Europe

Will the European economies fail the Lisbon test?

We are now three years into the EU�s 10-year plan to make Europe the world�s most dynamic economy: it looks as if Europe will get nowhere near its goal.

At the Lisbon Council of Ministers meeting three years ago, Europe�s leaders made an unprecedentedly bold specific policy objective. Europe was to become the world�s most dynamic knowledge-based economy within just 10 years. It is a pledge which is so far from being achieved that even now it looks like a source of potential collective humiliation.

Europe�s economy is not merely stagnant, it is losing ground to competitors in terms of productivity. EU member states are simply failing to implement agreed steps to introduce a more flexible and dynamic economy. One example was the introduction of a Community patent, which was only approved last month after three years of conflicts between member states, with each protecting narrow national interests, despite being seen by researchers and industry as essential to the more effective working of the internal market.

The European Round Table of Industrialists is clearly worried by the slow progress, saying that the Lisbon declaration was �admirable�, but that the test was its �implementation, not just declaration�. The key to progress, says the Round Table, is to invest in centres of excellence, backed by moves to raise the status and supply of scientists; to increase public spending and, in doing so, to build greater private R&D expenditure; and to increase legal protection for intellectual property, thereby reducing the bureaucratic hurdles which impede the launching of innovative products and technologies.

Members of the Round Table point out that, at present, the objective of Europe outperforming the US is unrealistic. Movement over recent years has been in the direction of a widening productivity and performance gap, in favour of America. Whereas, in 1990, there was only a marginal advantage for the US over the EU in terms of GDP output per capita, there has subsequently been a dramatic improvement in the US, with almost straight line performance in the EU. On existing trends, it will not be long before US output per capita doubles that of the EU.

Achieving a turnaround rests on several factors, not least heavy investment in R&D and new productive facilities. But research by the Round Table shows that, while members are planning to invest, they intend to do so outside the EU. A big increase in investment in Europe is unlikely, suggests the Round Table�s report, while the EU has only 5.4 researchers per 1,000 people in the labour force, compared with 8.08 in the US. This, in turn, has led to markedly fewer centres of excellence in the EU compared with the US.

Gerard Kleisterlee, President and chief executive of Royal Philips Electronics, explained: �Already a significant part of new hires at Philips Eindhoven comes from outside the EU. To get the best researchers we are recruiting worldwide for our research laboratories and, partly for the same reason, an increasing part of our R&D effort is based outside the EU.� He added: �Competence centres with �excellence� potential in Europe are too scattered over the various countries to achieve the required economies of scale and develop into true centres of excellence.�

Underlying these specific problems lie two general handicaps, argued the Round Table: �the lack of any sense of urgency to complete the Single Market and ineffective policies to achieve the Lisbon objective� and �the cumbersome political decision-making process for business-related issues in Europe�.

These concerns are echoed by another report, just published, which comes from the Centre for European Reform. It concludes that while the EU deserves credit for the spread of new technologies, as do most member states for removing obstacles to new business creation, there is disappointing progress in pursuing the Lisbon targets for raising employment rates for women and older workers, and on increasing R&D expenditure.

�Three member states - Denmark, Finland and Sweden - already meet most of the Lisbon targets and can be described as world-class economies,� says Alasdair Murray, the CER�s director of the business and social policy unit. �A second tier of countries - including Britain, Ireland and the Netherlands - are making good progress. Spain and Portugal are working hard to catch-up with the frontrunners. Similarly, EU accession countries - such as Estonia and Slovenia - are endeavouring to fulfil their Lisbon commitments.

�However, the eurozone�s three largest economies - France, Germany and Italy - have so far made little attempt to fulfil their Lisbon promises, particularly labour market and pension reforms. Unless they reinforce their reform efforts, they risk becoming a drag on the entire EU.�

Murray said that Denmark and Finland could be regarded as Europe�s �heroes� in trying to keep the EU on its Lisbon tracks - but that Germany and Italy were the �villains� for derailing the agenda.

