Monday, February 28, 2011

In Comments to European Commission, Big Four Oppose Mandatory Audit Firm Rotation and Endorse Market-Driven Selection of Outside Auditor

In comments on a broad and historic European Commission proposal to reform the system of outside audit of financial statements, the Big Four audit firms opposed mandatory audit firm rotation and endorsed the current market-driven selection of outside auditors. The firms said that removing the selection of auditors from the shareholders and the audit committee and giving to a third-party would violate sound corporate governance practice. The audit firms favor the current system, enshrined in the Statutory Audit Directive, of auditor selection by the company’s shareholders based on a recommendation from the audit committee, and reject the idea of third-party audit selection by a regulator.

While recognizing the potential conflict of interest in the auditor being appointed and paid by the audited entity, Ernst & Young said it has seen no evidence suggesting a need for change to the existing model. Audit committees and shareholders are best placed to decide which firm is best equipped to perform the annual audit and they should be responsible for that decision, emphasized E&Y, and the appointment of auditors by a regulator or government-appointed panel would undermine the duties of audit committees and shareholders. It could also expose the regulators to a much greater level of risk because they would be held accountable by shareholders for every perceived audit failure. In addition, if the audit function became an inspection function carried out on behalf of the regulator or government authority, it could result in the auditor having less access to information than is currently the case.

Similarly, in its comments, Deloitte said that it could not support the audit function becoming an inspection-type function carried out on behalf of the regulator. The removal of auditor selection from the shareholders and audit committee could disenfranchise both groups. The audit committee in particular has valuable insights into the audit needs of an entity. The appointment of an auditor by a regulator could also create inherent conflicts in the regulator’s relationship with the audited entity.

KPMG noted that the Audit Directive is already designed to ensure an appropriate degree of independence by providing that the auditor is appointed by the general meeting of shareholders based on a recommendation of the audit committee. The alternative suggestion by the Commission that a regulator should appoint the auditor and determine the remuneration and duration of the engagement would, in KPMG’s view, fundamentally undermine the key role that the audit committee should play within the corporate governance framework. It is also difficult to see that in the event of an audit failure it is in the taxpayers’ interests for a government body to be held accountable for the choice of the auditor.

PricewaterhouseCoopers warned that transforming the audit role into one of statutory inspection would represent a fundamental change in the basis of audit. The change in the nature of the relationship with management would affect openness and would be likely to require a more intensive forensic style of audit, which would be more costly and likely to raise questions around the promptness of reporting.

Instead of changing the current auditor selection process, the Big Four recommended that the Commission enhance the existing process. PwC suggested that the current framework could be enhanced by requiring the audit committee to provide an explanation both of the process they went through and the reasons for their recommendation of an auditor. Similarly, E&Y recommended strengthening the existing model by better defining the role of the audit committee in all aspects of the financial reporting and audit process, not just the appointment of outside auditors.

Deloitte recommended that the role of audit committees in recommending auditor appointments and monitoring the work of the auditor could be strengthened by requiring the committee to disclose the determining factors for their recommendations for auditor appointments. Also, consideration could be given to an EU-wide form of audit committee or supervisory board assessment of the auditor.

Audit Firm Rotation

The Big Four do not support mandatory audit firm rotation. Deloitte does not believe that the continuous engagement of audit firms should be limited in time and is not aware of any evidence that such rotation would enhance audit quality. Deloitte feels that the existing requirement under the Statutory Audit Directive for key audit partner rotation adequately addresses the risk of familiarity which this measure seeks to address.

Moreover, a mandatory requirement for a company to change auditors increases costs for business and risks reducing audit quality as the knowledge of the audited entity acquired by the firm in the past is lost. Deloitte and other Big Four comment letters cited a study carried out by Bocconi University in Italy, where audit firm rotation after a period of nine years is imposed by law for public interest entities, indicating that audit quality is lower in the first year of an audit mandate and that there are higher costs after rotation for both the audit clients and the auditors due to the new auditor’s lack of knowledge of the business.

