Europe

• Shelling out
• Europe�s Sarbanes-Oxley
• PPProblems ahead

Shelling out

Shell�s misreporting of the size of its mineral reserves is rapidly turning into one of Europe�s biggest financial scandals. It has already caused the departure of chairman Sir Philip Watts and head of the company�s exploration and production, Walter van de Vijver. Embarrassment was compounded when Shell was forced to delay its financial results after finding a second exaggeration of supposedly �proven� reserves.

As accounting & business went to press it was unclear whether replacement chairman, Jeroen van der Veer, and the chief financial officer of the last three years, Judy Boynton, would survive a rising tide of shareholder anger.

It has been widely reported that both the US� Securities and Exchange Commission and the UK�s Financial Services Authority are investigating Shell�s actions. As is standard practice, neither the SEC nor the FSA would confirm or deny whether they are examining the activities of Shell. But a spokesman for Shell said: �All we are saying regards the FSA is that we have been in contact with the FSA and will continue to work with them. The SEC is conducting a non-public civil enforcement investigation.�

Unconfirmed reports in the American press said that the US Justice Department is also investigating. But a Shell spokeswoman responded: �To the best of my knowledge, we have not been contacted by the Justice Department.� It is also believed that two Netherlands� regulators are examining the Royal Dutch half of the group.

SEC rules permit oil and gas companies in their filed statements to disclose only �proved reserves that a company has demonstrated by actual production or conclusive formation tests to be economically and legally producible under existing economic and operating conditions�. Shell concedes that it overstated the value of its proved reserves by more than 20%.

In the US, law firm Milberg Weiss has begun a class action suit against Shell on behalf of shareholders alleging that in overstating the reserves the company breached accounting rules in the preparation of its financial reports. Key directors - including van der Veer, Boynton and Watts - are named defendants alongside Shell. It is thought that billions of dollars in damages may be sought.

�The complaint alleges that defendants deliberately violated accounting rules and guidelines relating to oil and gas reserves which resulted in a shocking and unprecedented overstatement of oil and gas reserves, the eventual disclosure of which damaged purchasers of Royal Dutch and Shell Transport securities and rocked the investment community,� said a statement issued on behalf of investor claimants by Milberg Weiss.

Their statement continued: �The complaint alleges that Royal Dutch and Shell Transport had classified and reported, in SEC filings and other public documents, certain reserves as �proved reserves� from a project off the western coast of Australia called the Gorgon Joint Venture, and various projects in Nigeria. In fact, unbeknownst to investors, the reserves did not meet SEC and industry requirements necessary to be classified as �proved�, and were improperly reported as proved reserves in Royal Dutch�s and Shell Transport�s financial reports, thereby materially artificially inflating a key measure of the companies� financial position and competitive standing. As a result of these material misrepresentations, Royal Dutch and Shell Transport�s true value in the marketplace was severely overstated and misunderstood.�

The litigants claim that Shell�s correction of its misreporting had the effect of cutting its reserve life by almost three years; increased the company�s finding and development costs to a much higher figure than its competitors; and increased its five-year average reserve replacement cost per barrel to $12.57, against an industry average of $5.51. Share values fell in response by more than 7%.

�Following the belated disclosure, most analysts and commentators concluded that, because of the magnitude of the write-down and the clear SEC and industry guidelines relating to reserve classification, the reserve overstatements could not have been a result of error or accident but, rather, that the reserves were knowingly overstated to preserve the companies� credit rating and to shore up their competitive position,� argued Milberg Weiss.

A spokesman for Shell reacted: �We have retained US counsel and will respond in due course.� An earlier statement by Shell said: �There is no material effect on financial statements for any year up to and including 2003. The recategorisation of proved reserves does not materially change the estimated total volume of hydrocarbons in place, nor the volumes that are expected ultimately to be recovered. It is anticipated that most of these reserves will be re-booked in the proved category over time as field developments mature. The recategorisation itself is not expected to have a material impact on hydrocarbon production in the near term.�

But problems for Shell increased with several US and UK papers claiming to have seen internal Shell documents dating from 2002 circulated to directors discussing the problem of overbooked proved reserves. The company itself continues to deny that it has acted illegally, though it is no longer arguing - as it did initially - that it had throughout �acted in good faith�.

Aad Jacobs, chairman of group audit for the Royal Dutch Shell group of companies, issued a statement in response to reports that directors had significant prior knowledge of the misreporting. He said: �The group audit committee has delivered its preliminary audit reports to the boards and recommended to the boards and external auditors they can rely on the presentations of the group�s current senior management. Documents and information gathered in this review have been, and are being, provided to the SEC. The review is still in progress. Its main conclusions will be made public.� Less than a week later, the company was forced to announce a second downward revision to proven reserves.

The issue of resource recognition is not new. Twenty years ago, the SEC considered requiring exploration companies to adopt reserve recognition accounting practices in determining balance sheet reserve values. But the SEC backed down in the face of corporate resistance and, instead, the information is required under FAS 69 as supplemental notes. But also two decades ago some investment managers were warning shareholders that weak accounting practices used by some oil and gas exploration corporations meant that it was very difficult to establish energy companies� underlying asset value.

