RESTORING INTEGRITY IN THE GLOBAL FINANCIAL SYSTEM Center for Accounting Ethics, Governance & The Public Interest Robert Bunting, President International Federation of Accountants March 18, 2009 Introduction Good morning. I’d like to thank Dr. Kalbers and the Center for Accounting Ethics, Governance & the Public Interest for inviting me here today. I would also like to thank all of you for taking time from your busy schedules to hear what I have to say about restoring integrity to the global financial system, which, I’m sure you will agree, is in dire straits.
Before we get started, I would like to extend a particular welcome to the students in the audience. While it’s true that you’re inheriting a world that is in the worst financial shape that it has been in many decades, it’s a great time to be entering the accountancy profession.
The importance of accounting and auditing is being reinforced as it never could be in times of plenty. For example, who in the accounting world ever would have thought that we would be asked to explain ―fair value‖ to our non-accounting friends and even strangers who have a sudden interest in a financial reporting concept—let alone that they would be interested in our responses? This is, indeed, a rare time for the accountancy profession. You will be entering a truly global profession in terms of rapid convergence to a single set of auditing and financial reporting standards.
You will be on the ground floor of new systems for regulating the profession and the global financial markets.
And, you may be participating in a debate about the purpose of financial reporting: Is it for regulators and marketplace stability, or for investors and credit grantors?
Now, I’d like to focus specifically on the economic crisis.
The Economic Crisis The global economic crisis forms the backdrop of everything we do at IFAC and every speech we make these days. I’ll leave it to the economic historians to resolve the causes, though at present there seems to be no shortage of potential culprits and co-conspirators.
Regardless of who is to blame, the crisis was unquestionably exacerbated by corporate governance failures. Today, we are seeing: A lack of proper risk management processes within companies; Too many incentive arrangements and remuneration schemes within companies that reward short-term rather than sustainable results; And, questions about the systems of governance that do not seem to provide adequately for challenging management’s risky strategies.
In addition, there have been significant ethical failures across a broad spectrum of business activity. While scandals like Madoff, Standford, and Satyam may come to mind, these are really
frauds rather than ethical failures, and fraud is not among the principal contributors to the global meltdown.
Without tying them to any part of the crisis in particular, let me mention two broad-based areas of ethical failure:
First, there’s the practice of lending and borrowing when there is little prospect of repayment of the loans. Second, there’s a co-dependency of lenders, developers, credit-raters, appraisers, hedge funds, and investment bankers, among others, who put short-term self-interest first, and turned a blind-eye to the systematic risks they might have been creating—and did.
The Global Economy What makes all of these problems so much worse, of course, is our global interconnectedness. There’s no such thing as a local meltdown anymore—and shockwaves don’t only emanate from the most powerful nations. Who would have thought, for example, that banking failures in tiny Iceland would be felt in Russia, the UK, and Scandinavia, and that they would put the life savings of thousands of retirees in those countries at risk? This is only one example of how the interconnections that work so well in good times—as we sell, borrow, and do business with entities a continent away—can cause such havoc in bad times.
Suffice it to say that no national system of regulation can protect its citizens unless it is integrated into an equally rigorous international system.
What Role Will the Accounting Profession Play in This Brave New World? The most serious aspects of the crisis are beyond the ability of the accounting profession to resolve on its own. We can’t get the banking system working again or stimulate economic activity. Still, we have our roles to play—and they are significant.
For example, the auditor’s ―going-concern‖ opinion will be a tipping point for many individual companies seeking access to finance. Hundreds of audited financial statements for GM and Chrysler suppliers are being delayed in the hope that some kind of definitive future for those two major companies will be resolved, and many other companies have covenants on their loan facilities that make the loans due on demand in the event of a going-concern opinion.
More importantly, we have quite a lot to contribute to the development of a better designed international financial system for the future…and that will be the focus of my remaining comments today.
