Select Committee on Treasury Minutes of Evidence

Memorandum submitted by the Department of Trade and Industry and HM Treasury


  1.  This memorandum is submitted jointly by the Department of Trade and Industry (DTI) and HM Treasury to inform the Treasury Committee's inquiry into the arrangements for financial regulation of public limited companies in the United Kingdom, in the light of the Enron collapse.

  2.  This memorandum describes:

    —  The respective roles and responsibilities of the DTI, the Treasury and other organisations with an involvement in the regulation of public limited companies;

    —  The current framework of regulation; and

    —  The work the Government and relevant regulators have put in train to assess the implications of recent corporate failures for the regime in the UK and what lessons can be learned.


  3.  The DTI has overall responsibility for company law in Great Britain[18], which includes company reporting requirements, corporate governance, and the regulation of auditors. In Northern Ireland this is the responsibility of the devolved Administration. A number of specific areas are the responsibility of independent regulatory bodies, in particular:

    —  The Accounting Standards Board (ASB)—this is independent body responsible for the setting of accounting standards, which apply to companies' individual and consolidated financial statements intended to show a "true and fair" view. It is a subsidiary body of the Financial Reporting Council (FRC), whose role is to promote and secure good financial reporting. The Secretary of State for Trade and Industry and the Governor of the Bank of England jointly appoint the Chairman of the FRC. Another subsidiary body of the FRC, the Financial Reporting Review Panel (FRRP) is responsible for the enforcement of financial reporting by listed and large companies. The FRC and its subsidiaries are funded jointly by the accountancy profession, business and the Government;

    —  The professional accountancy bodies impose their own rules and standards on their members, in relation for example to qualifications, monitoring, complaints and discipline. Although the best known are the six chartered bodies of the Consultative Committee of Accountancy Bodies (CCAB), a range of other bodies represent accountants. The DTI gives delegated authority for regulating company auditors to those accountancy bodies[19], which meet the legislative requirements, ie they are recognised under the Companies Act 1989 as a supervisory body;

    —  The Accountancy Foundation—this has been established recently to provide independent oversight of the regulatory activities of the principal accountancy bodies; The Foundation has a number of associated bodies which have specific responsibilities:

      —  The Review Board—which has the role of reviewing the regulatory activities of the participating accountancy bodies and monitoring the operation of the system to ensure that it serves the public interest;

      —  The Auditing Practices Board (APB)—which is responsible for setting and developing auditing standards;

      —  The Ethics Standards Board (ESB)—which has the role of securing the development of ethical standards by the principal accounting bodies;

      —  The Investigation and Discipline Board (IDB)—which will investigate disciplinary cases of public interest.

  4.  The DTI also has powers to appoint inspectors to investigate companies and their affairs, and to requisition company documents.

  5.  HM Treasury has responsibility for maintaining a stable macroeconomic environment and for securing an efficient market in financial services, including the overall institutional structure of regulation for financial services, and the legislation that governs it. The Treasury also has an interest in the stability of financial markets and the general environment for business.

  6.  The Financial Services Authority (FSA) has responsibilities for both the regulation of the financial services sector and the UK Listing Authority. The FSA was established as an independent non-governmental body, given statutory powers by the Financial Services and Markets Act (FSMA) 2000. The FSA regulates the financial services industry in the UK. There are four main aims;

    —  Maintaining confidence in the UK financial system;

    —  Securing the appropriate degree of protection for consumers;

    —  Promoting public understanding of the financial system; and

    —  Reduction of financial crime.

  7.  The FSA has responsibility for the UK Listing Authority (UKLA)[20] and the maintenance of the Listing Rules. Through this process of vetting firms at entry, the FSA aims to allow only those firms and individuals satisfying the necessary criteria (including honesty, competence and financial soundness) to engage in regulated activity. Once authorised, firms and individuals must maintain the standards set out in the Listing Rules. Performance is monitored. Breaches are investigated and, if appropriate, those responsible are disciplined or prosecuted.


