Newsletter | Volume 1

The European Commission is working on a draft regulation that will create audit-only firms in the European Union. This seems to imply that there are flaws in how accounting firms currently operate, or that the regulations are inadequate in the protection of the public interest.

Accounting and financial auditing is a tough and intricate profession that requires strong core analytical skills covering a number of trades and industries and years of training and experience. However, softer skills like ethics, judgment and objectivity are necessary to perform a quality audit in the current complex business world.

It is a paradox how the major accounting firms rely on the exercise of robust governance by independent directors in the companies they audit. It seems that the accounting firms are not willing to fulfill this role because of the conflict of interest with their consultancy services.

In the EU, the Legal Affairs Committee of the European Parliament does not seem support the Commissions' initiative on audit-only firms. The slow and complex legislative machinery will probably take several years to produce any resolution. If a resolution does come, how long would legislation designed to segregate audit and consultancy work before a new definition of consulting services is created?

The 2002 Sarbanes-Oxley act (SOX) limits the kinds of non-audit services American accounting firms can offer to US-listed client already paying for audit services. However, it does not prohibit all consultancy services an audit company can provide. The intent is to protect large accounting firms from grey-area rent-seeking opportunities that auditors are supposed to protect investors and lenders from.

This resulted in the sell-off consultancy businesses by the accounting firms that led to the creation of new companies like Bearing Point, Cap Gemini and IBM. But in rebound, the consultancy component of the major audit companies today is now bigger than ever before.

Too Big To Audit

The "Big Four" accounting firms get bigger (almost) every year. Yet growth in their core business (auditing and the provision of independent assurance) has not been as large or fast as growth in the re-established consulting areas. But given the private status of the Big Four firms, they are not obligated to report their profits as segregated by major service areas. This raises multiple issues of transparency and ultimately, governance that SOX initially sought to resolve.

Revenue from auditing services is not that important anymore. Based on the available 2012 growth in the consulting component of services provided, continues on a double digit trend, whereas the auditing share is stagnant. As the auditing companies are adding consulting staff at twice the rate of audit staff, by 2017 there will be more consultants than auditors-the glove will be more valuable than the hand.

The question that remains: Are audit firms an extension of public oversight authorities and perceived as a "public utility"? Do the audit companies share this assumption anymore?

To ensure European and international uniformity in auxiliary audit services, the following issues should be addressed

The audit firms should undergo the same oversight scrutiny as the pharmaceutical industry: The rules in place when companies wine and dine their clients to keep them happy, keep the account, or win new consulting services should be extended to the audit companies.
When an audit firm threatens to expose an accounting inconsistency, the client should not be able to switch audit firms and/or the manager/partner. Auditors should not have to answer to as why she lost that account. Incentives that promote this behavior need to be established.
In principle audit firms should only perform auditing services. Only this can ensure their independence from their customers. The current positive list should be reviewed for conflict of interests and limited to areas without any direct relation to the annual financial statements and should be valid throughout the EU
If 3 above is not established, then all consultancy assignments are subject to internal due diligence to certify there is no threat of a conflict of interest and sent to ESMA. Firewalls and processes that segregate all consulting activities from auditing are put in place to protect the client, firm and stakeholders.
Audit companies are only be allowed to accept consulting engagements from clients for which they do not provide any audit or other independent assurance services.
When the audit companies reach a certain size, they should be publicly listed.
If a ban on non-audit services to audit clients (e.g. taxation) effectively reduces audit quality and effectiveness by curtailing auditor verification then 3rd party auditors should be brought in.
All non audit services are to be identified in advance and approved in advance by the audit committee.
Finally, Audit companies pay a tax or fee, based on their total revenues, to provide finances to an International "ESMA/PCAOB" who responsible for international guidance, a Code of Ethics and enforcing global auditing standards.

The future of the Big Four's business model and the entire auditing profession may depend on whether lawmakers in Europe and America are convinced that reform is necessary. However, it is not possible for the audit companies to conduct independent audits both professionally and responsibly when the advice processes and documentation and money come from the same source.

Source. CFO.com and The Economist.