Dispatch

• obstacle race
• breach of trust
• in the firing line
• Fannie did

obstacle race

Confidence is growing at the European Commission that its proposed audit directive will be approved by the European Parliament by mid-summer, fast tracked through a single reading.

The European Commission’s director-general for the internal market, Alexander Schaub, told a conference organised by the Fédération des Experts Comptables Européens (FEE) that ‘negotiations with the European Parliament and the Council are progressing well’. He hoped the legislation would be approved during the summer, with key measures operational across member states by the end of the year.

But serious obstacles to agreement remain. The large firms are indicating they would like auditor liability limitation included in the directive. The French are proposing new measures further limiting auditors’ non-audit activities. And FEE is keen to remove the Commission’s proposals for member states to have the option of requiring seven-year rotation of audit firms, or for lead auditors to change every five years.

Schaub defended the rotation proposal, saying: ‘For sure, mandatory rotation of auditors will lead to more independence. Increased rotation and more independence may even boost competition within the industry.’

European Parliament member Peter Skinner, who sits on its economic and monetary affairs committee, told accounting & business that fast tracking the directive through Parliament would be possible, providing the profession and other vested interests could jointly resolve outstanding issues.

The directive is being characterised as Europe’s version of the US Sarbanes-Oxley Act and at the heart of the directive lies the setting-up of a European equivalent of the Public Company Accounting Oversight Board (PCAOB) established by Sarbanes-Oxley. The Commission intends the US and European bodies to work closely together and says that details on the proposal were drawn up through months of discussion with PCAOB.

Other measures contained in the proposed directive include: group auditors taking responsibility for all companies contained in the consolidated accounts; for auditors to publish annual transparency reports for all public interest entities - defined as listed companies, banks and insurers; limitations on non-audit work; and steps to ban ‘low balling’ - the subsidising of audit fees in order to win non-audit work on the back of the audit contract.

But David Devlin, President of FEE, expressed concern that the directive would not achieve its aims. ‘It is disappointing that certain provisions of the current draft of the directive may in fact serve to undermine the objective of high quality audit,’ he said. In particular, he was unhappy at permitted variations on audit requirements which would be available to member states, which failed to ensure the audit consistency expected of the internal market.

Roger Adams, ACCA’s executive director - technical, said that he was relieved at progress in avoiding excessive audit responsibilities on small audit firms and SMEs. ‘We are reasonably confident that the directive as it stands is unlikely to impact adversely on smaller practices,’ he said. ‘What we are concerned about more immediately is still the top-down approach to the way international standards on auditing are set. There is a large firm, large company influence which needs to be addressed.’

breach of trust

A major clampdown on the use of trusts for avoiding tax could follow the UK general election, ACCA’s head of taxation, Chas Roy-Chowdhury, has warned. He said that advisers and taxpayers should bear in mind that many trusts currently in use may in future months be regarded as having been set up to avoid tax and accordingly face large tax bills.

‘The Government’s view is that trusts should not be a vehicle for saving tax,’ said Roy-Chowdhury. ‘It doesn’t like trusts. It thinks they are not transparent and they are a means of avoiding tax. In the future trusts will have to pay more tax, but also it will be more onerous to operate trusts than it is now.

‘If you are going for a trust just to avoid minors getting hold of assets until later, I think you will be all right. If you are setting up a trust to avoid a tax liability then you should be warned that [even] if it works in that way now, it may not in a couple of years. What we are seeing now in effect is retrospective legislation [to tax income and gains earned by some trusts] and I think this will continue.’

Roy-Chowdhury also predicted changes to the inheritance tax regime, which could see a lower tax rate but more people paying it through the adoption of a lower threshold, or even tax imposed on all large gifts. He argues that the systems introduced to tackle money laundering provide the basis for taxing significant cash gifts, which are ‘probably already reportable’.

Stephen Pallister, a trust specialist at Charles Russell solicitors, also believes that the return, in effect, to a capital transfer tax is possible after the election, though this might be subject to a lifetime gift allowance of perhaps £250,000 to £500,000. He says that while the Government has already very effectively controlled the use of trusts to avoid tax, there may be further attention to the use of trusts to avoid inheritance tax.