  8.  In considering the current framework of regulation, it is necessary to bear in mind that there have been a number of major developments over the past decade or so which have greatly changed the framework within which business operates. Previous problems and failures have led to changes in the regulatory regime, with the aim of strengthening the regime and making it more effective. For example, the setting up of FRC and ASB was a response to the accounting abuses of the 1980s. Similarly, after the collapse of Barings, the Bank of England commissioned the independent Tiner review, which made a number of recommendations, including highlighting the importance of a risk-based approach to regulation. This lies at the heart of the FSA's approach to regulation.

  9.  In a free market economy, corporate failure is an inevitable fact of business life. For example, some businesses will fail because the business model was unsustainable, or tastes or technology change. But a number of corporate failures have raised issues or concerns about regulatory or public policy. The Government has taken, and continues to take, such issues and concerns seriously, but in responding, has always been mindful that there is a trade-off to consider between the burden of regulation and the encouragement of wealth-creation and innovation. The current regulatory regime seeks to strike the right balance.


  10.  All companies are subject to the same broad framework of company law. The main piece of legislation is the Companies Act 1985, which consolidated earlier legislation, and also incorporates subsequent changes. In addition the Companies Act 1989 sets the framework for the regulation of auditors by recognised accountancy bodies (see also paragraphs 24 to 27 below).

Company Law Review

  11.  In 1998, the Government launched a fundamental review of the framework of core company law: the Company Law Review (CLR). Its objective was to create a framework of company law that promoted the competitiveness of British companies, struck the proper balance between the interests of the different parties concerned with companies in the context of straightforward, cost-effective and fair regulation, and promoted consistency, predictability and transparency in the law. The review was managed by an independent Steering Group and the final report was published in July 2001. The CLR proceeded on the basis of wide consultation and was able to build a wide consensus around many of the recommendations contained in the Final Report, which was generally warmly welcomed. It looked at the framework of core company law and corporate governance and made wide-ranging recommendations. Amongst these the CLR recommended that there should be a statutory statement of directors' duties to set out clearly the duties and responsibilities of all directors. The Review also made a number of important recommendations relating to transparency in corporate governance, ranging from a requirement for an Operating and Financial Review (OFR) for economically significant companies, to improved arrangements for company disclosure and shareholder voting.

  12.  The Government is committed to modernising the framework of company law in the UK to ensure that it is up-to-date and fit for the 21st Century. It has made clear that it warmly welcomes the broad thrust of the CLR proposals. The Government is developing legislation in response to the recommendations, which it will—in due course—publish in draft for consultation. This is a task of great scale and complexity.

  13.  This legislation will include measures to modernise the powers available to the DTI to investigate companies and their affairs and to requisition company documents.


  14.  The Companies Act 1989 introduced the current relationship between accounting standards and the law[21], giving effect to the recommendations of a committee chaired by Sir Ron Dearing. The legislative changes at that time also paved the way for the establishment of a new Accounting Standards Board, separate from the accountancy bodies; it also introduced the concept of control into the definition of those entities to be brought within consolidated accounts—in essence, that an entity controlled by the parent should be brought within the consolidation, regardless of the legal form.

  15.  These changes were a response by the DTI and the accountancy profession to standards of financial reporting in the UK in the 1980's that were increasingly seen as inadequate. Changes were also necessary to give effect to EU company law directives.

  16.  By requiring companies to state in their accounts whether their financial statements had been prepared in accordance with standards set by the Accounting Standards Board, the legislation gave effective backing to accounting standards. Standards are established as the authoritative means of giving a true and fair view in most circumstances. The early 1990s, following the establishment of the ASB, saw the rapid improvement of accounting standards. For example the ASB built on the Companies Act structure, attacking the use of off balance sheet vehicles by requiring the consolidated accounts to reflect the economic substance of a group.

