Memorandum submitted by the New Economics
"You have a great brew of greed, and hubris,
and excesses, and financial wishful thinking, and that adds up
to a weakening of the auditing processes. They've been infected."
The New Economics Foundation (NEF) investigated
the role of the global accountancy firms in its report The
Five Brothers: the rise and nemesis of the big bean counters,
published in March 2002. The report was a continuation of our
critical analysis of economic globalisation, corporate governance
and how economic activity is measured.
In particular we were concerned that the big
five accountancy firms, now reduced to four, had in recent years
dramatically increased their influence in the world of business
without there being a concomitant increase in their accountability.
From academia to the business press they were
now described variously as: "the back office of the global
markets" (The Economist); "Management's private
police force" (Professor Prem Sikka); and that they "in
effect run corporate Britain" (Aston & Warwick Business
Considering the threat posed by the audit failures
to the long-term public interest NEF believes that there is a
deep historical irony in the current situation. The advent of
Limited Liability companies effectively brought the accountancy
profession into existence. In order to create confidence and raise
funds for major public infrastructure works, this category of
company was created. The relative immunity it offered failed entrepeneurs
was seen at the time as a significant concession. The balancing
element was that these new companies had to present scrupulously
audited accounts to their shareholders. The historial irony now
is that a system designed to encourage good public works, is now
so flawed that it threatens to do more public harm than good.
Summary of initial concerns
Growing irrelevance of the orthodox audit: History
is passing by orthodox accounting, leaving it almost redundant.
Though still a legal requirement it is increasingly meaningless.
So-called "intangibles" now make up at least 70 per
cent of the value of the FTSE 350 companies. Yet there is no meaningful
measure for many of them such as trust, reputation, human capital
or innovative capacity. Where intagibles are measured, their accounting
lacks transparency and consistency. Additionally, new public expectations
of social, ethical and environmental corporate performance have
undermined the fuction and usefulness of the audit in aiding investment
decisions and informing shareholders.
Role in the global economy: The major accountancy
firms are actively facilitating the consolidation and concentration
of corporate power in the global economy, and in a context where
there is no global regulation in the form of competition authorities
to temper the trend.
A further concern is that even according to
research by the accountancy firms themselves 83 per cent of mergers
and acquisitions (M&As) were unsuccessful in terms of enhancing
shareholder value. Even worse, over half of deals actually destroyed
shareholder value. Yet, ironically, and a disturbing demonstration
of the capacity for self-deception with the sector, 82 of people
involved in negotiating deals thought that their own went well.
Conflict of interest are still not properly
addressed: The major accountancy firms have expanded to the extent
that their relationship both as service providers and auditors
to their clients represent a dangerous and inefficient conflict
The problem of "revolving doors":
The close relationship between the major accountancy firms and
their corporate and public sector clients means that they can
slip into a "spin doctor" role, compromising the integrity
of audits. This situation may be more likely to conceal information
that could damage confidence or that could reflect badly on a
clients' social or environmental accountability.
That the combination of political contribution
from the major accountancy firms and a revolving door linking
them to government departments can lead to collusion and cronyism
between the professional services and the state.
Aggressive tax minimisation: Through their intimate
knowledge of, and ability to work the international financial
system, the big accountancy firms are aiding forms of aggressive
tax minimisation that ultimately undermines democratic government;
and implicity supporting dubious financial regimes and other forms
of sleaze. Speaking to the New Economics Foundation, one director
of a big four accountancy firm told us that where money laundering,
bribery and other forms of dubious and illegal practice were concerned,
that the, "Only question is whether it happens in 30-40 or
50 affiliated country offices around the world".
Summary of initial recommendations:
Fresh air factor: NEF strongly supports
compulsory auditor rotation. Companies should be forced to change
auditors regularly to avoid "over cosy" relationships.
The FSA has recommended a five-year rotation, but an even shorter
rotation might be more appropriate.
Revolving doors: There should be
a minimum three year cool-off period between auditors taking jobs
in government or firms (or vice versa) where there is a perceived
conflict of interest.
No buying influencea ban on
political donations: Because of their unique role in the economy
the major auditors should stop making political donations. It
would be a first step to rebuilding public trust in the profession.