Further support for the pessimistic view of European economic prospects came from Unice, which brings together heavy-hitting European businesses. It condemned EU states for failing to implement promised reforms, saying it was essential they did so now if real progress towards the Lisbon objectives was to be made. Unice said the European leaders were guilty of cowardice in playing �a dangerous game� in expecting the US to lead the world out of recession. It predicted low growth in the EU over the next two years, with growth of just 1.4% this year and 2.2% next year.

To be fair, Commission officials are equally aware of the reform deadlock. In its new Green Paper on Entrepreneurship, the Commission seeks to answer the question of why so few people start a business in the EU compared with the US. The secondary question is why so few of those who do start then go on to create dynamic and fast-growing businesses.

Explanations put forward by the Commission cover both the cultural contrast between the EU and the US and the failure by member states to address structural hindrances to small firms. Entrepreneurship is still not as highly regarded in Europe as in America and failure is treated more critically. There is a strong belief in Europe that a new business should only be established if there is virtual certainty that it will be successful. It is far more acceptable in the US to �suck it and see�.

Many structural barriers to small firms� creation remain in place, varying in severity in different European countries, concludes the Green Paper. These include cost, support, skills, bureaucracy, tax and - echoing a point made by the Round Table - the lack of equity finance.

The challenge of structural reform has split member states badly over recent years, giving the appearance that all are agreed in principle with the need for reform, but lack consensus as to what constitutes essential structural reform - as compared with differences in systems which might be regarded as important national cultural variations.

Things have become so bad that Commission officials - notoriously delicate in their handling of members� sensitivities - are increasingly showing their frustration in reports. In the Commission�s recent report Choosing to Grow, which examines progress towards the Lisbon goals, the best and worst are shown for all to see. Finland, Denmark and Sweden are praised as consistently the best in �structural indicators�, providing the basis for the framework conditions for achieving a more dynamic economy. The member states which are performing worst are Greece, Italy, Portugal and Spain.

Perversely, the UK is both the fifth best and fifth worst member state for implementing structural reforms. In some instances it is an enthusiastic reformer, yet with other measures it has done little to introduce change. However, the Commission also makes the point that Greece, Portugal, Spain and Ireland have all made big steps forward in recent years in catching up with best practice and cannot, therefore, be regarded as the major stumbling blocks to progress.

Nowhere illustrates the political fallout from structural reform better than does Germany, where, for months, the fragile administration of Gerhard Schröder and the social democrat/green coalition has destabilised. Most recently, Schröder has unveiled a new package of reform proposals which aim to create a more flexible and dynamic labour market, without upsetting too much the trade unions on which his party�s support relies.

Schröder�s reforms would eliminate national pay bargaining; reduce redundancy protection for staff of small firms; simplify accounting rules for SMEs; cut taxes on SMEs; cut the size and duration of unemployment benefit that is paid; cut the cost of healthcare and the coverage provided by social insurance; and invest 15bn euros (£9.5bn) in regional infrastructure and housing.

On the face of it, Schröder�s proposals were radical and progressive. However, they were far from well received. They were criticised by the opposition Christian Democrats as insufficient. They were less revolutionary than some of the minority coalition partners in the Green Party had called for. But the measures were strongly attacked by the trade unions and many members of the ruling SPD as undermining Germany�s distinctive welfare state and social market model. Employers complained the proposals were short of detail. And analysts pointed out that Schröder was proposing the abolition of some measures which his own administration had introduced. It seems likely that they will now be subject to bitter debate, possibly leading to even greater political uncertainty.

Perhaps equally significant, Germany also called on the European Union to water down the stability and growth pact. Germany is finding the pact�s rules, limiting budget deficits to 3% of GDP, difficult to conform to.

Meanwhile, the British Government is arguing that the twin issues of pressures on the stability pact, plus the failure of the eurozone economies to implement market reforms, make it increasingly difficult for the UK to go for early adoption of the euro currency.

Plan for disaster and save your business

The 11 September attacks on New York were not only a terrible civilian disaster. They also illustrated how vulnerable financial systems were to disruption by an awful tragedy. Now the UK�s City regulator, the Financial Services Authority, has urged those working in the finance industry to recognise the real threat to financial systems and firms� viability that is posed in times of war and political instability.