  17.  In more recent years the setting of accounting standards has been increasingly influenced by the desire to converge on international accounting standards. In the EU, a Regulation is likely to be agreed shortly requiring the use by listed companies of international standards from 2005. The International Accounting Standards Board (IASB) is committed to a set of high quality global standards, which will not require a country with "advanced" standards, such as the UK, to settle for second best in order to gain the benefits of a global standard. The UK is pressing hard within the international standards setting process to ensure that this aspiration is achieved in practice.

  18.  A related reform introduced by the 1989 Act addressed the enforcement of accounting requirements and the revision of defective accounts. It provided legislative backing for the Financial Reporting Review Panel—to investigate complaints that listed or large public limited companies (plcs) do not comply with the reporting requirements in company law or accounting standards. The only formal power of the FRRP is to apply to the courts for an order requiring a company to revise its accounts. In practice these arrangements have proved a successful way of upholding accounting standards and the framework of company reporting.


  19.  There is one aspect of the Company Law Review proposals on reporting, on which it is worth commenting in more detail—the proposal for a statutory Operating and Financial Review (OFR), that goes beyond the content of the existing directors' report.

  20.  The CLR recommends that listed companies and large plcs—essentially economically significant companies—should have to prepare an OFR "to provide a discussion and analysis of the performance of the business and the main trends and factors underlying the results and financial position and likely to affect performance in the future, so as to enable users to assess the strategies adopted by the business and the potential for successfully achieving them." The CLR argues that the content of the OFR must not be unduly prescriptive, to allow room for its development through standards and guidance and to minimise the tendency towards set wording or "boiler-plating". It proposes that it should be the responsibility of the directors to prepare the OFR. The role of the auditors would be in essence to review the process used by the directors to prepare the OFR but not to second-guess the directors' judgements.

  21.  The OFR would have to include:

    (i)  the company's business, objectives, strategy and principal drivers of performance;

    (ii)  a fair review of the development of the company's business over the year; and

    (iii)  the dynamics of the business—that is factors which may substantially affect future performance.

  22.  The other elements of the OFR, for example policies and performance on the environment, or reputational issues would have to be included to the extent they are material to an understanding of the business.

  23.  As noted above, the Government is developing legislative proposals in response to the CLR.


  24.  The Companies Act 1989 also introduced a new framework for the regulation of auditors, introduced in part to give effect to the eighth EU Company Law Directive and to facilitate the recognition of auditors across the EU. In brief, auditors must hold a recognised qualification and have adequate relevant experience; they must be registered and subject to a supervisory regime administered by a recognised professional body, which includes the external monitoring of their work, disciplinary arrangements and requirements to uphold their interpretation.

  25.  The 1989 Act provides for the DTI to recognise the audit qualification of those accountancy bodies that meet the requirements of the eighth Directive. The DTI also authorises a number of bodies to register and supervise auditors. The DTI monitors the recognised bodies to ensure that these arrangements are working in practice and remain adequate.

  26.  Registered auditors must follow not only the rules and ethical codes of their own professional body but also standards for audit developed by the Auditing Practices Board. As noted elsewhere the APB was until recently an offshoot of the accountancy bodies. It now falls within the umbrella of the Accountancy Foundation. Auditing standards developed enormously through the 1990s. We understand that the APB has submitted its own memorandum that details those developments. As with accounting standards there are strong moves towards convergence of UK standards with international standards on auditing. The APB as one of the world's leading standards setters is closely involved in that process.

  27.  The CLR considered the role of audit and auditors in some depth. While it made some important recommendations—eg that directors and employees should have wide duties to assist auditors and auditors should be able to limit their liability within limits to be set by Government—it proposed leaving the current regime fundamentally unchanged.


  28.  Accountancy work in the UK operates within a statutory regulatory framework only in relation to company audit and insolvency work. The professional accountancy bodies impose their own requirements on members, requiring them to observe appropriate regulations and byelaws, including a code of ethics. A body may take disciplinary action against members who fail to meet the requirements on them. The sanctions available to the bodies are fines and/or exclusion from membership.

