Arguments against auditor rotation appear desperate

by Eric Tracey

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11 Jun 2012

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Hand wringing

THE FLURRY of consultations and proposals advocating mandatory auditor tenders and/or rotation of audit firms has led to a profound reaction from some of the major auditing firms.

The vehemence of their opposition to virtually any proposal for change in this area does suggest that any change would not be in their commercial interest. The volume of material and stridency of tone of much of their responses might be strong evidence that significant change would be beneficial on competition grounds.

I see nothing wrong in these firms defending their commercial interests. It would surely be odd it they did not. What I find amusing is the sheer audacity – or is it desperation? – of some of the arguments.

My favourite is the argument against changing auditors on the grounds of the immense disruption to the company whose accounts are being audited and the related threat to audit quality. Someone is having a laugh.

I have experienced many auditor changes – as an audit partner (pre 2005), an FD (2005), a NED (since 2005) and an investor advocating the change (2010). I have invariably seen improvements in audit quality in both the last year of the outgoing auditors and the first year of the incoming auditors – not a drop in quality. The competitive and risk management instincts of the major accounting firms seem to combine to ensure that quality is maintained or improved in these situations.

For a firm to argue that auditor change risks a decline in audit quality seems to be an argument in favour of their being able to keep all of their clients forever. Nobody can take that seriously. Arguing that an audit firm change correlates with lower audit quality is somewhat undermined by that firm's own aggressive pursuit of new audit clients whenever the opportunity arises. They cannot be arguing that appointing them to replace one of their competitors would reduce audit quality, can they? But that is a logical inference from their argument.

The argument that auditor change disrupts the company whose accounts are being audited has more substance. A new set of people arriving at every audit location and having to learn the ropes is likely to be a bit disruptive to well-oiled routines. That is not necessarily a bad thing and is probably far outweighed by the benefit of a fresh approach and willingness to challenge outdated assumptions or judgements. All of the major accounting firms pride themselves on their ability to "move quickly up the learning curve" and "manage the transition" as the many and varied tender documents I have seen all promise.

Moreover, the firms are also justifiably proud of how much they can demonstrate, from the very first meeting in a tender process, outstanding knowledge of a potential audit client's industry and the likely audit issues. They are very good at this – good enough to convince me that changing audit firms should not be against the shareholders' overriding interest in audit quality. That shifts the debate to how (in)frequently is too (in)frequently, for which compromise answers are a likely outcome.

There are some aspects of the audit independence rules as they apply to banks that are very onerous on both the banks and incoming auditors. The rules on what banking arrangements partners in an audit firm can have without contravening the firm's independence are draconian, an obstacle to bank auditor change and far in excess of anything required to protect genuine auditor independence.

The current rules effectively require all of the partners in the incoming audit firm who have banking relationships with the bank to sever them and set up fresh arrangements with another bank. A few thousand partners around the world with mortgages of circa 50% property values or deposits of circa a year's income is hardly a threat to independence whereas a loan to the senior partner of 20 times his income would be perceived as a threat. Rules that tackled only the latter type of unusual banking relationship would be more competition-friendly.

Eric Tracey is a partner in Investment Manager, Governance for Owners LLP, and was previously a partner in Deloitte LLP. He has been a finance director and NED at a number of companies

Image credit: Shutterstock

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