SpeechbyMr.RobertHodgkinson，ICAEWExecutiveDirectorontheThirdCPAForumofChina

Speech by Mr. Robert Hodgkinson，ICAEW Executive Director,

Technical Presentation on the Third CPA Forum of China

Beijing, 29 May, 2006

Introduction

I want to invite you to think about how the governance of accounting firms might evolve in China in the future. I will do this by describing the experience of the profession, mainly in the UK and the European Union (EU), over the past 5 years. Major changes in how accounting firms are expected to report publicly on their activities have helped to drive major changes in the governance of firms.

The governance challenge facing accounting firms

In 2002 because of US corporate scandals, the UK government set up a review of the accounting profession by the Co-ordinating Group on Accounting and Auditing Issues (the CGAA). My institute - the Institute of Chartered Accountants in England & Wales (ICAEW) - was represented on the CGAA through its President, Peter Wyman. The report of the CGAA issued in January 2003 noted that the right of accounting firms to act as company auditors is based on the public having confidence that firms are able to conduct effective and independent audits. In addition, the ability of firms to perform high quality independent audits depends in large part on matters that are internal to the accounting firms including their culture, procedures, safeguards and reward systems.

The standards expected of firms in terms of quality control processes and systems had been established through the work of the UK Auditing Practices Board in its auditing standard on quality control. However, the review noted that historically there had been little publicly available information on firms'' structures, processes and financial position. It therefore concluded that greater transparency was needed in order to improve public confidence in the audit work performed by accounting firms. In my view the challenge facing UK accounting firms and the solution proposed by the CGAA are relevant in other countries and are just as relevant today as in 2003.

The need for a positive but proportionate response

There are clear international expectations regarding how accounting firms will ensure that they perform quality audit work. They are set out in the International Standard on Quality Control (ISQC1) issued by the International Auditing and Assurance Standards Board (the IAASB). The standard identifies the elements of a system of quality control including leadership responsibilities for quality, ethical requirements, client acceptance and continuance, human resources, engagement performance and monitoring.

There are strong arguments for accounting firms to commit not just to compliance with a quality control standard but also to transparency about how such standards are applied and about other issues related to the governance of a firm. Auditors should readily understand the arguments for such transparency because they are the same arguments that are used to explain the publication of the financial statements that auditors are required to audit.

Any management team needs information in order run a business. However, where a management team''s ability to run a business depends on earning and maintaining the trust of other stakeholders, then management should also provide information to those stakeholders. The most obvious example of this is where there is a separation of ownership and control. When the owners of a company delegate the running of a company to a management team, they expect to receive information on how the management team is discharging its responsibility to look after the interests of owners.

Agency theory is used to describe such situations and owners are referred to as principals whilst managers are seen as their agents. The provision of information by agents to principals addresses the fundamental problem of "information asymmetry" which refers to the fact that agents have access to more and better information than principals.

However, agency theory also recognises that even where agents are required to provide information to principals, there is a risk that the information will be biased because agents may have an interest in not reporting bad news. This is the economic reason for the independent audit of financial statements. These matters are discussed more fully in the paper "Agency theory and the role of audit" published by the ICAEW in December 2005. By expressing an independent opinion on the information provided by management to owners, independent auditors can reassure owners that the information is objective and will enable them to judge how managers are discharging their responsibilities.

The same arguments apply to auditors themselves. If the investing public is to trust accounting firms with the right to perform audits, then audit firms should expect to provide the investing public with information on how they are discharging their responsibilities. They should also expect such information to be subject to independent scrutiny either by regulators or other auditors.

Nevertheless, the case for agents providing independently assured information to principals is an economic one. Therefore there is a need for proportionality and good sense. The nature and extent of the information and assurance that are provided need to be proportionate to the resulting increase in confidence and economic activity. There should be no requirement to provide extra information or assurance if experienced commentators believe that the costs would exceed the benefits.

In the context of disclosure by accounting firms, this means that there should be differences in the information provided by firms depending on the nature and economic significance of the businesses that they audit.

Areas for better information

Information about accounting firms can take many forms. Some are quite specific to the audit environment. For example:

• A firm can report on how it establishes and maintains an effective quality control system.
• There can be disclosure through a public register of information about firms and individuals within them who are entitled to perform audits. Such information has added credibility where the register is maintained by a regulator with powers to grant, withhold or withdraw firms'' entitlement to audit and to compel firms to provide information and to check it.
• Where a firm''s audit work is monitored and inspected, the relevant authorities can agree their findings with the firm and publish the resulting report.

Audit firms can also report the same type of information that other organisations with public accountability would be expected to publish, such as:

• financial statements with related management commentary;
• external audit reports;
• statements on governance practices, including how the board of the firm operates, how audit, remuneration and nominating committees work and how risks are identified and managed; and
• corporate responsibility statements on issues such as environmental performance, engagement in local communities and employment practices.

The benefits of changes

Many of these suggestions for better information would have appeared unthinkable only a few years ago. However, they can bring real benefits not just to society at large (because they increase confidence in external audit) but also to individual firms. For example:

• By making similar disclosures to those made by their audit clients, auditors can enhance their credibility and better understand the pressures their clients face. They are also no longer vulnerable to the criticism that can be aimed at people who say "do as I say not as I do". For similar reasons, the ICAEW’s recently published 2005 annual report contains audited financial statements prepared in accordance with the International Financial Reporting Standards (IFRS) that now apply to UK listed companies.
• Audit firms are better able to compete in the "war for talent". The brightest and best potential recruits to the audit profession are likely to want to join firms that are seen as transparent and aware of their broader social responsibilities. A survey published in the Sunday Times newspaper in the UK showed that the Big 4 accounting firms were all in the top 14 best big companies to work for in 2006. BDO Stoy Hayward, another significant accounting firm, was also recently named as one of the top 20 firms to work for in the UK.

