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22 October 2004
Speech by Callum McCarthy

1. It is an honour to be invited to address you in this, your anniversary year. My original training was as a historian, and I am much struck by the various important events - the important events other than your foundation - which occurred in 1854, the year of your foundation - events which marked themes which have proved of huge import over the subsequent 150 years. 1854 saw the first fractionation of petroleum by distillation - an invention which paved the way for the motor car age; it saw the first convention of the Republican party in the United States - still (at least until next year) the ruling party in the world's most powerful nation; it saw the treaty signed at Kanagawa which opened up Japan and Japanese trade to the world with all that flowed from that; it saw the famous demonstration - so critical to public health - by Dr John Snow in London that cholera was water borne - the foundation of modern epidemiology. And, of course, it saw the foundation of this, the oldest professional body of accountants in the world.

2. It is obvious that, in the 150 years since your foundation, there have been many changes in accounting and audit. Very recently, these changes have accelerated and financial reporting in the UK - and indeed around the world - is in the midst of the most radical and important change for a generation. From January 2005 we will have International Accounting Standards for all EU listed groups (the biggest change in financial accounting since the introduction of the 4th and 7th Company Law Directives). At the same time, the European Commission is moving rapidly towards requiring the use of International Standards on Auditing across the EU, and the UK Auditing Practices Board will anticipate that change by introducing International Standards in Auditing into the UK, with some additional UK specific rules, from 1 January 2005.

3. There are also changes to the standard setting and enforcement regimes in the UK. The Financial Reporting Council has new powers and responsibilities, and we can now safely say that all aspects of accounting and auditing standard setting and oversight are independent of the profession, while retaining a strong input from those in the profession who can provide their expertise. It is early days for the new FRC structure, but already we are seeing the development of ethical standards for audits, by the APB; a proactive risk based regime for enforcing accounting standards, from the Financial Reporting Review Panel; the development of a standard on the Operating and Financial Review, from the ASB; and of course a revised Combined Code on Corporate Governance. We also have the Audit Inspection Unit which is responsible for monitoring the audit of those entities which may impact on financial and economic stability. Since June, the AIU has been visiting audit firms to inspect the quality of the audit for specific economically significant entities.

4. Against this background of change, I want to focus on three aspects of concern to all of us: the FSA's interest and role in accounting and audit; developments at a European and international level; and the issues of principles and rules for accounting and audit. In some of these aspects I would like to emphasise the role you play as individual accountants and auditors.

5. Why does the FSA have an interest in accounting and audit? After all, we have no direct responsibility for any aspect of financial reporting or audit. The FRC has responsibility for accounting and audit, and is overseen by the Department of Trade and Industry. The FSA has a seat on the FRC (a post now held by my colleague Hector Sants); my quondam colleague at the FSA (and member of the ICAS) Paul Boyle has significant responsibilities within the FRC; and we work closely with the FRC's key Boards, but we have no control over the process. However, we are a major user of financial information, and one of our main objectives is to maintain confidence in the UK financial system. We therefore have an interest in market confidence in financial information. Let me give some examples:

   • As a prudential supervisor we require firms that we regulate to retain levels of capital that reflect the risk of their business. Those capital requirements are drawn from the audited financial statements, and we need to be confident that the accounts are relevant and reliable and have been independently audited to a high standard.

   • Again as a prudential supervisor we frequently use firms' auditors or another independent accounting firm to undertake reviews and investigations on our behalf. I would argue that we are often major customers of the accounting firms, and like any of their other customers we are heavily reliant on the quality of the profession's standards and quality control mechanisms. We clearly rely heavily on the independence of the accounting firm in these circumstances - a particularly important quality when we are relying on a firm which is both conducting an enquiry for the FSA and is also the auditor of the company subject to enquiry.

   • With our responsibility for overseeing markets (most particularly as the UK Listing Authority) we have an interest in high quality relevant and reliable financial information in order to maintain market confidence and the stability of markets.

   • London is often described as the world's most international capital market. Many of the participants are subsidiaries or branches of overseas holding companies, and we need to be confident that the overseas holding companies (and often the group as a whole) is adequately capitalised. It is therefore in our interest to have a single set of globally applied high quality accounting and auditing standards.

   • Finally we should not forget that the FSA has a responsibility for controlling financial crime. Lord Robertson touched on some of the important ramifications of this task. We therefore need to be confident that financial information provided to the market is reliable.

