Financial credibility has become a truly global issue. I talked
to Ian Ramsay about pushing corporate good behaviour buttons for In the Black.
Ian Ramsay has taken on a lot in the past two years. The Harold Ford Professor of commercial law at the faculty of law and director of the centre for corporate law and securities regulation at the University of Melbourne has been at the cutting edge of devising action to bring back credibility to auditing and the reporting of corporations themselves.
First he published the now famed Ramsay report on auditor independence in October 2001. He then joined the Task Force on Rebuilding Public Confidence in Financial Reporting (the Credibility Task Force) of the International Federation of Accountants (IFAC).
Chaired by John Crow, former governor of the Bank of Canada, it published its findings in August this year. Although commissioned by IFAC, the report was independent – IFAC didn’t vet it before release.
Ramsay says that one of the particularly useful things about the IFAC report was that it was international. Over the years many reports have been produced on the issues of governance and financial reporting but none have taken a global perspective. Most have been country specific often sparked by local corporate collapses such as, in Australia, the failures of One.Tel and HIH, which led to the government commissioning the Ramsay report.
Ramsay says one of the most important findings was the need to focus on the information chain. ‘If we are going to restore confidence in financial reporting then we need to focus on the fact that there is an information chain both within companies and outside companies that leads to what we hope is high quality financial reporting,’ he explains.
All participants in the financial reporting process have a responsibility to ensure it is carried out to a high standard, according to Ramsay. Sometimes too much attention is put on one or two players – the CFO, for example, or the internal auditors, external auditors or CEO. ‘All those people or positions are critical. But there is a chain. There is a number of participants in financial reporting,’ he says.
‘Our report is by and large about identifying the key elements of the information chain and identifying appropriate principles that should govern financial reporting at each of these links.’
The committee steered away from detailed comparisons between accounting standards and practices for different countries and looked at the big picture.
As Ramsay says: ‘It is a report that is aimed at putting forward broad principles. But what we hope are quite practical principles.’
While nobody doubts that reporting standards need to be tightened up, in Ramsay’s mind Australia is up to scratch. ‘In my view Australia does reasonably well in its credibility of financial reporting and we know that Australia, in terms of the recommendations in the report, has already implemented a number of them and is on the path to implementing a number of other recommendations in the report,’ he says.
Part of the cycle of capitalism is the continual birth and death of companies. Ramsay has no doubt that companies will continue to fail. But he believes that fewer companies will fail because of illegal or unethical behaviour. ‘And we hope that if we have got our corporate governance mechanisms and our laws right that companies that can’t operate competitively will actually see their resources move to companies that can use their resources more efficiently whatever those resources happen to be,’ he says.
Where do we go from here? Ramsay says the report represents a challenge for IFAC and its members. ‘I think the report itself is only one part of a much bigger picture that is leading to a renewed focus on ethical behaviour and creating or improving corporate governance.’
He thinks most companies in Australia behave ethically with ASIC regulating some 1.2 million of them. ‘But regrettably, very regrettably, we do have some companies who clearly operate outside the law, who don’t value ethical behaviour and we have to focus on them.’
Ramsay says even among companies that are compliant there is always the challenge to continually improve the ethical environment within which they operate. Practical suggestions include ethical codes of conduct within companies that ‘are highly desirable if they are done the right way’.
‘And I say if because codes of conduct done the wrong way can be just meaningless empty statements,’ says Ramsay. He says codes of conduct are an opportunity for a company to outline its ethical vision. But there are a couple of really big issues here. ‘They need to be continually reviewed, number one. Number two, they need to carefully monitored. Number three they must be enforced. And number four they need to be transparent to the outside community.’
Ramsay says companies should put ethical codes on their websites and demonstrate their commitment to the community – not just shareholders and to employees. They need to detail what is in the codes of conduct, how they are monitored and what happens when they are breached. They also need to show that a company takes a breach seriously and show that they are transparent and have some teeth.
He says: ‘Codes of conduct are being talked about at the moment but there is a real move to push this forward.’
Auditors, lawyers, analysts and other professionals also have their parts to play in bringing credibility back to reporting.
Ramsay says that audit firms should be more transparent in, for example, revealing their reliance on individual audits. Companies also need to think carefully about getting audit firms to do non-audit work so that they prevent any conflicts of interest.
‘If companies are going to purchase non-audit services from their audit firms they need to be transparent, you need to unbundle them, you need to disclose them. Also you need approval mechanisms. I see an enhanced role for the audit committee with independent people on it to approve or disapprove non-audit services.
‘It can be quite beneficial to allow your auditor to do non-audit services.’
One of the difficulties facing large companies is the lack in choice of big audit firms, now reduced to four since the collapse of Arthur Andersen. Ramsay doesn’t view the collapse of Andersen as a helpful development. He says it should have been punished for its mistakes with Enron but to destroy one of the five largest audit firms is extreme. He says: ‘It’s a long step to throw 80 000 people out of work.’
Findings of the credibility taskforce
Improving credibility is the responsibility of everybody along the financial reporting chain, according to the report Rebuilding Public Confidence in Financial Reporting.
This means it is the responsibility of primarily company management and boards of directors but also auditors, standards setters, regulators, lawyers, investment analysts, bankers and credit rating agencies. The conclusions of the study included:
Increased emphasis on controls and financial management. This responsibility lies with management, led by the CEO, with the board of directors approving financial information before publication.
Approval of financial reporting. Lines of responsibility for financial reporting should be formally set out for shareholders.
CFO’s responsibilities. The panel acknowledged the benefit of the diversifying role of the CFO into areas such as technology, financing and investor relations. However, this should not be to the detriment of core skills like financial controls and reporting.
Public reporting and internal controls. Management is responsible for the establishment and maintenance of effective controls supervised by the board. This responsibility extends outside the finance function to all members of management.
Role of internal audit. Many internal audit departments work on projects, fraud investigations and analysis of operational issues. Internal audits should refocus on its core role of internal controls. The audit committee should regularly assess the resources devoted to ensuring adequate internal controls.
Reduce incentives to misstate financials. Disclosure of overly precise profit forecasts may create incentives to misstate earnings.
Accounting for share options. Plans by the International Accounting Standards Board (IASB) to introduce standards requiring the expensing of the cost of share options and clear disclosure of their terms of granting are supported.
Approval of management compensation. Emphasis should be on long term performance with remuneration either decided by the board or a specialist committee, independent of management.
Corporate ethics code. One of the board’s most important roles is to ensure senior management creates an ethical environment that encourages openness and transparency.
Board oversight of management. As part of good governance boards need to strengthen their effectiveness in oversight.
Audit committee relationship to the board. The audit committee should regularly report to the full board. The audit committee is responsible for monitoring financial reporting and monitoring internal controls and risk management.
To be effective the committee must be objective. And to be credible, it must be separate from those overseen. Committee members should be independent of management.
The full study is available at http://www.ifac.org/.
Further reading
Ethics for CPAs: meeting expectations in challenging times Douglas R Carmichael, et. al John Wiley & Sons, 2003.
Rebuilding public confidence in financial reporting: an international perspective by Task Force on Rebuilding Public Confidence in Financial Reporting, IFAC 2003
‘Spill a few beans’ by Kath Walters, BRW, August 23 2003
The Ramsay Report and audit committees by Colin Parker, Ten Video, February 2003
Where auditing should head next Keith A Houghton, Australian CPA, March 2003