Post Enron Developments on the UK Audit - Assignment Example

POST ENRON DEVELOPMENTS ON U.K. AUDIT The 2001 Enron disaster served to turn the international spotlight on contemporary corporate governance, accounting and auditing practices. The definition of corporate governance has two parts. Firstly, it is a set of procedures, traditions, programme of actions and rules that govern the way a corporation is supervised, administered or controlled. Secondly, it encompasses the significant connection among the many players concerned – shareholders, board of directors, management, employees, creditors, banks, society and the environment. Corporations are expected to adhere properly and faithfully by this definition while they go about achieving their goals and objectives.1 Corporate governance focuses on three themes. The first theme is ‘accountability and fiduciary duty,’ whereby it recommends enforcing official recommendations and means to promote good behaviour and shareholder safety. The second theme is ‘economic efficiency view,’ that advocates targeting maximum economically favourable results, especially on issues involving shareholders’ welfare. The last theme is ‘stakeholder view,’ that recommends more serious consideration and accountability to those involved players who are not shareholders of the corporation, such as employees, creditors, banks, society and the environment.2 All players involved in corporate governance have either a straightforward, or an indirect interest in the proper functioning of the corporation. Shareholders obtain capital return in the form of dividend; directors, management members and employees get their remuneration in the form of salaries and/or benefits, as well as build up on their personal 1: Wikipedia. 2007. Corporate Governance. 2: Ibid. work experience and reputation; society (customers) acquire the products (goods or services) of the corporation; and suppliers, creditors and banks obtain an amount of money for the goods or services they provide to the corporation.3 The paramount factor that motivates shareholders and other stakeholders to invest financial capital in the corporation is the trust that they will be compensated by a reasonable and impartial amount of returns. The trust factor is based on the principles of truthfulness, adherence to moral values, frank openness, acting authority, loyalty and accountability of the corporation. If this crucial factor is compromised (as it glaringly happened in case of Enron in 2001, which focused mainly on irregularities associated with their audit conducted by the firm Arthur Anderson LLP),4 then stakeholder outrage fuels a gigantic public mistrust of corporate governance in general, and corporate governance practices of corporations in particular.5 It is the fundamental right of every shareholder to expect accuracy and reliability in the publicised account reports of the companies they invest in. The accuracy and reliability factor basically governs the shareholders’ relationship with the company, because such published account reports are the only indication about the company’s financial position (especially the soundness and proper functioning of its current investments), and as such, represents the basis on which the shareholders decide about investment in the company. Shareholders, therefore, need to be assured about the accuracy and reliability of the company’s published accounts. This is the reason why it is mandatory for companies to get their accounts checked by an independent auditor. High profile cases like the Enron disaster tend to not only lower the esteem of the auditing profession as a whole, but also 3: Wikipedia. 2007. Corporate Governance. 4: Hermes.co.uk. Auditor Independence 5: Wikipedia. 2007. Corporate Governance. to erode confidence of shareholders, making them doubt the authenticity of the reports published.6 An independent auditor is defined as “a Certified Public Accountant who provides a company with an accountant’s opinion, but who is not otherwise affiliated with the company.”7 The global auditing world is ruled by 5 auditing firms (called the Big Five) that have the capability to audit the largest public companies in the world. They are PriceWaterhouseCoopers (PwC), Klynveld, Peat, Marwick, Goerdeler (KPMG), Ernst & Young (E&Y), Deloitte & Touche (D&T), and Arthur Andersen (AA) {Europa.eu, 2002}. The Big Five attained their structure and position as a result of several mergers with other auditing firms (the last major merger involved Price Waterhouse and Coopers & Lybrand, who formed PriceWaterhouseCoopers, thereby trimming the Big Six to Big Five {Europa.eu, 2002}). After the