IN AUTUMN last year the European Commission published a Green Paper on Audit which has initiated extensive discussion on the responsibilities of auditors, their governance structures and potential changes that may be warranted in this important profession. The EC received about 700 responses with about 10,000 pages of suggestions in reaction to its document. The Green Paper was also a main topic at the Financial Reporting and Auditing conference organised by the EC in Brussels on February 9 and 10. In his opening speech the EU’s Internal Market Commissioner, Michel Barnier, told the conference participants that changes must be made in how auditors do their work so that there is more competition in the auditing business and auditors are more independent. He also presented a plan to prepare new legislation by November to curb what he called increased concentration in the audit market that is dominated by less than a handful of major firms, the so-called Big Four.
The Slovak Spectator spoke with Alica Pavúková, Partner of PwC in Slovakia; Peter Potoček, manager of the audit department of Ernst & Young in Slovakia and Mickaël Compagnon, managing partner of Mazars in Slovakia, about the Green Paper, their opinions about concentration in the auditing business, Barnier’s ideas for legislative solutions and how the financial crisis had impacted audit profession.
The Slovak Spectator (TSS): How do you perceive the statement of Michel Barnier that the auditing business is too concentrated and largely dominated by the Big Four (KPMG, PwC, Ernst & Young and Deloitte)? What is the situation in the Slovak market?
Alica Pavúková (AP): There is concentration in preparing the audits of the very largest companies and financial institutions that are [publicly] listed companies in a number of EU countries. However, there is fierce competition between the four largest players in this segment of the market. There is much less concentration in the auditing market for the next tier of companies.
It should also be borne in mind that the present structure of the auditing market for the largest multinational companies and financial institutions has evolved in response to the need for geographical and specialist capacities to enable these very complex audits to be undertaken – as the companies that are being audited have grown in size, sophistication and geographical reach.
With respect to the situation in the Slovak auditing market, approximately 50 percent of the top 200 companies here are audited by one of the Big Four, according to the annual ranking conducted by analysts of Trend weekly [magazine]. This is connected with the fact that the majority of these companies are owned by multinational groups that have a need for a global auditing firm which has a presence in the same geographical territories as the group. Not many of the audit firms, other than four largest, have such a global presence. These four largest firms compete with each other on a global scale to get hired to conduct these audits. The competition is fierce for the rest of the market in Slovakia and this includes both the large and the smaller auditing firms.
Peter Potoček (PP): While we agree that there are only a few audit firms of sufficient global scale to serve the upper end of the public company audit market, it must be recognised that the large auditing networks have grown to their current size over a significant period of time due to natural evolution and consolidation so that they are able to perform audits of large, complex, multi-jurisdictional companies. The huge investment needed to perform these audits to a consistently high standard world wide – in technology, intellectual property, infrastructure, training methodology, independence monitoring and compliance – has required larger firms to grow and merge their practices both to fund this investment and to maximize possible economies of scale. Breaking up the largest firms would diminish rather than enhance the quality of audits for companies that require the depth and breadth of the resources offered by the largest audit firms. For Ernst & Young in particular, we believe our highly integrated global organisation strengthens the ability of Ernst & Young firms to deliver seamless, consistent, high-quality service worldwide. A breakup, or ‘reverse consolidation’ as the EC terms it, would in our view go in the wrong direction by increasing risk and reducing audit quality to the detriment of investors and companies.
Mickaël Compagnon (MC): The extremely high degree of concentration of auditing firms preparing audits of [publicly] listed companies must be addressed as a matter of priority, not just due to the substantial market disruption that would likely occur if one of the dominant firms were to unexpectedly leave the market but also because of the benefits that would come from a more open and vibrant market. Voluntary market-based initiatives that have been tried in some countries have not yielded the desired results so a new approach is needed.
This should include, in particular: the prohibition of contractual clauses and other institutional biases in favour of the four dominant firms; regular reassessment of audit appointments thereby ensuring that audit committees and shareholders determine whether the current audit meets their needs and to consider the approaches of alternative firms; and the cooperative and global assessment of significant mergers or acquisitions by globally-dominant players that has the consequence of preventing other firms from developing international capabilities that would provide a real and credible choice.
As in each European market, the Slovak audit market is highly concentrated. European companies contributed to the EC Green Paper and they all underlined the need for a more open market and they called for a true competition that will provide a great benefit for firms and their investors.
TSS: How do you view the plan to curb increased concentration by new legislation?
AP: First, ideas for improving auditing services must have as their key objective the promotion and enhancement of audit quality. We strongly support innovations to auditing practice that will improve the quality of audits and ensure the continued relevance of audits to the financial markets and to society.