  29.  The most significant recent change to these self-regulatory arrangements has been the introduction of a new framework for the oversight of the regulatory activities of the accountancy bodies. This followed concerns within parts of the accountancy profession itself about the appropriateness in a contemporary context of "pure" self-regulation, and responded to a commitment in the 1997 Labour Party Business Manifesto for independent regulation of the profession. An agreement between the Government and the six chartered accountancy bodies in 1998 led to the establishment of the Accountancy Foundation and its related bodies. These arrangements are summarised at paragraph three above. It is too early to assess the impact, but the UK model has attracted a number of favourable comments from overseas jurisdictions, including the US. Although funding comes from the accountancy bodies, the Foundation and the Review Board include no practising members of the accountancy profession and there are non accountant (or in the case of the APB, non auditor) majorities on the other boards. The Government has made clear that it will review these arrangements after five years.


  30.  The 1990s also saw the development of a series of non-statutory codes of best position on corporate governance culminating in the Combined Code. This sets out good practice in the structure and operation of boards of listed UK companies, including the relations between shareholders, directors and auditors. Whilst there is no requirement to comply with the Code, the Listing Authority (now the FSA) requires listed companies to disclose the extent to which they comply and explain non compliance. Most recently—from the end of 2000—following the Turnbull Report, a company's directors must report to shareholders on the effectiveness of their internal controls and their procedures for risk management.


  31.  The table at Annex A[22] shows a summary of the Regulatory System for:

    I.  Company Law (relevant parts only).

    II.  Securities Regulation.

    III.  Corporate Governance.



  32.  On 27 February, the Secretary of State for Trade and Industry announced the setting up of a group to ensure that there was a co-ordinated and comprehensive programme of work by individual regulators to review the UK's current regulatory practices for statutory audit and financial reporting. The collapse of Enron and the resulting concerns over financial reporting and the role of the auditors have focused attention, amongst other regulatory issues, on our own corporate governance arrangements, including the relationship between companies and their auditors and financial reporting requirements. Although all the factors involved in the Enron case are unlikely to emerge for many months, we want to be clear that the regulatory regime in the UK, for financial reporting and audit, continues to be effective and provides appropriate underpinning for strong and efficient national and international capital markets.

  33.  Some of the main issues that have been raised in relation to accounting and audit are as follows:

    —  the adequacy of the existing ethical standards of the professional audit bodies in ensuring the independence of auditors, and in particular whether they provide sufficient underpinning independence where auditors also provide non audit services to audit clients;

    —  a possible requirement (for some or all companies) for the mandatory rotation of audit firms; or for the mandatory re-tendering for company audit; or for a strengthening of existing requirements for the rotation of the audit partner;

    —  the need for more detailed disclosure in company accounts of the fees paid to the auditors for audit and non audit services;

    —  the role of the Audit Committee in relation to the appointment of auditors and the purchase by the company of non audit services from the auditor;

    —  the implications for accounting standards in the UK;

    —  the implications for auditing standards in the UK.

  34.  There are a number of important factors to take into account in addressing such issues. The first is that they can no longer be seen simply in a UK context. As markets become increasingly global, careful account must be taken of what is happening elsewhere in Europe, in the US, and more widely. Secondly, while there are significant differences between the US and UK systems, it would be complacent to suggest that the UK is immune to the problems highlighted by the collapse of Enron. Third, much has changed for the better in the UK in recent years in terms of accounting and auditing standards, the regulation financial services business, and the regulatory framework for auditors and accountants. Fourth, it is also the case that much of the work relevant to the concerns raised by Enron was in progress before the collapse of Enron.

  35.  The Government recognises that different regulators have their own responsibilities. They have submitted or will submit their own memoranda to the Committee on the issues and how they are responding.

