Audit in their hands: what China can tell us about rotation

by Gavin Hinks

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30 Jan 2014

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TRADE with China makes headlines. But along with trade has come mounting pressure on audit in the country everyone wants to do business with. Last year saw the results from the first wave of companies forced to rotate their auditors in what is an important step for Chinese corporate integrity.

The move has been closely watched and the first tentative conclusions are already being drawn from what many see an experiment in the management of audit provision. What will it do to the concentration of high-profile audits in the hands of the Big Four? How will it affect the price of audit? And what can the rest of the world learn from the experience?

Audit action
The trade relationship between Britain and China has recently seen intense activity. At the end of last year prime minister David Cameron and the chancellor George Osborne visited the country to encourage business between the two nations while former Tory minister Kenneth Clarke visited this month (January) to drum up sales for UK health companies. Jaguar Land Rover recently reported sales that were better than ever before because of a boost from sales in China.

But China has shown some concern for the way the audit of large companies works and has acted emphatically. This has, however, been a change almost ten years in the making. The first action came back in 2003 when the China Securities Regularity Commission and the Ministry of Finance required public quoted companies to rotate auditors, but insisted that it was the personnel that should be switched. A year later the State Owned Assets Supervision and Administration Commission (SASAC) beefed up the demands by insisting that audit firms should change in corporations owned by central government every five years with an extra three years allowed for auditors positioned among the country's largest 15.

Falling fees
That made 2012 the crunch year when, under the new rules, the first audits went out to tender. Last yeat saw the first results of the reform start to come through. Captured in a book out in February, The Big Four and the Development of the Accounting Profession in China, by Prof Paul Gillis, a former PwC partner and an accounting expert at the Peking University school of management, the results are startling.

No audit contract went to a firm outside the Big Four but audit fees dropped significantly. The data is, as yet, incomplete but Gillis' initial work shows the Agricultural Bank of China switched from Deloitte to PwC with the fee falling 12% to RMB115m (£11.57m). Meanwhile the Bank of China swapped PwC for Ernst & Young with a 31% cut in the fee to RMB148m (£14.89m). Other banks won similar fee reductions.

Local aid
According to Gillis smaller local firms may have backed away from tempting offers to tender for the audits. "The Chinese government and some regulators went to the second tier firms and asked them to propose on some of the companies that were being rotated. And I know of at least one circumstance in which one of the firms that was requested to propose on banks refused to do so.

"They said they didn't have the skills to do it at this point in time." Gillis says the smaller firms wanted to win the audits of second tier banks before pitching for the market leaders.

However, there may be a sign that the Chinese government may be moving to aid local auditors in their efforts to win big audit assignments. The Third Plenum of the Chinese government - it's plan for forthcoming reform - suggests a loosening of the rules for foreign investment. According to Gillis this could be a step to enable local audit firms to hire Western partners experienced in complex audits.

"So, I'm predicting that come about 2018 we're going to see a lot of activity where the second tier poach partners from the Big Four, possibly with the help and encouragement from the Chinese government to do so."

But Gillis also believes the cut in audit fees will put pressure on the Big Four's ability to deliver quality. Local firms, conversely, have lower cost structure. "So that may in part be a leveller in the sense that the Big Four is going to have a tougher time keeping their quality up with these low fees. But those fees might be quite attractive to second tier firms," says Gillis.

He is not alone in seeing a risk. Sue Almond, technical director at ACCA, says regulators will be alert to the dangers. "If a rotation process does result in a downward trend that would raise questions."

Chinese hangover
And that could be one thing rule makers in Europe would be looking out for when seeking lessons from the Chinese experience of mandatory rotation. In December European leaders appeared to reach agreement on a deal that would see listed company auditors change every ten years in Europe.

Almond believes Europe could look to China to learn about the impact on audit quality and competition

"One of the main challenges in the European debates has been the lack of real evidence in this area and the Chinese experience will be particularly timely since, despite the recent agreement in principle in Europe, it will likely be a few years before rotation is operational. So there is an opportunity to gather evidence and consider where further practical measures or support may be needed," says Almond.

Prof Gillis sees lessons to be had too. "I think that the China experience with audit rotation should create concern among regulators elsewhere. Does the fervour of competition over rotated engagements cause accountants to behave irrationally? Do they cut prices so low to win these prize engagements that they must cut audit quality to survive?

"I predict there are going to be a lot of hangovers in China when auditors come to face the reality of doing these audits for a limited period of time at low fees. Maybe next round they will be less anxious to compete on fees."

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