Role of IFAC in Restoring Public Confidence in the Accounting Profession

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 theUnited 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 theUSand inEuropehave 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 aNominating 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. 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,Argentinadeclared 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 ofArgentinawould have had the opportunity to take action earlier.

Greece

In 2004, the European Commission launched legal action againstGreecefor drastically under-reporting its deficit. Following a request by a new Greek government, the Commission revisedGreece’s general government deficit for the years between 1997 and 2003.

Eurostat, the EU's statistical agency, was summoned to investigate the findings. 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 thatGreecehad been in breach of the EU budget rules every single year since 1997. Had the revised figures been known at the time,Athenswould 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.

Italy

Only a short time after it launched legal action againstGreece, the Commission also initiated an investigation intoItaly’s public accounts. Doubts about the accuracy ofItaly’s financial reporting arose from the fact that forecast annual budget deficits over the period 1997 to 2004 were consistently lower than the amount of cash borrowed to finance those deficits. In addition,Italy’s public debt had been falling more slowly than expected.

Subsequent revisions to the 2003 and 2004 deficit figures by Eurostat showedItalyin breach of the 3 per cent limit on budget deficits imposed by European Union rules.

Government of Pakistan

We might think that the problems experienced by these countries have nothing to do with us here inPakistan. Unfortunately, this is not true.

Just last month “The International News” reported that the National Accountability Bureau had confirmed the existence of a multi-billion rupees fraud involving “ghost” pensioners. The scam was so large that more than half the pensions being paid through thePakistanpost office’s savings bank account system were reported as being fraudulent. By one account, after the fraud was uncovered the number of pensions being paid through the post office’s savings bank in one area dropped from 35,000 to 13,000.

Had an appropriate level of financial management and reporting been in place, this fraud may not have been able to reach such proportions and may have been uncovered earlier.

The good news is that the Government of Pakistan has taken some initial steps to improve financial management and reporting in the public sector. In 2002 it established the National Accountability Bureau to monitor accountability of government entities, and established the Project for Improvement in Financial Reporting and Accounting with the assistance of PricewaterhouseCoopers. I would be very pleased to hear of the progress of this project. These are both significant developments which deserve to be encouraged.

US Federal Government

In the USAthe federal, state and local governments report on an accrual basis in accordance with generally accepted accounting practice, and their financial statements are subject to independent audit. However, despite a long standing drive for better financial information and millions of dollars being spent on upgrading financial systems, the US federal Government continues to experience difficulty in getting a clean audit report on its financial statements and has a deteriorating fiscal condition. Technically, it has not received an audit opinion at all, the auditor, the Comptroller-General, having declined to express an opinion on the grounds that the information was insufficiently reliable.

The 2004 financial report shows:

• Government revenues of $1.9 trillion;
• Net cost of the government's operations of $2.5 trillion; and
• A net operating cost of $615.6 billion.

The reported deficit of $615.6 billion in the financial statements is more than the actual “budget deficit” of $412 billion referred to on the Office of Management and Budget website. In the words of one commentator: “It mostly has to do with Social Security costs and cash vs. accrual accounting.” And so it may, but wouldn’t it be easier for the public if forecast and actual budget outturns were calculated using the same rules as the financial statements? If we are to have informed public debate, it helps if we are all using the same numbers. I will discuss recent moves to align different systems of reporting later in this speech, but would note again that such reporting disparities would not be tolerated by the government in relation to listed companies.

The US Government Accountability Office (GAO) report also highlighted concerns with the government’s reported fiscal position. Last year (May 20, 2005) the Comptroller General, David M. Walker, told a group of New York CPAs that the federal government's current fiscal business model isn't sustainable and major changes need to be made. As well as expressing concern about the government’s worsening financial state, Mr. Walker called on CPAs to educate the public about these issues, noting that as CPAs they had a responsibility to act in the public interest.

There is one particular statement in the latest GAO report on theUSfederal government’s financial statements that warrants mention. To quote:

“As in the seven previous fiscal years, certain material weaknesses in internal control and in selected accounting and financial reporting practices resulted in conditions that continued to prevent us from being able to provide the Congress and American citizens an opinion as to whether the consolidated financial statements of the U.S. government are fairly stated in conformity with U.S. generally accepted accounting principles.”

Why the disclaimer? The reasons are discussed more fully in the audit report, but let me quote just one, telling, paragraph:

Just as concerning, the GAO gave an adverse opinion on internal control. As a consequence of poor internal controls, some agencies are meeting their financial reporting requirements by preparing information outside the financial reporting systems. This, as we all know, is an extremely inefficient and risky way to prepare financial statements. What is more, and worse, it tells us that this financial information is not available for financial management purposes within the period. 

For fiscal year 2004, 18 of 23 CFO Act agencies received unqualified audit opinions. This is two less than in 2003 and 2002. This means that approximately 80% of CFO agencies received an unqualified report. However, 20% did not. The government would not accept this standard of financial reporting from the private sector.

