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2013-12-12 11:12:37
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