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Making companies auditors more independent will be a tough task for regulators
Dec 7th 2013 | NEW YORK | From the print edition
EVERY financial meltdown prompts a hunt for scapegoats. In the wake of the most
recent one, calls to reform accounting have grown particularly loud, and action
is on the way. In the coming months both America and the European Union are
expected to introduce new rules aimed at enhancing auditors independence. But
for all the heated debate over the changes, any improvement is likely to be
modest.
America s bean-counters were effectively self-regulating until 2002. That year,
following a wave of accounting scandals, Congress passed the Sarbanes-Oxley act
to reform corporate governance. It limited the consulting work firms could do
for their audit clients and set up a new regulator, the Public Company
Accounting Oversight Board. At a meeting on December 4th it outlined three
policies it expects to implement by the end of 2014.
One aims to make audit reports more useful by requiring a section highlighting
critical audit matters the high-stakes judgment calls that keep accountants
up at night, such as how the business being audited has valued its intangible
assets. Another would cut the share of an audit that accounting firms can
outsource without disclosure from 20% to 5%. Such information is valuable in
emerging markets, where local accountants vary widely in quality. The most
controversial reform would identify by name the lead partner responsible for
each audit. Pressure for this measure grew more intense after Scott London, a
manager at KPMG, was caught sharing private information about the firm s
clients in 2012. He later pleaded guilty to insider trading.
Although identifying partners does not increase their legal liability, it does
put their reputation on the line. This seems to make accountants more cautious.
One study found that after Britain required the naming of auditors in 2009, the
share of public companies reporting a trifling profit an outcome often linked
to earnings manipulation, given investors appetite for steady profit growth
fell from 19% to 9%. However, accountants demanded compensation for the added
accountability: the policy led to a 13% increase in audit fees.
Conspicuously absent from the American proposals is the idea that would most
incense the industry: mandatory audit rotation. There are fewer qualms about
infuriating accountants across the Atlantic. The European Commission is putting
the finishing touches to a rule which is expected to require firms to put their
audits out for tender once a decade and to change auditors every 20 years (or
15 years for financial-services firms). Officials in Brussels are racing to get
it ratified before next year s European Parliament elections.
The case for rotation is that auditors who keep the same client for too long
get excessively cosy with its management. As Richard Breeden, a former head of
America s Securities and Exchange Commission, has put it, When the same
incumbent firm has been in place for 100 years, to me that s not an audit, that
s a joint venture.
Most academic studies have either found no link between the length of a
relationship and its quality, or determined that longer tenures yield better
results, because the accountants have time to master the intricacies of clients
businesses. Obliging companies to solicit bids at regular intervals, as
Britain does, has shaken up the business: HSBC said in August that it will drop
KPMG in favour of PwC; on December 2nd Unilever announced that it is making the
opposite switch. Indeed, the Big Four accounting firms KPMG, PwC, Deloitte
and EY argue that forced rotation would reduce competition by preventing the
incumbent from bidding.
Proponents counter that the accounting giants, and academics whose research is
often financed by them, have good reason to resist change. Among the reform s
strongest supporters are smaller firms that hope to break the Big Four s
stranglehold. The argument that changing the auditor harms quality does not
apply if the rotation period is 15 or 20 years, says Nick Jeffrey of Grant
Thornton, the sixth-biggest audit firm. There will be more opportunities for
us to overcome the institutional prejudice we ve been fighting for so long.
Yet even the most vocal advocates of mandatory rotation concede that it is no
cure-all. Auditors have a conflict of interest at the heart of their business
they are paid by the companies they are supposed to assess objectively. Unless
that changes, there will be no substitute for investors doing their own due
diligence.
From the print edition: Business