Second, ideas for changes to the regulatory regime should be well-grounded with data, experience or other evidence that clearly demonstrates how new initiatives will enhance audit quality. Moreover, such evidence must demonstrate that the benefits of proposed changes to audit quality outweigh the costs that inevitably will arise.
We have several ideas such as greater transparency around judgements and inherent risks in financial statements and regular dialogue [by auditors] with regulators of financial institutions.
PP: There is clearly a need for diverse auditing firms of various sizes and scale that match the scale and needs of a wide range of companies. In addition, there must be an absence of bias in the choice of service providers and robust market competition. To foster these objectives, which we believe contribute to audit quality, the public interest is best served by maintaining public company auditing as a private sector enterprise, subject to external oversight by independent audit regulators who cooperate and share information with each other.
In addition, the EC is understandably concerned about concentration and the effects on markets and investors if a large audit firm were to fail. We believe it is important to reduce the likelihood that one of the large firms could be forced to exit the market. Therefore, we suggested that the EC considers encouraging auditing firms to work with their regulators to develop contingency plans as well as developing reasonable limitations on an auditor’s liability which in many countries is the single largest threat to the sustainability of uninterrupted auditing services to the market due to the unlimited and uninsurable nature of the risk.
MC: Mazars warmly welcomed the publication of the Green Paper and the launching of a wide-ranging public debate on the future role of the auditor and the future shape of the auditing market in the EU. We have answered the 38 questions in the Green Paper in a very detailed manner as we believe the construction of a single market for auditing, less concentrated, more efficient, integrated and competitive, is essential to enhance financial stability in Europe and to serve the public interest. We believe that the EU has a role to play in fostering the development and efficiency of a well-balanced global auditing market. This consultation is an opportunity for the EU to assert itself as a robust and competitive part of this new global framework for the auditing market.
In our view, there are two ways to foster progress: by law or by best practices of market players themselves. Both are necessary and complementary. Best practices that are in line with the public interest, in particular with already tested positive impact, should naturally be enacted and generalised. At Mazars, we have made some important choices and thus provided our contribution. These are along the same lines as the propositions supported by the EC: a globally integrated organisation; transparency of financial performance and governance; and an open and vibrant market environment.
TSS: At the conference Commissioner Barnier introduced several ways that the auditing market could be made more open, for example by limiting market shares for auditing larger companies, through the concept of audit partners, or by creation of the ‘European passport’. Which of these do you see as feasible and beneficial to the Slovak market?
AP: We are supportive of the EC’s efforts to enhance cross-border mobility of auditing professionals and we are ready to assist in the development of the practical arrangements of a European passport for auditors as mentioned in the Green Paper. However, this mobility must be accompanied by controls in place to ensure that the auditing professionals practicing in a particular country have the required knowledge of local legislation. Further, this mobility should not be used to escape from professional regulation.
In particular we encourage the EC to also work with other regulators to support mobility of auditors between Europe and other jurisdictions outside Europe. We believe this could be beneficial to the development of auditing capacity by facilitating the exchange of persons to gain and to deploy expertise and specialised knowledge.
We do not support ideas such as limiting market shares for auditing of larger companies as we fear loss of auditing capacity and consequent risk to economic growth and stability.
We consider that the disadvantage of mandatory rotation of audit firms, on the evidence available, outweighs the claimed benefits. We also see disadvantages in compulsory joint audits. Companies currently are free to choose a joint audit but few do so in practice.
PP: In the context of the market for auditing of public companies, the three issues of concentration, choice and competition are quite distinct, though often confused. There is concentration in the upper end of the global public company auditing market, and the number of auditing firms from which to choose may be limited for the very largest companies where the global reach and capacity of the very largest auditing firms are essential. Nevertheless, most companies around the world do not face this constraint because they are not as global or complex in scale. Importantly, even within the upper segment of the market, competition among accounting firms is intense, with firms competing fiercely based on accounting expertise, audit quality, industry knowledge, firm culture, geographic reach, and other factors. In other words, concentration has not led to an absence of competition. Nor does concentration in any way diminish audit quality.
We support efforts to increase the choice of auditor, provided that such measures would not impair audit quality or erode the responsibility of audit committees to appoint the auditor and oversee the audit process. For example, there could be measures to increase the visibility of firms outside the largest networks, giving them the incentive to make the investments necessary to serve larger and more complex companies. Policymakers should consider encouraging audit committees to reflect upon their audit needs and consider a wider universe of audit firms when re-tendering the audit, taking into account the necessary breadth and depth of audit resources. In addition, contractual restrictions that prevent companies from appointing auditing firms outside the largest networks should be prohibited.