Firms should take steps to ensure that, in the event of a terrorist attack on financial areas, they have back-up systems sufficiently effective to ensure �business continuity�, says the FSA. The guidance applies to all regulated providers, including about 700 accountancy and law firms providing investment advice in the UK.

A spokesman for the FSA said it was not attempting to be prescriptive - for example, by saying that back-up computer facilities must be a minimum distance from the headquarters� offices - but was telling firms they need to take steps to ensure that the financial markets were resilient to a major terrorist attack or other disaster. Ultimately, said the spokesman, it was largely up to commercial and reputational pressures to force large companies to adopt sensible protective measures.

In support of this, the FSA, the Bank of England and the Treasury have launched a website, www.financialsectorcontinuity.gov.uk, to provide guidance for financial firms on what steps they should take, including measures for assessment, design, implementation, measurement and testing of continuity management.

Michael Foot, managing director of the FSA, said: �Last year we undertook a review of the key 40 or so firms and markets which found that there had been considerable improvement in their business continuity and capability to recover from either a 11 September-type event or a local incident, such as flood or telephony/IT problems, which can have a major effect on individual firms.� He added: �Although our priority focus is on key firms and markets, our guidance applies to the other 12,000 firms we regulate.�

Rick Cudworth, who leads KPMG�s Business Continuity Services, which helped produce the guidance, commented: �Worries about war in Iraq and growing concerns over terrorist threats have led many organisations to re-examine their approach to business continuity. This has certainly been the case in the financial sector and, for many financial services organisations, the highest priority right now is to implement and maintain improvements in their resilience and recovery capabilities. This guide provides a step-by-step approach to help organisations address the challenges, supported by insights from leading specialists from financial institutions and their advisers.�

The UK Treasury has launched its own plans to take over the running of key City institutions in the event of a major calamity, such as a biological, chemical or nuclear attack on commercial London. It is determined that an attack should not cause financial systems to collapse, for example by preventing salaries to be paid. Even fairly short-term disruption could have knock-on effects, pushing major companies into technical insolvency and destroying confidence in key institutions, fears the Treasury. Although the proposals are just at consultation stage, an indication of the urgency with which they are being treated is that the consultation period is lasting a mere eight weeks and will be completed later this month.

There are many other signs of the way in which governments are now treating the threat of terrorism, coinciding with or following war with Iraq. Emergency planning has been strengthened in the UK, with the major fear being an attack launched on the London Underground. And the Metropolitan Police has revealed that it will use London�s new ring of cameras around the City - which enforce the congestion charge - as a means of monitoring potential terrorist activity.

Even more alarmingly, US health secretary Tommy Thompson has predicted bio-terrorism attacks on the powerful Western nations and urged their governments to spend billions of dollars upgrading health systems to cope with such an event. In line with this, the US Federal Government plans to spend billions on what are termed �biodefense initiatives�. These include devices which detect the presence of anthrax, smallpox and other micro-organisms that could be released as part of a war on civilian populations. Parallel with this, the US administration is also spending heavily in fear of �cyberterrorism� - antagonistic software viruses designed to wipe-out state and commercial computer systems.

Many critics will claim that governments have entered a paranoid frame of mind, yet have only a limited capacity to counteract the range of potential threats. But it is legitimate to ask whether the private sector is taking the threat of civilian attack sufficiently seriously in the light of the commitment shown by governments.

According to a new survey from PKF, small firms are in fact woefully underprepared. More than half have no operational disaster recovery plan at all, the research shows.

Nick Winters, a partner at PKF, said: �It�s all too easy to focus on the day-to-day and short-term goals in business - but the uncertain economic climate and current war, together with possible terrorist attacks, are timely reminders that disaster can strike at any time. Every company should have a crisis management plan because once you�re hit by a problem you don�t have the luxury of time to think through the best options and ensure your systems are backed-up, your staff are trained and you have a route to recovery.

