Opinion
5 Sep 2014 01:26pm

Debate: Audit rotation

Will mandatory audit rotation negatively affect audit quality?

Yes

Steve Barber audit committee chairman, Next

No

RA Collinge, head of corporate governance group, UK Shareholders Association

 

80% of 10-year plus FTSE 350 companies had not changed auditors for at least 10 years

 

NO RA Collinge

By law an auditor reports and is responsible to the shareholders of the company being audited. The auditor is required to be independent of management, but they are the people he is appointed by, works with and the people who sign the cheque.

Laura Carstensen of the Competition Commission commented: “Shareholders play very little role in appointing auditors compared to executive management… firms naturally focus more on meeting management interests”.

When first appointed, the auditor will have explored all the material accounting processes and policies of his new client and decided on their effectiveness and fitness for purpose. At that point he could challenge any policies he was uncomfortable with, check his firm’s view with its technical department and either accept them or not. A working relationship with management was established.

Such relationships can go on for a long time: 80% of 10-year plus FTSE 350 companies had until recently not changed auditors for at least 10 years, some for over 100. This has been a factor in the failure of auditors to warn of the bank collapses. In the EU alone, 114 banks received either capital injections or asset relief aid. None had a qualified audit report prior to the crisis.

Auditors need to do better. Audit rotation is part of the answer. It will bring new thinking on processes and policies; peer review of audit work; and fresh effort to ensure the audit is as effective as possible.

 

Yes Steve Barber

I’m responding with the benefit of having been a FTSE 100 auditor, a CFO, and now a FTSE 100 audit committee chairman. The theory that rotation of auditors should lead to better quality audits is fine – but will the reality match that expectation?

First, let me deal with the myth that management appoint the auditor. This was true 30 years ago but nowadays the audit committee has a powerful voice. Most FTSE 100 audit committees comprise experienced professionals who will not allow management to appoint the auditors.

The audit firms may not have helped themselves by giving various banks clean opinions but, most likely, behind the scenes the central bank would have been influential. Qualifying a bank’s accounts would be a rapid, self-fulfilling prophecy and I doubt whether the Bank of England would allow it.

Audits are not performed by firms but by individuals. The capability and independence of the people is critical and mandatory partner rotation is probably more important for audit quality than rotation of the firm. When selecting a new auditor, more weight is attributed to the quality of the teams than the firms. Be careful what you wish for. Audit quality may not improve in the short-term but fees will inevitably rise.

 

No RA Collinge

Steve Barber understates the case when he says audit firms “may not have helped themselves”. What was missing was the rigorous challenge that should have persuaded banks, their directors and management to be more realistic. That is what mandatory audit rotation should help to provide.

Steve talks about audit teams and the need to keep them up to the mark by partner rotation. He does not mention that the big audit firms have technical departments that have to be consulted on the tricky decisions the partner makes. Those are equally inhibited by the decisions and approach the firm has taken previously. That fresh view is not real.

Knowing a new team, technical department and firm will in due course review the work being done will encourage that greater rigour. The pressure to agree with management and the audit committee will be reduced when it is known the mandate will inevitably be lost. The new arrivals will ask new questions and come to new views unencumbered by decisions and agreements of the past. It will take time and make life a little harder for management. It may cost more, but savings to shareholders, taxpayers and the economy will outweigh those downsides.

 

Yes Steve Barber

I have no idea how rigorous a challenge there was by auditors of the banks, but I don’t think they would have signed off without extensive debate and careful consultation. This would have included technical departments and, in my experience, they were never inhibited by previous decisions.

Pressure to agree with management is reduced when it is known the mandate will be lost but this is only in later years prior to mandatory rotation. New arrivals asking new questions may not be very different from a new partner from the same firm rotating on to the audit.

I struggle to see how the savings to shareholders and the economy – or even the taxpayer – will outweigh the additional audit and tendering costs. Even in the case of the banks, the costs to the taxpayer would have happened anyway (and may have been accelerated by an audit qualification).Managements made the decisions to take on the risks that created the losses. Whether the auditors understood them may be another matter.

Which brings me to a crucial concern – the quality of the people doing the audits. This comes down to recruitment, training, experience and expertise, and location. The largest of the Big Four inevitably have more partners and managers with relevant experience; this is important in banking and insurance where there are a limited number of experts. Not all the firms have them, so mandatory rotation may not offer a better quality audit.

 

No RA Collinge

I think Steve and I will have to disagree on technical departments. They are as inhibited by previous decisions as anyone else. The key point is, as Steve says, pressure to agree with management will be reduced by mandatory rotation.

In the case of banks, management took on the risks. I would be worried if those risks were not understood by the auditors. Qualified audit reports will still be rare as the new auditor will be expected to take a firm line where it feels a different approach is required. Rotation means a new team can ask about the risks attached to any new ways of trading, or, in the banks, new financial products, without the embarrassment of feeling they ought to already know.

Although the Big Four have a lead in the area of recruiting and training specialist staff, other firms can equally recruit, train or buy in specialist skills when they need. Mandatory rotation will help open up the audit market of the largest companies. Mistakes were made in allowing the mergers that eventually resulted in the Big Four. Change is needed.

Mandatory rotation will be a start towards new and better thinking, better supply in the audit market and better challenge to managements where that is needed.

 

Yes Steve Barber

Given the banks may not have understood the risks they were taking, it is possible the auditors may not have either. The impacts of CDO squared are a nightmare to understand, let alone audit. Not even the Big Four have such expertise. In view of the constraints of independence, there may not be a firm with the necessary expertise available to rotate to.

Rotating audit firms will result in the cumulative knowledge base being lost – and it takes a few years to get up to speed with complex businesses.
Allowing the Big Six to become Five, then losing Andersen, has left the Big Four virtually unassailable. I cannot imagine GT or BDO could invest the sums needed to become credible worldwide competitors; it would take at least a decade of reduced earnings – which the partners would not tolerate – and even then they might not gain the necessary expertise.

The audit committee must appoint the auditors and set their fees, not management. This, together with mandatory rotation of audit partners would, in my view, lead to better quality audits. Enforcing mandatory rotation may lead to reduced quality. 

 

 

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