Enron scandal in 2001, AA was struck off the Big Five list with the result that there are now the Big Four audit firms. Within the U.K, PwC is the largest audit firm, although by a worldwide comparison, the Big Four are almost evenly matched.8 Public concern about the independent status of auditors stems from the trend of audit firms to diversify to other non-audit services such as legal consulting, IT consultancy, corporate finance and management consulting. Some of these services have no relation with the audit, but there are others like tax accounting and merger-related work, that are characterised by a close relationship with auditing; given the fact that the auditing firm’s clients are supplied such services, this scenario causes suspicion among shareholders that 6: Hermes.co.uk. Auditor Independence 7: Investorwords.com. Independent Auditor. 8: Oxera.com. 2006. Competition & Choice in the U.K. Audit Market. the audit process may be endangered by fraud.9 Shareholders’ concerns are fuelled by the fact that non-audit fees are much more than audit fees.10 The audit fee in itself is quite high - a study showed that the top 10 auditing firms in the U.K earn over £ 1.5 billion in audit fees every year,11 but when compared to non-audit fees, this figure pales in comparison. A 2002 ‘Financial Director’ magazine survey of the FTSE 100 companies disclosed that while the average audit fee was £ 2.21 million, average non-audit fees done by their auditors was £ 6.5 million.12 This study came soon after another 2000 survey by ‘Brand Finance’ involving the FTSE 350 companies found that the audit fees paid to the Big Five was £ 300 million, while non-audit fees paid to them was £ 500 million.13 These studies also contain cases where the non-audit fee is 10 to 12 times higher than the audit fee, both paid to the same auditor; in a few ‘freak’ cases, the non-audit fees were 47 to 78 times higher than audit fees.14 It is no wonder then that the spectre of significant conflict of interest started looming larger with the publication of each company’s account statement. Following the passing of the Sarbanes-Oxley Act by the U.S. in 2002, the U.K. passed its own equivalent to that Act on January 29, 2003 in the form of the Hewitt-Brown reforms. The main reason for the reforms was to improve standards of corporate governance in general, and to regulate the previous practice of letting U.K. industry depend on self-policing of its practices. Praised as a “very measured,” and not a “knee- 9: Hermes.co.uk. Auditor Independence 10: Ibid. 11: Oxera.com. 2006. Competition & Choice in the U.K. Audit Market. 12: Hermes.co.uk. Auditor Independence 13: Ibid. 14: Ibid. jerk” response by Peter Wyman, president of the Institute of Accountants in England and Wales, the reforms were prepared by Patricia Hewitt, secretary of state for trade and industry, and Gordon Brown, Chancellor of the Exchequer.15 The Hewitt-Brown reforms are applicable to all listed companies in the U.K. In keeping with the traditional British procedure of not using detailed rules to instruct corporation boardrooms how to operate, but to make available best practice codes (thereby creating a situation where the market, and not the government, is the judge), the Hewitt-Brown reforms leave it to the individual listed companies to make a choice whether they would like to adopt the reforms. If they choose not to do so, then it is left to them to explain the reason for such non-compliance to their shareholders; the latter option is predicted to bring meaningful pressure on them for compliance.16 The Hewitt-Brown reforms are contained in a set of four suggestions by specialist Groups; these suggestions were studied, accepted and official approved as reforms on 29 January 2003 during Patricia Hewitt’s address to the House of Commons.17 The Coordinating Group’s suggested reforms were aimed at auditors and their independence. These reforms enjoyed the full backing of U.K. professional institutions such as the Institute of Chartered Accountants in England and Wales. Firstly, listed companies should strictly ensure that the guiding audit partner is replaced within a period of five years. Secondly, partners or employees of audit firms should be forbidden to be employed by the listed company within a span of two years from the date of their resignation or termination from the audit firm. Lastly, the audit firms should publish 15: Pfanner. 2003. In Wake of Enron U.K. Tightens Accounting Rules.. 16: Hewitt. 2003. Strengthening Corporate Governance. 