In short, transparency reinforces the profession''s credibilty and reputation for integrity. Competition in the audit market can also be improved if better information is available to buyers of audit services, such as audit committee members.

Examples and experience from the UK and the EU

The types of disclosure that I have referred to are already no longer dreams but reality and the recently approved EU revised 8th Directive on Statutory Audit contains provisions requiring all 25 Member States to introduce requirements for:

• a register to protect third parties which contains up-to-date basic information on all approved auditors and audit firms and which is accessible to the public;
• annual reports on the overall results of independent audit quality assurance reviews; and
• a transparency report to be published on its website by each firm that carries out statutory audits of public interest entities setting out information on legal structure and ownership, network arrangements, governance, internal quality control systems, the date of the last regulatory inspection, public interest audit clients, independence practices, continuing education policy, fee analysis and the basis of partner remuneration.

In the United States, the emphasis of the reforms in the 2002 Sarbanes-Oxley Act was on public register information and public reports on inspections of audit firms by the Public Company Accounting Oversight Board (PCAOB). However, EU reforms go much further than in the US in relation to transparency reporting.

In the UK, a public register of auditors has existed for many years and transparency reporting is also not new. The final CGAA report in January 2003 endorsed a voluntary approach to disclosure whereby 12 leading firms that audited the overwhelming majority of listed entities agreed to disclose:

• governance arrangements, including relationships with associates, the basis of partner remuneration related to non-audit services to audit clients, and the structure of international networks;
• arrangements to achieve and monitor the quality of their work; and
• independence procedures.

In addition, in 2003 many audit firms were turning themselves into limited liability partnerships (LLPs) that were required to publish audited financial statements which complied with UK Generally Accepted Accounting Principles. All 12 firms committed to publish financial statements which met the legal reporting requirements for LLPs in accordance with the relevant Statement of Recommended Practice (the LLP SORP) and also committed to prepare an Operating and Financial Review (or management commentary) in accordance with the UK Accounting Standards Board''s planned standard.

The overall impact of the culture of transparency is illustrated by the latest annual reports of the major UK accounting firms which are comparable to those of any large UK listed company. For example, the September 2005 UK Annual Report of KPMG LLP contains:

• a Chairman''s Statement;
• a statement of values and a report on HR practices;
• a commentary on financial performance by segment;
• a corporate social responsibility report;
• a 5 page report on corporate governance and risk management which includes all the disclosures that will be required under the EU''s revised 8th Directive;
• the formal report to members required under the LLP legislation;
• full financial statements in accordance with UK accounting standards; and
• an independent auditor''s report from Grant Thornton UK LLP prepared in accordance with UK auditing standards.

Potential pitfalls

I wouldn''t expect this audience to accept what I have just described as a perfect vision of an inevitable future that awaits all accounting firms around the world including China. As accountants it is right that we should ask questions:

• The annual reports produced by the major accounting firms can be subjected to the same criticisms that are sometimes made about the reports of major listed companies. Are they too long? Are the financial statements too complicated? And is the non-financial information in danger of becoming bland boilerplate? However, as a profession we need to address these issues for all types of business. Accounting firms cannot wait on the sidelines until they have been resolved.
• Questions can be asked about why reports are prepared for firms on a national basis rather than for the global networks to which national firms belong. However, the preparation of reports for national legal entities allows practice to develop in response to different national pressures and traditions. Moreover, it can be argued that global reports can only be prepared when a reduction in legal, regulatory and risk management concerns makes it possible for firms to operate on a truly unified global basis.
• Sceptics can also point to the danger that what is seen as appropriate for a small number of large firms carrying out public interest audits will become a benchmark for hundreds of thousands of smaller accounting firms. Isn''t it inevitable that there will be some imposition of unnecessary regulations on these firms? There is certainly a risk of this happening. The 8th Directive public registers could become too complicated and transparency reports could catch firms that really should not qualify on public interest grounds. However, such risks are not confined to accounting firms. As a profession, we need to respond to the needs of businesses across all sectors for reporting requirements that are proportionate and avoid unnecessary complexity.

Summary

To summarise:

• Accounting firms that do audit work need to respond to the perception that historically there has been little publicly available information on their structures, processes and financial position.
• Accounting firms need to acknowledge that there are strong arguments for committing not just to compliance with standards for doing quality work but also to transparency. Auditors should readily understand the arguments because they are the same arguments that support the publication of the financial statements that they audit.
• If the accounting profession embraces the need for transparency there will be real benefits for society as a whole, in terms of increased confidence in external audit, and also for the profession and individual firms. It will reinforce trust and the profession''s reputation for integrity.

Future actions

I know that you are working hard to develop and strengthen the accounting profession in China and that there are many priorities. The ICAEW is committed to working with the accounting profession in China and recently signed a Memorandum of Understanding with the CICPA to train CPAs as ICAEW Chartered Accountants.

Today I want to invite you to think about how the governance of accounting firms might evolve in China in the future. Accounting firms outside China have followed the standards of transparency set by the wider business community. However, in China you have the opportunity to show leadership and set an example for the whole economy.