Post Enron: Accountants and Accountability

John F. Bankes, Managing Director, Artemis Management Group Inc. and Past President, The Empire Club of Canada; Blake C. Goldring, CFA, President and CEO, AGF Management Limited and Director, The Empire Club of Canada; Shannon Culver, Student, Etobicoke Collegiate Institute; The Reverend Dr. John Niles, Victoria Park United Church; Karen Maidment, Executive Vice-President, Bank of Montreal; Colleen Moorehead, President, Etrade Canada; David Smith, President and CEO, The Canadian Institute of Chartered Accountants; John C. Koopman, Partner, Heidrick & Struggles and 2nd Vice-President, The Empire Club of Canada; Marie Oswald, VicePresident, Investigations and Enforcement, Market Regulation Services; Axel Thesberg, Senior Professional Partner, KPMG LLP; and David A. Brown, QC, Chair, Ontario Securities Commission.

Introduction by Bill Laidlaw

There are a number of incidents that block our society… wars, weather, terrorism, sacks, government scandals and corporate failures. We certainly have had our fair share of these events in Canada and in the world. Not only do they impact us here in Canada, but what happens anywhere in the world has a potential effect on all the nations of the world. We are getting more and more closely linked. The issues that affect us most are those that affect our pocketbook. Those issues of interest today impact the stock market and our life-savings and pensions. So people are more concerned than ever with these world events.

In terms of major corporate events there are a number of checks and balances in the system to monitor the activities of corporations. Governments appear at one point to be looking at more selfregulation, while at the same time introducing more regulation. We certainly have enough regulatory bodies. Nothing more amorous or more sacredly profound is the relation between a corporation and its external accounting firm. It is a trust under which an entire system of business evolves. As we know that system breaks down on occasion with disastrous consequences. The most notable case is the case of Enron, which has so badly shaken its business around the world and the accounting firm that has served it. We have been reading on a daily basis the events of the Enron case, and it has become as fascinating as Watergate.

Today we are very fortunate to have as our guest Bill MacKinnon, Chairman and CEO of KPMG. Few people are as well equipped to comment on the current state of affairs in accounting and how this event south of the border will play out here and in the rest of the world.

A little bit about our speaker whom I have just met today.

Prior to becoming Chairman, Bill was the Vice-Chairman of Macklin Consulting and the managing partner for KPMG's Toronto office from 1988 to 1993. Since becoming a partner at KPMG in 1977, Bill has been the engagement partner for a number of major accounts, including Rogers Communications Inc., the Toronto Dominion Bank and TSN. Throughout his accounting career Bill has been an active member of the Institute of Chartered Accountants of Ontario. From 1975 to 1985 he was a lecturer and served on the ICAO's education committee.

Originally from Winnipeg, Manitoba, Bill completed his Bachelor of Commerce degree at the University of Manitoba in 1967. He went on to receive his Chartered Accountant designation in 1971 and was appointed a Fellow of the Institute of Chartered Accountants of Ontario in 1994. That's a lot of accounting Bill.

A strong believer in community service, Bill has served as Treasurer and Director for the Canadian Stage Company for almost a decade and was the Stage's Company President and Chairman from 1997 to 2001.

And I was saying to Bill when we came in, I've had a number of volunteer experiences myself and if it wasn't for KPMG and all the volunteer partners that help out I don't know where the volunteer sector would be today.

In addition he has served on the United Way Cabinet Campaign and served as Co-chair, Special Gifts Group, for the Salvation Army's Circle of Caring Campaign. We are indeed fortunate to have with us today Bill MacKinnon as our guest speaker.

Bill MacKinnon

Thank you to the Empire Club for allowing me this opportunity to put on the record my thoughts on reform of the accounting profession.

And my thanks to my colleagues at the head table who have joined us today.

Last month, the Wall Street Journal declared the era of bean counter jokes to be passe. According to the Journal, we are now regarded as sexy!

Even the jokes are becoming more topical. According to a cartoon in the New Yorker, a woman in a bar says to a friend, "Being an accountant gives him that extra aura of danger."

This confirms what we already knew: yes, we are sexy. However, this recognition came about in a hell of a way.

I am here to talk about what I think it will take to improve the public's trust in us, the financial accounting system and the capital markets.

It is a truism that those of us who practice accounting and audit public companies are critical to a credible, functioning financial system.

