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October 2, 2011

Barnier’s vision is good and bad for audit

Arvind Hickman comment on Barnier reform

If there were ever any doubts about Michel Barnier’s conviction to revolutionise the audit industry they have now been put to bed. Leaked draft proposals on audit industry reform could threaten the Big Four business model while provide mid-tier firms with greater opportunities.

The proposals recommend mandatory audit firm rotation, the banning of non-audit services, joint audits, audit quality certification, expanded audit reports and EU oversight reform.

Although more hard-hitting than first anticipated, it is important to remember that these are draft proposals and are still being worked on before they are made public in November. After this stage, the regulation must then navigate a path through the EU’s Council and Parliament, where further horse trading is likely to take place before a watered down version becomes law. In other words, it’s still early days.

Some of the proposals will be welcomed by mid-tier firms, such as the abolition of restrictive lending clauses and joint audits. But the major reforms strike at the heart of the four largest networks – Deloitte, PwC, Ernst & Young and KPMG.

Proposals on the provision of non-audit services could lead to Big Four firms being forced to shed audit clients or risk losing their consultancy businesses, which after years of building (and re-building in some cases) is a huge blow.

Mandatory rotation not the answer

Barnier’s proposal on mandatory firm rotation is an attempt to improve auditor independence and scepticism. It’s due to a perception that some audit firms are too cosy with management. When you consider some firms have audit relationships with companies for more than 100 years, it is easy to see why capital market stakeholders could form that view.

However, mandatory audit firm rotation every nine years and mandatory re-tendering every five years, in addition to current rules on mandatory partner rotation, could prove a real headache for firms and companies. 

This proposal sounds unlikely to navigate a path through EU Council and Parliament because it’s not practical. Not only will it place a huge cost burden on companies, which in times of recession is particularly unpopular, it will have an affect on the audit procedure and productive auditor/client relationships, which take many years to build in the largest companies. Research on mandatory firm rotation shows it undermines audit quality.

There’s nothing wrong with exploring a mechanism to shorten audit engagements that span many decades but firm rotation must be considered in the context of current policies on partner rotation and retendering. Too much change too soon in the name of independence will affect quality and compromise the role of the auditor.

Non-audit ban makes no sense

Barnier is planning to abolish a broad range of non-audit services on tax, consulting, actuary, risk management, valuations and bookkeeping for networks that generate a significant proportion of their European audit revenue from large public companies or ‘public interest entities (PIEs)’.

Let’s not kid ourselves, this is a direct attack on the Big Four and it’s unwarranted.

Michel Barnier on audit regulationTo fall under the non-audit ban, firms must generate a third of their audit revenue from large public companies and belong to networks that have revenue in excess of €1.5bn. The Big Four certainly fall into the latter but where it’s hazy is how much audit revenue they receive from large PIEs – defined as the 10 largest public companies in country by market capitalisation and PIEs that have market capitalisation of more than €1bn.

Just this week, the world’s largest network Deloitte announced its global revenues soared by more than 8% to a record $28.8bn, with nearly 38% of revenue in consulting and financial advisory services. If Barnier’s proposals are passed, it would threaten the growth of Deloitte and its rivals.

If Big Four firms were to be affected by this regulation they would mostly likely need to assess whether to drop audit clients in order to redress the amount of revenue they obtain from large public companies or split their operations altogether.

Importantly, having ‘audit only’ firms would affect the ability of firms to attract the diverse range of skills that make them important service providers to business. Breaking up the Big Four would mean destroying the largest and most effective business graduate training grounds in the world.

One immediate question that springs to mind – what is the justification for all this?

There are already quite strong independence requirements on non-audit services in many markets, such as the UK, so a lot of services that would impede audit independence are already banned. The basic litmus test of independence is that a firm should not be able to audit the financial statements of a client if its non-audit services influence reporting. In layman’s terms, you shouldn’t audit your own work.

The case for audit firms providing certain non-audit services to clients is that auditors are best placed best to provide them and to hire an external provider would be a waste of money and a repetition of work.

At a time when business leaders ponder a double dip recession, shouldn’t the EC look to remove unnecessary cost rather than increase it?

Joint audits should be considered

On the positive side, there is merit in at least exploring joint audits on a broader scale than France. Whether it works or not is open to debate, depending on who you talk to, but if it does help dynamise the market without affecting audit quality it is worth a shot. Although the Big Four will contend there is plenty of competition between them, it wouldn’t hurt for other firms to gain experience and market share auditing the largest companies provided it does not lead to inefficiencies and reduced quality.

Barnier must also be given credit for abolishing restrictive lending clauses and promoting an ‘EU audit passport’ that cuts red tape. Strengthening the tendering processes, ensuring greater transparency around auditor appointments and an enhanced dialogue between auditors and prudential supervisors are also sensible initiatives being put forward.

Linking audit to GFC a mistake

A major fallacy of the draft is its tone. Barnier implies ‘robust audit’ is the key to re-establishing trust and market confidence after taxpayers have spent billions bailing out banks during the financial crisis. Such a statement is worrying because it implies auditors are partly responsible for allowing the financial crisis to occur. Surely Barnier must know better.

If Barnier is fishing for reasons to change the audit industry, he ought to cast his rod in a different pond. Auditors did not cause the financial crisis and any reform to the industry should be made for the right reasons and focus on audit quality. It is the perception gap of what people believe auditors do compared to reality that has not adequately been addressed.

What must also come into question is the consultation process itself. Are these recommendations really what capital markets stakeholders want? In some of the more controversial proposals, I suspect not.

The draft proposals still have a considerable journey before they are enshrined in law but Barnier’s mission is clear for all to see – the status quo is no longer acceptable.

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