Breaking up Big Four ‘oligopoly’ is regulators’ goal.
LONDON (Reuters) – The world’s top four audit firms will have to split up and rename themselves under a far-reaching draft European Union law to crack down on conflicts of interest and shortcomings highlighted by the financial crisis.
“Investor confidence in audit has been shaken by the crisis and I believe changes in this sector are necessary,” Internal Market Commissioner Michel Barnier said on Nov. 30.
The big auditors said the plans would bump up costs and would not improve audit quality, while smaller rivals accused Barnier of a climbdown.
Policymakers have questioned why auditors gave a clean bill of health to many banks which shortly afterwards needed rescuing by taxpayers as the financial crisis began unfolding.
Barnier said recent apparent audit failures at AngloIrish and Lehman Brothers banks, BAE Systems and Olympus “would strongly suggest that audit is not working as it should”.
More robust supervision is needed and “more diversity in what is an overly concentrated market, especially at the top end”, he said.
Just four audit firms — Ernst & Young, Deloitte , KPMG, and PwC — check the books of 85 percent of blue-chip companies in most EU states, a situation the Commission said was “in essence an oligopoly”.
UK data shows the Big Four profit margins are 50 percent higher than the next four audit firms, the commission said.
Under Barnier’s plan, the four top firms will have to separate EU based audit activities from non-audit activities, such as tax and other advisory services — “to avoid all risks of conflict of interest”.
Rebranding
There would have to be legal separation of audit and non-audit services if over a third of revenues from auditing comes from large listed companies and the network’s total annual audit revenues are more than 1.5 billion euros in the EU.
Claire Bury, one of Barnier’s top officials, said these conditions, if approved by EU states and the European Parliament, would alter all the Big Four’s business models and even one or two of the next tier down in some member states.
“They will have to change names as well. I suppose we will have branding issues at the end of the day,” Bury told a press briefing.
KPMG’s European head Rolf Nonnenmacher said: “The capability of firms to provide quality audits will be diminished if auditors are separated from wide-ranging advisory expertise including, crucially, risk management in the financial sector.”
PwC’s UK Chairman Ian Powell said Barnier has not provided “any concrete evidence for any positive impact of these proposals on audit quality or properly assessed the additional cost burdens for business.”
Deloitte said the plans would create an audit regime in Europe inconsistent with those in other markets while Ernst & Young said they would have minimal impact in preventing future financial crises.
The Commission said it was difficult to quantify the costs.
Public tendering of audit work by listed companies would be compulsory and include consideration of second-tier auditors.
Commission officials indicated that as the measure dealt with major structural reform of the market, the industry would need time to adapt but they hoped the new rules would be in place within three to five years.
“It’s not something that can be rushed through,” Barnier’s spokeswoman said.
EU states and the European Parliament will have the final say on Barnier’s draft law, a process that involves haggling and likely changes.
BDO, one of the next tier audit firms, criticised the Commission for ditching mandatory joint audits following “lobbying and extensive influence of the largest firms”.
“The remaining proposals appear to be worse for the market than no proposals at all,” senior BDO audit partner James Roberts said.
Rotate
Barnier, under pressure from some fellow commissioners, dropped at the last minute a key element of his plans — mandating “joint audits” of listed companies as a way to improve audit quality and help smaller auditors have experience of checking the books of big companies.
Instead, he has tried to introduce incentives to encourage joint audits by finessing another part of the measure — the mandatory switching or rotation of auditors.
A sole auditor would only be allowed to audit the same firm for up to eight years but, if a joint audit was being done, this mandate could be extended up to 12 years.
An audit firm would not be allowed to offer non-auditing services, such as tax and other consultancy services, to a company it is auditing.
UK accounting body ACCA said both elements will be hard to implement and could prove counter-productive.
The EU plan also bans so-called loan covenants whereby banks lend money to companies on condition they are audited by one of the Big Four.
The UK Competition Commission is already probing the sector and regulators in the United States are looking at audit firm rotation as well.
Kyiv Post: Do you expect the European Union will adopt the draft law that proposes to split up big auditors and crack down on conflicts of interest as well as shortcomings highlighted by the recent global financial crisis?
Alexei Kredisov: I don’t think this law will be adopted in this strict formulation, demanding separation of auditing business from non-auditing. I do, however, expect a dialogue on this issue to be conducted openly and behind-the-scenes. And I think some kind of oversight and monitoring will be introduced to decrease the potential of dependency of auditors on clients.
KP: Are such proposed legislative changes necessary?
AK: It would add a new layer of control to keep auditors independent. It is needed for two reasons. We know sometimes that scandals happen, when it is revealed that an auditor did something wrong. So, some oversight is needed.
Alexei Kredisov, managing
partner of Ernst & Young in Ukraine
The second reason is public expectation. Stakeholders, investors, companies, analysts and regulators expect something to be done. It’s not a secret that [global] financial systems have been causing trouble as of late. Something needs to be done.
KP: How could such EU legislation influence Ernst & Young’s Ukraine office, it’s more than 500 employees and clients?
AK: For good or bad, we are not in the European Union. Much depends on how it will influence our companies in the EU. It will make an indirect impact on our Ukrainian office.
For example, if some mandatory staff rotation will be implemented in Europe, in which the staff will have to rotate every five or 10 years, this will also affect our business in Ukraine.
Or, for example, if the rule of joint audit is to be implemented, one not two audit companies will be required to perform an audit. In such a scenario, Ukrainian companies headquartered in the EU will have to apply this rule for their affiliates in Ukraine.
Kyiv Post: Do you expect the EU will adopt the draft law that proposes to split up big auditors and crack down on conflicts of interest as well as shortcomings highlighted by the recent global financial crisis?
Andriy Bulakh: It was our understanding that the European Commission is due to publish its proposals on changes to audit regulations late this year, following the European Union Green Paper on Audit Policy entitled “Lessons from the Crisis,” which was issued last October.
Andriy Bulakh, partner in
Ukraine for Deloitte
The ultimate passage of final proposals is a lengthy process with ample opportunity for all stakeholders to inform and impact the ultimate outcome.
KP: Do you believe such legislative changes are necessary?
AB: Deloitte is firmly committed to supporting measures that would sustain and enhance audit quality and build confidence among investors and other stakeholders. This includes proposals that would enhance independence, as well as measures that would contribute positively to the capital markets and support economic growth.
But we do not support certain matters that have been discussed such as joint audits, mandatory rotation and tendering, and a complete ban on non-audit services. We are steadfast that any changes to the audit market must not be detrimental to audit quality and should not harm the capital markets or the critical focus on economic growth.
In addition, we believe that the costs of any proposals for audited entities should not outweigh the benefits derived from improved audit quality and auditor choice.
