Memorandum submitted by Grant Thornton
We are grateful for the opportunity to make a written submission to the Treasury Committee on this important topic.
INTRODUCTION AND KEY POINTS
We are aware that others, including the professional accountancy bodies, have also received a similar invitation to comment. Whilst this submission discusses some of the background that others will no doubt also cover in detail their submissions, we do so only to the extent necessary to set our comments into a proper context.
The full details of the circumstances surrounding the collapse of Enron, and the roles played by its senior management (including the non-executive directors), its auditors and other advisers will take to time to emerge. In the meantime, public opinion on both sides of the Atlantic is not unnaturally concerned that there could be systemic flaws in the ways in which listed companies report to their stakeholders and auditors make their reports on financial statements that could lead to other corporate failures in the future.
In our view, it is not credible to proceed as if nothing has happened because Enron has called into question in the public's mind the issue of auditor independence. Whilst the Government and regulators in the UK have a responsibility to respond in these circumstances, we believe that it is vital that they should:
take full account of differences in the regulatory, legal and professional requirements that currently exist on the two sides of the Atlantic;
resist the temptation to adopt "knee-jerk" reactions to the apparent causes of the collapse of Enron in the US before full details of the actual contributing factors have been established;
recognise that differences between the "public interest" sector and other parts of the UK economy justify different regulatory regimes and that a "one size fits all" approach to regulation post-Enron could be inappropriate and damaging to the UK economy as a whole;
appreciate that the role played by the auditor is only one aspect of the framework of financial regulation of companies: other aspects include the key role played by non-executive directors and audit committees;
not place UK companies and their auditors under a regulatory structure that is (at best) inconsistent with current or planned regimes elsewhere in the EU or (at worst) puts UK companies and their auditors at a significant disadvantage compared with their EU counterparts.
The background to these views is explored in more detail in the remainder of this submission.
BACKGROUND ABOUT GRANT THORNTON
Grant Thornton is the leader in providing accounting and professional services to entrepreneurial businesses and their owners. Our clients frequently regard us as their financial and business advisors. These companies both want and need a variety of assurance and advisory services and tax services to help them compete, grow and prosper in today's global market place.
We fully support the IFAC Code of Ethics issued in November 2001. The IFAC Code sets the global independence and ethical standard for auditors. Grant Thornton issued global policies and procedures in August 2001 with the intention of being one of the first audit firms to comply with the IFAC Code throughout the World.
Grant Thornton is on record supporting the current reviews being undertaken by the SEC and European Commission of the vital public perception issues which surround auditors' independence.
Grant Thornton takes a leading position, as a Founding Member of the Provisional Forum of Firms, in supporting the IFAD Vision of the provision of reliable, consistent and transparent financial reporting throughout the World. We have developed a global audit quality assurance programme designed to ensure that Grant Thornton audits are carried out to a uniformly high standard in all our member firms.
Grant Thornton's global audit approach (Horizon) enables all of our member firms to perform audits in accordance with current International Standards of Auditing.
Grant Thornton has designated experts to assist our clients who intend to adopt International Financial Reporting Standards endorsed by IOSCO.
RELEVANCE OF THE COLLAPSE OF ENRON TO THE UK CONTEXT
Whilst public concerns about the collapse of Enron are to be expected, we believe that it is vital that lessons are drawn only after full and careful consideration of the US context and full account has been taken of the very different corporate and professional regulatory environment that exists in the UK.
In particular we would wish to highlight the following differences that we believe to be key:
financial reporting standards and auditors' independence requirements in the US are principally rule-based, rather than principles-based as in the UK: we believe that a principles-based approach in these areas is more likely to lead to the provision of reliable and transparent information in published financial statements;
in the UK, the representation of interests from outside the accounting profession on the Accountancy Foundation (and its subsidiary bodies) which oversees the profession and the setting of professional auditing standards (including ethics and independence) means that an independent body oversees the running of the audit profession in the UK;
the independent audit quality reviews that are performed in the UK by the Joint Monitoring Unit have many advantages over the peer review approach in the US;
the UK has made great progress in establishing:
an effective framework for corporate governance arrangements;
the Financial Reporting Review Panel as an independent and widely respected accounting standards enforcement agency;
UK disclosure requirements that enable audit committees and investors to satisfy themselves that the provision of non-audit services does not compromise the appropriate relationship between auditor and management;
the UK has implemented many of the above reforms in the light of corporate failures from earlier decadesthe US is only now beginning to react to such problems. Indeed, the previous SEC chairman (Arthur Levitt) praised the UK auditing profession for the steps it had taken to demonstrate its commitment to meeting its public interest responsibilities and the current SEC chairman (Harvey Pitt) is clearly looking to the EU (and the UK in particular) for possible ways forward for the regulation of the US profession;
the tough proposals of the draft EU Recommendations of Auditors' Independence and IFAC Code of Ethics were established after much consultation and considerationthese measures should be given the chance to bite rather than scrapping them in favour of knee-jerk reactions to Enron.
