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October 4, 2011

Comment: The future of public company audit

The EC’s draft regulation on audit has a number of recommendations that are designed to promote greater competition in the audit market. Crowe Horwath International chief executive Frank Arford and international A&A director David Chitty share their views on the proposals.

Crowe Horwath International global AA director David Chitty and CEO Frank Arford.The European Commission’s draft regulations are now in the public domain and, in our view, the solutions proposed should apply to large public companies.

We believe the debate over expectations and the structure of the market has not extended to the audit of other public companies, private companies and other sectors, and there is no case for change beyond the large public company sector.

The EC has encouraged discussion regarding the expectations of the audit of large public companies. The traditional format of the audit report was questioned. A more detailed ‘long form’ audit report is now proposed.

We agree with this proposal for large public companies as it is important stakeholders have more information about the conduct and outcome of the audit.

The EC has expressed concerns there is a concentration and competition issue in the market for large public company audit services in Europe. The public audit market is deemed not to be competitive and there are barriers to entry by new participants.

Ninety-nine of the FTSE 100 companies in the UK are audited by the Big Four audit firms and 27 of the DAX 30 in Germany are audited by two firms.

There is a view the UK Office of Fair Trading (OFT) has reported that the average period of appointment of an auditor of a FTSE 100 company is 43 years.

The EC has proposed joint audit for large public companies involving a Big Four firm and a non-Big Four firm. This will increase participation in the public company audit market by non-Big Four firms.

We believe that joint audit of large public companies can make a real change, as it will enable more audit firms to participate in the audit of larger public companies. This is clearly the case in France where joint audit is a legal requirement.

This reform will make the market more competitive and reduce the risk of the market being dependent on a small group of very large providers.

Joint audit has the potential to enhance audit quality as the two audit firms will co-operate and work together to form an opinion. They will review each other’s work and test each other’s views and conclusions.

Periodic tendering, mandatory rotation

Many large European listed companies appear to have rarely, if ever, put their external audits out to open tender. A discussion prepared by the UK OFT supports this view in the context of the UK market.

The commission is proposing to make periodic tendering for public companies a requirement along with greater disclosure about the process. Open and transparent tendering, at periodic intervals, will enhance confidence in the process of appointing the auditor, particularly where the incumbent is reappointed.

This proposal could help to widen the market for audits. Greater competition has the potential to enhance audit quality as quality should be one of the criteria assessed by audit committees when making an appointment.

The EC is proposing mandatory rotation with a maximum tenure by an auditor of nine years. Research has demonstrated that frequent rotation has undermined quality and we do not believe mandatory rotation will enhance audit quality.

Another proposal is a total prohibition of non-audit services. This has attracted headlines because the EC is proposing the Big Four firms split their audit and non-audit businesses.

We do not agree that there should be a total prohibition on the provision of non-audit services or a breakup of existing firms. There are perception issues but we do not believe the provision of non-audit services should be prohibited outright.

We propose auditors should not be permitted to provide non-audit services of an aggregated value which substantially exceeds the audit fee.

Can the middle market networks deliver?

If the proposals to change the market are to win stakeholder approval and maintain, if not enhance, audit quality, then the middle market networks of audit firms have to demonstrate they are willing and able to service larger listed companies.

The middle market networks have the required global reach needed to service this market. The networks have implemented policies and procedures to ensure their members have the skills needed to service the clients of the network, whether present or future.

These include global quality control standards, global audit processes and global training programmes which apply global accounting, auditing, and quality standards.

Many network member firms are already subject to the top level of regulatory compliance in their own countries, and provide the audit capabilities and quality comparable to their larger competitors.

Market change will need to take place over time as large public company audit arrangements cannot be changed immediately.

As the debate on the proposals begins, it is essential that, whatever the final form the regulations take, the solutions enhance stakeholder’s confidence in auditors and enhance the quality of audit work.

This outcome will make the discussion, debate and controversy over some of the proposals worthwhile.

*The views expressed are the personal perspectives of the authors and do not reflect the official position of Crowe Horwath International

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