This article was first published in the May 2012 China edition of Accounting and Business magazine.
Accountancy firms in Asia Pacific are distinctly unenthusiastic about the Public Company Accounting Oversight Board’s (PCAOB) Concept Release on Auditor Independence and Audit Firm Rotation.
In its letter to the PCAOB, CPA Australia opposed mandatory audit firm rotation due to a lack of clear evidence of the audit quality improvement that would result. The Japanese Institute of Certified Public Accountants said that mandatory audit firm rotation would make it difficult for audit firm personnel to gain specialised knowledge and experience in specific industries or areas and may also result in low-balling of audit fees, while increasing audit costs.
The Hong Kong Institute of Certified Public Accountants (HKICPA) is also against the system, as noted in its submission to the European Commission’s (EC) green paper on audit policy back in December 2010 and subsequent views on the PCAOB’s concept release.
‘There is nothing to suggest that mandatory rotation actually increases auditor quality,’ says Chris Joy, executive director of the HKICPA. ‘Our view is that the quality of audits is absolutely paramount and anything that might detract from audit quality is not a sensible move.
‘Simply put, we do not favour mandatory rotation. There are very few jurisdictions where it is required and I am aware that in places where it has been implemented it has been quietly dropped some years later. Basically, it doesn’t work,’ he says.
The evidence against mandatory rotation isn’t hard to find. The most widely quoted study is one from 2003 by the SDA Bocconi School of Management in Italy. It found that the practice increased concentration in the audit market and had a negative impact on audit service costs while increasing startup costs and decreasing audit fees.
Similar results emerged in a 2010 paper by academics from Hong Kong’s Lingnan University, the Chinese University of Hong Kong and the Central University of Finance and Economics in Beijing. They used data from China, which has a two-year cooling-off period, and found that audit partners with a lengthy partner-client relationship were more likely to rotate back to their former client. Furthermore, the rotation back of audit partners was associated with weakened audit quality in the second year of the cooling-off period.
As if this wasn’t enough to seriously undermine the sagacity of the proposal, the majority of firms don’t want it. To date, 96% of submissions received from the profession oppose mandatory rotation.
In Hong Kong, the majority of firms agree with the HKICPA, lending their support to broader regulatory concerns about mandatory rotation. At KPMG International, for example, Hong Kong-based global chairman Michael Andrew says that the proposal would drive audit costs up in the long term and decrease audit quality.
‘Companies might be prepared to sacrifice quality for cost. Equally, if a firm can only do the audit for a set period and can’t get any other services it may as well reprice the audit because its ability to achieve proper margins and utilisation may be compromised. I suspect it would drive down costs in the short term but increase them in the longer term. It will also increase costs for the company transitioning the auditor because it will also have to change its internal auditor, valuer, actuarial consultant, maybe even its tax adviser,’ he says.
In terms of the impact on choice of auditor, Andrew highlighted the very real possibility of a greater concentration of audit firms in the marketplace. ‘The larger firms have more financial clout. Auditors may become circumspect about whether they take on some of these audits. If they’re doing significant work elsewhere economics may dictate that it’s better not to take on another audit, which is a relatively low-margin, high-risk exercise.
‘The overall impact of this being imposed could be significant. We’ll lose some audits and gain others but there’s a huge cost to doing this. Tendering for an audit is an expensive process. It ties up time in terms of the management, the company and the auditors. It’s hard to see the merits or the advantages or even the problem that this proposal is trying to redress,’ he says.
In some respects, the profession needs to take a step back and determine the objective of mandatory rotation in order to tackle the bigger question of how to improve audit quality in the post-global financial crisis world. It is two-fold: first to deal with the risk of over familiarity, that audit firms working for a client over a number of years will lose their independence; and second, that by rotating the audit firms, this may provide more opportunities for the mid-tier firms.
To address the first objective, the issue of auditor firm independence, there is already a requirement for listed companies in Hong Kong to rotate the audit partners under the code of ethics in the Hong Kong Standards on Quality Control. According to Albert Au, chairman of BDO, that is a more effective way of reducing familiarity threats than mandatory rotation.
‘Mandatory rotation increases the costs of an audit and also could inadvertently affect the quality of the audit itself, particularly for a large multinational client with complex businesses. Just to take on a client of that size and complexity would mean that an audit firm would have to put in substantial investment in terms of educating its people and gearing up resources. If you were then to impose mandatory rotation in a six-year cycle, which is what the EC has put forward, this is too short for any efficiencies or knowledge to kick in,’ he says.
To provide mid-tier firms with more opportunities, Au notes that BDO’s experience in jurisdictions where mandatory rotation is imposed was that it had seen a greater concentration of business in the hands of the Big Four firms. ‘For a large audit client to get rotated out of BDO the chances are the business will then go to a Big Four firm. But for a Big Four audit client being rotated out the chance is smaller that the business will then go to a mid-tier firm. Our experience is that we suffer a net loss of large clients,’ he says.
Swimming against the tide
One firm, however, has come out in support of the proposals. In a letter to EC president José Manuel Barroso and EC commissioner Michel Barnier, RSM International expressed support for reforming the audit profession, stating that the proposals will ensure more competition in the industry if the extent of external auditor concentration at the top of listed company markets is reduced. The network said more action is needed to reduce the market share of dominant audit networks and maintain regular, fair and transparent tendering as well as joint audits to include non-Big Four participants.
Should the proposal move ahead in Hong Kong, the territory would likely look to mainland China for guidance, as mandatory auditor rotation for financial institutions and some state-owned enterprises has already been implemented. Furthermore, China’s Ministry of Finance is understood to be propagating rules that may require mandatory rotation for the very largest publicly listed companies. This may add to pressure on Hong Kong to align with capital markets over the border despite the fact that few in the territory are clamouring for it.
‘In Europe, most of the economic studies carried out on the proposals demonstrate that it’s detrimental to the economy not advantageous,’ Andrew says. ‘The only people who seem to like it are politicians and academics. No one in business, not many regulators and not many auditors think it’s a good idea.
‘The major audit firms have suggested a number of positive steps that are much more meaningful in terms of addressing the issues: for example, working more closely with prudential supervisors and being prepared to audit the assurance investor information, risk models and critical KPIs that an investor needs. This mandatory auditor rotation proposal misses the point of how to improve audit quality. I call it a lost opportunity.’
Kate Watson, journalist