It is also abundantly clear that the vast majority of the time we do our job very well. But are we capable of improving and moving forward in the interests of all stakeholders? You bet. Do we need to? Absolutely yes.

The collapse of Enron has been likened to "the perfect storm."

Many factors converged to create this storm, including economic conditions, a flawed business model, problems with current accounting standards and a failure of corporate governance. The roles of management, directors and auditors have also been called into question.

However, unlike weather systems over which we have no control, we can do something about the weak or inadequate systems that allowed the rise and fall of Enron.

And in doing so restore confidence and credibility in financial reporting--which, after all, is the cornerstone of our capital markets.

Many have come forward with ideas for reform. We have heard everything from: "take responsibility for audits away from private accounting firms altogether and give it lock, stock and barrel, to the government"--this an early recommendation from The Economist--to the suggestion of Financial Post columnist Terrence Corcoran that auditing become "a private decision and a competitive business, controlled by directors charged with looking after shareholders." Regulators would not be welcome in his scenario.

Needless to say, we don't agree with either extreme, and we don't believe in quick fixes to complex problems. For the next few minutes I'd like to focus on six issues that KPMG, my colleagues in the other major firms, and the Canadian Institute of Chartered Accountants believe are important in this debate. They are:

• public oversight of our profession;

• accounting standards;

• the financial reporting model;

• reporting transparency;

• the role of the audit committee; and

• our business model.

To start, the issue of public oversight.

I want to emphasise that we already have strong public oversight of accounting standards in Canada. The Accounting Standards Oversight Council (AcSOC) was formed as an independent body two years ago to oversee accounting standards setting. This council includes people from both inside and outside the profession who have an oversight role in the development of standards. By far the majority of the members of the council are individuals who are not members of our profession. The council has formed a subcommittee to address the implications of Enron and we support this initiative.

Even so, we do believe the profession needs greater public oversight of audit standards and audit quality. Up until now, the public accounting profession has largely been self regulated in these two areas. This model is no longer acceptable. It's clear that we need greater public oversight here and I am pleased to report that we are already moving very quickly to put this oversight in place.

David Smith, the President of the Canadian Institute of Chartered Accountants, who's here at the head table, has advised that the profession, in consultation with regulators, will soon present new proposals to establish an independent body that will provide a more rigorous review of the firms that perform the vast majority of public company audits.

I believe investors can feel confident we have heard their concerns and we are responding.

Now to the second issue--accounting standards. Canadian accounting standards are, in certain ways, different from those in the U.S. and other jurisdictions. Those differences, we believe, make it less likely that an Enron-like event could happen here.

Canada has in place what is largely a principles-based system of accounting standards. The CICAs Accounting Standards Board is responsible for identifying sound principles. When making decisions about accounting treatments, the members of the CA profession are required to exercise professional judgment based on those principles.

The U.S. has a different system. There, accounting standards have evolved into a set of detailed and prescriptive rules. Accounting decisions are made based solely on these rules--which can encourage the attitude of "show me a rule that says I can't do that."

We believe that the rigid application of rules is no substitute for the informed professional judgment of a qualified auditor the approach we use here in Canada.

But this approach to standard setting is under pressure. As David Brown of the OSC has highlighted, the convergence of North American business has started to change our approach in Canada. More and more, we have been seeing rules-based accounting standards as Canadian standard-setters attempt to harmonise with U.S. GAAP As these pressures continue, I believe we need to ensure that we continue to have the right principles in place for our accounting standards.

For the future, we hope that the profession globally will be moving more closely to the standards proposed by the International Accounting Standards Board. The IASB is now a key player in restoring confidence in the system. We support the IASB's project to create a common global standards framework that incorporates "the best of the best" from countries around the world.

However, the challenge in Canada is that the U.S. is our largest trading partner. So, even though we need to preserve and enhance a principles-based approach, we must not create accounting standards that disadvantage Canadian companies in the U.S. capital markets. As accounting standards evolve, managing this relationship will be a delicate balancing act for us.

Now to the third issue--the current model for financial reporting.

Today's model is based on point-in-time corporate reporting and after-the-fact review of that reporting by an independent third party: the auditor.

To restore long-term confidence in the system, we believe this model needs to be transformed.