   So much for the first of my themes: the interest which the FSA has in your activities. It is a keen interest, and you should expect us to follow your performance with great attention.

6. As I have already said, the changes to financial reporting that we are seeing in the UK are being replicated in all of the major financial markets around the world. These international developments are my second theme. Much of the work to foster development of international standards is done by the various international organisations of regulators, most notably IOSCO (the International Organisation of Securities Regulators) and CESR (the Committee of European Securities Regulators) where the FSA plays an active role, and where my colleague John Tiner is the chair of the most important relevant committee, CESRfin.

7. IOSCO endorsed International Accounting Standards for use in cross border offerings in 2000, and has a similar project underway on International Standards on Auditing. It has developed principles for oversight of auditors and for auditor independence, and has started work on developing a mechanism for co-ordinating work on enforcement of accounting standards.

8. CESR has a standing committee on financial reporting (CESRfin), which as I said John Tiner chairs, and which has a similar agenda to IOSCO but with the more immediate objective of facilitating consistent application of IASs in the European Union from 2005. In the last 18 months, CESRfin has published standards on the enforcement of accounting standards and the co-ordination of enforcement activities on accounting standards. Both these standards take a principles based approach to the subject of enforcement. CESRfin has also published late last year recommendations on the information that companies should provide in their 2003 and 2004 annual accounts to explain the transition to IASs in 2005. Essentially there are four elements to this. First, companies should explain in their 2003 accounts the steps they are taking to prepare for the change of accounting framework. Second, in 2004 they should - if possible - publish reconciliation from local GAAP to IASs. Third, their 2005 interim accounts should be based on IAS measurement and presentation principles. Finally, 2005 year end accounts should - of course - follow IASs. By following these recommendations, and communicating with the market in this way, companies can ease the impact on the market of the transition to international accounting standards. As professional accountants, you can support your companies either as preparers of accounts, as advisors or as auditors, by ensuring that they are provided with your full support in implementing these recommendations.

9. However, it is still not absolutely clear which standards will be applied in the EU next year. The IASB met the timetable it agreed with the European Commission and completed the set of standards to be applied in 2005 at the end of March. The standards have to be formally endorsed by the Commission's Accounting Regulatory Committee before they can be required to be used, and the mechanism for completing that endorsement is now well established and working efficiently. However, there are continuing problems with the two standards on accounting for financial instruments - IAS 32 on disclosure, and IAS 39 on measurement. The arguments have gone back and forth between the Commission, the IASB and the European banking and insurance sectors, as they have tried to resolve the remaining difficulties with the standards. The Commission has now endorsed IAS 39, but with a 'carve out' of two particularly controversial areas: the use of the fair value option and provisions relating to hedging. Though we understand that these 'carve outs' are temporary, and - in that phrase which is by definition a contradiction in terms - "this is not a precedent" - we are still concerned about the consequences of the Commission's approach.

10. The serious disadvantage of the Commission's partial endorsement of IAS 39 is that it is a departure from the principle that only standards issued by the IASB should be endorsed. It therefore could undermine the move to global accounting standards by creating separate 'European standards'. We would not welcome this move. This is our major concern, but there are also many other concerns about the feasibility of the Commission's particular approach. The process by which the decision was made was woefully inadequate, and seriously lacking in due process. Not surprisingly, the result leaves many questions unanswered. For example, can companies declare compliance with all international accounting standards, as required by IFRS 1, if they are not fully complying with IAS 39? Can individual listed companies still apply the full version of IAS 39? Have the full technical consequences of these carve outs been thought through? At a very late date, these issues have still not been resolved.

11. The Commission has now announced that Member States will have the option of applying the IAS 39 rules on hedging in full even though they are more stringent than the rules in the endorsed standard. This is unexpected and we have been discussing with the FRC, DTI and HMT whether the IASB's version of the standard should be required to be applied in the UK. The DTI is responsible for this issue, and is very aware of the need to tell the market what is happening as soon as possible.

Meanwhile the ASB issued a press statement on 11 October, stating that it strongly supported the view that all UK companies should comply as far as possible with the full hedging provisions of the standard and not the amended version; it will be issuing guidance on this and the amended fair value option as soon as possible; it will shortly be issuing a UK standard implementing in full the measurement and hedge accounting criteria of the un-amended IAS39 which will apply to 2005 year ends for all listed entities still following UK standards.