  36.  It is also important, however that the work of each regulator is well informed by that of others, and there is close co-operation and co-ordination. The Secretary of State for Trade & Industry and the Chancellor of the Exchequer therefore invited Melanie Johnson, Minister for Competition, Consumers & Markets, DTI, and Ruth Kelly, Economic Secretary, HM Treasury, to lead a co-ordinating group on accounting and audit issues, which will:

    —  ensure that there is a comprehensive work programme, to be undertaken by individual regulators, and avoiding unnecessary overlap;

    —  provide a progress report by the summer, with a final report at a later stage;

    —  commission additional work or reviews, if that is judged appropriate; and

    —  reach a view on the adequacy of the proposals, and, if appropriate, make specific recommendations.

  37.  The members are as follows:

Melanie Johnson MP, Minister for Competition, Consumers & Markets, DTI;

Ruth Kelly MP, Economic Secretary to the Treasury;

Sir John Bourn, Chairman, Accountancy Foundation's Review Board; and Comptroller and Auditor General;

Michael Foot, Managing Director, Deposit Takers and Markets Directorate, Financial Services Authority;

Mary Keegan, Chairman, Accounting Standards Board;

Professor Ian Percy, formerly Chairman, Accounts Commission for Scotland. Former Deputy Chairman, Auditing Practices Board;

Rosemary Radcliffe, formerly a member of the Company Law Review Steering Group and Chief Economist, PricewaterhouseCoopers. Complaints Commissioner, Financial Services Authority.

  38.  The group held its first meeting on 11 April. There was an initial discussion about the work the regulators have in hand to address the key regulatory issues for audit and accounting raised in the wake of the Enron collapse. This focused on audit quality and auditor independence, financial reporting and auditing requirements, and corporate governance, in particular the role of the Audit Committee. The group will ensure that there is a comprehensive and co-ordinated 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.

  39.  The group also agreed to invite the principal accountancy bodies to be represented at the next meeting in view of their regulatory responsibilities, and to report relevant work they are undertaking.

  40.  The Government is also involved in international work to examine issues arising from recent corporate failures such as Enron, both within the European Union and beyond. In particular, the Financial Stability Forum (FSF), comprising finance ministries, regulators (both national and international groups) and international financial institutions, discussed this at its meeting in March. The FSF chairman will submit a report on the work being taken forward to G7 Ministers and Governors at their meeting in Washington later this month. The European Commission is expected to adopt shortly a Recommendation to Member States on auditor independence, and is working with Member States to identify policy areas for consideration in the light of Enron.


  41.  Also on 27 February, the Secretary of State for Trade and Industry announced an independent review of the role and effectiveness of non-executive directors. From the point of view of UK productivity performance the progressive strengthening of the role and quality of non-executive directors is strongly desirable. The review will consider how this can be delivered, building on the work of the CLR and the Myners Review Institutional Investment in the UK, including the Government's recent proposal to strengthen the duties of institutional investors. The CLR also noted "a growing body of evidence from the US suggesting that a strong contingent of non-executives produce superior performance".

  42.  On 15 April, the Secretary of State for Trade and Industry and the Chancellor of the Exchequer announced that Derek Higgs would lead this review. Derek Higgs is Chairman of Partnerships UK and a non-executive director of Egg plc, The British Land Company plc, Allied Irish Banks plc and Jones Lang La Salle Inc. The terms of reference of the review are set out in Annex B.

  43.  Overall, the work announced by the Secretary of State for Trade and Industry is aimed at:

    —  ensuring that companies can fulfil their potential and improve productivity;

    —  strengthening the UK's framework for how companies operate; and

    —  and encourage greater transparency.

April 2002

18   Company Law matters relating to Scotland are reserved to the UK Parliament and those relating to Wales have not been transferred to the National Assembly. Back

19   Association of Chartered Certified Accountants (ACCA), Institute of Chartered Accountants in England and Wales (ICAEW), Institute of Chartered Accountants in Ireland (ICAI), Institute of Chartered Accountants of Scotland (ICAS). Back

20   Some, but by no means all, public companies are listed companies. Back

21   By amending the 1985 Act. Back

22   Ev 80. Back

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