Auditing Is Too Important to Be Left to the Auditors!

Clemenceau was right.[1]  Reforming a profession cannot be left to the professionals. A cascade of auditing scandals — in the U.K., the U.S., Europe, and South Africa — has convinced many that reform is necessary. The political reaction has been the most intense in the U.K., where two governmental reports were released last month, each sharply critical of the auditing profession and its regulation. One has called for a new audit regulator that would be financially independent of the industry,[2] and the other by the U.K.’s Competition and Markets Authority (“CMA”) has proposed a number of measures to increase competition within the audit industry (where the Big Four now audit 97% of the FTSE 350 — a clear indication of oligopoly).[3]  Meanwhile, the Labour Party has promised to “break up the Big Four” if it is elected to power.

A number of reform proposals seek one or more of the following: (1) greater restrictions on the provision of consulting services by auditors to their audit clients (in the belief that lucrative auditing services seduce the auditor into acquiescence), (2) greater competition within the industry, or (3) greater governmental involvement in the selection of the auditor.

Sadly, these proposals miss the forest for the trees. As I argue in a recent paper on SSRN, and available here, these reforms address the symptoms, not the disease. The facile assumption that restricting consulting revenues will enhance auditor independence must confront two problems: First, existing rules in the U.S. and Europe already place substantial restrictions on the provision of consulting services to audit clients. Although these rules could be tightened further, we have likely reached the point of diminishing returns in terms of what further rules can achieve. The second and larger problem is the false premise that auditors are compromised simply by the hope for lucrative consulting assignments from their audit clients. The darker truth is that auditors are much more compromised by the desire of corporate managements for a compliant auditor and a deferential and perfunctory audit.[4] In a corporate environment that increasingly compensates senior management through incentive equity compensation, managers may perceive the auditor as simply an obstacle to their enrichment (and the lesser obstacle is to be preferred). The more compliant the auditor, the easier it is to spike the stock price and achieve this goal.

From this perspective, some recent reforms look counterproductive. Mandatory rotation of auditors was intended to protect auditor independence by preventing permanent relationships. But mandatory rotation may actually facilitate the ability of management to seek more frequently the most accommodating auditor (who is willing to face more risk of scandal than its rivals). Similarly, proposals to increase competition will not work if that competition is only for the favor of management. In such an environment, auditors learn quickly that they are in a “commodity business” where they cannot compete successfully based on the quality of their services. Instead, the only rational strategy is to minimize costs, investing little in new technology and preferring lower priced personnel. Oligopoly reinforces this problem, because in an oligopolistic market, a Big Four auditor no longer needs an unblemished reputation, but only one that is roughly comparable to its few rivals. If all the Big Four are involved in a comparable number of scandals, none of them suffers relative reputational loss.

A rational policy needs to recognize these realities. As a starting point, we must realize that although auditors serve investors, they are selected by managements (and the interests of shareholders and managers are not well aligned). The goal of reform should be to make auditors more accountable to investors (and less to managements) — in short, to reduce the agency costs in this relationship. Today, shareholders merely ratify management’s choice of the auditor, and typically this receives only cursory attention. But it is possible for shareholders themselves to select the auditor. The major barrier today is that shareholders do not know enough about auditor performance (and the differences between auditors are opaque to investors).

Thus, a superior strategy for auditor reform should have two elements: (1) the audit regulator should annually grade the auditor’s performance on a client-by-client basis (in the case of public companies) and publish its grades, and (2) a defined percentage of the shareholders (say 10%) should be entitled to nominate a different auditor and place its nominee before the shareholders for a vote at the annual meeting. Neither step is radical. In fact, grades are today given by the audit regulator in the U.K., but the process is far from transparent. Under the U.K. Companies Act, shareholders can appoint the auditor.

Who would respond to this new opportunity? Although it is often assumed that large diversified institutional investors prefer to remain passive, this misstates their preferences. Because of the large number of companies in their portfolios, these institutions are reluctant to become involved in firm-specific disputes, but they do participate and exercise voice with respect to more generic issues of corporate governance that recur across their portfolios. For example, they support shareholder proposals on board diversity, climate change, and basic corporate governance issues, in part because they can follow a common policy. Selecting the auditor represents such a generic issue because, across their portfolios, institutional investors want objective information and could follow a common policy of voting against a poorly graded auditor.

Another class of investors could prove to be the catalyst here. Activist investors (such as hedge funds) are today searching for governance issues where they can present themselves as the shareholders’ champion (and then seek board representation). They are more than happy to play the role of instigator and bear costs. Proxy advisors (such as Institutional Shareholder Services) are similarly ready today to advise shareholders to vote against management’s position, and they deem audit quality to be a leading issue. Thus, if we arm institutional investors with accurate information from the audit regulator and their proxy advisors offer recommendations, proposals to change the auditor will get a receptive hearing from institutional investors.

If shareholders are given a central role, auditors will learn to market themselves to investors. In contrast, proposals to have the audit regulator select or approve the auditor do not have this effect. We have never asked regulators to appoint directors; nor should they be asked to appoint auditors. Only institutional shareholders have the correct incentives, because they want objective, unbiased information. As a general rule, giving power to those with the best incentives works better over the long-run than just trusting the regulator. Sadly, if all that happens from these scandals is that further restrictions are placed on the receipt of consulting income from audit clients, then these reforms will have done little more than re-arrange the deck chairs on the Titanic.

ENDNOTES

[1] Although lawyers will recognize the Clemenceau quotation here paraphrased, I should explain for others that it was: “War is too important to be left to the Generals.”

[2] See John Kingman, Independent Review of the Financial Reporting Council (December 2018). This report — known popularly as the “Kingman Review” — was commissioned by the U.K. government and focused on the U.K.’s audit regulator, the Financial Reporting Council (or “FRC”). The FRC is a private body, without legislative authority, and is financed by voluntary levies on the audit industry. These proposals would make it more like the U.S.’s Public Company Accounting Oversight Board (or “PCAOB”). Sir John Kingman is the chairman of Legal & General Group plc, one of the largest insurers and institutional investors in the U.K.

[3] See Competition and Markets Authority, Statutory audit services market study (updated Paper 18 December 2018). This study recommends that the audit regulator become more involved  in the selection of the auditor and that joint audits be conducted in which at least one auditor would not be a member of the Big Four. It also proposes greater restrictions on consulting by the auditor and some separation of auditing from consulting.

[4] The recent evidence does suggest that clients search for the most compliant auditor. See Mark DeFond, Jieying Zhang, Yuping Zhao, “Do Managers Successfully Shop for Compliant Auditors? Evidence from Accounting Estimates,” (09 January 2019) (Available at ECGI Global Working Papers) (432/ 2018).

This post comes to us from Professor John C. Coffee, Jr., the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.

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