Memorandum submitted by the Association of British Insurers
In the light of the Committee's enquiry into the above, I thought it might be helpful for you to see the position paper prepared by the Association of British Insurers on the impact of the Enron collapse. Our members have considerable interest in this subject because, as large investors, they own something approaching a quarter of the shares listed on the London Stock Exchange. Transparent accounting therefore matters very much.
You will see from the paper that we do not propose radical reform in the sense of rotation of auditors or formal separation of audit and non-audit work, but we are keen to see audit partners rotate more frequently and for the audit committee to take a much stronger role in overseeing the independence of the audit process and the allocation of non-audit work. We are already taking practical steps to promote such an enhanced role for audit committees by sending letters to a number of companies which have not disclosed sufficient information in their annual report.
On another issue, we are concerned about concentration in the accountancy sector. Though there are no easy solutions, we feel this is a problem which needs to be addressed.
3 April 2002
Strengthening the Audit Process after EnronA Discussion Paper
The Board and the Investment Committee of the Association of British Insurers have been examining the impact of the collapse of Enron. This paper outlines their preliminary conclusions as to how to strengthen the audit process in the wake of that event.
It is written on the basis that knee-jerk reactions would be dangerous and there should be widespread and careful debate about any changes to make sure that they are genuine improvements. It makes the following main points:
Forcible rotation of auditors is not desirable because scrutiny would be weaker during the transition from one audit firm to another. Instead, it would be more sensible to rotate audit partners more frequently than the current norm of seven years.
New auditors should, however, be engaged if the audit partner is appointed to a senior position in the client, for example as finance director.
It is not practicable to force a separation of audit and non-audit work because there are too many definitional problems. For example auditors are best qualified for the task of preparing regulatory returns for insurance companies.
However, audit committees should be made more accountable for ensuring that the audit process is independent, and that non-audit work has been awarded on an appropriate basis. They should reassure shareholders on this point by disclosure in the annual report. ABI plans to step up its governance effort work in this area by seeking explanation of how work has been awarded in cases where audit fees exceed non-audit fees.
Audit work should not be a loss-leader. High quality audit may require higher fees. These would be worth paying if the result was improved protection against Enron-style collapse, but higher fees should not simply reflect diminishing competition as a result of a contraction in the number of large firms offering the service.
INTRODUCTION AND BACKGROUNDS
The Enron collapse has focused world attention to accounting standards and the role of auditors. ABI has been reviewing the issue because it concerns members in two ways.
As investors they need to consider the corporate governance implications and possible regulatory impact, especially with reference to the impending government review. As preparers of accounts, they need to reassure themselves that UK practice is sufficiently robust and that any regulatory changes following Enron will lead to genuine improvements without adding unnecessary cost.
More generally the financial and business community has an important interest in ensuring that confidence in the audit process is maintained. Otherwise there is a risk for companies and their shareholders of abrupt and arbitrary withdrawal of capital from suspect business.
The issues are complex and it is clear that knee-jerk reactions are not appropriate. Hasty conclusions will not necessarily strengthen the system. Indeed, they may open up the risk of further trouble in future.
This paper sets out some preliminary conclusions that follow from discussion of the issues in the ABI's Board and Investment Committee. It makes suggestions, which focus on the need to ward against conflicts of interest between auditors and their clients. These are not a complete and definitive list of proposals for change, but more an initial contribution to what needs to be a wide-ranging debate.
WHY PROBLEMS ARISE
A number of separate groups have an interest in a company's accounts: management, shareholders and lenders, and, where relevant, regulators. While all have a genuine interest in understanding the business and its prospects, the motivation may not be the same in every case. Management has an incentive to paint a positive picture to the other groups. Shareholders and creditors need an objective view.
Accounting rules need to be robust in order to ensure that the picture is objective. The audit process needs to be independent in order to prevent undue influence by management. Though a complete picture has yet to emerge, it looks as though Enron's collapse revealed shortcomings on both counts of robustness and independence.
It is thus appropriate to review UK practice from these standpoints. There may be a case for change in some areas, but these should not generally go in the direction of detailed prescription and additional rule-making. UK Practice differs from that of the US in that it is more flexible and less rule-bound. Because it values substance over form, it is likely to produce more reliable outcomes. This approach should also be preserved for the elaboration of international standards, which are due to enter force in the European Union in 2005. It would be wrong to shift towards a more rule-based approach in the wake of Enron, not least because that would encourage companies and their auditors to seek loopholes.