Audit responsibility for Shell - as with some other multi-national groups with complex structures - is split. KPMG audits the Royal Dutch element, while PricewaterhouseCoopers audits Shell International. KPMG and PwC declined to comment on grounds of client confidentiality, but it is clear that the auditors believe it is beyond their responsibility and their technical competence to confirm the size and status of unextracted minerals.

David York, head of auditing practice at ACCA, said: �The responsibilities of auditors are clearly defined and do not extend to the level of [mineral] reserves.� He added that the International Auditing and Assurance Standards Board is currently considering the wider issue of materiality and supplemental notes and may put forward proposals for new requirements later this year.

Europe�s Sarbanes-Oxley

The European Commission has proposed a new Directive on statutory audit which is being dubbed Europe�s Sarbanes-Oxley Act. It addresses audit weaknesses exposed by Europe�s own corporate scandals of Parmalat and Ahold - though the measures might have done little to prevent the distinctive accounting problems facing Shell and its investors.

The proposed Directive would clarify the duties of statutory auditors and underpin these with ethical principles to ensure auditor objectivity and independence. There would be an option for member states to require a rotation of auditor every seven years. And, as expected, the group auditor of consolidated accounts would be required to accept responsibility for the audit of all companies in the group. There would be stronger restrictions on firms providing non-audit services.

Companies themselves would be obliged to strengthen their own corporate governance arrangements and auditor liaison. Audited companies will have to set up an audit committee comprising independent members to oversee the audit process, communicating directly with the auditor. That committee will have responsibility for selecting the auditor and proposing auditor appointments to shareholders. Where a listed company dismisses an auditor, it would be required to explain its reasons to its national regulatory authority.

There is also to be a tougher system of external quality assurance, ensuring robust public oversight over the audit profession and improving co-operation between EU member states� national regulatory authorities. The EU itself would form an audit regulatory committee of representatives from member states, enabling detailed measures implementing the Directive to be adopted or modified.

It is intended that Europe will use international standards on auditing for all statutory audits conducted in the EU with institutional regulatory co-operation with third country regulators, such as the US Public Company Accounting Oversight Board (PCAOB). The international auditing standards will be developed and approved by the Commission after consultation with member states. It is expected that the audit standards would include compulsory continuing education of audit staff intended to ensure thorough knowledge of relevant standards. Before audit staff would be allowed to undertake statutory audits in another member state they would need to demonstrate their aptitude and knowledge of that country�s legislation.

All auditors and audit firms would be obliged to undergo quality assurance reviews. Firms which audit listed companies, banks or insurance companies would have to publish annual transparency reports allowing an insight into the audit firm, its international network and other non-audit services provided by it. This report would cover among other things a governance statement, a description of the internal quality control system and a confirmation of its effectiveness by the management of the audit firm.

Internal market commissioner, Frits Bolkestein, said: �Auditors are our major line of defence against crooks who want to cook the books. Parmalat was a reminder of what happens when that defence fails. Faith in financial reporting and in the markets is destroyed. Unless it is swiftly restored, investment, jobs and growth will be lost. We cannot let that happen. No one is naïve enough to think any Directive will stop accounting fraud at a stroke - you cannot abolish crime - but what we are proposing would inject more rigour and a stronger dose of ethics into the audit process, bolstering that defence on which all market economies rely. At the same time it will remove some unnecessary restrictions on ownership and management of EU audit firms and lay the foundations for agreements to limit red tape for European audit firms working outside the EU.�

As well as providing greater control over audit firms and listed companies, the Commission says the package will provide greater opportunities for firms - but probably in particular for middle tier firms. �The proposal would provide new opportunities for the vast majority of honest, conscientious and competent auditors,� said the Commission�s statement. �It would, for example, allow auditors from any member states to own and manage audit firms in all the others. This would facilitate further integration of European audit firms and help open up the market.�

The Commission�s move was backed, with reservations, by ACCA. Roger Adams, ACCA�s executive director - technical, said: �While ACCA believes that, overall, the Commission�s proposals properly reflect post-Sarbanes-Oxley and Parmalat concerns, we recognise that it would only take one more Parmalat for the whole principles-based approach to audit, oversight, ethics and the education of the accountancy profession to fall into disrepute. Parmalat has clearly made Europe move much closer to the US �rules-based� culture enshrined in Sarbanes-Oxley. Auditors and regulators must be fully aware of this and seek at all times to be seen to be engaging in best practice. The important thing is to get the regulatory balance correct across the whole of the newly- expanded European Union.�

ACCA is anxious that registration requirements arising from independent oversight boards in each member state should not provide an excessive burden for audit firms, in particular that small firms should not share the same oversight regime as auditors of listed companies and �public interest entities�. It is essential to get a clear definition of public interest entities to prevent this, argued ACCA. Co-ordination between oversight boards will also be vital, rather than any attempt at a crude �one-size fits all� approach to the issue, it added.

ACCA strongly supports the EC�s proposals for a mandatory corporate audit committee, although it recognises that this may be contrary to UK practice, post-Higgs, which adopts a �comply or explain� approach to corporate governance issues.

