Speeches: Clarity begins at home | Securities Commission

Clarity begins at home

Institute of Internal Auditors
Wellington Branch Education Day
15 November 2002

Jane Diplock
Chairman
Securities Commission

The sharp focus in this day and age on corporate governance, financial reporting, risk identification and disclosure, confirms that management's need for fearless, effective and appropriately independent internal auditors is, if anything, greater than ever.

I say "fearless" with good reason. It was a very brave trio - Cynthia Cooper, Gene Morse and Glyn Smith - the internal audit vice president and two members of her team at WorldCom - who, according to the Wall Street Journal, doggedly and determinedly uncovered the evidence of the fraud which sent WorldCom into bankruptcy.

They were obstructed by fellow workers, thwarted by the company's external auditors, and asked to delay their investigation by the company's CFO, but they persevered.

In the latter stages of the investigation they were concerned that others in the company would try to destroy the evidence they had gathered and they made secret copies of the incriminating data. In the end they took their evidence to the board's audit committee and very shortly after that WorldCom made the announcement that stunned Wall Street, that it had inflated profits by $US3.8 billion over the previous five quarters.

Subsequently WorldCom has admitted that the extent of the fraud is approximately $US9 billion going back at least till 1999.

Cynthia Cooper and her colleagues were very brave people and their story makes fascinating reading.

That story highlights the significance of internal audit as a properly used governance tool. Internal audit underpins the corporate governance and internal control structure of a company or entity. It is the means of effective internal control, of identifying and reporting any risks and weaknesses in the internal control structure, and of identifying and reporting fraud by management, employees or third parties who interact with the entity.

This is currently being recognised in the United States. The New York Stock Exchange has a new Listing Rule which requires every listed company to have an internal audit function. Other new moves in the United States include requirements, both under the new Listing Rules and the Sarbanes-Oxley Act, for certifications by chief executives and chief finance officers to accompany annual and quarterly reports of listed companies. Internal audit groups will have a vital role in assisting companies to meet these compliance requirements.

Financial reporting and corporate governance are also highly important topical issues here in New Zealand. There is no doubt that the debate on corporate governance and financial reporting reforms will rage for some considerable time. It is a debate in which the Securities Commission is taking a great interest. We intend before long to make public our thoughts on the important principles that need to be reflected in resolutions of that debate. Internal audit is one of those principles because, applied effectively, it strengthens an entity's internal control environment, contributes to the integrity of both internal and external information reporting processes, and enhances an organisation's responsiveness to risk.

The world scene
World securities markets are facing unprecedented change and upheaval. Just a little over a year ago regulators were commenting on the changes that were presenting universal challenges - the globalisation of capital markets, greater demands by investors for access to international markets, growing cross-border activity, and new trading technologies.

Since then we have had September 11, the war on terrorism, corporate collapses, and the accounting and auditing scandals particularly in the United States. New aspects have been added to the challenges confronting market participants and those who regulate the markets.

In particular, there is an international focus on corporate governance and financial reporting and the importance of convergence to internationally recognised standards. It is critical that New Zealand be seen as a world player in these respects if we are to attract incoming capital flows and maintain our standing as a developed capital market.

Investor confidence
Investors now have vastly increased access to securities market information, reliable and otherwise. They have more opportunities to invest directly, and greater choices of where to invest both in domestic and overseas markets.

As borders become less relevant for investment, markets must compete for investors. To attract its share of investment, both from within the country and overseas, New Zealand must ensure that investors have confidence in its capital markets. This is not a confidence that every investment will be a winner - investment always will and should carry risk. It is confidence in the underpinnings of the market that is needed; the soundness of its basic structures and the regulatory framework in which it operates.

For overseas investors there is confidence in familiarity. Investors will have greater confidence in a market with standards that accord with best international principles. This means we must look at the place of our capital markets in a larger regional and global context.

Capital market regulation in New Zealand has been relatively light-handed by international standards. This was seen as appropriate in the context of the small and relatively isolated New Zealand market and the burdens that can be imposed by compliance costs in such a market. In seeking to make our market attractive to investors we must not lose sight of its unique features. But we need to assess compliance costs in the wider context of the costs and risks of having a regulatory structure that is seen as unique and which may not inspire the confidence of overseas investors.

It is fair to say that the ideological theories of the market that have driven New Zealand's approach to regulation throughout the 1980s and 1990s, and that are still paraded by a few, are now being assessed internationally with a more critical eye.¹ The international evidence shows that solid laws and good enforcement provide positive results in terms of capital market development and the ability of issuers within a market to attract outside capital.²

The Economist said, in May this year, "Behind every great market is good regulation - whether by a government agency or organised by the market participants. Internationally mobile capital has tended to reward regulation that protects investors and minimises privileges for market insiders."

New Zealand has not had an Enron or an HIH debacle, but it has not escaped the nervousness that has enveloped the world's markets in the wake of the scandals that have hit major corporates overseas.

However the Government is already addressing some issues of corporate disclosure and market behaviour through an important legislative package designed to increase confidence in New Zealand's market, the Securities Markets and Institutions Bill.

New legislation
A key feature of this legislation is a new co-regulatory framework in which the Securities Commission and the New Zealand Stock Exchange (NZSE) will work together and share information to encourage the highest standards of corporate disclosure, corporate governance, and corporate behaviour for New Zealand's public securities market.

This new legislation will bring about significant changes for the New Zealand market. Its main features are:

The government is also conducting a wider review of New Zealand's insider trading laws and other market conduct laws such as those relating to market manipulation. The Ministry of Economic Development released discussion documents earlier this year and we now await analysis of the comments received and preparation of proposals.

This reform process will, I believe, improve perceptions of New Zealand's securities market. It will signal to investors here and overseas that New Zealand has a well regulated market.