Conflicts of interest: The separation
between auditing and consultancy work should be thorough, and
made permanent and mandatory. Regulators should guard against
Reasonable suspicion: To strengthen
the auditor's hand they should be able to report "reasonable
suspicion of fraud" to officials without compromising client
Because of the special circumstances
surrounding the collapse of Andersen and the further consolidation
of the auditing sector, NEF recommends the establishment of a
one-off ad-hoc global competition commission to audit major
accountancy firms and investigate the implications of their global
domination of the accountancy industry.
Assessing stakeholder not shareholder
value and redefining corporate value in the public interest: new
models are needed to assess the social and environmental well-being
and impact of corporations. Increasingly, orthodox accounting
will need to be complemented by other assessments that highlight
essential information to investors and stakeholders, such as political,
social and environmental risks. The Global Reporting Initiative
(GRI) presents a new global framework for corporate reporting.
It is only a voluntary initiative but provides a model for stakeholder
engagement that could mature into a regulatory framework. New
toolssuch as the Local Multiplier Effect, which measures
the catalytic effect of companies on local economiescan
be adopted to create an audit for the real world.
Measuring the unmeasurable: while
the stated value of modern corporations tends to greatly exceed
their market capitalisation and hard assets, the basis on which
such estimates are made is rarely clear. Up to 75 per cent of
corporate value is now represented by "intangibles",
such as reputation, innovative capacity, trust and human capital.
Valuation of a company should be based on a company's real value
including its intangible asset base. The formulae accountants
use to determine a company's "true"value therefore need
to be based on clear, standard and transparent measures.
Highest common denominator transparency:
To lead by example auditors should at least meet the highest standard
of transparency practiced by the publicly listed companies they
Setting up stakeholder councils:
Only by opening up the ossified rituals of the boardroom can real
change happen in the world of corporate governance. NEF proposes
new bodies such as the stakeholder council, that represent the
interests of all stakeholdersemployees, customers, suppliers
and anyone else affected by the firmrather than just the
interests of partners, directors and shareholders.
Since Enronthe state of play
According to Sir Howard Davies, Chair of the
FSA, the British system could not "stop an audit firm becoming
too close to a client and misleading investors".
On 15 June 2002, the federal jury hearing the
Andersen/Enron case finally delivered its decision after 10 days
of deliberation. Andersen was found guilty of obstruction of justice,
although the company was let off on the potentially more serious
charge of deliberately destroying evidence in the document-shredding
that followed Enron's collapse. Pending appeal, the decision means
that Andersen will be banned from auditing publicly listed companies
for a period of up to five years, and has left an indelible stain
on the companies reputation.
Andersen offices in dozens of cities worldwide
have been bidding to merge with rival professional services firms.
The Financial Times remarked at the "astonishing speed"
with which Andersen's global empire has been carved up. As of
early May, the "scramble for Andersen" had seen all
but a handful of the company's 84 country practices announce their
intentions to merge with another firmmost of them Big Four
NEF's major concern is that there is no guarantee
that what has happened to Andersen could not happen again. The
problems exposed by Enron and previous, less publicised scandals,
have not fundamentally been addressed. If anything, things have
become more unstable due to the increased concentration of power
into the hands of just four companies following the Andersen land-grab.
Conflict on interest: We are concerned that
very real conflicts of interest concerning the professional services
firms are still not taken sufficiently seriously within the remaining
big four firms. This was illustrated by the reticence shown by
James Copeland, the director of Deloitte Touche Tohmatsu, who
stated that the company's decision to devolve its consultancy
arm had been taken "very, very reluctantly", and that
in his eyes, "the independence issue related to providing
both auditing and consulting services is one of perception only."
Deloitte has not left the consultancy business
at all. While Deloitte Consulting, the by-product of DTT's disaggregation,
has taken many of the parent company's clients in the US, reportedly
the same has not happended in the UK. In Britain, and in Europe
as a whole, DTT continues to perform consultancy work through
its Management Solutions division, which is fully owned and controlled
by the parent company. In 2000, Management Solutions reportedly
brought in 68 per cent of DTT's consulting revenue in the EU.
In fact, far from making a clean break from consulting, DTT's
role is set to increase. Management Solutions has recently incorporated
600 new staff, cannibalised from the carve-up of Andersen's UK
business consulting division. Similarly, Ernst & Young undertakes
numerous consultancy-related activities, including tax consulting
and "tax risk management", as well as advising on information
systems and corporate finance strategy.