THE ROLE OF THE DIRECTORS
The auditor has an important job to play in ensuring that capital markets have relevant and transparent financial information. However, we believe that is important for the Committee to recognise that directors, not auditors, have primary responsibility for the preparation of the accounts of a company, whether a plc or a private company. In this regard "accountants" within a company and "accountants" within an audit firm have very different duties and responsibilities.
In the case of public interest entities such as listed companies, the non-executive directors have a key role to play in ensuring that executive management is adequately challenged in connection with periodic financial reporting (namely interim and preliminary announcements and the publication of annual accounts), particularly the accounting bases and policies that are applied by the company. In a situation such as that of Enron, this would include the treatment by executive management of special purpose companies in the group accounts.
In addition, audit committees should keep under review the credentials of the external auditors and any factors that might give cause for concern (whether perceived or actual) about their independence. As part of transparent financial reporting, we would support clear disclosure of fees paid to auditors for non-audit services and, where significant fees were paid for non-audit services, the reason to be given as to why the auditor (rather than another firm) was engaged to do that work. Such disclosures would help those charged with corporate governance (and investors) to guard against the relationship between the auditor and executive management from becoming inappropriate.
We also believe that steps should be taken to improve corporate reporting of business risks: this could be achieved through the medium of the Operating and Financial Review ("OFR")-currently a non-mandatory part of the annual reports of listed companiesor could be made a required disclosure by amendments to the current corporate governance requirements of the Listing Authority's "Purple Book". Although such disclosure alone would not prevent the failure of companies, greater transparency about the risks that they face should enable investors and other stakeholders to make more informed choices when interpreting published financial information as a basis for deciding whether to acquire or retain shareholdings.
THE ROLE OF THE AUDITOR
Andersen, the auditor of Enron, has been a focus of considerable media attention, much of which was generated by allegations that documents related to the audit were destroyed after the announcement of US Government enquiries into the collapse of the company. As with other aspects of the collapse of Enron, the standard of conduct of Andersen will only emerge once there has been full consideration of the detailed circumstances leading up to Enron's collapse.
However, concerns have already been expressed publicly that Andersen's expected level of independence as auditor was compromised by the level of fees that it received from its client, particularly for non-audit work, and the length of the association between that firm and its client. As a result, many commentators have called for a number of changes to be made to the framework of professional independence rules, including:
restrictions on the extent to which accounting firms should be allowed to provide other ("non audit") services to their audit clients;
mandatory rotation of audit firms and/or more frequent rotation of the partner responsible for the audit;
a "cooling off period" for situations where senior personnel of an accounting firm join an audit client at a senior level.
In addition, some have suggested that there may be merit in adopting the approach in France, which requires joint auditors of listed companies.
Whilst each of these steps has a superficial appeal, the Committee should be aware of the practical arguments that may be levelled against them, which are summarised below.
RESTRICTIONS ON NON-AUDIT SERVICES
In our view, a restriction (whether in absolute monetary terms or by reference to the level of audit fees) would be arbitrary and unnecessary. There is no evidence in the UK or elsewhere that large fees, whether for non-audit work or complex multi-location audits, have been at the root of "audit failures" in the past. Taken to an illogical extreme, the argument that fees prejudice independence could be levelled at all audits because fees are agreed by the executive management of client companies.
In practice, the market demands for audit and assurance services are moving away from merely reporting on historical information the provision of assurance that businesses identify the key risks which they face, establish effective control systems to manage those risks and have reliable information systems that ensure that the financial information they use and publish is reliable and transparent. Wide scale prohibition of auditors from providing advisory services would mean that the audit profession could not react to these new demands from the capital markets. In our view, it is the market that should drive any change in the provision of non-audit services to audit clients rather than further legislation or regulation.
The ability to recruit the best professionals is essential to audit firms conducting audits of the highest quality. If audit firms are precluded from offering their personnel a route into a wider business career they will be unable to recruit personnel of the quality they require.