Roger Adams added: �We believe the audit committee has a vital role to play in the corporate reporting process and should be a key check on company management. But the related proposals on auditor independence should not be seen as a panacea to post-Parmalat criticisms of auditors. We do not believe that allowing member states the option of mandatory audit firm rotation every seven years respectively will greatly improve the situation. Italy already applies this in practice and, of course, it did not prevent Parmalat. The new proposals will take time to work through and must be closely monitored at the EU level to ensure consistent application in each member state.�

The Commission�s proposals for International Standards of Auditing (ISAs) were endorsed by ACCA. ISAs should be introduced once they have been approved by the International Auditing & Assurance Standards Board (IAASB), but should not be made subject to the sort of complex endorsement mechanism which has been created for international accounting standards, suggested ACCA.

The European Commission�s proposals were also welcomed by the Federation of European Accountants, FEE. But it added that it believed the suggested measures were too weak in regard to measures on oversight, audit standards, independence and liability.

FEE President, David Devlin, said: �Auditing is central to ensuring the credibility and reliability of financial reporting. Over the past number of years, FEE has developed a series of detailed proposals aimed at restoring trust in financial reporting for capital markets. We support many of the proposals in the revised Directive published by the European Commission, noting its consistency with the FEE policy on key issues such as audit committees, international standards on auditing, internal rotation of audit partners and statutory backing for robust quality assurance and inspection.

�The proposed Directive also addresses international aspects. FEE welcomes enhanced co-operation between international regulators that can bring about a reduction of inefficient regulatory overlap. We also welcome enhanced co-operation which results in consistent quality of oversight.�

PPProblems ahead

New EU member states have been warned that Public/Private Partnerships are not a simple cure to poor infrastructure, while enabling countries to live within the eurozone fiscal rules. �Many people, even colleagues, consider PPP as a miracle that will overcome this problem,� Slovak finance minister, Ivan Miklos, told a World Bank conference on PPPs in the accession countries. He added that his country�s experience was that in road building, construction contractors demanded explicit government guarantees which undermined the principle of governments� arms length involvement in public sector infrastructure provision.

Andy Wynne, head of public sector technical at ACCA, endorsed the view that new EU member states should not rush to PPPs as a catch-all solution. �I think they have to be very careful that they are likely to provide value for money and that the attraction of possibly getting round Maastricht-type criteria should not unduly sway them,� he said. �The experience in the UK is mixed and the Treasury is still substantially revising its guidance on how value for money assessments should be undertaken.

�It is not easy when you are trying to make estimates of costs and benefits over a possibly 30 years or longer timescale to produce estimates on which you should rely. There is not an agreed model in which you put the figures in and get the answer out of. The figures at best should be a guide to the best approach. If one reason for using PPPs is to change a revenue transaction to a capital transaction, it is questionable whether the nature of the transaction is being changed.�

Improving essential public infrastructure is a political priority in Eastern European accession countries. The condition of roads and railways, in particular, jeopardises the assumed economic benefits of EU enlargement. �The imbalance between the shortage in transport and the abundance of new infrastructure will create problems that risk endangering the competivity of the Union,� European transport commissioner, Karel Van Miert, said last year.

The Commission calculates that to service the new member states - plus Bulgaria and Romania, which expect to join in 2007 - some 20,000 kilometres of road and 30,000 kilometres of railway lines must be built. New airports will have to be constructed and others modernised. The total cost of this transport infrastructure is calculated by the Commission at _100bn (£68bn).

Priority schemes include a new motorway in Poland to provide a major high quality road link direct from Berlin to Moscow, with other motorways from Prague to Vienna and Dresden. The Czech Republic wants to modernise its railways over the next two years to enable trains connecting Prague with Vienna and Berlin to travel at 160 kilometres an hour. Germany, too, is looking to complete more upgrades from the old East Germany with its Eastern neighbours, as is Austria.

EU funding of transport infrastructure in the accession countries triples when they join in May, but the new member states will themselves have to contribute or find significant investment to top-up the money coming from the EU.

The Commission is easing the use of PFI and PPP schemes for big infrastructure projects. Where governments can demonstrate that risk is genuinely transferred to a private sector contractor, new Eurostat rules will enable liabilities not to appear on governments� balance sheets, thereby assisting them to comply with the Stability and Growth Pact�s 3% deficit rule. The new rule interpretation is expected particularly to assist those countries which are keen to use PPPs heavily to improve infrastructure - which includes Ireland and Portugal of established member states, as well as the Eastern European new members.

However, the underlying risks attached to PPPs was well illustrated by the continuing problems with Eurotunnel. It has just announced a net loss for 2003 after an impairment charge of £1.3bn and a trading loss of £148m. Eurotunnel pre-dates the creation of the PPP structure, but in practical terms is an example of the type of infrastructure project that, in past decades, would have been built by the public sector but is now designed, built, operated and financed by the private sector. The trouble is that with the continuing levels of loss being suffered by Eurotunnel it looks entirely plausible that it will ultimately have to be bailed out by the UK and French states.