�The more prepared you are to cope with it, the better your chances of getting through a disaster as quickly as possible and with the least disruption and trauma. It could be the difference between saving and losing your business.�

Auditor suffers direct action from rights activists

The controversial drug testing company Huntingdon Life Science has been forced to seek another auditor after a campaign against Deloitte & Touche led it to announce it will withdraw from the role. HLS is thought to be considering asking the UK Government to act as its auditor, as well as its other stopgap roles as insurer and banker.

Two groups, Stop Huntingdon Animal Cruelty and the Animal Liberation Front, carried out 10 days of direct action against D&T and its offices, staff and partners before the firm announced it had suffered enough. �Having completed the audit for 2002, we will not be offering ourselves for re-election as auditors to Huntingdon Life Sciences,� said D&T�s managing partner, John Connolly.

Tactics used by the campaigners included creating what they called �electronic protest software�, which led to key staff in the firm being deluged with thousands of e-mails a day to their individual mailboxes. Two partners� homes in the English Midlands were besieged with leaflets, with protesters using an airhorn and a megaphone to let neighbours know the reason for the demonstration. A partner in Mannheim in Germany had similar treatment and another partner in London had offensive graffiti daubed on his property.

Some office locks were superglued and other premises were invaded. Offices in Berlin, Mannheim, Wellington in New Zealand and Glasgow were visited by campaigners, while others in England, Scotland, Sweden and the US were subject to demonstrations. Deloitte said that many of its staff�s homes had been attacked, with cars vandalised, windows broken and doors superglued.

A spokeswoman for Deloitte declined to comment on the suggestion that its staff had leaked information to Stop Huntingdon Animal Cruelty. She regretted that the firm had been targeted in its role as auditor. �It is unfortunate,� said the spokeswoman. �We have not been in that situation before. We have finished accounts for this year and we are not asking the client to reapply. Our relationship is terminated.�

Huntingdon Life Sciences said it was not prepared to talk about the appointment of new auditors, or to say anything which might encourage protesters to take further action against any possible target.

Ahold�s troubles are �warning to Europe�

Assumptions that European accounting standards are stronger and more resilient than those of the US - with Europe avoiding corporate scandals of the Enron kind - have been dealt a severe blow by the unravelling of the Dutch grocery giant, Ahold.

Ahold�s survival as a single entity was looking uncertain as accounting & business went to press. Already its chief executive, Cees van der Hoeven, and its chief financial officer, Michiel Meurs, had been forced to leave office, while Jim Miller, chief executive at the Ahold subsidiary US Foodservice, was under increasing pressure.

The underlying issue is - yet again - revenue recognition practices. It has emerged that the early booking of revenues by US Foodservice led to inflated profits of $500m (£311m). The impact of this was multiplied by the claim that Ahold had failed to notify the markets immediately when it learnt of the problem. This allegation is currently being investigated by the Euronext Amsterdam stock exchange. The Netherlands� Authority for Financial Markets is examining suggestions that shares in Ahold were traded in unusually heavy quantities just before its accounting problems at its US subsidiary were revealed.

Meanwhile, a separate investigation is taking place into the trading activities of an Argentinian subsidiary, Disco. This is examining Ahold�s purchase of assets for $492m from Velox Retail Holdings and seeking to establish whether these assets were pledged collateral on a loan, and therefore barred from sale. The VRH case is being examined by the legal system in Uruguay.

As well as the Uruguay case, there are now three investigations into Ahold by Dutch regulators, plus an SEC investigation into accounting practices at US Foodservice. A class action law suit has been filed in New York by Ahold shareholders against auditors Deloitte Touche Tohmatsu. Deloitte is expected to defend the action vigorously, saying that it had advised the client of the accounting problems.