Instead of limiting the provision of non-audit services, we believe that regulators should strengthen the responsibilities of audit committees: their members should have a specific duty to consider whether existing and new professional work that is not directly related to the audit should be placed with the company's auditor. Factors to be considered would include the linkage (either beneficial or prejudicial) with the firm's audit role and the scope for the audit firm's involvement in providing the additional services to impact on their perceived or actual independence. A consideration would be whether the safeguards established by an audit firm which provides non-audit services to its client comply with the IFAC Code of Ethics and other suitable guidance (for example, the draft EU Recommendation on Auditors' Independence).
The accounting profession has not been inactive in this area and Grant Thornton believes that IFAC Code of Ethics and the draft European Union Recommendation on Auditors' Independence represent excellent work designed to ensure that audit firms adhere to the highest standards of independence and ethical behaviour. We believe that these Codes should be given the chance to demonstrate their effectiveness.
In our view, the perception of independence threats arising from the provision of non-audit services is greater in the context of large listed companies with professional management who are distant from public stakeholders than is the case with owner-managed businesses. Whilst we recognise that the terms of reference of the Committee refer specifically to "financial regulation of public limited companies", we believe that should the Committee conclude that changes should be made in respect of audits and auditors of those companies, it should record in its findings that the application of those same measures to the owner-managed business sector would carry less justification and would be damaging as a result of the features that distinguish the owner-managed business sector, namely:
Owner-managed businesses need access to a range of financial and business advisory services. Audit firms are ideally placed to provide such advice to these clients because of the understanding of the business they acquire through providing the annual audit. If these clients are forced to obtain this advice from other sources, which have less understanding of the business, it is likely that their costs will increase or that they will simply not seek that advice. Either way owner-managed businesses will become less competitive.
In owner-managed businesses there is frequently a strong overlap between ownership and management. In these cases it is essential that the auditor understands the motivations of the owner-manager and the provision of advisory services helps to provide this understanding and leads to improved audit quality.
In summary, we believe that unnecessary legislation or regulation in respect of the provision by auditors of non-audit services will reduce competition, which will ultimately be to the detriment of the health of the business community. Instead, we believe that IFAC Code of Ethics and the draft European Union Recommendation on Auditors' Independence should be given the time to demonstrate their effectiveness. Should it be considered necessary in the public interest to tighten the auditor independence requirements, we would argue strongly that "lighter" regulation should apply to audits outside the public interest sector.
ROTATION OF AUDIT FIRMS
Professional independence requirements currently call for the audit partner who takes responsibility for an audit firm's audit opinion on the accounts of a public company to be changed (or "rotated") at least every seven years. We support this approach because it ensures that the audit issues receive a fresh view and therefore the audit does not become stale; at the same time, the audit retains the benefit of the firm's collective knowledge accumulated from audits performed in previous years.
However, we do not support the periodic rotation of audit firms, since most audit failures occur in the first two years of the audit relationship and such rotation will also drive down audit fees and quality. We do not believe there is any evidence from countries such as Italy that demonstrates any improvement in audit quality as a result of mandatory rotation of audit firms.
COOLING OFF PERIOD WHEN SENIOR AUDIT STAFF JOIN AN AUDIT CLIENT
In our view, the IFAC Code of Ethics provides adequate safeguards in cases where a former audit partner joins an audit client, but we would not have any strong concerns if additional safeguards were imposed by regulation in this respect.
JOINT AUDITS OF LISTED COMPANIES
It is the practice in France for listed companies to have joint auditors i.e for two separate firms to be appointed jointly to the role of company auditor. It has been proposed in some quarters that the wider application of this principle to audits of listed companies in other parts of the EU would address public concerns about possible commercial or other pressures on the independence of sole auditors. For example, one firms could be from the "Big 5" and the other from outside the "Big 5".
At this stage, we believe that such a suggestion is worthy of consideration, but we have concerns about how the relationship and sharing of risk between two firms of (potentially) very different sizes should operate in practice.
The UK already has stronger controls in place than currently exist in the US. Further measures are already being introduced by the EU and IFAC and we believe that these should be given the chance to demonstrate their effectiveness before there is any knee-jerk reaction to Enron, which arose in a different (US) context.
We hope that the content of this submission will assist the Committee in its consideration of this important subject. Should the Committee require further input from us, contact should be made at the first instance with Steve Maslin, Head of Assurance Services, or Peter Rowley at this office address.
5 April 2002