As we can see, even in a country that has relatively advance public sector financial reporting, problems can arise.

Responses to governmental failure

The examples I have given you are merely a snapshot of poor financial reporting and poor financial management by governments internationally. There were many, many more examples I could have used.

In the private sector we have witnessed the immediate and powerful reaction of regulators and the profession to large scale corporate failures. By contrast, who is demanding action and who is taking action in relation to governmental financial management and financial reporting failure? While there are some who are attempting to address these issues, and IFAC can be counted amongst those, the primary actors, governments themselves, are not doing enough. Neither is there sufficient comment on these issues in the media. 

I find it interesting and regrettable that, despite the widespread international adoption of International Financial Reporting Standards (IFRSs) in the private sector, there have been few commentators arguing for the adoption of equivalent international standards by governments. As I will discuss presently, such standards are available.

There are, however, a number of organizations that are involved internationally in improving the quality of governmental financial reporting, and, more broadly, the transparency of governments. 

My focus today is on the international scene, and I would like to give some examples of what has been happening internationally and in other countries to strengthen government financial reporting. 

IFAC

Let me start with my own organization – IFAC. 

IFAC’s International Public Sector Accounting Standards Board (IPSASB) focuses on the accounting, auditing, and financial reporting needs of governments and government agencies. This Board has produced International Public Sector Accounting Standards (IPSASs), based on IFRSs, for the best part of a decade. The IPSASB has now issued 21 accrual basis standards and one comprehensive, cash basis, IPSAS. It has also produced other studies and papers designed to provide information on the adoption of accrual accounting and financial reporting initiatives in various jurisdictions. 

I think it appropriate at this point to acknowledge the contribution of Mr. Mohammed Rafi, who served as thePakistanmember on the IPSASB’s predecessor the Public Sector Committee from 2000 to 2002. Mr. Rafi has long been active in theInstituteofCostand Management Accountants inPakistanand is currently a member of that IFAC Member Body’s Council. The development of standards by the IPSASB takes considerable time, effort and expertise – all on a voluntary basis – and IFAC is extremely grateful for the contribution of IPSASB and PSC members such as Mr. Rafi.

Key components of any governance and accountability system in the public sector are the preparation of financial statements in accordance with well understood and generally accepted accounting standards. IPSASs, therefore, provide the foundations for better reporting. We must move beyond the situation where each government writes its own financial reporting rules to one where governments report using the same set of standards. Again, it would not be acceptable for a reporting entity in the private sector to write its own rules, yet this is the case for virtually all national level governments.

Recently, the United Nations’ High Level Committee of Management announced that it would recommend to the General Assembly later this year, that the UN System adopt IPSASs as the basis for preparing financial statements by entities within the UN System.

A press release issued following a high level conference in September 2004, organized jointly by the European Commission and the Fédération des Experts Comptables Européens (FEE), the representative body of the European accountancy profession, advocated the adoption of IPSASs as essential to the development and strengthening of financial reporting by governments.

In 2004, Sir Andrew Likierman, until recently Head of the Government Accountancy Service of the UK Treasury, chaired a Review Panel which conducted an independent review of the activities of the IPSASB, then called the Public Sector Committee (PSC). The review panel made a number of recommendations concerning the composition and governance arrangements of the PSC. The report of the panel noted that over 85% of the respondents to a survey it conducted supported the existence of an independent financial reporting standard setter for the public sector. 

The panel concluded that the PSC had made an effective contribution to global public sector financial reporting through its pronouncements. 

The World Bank, along with others, has supported the development of these standards and encourages their adoption. IPSASs have been, or are being, adopted by a number of governments and public bodies (for example, the Organisation for Economic Co-operation and Development (OECD), the European Commission and the North Atlantic Treaty Organisation (NATO)) and are having a very significant influence on the development of national standards.

In addition, the report stated:

“The success of the Standards Program cannot be gauged purely through the number of jurisdictions and entities that have adopted IPSASs. There is considerable evidence emerging, particularly from East, Central and Southern Africa, South America, Asia and Europe that the pronouncements of the Committee are becoming more influential. … National standard-setters are increasingly reflecting the views of the PSC in their own debates on public sector financial reporting.”

I am very pleased indeed that the IPSASs are having this level of influence internationally. However, I am also aware that we have a very long way to go before there is general adoption of these standards around the world. Obviously, I would want to encourage you all in the ICAP to work to alignPakistan’s public sector accounting standards with international standards.

Setting financial reporting standards is not the only means by which IFAC is seeking to improve the quality of financial management and financial reporting in the public sector. IFAC is also working to ensure that all professional accountants – whether in public practice, business, industry, or in the public sector – have high quality guidance on ethical conduct. IFAC’s International Ethics Standards Board for Accountants has been progressing a project to develop additional guidance for professional accountants in government. The project will consider whether Part C of the Code (which applies to professional accountants in business) should contain additional guidance for professional accountants who work in government. The project will also develop independence guidance for professional accountants in government.

