Accountancy: Internal controls plan flawed - The guidance on implementing one of Cadbury's key recommendations needs a fundamental rethink, argues Roger Marshall

THE Cadbury Committee's recommendations are already having a noticeable impact. Many public companies are reconsidering various aspects of their corporate governance, and changes will undoubtedly continue.

But one aspect of the changes to come is causing controversy - the proposed reporting on internal controls. We in Price Waterhouse believe that a fundamental rethink may be needed.

Preparing guidance to support Cadbury's recommendation that directors should report on the effectiveness of internal controls has clearly not been easy. The draft published in October 1993 is reputed to be the working group's 17th version.

It runs to 67 pages, including six appendices that list in detail the matters directors might consider in determining whether: 'the company maintains a system of internal financial controls, including suitable monitoring procedures, in order to provide reasonable but not absolute assurance of the maintenance of proper accounting records and the reliability of financial information used within the business or for publication'.

It proposes that directors should publicly conclude that they 'are satisfied that these controls operated effectively during the period covered by the financial statements'.

Such a statement is likely to raise considerable expectations among readers of the annual report, particularly as directors are only expected to qualify their conclusion when a weakness that had a material impact on the financial records was not detected and rectified in a timely period. Such errors are likely to be few and far between.

A standard reassurance of directors' satisfaction with their control systems is thus to be expected in most companies' annual reports - from those with comprehensive control systems to those that have only just missed reporting material weaknesses.

Of course, requiring directors to make such a statement in the annual report might still be thought worth while, if only to focus their minds on ensuring that controls are working properly.

However, one has to question whether the proposed process, which focuses on detailed controls, would really prevent the recurrence of some of the corporate scandals of recent years, such as Maxwell and Polly Peck.

Unfortunately the preparers of the draft guidance may not have given enough thought to the likely costs to companies of making an apparently simple statement on controls.

The requirement to make this statement will impose on many companies a considerable burden, requiring directors to gather evidence to support a formal, quasi- legal, conclusion.

In the best-run companies, directors naturally impose tight control at all levels to ensure that the functions of the company are operating properly. But providing detailed evidence of the operation of each of those controls may be quite a different matter.

And on the question of evidence, Cadbury recommended that the directors' statement be reviewed by the auditors. Although the Auditing Practices Board has yet to publish guidance for auditors, it seems clear that this could lead to substantial additional audit cost.

Directors' and shareholders' sympathy for this proposition is unlikely to be boundless. Don't the auditors already test controls?

Auditors normally choose the most cost-effective way of auditing each area of the accounts. The auditor may, for example, decide to attend the annual stock-take to satisfy himself on physical stock quantities and not test in detail the stock recording system. This may be the cheapest and most-effective way for him to express an opinion on the balance sheet, but it hardly enables him to concur with the directors' view that detailed stock controls are effective.

But is the likely cost and bureaucratic effort of supporting a formal conclusion on internal controls worth while? In our view it is not. If almost every company reports the same bland, unqualified conclusion, how will shareholders be any the wiser?

The problem is accentuated by the subjectivity of the whole process. The working group did not consider it practical to provide a comprehensive list of control criteria suitable for all businesses. Instead they provided a set of control 'features'.

While we sympathise with the draughtsman's predicament, directors and auditors have not been given a solid and objective platform on which to base their conclusions. So how will investors know whether all have been judged against the same standards?

It is not too late to adopt a simpler and less subjective solution. It ought to be possible to specify certain high-level controls that all should have - essentially direct functions of the board. Directors and auditors of financial institutions are already used to such a framework in reporting to the Bank of England.

The relevant controls might include detailed plans and monthly budgets for each operating unit, and comprehensive monthly management accounts, with comparison against budget. Boards should have no difficulty satisfying themselves, or their auditors, that such controls exist.

But how might the UK business community decide which are the high-level controls that 'all should have'?

Perhaps, in the first instance, directors should just be asked to describe in the annual report those aspects of a board's function which they consider critical to the success of the control structures they have established. Companies with well-developed controls could make considerable capital of such public reporting - encouraging others to emulate the achievements of the best. Companies unable to make many positive statements would face challenge.

Public reporting on internal controls is very new, and must be an evolving process. Developing a bureaucratic and expensive process which risks producing simplistic and potentially misleading conclusions cannot be the right answer. We need to explore better ways of providing good information of real value to shareholders.

Roger Marshall is senior client partner at Price Waterhouse

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