It is commonly considered that, had Enron been incorporated in the UK, it would not have been able to move so much of its business off its balance sheet, or to book future profits prematurely, or to treat turnover in energy trading as revenue.
Nonetheless it is appropriate that investors and audit committees should tighten their scrutiny of the audit process. Beyond that, it is particularly important to examine ways in which the system can be strengthened to limit conflicts of interest. Auditors must be in a position to resist pressure from managements to present an overly positive view of the business. They must not make themselves vulnerable to such pressure by coming to rely heavily on fees for non-audit consultancy work from companies whose accounts they audit.
ELIMINATING CONFLICTS OF INTEREST
Two main means of preventing conflicts of interest have featured in the debate over Enron. Some have suggested that auditors should be rotated on a regular basis. Others have suggested that there should be a formal separation of the roles of auditor and consultant. Both ideas have attractions. Both have flaws.
Of the two, that of rotating auditors is the more problematic, because there would be regular periods of transition during which scrutiny would be weak. Critical issues might thus be overlooked.
A more practical approach might be to impose more frequent rotation of audit partners than the current seven year norm. This would be part of a process that would also ensure a steady and continuous rotation of audit teams. Some ABI members believe the audit partner should be rotated every three years.
Another suggestion is that the audit partner be named in the annual report. This, it is argued, would instil a greater sense of personal responsibility and raise the quality of the audit.
Another idea, to which shareholders attach considerable importance, is that the audit partner should not move across to a senior position within the client company, particularly as Finance Director. While shareholders are not in favour of rotating auditors, they do believe that such an appointment should automatically trigger the appointment of new auditors.
The idea of separating audit and consultancy work also finds some support. This is also the direction in which the market is moving, especially in the US.
However, there are reservations on two counts about prescribing such change. First there are definitional problems. Some types of non-audit work fall naturally to auditors. An example is the preparation of regulatory returns for insurance companies.
For this reason the ABI has resisted the temptation to prescribe a formal separation of the audit/consultancy role or to prescribe any maxima for the ratio of non-audit to audit fees.
There is, however, scope for strengthening governance in this area, even as an interim measure pending the conclusion of broader debate. The ABI's Institutional Voting Information Service already monitors the ratio of audit to non-audit fees. When the latter exceed the former, we now plan to follow through with a letter to the chairman of the audit committee, asking for an explanation of the fees, confirmation that the committee is comfortable with the award of non-audit work to its auditor and to state whether non audit work had been put out to tender.
A second concern that is sometimes voiced in this debate is that auditing will cease to attract talented individuals if it becomes a dead-end activity. This is all the more questionable in that it is sometimes put forward by audit firms in order to justify their activity as consultants.
The notion that audit work is simply a means of acquiring the contacts and knowledge that lead on to consultancy work debases the importance of the audit process. It suggests that there may be an element of cross-subsidy in which the audit is effectively a loss-leader designed to attract lucrative consultancy work.
If institutional shareholders want to ensure that company accounts are properly audited, they must be prepared to sanction appropriate fees. It may well be that audit fees should rise as standards are tightened in the wake of Enron. Shareholders should support this if it leads to higher quality audits and reduces the temptation for audit firms to raise additional revenue through consultancy.
There are two provisos. First, it would be wrong to concede higher fees simply because a contraction in the number of large audit firms had reduced competitive pressure. Companies need a diversity of choice when looking for an auditor. Second, higher fees would also require higher standards of supervision.
There is a strong case for revisiting the role of the audit committee and for requiring it to make regular disclosure in the annual report about its activity in supervising the audit process. Such disclosure would increase the accountability of the audit committee. It would include confirmation that the committee had assured itself that the audit process was suitably independent and that any non-audit work had been awarded on an appropriate basis. Shareholders should satisfy themselves that the audit committee was qualified to make such assurances.
There are two main ways in which the present system could be strengthened. First audit partners should be rotated more frequently and actively discouraged from moving to senior jobs within client companies. This would prevent them from becoming too close to the companies with which they are involved.
Second, short of a formal ban on consultancy work, there is a need to encourage a greater awareness of the importance of ensuring that consultancy work is awarded on an appropriate basis. Putting non-audit consultancy work out to tender would help but is not the entire answer. There must be a strong onus on audit committees to ensure that auditors are producing objective work and that non-audit work is awarded on an appropriate basis.
The diminishing opportunity to cross subsidise audit work from consultancy fees may mean that audit fees would have to rise. However, this would be a price worth paying to prevent a repetition of a collapse as damaging and expensive to so many people as that of Enron.