Dispatch

• inspections scrutiny
• pensions deficits spiral
• European Parliament investigates Equitable Life
• access all areas for Euro accountants

inspections scrutiny

The Big Four firms have now all received their first full inspections by the US Public Company Accounting Oversight Board - established under the Sarbanes-Oxley Act. The results make uncomfortable reading, especially for PwC and KPMG.

While there are moves to water down some of the Sarbanes-Oxley Act, the Public Company Accounting Oversight Board (PCAOB) looks like a permanent fixture. The Big Four firms might be tempted to wish it was not.

All the Big Four have now had their first full inspections from PCAOB published - the 2004 PCAOB reports were only limited inspections. The results provide a mixed picture of the precision of the firms’ work. PricewaterhouseCoopers and KPMG were particularly buffeted by the number of issues raised by the PCAOB, although the Board cautioned against drawing conclusions about the comparative merits of firms based on the number of reported deficiencies due to the relatively small sample of audits scrutinised. Indeed, the inspectors concluded that all four firms had audited some accounts without sufficient evidence to support their audit opinions.

The PCAOB report on PwC was notable for the large number of audit decisions challenged and for their significance. In some instances, PCAOB concluded that the firm had completed its audit without ensuring the accounts complied with accounting standards. The inspectors found, in one case, a deferred tax liability was not properly recorded. In another set of accounts, there was no evidence that the auditors had evaluated the treatment of option and contingent purchase contracts for land - despite being recorded as worth 20% of the company’s total assets.

PwC also did not consider the appropriateness of the inclusion of a settlement with a customer in net sales, without disclosing this in the accounts - despite its significant impact on net sales figures, claimed PCAOB. In another audit report, PwC allegedly failed to evaluate the appropriateness of the treatment of net deferred income tax liability as non-current, despite it representing 12% of total liabilities. PwC was criticised for over-reliance on companies’ internal auditors’ assessments.

The PCAOB also claimed in its inspection report that KPMG failed to ensure the accounts of some of its audit clients complied with all relevant accounting standards. There was strong criticism by the inspectors of treatment of a sale-leaseback transaction that allegedly breached SFAS standards. Two other clients invested one-third and 43% of their reported cash holdings in securities that should not have been classified as cash, said the inspectors.

The accounts of another company audited by KPMG used accrual accounting for the valuation of derivatives, when SFAS standards required these to use fair value. In the same accounts, an overstatement of liability for stock appreciation rights could have equated to as much as 80% of quarterly income. The same company had inappropriately capitalised some deferred costs, but, said the inspectors, the firm did not evaluate the extent to which the costs should not have been capitalised, nor did it propose a related audit adjustment.

Inspectors also concluded that KPMG took insufficient steps to independently assess a client’s stated oil and gas reserve estimates.

The volume of criticisms identified by the PCAOB’s sample in respect of Ernst & Young was smaller. But E&Y, too, was alleged to have failed to identify the departure of clients’ accounts from GAAP. In one instance, a client accounted for a lease as an operating lease when the conditions meant this was inappropriate under SFAS standards.

Deloitte’s PCAOB inspection report was published early last year, whereas the other three firms’ reports were published at the end of 2005. Like E&Y, there were fewer alleged serious errors recorded by the inspectors in the relevant sample than against KPMG and PwC.

In the most serious challenge to Deloitte’s audits, PCAOB claimed that one company reported to the auditor significant changes to the assumptions used to calculate gains on securitisation transactions at the same time that it reported it had overstated the recorded value of interest-only strip assets and related interest income. These changes were advised to the auditor two days prior to the audit report due to be filed to the Securities and Exchange Commissioner, and had the effect of cancelling each other out. This was not reported in the accounts or the auditor’s report, nor was there evidence that the firm had evaluated that the interest-only strip assets had been accounted for at fair value, as was necessary under the relevant SFAS standards.

The full public versions of the PCAOB’s inspection reports for 2004 can be viewed at www.pcaobus.org/inspections/public_reports/index.aspx.

pensions deficits spiral

Companies’ provisions for future pensions liabilities may have been seriously underestimated, suggests new analysis. And despite the stock market bounce, the deficits just keep getting bigger.

