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Analysis: Auditors face shakeup in their largest market
(Reuters) - A draft European Union law unveiled on Wednesday has the world's biggest audit firms bracing for a major shakeup in their biggest market.
The proposals would go much further than corporate auditor restrictions in the United States, their second-largest market, where they have had some success fighting reform plans.
In one of the biggest crackdowns yet on the audit profession, the European Union's Internal Market Commissioner Michel Barnier proposed forcing the largest audit firms to separate their consulting businesses and either share audit work with smaller rivals through joint audits, or rotate clients every six years.
The proposal must be approved by the European Parliament, but lawmakers have shown a strong appetite for tough regulations and had already called on Barnier to make such proposals.
The draft law and the mandated legal separation of audit and non-audit services could strike at the heart of the business model of the Big Four, which have branded themselves as full-service, global professional services firms.
"These sets of proposals would be a game changer," said Robert Hodgkinson, executive director of the Institute of Chartered Accountants in England and Wales, an accounting body based in Britain. "They have hugely complex effects. What is eventually enacted we don't know."
For a graphic link.reuters.com/zew35s
Potentially the most far-reaching change is a requirement that the largest audit firms split off their consulting arms into separate and renamed legal entities.
That move could undermine branding efforts of the Big Four audit firms -- Ernst & Young, Deloitte, KPMG, and PwC -- and hurt their ability to seamlessly serve big multinational companies.
The moves are the harshest response yet from authorities to conflicts of interest and the role of audit firms during the global financial crisis, when auditors failed to warn of problems at major banks that collapsed or required massive government bailouts.
EUROPE A $39 BLN MARKET
"Firms in Big Four networks work very closely on multinational clients, and if you have such major structural reforms as these it must surely have an effect on how they operate globally," said Arvind Hickman, editor of the International Accounting Bulletin.
Europe accounted for about $39 billion of the Big Four's $95 billion in total revenues in fiscal year 2010, while $31 billion was earned in the United States and $25 billion in the rest of the world, according to data from the International Accounting Bulletin.
The Big Four auditors said the proposals would increase audit costs.
PwC's UK Chairman Ian Powell said Barnier has not provided "any concrete evidence for any positive impact of these proposals on audit quality."
KPMG's European head Rolf Nonnenmacher said the ability of firms to provide quality audits "will be diminished if auditors are separated from wide-ranging advisory expertise."
Deloitte said the plans would make Europe's audit regime inconsistent with those in other markets while Ernst & Young said they would do little to prevent financial crises.
The changes are meant to increase auditor independence and address criticisms that auditors have turned a blind eye to questionable accounting for the sake of holding on to lucrative consulting fees.
Consulting has been the fastest-growing business for big audit firms and makes up about 25 to 35 percent of their global revenues, according to the International Accounting Bulletin.
Audit makes up about 45 to 50 percent of Big Four revenues, though growth is slower in that area.
Details of the EU's draft law remain sketchy, and parts of it are sure to change before it becomes law. Britain is expected to try to soften the draft, but it has often been outvoted on other rules. The final law would be binding on all EU states.
CLIENT-PAY MODEL STILL AN ISSUE
The EU's proposals go further than 2002's U.S. Sarbanes-Oxley auditor reform act, which limited the types of consulting services that audit firms could provide to their audit clients, but left them free to sell consulting services to non-audit clients.
Because Congress has already addressed consulting conflicts, it is unlikely to revisit the issue, said Lynn Turner, former chief accountant for the Securities and Exchange Commission.
"I don't think Congress will give what Barnier's proposing a second thought," Turner said.
The main U.S. auditor watchdog, the Public Company Accounting Oversight Board, is considering mandatory auditor rotation, though the proposal's fate is uncertain.
After a major lobbying effort, the Big Four were successful in beating back some of the harshest measures considered by the U.S. Congress in response to the Enron and WorldCom accounting scandals a decade ago.
For example, Congress had considered auditor rotation but that was not part of the final Sarbanes-Oxley Act.
(Reporting by Dena Aubin in New York; additional reporting by Huw Jones in London and Nanette Byrnes in New York. Editing by Howard Goller and Kevin Drawbaugh)
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The past few months have seen intense lobbying by both the Big Four (appalled at mandatory rotation breaking their very comfortable market dominance) and the mid-tier (hoping for a new market bonanza with the introduction of compulsory joint audits).
But the final Draft Regulation, in abandoning the introduction of compulsory joint audits while retaining provisions for mandatory rotation, would appear to be a welcome victory for both clients and common sense.
Barnier is to be commended for standing up to lobbyists on both sides and for putting forward the most crucial reforms likely to benefit clients. While both the Big Four and the mid-tier have lobbied intensely against its introduction, we have always maintained that mandatory rotation, in particular, is the only way to break the obvious over-concentration in this market – and provide public interest entities with a proper choice.
The introduction of mandatory audit rotation had been almost universally condemned – by industry and academia as well as both the Big Four and the mid-tier accounting firms. But at Russell Bedford, we have always endorsed the one overriding argument in its favour: that the mid-tier firms would never get a chance to compete for the audits of the larger listed companies without it.
Unless and until the mid-tier accounting firms are given a real opportunity to compete on a level playing field for the audits of mid-cap listed companies, clients will see no reduction in costs and will have no greater choice.
On the practical management of end-of-tenure handover under mandatory rotation, however, the proposals do appear to be somewhat lacking in detail.
We have never shared our peers’ enthusiasm for obligatory and permanent joint audits. Quite apart from the (now well rehearsed) arguments against inefficiencies and costs, we have always believed genuine market access would allow ourselves and others to compete directly for greater market share, without the need for the sort of market ‘nannying’ that obligatory joint audits would introduce.
But for mandatory rotation to be effective, regulators do need to consider very carefully how this is to be handled in practice. How will handover be managed?
It is often argued that mandatory rotation is likely to lead to loss of detailed knowledge of the audited entity on the transition between audit firms – and there is some evidence to support this view. It is here that the introduction of joint audits could have a limited utility. This potential problem could be resolved through the introduction of a transitional joint audit arrangement, involving both the out-going and in-coming audit firms, for a (strictly limited) period of two years.
Given their approximate 85 per cent market share of the audits of FTSE 350 equivalent companies in Europe, the need to control the Big Four’s dominance of the audit market can no longer be ignored, and in retaining proposals for mandatory audit rotation, Barnier has secured the one single mechanism likely to achieve this. The abandonment of obligatory joint audits is also a welcome assertion of clients’ needs over those of the profession. But it is now time for both the mid-tier and the Big Four to put aside what has, for far too long, been a quite damaging display of self-interest in favour of a concentrated and practical analysis of how Barnier’s attempt to improve market access can be secured in practice.
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