Similarly, a study carried out by the US General Accountability Office concluded against mandatory audit firm rotation. Further, Deloitte noted that mandatory audit firm rotation is very difficult for multi-national companies to implement in practice. E&Y said that companies and their shareholders should be free to appoint the audit firm that best meets their needs at the time they believe appropriate. Audit partner rotation, coupled with independence requirements and effective regulatory oversight, better addresses the concerns raised by the Commission.

In its comments, KPMG emphasized that sound corporate governance demands that the audit committee recommend to the shareholders the best auditor for the job. Setting arbitrary time limits and requiring change when it may not be merited is inconsistent with that objective. While audit partner rotation has been common practice in some countries for a number of years, noted KPMG, it has only recently been adopted by all EU Member States. Audit partner rotation contributes strongly to objectivity and independence. The Commission should assess how partner rotation is working in practice before making further changes.

PwC noted that audit committees approach the auditor appointment decision very seriously each time it is taken. They specifically consider the incumbent firm’s performance and whether it is in the interest of the company to retain the existing firm or make a change. PwC cautioned the Commission not to infer a lack of independence from the fact that many companies decide to retain the incumbent firm. Current standards effectively minimize any threat of familiarity, said PwC, because there is regular rotation of key audit team members and, with the passage of time and circumstances, changes in others involved in the audit, as well as changes in the composition of the board, the audit committee and company management.

Instead of mandatory firm rotation, PwC suggested formalizing the governance practice which many audit committees currently follow whereby they evaluate the effectiveness and competencies of the auditors at intervals with disclosure by the audit committee of the processes employed in the interest of transparency. The auditor is aware of this procedure so it acts as a driver of good quality and innovation without the expense and disruption to the company of formal tendering.

Audit Firm Concentration or "Big Four Bias"

KPMG opposes regulatory intervention to specifically increase the market share of non Big 4 firms since it is not based on increasing the quality or value of the audit and therefore should not be the driver for change. KPMG believes that the high concentration levels in the Big Four reflect market choice in a fiercely competitive market. The market operates through audit committees having the freedom to make the choice of who is the best auditor for the job and recommending that choice to the shareholders. They are in the best position to do this as they see and can assess the quality of the people on the audit team.

According to KPMG, current good governance practice allows audit committees to test the market whenever they believe necessary through competitive tendering and this allows all firms to compete on an equal basis. Some proposals being consulted on by the Commission would prevent companies having that choice and thereby undermine one of the key principles of modern corporate governance, and may also result in incremental cost and administrative burden for companies and may also result in a decline in audit quality without necessarily reducing market concentration.

E&Y said that audit firm concentration or "Big Four bias" could be addressed by providing smaller firms with the incentive to invest in creating greater breadth and global scale to meet the needs of the market they wish to serve. In addition, institutional investors and audit committees should be better informed about the scale, geographical reach and competencies of audit firms outside the largest firms. KPMG would support the elimination of boilerplate terms in lending agreements which require the shareholders to employ a Big 4 firm. Similarly, E&Y backs the prohibition of contractual restrictions that prevent companies from appointing audit firms outside the largest networks, so-called "Big Four-only" clauses.

Ernst & Young, together with the other large audit networks, have tried to tackle the issue of "Big 4 bias" by writing collectively to the OECD in October 2009. They observed that in certain countries, including the US, UK, and Germany, they have encountered clauses in contractual agreements between companies and their banks or underwriters that state that only the Big 4 audit firms may provide audit services to the company. In some cases, higher interest rates will be applied if these clauses are breached.

The six-firm letter stated that these contractual limitations can distort the market for audit services by excluding certain audit firms from competing in this market segment even if these firms have the necessary size, sector-specific skills and geographical coverage to perform the audit in question. Such clauses could also create the perception that only the largest audit firms have the necessary attributes to audit large corporations, thereby potentially limiting competition.