May 18, 2018

Clients need more audit partners for real accountability.

Following the financial meltdown of a key government contractor in the U.K., Carillion Plc., legislators and professionals are discussing the breakup of the Big Four auditing firms. Such a drastic measure, however, would probably do less to increase the relevance of audits than a different change, also unpopular with auditors.

Carillion’s demise caused the debate because, as the construction firm grew increasingly reckless in taking on projects and using creative accounting, KPMG, one of the Big Four, remained its auditor for 19 years — and failed to alert shareholders and regulators of the impending disaster. At the same time, Deloitte served as Carillion’s internal auditor and EY had a consulting arrangement with it. PwC became Carillion’s liquidation administrator because it was the only one of the Big Four firms that didn’t have a conflict of interest.

The audit and financial consulting market is so incestuous because it’s insanely concentrated. In the U.K., the Big Four audit 97 percent of the FTSE 350; in the U.S., 99 percent of the S&P 500 and some 44 percent of all listed companies are their clients. Breaking firms up is the knee-jerk regulatory reaction to oligopolies. Create more competition, the logic goes, and the quality of services will go up. Split the Big Four’s consulting business off from its auditing business, and there’ll be fewer conflicts of interest.

Counterarguments include the difficulty of auditing a multinational company without being one and the sharing of knowledge between professionals in different lines of business within the big firms. It’s also difficult to design a breakup that would make sense.

Splitting a firm down the audit/consulting line won’t create any more competition in the audit field. Cutting up the Big Four into specialized auditors for specific industries would only create oligopolies in each sector. No breakup pattern does much to prevent lasting relationships from forming between auditors and client companies’ managers and to make auditors work for shareholders, not executives — the holy grail of any auditing profession reform, as my Bloomberg Opinion colleague Chris Hughes pointed out in a recent column.

More likely, a regulatory solution lies along a different path: that of requiring firms to more regularly change auditors.

The U.S. rejected the idea of a mandatory rotation in 2013, but the European Union instituted it in 2016. On the EU level, however, the regulation is quite lax: Public companies and banks are only required to change auditors once in 10 years, and another 10 can be added if the company holds a tender but then reappoints the same auditor. Member states have the option to speed up the rotation, but, as a rule, they don’t. Italy’s nine-year rotation, for example, isn’t sufficiently different from the general rule. In the developing world some countries have gone further: Brazil has a five-year rotation rule, China sets the same time frame for bank auditors, and Kenya demands a three-year auditor rotation in its financial sector.

Ten to 20 years is an eternity. Such slow changes can do little to increase competition or stop toxic relationships from forming. But a more dynamic rotation has been difficult to introduce because the Big Four have put a lot of lobbying effort into defanging the regulation. They have argued that rotation reduces audit quality because a firm doesn’t get enough time to learn in-depth how a client operates. They have cited research that has showed any rotation only results in more business for the Big Four, that shorter relationships with clients only reduce auditor skepticism, that prices in a market with mandatory rotation go up.  They pointed out that the need regularly to change auditors is costly for clients because they have to repeat the selection process more often than they would in a free market. And indeed, clients often don’t want the hassle and the expense, so you don’t see public companies lobbying for mandatory rotation.

And yet they probably protest too much. In late 2016, Scott Bronson, Kathleen Harris and Scott Whisenant of the University of Kansas published a paper exploring the real effects of mandatory rotation in Italy, South Korea and Brazil. They found significantly less “earnings smoothing” and management toward targets — in other words, creative accounting — and timelier loss recognition while mandatory rotation was in effect than when clients could change auditors whenever they wanted. However, they noticed that the audit quality dropped in the first year of an auditor’s engagement, when the audit firm gets to know the client, and in the last year before the forced rotation, when it’s not as important to lave a good impression.

Still, the research team concluded that “the benefit to audit quality (of adopting rotation rules) appears to be larger by a factor of at least two (in some cases higher) than the costs of audit quality erosion at the forced rotation audit engagements.” In other words, mandatory rotation creates a trade-off that is generally worth it. For the equation to work, the rotation period can’t be too long or too short, though. The optimal period can only be determined experimentally.

The problem with such experiments, of course, is that they create an unstable environment in which competition can hardly increase. There’s no point in creating more firms if regulations can change at any point, driving clients back to the safe haven of the Big Four. But when it comes to fixing the auditing market, instant gratification is not an option. The world has lived with the accounting oligopoly for decades; audit quality is the more pressing problem to solve.

Auditors will always work closer with the clients’ management than with shareholders or regulators, no matter how one tries to strengthen oversight. So the potential for corner-cutting will always be there while the relationship can last longer than the average marriage. When the duration of an auditor’s contract is known in advance, there’s a better chance problems like Carillion’s will come out long before a company loses its way completely.

[Bloomberg]