October 2005: Sarah Perrin discusses the key role that the audit profession must play in ensuring high standards of corporate governance.

This autumn should see new standards being set for corporate governance in Europe. The European Commission has been working for some time on replacing the existing 8 th Company Law Directive with a new version dealing with the statutory audit of accounts. Agreement is expected imminently on the new common standards required of Europe’s listed companies.

Achieving agreement has not been easy, and the EC’s experience serves as a reminder of the challenges involved in creating a workable cross-border corporate governance structure – one that is tough enough to encourage investor confidence, flexible enough to allow for national variations, yet harmonised enough to foster increased capital flows across borders.

One of the most contentious issues has been the proposal that European “public interest” entities (effectively listed companies, banks and insurance companies) should set up audit committees. In countries with a culture of establishing supervisory boards, this seemed like unnecessary repetition of labour. In the UK this and other proposals smacked of over prescription, a threat to the favoured “comply or explain” principle. The good news is that common sense seems to be prevailing. The final directive looks set to allow an opt-out, whereby the functions of the audit committee may be carried out by an administrative or supervisory body instead. Another controversial proposal, the requirement for audit firm rotation, has also been dropped. These positive changes reflect the impact of intensive lobbying by interested parties, in which the audit profession has played its part.

Input from auditors (internal and external) is essential whenever rules are being formed in high places. Auditors have a key role to play in ensuring the corporate governance regulations we get are the ones we deserve – or at least require. They help to keep under control two of the more powerful forces behind regulatory change – governments’ desire for voter popularity and regulators’ interest in empire building. Even where regulators are keen to do the right thing, inspired by pressure from a changing society with new priorities and concerns, they still need practical advice. (For example, greater transparency is good, but burgeoning annual reports are a problem.) The considered insights and practical experience that auditors gain from working inside companies and with boards of directors must therefore be shared with rule makers. Influencing the formulation of rules and codes is the best way to avoid problems later on.

Once those codes are in place, achieving compliance becomes the priority. Although directors are responsible for their organisations’ corporate governance performance, they will look for guidance as to what they should do, and the degree to which non-compliance may be acceptable. Auditors need to be able to apply an objective eye to the situation (forgetting as far as possible that the people asking the questions and paying their fees and salaries may have a preferred answer). The ability to be challenging but not rule bound, assertive but not aggressive, remains a key auditor skill.

Achieving high levels of compliance is important, not only because it provides reassurance for shareholders and encourages healthy capital markets. It also reduces the likelihood of corrective action from regulators and governments in the form of yet more rule making. German listed companies recently discovered that failure to react to market expectation can have unpleasant consequences. Lack of willingness to disclose individual amounts of directors’ pay ultimately led to government interference and a new legal requirement to disclose such detail. The loss of the “comply or explain” approach even in this one area is bemoaned in Germany by those who value the relative freedom and flexibility it allows. Such a loss is not one that companies and their auditors elsewhere in Europe want to suffer.

This autumn the UK’s Financial Reporting Council will be reviewing evidence of how successfully companies are implementing the 2003 revised Combined Code. Separate surveys conducted by corporate governance specialists have shown that progress has been made, but some requirements of the code are more difficult to satisfy than others. For example, even many of the largest listed companies are having a hard time finding the requisite proportion of independent non-executive directors. There are also concerns around the length of time that some non-executives remain on board, casting doubt on the genuineness of their independence.

While such problems are noted, there seems a general understanding in the UK that complying with new rules can take time. A measured response is acceptable to regulators and investor bodies, who believe that quality is important – you don’t want anyone to be brought onto the board just to make up the numbers. Nevertheless, it is important that progress continues to be made.

Market forces should help to drive improvements. If investors care about the independence of non-executives, they can make their feelings known both in private discussions with directors and at AGMs. Nestlé felt the impact of investor disapproval earlier this year when its b oard announced that CEO Peter Brabeck-Letmathe would also take over the chairman’s role on the then incumbent’s retirement Although this did not actually breach the Swiss Code of Best Practice, various  small Swiss pension funds introduced a resolution to the Annual Meeting opposing it, receiving support from  Institutional Shareholder Services, the  US-based corporate governance and proxy voting specialist, and other corporate governance agencies.In the event, the opposition failed but it did generate unwelcome publicity.

Auditors cannot, however, rely on market forces to drive through high standards of corporate governance. Problems with shareholder voting rights can leave investors impotent. For example, in some Nordic countries shareholders are required to be physically represented at AGMs if they are to vote, creating a potential barrier to voting for overseas institutions. Shareholder democracy is in fact flawed across Europe. According to research by Belgian corporate governance research agency Deminor Rating, the principle of one share-one vote is met by only a third of companies in the FTSE Eurofirst 300 index.

Such market imperfections make it even more important that internal and external auditors themselves take a lead role in encouraging high standards of corporate governance. Governments will be more likely to stay their rule-making hand if they know that auditors are working to maintain high standards. Regulators will have a harder job justifying more red tape. The credibility of the audit profession as a whole will be strengthened – which means that the next time consultation on new rules is being considered, auditors will have even more influence. A virtuous circle if ever there was one.