MC: We are just at the beginning of the process of creating a truly integrated EU single market in auditing services, a move which will bring benefits to investors, audited entities, auditing firms and the market as a whole. A range of measures is needed to facilitate auditors working more easily across borders as well as initiatives giving firms the opportunity to be registered and supervised on a pan-European basis. Further harmonisation of the requirements governing the relationship between auditors and the entities they audit and the adoption of International Standards on Auditing would contribute to ensuring more uniform audit quality in the single market and a level playing field across the EU.
A ‘passport’ could help, but we do not know for the moment what the requirements will be and the perimeter of it. We do not think that limited market shares would be the right way to enhance competition. We would prefer the implementation of a joint audit which improves the independence of the auditors, the quality of the audit (four eyes are better than two) and allows alternative firms to increase their experience and prove their expertise.
In our detailed response, we suggested a number of practical regulatory measures forming a consistent and pragmatic ‘reform package’ which includes the following: registration and supervision of auditors at the EU level; transparent, regular and fair tendering; prohibition of contractual clauses and elimination of bias in favour of dominant players; progressive and balanced joint audits; rigorous and global monitoring of anti-competitive “up-stream” mergers and acquisitions by dominant players; enhanced governance and transparency of auditing firms; better identification and assessment of risks by auditors; More extensive communication on audit findings and appropriate liaison with supervisors; additional assurance relating to narrative reporting.
On the basis of our commitment to the public interest we believe this will increase transparency and confidence in capital markets, favour financial stability and healthy economic growth and help develop a fair, open and diversified auditing market. It’s true for all markets and also for the Slovak market. For Slovak companies, the increase in competition within the auditing market will be beneficial.
TSS: How did the economic crisis change the auditing market and the role of auditing firms? Did the Slovak experience differ from other countries?
AP: PwC has no doubt that auditing needs to change to respond to the lessons from the crisis. PwC member firms are pursuing several initiatives to achieve this. PwC agrees with the Green Paper's suggestion that the way auditors communicate externally needs to be revisited to improve understanding and raise the awareness of the value added by an independent audit.
Changing the statutory audit report will take time and the most immediate way to give transparency to the audit is through the audit committee’s report, or its equivalent, where there is greater discretion over content.
Our UK firm is already discussing this idea with their clients to see if, working together, they can agree on disclosure of certain matters such as the significant risks of misstatement addressed by the audit and the key judgments made in concluding the audit. Also, our firm in Germany has launched a discussion about how the auditor’s role could be extended to support audit committees in fulfilling these new supervisory obligations.
PP: There has long existed an ‘expectation gap’ between the reality of the role and responsibility of an auditor and the public perception of the auditor’s role and responsibility. As a result of the financial and economic crisis, this expectation gap is being appropriately highlighted and challenged again. When considering potential changes to the governance framework of auditing or the role of an audit, it is instructive to compare the recent economic crisis with the crisis at the beginning of the last decade. The earlier crisis was characterised by a large number of financial restatements and could quite rightly be called an accounting and auditing crisis.
The recent crisis is quite different. It was not prompted by a failure of accounting or auditing but rather was an economic crisis replete with credit and housing bubbles coupled with dramatic fluctuations in asset values. Financial statements generally did not require restatements. But since some financial institutions later ran into operational difficulty or peril, it is legitimate to ask about the value to the market of companies’ historical financial statements and the audits of those statements.
However, particularly as a result of the financial and economic crisis, some have asked whether an audit opinion should (or could) provide a greater level of assurance as to a company’s ability to continue in business, beyond the issue of being a “going concern”, perhaps by increasing the auditor’s focus on a company’s business model, including its future risks and its future prospects.
MC: We all have a responsibility to learn from the recent financial crisis and to accept that 'no change' is not an option for any of us, however uncomfortable that might be.
We recognise that there is a need to seek agreement on the nature and scope of the changes that should be made and while our firms have formed their own views on the way ahead, we have taken the historic step to contribute on the issues where we believe there can be meaningful change that will address concerns and will also enhance the quality of the auditing profession.
We recognise the privilege bestowed upon us by law as statutory auditors and our responsibilities to serve the public interest. We support a review of how audit findings are reported and are conscious of the growing demand by investors and supervisors for more information particularly concerning the identification and assessment of risks. There is also an opportunity to offer a greater level of assurance on the increasingly important narrative reporting, especially regarding the management and governance bodies’ views on the uncertainties facing the business. There is also significant merit in considering the progressive implementation of joint audits or consortia audits (which may come in various forms) in order to strengthen confidence in the audit and improve the diversification of the auditing market.
With these objectives in mind, Mazars looks forward to actively participating in the next steps of this key project for the EU for which, indeed, ‘no action’ is not an option. The EU has an important role to play and it has the capacity to contribute to enhancing global financial stability and fostering economic growth.
28. Feb 2011 at 0:00 | Jana Liptáková