Ernst and Young and other big four companies
employ a series of satellite firms providing other consultancy
and legal services. Through these associated businesses, each
of the big four can essentially provide all of the same services
as they did before breaking up. Dr Chris McKenna, whose study
of the management consultancy industry is due out next year, observed
"The questions people ask their accountants almost inevitably
lead to business advice, and it's hard to draw a distinct line
between the two". McKenna predicts that unless regulation
bans it, in 10 years' time the accountancy/consultancy conglomerates
could well be back.
Concentration of Power: The amalgamation of
Andersen offices around the world by its big four rivals reveals
the continuing trend within the industry for becoming ever-larger
and more powerful. Ernst & Young and Deloitte Touche Tohmatsu
have, to date, grabbed the largest shares of the Andersen pie.
Both companies gained offices reportedly worth approximately $2
billion in combined annual revenue, as well as 15,000 staff each,
swelling their ranks to around 100,000 and 110,000, respectively.
As the number of leading players in the industry shrinks, an already
dangerously oligopolistic sector has become even more concentrated.
What has been done to address the situation so
As a direct result of the Enron collapse, major
changes are in store in the regulatory environment. Among the
steps that have already been taken are:
The Securities and Exchange Commission
(SEC) has already announced plans to create new organisations
outside the structure of the American Institute of CPAs (AICPA)
to oversee auditors of publicly held companies. A disciplinary
board would be created to accelerate the investigation of alleged
audit failures and provide more transparency, and the current
program of firm-on-firm triennial peer reviews for auditors of
publicly traded companies would be replaced by an annual quality
monitoring process for the largest firms, administered by a new
organisation. This new body would have expanded authority to monitor
compliance with SEC practice standards and to refer instances
of non-compliance to the disciplinary board. Both new entities
would have a majority of public members and operate outside the
profession's self-regulatory structure.
Following from this, the Senate Banking,
Housing and Urban Affairs Committee will mark up a draft bill
that would establish a new organisation to monitor the accounting
profession (to be overseen by the SEC). Unlike the House Accounting
Bill (HR 3763), the legislation would fund the new oversight board
mostly through fees assessed on accounting firms and their corporate
clients, and would give it "full authority" to obtain
documents or testimony in the course of investigations.
In response to these proposals by
the Chairman of the SEC, the member of the Public Oversight Board
(POB) announced their intention to terminate the board's existence
no later than 31 March 2002. Currently, the POB oversees the peer
review, quality control inquiry, and other activities of the SECPS
and the standard setting efforts of the Auditing Standards Board.
Reversing a longstanding position,
the AICPA has announced it will not oppose limits on providing
certain non-audit services to pubic company audit clients.
The Government is looking at the
role of non-executive directors and on the way financial reporting
and auditing is undertaken. The Financial Services Authority is
in talks to take over financing of the profession's watchdogthe
Accountancy Foundation. The intention is to improve the profession's
image by switching the fundng of existing regulatory structure
from the six accountancy institutes to the FSA. The FSA is also
examining the possibility of compulsory rotation of auditors.
Furthermore, the Treasury, Financial
Services Authority and the Accountancy Foundation have been pulled
together to form a special group to address the role of auditors
in the UK. The first meeting of the group was held on 11 April
2002. The members are: Melanie Johnson MP, Minister for Competition,
Consumers and Markets; Ruth Kelly MP, Economic Secretary to the
Treasury; Sir John Bourn, Chairman, Accountancy Foundation Review
Board; Michael Foot, Managing Director, Deposit takers and markets
directorate, FSA; Mary Keegan, Chairman, Acocunting Standards
Board; Professor Ian Percy, formerly Chairman, Accounts Commission
for Scotland and Rosemary Radcliffe, Economist, and Complaints
Commissioner at the FSA. The first meeting focused on work the
regulators have in hand to address; including the quality of audit
(particularly with regards to strengthening the independence of
auditors), financial reporting and corporate governance, in particular
the role of the Audit Committee. The group are working to ensure
that there is a comprehensive and coordinated work programme to
be taken forward by regulators over the coming months. It will
provide a progress report by the summer, with a final report at
a later stage. NEF is concerned, however, that this process is
heavily dominated by technical experts and not wider stakeholder
The Accountancy Foundation is also
considering whether to establish an independent appointments board
that would select the auditors for Britain's publicly listed companies.