Just like everyone else who wants to be part of the future solution, we must start with a careful examination of the standards and methods we are using and the strengths and weaknesses of what we produce for the global economy. This includes such things as: Are we using the correct standards, and is their application consistent and fair? Are we doing enough to prevent and detect fraud? Are our going-concern opinions authoritative enough for the role they are playing in the current environment?
Are the results of fair-value accounting as reliable as they should be? I’d like to touch on this one for a moment, because it has come in for what I consider undue criticism—when it’s the shallow, illiquid markets produced by this crisis that are the problem, among many other problems. The harsh assessment of fair value only deflects attention from the more significant aspects of the world’s current financial woes, and finding ways to fix them.
Another matter I want to mention is balancing accountability of the profession with sustainability. The accountancy profession is vital to the operation of capital markets and to economic development and growth. Yet two issues continue to challenge its sustainability: audit firm concentration and the ability to attract and retain professional accountants.
Plain and simply, the combination of unlimited audit firm liability in many countries coupled with limited choices of audit firms for the largest international corporations injects additional risk into the financial system. The majority of large global corporations use the Big Four accounting firms for auditing work. If one of the large firms should fail for any reason, and liability is the most likely possibility, the viability of the whole system would be placed in jeopardy. This concentration issue is thus one we must address. In addition, we must consider how the pressure for accountability reflects on the attractiveness of the profession and its ability to retain high-quality people. I believe in accountability; it must, however, be balanced and realistic.
Putting the public interest first is a priority for our profession, but we must ensure that there are professional accountants who can carry out this responsibility.
IFAC is taking a hard look at itself and the profession as it addresses these issues. And we are doing so in collaboration with global regulators, such as the International Organization for Securities Commissions (IOSCO), Basel Committee on Banking Supervision, and IFIAR—the International Federation of Independent Audit Regulators.
While it is important that we examine our own past and future roles, we also must consider the appropriate future roles of standards setters and regulators in the new and better future economy. I’d like to share some thoughts in those areas.
Convergence I cannot emphasize enough that the international nature of the financial system cries out for convergence in financial reporting and a variety of other standards and practices. The G20 has recognized this need in its work plan and working groups leading up to the planned April 2009 meeting of finance ministers from the G20 countries.
This is because operating in an interconnected way links directly to the global public interest. The interconnectedness referred to above is a good thing. It has led to huge growth in developing economies around the world. But there is a need for a ―level playing-field‖ if the system is to be seen to be fair and, therefore, likely to achieve ―buy-in.‖ This is what convergence is about.
Convergence has been a central focus for IFAC activity, across a range of areas – not only for accounting and auditing, but also in ethics and education. This needs to be pursued even more vigorously, moving the focus from adoption of international standards to their implementation. In fact, this is one of the four major themes in IFAC’s strategic plan.
It is also at the heart of the global compliance program that IFAC has developed a program that regulators and development agencies, such as IOSCO, The Basel Group, IFIAR, the World Bank, and others, are quite interested in. The compliance program tracks national efforts to implement our auditing, ethics, and education standards for all IFAC members in 122 countries.
At present, this is a self-assessment program supported by mentoring of developing economies by developed economies, through support from international firm networks, and by improvement work plans developed jointly with IFAC. A similar program is needed for the implementation of International Financial Reporting Standards around the world.
Another area of focus in terms of convergence is the competence and expectations of the preparers of financial information: professional accountants in business. While it may surprise some of you in the audience, not all preparers of financial statements in the corporate world have met the education, experience, and continuing professional development criteria required to be a ―professional accountant‖—and some do not subscribe to a code of ethics.
You might be equally surprised at the lack of professionally qualified accountants in many Esuites and on the boards of public interest entities around the world—and the fact that not all
governance structures subject senior management decisions to the rigors of financial and cash flow analysis. Of the developed countries, only the United Kingdom has any sort of regulatory requirement covering this area. There is some empirical data that suggests a positive correlation between the presence of professional accountants in the E-suites of listed companies and their transparency and quality of reporting, among other things. In part at the urging of regulators, IFAC is supporting further data gathering and research to prove or disprove this notion.
