Dispatch

• limited liability agreement
• review gives judgement on implications of IAS
• getting tough on transfers
• fraud going round in circles

limited liability agreement

Auditors and clients will be permitted to agree proportionate liability contracts under the newly published Company Law Reform Bill. The limit of liability will not be set by the contract, but by the courts’ view of proportionate blame for financial problems in the event of any subsequent legal action. Auditors could still be engaged on unlimited liability contracts, but would then be likely to require much higher fees.

The provisions of the Bill were welcomed, with reservations, by ACCA. Allen Blewitt, ACCA chief executive, said: “ACCA supports the Government’s proposal to enable companies and their auditors to agree to limit the liability of the latter to the former on a ‘proportionate’ basis. Contracts entered into on such a basis would establish a fairer basis for determining an auditor’s liability for negligence, since the new arrangements would implicitly provide for the responsibility of all parties involved in causing financial loss to shareholders to be taken into account by the courts.

“While supporting the principle behind the proposal, it must be remembered that the whole audit process exists to protect the interests of the company’s shareholders. In view of this, it is vital that any initiative which would affect shareholders’ rights of redress where they have suffered loss be made subject to their explicit approval. The level of majority required to approve a liability limitation agreement will be a significant issue. And, most importantly, it is essential that the two sides enter into a liability limitation agreement freely and without undue influence from either side. The Government should be prepared to monitor the working of the proposed reform and, if necessary, to introduce safeguards, statutory or otherwise, to ensure that both sides retain real discretion in the process of approval of any contract.”

The Bill will also introduce a legal offence, carrying a maximum prison sentence of seven years, where an auditor “knowingly or recklessly causes a report to include any matter that is misleading, false or deceptive”. ACCA said it was pleased that this varied from the proposal included in the earlier white paper, which would have created an offence of knowingly or recklessly giving an incorrect audit opinion. The revised wording “is much clearer and more workable for auditors”, said Blewitt.

Other measures affecting auditing are contained in the Bill, not least by implementing into UK legislation the European Union’s Audit Directive. Measures adopted include the extension of statutory audits to banks, credit institutions and insurers which are not companies, and the provision of a system of registration and regulation of auditors operating from third countries who audit UK listed companies which are incorporated outside the EU. In addition, the Bill implements a recommendation of the Sharman review of public sector auditing, to enable the National Audit Office to conduct audits of companies which receive public funds.

Among the respondents to the Department of Trade and Industry’s consultation were several representations on behalf of institutional investors. While the DTI is not publishing the content of those representations, it is thought that some argued that the introduction of proportionate liability for auditors was inappropriate alongside the adoption of International Standards of Auditing.

Blewitt responded: “We do not agree with those investors who have been claiming that the introduction of International Standards of Auditing is a retrograde step and a reason for doing nothing on audit liability. ACCA believes ISAs are high quality standards and should be capable of being introduced by countries without insisting on additional requirements to meet national issues. This insertion of so-called ‘ISA-pluses’ just complicates and detracts from the acceptance and implementation of common auditing standards, globally.”

Firms welcomed moves which could reduce the number of desperate legal actions to avoid company collapses by blaming the auditors. Neil Lerner of KPMG said: “We are the deep pockets left after the actual perpetrators have left, or if they have no assets.”

Several other measures may subsequently be introduced into the Bill, possibly including a codification of existing legislation regarding auditors’ responsibilities. The DTI said that, alongside the Bill, it was initiating a research project to be jointly managed by the Financial Reporting Council to examine factors that could promote competition and choice in the audit market.

The Company Law Reform Bill will be presented to Parliament after the end of the summer recess in October. The earliest it can pass into law is likely to be next year.

review gives judgement on implications of IAS

“The concept of the ‘true and fair view’ remains a cornerstone of financial reporting and auditing in the UK,” says the Financial Reporting Council. Replacing the phrase “true and fair” with “fair presentation” as the over-arching test of financial statements has not substantively changed the objectives of audits, or the nature of auditors’ responsibilities, explains the FRC.

