THIRD FCM CONFERENCE – BUCHAREST, 26 – 27 MAY 2003

CHALLENGES FACING THE PROFESSION

CREDIBILITY AND INDEPENDENCE

Remarks of Graham N C Ward, Board Member: International Federation of Accountants

Chairman, thank you very much for your kind introduction and for the opportunity to share some personal ideas with you, distinguished fellow panellists and this distinguished audience today. Although the title of this session is “Credibility and Independence”, I will cut the cake slightly differently: into three slices rather than into two. Indeed, I believe that the slice “independence” is not really the key issue. What matters is integrity. Independence, certainly the badges of independence referred to in the literature, is simply an often imperfect indicator of whether or not integrity is present. My three slices are quality, integrity and understandability and they relate as much to the people involved in the financial reporting process as they do to the financial reports themselves.

Quality, Integrity and Understandability

I can think of no better way to express the imperative for quality than to look to the utterances of a great Chinese leader. I do not, however, need to return to Confucius but only to November of last year when the Chinese Premier Zhu Rongji (R.)said simply “make no false accounts”. This is a fundamental principle to which we all would wish to adhere, but how will it be achieved?

Integrity will best be served by being clear about where duty lies. My proposal is to give all those involved in the value chain of corporate financial reporting a duty, when engaged in corporate financial reporting, to act in the public interest and to make them accountable accordingly.

On understandability, my thesis is that we should use global standards to facilitate clear communication.

Let me develop these themes.

Make no false accounts

The purpose of external financial accounting is reporting, not management. Contrary to the opinions of some it is not the responsibility of accounting to produce profit, it is the responsibility of financial accounting to report a profit if a profit is made and a loss if a loss is made. One approach to achieving this is to say that the accounts should show the truth, the whole truth and nothing but the truth. Clearly, the second behest, if taken literally would produce reports of unmanageable length, achieving little more than obfuscation through information, but the first and third elements must be there and must be rigorously enforced.

Achieving the whole truth in a way that will produce clear communication requires selectivity and succinctness. It is the job of the law and of accounting standards to help in selecting what should be reported. What must not happen, however, is to use detailed standards as a justification for telling other than “the truth and nothing but the truth”. Virtue will be achieved by fair application of proper principles which can be applied to varied and changing circumstances. It will not result from detailed rules, which encourage automatic application rather than the exercise of professional judgement and can give rise to nonsense results. In short: principles encourage compliance, detailed rules encourage avoidance. Indeed, some have described the detailed rules approach as no more than a route map for abuse.

This principle based approach leads to more than truth, it leads to accounts which are true and fair, a formulation familiar in the United Kingdom for example. This formulation has the benefit of encapsulating both relevance and reliability: fundamental characteristics for useful information.

The key question in selection, however, is relevance to whom. Who will use the information, what are their needs and what are the duties of those who report. Companies have relationships with a wide range of parties: investors (both equity and debt), employees, customers, creditors and indeed society as a whole. Companies have a licence from society to exist, as do the professions and others who advise them. The right to this licence is not a once and for all matter, it has to be earned and earned again and fair reporting is fundamental to licence renewal.

To try to guess all of the needs of such a diverse group would, result in such a bulk of disclosure as to fail the test of “communication not obfuscation”. Clear guidance is needed on what is material. Such a breadth also introduces the potential of liability for directors and auditors to such a wide population and in such indeterminate amount as to make the position of those involved in financial reporting untenable. A good working approach, therefore, is to report information of relevance to investors, either:

-directly, or

-indirectly as a result of the significance that it has for other stakeholders and thus the company.

Users need information on substantive changes in value in both tangible and intangible assets covering the bad news as well as the good. Reporting should not be a cosmetic tool for share price manipulation to enrich a few vested interests.

The above means that information needs include understanding and sharing management’s understanding of what is going on in the business. What drives the business and drives value? What is management doing about these factors? How successful are they? What about the people who manage the business? We need information about them and about how the company develops them and values them. Above all, people want to know about the future even more than they want to know about the past.

The upshot is that the Operating and Financial Review (or Managements’ Discussion and Analysis) becomes the main vehicle for reporting and traditional financial statements become supporting information. This will not happen overnight but it is the direction in which reporting is travelling.

Give all involved a duty to act in the public interest

PricewaterhouseCoopers, in its book “Building Public Trust – The Future of Corporate Reporting” identifies a corporate reporting supply chain. This comprises company executives, boards of directors, independent auditors, information distributors, third party analysts, investors and other stakeholders. At present, only some of these are conventionally considered to have duties and some of them seem to consider that integrity is a matter for others.

My thesis is that all involved in the supply chain of corporate financial reporting should have a duty to act in the public interest and be accountable accordingly. This entails high standards of governance and ethics within both companies and all firms advising them. It is just as important for managers and directors within companies, and for lawyers, bankers and public relations firms, who advise companies on reporting issues, to abide by published codes of ethics and to act in the public interest as it is for company auditors to do so. Its importance extends to investment analysts, advisers and reporters. Such requirements, however, will only have credibility if they are enforced and are seen to be enforced. Success here depends on a close partnership amongst standard setters, professional bodies and regulators. It requires all parties to have their work monitored and for the results of this monitoring to be reported to a credible public interest body and for there to be a disciplinary mechanism to deal with the bad apples.

Integrity depends on having high quality people in positions of responsibility at least as much as it depends on systems and standards. It is vital that high quality people are attracted and retained as directors, both executive and non executive, as auditors and as participants in all other parts of the reporting supply chain. This will only be possible if there is a fair liability regime giving a proper balance of risks and rewards. For at least ten years, my own view has been that a regime of proportional liability is fair in this regard. Recent events, however, indicate that this should be supplemented by a reasonable safety ceiling in order to provide a truly fair balance of risk and reward and attract the best talent into the reporting supply chain.

Use Global Standards to facilitate clear communication

Securities are traded 24 hours a day, 7 days a week. Investors, based in one country, buy and sell shares in a market based in a second country, in a company based in a third country. Why should there be any variation in the requirements for financial reporting around the world? Indeed, variations in requirements from country to country create confusion, encourage error and facilitate fraud. A single set of global standards is required in each of the areas of accounting, auditing and ethics. This approach will facilitate clear communication because both users and preparers will need to learn only one financial language to read and form the messages in published accounts. Accuracy will be improved because the error prone steps of translating accounts from one set of standards to another, in order to prepare consolidated accounts, will disappear. The nonsense of a company reporting a profit under one country’s standards but a loss under another’s, in respect of the same underlying economic performance, will stop.

Human nature is such, however, that global investor confidence can arise only from a standard setting process that is itself genuinely global and participative. In the world of financial reporting, only the International Accounting Standards Board and the International Federation of Accountants have truly global funding of and participation in their standard setting processes. They both deserve our wholehearted support.

Conclusion

In conclusion, Chairman, credibility of audited financial information will be enhanced by steps to improve its quality, integrity and understandability. Three underlying principles must drive the change:

-Make no false accounts

-Give all involved in the production of audited information a duty to act in the public interest

-Use global standards to facilitate clear communication

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