That would follow the system already used in the public sector,
where the Audit Commission appoints firms to hospitals, local
authorities and other private bodies. Under current rules, shareholders
have to vote on the appointment and dismissal of auditors, but
they are normally selected by the board.
Corporate Responsibility Bill
The new Corporate Responsibility Bill, sponsored
by Linda Perham MP and supported by the New Economics Foundation
and other groups, makes provision for companies with an annual
turnover of £5 million or more to:
Produce and publish annual reports
on environmental, social, economic and financial mattersboth
for the preceding year, and to outline the above impacts of proposed
To consult on proposed operations
of the company and the impacts these will have on employees. This
includes relationships with Governments and donations to any political
To specify certain duties and liabilities
To establish a Corporate Responsibility
Board made up of as wide a section of stakeholders as possible.
The Bill has been introduced in response to
some of the issues raised by the recent Company Law Review Steering
Group and the fall-out from recent corporate and accountancy failures.
It is hoped that the Bill will make companies more accountable
for their activities by:
Expanding directors duties beyond
Establishing an environmental and
social standards board to develop guidance for and ensure the
compliance of reporting on environemtal, social, economic impacts.
Making background documents on company
practice more widely available to the public.
Consulting a wide section of stakeholders
before embarking on major new projects.
The Bill is supported by a wide cross-section
of NGOs and stakeholders, including the New Economics Foundation,
Friends of the Earth, Save the Children Fund, Traidcraft, CAFOD
and Amnesty International.
What still needs doing?
Regular rotation of auditors is essential
to encourage transparency and guard against cronyism. At the very
least, companies should be compelled to put their audit out for
tender on a regular basis.
Comprenhensive reporting on non-financial
matters should be part of a transparent auditing procedure. The
production of social and environmental reports would enable shareholders
and others to gauge potential risks that wouldn't be shown through
a standard auditor's report.
Two of the big four, PwC and DTT,
still do not publish annual financial reports. Auditors for publicly
quoted companies need to practice what they preach and publish
their own annual reports. In a market as big as the UK, revenues
should also be broken down to country-level.
The National Audit Office currently
cannot audit nor investigate private companies that have received
central government money. The Sharman report published last year
advocated widening the NAO's powers so that it could do sobut
to date the government has so far remained silent. The Sharman
report's recommendations should be implemented forthwith.
Stakeholder governance: "In
the 1920s, the chairman of General Electric, Owen Young, pushed
the idea of stakeholder boards." In order to ensure that
conflicts of interest do not interfere with the integrity of financial,
social and environmental reporting, the Big Four should open up
their governance to a wider group of stakeholders. This recommendation
is also consistent with those of the Turnbull report, published
by the Institute of Chartered Accountants, to devise ways of company
boards to implement a "sound system of internal controls"
to safeguard shareholder and investor interests.
Jam the revolving doors between accountancy
firms and their corporate clients. Auditors who work for one of
the Big Four firms should be barred from working for any of the
companies they have audited for a period of at least three years
to prevent conflicts of interest from arising.
Closer scrutiny of political ties
and donations, particularly when the big four are subsequently
bidding for contracts with public service providers and government
Different accounting rules are needed
for countries whose domestic economic situations are very different,
for example in the size and importance of capital markets. Great
caution is required in the evolution of international standards
to avoid imposing inappropriate accounting practices on countries.
Summarythe causes of current corporate
failure are systemic
The current crises are not chance aberrations:
To suggest that the Andersen case was a one-off example of weak
management and poor business practice is to ignore the systemic
causes that contributed to the company's downfall. The fact that
warning signs from previous accounting scandals involving Andersenas
well as other Big Five companieshad been ignored was a
lost opportunity to make meaningful changes to the way the professional
services sector is regulated and monitored.
Don't let them slip: Now, as the fallout from
Enron begins to recede from the public eye, only to be replaced
by scandals involving other large corporations, accountancy's
trade associations appear to be trying to ride out the storm of
unrest without conceding the need for major changes to the regulation
of accountancy. NEF believes that losing momentum for reform,
as it was lost after the Asian financial crises of 1997-98, will
miss their best opportunity to date to intervene in an industry
that has become dangerously unstablethreatening not just
shareholders interests but the livelihoods of millions of people.
4 July 2002