A spokeswoman for Deloitte said: �As Ahold has publicly announced, Deloitte discovered in the course of its 2002 audit, on which Deloitte has not issued a report, certain information regarding potential irregularities in the recognition of income related to promotional allowance programmes at US Foodservice, as well as information that had not previously been made available to Deloitte concerning Ahold�s consolidation of certain joint ventures. As a result of the information discovered by Deloitte, it has suspended its 2002 audit pending completion of investigations by the Supervisory Board of Ahold. Deloitte is precluded by professional standards from commenting further.�

The consequences of Ahold�s situation could be considerable. Several insurers are reported to be worried about their exposure to liabilities arising from class action law suits. And a syndicate of leading European banks had previously provided 3bn euros (£1.9bn) in emergency loans to Ahold. The company�s total debt is now over 12bn euros and its share value has fallen to just 3bn euros, having been nearly 30bn euros a year ago. Ahold spent 19bn euros in recent years in making international acquisitions, including US Foodservice, Alliant Exchange, Giant Foods and Stop & Shop, all in the US. Although Ahold was based in the Netherlands, most of its turnover is now generated by its US subsidiaries, while it has interests across continental Europe.

In addition to dealing with the investigations into its accounting and other practices and the massive drop in its share price, Ahold also faces a major challenge in repaying, this year, over 3bn euros in maturing debt. It is now widely predicted that Ahold will be forced into a �fire sale� of much of its empire.

As a result of previous scandals over the accounts of Dutch firms - including the collapse of KPNQwest - the Dutch Government had already initiated a programme of regulatory reform. This will lead to the securities regulator, the Authority for Financial Markets, taking a wider ranging role, closer to that of the US� SEC.

Roger Adams, ACCA�s executive director - technical, believes that the Ahold crisis has some important lessons for the profession around the world. �ACCA feels that this demonstrates we were correct in 2002 not to take an �it can�t happen here� stance,� said Adams. �You can�t eliminate risk - Europe is not immune.

�Secondly, it underlines some of what is happening at the moment on oversight of the profession and the strengthening of governance procedures. This shows the need for proper risk management systems.�

Similar warnings had already been shown by the catastrophic losses which hit the Allied Irish Bank and Barings, where individuals had been able to work outside the properly monitored and managed operations of the banks, said Adams. �With Ahold, it was the auditors who found the problem,� he added. �But where were the internal auditors? Where were the risk reviews, and so on? Ahold raises questions about internal controls in multi-national companies as much as the governance issue - especially when, as here, you are dealing with a subsidiary of a subsidiary. You have to ask how far down the parent company�s management could reach into the subsidiaries.�

Adams added that the international character of Ahold�s problems emphasised the need for an international approach to accounting standards, governance practices and audit regulation. �Clearly you will get more attention to that in the future,� he predicted.

More prosecutions, please

The UK�s Inland Revenue is not doing enough to prosecute tax evasion, nor to challenge public perceptions that tax evasion is acceptable, according to a report from the National Audit Office.

In particular, the Revenue is advised to make greater use of the new offence of �evading income tax�, introduced in 2001, says the report Tackling Fraud Against the Inland Revenue. The Revenue was also advised to take urgent steps immediately to tackle misuse under the new Child Tax Credit and Working Tax Credit.

The NAO and the Revenue believe that offshore accounts are being heavily used by higher rate taxpayers to mask the ownership of their assets. Over the last four years, the Revenue has concentrated on increasing its intelligence on offshore accounts with a view to launching prosecutions.

Jointly working with authorities in tax havens and other agencies, the banking and credit card industry and professional representative bodies have led the new Revenue approach. But, added the NAO, these steps have yet to realise fully the potential benefits of reporting requirements introduced by the Proceeds of Crime Act 2002. In one tax investigation project undertaken by the Revenue, it was discovered that 500 individuals had committed tax frauds to the value of an estimated £90m by concealing funds held offshore.

At present, individuals who own or control SMEs and evade tax through their control of the cash balances in their firms, and accountants and other professionals who advise small firms on tax evasion, are the Revenue�s acknowledged targets for fraud prosecutions. About 60 such cases are prosecuted each year, with a 75% conviction rate leading in most cases to imprisonment.

