PracticeAuditAll Change Please

All Change Please

In the months following the collapse of Enron and WorldCom, senior executives, governments and regulators around the world have been keen to develop a tough response to the issue of auditor independence.

In the UK, we have heard calls from many quarters for the introduction of the mandatory rotation of auditors, among other reforms. These measures are intended to boost public confidence in the quality and transparency of company accounts, but there may also be dramatic consequences in the employment market for audit professionals.

If auditor rotation is introduced in the UK, there may be an increase in movement of audit partners and other key staff between firms, as the new audit firm seeks their knowledge and relationships. The net result would be little change to the current situation – auditing staff will remain involved with the same client, albeit under the umbrella of a different firm.

The government appears to be squarely in favour of introducing auditor rotation. Patricia Hewitt, secretary of state for trade and industry, announced in July that the Treasury select committee examining the issue of auditor regulation had come out in favour of rotation. Its primary aim was to avoid what it saw as the ‘undesirable cosiness between some firms and auditors’ and to this end the committee argued there was a strong case for the rotation of audit firms every five years.

While a good idea in principle, it is not without problems. Most worryingly, experience in Italy suggests auditor rotation could prove damaging to the standard of corporate governance. Italy is the only major industrialised nation to have introduced mandatory auditor rotation, yet by international standards, Italy ranks poorly for standards of corporate governance and financial reporting.

This view was supported by a study carried out earlier this year, which revealed that while public confidence in quoted companies was improved by rotation, these companies were more likely to be cautioned by the regulator in the first year after appointing an auditor than any other year.

In considering the people element, it is easy to see how rotation of firms could facilitate greater movement of employees. Audit firms have to invest significantly in people to develop niche expertise relating to specific industries in order to work with clients in specific sectors.

Also, working for one client for years enables the team to amass invaluable knowledge on the workings of that company. The likely consequence of mandatory rotation is that when the companies rotate to a different firm, the new firm will seek to acquire as many partners and key personnel as possible from its predecessor in order to tap into their knowledge and relationship base.

In this way, we believe any new legislation will not be wholly effective in changing the status quo of the industry in the sense that companies will still be able to maintain long-running relationships with audit professionals regardless of the firm for which they work.

Rotation presupposes the relationship exists between audit firm and client, or senior audit partner and client. This fails to reflect the reality that many less senior members of the audit team, particularly at manager level, are frequently the key client facing contacts, often being based on client site.

Mandatory rotation will make these individuals more attractive to other firms, holding an important component of the client relationship. In this sense, rotation will stimulate movements at all levels, not just among the upper echelons.

Another consequence of compulsory rotation will be to draw attention to the limited choice of audit firm available to larger companies. Raising the rate of turnover in the closed market of the Big Four will compel those appointing auditors to consider options other than the status quo more often than in the past. The increase in opportunities this creates will make it easier for the mid-tier audit firms to tender for new business and perhaps even go some way towards making significant inroads into this segment of the market for audit services.

This movement of the mid-tier firms into the audit market, traditionally dominated by the Big Four, will impact on those in the industry. Audit partners in large firms, who may be suffering from added work pressures imposed by rotation, could provide the next tier of firms with the experience necessary to capitalise on new opportunities.

Second tier firms can offer employees of their larger peers an office environment lacking, for example, the cultural disparities resulting from mergers that produced the multinational giants of the industry and the internal politics of a large corporation. The second tier could further attract talent by offering former Big Four employees greater financial rewards, a wider range of responsibilities and chance to play a part in the development of the practice. In this way these firms may be able to acquire necessary talent for auditing work with larger companies that was formerly held by the Big Four.

Ultimately, we believe the government will be compelled to address the public anxiety about corporate transparency because it affects confidence in the markets. In Italy, rotation was proven to do this, despite its demonstrable negative effects on corporate governance. So, it seems likely that any future legislation could introduce the mandatory rotation of audit firms in some way.

Whether it requires audit contracts to be periodically tendered, or an obligation to actually change auditor, those in the industry should already be reflecting on how the change will affect the way they work.

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