New reports suggest that the scale of deficits in UK and US companies may be substantially higher than previously estimated. Previous calculations that FTSE 100 companies may be carrying deficits of £50bn may be optimistic by a factor of three, James Fraser, head of LEK Consulting’s financial services practices, suggested in an article in the Financial Times. He bases his £150bn deficit calculation on the latest guidance from the Pensions Board of the Faculty and Institute of Actuaries. The £50bn figure, produced using FRS 17, may be an under-estimate because many funds continue to fail to take into full account the increased longevity of current and future pensioners. Further, under the Pensions Act of 2004, the full debt faced by companies is not the FRS 17 calculation of deficit, but the “full buy-out value” at wind-up. Because insurers take particularly conservative assumptions of future risk, including longevity, the buy-out deficit could, in some instances, be as much as five times greater than the FRS 17 deficit calculation, suggests Fraser.

Latest assessments of pension deficits by pensions consultants, Mercer, also suggest that funding holes may be rising significantly. Its calculations show a deficit of £93bn in FTSE 350 companies, compared to £75bn in 2004. Although pension fund asset values grew by £60bn last year to £422bn, liabilities grew even faster. Falls in yields on gilts and bonds have seriously exacerbated the problem.

“Favourable investment performance did little to dilute the value of pension scheme deficits in 2005,” said Tim Keogh, Worldwide Partner at Mercer. “Bond markets rose at the same time as equity markets, causing yields to drop and liabilities to grow. The need to allow for increased longevity has been an additional headwind. Just as people have to pay more to trade up their house after a property boom, despite the value of their current home increasing, employers have to contribute larger cash sums to reduce their pension scheme deficits when all markets rise.”

Keogh told accounting & business there was not necessarily any conflict between Mercer’s assessment of deficits, based on FRS 17, and the figures suggested by LEK Consulting, using buy-out valuations. He explained: “The point is that there are different ways of calculating it. It is no secret that if you use the buy-out calculation, then you will come out with a different figure. I am not sure that means the companies’ accounts are wrong. In effect, it is the difference between the break-up and going-concern values of a company.”

The scale of the pension fund deficits explains the strong trend of employers moving away from final salary and other defined benefits schemes, adopting in their place “money purchase” schemes - which define contributions, not benefits. Many companies are also requiring higher employee contributions and later retirement ages. In the UK, both Rentokil Initial and BHS have recently announced plans to end their final salary schemes.

A parallel process is taking place in the US. IBM, Lockheed Martin, Motorola and Verizon have all, in recent weeks, announced the ending of final salary plans, with their replacement by defined contributions schemes. IBM, which runs the third largest corporate pension scheme in the US, had already closed its pension plan to new employees. There is speculation by commentators that many other companies in the US will copy the IBM example, while in the UK companies may be waiting to see what happens to the Rentokil Initial initiative.

But there are some differences in approach internationally. In the UK, the Co-operative Group’s stated intention to move from a defined benefits scheme based on final salaries to one based on average pay across an employee’s entire career has sparked a strike threat by unions. National Australia Bank - which owns the Yorkshire and Clydesdale banks in the UK - has proposed a similar move to tackle its £430m deficit on its UK pension fund. Yet the move to basing payments on average pay was welcomed by Australia’s Finance Sector Union, which said it reflected the reality of a more flexible labour market.

European Parliament investigates Equitable Life

The European Parliament is to investigate the Equitable Life crisis. Policyholders hope this will lead to compensation from the British taxpayer for the £1.5bn they lost when the society was unable to meet its liabilities.

The focus of the Parliamentary inquiry will be whether the UK Government properly implemented European law and whether any failure to do so may have affected the regulation and decisions of Equitable. Members of the European Parliament will also examine whether the European Commission carried out its duties properly in monitoring the adoption of European law in the UK and make suggestions about how lessons learnt from the Equitable failure can lead to improved regulation in the future.

But the most significant element of the inquiry will be to “assess allegations that UK regulators [at the time the Department of Trade and Industry and the Treasury, but, subsequent to the crisis, the Financial Services Authority] consistently failed, over a number of years, and at least since 1989, to protect policyholders by exercising rigorous supervision of accounting and provisioning practices and the financial situation of Equitable Life”.

Over a million UK policyholders and more than 15,000 policyholders in other EU countries, particularly Germany and Ireland, incurred major losses to their pensions, savings or investments following the near collapse of Equitable Life. Groups representing policyholders have been involved for the last two years in lobbying MEPs to investigate allegations of regulatory failure.

