EU Audit Reforms

I may seem a little late responding to the EU Commission's proposed reform of auditing for public companies that was announced on November 2011. However, it often seems best to let the dust settle after the first outpouring of responses, to get a clearer view.

This is an important corporate governance issue, or rather several;

• are boards too close to their auditors, preventing necessary criticism?
• do auditors have conflicts of interest?
• is there sufficient competition for audits?

The Commission is responding to the undeniable fact that banks that collapsed or have had to be rescued as a result of the financial crisis had clean audit reports. They believe those banks had not adequately assessed their risks and nor had their auditors and that SOMETHING MUST BE DONE!

Always beware when there is an outcry that "something must be done": it will usually be the wrong thing aimed at the wrong target. For example, the global financial crisis was not fundamentally a result of poor bank regulation but the result of global trade imbalances - which are the fault of governments (who do not seem to be in the firing line). If it had not been an investment bubble in US mortgages it would have been an investment bubble in dotcom businesses or in something else.

Two little questions I would pose to the Commission;


1  Where were the regulators in all this?
If the banking regulators failed to notice the levels of risk being taken on by banks what makes you think that auditors would do any better?

Oh, and by the way, the banks own executives and risk committees failed to assess the risks correctly.

2  Will the proposals achieve what they hope without unacceptable consequences?
The main proposals, applicable to all listed companies, are to;

1. rotate audits every 6 years
2. forbid auditors from offering consultancy services
3. mandate open tenders for audit work
4. commission supervision of auditors

Auditors argue that it takes some time to get up to speed with a new client and that rotation every six years will add to costs. I am a little dubious about this argument; are they saying that we can't trust an audit in the first year - I hope not? The problem with consultancy services is that they create conflicts of interest and contribute to development of an oligopoly of huge firms. On the other hand, if a firm develops tax expertise, for example, in order to audit a client's tax affairs, how can you reasonably forbid them from offering that expertise in advance? The same argument applies to other consultancy services and, if implemented, must create duplication of work and added cost. Further, you would expect the development of expertise for provision of consultancy services to improve the quality of expertise available for auditing as well; so if you prevent that you are reducing not improving auditors expertise and the probability they will get it right. As for open tenders, how do you deal with simple dislike of a client for the auditor: are they to be forced to take the lowest bid? In practical terms you have to get on with your auditor if the relationship is to work but how do you write that into legislation? And finally to commission supervision of auditors....hmmm....not so sure that's the sort of thing we want the EU to be getting into.

But finally - what about behaviours? The thing is that people change their behaviour when there is legislation. So, in Italy, it is common for an audit team to jump ship to a new audit firm when the audit transfers. How do you stop that in a free society and does the practice not make a nonsense of rotation? And if auditors only offer consultancy to non-audit clients how does that reduce the dominance of the the big four auditors? Or if the cost of consultancy is pushed up due to duplication of expertise how does this help anyone? How else might behaviours change in ways that would thwart the intention of the proposed legislation?

But let us not throw out the baby with the bathwater. As executives, directors and investors we must ask whether any of the proposals could be sensible improvements to governance. Some rotation of audits seems a sound idea and audit committees should keep an eye on whether they are putting so much business with one firm that their independence is compromised. How about requiring audit reports in the annual accounts that report on these issues and that give a genuine assessment of risk rather than legal boilerplate?