Convergence also applies to corporate governance standards. At IFAC, we support global convergence to the corporate governance principles of the Organization for Economic Cooperation and Development (OECD), which reflect best practices. The OECD’s framework is designed to promote transparent and effective markets and focuses on the roles and rights of stakeholders, the responsibilities of management and the board of directors, and other parts of the corporate governance structure.
Like IFAC, the OECD requires that its member states make best efforts to comply with its guidelines and best practices—and, like IFAC, it believes that one should ―inspect‖ what one ―expects.‖ IFAC’s recently released international governance good practice guide is consistent with the OECD framework.
Regulation in Times of Crisis I’d like to comment briefly now on the direction of national regulation in the midst of a crisis. I believe it is a time to seek out solutions—and for regulators to resist knee-jerk reactions, and the search for scapegoats and silver bullets.
I strongly believe that we must resist retreating into a national focus and its manifestations, such as protectionism, national carve-outs of standards and regulations, and other short-sighted political solutions. Rather, it is an opportunity to build stronger international institutions.
One of these opportunities is to strengthen the international financial institutions like the Financial Stability Forum, which brings together national bodies of sector-specific regulators, central bankers, and industry supervisors to deal with the consequences of the increasingly integrated global economy.
It is also a time to build up newer organizations, like the International Federation of Independent Audit Regulators, a three-year-old global organization that The Public Company Accounting Oversight Board—the private-sector non-profit, created by the Sarbanes-Oxley Act to oversee the auditors of public companies—has recently joined.
We at IFAC would be pleased to share our knowledge of how to make an international organization work effectively to develop common standards and best practices.
We must keep in mind that a quality system of regulation is critical to the functioning of honest and transparent markets. Such systems create an environment and culture that supports compliance; must be supported through accountability and enforcement; and must be cost effective—meaning that the cost of regulation cannot exceed the benefit to the public. In times of crisis, when regulations are developed quickly and without due process, the consequences can be as inimical to the public interest as the problems they were designed to solve. In particular, it is important for regulators to keep in mind the challenges of small and medium enterprises and to
avoid placing unnecessary burdens—and even unintended ones—on them. Doing so means placing the potential growth of the global economy at risk.
I’ve already mentioned fair-value accounting and how its reliability has been questioned as people look for an easy scapegoat for the crisis. There is another example of a concept that the financial crisis and recent scandals have brought to the forefront: management audit firm rotation.
Rotation of key players on audit teams every five to seven years makes sense as it injects new perspective and a refreshed sense of objectivity into the audit team. If this is true, then audit firm rotation would seem to make even more sense as it removes any ―firm‖ bias that may attach to past decisions.
However, when considered in the light of another issue—audit firm concentration—it makes no sense at all. In most parts of the world, there are not enough choices to allow for this without forcing companies to choose audit firms that have no expertise in their industry, such as banking and insurance, among others.
While several countries have experimented with and subsequently abandoned firm rotation, it is being considered as a regulatory response to Satyam in India. This is not necessarily the right solution. The point is that regulation must be considered pragmatic and cost effective. And it must be both complemented and supported by high ethical behavior.
I believe we must promote the value of the right balance between well-designed regulation and the promotion of, and reliance on, ethical behavior within a professional setting.
True, it is difficult; but it is not impossible, and it must be done. This applies to a number of the players in the international financial system, including the accounting profession but also including the credit rating agencies.
Clearly, the public interest is best served when there is confidence in the ethics of the accounting profession—this is a job for the profession itself, even when it operates within a regulatory framework
Conclusion In closing, I’d like to briefly summarize some of my key points today.
We’ve discussed how the global financial markets require many kinds of trust to operate effectively—trust in the regulatory schemes and the regulators, trust in the financial information providers and their institutions, and trust in those who provide safeguards, such as auditors and insurance providers.
While the ethics of the accountancy profession have not been called into question in the current crisis, we understand full-well the consequences of a failure of trust. Trust, ethics, and confidence go hand in hand. The current crisis emphasizes in a very dramatic fashion how high the stakes are when ethics are sidelined and confidence is lost.