And City lawyers, DLA, believe that the Revenue will, using existing powers under the Inheritance Act of 1984, tackle the use of offshore employee benefit trusts by companies. It says that the Revenue has told them that advisers and financial institutions must notify the tax authorities where offshore trusts are used, even where these have been set up by a non-domiciled person and previously thought to be outside the scope of the disclosure requirement.

Aileen Barry, national tax investigations director at the firm, described this as ‘a dramatic new interpretation’ which could catch large numbers of companies. DLA said that the move followed Revenue calculations that one in four cases of tax evasion involved the use of offshore accounts and trusts, and that closing these down could form a centrepiece of the Revenue’s requirement by the Chancellor to recover £1.6bn of evaded tax.

John Whiting, tax partner at PricewaterhouseCoopers, agreed that we are now ‘in a period of change for trusts’, following the Chancellor’s consultation on the future of trusts. ‘Some proposition will no doubt come forward with the Budget on the modernisation of trusts,’ he predicted. ‘It will probably not make things easier. It will increase attention and there is already evidence of increase in attention being paid by the Revenue to trusts and trust situations, with them getting more information and checking back on settlers. But I don’t think there is any danger of the complete abolition of trusts because they are so much part of the fabric of our legal system.’

in the firing line

There is no ‘smoking gun’ or ‘red flag’ in the independent report on the United Nations’ Oil-for-Food programme in Iraq, says Paul Volcker, chairman of the independent inquiry committee investigating allegations made by the CIA and the US General Accounting Office. The GAO concluded that the Iraqi regime of Saddam Hussein had misappropriated $10bn from the $60bn Oil-for-Food programme (OFFP), calling it ‘the biggest scandal of all time’.

But despite what might be regarded as a ‘not proven’ verdict, Volcker - who is also chairman of the trustees of the International Accounting Standards Foundation - and his colleagues paint a picture of such weak audit and inspection within the UN that it will win the organisation few friends and provides ammunition to its powerful enemies in the US.

Allegations that Saddam Hussein and his Government ‘skimmed-off’ massive funds through the connivance or innocence of UN officials emerged last year in the US and were examined in detail by Congressional hearings. One prosecution in the US has already earned a guilty plea from a businessman who illegally resold Iraqi oil to earn millions of dollars for himself and assisted Saddam in bringing in billions of dollars for allegedly personal use by members of his Government.

According to complaints from a CIA weapons inspector and papers apparently found in Iraq, some of the fund’s proceeds were used to bribe foreign officials and politicians. There is also concern at the lack of transparency in the UN’s handling of $1.1bn retained by it as a handling fee for administering OFFP.

Even if officials at the UN have not been found guilty of involvement in wrongdoing, the report suggests a badly managed organisation. Control weaknesses, which put at risk $1.4m, had been identified by internal auditors, reported the independent inquiry, yet in some cases were not followed up. The UN was most strongly criticised for its approach at its New York headquarters, whose role in programme administration was not audited despite accounting for 40% of the scheme’s spending.

Vulnerabilities highlighted in the latest report included failings in monitoring both the oil exported by Iraq and the food and drugs imported in exchange. The report says that the lack of monitoring of the trade flow is especially surprising as it had been widely predicted that there would be attempts to under-price oil and over-price humanitarian goods in order to obtain illicit payments.

Two companies were responsible for monitoring humanitarian imports, the London-based Lloyd’s Register Inspection Ltd which was contracted from 1999, and Cotecna, which took over in 2003. Lloyd’s Register issued a statement saying that it ‘did a very good job for the UN’, had not overcharged for its services and had been unaware of any complaints until the independent inquiry opened. Cotecna also issued a statement, saying that it had worked ‘professionally and ethically’ on its contract with the UN. It added that while it confirmed that UN secretary-general Kofi Annan’s son had received payments from the company, this was not connected to OFFP.

