OPINION - GEORGE M. MANGION | Wednesday, 06 February 2008

Are audit firms over-regulated

The scandals that rocked the accountancy profession show no sign of dying away.
Over the last few years public confidence in the auditing of company accounts was seriously shaken by corporate scandals such as Enron in the US, Dutch retailer Ahold, Italian Parmalat and Societe Generale in France.
In response to these scandals and as part of the preparations for a broader action plan on corporate governance the EU Commission has conducted a number of studies. One such study has concluded four key areas.
These covered the international market for statutory audits of large and very large companies as this is highly concentrated and dominated by the Big-4 networks. As a result of pressures from accounting and corporate governance scandals the EU Commission implemented a new audit directive. This includes inter alia mandatory audit committees at listed companies and the need for compulsory rotation of audit firms on a seven year term. This is a heavy piece of legislation concerning the regulation of auditors.
As members of the EU once this directive is implemented then rotation of auditors of quoted companies at Malta Stock Exchange may start.
In practical terms this means we shall see the banks and insurance companies rotating their auditors like musical chairs among the big four audit firms. Realistically the revised Eight Directive the EC is not seeking to alter the fundamental mechanics of the relationship between the auditors and the market-but merely to ensure that these mechanics are based on high international standards. They are perceived to be more transparent and are subject to greater external oversight.
Independence proposals include auditors being banned from taking up jobs that pose a threat to their independence and from being involved in management decisions in their client firms. It will also stress that audit fees should be adequate as in some case these are low balled on purpose being amply compensated by the provision of lucrative non-audit services.
The proposals are close to be approved by EU ministers and the European parliament yet these provisions have already attracted considerable criticism from senior accountants. But to its defence internal market commissioner Frits Bolkestein said “auditors are our major line of defence against crooks who want to cook the books” so that Parmalat was a reminder of what happens when that defence fails. But if the present heavy risks associated with in the profession continue uncapped then the likelihood of new entrants into this market is very limited in the coming years. Additionally, under the current circumstances, middle-tier firms are unlikely to become a major alternative if a Big-4 network fails. Naturally the risk of a failure is reduced if the authorities agree to a limitation on auditor liability. The possibility of the big four becoming three in the event of another Andersen –style collapse may well be a frightening enough prospect facing the inevitability that no insurance company will take on auditors risks.
On the insurance front one finds that the level of auditor liability insurance available for higher limits has fallen sharply in recent years. The remaining source of funds to face claims may essentially be the income of partners belonging to the same international network. Such a consequence of the resultant failure of a large network could lead to difficult consequences for the wider economy like a significant reduction in large company statutory audit capacity possibly creating serious problems for companies whose financial statements need to be audited.
All this culminates in the post Enron debacle where we witnessed the demise of the then fifth largest global firm Andersen. History has shown us that the Andersen’s case was not the only rotten apple in the barrel. Regulators in various countries must improve public perception to understand the way the accountancy profession is being the most heavily regulated sector. Having said that what safeguards are in place to avoid repeating the recent bad image that the profession received in the past out of the Shell’s overstatement of its oil reserves. The impact on earnings averages around $100 million per year, less than 1% of earnings in the period 2000-2003. The statement follows the completion of a report by Shell’s group audit committee into how the oil reserve figures were overstated and is being accompanied by a review of the company’s corporate governance processes. In Milan the spectre of Parmalat and its subsidiary companies around the world looms large but this pails in comparison with the $4.9 billion black hole in Societe Generale .This was suddenly revealed last month in the nefarious workings of a rogue trader.
The Financial Times revealed Société Générale is to call in independent auditors to examine events leading to the rogue trading scandal. By a twist of faith Societe Generale illustrated the case of auditor’s liability .Turning to the Netherlands the collapse of Ahold illustrates that there could still be scandals lurking in a corporate Pandora’ s box waiting to be unleashed. Seven years ago, Ahold bought US Foodservice, which sells catering supplies to restaurants, schools and prisons. The accounting profession in Netherlands has never had this kind of negative exposure. Critics refuse to draw a parallel to what happened three years ago in America when blowing the whistle on Andersen, it imploded after facing intense scrutiny for its role as auditor of Enron. The Wall Street Journal said that Andersen officials admit the audit documents were shredded after federal regulators requested information.
The key issue identified for the accounting profession, and its clients, to consider is whether to agree to a proportional limit on liability, or a monetary cap. Reputational risk is a bigger issue for auditors, and limited liability does not protect against that. The greatest priority for the business, however, is audit quality and maintaining a healthy relationship with its audit firm, which should be considered before replacing a trusted provider. There is a common misconception that in a corporate collapse when the company, its directors and shareholders may be all be wiped off , the auditors are the only ones with deep pockets. Creditors and litigants then focus entirely on the auditor and seek full compensation from the audit firm . There is also a real fear that unless auditors liability is capped then there will soon be a situation that the big four firms will start refusing risky audit work.
Critics argue against limiting auditors liability yet the stark truth is that auditing some companies may simply become so risky that no audit firm will oblige. Caps on auditors liability have been heavily criticised, with some arguing that they would only be used by firms looking to abdicate their financial responsibility for a dodgy job.
Some audit firms would argue that a cap does not impact on quality or efficiency, but the next question would be where to set the limit. Would you choose an auditor because it offered the highest cap? How does that guarantee, or impinge on the level of quality of the audit? The answer is not easy to fathom but to bolster the credibility gap arising out of recent scandals the Auditing Practices Board in Britain has decided to adopt six new standards on auditing. These cover areas on audit risks, fraud and quality control. The new standards are designed to enable auditors to more clearly focus on areas where there is greater risk of misstatement and increase the linkages of audit procedures and assessed risks. The adoption of the new standards will require some audit firms to make significant changes to their audit approaches. Having seen auditors woes and witnessed the baffling collapse of the supermarket group PriceClub in our midst we act recklessly if we expect that Malta is immune to the scary stories of Societe Generale.

The writer is a partner in PKFMALTA an audit and business advisory firm