17: Ibid. detailed annual reports.18 The Coordinating Group suggested a second set of reforms that envisaged a pro-active enforcement of the Hewitt-Brown reforms. Firstly, the Financial Services Authority should be directed to assist the Financial Reporting Review Panel on enforcement issues, especially in pin-pointing hazardous cases that are in need of very extensive scrutiny. Secondly, the existing range of functions of the Financial Reporting Council (FRC) should be expanded to include the functions of the Accountancy Foundation, thus elevating the FRC to the position of an independent U.K. regulating entity with three distinct roles: formulating accounting and auditing levels of quality, pro-actively imposing and monitoring them, and supervising the activities of self-regulatory professional institutions.19 The Group led by Sir Robert Smith and Derek Higgs put forward the third set of suggestions. They focused on the Combined Code of Corporate Governance. Firstly, the jobs of chairman and chief executive should be distinct and separate. Secondly, at least 50 percent of the remuneration committee members should be independent. Thirdly, the functions of the board, chairman and non-executives should be reviewed and revised. Fourthly, at least 50 percent of the board members, as well as the nomination committee members, should be independent. Fifthly, the practice of appointing directors through private connections and friendships should be discontinued, and be replaced with an extremely precise and exacting, impartial and freely accessible appointments procedure. Sixthly, the corporation’s audit committee members should be totally independent, and at least one of them should have reasonable financial knowledge or skill. Seventhly, the 18: Hewitt. 2003. Strengthening Corporate Governance. 19: Ibid. corporation’s audit committee should exercise utmost vigilance when regularly reviewing auditor activities. Eighthly, the practice of allowing auditors to supply non-audit services to their audit clients should be stopped.20 The last set of suggestions was put forward by the DTI’s Review Group. It focused on monitoring audit activities. Firstly, professional institutions should hand over standard-setting duties to the Auditing Practices Board. These standards include freedom from dependence or control by others, the ability to perceive things without being influenced by personal emotions or prejudices, and the quality of possessing and steadfastly adhering to high moral principles or professional standards. Secondly, a new Professional Oversight Board should replace the Ethics Standard Board, taking over the latter’s function of overseeing ethical standards. Thirdly, the FRC should create a new Independent Inspection Section within its structure to take over (from professional institutions) the task of monitoring audits of listed companies, pension funds and prominent charitable organisations. Fourthly, a new Investigation and Discipline Board should be formed to act as an independent medium of expression to judge important public interest cases relating to the enforcement of rules of behaviour.21 Auditing firms too came up two recommendations that listed companies would do well to adopt as alternatives to the Hewitt-Brown reform that recommends auditors should no longer perform non-audit services to its audit clients. The first solution was that the auditing firm should split its business into two – one firm dealing only with auditing, and the other handling non-audit services. Two of the Big Four took steps in this direction: KPMG created a new firm called KPMG Consulting, and E&Y sold its non-audit 20: Hewitt. 2003. Strengthening Corporate Governance. 21: Ibid. consultancy service to Cap Gemini of France.22 The second solution was for the firm to retain a small part of the non-audit service capacity in-house. This solution helps audit clients who prefer that their auditors go on providing non-audit services, because such services (especially tax consultancy) would be very much higher when paid to a firm other then the auditor. This solution was implemented by D&T.23 Audit clients (listed companies) have expressed favour regarding the need to rotate auditors within a fixed period of five years. This is a good sign because a study reveals that more than 70% of the FTSE 100 companies have not held a competitive tender during the 15 years.24 The fact that the fresh eyes of a new auditor will be reviewing their work, will induce existing auditors to be more conscientious and painstaking in their efforts. Although this would add a burden (constant tendering for auditors would result in an increase of audit fees), it would be more than offset by the perceived advantages, the most important being a significant enhancement