Today, reporting focuses on the financial flows that underpinned industrial-age companies. The model is based on hard assets: bricks and mortar, machinery. That was how all companies made money up until about the 1970s. The old time reporting system worked fine because the hard assets didn't pick up and leave abruptly.

But this system does not provide enough information or the right information to accurately describe modern day corporations. Such companies have huge assets, including their intellectual capital, people and technology, that are not included on their balance sheets.

Their performance and potential is revealed in key performance indicators--not all of which are included in their financial statements.

Furthermore, today's audited financial statements are issued annually--and typically two months after yearend. That's not good enough any more. Today, the market reacts to information daily, if not hourly.

And for that reason, retrospective analyses of performance must give way to real-time reporting. Once real-time reporting is in place, there must be real-time auditing based on error prevention rather than after-the-fact detection.

But let me say that improving the financial reporting model is not something we can do overnight. The problem does not lend itself to a quick fix. It will take a lot of hard work by all stakeholders: the regulators, the auditors, the issuers and, of course, the users in the investing community.

Moving on to our fourth issue. As this work to create a new financial reporting model proceeds, we believe we all need to focus on improving transparency in financial reporting to better inform investors about risks and opportunities inherent in business operations.

It's one thing to call for transparency, but getting there will be hard.

For example, we currently lack robust standards for financial information disclosed in press releases. Those popular vehicles for communicating financial results have, in some instances, a habit of putting the best spin on a tough quarter or year.

We have seen alternative financial data such as pro forma earnings, cash earnings, and such being used as either supplements, or preferred disclosure options, to GAAP Some of these disclosures are good and provide useful information. But we need to ensure that we do not invent a new disclosure standard which some label "EBABS," or earnings before all the bad stuff.

Auditors need to play a role in improving reporting transparency. A simple suggestion: have the audit committee and the auditor review the press release. Why not ask those who sign off on the audit to make sure that the headline and lead paragraph provide a balanced view of the results?

Or at a more complex level, auditors could be asked to provide an opinion on a company's quality of disclosure--on the basis that the shareholder has a right to know the strength of the financial foundation on which the public company rests.

The problem with these kinds of proposals is that, currently, there are no standards that define and mandate reporting transparency. We, the auditors, currently have responsibility for reporting on the financial statements only; we can't dictate what kind of additional information public companies should provide. That responsibility lies with the securities regulators. The solution is a dialogue between regulators, companies, ourselves and the user community to determine what kinds of disclosures are important.

The fifth issue--the audit committee. On this subject a great deal has been said and written. Virtually every audit committee meeting these days revolves around the question, "How do we make sure this--meaning Enron--doesn't happen here?" Such discussions are an important step since these participants constitute a three-part system of responsible disclosure and active oversight.

The first part is management--the people responsible for the company's financial reporting process and internal control structure. This includes understanding, assessing and implementing policies to mitigate risk.

The independent external auditor is second. The auditor is accountable to the shareholders, the board of directors and the audit committee and is responsible for auditing and reporting on the financial statements. The assessment of the system of internal controls is an important part of the audit process.

Finally, the audit committee, which should be made up of independent directors, who oversee and evaluate the company's financial reporting process and internal control structure and evaluate the independence and effectiveness of the external auditor.

Independence and financial literacy are the two most essential characteristics required of the audit committee. But I would add toughness as well. How else to ensure that management doesn't dominate the audit committee agenda?

A few weeks back, Bob Herdman, Chief Accountant of the SEC, had some very insightful things to say about the role of the audit committee. He advised audit committees not to rely on what is put before them. In his words, "Analyse it, throw a couple of rocks at it, kick it around."

I think that's great advice. It sums up the role that the audit committee needs to play--the role of a sceptical inquirer: a knowledgeable, independent voice that is not afraid to ask the tough questions of management and the auditors, a body that has the confidence to challenge, is actively engaged, and works to get at the real implications of accounting policies, disclosures and judgments.

I could go on at some length about this subject. But let me say that, based on my experience in working with audit committees, the people who serve on these committees do continually seek to enhance the effectiveness of their oversight role.

The last issue I promised to address was what I am calling the "business model" of the accounting firms. That is a nice way of getting in to the touchy question of CA firms providing non-audit services to their audit clients.

This issue has received plenty of air time in the public debate over auditor independence. One thesis is that an audit firm can potentially lose its independence if it is providing non-audit services to the companies it audits.