In relation to the International Standards on Auditing that IFAC’s International Auditing and Assurance Standards Board sets, there has been increasingly close cooperation with International Organization of Supreme Audit Institutions (INTOSAI). 

INTOSAI

INTOSAI is the international organization of supreme audit institutions in countries that belong to the United Nations or its specialist agencies. The Office of the Auditor General ofPakistanis a member of INTOSAI.

The Auditing Standards Committee (ASC) of INTOSAI is working in close cooperation with IFAC’sIAASB in developing financial audit guidelines. TheIAASB develops International Standards on Auditing for the private sector. The ASC is working with theIAASB with the aim of including public sector considerations in the ISAs.

Other ongoing work of the ASC includes:

• Principles for independence ofSAIs; and
• Implementation guidelines for Performance Audit. 

World Bank and the IMF

The World Bank and the International Monetary Fund (IMF) have both actively supported and been involved in the development of IPSASs. The two agencies have also engaged in their own exercises entitled “Reports of the Observance of Standards and Codes" (ROSCs) which assess a country’s observance of selected standards relevant to private and financial sector development and stability. They include assessments of fiscal transparency. As part of the ROSC initiative, the World Bank has established a program to assist its member countries in implementing international accounting and auditing standards for strengthening the financial reporting regime, including that of the public sector. 

Developments in Various Jurisdictions

Although I have been critical of the standard of financial reporting by governments, it is only fair to acknowledge that a number of governments have established or are establishing a high quality of financial reporting. TheUSgovernment is producing accrual based financial statements, as noted earlier, and that certainly constitutes progress.

The United Kingdom government has adopted accrual accounting within both local and central government. At present, this is still at an agency and local authority level, but consolidated audited reports are expected in 2006/07. The consolidated financial reports will encompass both local and central government, as, for the purposes of financial reporting, the central government is considered to control local government.

The Australian andNew Zealandgovernments have been reporting on the accrual basis for over a decade now. Notably, both countries have recently announced the adoption of IFRSs in full, not only in respect of companies but also for the public sector. This move illustrates how governments can lead by example - reporting in accordance with exactly the same reporting standards as they expect from companies. In the case ofNew Zealand, the public sector currently reports in compliance with New Zealand Financial Reporting Standards, which are sector-neutral, the same standards applying to both sectors.

Many other countries are looking to move to adopt an accrual basis of reporting and, while the direction is to be applauded, the speed and urgency are, generally, well short of what we should expect and demand. 

Those jurisdictions that have fully adopted the accrual basis (incorporated into appropriations, budgeting and reporting processes) have found it to generate very significant benefits. I do not consider the impediments to proper accounting by governments (at least in developed countries) to be related to cost, nor do I believe them to be related to available expertise. I do believe it requires more than the goodwill of committed professionals – it requires a commitment at the political level that transparency is not a choice but an obligation, and, like the private sector, the rules are written not for the reporting entity but for the users of the financial statements.

Conclusion

I began this talk by noting that there have been some serious corporate failures in the private sector. However, regulators and the profession have done a very great deal in short order to address failures in accounting, auditing and financial reporting and to restore public confidence in financial reporting. 

Unfortunately, and notwithstanding the efforts to which I have referred, we cannot say the same with respect to the public sector. There is ample evidence of financial reporting failure within governments, and I gave a small number of examples of this. I noted that there are organizations, including the ICAP and IFAC, that are working hard to improve the quality of financial reporting by governments. Occasionally, the media comments on the need for better quality reporting by governments. However, the response to governmental financial reporting problems is very much weaker, and appears to reflect a lower level of concern, than we see in relation to the private sector.

What is most troubling is the lack of demonstrated commitment on the part of governments themselves to the production of high quality financial reporting. At best, it seems to be something governments will address as a “nice to have” “when resources permit.” It is not seen as a fundamental obligation. Yet, ultimately, investors can choose whether or not to invest in a corporation – as citizens we have no such choice in relation to the contribution we make to government through taxation. I would argue that within a representative government the exercise by governments of the power to tax carries a fundamental responsibility to account properly for the money so raised.

If governments around the world genuinely believe in the importance of transparency in financial reporting, as suggested by their regulation of public companies, then they need to lead by example. The consequences of poor financial reporting and poor financial management within governments are arguably even more serious than a loss of confidence in securities markets. It violates the relationship between the governed and the governing. It creates an environment ripe for corruption and fraud. And it puts at risk the growth of the global economy and, therefore, the welfare of citizens.

Ladies and gentlemen, we must raise our expectations of governments around the world, just as they have raised their expectations of the private sector.

Thank you.