Reforming the Regulation of Accounting and Auditing New Responses to New Challenges

1. Reforming the Regulation of Accounting and Auditing New Responses to New Challenges John Hegarty World Bank Group

2. Regulatory Reform –Our Common Challenge • From the Asian Crisis (1997) to the Enron Collapse (2002) • Regulatory reform not only an emerging market concern • Widespread international pressure for change

3. “Enron”– Symbol of Systemic Weaknesses Problems relate to • More than one company • More than one audit firm • More than one country

4. Enron - What went wrong?Financial Reporting • Aggressive application of accounting rules • Inadequate disclosures of risk exposures and related party transactions • Incomplete consolidation of all group entities • Exaggerated reporting of revenues • Innovative use of fair value measurements • Non-accounting for stock options

5. Enron - What went wrong?Auditing • Combination of audit and advice • Tensions between objectivity and advocacy • Combination of internal and external audit • High reliance of one office / partner / audit team on one client • Incentives within the audit firm • Checks and balances within the audit firm • Competence seems not to be an issue

6. Enron - What went wrong?Corporate Governance • Weaknesses in management and organizational culture • Perverse / misaligned incentives (stock options, related party transactions) • Ineffective Board oversight • Ineffective Audit Committee oversight • Absence of shareholder challenge • Absence of “reputational agent” challenge

7. Enron - What went wrong?Other Parties • “Aggressive” investment bankers • “Non-objective” financial analysts • “Supportive” legal advisors • “Relaxed” debt rating agencies • “Optimistic” investors and commentators • “Non-interventionist” regulators

8. What are the drivers of quality accounting and auditing? • High quality standards • Education and training • Robust regulatory frameworks • Effective monitoring and enforcement • Adequate incentives and sanctions

9. Filling the gap • Reaching international consensus on a common framework of principles for the regulation of accounting and auditing • IAS and ISA are not enough • Contrast with the OECD, IOSCO, Basel and IAIS principles • No country has a perfect system

10. The Joint Forum Core Principles Cross-Sectoral Comparison Scope of regulatory principles • Attributes of supervisory systems • The supervised entity • Ongoing supervision • Prudential standards • Markets and customers

11. Getting the Standards Right • Acceptability of the standard-setting process • Balancing rules and principles • IAS/IFRS are not an appropriate framework for all enterprises • There is also a need for “Little GAAP”, but preferably international • ISA can be applied to all audits • The audit requirement should not be too extensive • Clarifying the role of national standards

12. Regulatory Framework • Recognizing the primacy of the State • Accepting the limits of self-regulation and the need for effective public oversight • Focus on the audit function • Acknowledging the role of the audit firm and of the international audit firm networks • Ensuring integration with corporate governance and market regulation • Incorporating the international dimension

13. Linkages with Corporate Governance and Market Regulation • Effective monitoring and enforcement • Adequate incentives and sanctions

14. The EU Approach • Enhancing the quality of accounting, auditing and corporate governance • Creating a single market for accountancy services • Supporting the development and integration of a single Eurozone capital and financial market

15. The EU Approach • Delegated regulation, not self-regulation • Explicit State oversight of financial reporting and auditing • Independent monitoring, not peer review • Growing involvement of market regulators • Pure IAS for all EU listed companies (2005) • National “Little GAAP” for non-listed companies • ISA-plus for all audits (2005) • Principles-based approach to auditor independence

16. Outstanding Global Issues • Acceptance of IAS/IFRS and ISA • International “Little GAAP” • Development of a comprehensive framework of principles for the regulation of accounting and audit • International external oversight of the accountancy profession and audit firm networks • Supporting the post-Doha WTO negotiations

17. The International Dimension • Lowering of barriers to international trade and investment in audit services • Reducing regulatory divergence • Creating the confidence for mutual recognition • Governance of international firm networks • From private contract to public interest • Governance of IFAC • International standards as public goods • The death of “pure self-regulation”

18. Development of a Comprehensive Framework of Regulatory Principles • Beyond accounting and auditing standards • Regulatory oversight; enforcement; discipline; independence and ethics; governance of audit firms and international networks; etc. • Linkages with Basel, IOSCO and IAIS principles • Integration with the OECD Corporate Governance principles • Reliance on corporate governance to improve audit? • Implications of/for trade and competition policy

19. International Developments • International Accounting Standards Board (IASB) • International Federation of Accountants (IFAC): IAASB, Ethics Committee, Compliance Committee, Forum of Firms / Transnational Auditors Committee • Financial Stability Forum • Organization for Economic Cooperation and Development (OECD) • IOSCO, Basel Committee • International Forum on Accountancy Development (IFAD)

20. Unresolved Issues • Are we expecting too much from audit? • Protection from liability -v- relevance • How will the US post-Enron debate conclude? • Aligning auditor incentives with the public interest • Impact of non-audit activities on audit incentives • Governance of professional bodies • Governance of audit firms (Volcker proposals) • Scope of the profession, scope of practice • Competition policy considerations • Linkages with corporate governance and market regulation

21. The Role of the World Bank • ROSC accounting and auditing assessments • Support for international standards • Support for the development of an International Little GAAP and principles for the regulation of accounting and audit • Partnerships with other international organizations • Policy advice and development assistance to client countries

22. Lessons for Slovenia?