The independent report was welcomed by the UN. ‘What this initial briefing from the committee does show is that there was a dynamic auditing process generated by the UN itself, as well as the reports of external auditors which have already been made public,’ said UN spokesman Stephane Dujarric. He asserted that all internal and external audits were conducted in accordance with internationally recognised standards. But he conceded ‘there were deficiencies in the management of this unique and highly complex programme, which had to be implemented in an acutely difficult political environment’.

The UN added it is committed to improved management and accountability standards, promising an overhaul of the UN’s management structure and systems in order to improve performance and accountability. It said that lessons from the Iraq experience were being applied already in the tsunami relief effort.

In a separate move, almost coinciding with independent review of OFFP, the UN published its own report into the operation of the Development Fund for Iraq under the US-led Coalition Provisional Authority. This concluded that there had been insufficient controls to provide reasonable assurance regarding the accuracy of figures for oil product sales, or that funds had gone for the purposes intended. The UN report found control weaknesses over oil extraction, resource administration by the Coalition Provisional Authority and within Iraqi spending ministries.

Fannie did

For those outside the United States, it may be difficult to understand the significance of the Fannie Mae financial scandal. But the reality is that its problems really do matter, and not just in the US.

Say it slowly to allow it to sink in: Fannie Mae owns or guarantees over $4,000bn of home mortgage debt in the US. And yes, that is billions - it is no misprint. Fannie Mae is the world’s biggest financial institution outside of banking. So when Fannie Mae gets pneumonia, a lot of other people expect at least to get a bad dose of the flu.

The Securities and Exchange Commission has determined that Fannie Mae breached FAS 91 and FAS 133 from 2001 until the middle of last year, having used ‘unique methodology to assess whether hedge accounting was appropriate’, said the SEC. As a result of the decision, Fannie Mae must restate earnings and declare losses of around $9bn, arising from previously undeclared losses on derivatives. In doing so, Fannie Mae also goes into breach of its minimal capital requirement laid down by its regulator, the Office of Federal Housing Enterprise Oversight (Ofheo).

It was Ofheo which initially blew the whistle on Fannie Mae, alerting the SEC to the scale of the disaster. The company was involved in ‘cookie jar’ accounting, said the regulator, by manipulating reserves and the timing of recognition of earnings.

One result by-product of this smoothing was that what executives were enabled to earn also became eligible for huge bonuses. Franklin Raines, chief executive of the company until forced out in December, obtained incentive pay of $26m over the last three years on top of his salary for that period of $14m. Finance director Timothy Howard obtained $7m of incentive pay additional to his $4m in pay.

Senators are now demanding that Raines and Howard return their bonuses and there has been discussion as to whether under the Sarbanes-Oxley Act these can be forcibly withdrawn, as laid down by the Act. The general view is that probably only bonuses awarded after the passing of the legislation can be taken back through legal process, even if the SEC finds the directors guilty of misconduct - which they have not been as yet.

But ramifications over the Fannie Mae scandal are more widely felt. Raines is a leading Democrat and was a member of President Clinton’s budget team. Both Raines and Fannie Mae were influential players in the Washington theatre. And the structure of mortgage support which generated Fannie Mae - and its smaller sidekick Freddie Mac, itself engulfed in accounting scandal in 2003 - is now being reviewed.

Fannie Mae was established during the Depression to promote home ownership. Rather than issue mortgages itself, it buys loans from banks to free up liquidity in the market and keep down interest rates. It was part of the federal government until 1968, when it became a traded company. But its debts are effectively guaranteed by the state, despite attempts in recent years by Alan Greenspan, as chairman of the Federal Reserve, to withdraw this protection.

We are now set for a period of uncertainty, in terms of both the political and commercial fall-out. The Securities and Exchange Commission is investigating the behaviour of the company and its directors - who are expected to deny wrongdoing. And the Public Company Accounting Oversight Board is examining the work of the company’s auditor KPMG, which is likely to argue that the case arose from differences of interpretation over the application of extremely complex accounting standards.

A spokesman for KPMG said: ‘In situations like the Fannie Mae matter, it is to be expected that the PCAOB will become engaged, and we recognise the responsibility of the PCAOB to investigate matters such as these that come to their attention.’

Deloitte has now taken over as Fannie Mae’s auditor.