the European Union to resolve these problems?
  (Mr Grant) I am certainly not saying that. What I am saying is, the likelihood is that they will require international auditing standards to apply in the UK from 2005.

  194. Sir John, I keep asking these questions, and whenever I ask them it is always somewhere else, the responsibility always lies somewhere else, there is always some new bunch of stakeholders who have to be talked about, there is something going on in the International Standards Board, the European Union are involved. Do you not accept that somebody has to accept some responsibility? The Auditing Practices Board raised the issue of aggressive earnings management; do you not think there is some obligation to do something that will tackle this issue?
  (Sir John Bourn) I do, and I see it as the Review Board as the body, in taking account of this, and this will be an aspect of the subjects that we will look at. I think all this turns round the idea of the audit, in a sense, being more up front, telling you more about what is going to happen, what the risks are, and having that ventilated in a more public way. Aggressive earnings management is in order to smooth out figures and curves and affect the perceptions of the analyst, and then the analysts seek to second-guess aggressive earnings management; and I see it certainly as the Review Board to be able to pull this together, to be able to say what we think on issues of that kind. I take your point, there is an enormous number of people involved in this, and, while the complexities of company law, and all the rest of it, have to be understood and respected, I think there are a number of relatively simple headings under which we can take matters forward, and I hope that I and my colleagues will do so. This is why we joined, after all. So I take your point, Mr Cousins.

  Chairman: On further possible changes, David Laws.

Mr Laws

  195. Sir John, just as an introduction to this section that deals with some of the changes that people have discussed, in terms of the way the audit business in this country works, could you just tell us, as briefly as you can, why you think the auditors failed in the case of Enron?
  (Sir John Bourn) I think, and this is my view, the auditors failed in the case of Enron because they were too close to the client, too many of them sought to get jobs with Enron, to translate themselves from working for the external auditor to get a good job in the auditee; so there was too close a set of relationships between the auditee and the auditor. One of the things that we are interested in is the idea that it should not be a matter of shutting your desk as an auditor on Friday and appearing in the finance division of a company on Monday. One of the reasons for the temptation, I think, to shut eyes was because of easily changing jobs; so that was one of the things that went wrong with Enron. I think another thing that went wrong with Enron was that, and this has been touched on, you had a set of very detailed accounting standards, so if you have 100 rules, clever people will be able to think up Special Purpose Vehicles which skate round the 100 rules, and so then they say, "It's all alright, this conforms with the 100 rules." If you have systems under which you say "substance rather than form", you are in a position where it is the duty and the ability of the auditors to say, "Whatever you may say, in fact, Enron is responsible for these entities and responsible for the debts that they have incurred." So that is another thing that went wrong. A third thing, I think, that went wrong is that, in Enron, the non-executive directors were not paying full attention to the complexities of the issues, it is very difficult for them to do that, but I think it is the duty of the non-executive directors to say, "I just can't understand your accounts; what are all these Special Purpose Vehicles, why have we got them, explain this to me clearly?" And have a direct dialogue with the external auditor, if necessary, without the executive management there. I think non-executive directors needed to understand that, and, from all the evidence, I would hope that I am not doing them an injustice, they had not done that, they could have done it but they had not done it. And I think, also, you have the euphoria of success; for years Enron was a terribly successful company, so, in those circumstances, people are reassured, they do not know actually how it is making all this money, but it seems to be doing it, and so people relax. And I think all those are the things that went wrong with Enron. Another thing, I think, they had whistle-blowers in the company and they sat on these people and did not take notice of them, whereas they should have had a culture and a climate to listen to these people, middle-level people, junior people, speaking up. So all those things went wrong with Enron.

  196. That is very useful, thanks. Can I just ask you, on your second point there, Sir John, which was, due to the complexity of all the rules and regulations, it was possible for people actually to create very complicated structures and then say that they had satisfied the rules; so you see that aspect of it as a criticism of the accounting rules, or is that part of the problem, that the auditors were so close to the company that they were willing to waive through that type of interpretation of the rules?
  (Sir John Bourn) I would say, 70 per cent the rules, 30 per cent the auditors.

  197. Okay; that is great. Can I move on then to look at some of the detailed proposals that various people have trailed, to deal with these aspects, and particularly the relationship between the auditor and the client. What is the view of the Board about the issue of mandatory auditor rotation, do you think that actually would help to address some of the problems you have alluded to?
  (Sir John Bourn) Certainly, all the evidence coming, and my view, is that it would not, because mandatory auditor rotation and doing these things by rules and regulations is not the way forward. The fact of the matter is that, and under my way of looking at it, the determination of who the external auditors should be the responsibility of the non-executive directors on the audit committee, and they should be the people who decide how good is the auditor, do we need to change him, do we have the advantage, because he has been with us for eight years and really understands us, and there would not be an advantage in changing him; there is nothing that requires the company to stick with the auditor, and the companies themselves are the people who should make the judgement. People say, if you have compulsory rotation of auditors then you have got the long learning curve; two years with the new auditor, and then if he knows he is there for only five years is he really going to try in the fifth year, and I think there is a lot in that. So I do not see it as the compulsory rotation, but what I do see is the audit committee looking in a more considered and intelligent way at whether it is time to change the auditor; and, I think, in many cases, they should change them more, and they have the power to do it.

  198. Do you think though that that fails to address the criticism you made earlier on about Enron, where you were saying that perhaps the relationship between the auditor and the company was too close? And is not there a difference, potentially, between a situation where those at the top of the company have a high degree of probity, in terms of the accounts, and are bringing in auditors in order to make sure they are doing a very good job of scrutinising, and a situation, for example, in a company where those people at the top of the company might be aware of some of the rather devious practices, and might therefore find it quite convenient to keep on an auditor with whom they had built up a close relationship, they had gone through the process of deciding to account for things in a particular way, and the auditor was not very challenging? And is there not, therefore, potentially, a need to have some kind of rotational process that keeps a check on the directors themselves?
  (Sir John Bourn) I think there is a case for rotation, but I think that it should be a considered rotation rather than an automatic one. Because, if you have the automatic rotation of auditors, and you know next year you are going to have somebody new then you think, "Well, maybe I can sort of arrange things and rush it through the new boys as soon as they come." I think, within the context of the Enron culture, you would not have changed that, you would have had to change a lot of things, and they would have exploited the automatic rotation of auditors as they exploited the other things. So I do not support the automatic rotation of auditors; what I do think is that you need to have the non-executive directors' report, and maybe they report every three years or five years, on why they have not changed the external auditor; they should say, "why we've done it or why we haven't done it." I think the people themselves should be responsible for doing that, but they should give reasons for why they have either kept them on or changed them.

  199. Is there a case for any lesser degree of rotation, either in terms of the rotation of the lead individual, the lead partner, perhaps, on an audit, or is there any case for regular mandatory retendering for audits?
  (Sir John Bourn) I think that there is certainly a case for changing the people who are doing the audit, so that you do change the partners in the audit firm who are doing the work.

5   Ev 129. Back

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