Another area of concern has been so-called �pensions busting� arrangements, where individuals have obtained early access to preserved pensions benefits. So far, 12 such schemes involving 1,350 individuals have been investigated. It is claimed that these schemes have enabled between £80m and £100m in pension funds to be accessed, causing a tax loss to the Revenue of £35m. Criminal charges have so far been brought in two cases, but inquiries are continuing. The Revenue is currently working with the pensions industry to strengthen regulation and controls.

The NAO believes that the Revenue must take greater action to assess the true scale of the problem of tax evasion. Once this is done, the Revenue should set performance targets to reduce the loss, allocating more resources to the challenge where this is appropriate.

Sir John Bourn, comptroller and auditor-general and head of the NAO, said: �It is important that the Inland Revenue has a clear view of the risks and scale of external fraud and the resources and approaches it is going to use to tackle them, for even a small percentage loss to fraud could amount to billions of pounds.�

Detailed recommendations made by the NAO include the adoption of greater cross-departmental operations targeted at businesses working in the shadow economy, reflecting the finding of Lord Grabiner�s enquiry that these activities will typically involve frauds against several government departments. More staff should be allocated to the Joint Shadow Economy Teams, there needs to be closer links between these Joint Teams and the Revenue�s Special Compliance Office, more referrals should be made from external sources to the Joint Teams and greater awareness is required within the Revenue about the work of the Joint Teams. As the operations of the Joint Teams become more effective, so the level of information sharing and liaison with the Revenue and other agencies should improve.

While the work of the Special Compliance Office is regarded as effective and cost-efficient, the NAO proposes tighter management arrangements involving closer monitoring of cases in progress. Similarly, the SCO should make stronger efforts to identify potentially serious fraud cases at an earlier stage. The SCO should also improve its liaison with other parts of the Revenue. The number of prosecutions brought by the office should increase.

The NAO also proposed that the operation of the Business Anti-Fraud Hotline should be less restricted, open to a wider range of complaint and be better publicised.

Farewell to audit?

The day when the Big Four turn their back on audit work could just conceivably be sooner than later. At least, that appears to be the meaning of the comments of Piet Hoogendoorn, the global chairman of Deloitte Touche Tohmatsu.

Hoogendoorn - who is also President of NIVRA, the accountants� professional body in the Netherlands - claimed that the major firms were considering abandoning audit work altogether. He said the reasons were the increasing difficulty and cost for auditors of obtaining professional indemnity insurance.

But it is equally true that, in the wake of Enron, WorldCom, Xerox, Equitable Life and Ahold - where Deloitte was the auditor - the firms are under growing financial pressures from possible legal actions. Meanwhile, the reputational and brand-building benefits of undertaking audits are diminishing because of the criticisms of auditors.

Pressure on the Big Four to unravel their range of businesses further was increased by Paul Volcker - chairman of trustees of the International Accounting Standards Board, a former chairman of the US Federal Reserve and the man brought in by Andersen as a clean pair of hands to try to save them - who called for an end to auditors providing tax advice to audit clients.

Volcker said that he hoped that the US Public Company Accounting Oversight Board - the new SEC subsidiary in charge of audit regulation - would ban tax advice from auditors. He argued that there was an unacceptable conflict of interest where auditors were auditing tax-minimisation practices which they had recommended.

A spokeswoman for Deloitte declined to comment on Hoogendoorn�s remarks, beyond saying that: �He was speaking in his NIVRA capacity not in his Deloitte capacity.�

It is recognised that the profession and the firms face particular difficulties in the Netherlands. As well as the problems afflicting Ahold, the country�s largest retailer, there have been a series of cases in which auditors have been criticised - leading to the creation of an SEC-style super-regulator (see Ahold�s troubles are �warning to Europe�).

Rodger Hughes, managing partner, marketing, for PwC in the UK, said: �There�s a real danger that the risk/reward ratio of auditing could get fundamentally out of balance. When you compare the potential liabilities if something goes wrong and the margins you earn on an audit the odds don�t look great.�

However, given the conflict between the firms� desire to limit liability arising from audit on the one hand and the resistance from the Securities and Exchange Commission to approving any such limitation, the withdrawal of the Big Four from the audit market is becoming conceivable.