Law reform and regulatory action will not by themselves, however, sustain the reputation of our market. Market participants, and in particular corporate leaders, must demonstrate that the New Zealand market is ethical and trustworthy, a market in which investors can confidently place their savings.

The Commission's role
The work of the Securities Commission relates largely to entities which raise money from the investing public. The rules for disclosure of information by these entities are set out in securities law. Disclosure of information, both for initial public offerings and by subsequent periodic reporting, allows investors to make informed investment decisions and to monitor the strength and ongoing health of the entity.

The Commission is frequently involved in financial reporting issues. We have, for many years worked with the Institute of Chartered Accountants of New Zealand making comments on the exposure drafts for accounting standards and engaging in advocacy for matters such as financial reporting standards for prospective and summary financial statements.

On the international scene there is much current discussion on the question of harmonisation of standards and the possibility of adopting international accounting and auditing standards. The Financial Reporting Council of Australia supports adoption of international accounting standards by 2005 and the Australian Government has announced its support for this more in the most recent chapter of its Corporate Law Economic Reform Program, CLERP 9. The European Union has also decided to move to international accounting standards from 2005.

The Commission believes the question of harmonisation or convergence with international accounting standards is of vital importance to the world's capital markets. The aim is to enable investors to compare the financial reports of issuers in different countries. How this goal is achieved, however, is an ongoing debate in which we will be taking a strong interest.

In recent months the Commission's involvement in financial reporting matters has been largely from an enforcement perspective.

One inquiry related to the financial statements for the 6 months to 31 December last year of Telecom New Zealand. There was intense media interest in both Australia and New Zealand in this matter. We obtained relevant information from Telecom to enable us to analyse and review the financial statements.

Our review found that the accounts did comply with New Zealand generally accepted accounting practice. It also, however, highlighted the fact that differences between the United States and New Zealand GAAP had created some market uncertainty when the accounts were released. The financial press noted these differences and questioned the quality of the financial information reported under New Zealand GAAP.

Telecom is listed on both the New Zealand and the New York Stock Exchanges. The company reports according to New Zealand GAAP but is also required by the US Securities and Exchange Commission to reconcile its financial statements to United States GAAP.

This situation demonstrates the clear need for harmonisation of international accounting standards.

Another recent matter relating to financial reporting and corporate governance was our inquiry into the initial public offering by Wakefield Hospital Limited.³ In this instance we reviewed the prospective financial information in the company's prospectus. The Commission concluded that aspects of the prospective financial information were unsatisfactory and likely to mislead investors about the company's prospects.

The prospective financial information did not comply with the relevant financial reporting standard. In our view, where an issuer's accounts are not prepared in accordance with the financial reporting standards it is likely that those accounts could be misleading to investors.
Forecasts need to clearly state principal assumptions, taking into account the degree of uncertainty around those assumptions, and the potential effect on the prospective information.

The directors of a company have an obligation to fully assess that the assumptions made in the company's forecasts are reasonable and supportable. Offer documents must disclose all the material risks of an investment. The assessment of these risks must consider both the likelihood of a risk occurring and the potential impact if it does.

We expressed the opinion that a failure by directors to maintain an objective view of the company's proceedings, and to engage external advisers where appropriate, can contribute to the chances of the company's financial disclosure being misleading to investors. We noted that liability lies with the directors to act with due diligence in performing their duties or to risk facing up to investors for losses caused by their failings.

Some commentators have suggested that our statements in this report on the obligations of issuers and their boards represent a "raising of the bar" for compliance. This is not so. In the report the Commission articulated the existing standard required of company directors.

Wakefield directors failed to meet that standard. In our view this existing standard is simple and eminently fair - the offer documents and financial accounts of those who seek to raise money from the public should not be misleading, deceptive, or confusing.

Given the accounting scandals in some US corporates, and particularly in the case of the Enron affair, attention has tended to be focused on professional advisers, in particular auditors, for not acting to prevent financial reporting abuses.

Of course, I would not want to understate the responsibility of the auditors of public companies to monitor compliance of an issuer's accounts with relevant standards. But good reporting must begin within an organisation - in short, clarity begins at home.

And this is where your profession comes into its own. An in-house focus on compliance and ethics, internal control structures and reporting systems, operational performance and quality control, and detection of fraud, must provide a sound basis from which an organisation can deliver financial reporting of the highest possible standards.

The issues of independence of auditors - internal and external, and the reporting lines between directors, management, internal audit, audit committees, and external auditors - are being wrestled with around the western world at present.

One of your members, Brian Brown, president of the Winnipeg Chapter of the IIA talks of four pillars of good governance - the board of directors, management, internal auditors and external auditors. In the National Post, Toronto on 20 September 2002 he says, "strength in each of these areas is important but independence between the four pillars increases their effectiveness. For corporate governance to be effective each of these four must operate independently. When they don't massive problems can occur."

It may be that Enron's wrongdoings best illustrate how important this is. It would appear that Enron's internal audit function was contracted to Arthur Anderson and so an apparent lack of independence reduced the effectiveness of the internal audit fraud detection role.

Looking ahead
The Commission's role is to strengthen confidence in New Zealand capital markets. We do this by promoting the efficiency and integrity of these markets. Increasingly we are involved in enforcement work which includes a focus on financial reporting and corporate governance as well as more traditional areas such as insider trading.

The Securities Markets and Institutions Bill, currently before Parliament, will increase the Commission's powers of enforcement.

Overseas research is providing significant evidence that countries with good regulatory environments attract investors. In an international environment where investors are feeling the effects of corporate scandals the challenge for New Zealand is to promote itself as a securities market in which investors can have confidence.

If we are to achieve that all market players - internal advisers, directors, external advisers and regulators - have important roles to play. We must all strive for high standards and maximum compliance with them.