INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN
International Conference
Role of IFAC in Restoring Public Confidence in the Accounting Profession
February 1 - 2, 2006
Karachi, Pakistan
Government accounting
Presentation by Ian Ball, Chief Executive
International Federation of Accountants
The 10th anniversary of IFAC’s program to establish international public sector financial reporting standards is approaching. Ian Ball’s presentation will cover the progress made in governmental financial reporting during this period against the backdrop of financial reporting failures in the private sector, actions by governmental and regulatory authorities to restore confidence in financial reporting, pressure for more efficient and accountable government and, from a corporate governance perspective, the importance of governments leading by example. Ian’s presentation will also touch on recent developments and current topics in international financial reporting and auditing.
Introduction
Ladies and gentlemen, thank you for inviting me to address you today.
As the title of my presentation suggests, I am going to talk about public sector financial reporting and why we need to raise our expectations of governments. However, I want to frame my comments in the context of our expectations of financial reporting in the private sector. Over recent years our expectations of the quality of financial reporting and auditing in the private sector have increased dramatically, and the efforts that have been devoted to achieving those changed expectations have been enormous. I wish to contrast this with what has happened, or more accurately, what has not happened, in the public sector. To be clear, I am not suggesting that nothing has happened in the public sector. Indeed I have been personally involved in some of that change, as, I am sure, have many of you. However, I do observe a large gulf between the inclination of governments internationally to act to enhance private sector financial reporting and the relative lack of urgency devoted to improving their own financial reporting and financial management.
Let me begin with some comments on corporate failures and the response of regulators and the accountancy profession to those failures.
The Response to Corporate Failures
We are all only too well aware of the scandals that have rocked the private sector in recent years. Examples, from around the globe, include Enron, Global Crossing, Royal Ahold, HIH Ltd, WorldCom and Parmalat. Such failures weaken the public’s confidence in the integrity and transparency of securities markets. The sheer size of the companies concerned, and the impact on public confidence, has been so great that the failures have led to dramatic national and international responses – responses that might be described as a watershed similar to that of the 1930s securities legislation. Over the last few years there has been a raft of regulatory and professional reforms designed to protect investors from financial reporting and audit failure, and from other forms of corporate malfeasance.
The reforms have been especially dramatic in the United States, where, amongst other things, the Sarbanes-Oxley Act created the Public Company Accounting Oversight Board (PCAOB). These reforms have given the Securities and Exchange Commission (SEC) and the PCAOB extensive powers over private sector accounting and auditing, putting in place regulations that affect every facet of private sector accounting and auditing in America and that have had far-reaching international ramifications as well. To curb corporate corruption, strengthen corporate governance and ensure reliable and accurate financial reporting, the Sarbanes-Oxley Act did, amongst other things, make accountants and auditors more accountable, stiffened fines for law-breaking by corporate officers and directors, limited insiders from selling stock during "blackout periods" and directed the SEC to create new rules for financial reporting. Whether the very broad scope of the reforms is cost-effective remains to be seen, but the Act has provided impetus for similar reforms around the world and has unquestionably resulted in significant benefits.
In Europe, the European Commission, through its requirement for the adoption of International Financial Reporting Standards (IFRSs) and its strengthening of the Eighth Directive on Company Law, is also raising the bar significantly for private sector accounting and auditing. As with the Sarbanes Oxley Act, there is debate about the scope and rigidity of the Directive, which is designed to improve governance of EU-listed organizations and the quality of audits. Like Sarbanes-Oxley, at the core of the Eighth Directive is a commitment to restore investor confidence in the markets. So, for example, the Directive specifies the responsibilities of audit committees to include oversight of the internal audit function, internal controls and auditor independence.
The changes we have seen in the US and in Europe have been mirrored in many other countries. There really has been a dramatic shift in the regulation of financial reporting and the accounting profession internationally.
The corporate failures have resulted not just in regulatory action. There has been action by accounting professional institutes at national and international levels, and by accounting firms, amongst others.
I could spend quite some while outlining the actions and initiatives taken by these groups, but will not. It will suffice to sketch just some of the key responses by IFAC and by the firms.
IFAC has developed a series of reforms to help ensure that its standard-setting activities reflect the public interest and are fully transparent. This set of reforms is the most significant shift in IFAC’s governance since its creation in 1977. One of these reforms was the establishment, early last year, of the Public Interest Oversight Board (PIOB). The PIOB oversees the work of IFAC's auditing, ethics and education standard-setting committees and of its Member Body Compliance Program, to ensure that those issues of greatest importance to the public interest are properly addressed. The membership of the PIOB is chosen by a Nominating Committee comprised of representatives of the International Organization of Securities Commissions, the Basel Committee on Banking Supervision, the International Association of Insurance Supervisors and the World Bank.
IFAC has also released a revised Code of Ethics to provide more guidance to all members of the profession – including those in business, public practice, education, and government – on how they can meet their responsibilities to act with integrity and independence.
IFAC has also, through its International Auditing and Assurance Standards Board (IAASB), issued two standards on quality control in relation to audits, which significantly enhance the requirements for quality control in relation to audits.
Audit firms, too, have taken a very hard look at their operations, clients, and services to determine how they could best respond to the changed environment. I will mention just a few, by no means all, of the examples of the response by audit firms to the new regulatory environment.
§ First, most major firms have restructured their services, divesting their consulting arms.
§ Firms are also more focused on educating clients and investors, producing a plethora of guidance for clients and investors.
§ Quality control processes have been strengthened.