The FRC made its judgement clear in its newly published analysis of the implications of the adoption of International Accounting Standards, responding to concerns by some investors about the implications of IAS - and new International Auditing Standards - on the quality and consistency of accounts. But the review should also assist investors and others to better understand how IAS affects financial reporting, believes the FRC.

FRC chairman, Sir Bryan Nicholson, said: “This analysis provides useful guidance to preparers, auditors and users of financial statements on the implications of recent changes to financial reporting in the UK. Our analysis provides reassurance that, notwithstanding the changes that have taken place, the framework for financial reporting and auditing remains robust. The FRC is committed to facilitating a clear channel for all stakeholders to participate in the debate on the future evolution of the framework.”

The analysis rejects criticisms of IAS that it weakens safeguards against corporate scandals, or that new auditing standards involve a “tick box” approach. But FRC concedes that, given the lack of legal case precedent inevitably attached to new standards, “many years may elapse before the courts can provide legal certainty (if ever)” on the obligations of companies and accountants in discharging their amended duties.

The paper also stresses endorsement for International Auditing Standards by the FRC’s Auditing Practices Board. The APB supports ISAs as a means of achieving the international harmonisation of auditing standards, requiring international groups having accounts in different territories audited to the same high quality. Auditing standards will now reflect the latest considerations on audit risk, fraud and quality control, and standards will benefit from continuing development based on the most advanced thinking, says the APB.

But the paper accepts that, in some instances, the old UK auditing standards are of higher quality than the new ISAs. Where this is the case, some material from the old UK standards has been incorporated into the ISAs for application in the UK and Ireland.

The FRC also emphasises, to reassure investors, that in 2001 the APB extended the requirements on auditors to advise shareholders of additional material factors, such as the auditor’s independence from the client and the auditor’s opinion on the quality of the client’s accounts and reports.

getting tough on transfers

Most international financial services companies expect tax authorities to challenge their transfer pricing practices and have set aside reserves to meet the cost of higher tax bills, according to research published by Ernst & Young.

“Transfer pricing is a critical tax area for financial services companies,” says Claire Acard, Ernst & Young’s Global Financial Services transfer pricing leader. “Tax authorities around the world have been stepping up their efforts to enforce these rules, as it gives them a way to increase tax revenues without raising headline tax rates.”

Financial services firms are expecting action within the next two years, as governments respond to the dual pressures of needing greater revenues, yet face resistance to increased tax rates. More than 80% of firms estimate the prospect of challenges to their transfer pricing policies at more than 60%.

Activities giving rise to transfer pricing include head office services, IT services and inter-company debts and guarantees, says Ernst & Young. Countries listed as having audited transfer pricing policies in recent years include the US, the UK, Japan, France, Germany and Australia. Respondents to the research rated the UK Government as the most likely to impose new tax treatments on transfer pricing practices, followed by the US. But another 26 countries, including non-traditional financial services centres such as South Korea and India, are also predicted to adopt stronger scrutiny of transfer pricing.

Ernst & Young advises companies in the sector to increase their management focus and to allocate additional resources to the issue. “In today’s environment, tax directors and CFOs have the increased responsibility of anticipating and effectively managing potential tax risks that, if left unchecked, could compromise the integrity of financial statements and lead to significant costs resulting from double taxation, interest, penalties and, importantly, the costs of management time required to respond to the challenges,” says Acard.

Only just over half of the surveyed companies perform the economic analysis required to demonstrate to tax authorities that their pricing policies are consistent to meet the agreed standard of comparability of charges with an external supplier.

Danny Beeton, director of European transfer pricing services at Grant Thornton, endorsed the view that tax authorities were looking more closely at transfer pricing practices. “It’s a way of raising tax without raising headline rates,” he agreed.

But he suggested a different emphasis is likely to be adopted by tax authorities. “I am surprised they [Ernst & Young] have highlighted head office charges and company loans and guarantees. There are also going to be challenges over the allocations of profits on sales and trading. Those are the typical issues. There are different approaches on how you can carve up profits on those activities, and none of those are really based on science. I think that will be reviewed much more thoroughly.”