In February of this year, we announced our support for the SEC's proposed rules prohibiting the provision of financial systems design and implementation and internal audit outsourcing to audit clients. This proposal has received the support of the major accounting firms and all have sold or are in the process of disposing their consulting units.

However, some believe the regulators need to go further, and prohibit auditors from providing all non-audit services, such as risk assessment, tax, forensic and accounting advice, to their audit clients.

We don't believe that kind of prohibition on specialised services would serve the interests of investors. We believe that audit firms should continue to provide some specific non-audit services to clients.

Why? Well, in the first place, these days an effective audit requires the involvement of specialists. Without tax, IT, forensic, and financial risk management expertise, it would not be possible to complete an audit properly. These services deal with overall business risk issues. The audit firms need to have a business model that enables them to draw on them.

Often the company's auditor is the best choice to provide certain kinds of advice, as they know the company and its issues best and therefore are in a better position to understand the full implications of a transaction in the context of the business's activities.

For example, the auditor will be aware of similar transactions in a subsidiary or about corporate interrelationships that might affect a transaction's substance or that three years ago that company tried to do something exactly the same and the answer was "no." The auditor has institutional knowledge to put the transaction in context.

Moreover, the audit firm has internal checks and balances in place to ensure that transaction structures are appropriate.

At KPMG, for example, on every audit we require a mandatory independent review by a concurring partner who otherwise has nothing to do with the engagement. He or she must be satisfied with proposed accounting treatments and if not, he or she has the right to require that a change be made.

We also have a national professional practice group that provides an independent review of complex accounting treatments. These reviews are even more rigorous than the profession's quality control standards. Our professional practice people are empowered to require accounting changes if they do not agree with the decision made by an engagement partner.

We believe the appropriate approach for a company to take in purchasing non-audit services is as follows: first, consider the type of service; then consider who might best provide the service; third, ensure that the right controls or review procedures are in place to ensure that the service is completed properly; and finally, have the nonaudit services subject to ultimate approval by the company's audit committee.

We also believe that the move to disclose all fees paid to a public accounting firm by its clients--separating audit and audit-related from other services--is an excellent idea. It is a sound recommendation and one that will serve the public good. Very often public disclosure of what is being done is the best solution to ensure that the activities are balanced and within the company's best interests.

Some have argued that providing additional non-audit services creates potential for an auditor to become economically dependent on a particular client.

We don't believe economic dependence is an issue for any of the major Canadian audit firms--and certainly it's not at KPMG. Today no single audit client of ours represents more than 1 per cent of our total revenue in Canada--no matter what services we provide. The cost to us of losing the revenue from any one audit client is totally insignificant compared to the potential cost of losing our credibility in the marketplace.

So, to sum up, the failure of Enron has produced many excellent proposals for making our audit system work better for all of us: companies, regulators and users of financial statements. It certainly helped to move some important items from discussion table into action.

Before I close I would like to take a couple of minutes to speak to a couple of personal observations. First, to my colleagues at Andersen. I don't want to in any way diminish the very terrible consequences of Enron to its employees, creditors, shareholders and its pensioners. I am certain from a financial and emotional point of view the consequences have been devastating. However, I also believe the consequences to Andersen, its employees, its partners and its clients have been very difficult. They have our best wishes, and I hope that this works out as well as it possibly can for them.

Finally, I am very proud of my profession. I have been a CA for 31 years. Public accounting is a great profession full of honourable people--people of integrity, people of goodwill, people who work very hard at doing the right thing. Nonetheless, I understand that we need to challenge what we do, with a view to doing it better. We need to be very responsive to criticism and ensure that we change--and we will.

We believe the approach we are taking to improve public accountability, financial reporting, the transparency of the reporting model, auditor independence, improving the quality and approach of the audit committee, and how auditing standards and accounting standards are created will go a long way towards dealing with these issues. We need to focus on these initiatives and ensure that we deal with them fully and quickly.

The 68,000 members of Canada's CA profession recognise that we are an integral part of the capital market system that is vital to our economic well-being. You have my commitment that we at KPMG, working with our colleagues in the other accounting firms, regulators, clients, shareholders and other interested parties, will fulfil our role to the high standards expected of us.

Thank you.

The appreciation of the meeting was expressed by John C. Koopman, Partner, Heidrick & Struggles and 2nd Vice-President, The Empire Club of Canada.