§ Additional focus is placed on internal control, including the provision of resources for investors and financial market participants.
§ There is greater transparency as to the structure of the firm networks.
§ The firms have also acted to strengthen their independence policies.
To summarize thus far: the financial reporting failures in the private sector have had a dramatic impact on the regulatory landscape, on accounting professional institutes and on accounting firms. In rounding out this section of my presentation, I would note that there has been a lot of attention given recently to the cost of these reforms. Around the time of the introduction of the Sarbanes-Oxley Act, some smaller firms estimated the cost of complying with the new legislation at between $300,000 and $500,000 annually.[1] More recently estimates of the average cost of compliance with Sarbanes-Oxley for an individual company have ranged from $2m to $3m. According to Financial Executives International (FEI), just complying with section 404 of the Act will cost an average of 62% more than previously anticipated, create a 109% rise in internal costs, a 42% jump in external costs, and a 40% increase in the fees charged by external auditors (PR Newswire, 2004). Estimates of the total cost of compliance for US businesses range from $2bn to $5bn per year.
My point is this: the new regulatory environment implies very substantial costs. While the costs may be higher than anticipated, it was always clear that the cost would be high. The judgment of the US Government and the European Commission, mirrored by many other governments, is that high quality financial reporting is worth that cost, given the benefits it creates through improved accountability, better decision-making and public confidence in institutions.
The reason I have begun this talk by focusing on corporate failures and their consequences is to highlight the importance to investors and others of being able to rely on the financial information produced by companies and to note the dramatic steps taken to enhance the quality of financial reporting in the private sector. When the objective is important enough, action can be rapid and radical. The crucial importance of financial reporting in the private sector is a useful benchmark when considering financial reporting in the public sector.
IFAC’s Mission
IFAC's mission is to “serve the public interest, strengthen the worldwide accountancy profession, and contribute to the development of strong international economies by establishing and promoting adherence to high-quality professional standards, furthering the international convergence of such standards, and speaking out on public interest issues where the profession's expertise is most relevant.”
The public interest objective outlined in IFAC’s mission statement encompasses both public and private sectors. Companies influence the strength of an economy – but so, too, do governments. Given the size of the public sector internationally, poor financial management results in a huge economic cost to the world’s economy, and that really is important.
While there are certainly public interest issues associated with the transparent reporting of information on a company’s performance – I would argue that there is an even stronger public interest argument for demanding transparent financial reporting from governments.
Governmental financial reporting
In my discussion of private sector financial reporting, I highlighted the recurring theme of restoring public confidence in financial reporting and financial markets. I wish now to consider the extent to which we can have confidence in governmental financial reporting, but, before doing that, it is appropriate to remind ourselves of the reasons we should expect high quality reporting from governments.
There are at least three key reasons:
§ Performance: Governments internationally shift billions, trillions, of dollars from the private sector to the public sector, with the objective of improving the well-being of the society and economy. If governments do not operate in an efficient and effective manner, or invest wisely, this represents a huge drain on an economy. Governments, just like companies, need timely and accurate financial information to monitor and manage their performance.
§ Accountability: Governments are not spending their own money. They are spending our money. They are entrusted with the management of assets and liabilities that have been built up over decades and which will have an impact on the welfare of citizens for many more decades. Taxpayers and citizens are entitled to information which allows then to hold governments accountable for their use of public resources, including the extent to which current revenues are sufficient to pay for the services provided, and whether balance sheets are strong enough to withstand external shocks, not to mention meeting their current obligations associated with long-term trends like an aging population.
§ Representative government: A government, regardless of the form it takes, represents the interests of the people it governs. Good government requires that constituents have confidence in those that govern. This confidence is enhanced when governments fully inform their constituents, and provide them with reliable financial information. Transparent financial reporting is one means by which governments can engage constituents in the political process and engender confidence.
Having established that we have a right to demand high quality reporting from our governments, what do we see in practice? Internationally, we see widespread and continuing poor quality financial reporting. By contrast with many governments, Enron would be a model of transparency. Such reporting failures do not generally lead to the bankruptcy of governments, but they do impose an enormous burden on an economy and have a very direct impact on economic growth.
Let me give you a very few examples of poor financial management and financial reporting by governments.
Argentina
In late December 2001, Argentina declared the largest sovereign debt default in contemporary history.The aftermath of that debt default is still being worked through. There were a number of contributing factors: the growth in public debt, the denomination of that debt, Argentina’s unusual exchange rate regime and the Argentine government’s failure to adequately manage its liabilities.
One element of the poor financial management observed in many jurisdictions is the poor quality of financial information. If the Argentine government had prepared timely financial reports based on generally accepted accrual accounting practices, its failure to properly manage its liabilities would have been evident much earlier, and the government, lenders or the citizens of Argentina would have had the opportunity to take action earlier.
Greece
In 2004, the European Commission launched legal action against Greece for drastically under-reporting its deficit. Following a request by a new Greek government, the Commission revised Greece’s general government deficit for the years between 1997 and 2003.[2]
Eurostat, the EU's statistical agency, was summoned to investigate the findings.[3] Military expenditures and interest payments had been serially under-recorded, and the surplus recorded in the social security account had been overstated. The revised figures showed that Greece had been in breach of the EU budget rules every single year since 1997. Had the revised figures been known at the time, Athens would not have been allowed to join the euro zone in 2001.
This saga prompted calls for an improvement in the quality of financial information provided by governments in the European Union, a strengthening of the independent process for compilation of such information, and the need for an independent audit of the output. Little substantive action has yet resulted.