The committee has a timetable of a year to complete its work, after which its report will be submitted to the European Parliament. An interim report will be completed within four months. The European Parliament has the power to set up a committee of inquiry to investigate “alleged contraventions or maladministration in the implementation of Community law”. The committee will hold hearings and can invite European Commission officials and representatives of government to testify, as well as request relevant documentation from government departments and regulatory bodies.

The decision to investigate is supported both by Equitable Life and its members, who have doggedly complained about misadministration both by the mutual and its regulators.

Liz Kwantes, co-ordinator of the Equitable Life Members’ Help Group, said: “It’s fantastic news. We worked very, very hard to get them to accept [the petition, requesting an investigation of the Equitable problems]. We had to get 25% of MEPs to accept it. The towel has been thrown in our face so often by the Government in this country. At last somebody is going to look into it properly - people without a vested interest. The European Parliament will look at the FSA, as well as the DTI and the Treasury.”

Kwantes hopes the investigation will lead to the payment of compensation to Equitable annuitants by the Treasury. “I must have lost well over 30% of my fund and everybody else is in the same boat,” she said. “I know somebody who has had to sell his house because of the problems.”

Alistair Dunbar, a spokesman for Equitable Life, said: “We welcome any action which will lead to compensation for our policyholders.”

While it is possible that the actions of accountancy regulators will be investigated, it is unlikely that the investigation will consider the role of Equitable’s auditors, Ernst & Young. Equitable dropped its claim for compensation against E&Y last September.

access all areas for Euro accountants

Accountants operate in a European market without rules restricting access, according to a survey conducted by the European Federation of Accountants (FEE).

“The survey found that the accountancy profession primarily operates in activity areas where there are no market access rules restricting or prohibiting the entry of other service providers,” said Jacques Potdevin, Deputy President of FEE. “Where there is choice of service provider, the market knows that professional accountants have the necessary expertise and safeguards to maintain standards. In markets free of access restrictions, professional institutes of accountants are a beneficial instrument of consumer protection as they promote high quality service provision by their members.”

Only in the areas of statutory audit and some other reports required by European company law directives do market access rules apply, FEE found. Most EU countries regard professional accountants as having tax expertise, and over half the countries surveyed treat tax services as an area of free consumer choice. A small number reserve the provision of tax advice to regulated professionals - qualified accountants and lawyers. In several countries surveyed, there are significant restrictions on the ability of accountants to provide tax services.

FEE says that while professional accountants compete in non-regulated service areas with other service providers who do not submit themselves to the same education and training requirements as do accountants, this is not necessarily a problem. There is “significant market appreciation of the benefits of using the services of professional accountants”, concluded FEE.

Limitation of the provision of statutory audits to qualified accountants was determined by the Eighth Company Law Directive, dating from 1984. In this the EU is in line with global practice. However, registration of statutory auditors is organised in different ways across EU member states. In a minority of EU countries, individuals who are not members of a FEE member body are permitted to carry out statutory audits, but usually only for small firms and not-for-profit organisations. In these instances, auditors are required to register with their local authority.

Some other activities carried out by professional accountants are regulated by EU directives, but this has not always resulted in the reservation of these activities to qualified accountants. Expert reports on mergers of public companies, the division of public companies and on contributions in kind are reserved to professional accountants in most, but not all, EU member states.

Contractual engagements to provide non-statutory audit and review services are reserved to professional accountants in most member states as an extension of the statutory audit. But in more than a third of EU member states there is no such reservation. In practice, in all countries surveyed professional accountants did carry out this function, with clients recognising the benefits of using professional accountants.

There are, though, some important restrictions on the ability of accountants to enter niche markets. In six countries surveyed, professional accountants are prevented from becoming EMAS verifiers under the EU’s environmental management scheme. In most European countries, the “liberal professions”, including accountants, are prevented from carrying out certain commercial activities. In many countries, there is not a blanket ban on accountants from carrying out some legal services related to their areas of special expertise.

The objective of the report was to consider the relationship between the need for a degree of regulation of the profession and appropriate competition rules. In particular, FEE was motivated by the concern that the desire to regulate might become more powerful than the development of an open market with free competition.

FEE recommends that, in areas where there are no market access restrictions, the most appropriate way to serve the public interest and to protect consumers is to strengthen the relevant professional bodies that promote high quality service provision by their members. “Professional bodies acting under appropriate oversight are a necessary and beneficial instrument of consumer protection,” says FEE’s report.