of the company’s accounting information in the eyes of its shareholders and prospective investors.25 Responding to two of the Hewitt-Brown reforms that require auditors to abstain from performing non-audit services to their audit clients, as well as publish detailed annual reports, several audit clients have identified these matters as high stakeholder interest areas and have taken it upon themselves to adopt an accounting report that shows non-audit fees in full detail, as completely different from audit fees. A good example of this is the report dated 31.12.2000 of U.K company Halifax Group Plc. Relevant parts of it are provided in the attached appendix.26 22: Hermes.co.uk. Auditor Independence 23: Ibid. 24: Oxera.com. 2006. Competition & Choice in the U.K. Audit Market. 25: Hermes.co.uk. Auditor Independence 26: Ibid. In conclusion it can be said that the combination of the Hewitt-Brown reforms initiated by the government, along with precautionary steps by auditing firms and auditing clients, will go a long way towards preventing the U.K. public seeing a repeat of chilling accusations leveled against auditors, such as during the Enron debacle, namely, creation of partnerships with shell companies to hide its own liabilities, deliberate destruction of evidence, obtaining special favours by political contributions, and worst of all, knowing that the company was sinking fast, the act of Enron executives selling $ 1.1 billion in stock while at the same time motivating Enron employees and other investors to keep buying stock.27 In the event of another loss of a Big Four firm caused by professional misconduct, the effects of a four-to-three scenario28 would, among other effects, erode investor confidence to an unprecedented low, one from which it would take years to recover. 27: Kadlec. 2002. Enron: Who’s Accountable. 28: Oxera.com. 2006. Competition & Choice in the U.K. Audit Market. Appendix29 Reproduction of part of Halifax Group Plc annual report dated 31.12.2000 Details of expense Year 2000 Year 1999 Remuneration of auditors & their associates (including VAT) 2.0 1.7 Non-audit services 4.0 1.4 Non-audit services comprise the following: Regulatory reporting 1.9 0.6 Tax services 0.8 0.5 Consultancy 1.0 0.2 Other 0.3 0.1 Total non-audit services 4.0 1.4 Non-audit fees of £ 0.4 m have also been incurred by the Group I the year ended 31 December 2000 relating to acquisition (1999: £ 0.1 m). The Company’s audit fee, which is included in the figure for audit services to the Group, amounted to £ 29,375 (1999: £ 34,000). A competitive tendering process is prescribed for the appointment of consultants where the expected fee exceeds £ 50,000 (excluding VAT). If the tendering process results in the external auditors being the recommended supplier, the decision has to be approved by the Group Finance Director. The Group Finance Director also has the authority to appoint the external auditors in cases where an urgent appointment is necessary, or for certain specific areas of work where he considers that the auditors’ experience of the Group’s activities is required. Fees payable to the external auditors are reported regularly to the Audit Committee, which monitors the auditor’s independence on behalf of the Board. 29: Hermes.co.uk. Auditor Independence References used: Anon. N.d. Auditor Independence: Hermes.co.uk. [Online]. Available: http://www.hermes.co.uk/pdf/corporate_governance/commentary/comment_on_auditor_independence.pdf [6 March 2007] Anon. 2002. Commission clears the Takeover of Andersen’s UK Business by Deloitte & Touche: Europa.eu. [Online]. Available: http://europa.eu/rapid/pressReleasesAction.do?reference=IP/02/968 [6 March 2007] Anon. 2006. Competition & Choice in the U.K. Audit Market: Oxera.com. [Online]. Available: http://www.oxera.com/cmsDocuments/Reports/DTI%20Auditors%20executive%20summary.pdf [6 March 2007] Anon. 2007. Corporate Governance: Wikipedia. [Online]. Available: http://en.wikipedia.org/wiki/Corporate_governance [6 March 2007] Anon. N.d. Independent Auditor: Investorwords.com. [Online]. Available: http://www.investorwords.com/2423/independent_auditor.html [6 March 2007] Hewitt, P. 2003. Strengthening Corporate Governance: Dti.gov.uk. [Online]. Available: http://www.dti.gov.uk/ministers/speeches/hewitt290103.html [6 March 2007] Kadlec, D. 2002. Enron: Who’s Accountable: Time.com. [Online]. Available: http://www.time.com/time/magazine/article/0,9171,1001636,00.html [6 March 2007] Pfanner, E. 2003. In Wake of Enron, U.K. Tightens Accounting Rules: International Herald Tribune. [Online]. Available: http://www.iht.com/articles/2003/01/30/account_ed3_.php [6 March 2007] Read More