Beeton added that he expected tax authorities to make growing use of OECD guidance and research on global trading in interpreting profit allocation on transfer pricing. He agreed that modern commercial practices meant there was typically a more integrated, international transaction offered by a financial services company, which was more difficult to break up into clear and discrete national profit centres. But he disputed the notion often put forward that transfer pricing is widely used by multi-national corporations as a means of tax avoidance.

“For about 90% of companies it’s just something they haven’t looked at properly and they have done it wrong,” said Beeton. “About 10% of companies have used it to control or manage their tax charge.”

fraud going round in circles

Carousel fraud has lost the UK Government about £20bn through unpaid VAT in the last seven years, despite warnings three years ago by the National Audit Office and the House of Commons Public Accounts Committee that Customs officers must get a grip on the problem.

Although hundreds of extra Customs staff have been given the job of stamping out missing trader fraud, and legitimate businesses warned they could pick up the bill from disappearing VAT charging fraudsters, the scale of the problem seems to be increasing.

The size of the carousel fraud crisis was revealed when it became clear that shifts in export destinations for mobile phones and computers’ central processing units from France to Dubai were responsible for probably most of the £300m increase in monthly trade with Dubai. This fraud is of such a magnitude that, if it could be closed down, the Chancellor’s fiscal problems would be significantly reduced. It may be worth as much as three pence in the pound on income tax.

Several billions a year are being defrauded through an international merry-go-round of reselling electrical goods such as mobile phones and computer chips. Revenue & Customs believes that some items are moved through international destinations as many as 35 times - though, in many cases, the goods supposedly being sold and resold remain firmly in a UK warehouse and only the invoices move.

Typically, a consignment of high value but low weight items is sold from the UK to Dubai, VAT free; sold onward to the Netherlands, duty unpaid; reimported to the UK where the goods are resold inclusive of VAT; but then the business folds and disappears without forwarding the collected VAT to the Exchequer. In some instances, the selling and buying companies are related, and while the company paid inclusive of VAT disappears, the sister business claims its VAT rebate from Revenue & Customs.

In a recent case, successfully prosecuted by Revenue & Customs, four people were convicted of defrauding £40m in withheld VAT. A Dubai based musician, a former environmental law judge in New York, a fitness instructor from London and a record label director, also of London, were found to have committed the fraud over a two-year period, buying mobile phones from three fictitious companies, using false receipts to charge VAT on the transactions. Proceeds were sent to the Hong Kong bank accounts of several companies created to perpetrate the fraud, using similar names to British companies which were genuinely trading in mobile phones. VAT was charged on sales in the UK using actual VAT registration numbers of the legitimate companies, with invoices constructed to resemble those of the actual companies. Payments were made into the Hong Kong accounts.

Although there are now several hundred such cases awaiting trial, the depth of the problem, and the existence of millionaire crooks who have successfully carried out the fraud, is creating growing pressure for Revenue & Customs to adopt even more stringent business identification checks and safeguards when approving VAT registration.

A second problem associated with VAT free international trade has emerged, through some entirely legal though rather sharp commercial practices by large retailers. The tax status of Guernsey, Jersey and the Isle of Man has long been a source of irritation to the UK Treasury, but there has always been a sense that it was an unavoidable nuisance. But the cost has now reached a level that - at least as far as VAT is concerned - it could be that the suffering from the tax loss is in excess of the pain of seeking a solution.

Over recent months, a number of leading stores have opened “export centres” in the Channel Islands. But the offshore sales divisions of these multi-nationals, such as Tesco’s, are actually extremely small and are no more than effectively accommodation addresses. By having postal addresses in the Channel Islands the stores can service UK customers for orders below £18 for items such as CDs and DVDs without charging VAT - even though the orders are met through the stores’ UK warehouses.

It is estimated by the Forum for Private Business - whose members are as annoyed as the UK Government over the problem - that the Treasury is now losing tens of millions of pounds a year through the use of Channel Islands’ accommodation addresses. The National Audit Office is currently preparing a report on the problem, which is likely to lead to recommendations from the Public Accounts Committee for decisive action.