12. This uncertainty is of great concern for the EU securities regulators including, not least, the FSA. In the EU banking and insurance sectors, which are highly reliant on the confidence of markets in their financial reporting, there is still uncertainty about how to measure and present the most important assets and liabilities on their balance sheets. That is not a healthy basis on which to embark on a programme of harmonised accounting across Europe, still less the world.

13. Let me now turn to my third theme - the important issue of principles based standards. This is a continuing debate for those concerned with international accounting and auditing standards. On the one hand, a concern is expressed that principles, in accounting or auditing standards, many be too general and insufficiently robust in application by accountants and auditors. On the other hand, concerns are expressed that a focus on rules in such standards may lead to 'creative compliance' with the form of the standard rather than the spirit. Recent examples of corporate failure (of which more later) suggest that the culture of creative compliance is more of a concern.

14. This is a major issue for UK standard setters. We have long been accustomed to a standard setting regime where the standards describe the principles to be followed and expect preparers and users to exercise judgement in applying the standards to their particular circumstances. That framework has been used for accounting and auditing standards; it underpins the Combined Code on Corporate Governance; and it is the objective of the FSA's work on reviewing the Listing Rules. For reasons I have already explained, the FSA's declared long term objective is a single set of globally applied accounting standards that are capable of consistent application, interpretation and enforcement, and such a set of standards can only be made to work if they are principles based. It would not be possible to develop a set of rules that would work in every capital market in the world, and in any event experience in other markets is that detailed rules either stifle innovation or promote dysfunctional or even fraudulent financial engineering - or sometimes both. We have reflected this approach in our contribution to the European recommendations and standards issued by CESRfin.

15. The UK system of corporate governance has developed to foster the consistent application of principles based standards. The changes introduced by the FRC last year reinforced that approach. However, it is important to emphasise that principles based standards should be applied in a principled manner, by preparers and auditors alike. Essentially, I think there are three elements to this and this is where I would like to focus on your role as individual professional chartered accountants and as an Institute.

16. First, we need company executives who are committed to provide relevant and reliable information to investors and who want to comply with the spirit of the standards - in accounting terminology to provide a true and fair view and to represent the substance rather than the form of transactions.

17. Second, we need strong minded and independent auditors who can see the bigger picture and who will apply the principles through their professional judgement, even if standards do not specifically address the particular issue - again in accounting terminology, auditors who believe that the true and fair view is paramount.

18. Third, we need high quality independent non-executive directors to monitor the relationship between the executives and the auditors, and make sure that the auditors' independence is not compromised.

19. It is hard to exaggerate the importance that these principles should be applied in practice. Reliable financial information is essential if markets are to work. It is necessary for the market system to survive. Yet we have undergone what can only be regarded as a crisis in terms of the provision of reliable financial information, and the maintaining of standards of truth and fairness. In the US we have had the scandals of Enron and Worldcom, which have led to the legislative response of Sarbanes-Oxley - a legislative response which passed the Senate without dissenting vote and passed Congress with an overwhelming majority, a measure of the strength of political feeling. We cannot regard the scandals which gave rise to this political reaction as a uniquely American phenomenon. In Europe, we have had issues of financial reporting in companies as varied as Ahold, Parmalat and Shell. There is no doubt that these events, occurring in various countries and involving firms which were considered of the highest standing, have cast an unflattering and damaging shadow on those who provide financial information - including those who provide audit opinions. We need to change this - and you have a central role in making this change. A great deal is at stake. We have in Europe avoided the sort of political reaction to incomplete or misleading information which led to the Sarbanes-Oxley Act, but it could easily have happened. And with further scandal it could happen.

20. I started this speech by identifying events which had occurred in 1854 which still shape our world today. It is not fanciful to put among those events the foundation of this, the oldest professional body of accountants, as being as significant as the opening up of Japan or the spread of the internal combustion engine. The economic engine which drives all market economies is fuelled by reliable information. Developing the techniques which make that information meaningful, and maintaining the standards which result in true and fair information has been the task of accountants over the last 150 years. It remains as important today as ever. As professional accountants, you have a key role to play in UK, European and International developments in accounting and audit both at a macro level, through participating in the various committees that draft or comment on international standards, and at a micro level, through your individual professional behaviour as auditors or accountants. In this speech I have outlined the interest and role of the FSA in these areas and the key role that you play.

21. I encourage all of you, as members of the oldest professional body of accountants in the world, the Institute of Chartered Accountants of Scotland, to play that key role - more important today than ever before.