2 Feb 2017 01:45pm

The big debate on audit

George Rozvany, foundation director at the International Society for Promotion of Ethical Tax Behaviours and Gilad Livne, professor of accounting, Exeter University Business School go back and forth on audit, non-audit services and reform

George Rozvany

English law has led the world in developing robust legal concepts for commerce. With the onset of the industrial revolution and its much greater financial requirements for the new industrial behemoths, the Joint Stock Companies Act introduced, in 1844, the concept of incorporation and, in 1856, the requirement for external auditors to ensure the integrity for stakeholders of the profit and loss statement and balance sheet. These were the halcyon days of the profession as “the guardians of commerce” and the new breed of auditors did their job well, resulting in an unprecedented period of growth and power for ‘the Empah’.

Turn the clock forward 160 years and the accounting profession is arguably besieged by both tax and accounting scandals of which the financial collapse of Lehman Bros, the Lux Leaks and the Mossack and Fonseca scandals are poignant reminders. This global loss in confidence has been compounded by the concentration of audits whereby 98% of companies over US$1bn are now audited by the Big Four accounting firms.

This concentration in major audit activity and the regularity of public scandal associated with such audit activity strongly suggests that after 160 years an end to end review for the audit profession is well overdue and indeed would be welcomed by most stakeholders. Such a review may reasonably conclude that the audit and tax functions could be split in to separate firms to ensure arm’s length testing of the tax calculations to improve integrity. Further, to ensure competition, the tax and accounting firms could be split in to two to create eight audit firms and eight tax advisory firms. However, the devil is in the detail as to whether such measures will achieve that outcome and will likely require further associated changes.

Gilad Livne

The tasks auditors face today are more complex than they were 160 years ago, and dare I say, they have turned progressively more complicated in the last 20 years. There may be simple solutions, but the idea of disallowing audit firms to provide tax-related services does not seem to me as one of them. Auditors are already prevented from providing many non-audit services. This has been the case in the US, following the Sarbanes-Oxley (SOX) Act of 2002. Did this massive piece of regulation help with the financial crisis of 2007-2008? Many banks went bankrupt without any warning from auditors. One needs to provide evidence as to the efficacy of a particular solution. Academic research has been quite skeptical of the idea that curbing non-audit services advances the cause of auditor independence. Not only this, allowing the auditor to look into tax matters likely makes the auditor more knowledgeable of the state of affairs at the client they audit.

I am also unclear as to whether having four main audit firms is unusual in the broader context of the economy. Take the supermarket industry in the UK where we have had four major players, and yet often we see they compete on prices and quality. So the concentration among the Big Four need not be a problem in itself. We need to consider the facts: what is the evidence that the audit market does not work well? What prevents clients from employing a non-Big Four auditor? What evidence do we have that smaller audit firms provide a better service? Are there benefits to economy of scale in the audit market?

Only when we have some clear answers for these (and other) questions, can we start devising solutions. And the solutions of today, may not fit for purpose tomorrow. I believe that some changes will happen in a natural way without regulatory intervention. In fact, a big tidal wave is already underway. As Big Data become more commonplace (cheaper and better understood), it is not a fantasy to expect that audit can be, and will be, conducted by smaller teams with perhaps specific analytical skills. These teams will operate from their home laptops. That is, the current model of the audit market may not survive technological developments already in the making and a breakup of the Big Four might take place before too long. I understand that audit firms already invest in this technology and once it becomes replicable (and it will), we will have several audit outfits competing with each other on the basis of their sophistication, quality and price. But I am not sure that even this will solve the fundamental problem of auditor independence.

George Rozvany

My views are those of the most senior insider in the world to come out publicly on these issues, who has over 32 years written the transfer law in his country, worked deep within three of the Big Four firms, not lost a tax dispute in 25 years, and truly loved the game. My concern is that the game has become so successful it is reducing corporate tax collections to a point where real damage is being done to the global society.

What audit partner would not admit in private that an aggressive tax partner demanding modification on an audit finding will be beaten on all occasions? The only solution is to allow auditors to independently interrogate the tax treatments from another firm.

The cartel issue can be simply addressed on pure numbers. With just the four firms servicing 98% of global audits of companies above $1bn and not suffering any regulatory intervention, the Big Four are the masters of cartel protection.

The profession has been around for 160 years and it is now time for a review embracing all key stakeholders and these and many other practical changes can be safely introduced.

Gilad Livne

I accept that shareholders may want aggressive tax planning. But what they do not want is a set of accounts tainted with lack of credibility. Andersen went down not because it was found to commit a criminal act. It lost clients who could not trust it, well before the legal proceedings were concluded.

The answer to auditor independence is not necessarily to sever the link between tax and audit. Forcing a breakup may not work either because the problem is that the auditor is not independent of the paymaster. Shareholders should be better empowered to directly nominate and decide on the fee auditors are paid and terms of engagement. Let them shop around.

We should start a serious dialogue with the investor community. Ultimately, if the audit partner is directly answerable to the shareholders, the tax partner will have little power over the audit partner.

Current corporate government arrangements do not facilitate auditor accountability to shareholders. Recent reforms have transferred decisions to audit committees. If audit committee members are nominated by the CEO, what incentive do they have to represent shareholders?

George Rozvany

There is little doubt that auditor independence must be safeguarded. Restructuring of fee arrangements to allow auditors to determine the necessary scope of their work and charge accordingly, fixed audit terms followed by a compulsory rotation to another audit firm, and separating audit and tax into separate firms will, if introduced, strengthen the auditors’ position of independence and should be given due consideration.

Splitting audit and tax into separate firms is part of the solution, but the new audit firms themselves must build teams to sufficiently interrogate tax arrangements to actually achieve this. The current position should be and can be improved to satisfy demands for certainty.

There is a reasonable view that there is insufficient competition in the market. If a companydecides to change its auditors or tax advisors and a conflict arises, the choice may be as little as one firm, which is obviously not competition. This must be changed. The accounting profession is in an ideal position to identify areas of concern and suggest improvements, which have the opportunity to gain political and regulatory support.

Gilad Livne

George and I agree on the problems. We probably differ on solutions. There is nothing special about the audit market. What I take from the fact that there are only four big players is that new entrants have not found auditing to be a rewarding economic activity.

Faced with low fees, auditors are perhaps more amenable to pressure from clients. I am not sure how much legal, regulatory and reputation threats mitigate against this. As long as we do not find ways to make fees more rewarding AND give shareholders the power to retain, hire or dismiss the auditor, nothing will change – except for when other market forces bring a new auditing Uber, as a result of technological changes. I believe this will happen before too long and then we may be able to empower shareholders.

Why not use technology to facilitate direct communication between auditors and their clients – the shareholders? The beauty of this? Managers will be removed from the process and will face strong incentive to be forthcoming with the auditor (otherwise, shareholders can be notified in real time by auditors).
In short, we need innovation, not regulation.