Substance over Form

In financial reporting, the issue of substance over form is evidenced in a number of areas
including:

• Finance Leases
• Goodwill and Intangible Assets.
• Revaluation of Investments
• Accounting for Inflation

Baker & Hayes[1] argue that failure to apply the concept of substance over form at Enron
caused investors and creditors would have a unrealistic view of the company’s financial
position.

The distinction in financial reporting between substance and form raises important
concerns in ontology and the philosophy of law[citation needed]. Accounting standards require
the reporting of the substance of the matter, rather than merely the legal form of a
transaction.[2] For example, finance Leases may be treated as sales rather than as lease
expenses, in spite of their legal form.[3]

The real-world consequences of reporting form rather than substance can be severe.
Baker and Hayes argue that failure to apply the concept of substance over form at Enron
caused investors and creditors to have a unrealistic view of the company’s financial
position.[4]

The substance over form issue has been thrown into greater prominence in the US
context by the Enron events. Baker and Hayes (2004) make a number of interesting
comments. They suggest that historically, substance over form has been less
dominant under US GAAP than under IFRS (pp769-70), and that an increase in
emphasis on substance would certainly be beneficial, though not a simple panacea, in
the US. Most tellingly from the viewpoint of our arguments in this paper, they make
an explicit allegation against the FASB (p783):
In effect, the FASB has allowed SPEs to be created knowing that they
represent form over substance (emphasis added).

The Enron collapse in the US has been on such a scale that it has made waves elsewhere
in the world, and certainly in London. The big question is - could it happen here?

The only honest answer is yes. But we have rather different arrangements for the
oversight of the accounting profession and for financial regulation.

As far as accounting is concerned, our standard setters argue the UK approach

emphasises substance over form and seeks to address the underlying economic reality in
consolidated accounts, rather than staying close to the particular corporate and legal
structure adopted.

I would note that that approach has not prevented corporate failures in which accounting
treatment has been an issue, but the general principle must be right.

The UK profession also argues that the arrangements for the oversight of auditors and
audit quality are somewhat more robust than those in the US. In our case there is, now,
after a lengthy gestation, an Accountancy Foundation overseeing the Auditing Practices
Board, which, in turn, aims to monitor the quality of audit work.

While accountancy remains a self-regulating profession, audit is - formally at least -

covered by some statutory controls. Companies Acts regulate the qualifications of
auditors and set out their duties and rights.

But in spite of the strong injection of public interest representatives, the oversight
arrangements remain substantially a self-regulatory system. There is nothing so different
about our system that it can stop an audit firm becoming too close to its client and
colluding in accounting practices which mislead investors, deliberately or inadvertently.
There is nothing to stop an audit firm working indefinitely for the same client. There is
nothing to stop a firm undertaking consulting business for the audit client on a very
substantial scale. So investors and politicians are reasonably asking whether we should
make changes to outlaw such practices. Indeed, these were questions the FSA already
intended to raise, in relation to listed firms, in this year's review of the listing rules.

There are, in principle, three possible steps one might take to deal with potential conflicts
of interest for auditors.

First, we could require rotation of auditors at a defined interval, perhaps every five years.
The present requirement is that the lead partner on an audit must rotate at least every
seven years, but there is no requirement for firm rotation. Would that be a justifiable
intrusion into the commercial freedom for companies to choose their own auditors? Or
would it help to prevent excessively close relationships, and emphasise the regulatory,
public interest role of the audit function?

At the audit commission, which appoints auditors to many public bodies in the UK, audit
rotation is planned as part of the process. When I ran the commission I found it a helpful
discipline, and one which had the useful effect of making auditors more ready to
challenge clients.

A second possibility, which would have a less intrusive effect, would be to require
regular re-tendering of audit work, but not to rule out the possibility that the current
auditor would be reappointed. The aim would be to break the normal assumption that
auditors are re-appointed year by year, and would require audit committees to ask
themselves direct questions about audit performance. It would also give other firms the
opportunity to set out the case for a fresh pair of eyes.
A third option might be to impose limits on the amount of non-audit work an auditor can
do for an audit client. Once again, that is a feature of the audit commission's regime. But
there are potential drawbacks. Firms might reasonably argue that some audit work can
most effectively be carried out by a company with a good knowledge of the clients'
systems. And policing such a restriction could also be rather difficult in practice.

We shall be consulting formally on these possibilities later in the year, but I can see
advantages in opening up the question for debate now, since the Enron collapse has
raised these questions here.

But in each case the role of the audit committee would remain crucial. Unless such
committees work effectively, any change to the arrangements for appointing auditors will
have little impact. And we have to recognise that there may be consequences for audit
fees. It is arguable that they do not now fully reflect the risks auditors take - and the
contribution they should make to market integrity.

The second area where there are differences in the UK is financial regulation.

One should not overstate these differences. It is certainly possible in the UK for a non-
financial company to undertake extensive activities in financial markets, as Enron has
done. And financial regulators here, as in the US, do not seek to regulate the non-
financial parent on a consolidated basis. But we do maintain closer regulatory oversight
of the financial subsidiaries of unregulated groups.

There are also two features of our new legislation which help.

First, we have introduced some specific powers over the auditors of financial firms, over
their terms of appointment, for instance. There are new whistleblowing requirements.
Auditors of a regulated firm must report directly to us any contravention relevant to the
exercise of our powers. If they do not do so, we can disqualify them.

The second advantage is that our unified regulatory system allows us to look at all of the
financial activities of a diversified group together. It is clear that almost all financial
crises these days cross traditional sectoral boundaries.

No regulatory system is foolproof, and internationally we need to work more on

implementing appropriate disclosure rules, especially of complex derivatives, to promote
effective market discipline. That is likely to be the most effective way of preventing more
Enron-type collapses.