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Audit regime change?

The Commission is concerned that the audit market is uncompetitive (Photo: Luc Deflorenne)

The Commission is concerned that the audit market is uncompetitive (Photo: Luc Deflorenne)

Stephen Nye is a Partner at KPMG Luxembourg and carrying out doctoral research at Manchester Business School, University of Manchester in the international development of professional service firms.

Auditing is changing. On 13 October the European Commission published a Green Paper, “Audit Policy: Lessons from the Crisis”, inviting comment on possible policy changes for organizing and regulating the audit profession. Notably, the paper proposes reducing the audit dominance of the Big 4 firms – Deloitte, Ernst & Young, KPMG and pwc – offering non-Big 4 firms, including the next tier BDO, Grant Thornton and Mazars, a unique opportunity to change their market position. Measures considered include outlawing contractual requirements to use a Big 4 firm, requiring joint audits using Big 4 and non-Big 4 firms, nomination of auditors and fixing of fees by a regulator, the legal separation of audit practices from other activities, mandatory rotation of auditors and even reversing the mergers which created the Big 4 firms. The Commission is concerned that the audit market is uncompetitive and that the failure of one of the Big 4 would be a systemic risk to the European economy. Discussion of the various proposals will be animated and inevitably there will be compromises but EU Commissioner Michel Barnier’s position is clear: “The status quo isn’t an option”.

Vested interest?

The Big 4 will no doubt vigorously defend their position and some will accuse them of fighting for their vested interests. Yet the issues are genuinely complex. In a recent book,“The Financial Crisis: Who is to blame?”, Howard Davis, Director of the London School of Economics, identifies 38 possible causes of the Financial Crisis ranging from economic to ethical by way of Lara Croft video games (read the book). Davis eliminates a few and claims that others had little or no impact but his concludes that the crisis arose from an intricate combination of numerous political, economic, behavioural and other factors. The crisis had no single cause and there can be no simple solution to prevent it happening again. Audit only plays a minor role in Davis’s account and perhaps the problem is more whether audit remains relevant in its current form rather than whether auditors were complicit in the crisis. There is no point in instituting auditing reforms for the sake of reforms or for ideals of perfect market competition if they don’t in practice improve the quality and value of auditing.

5,000 people in Luxembourg

What’s at stake for Luxembourg? In terms of employment and economic impact alone, nearly 5,000 people in Luxembourg work in the Big 4; a significant contribution to the economy as service providers, tax payers and consumers. Audit is also critical to an effective system of economic accountability and regulatory control. At a time when Luxembourg’s regulatory and governance regimes are under intense international scrutiny, changes in the way that audit is structured have significant implications for Luxembourg’s attractiveness and reputation. Traditionally, auditors are caricatured as conservative and resistant to change (although they tend to do rather well out of new regulations) but evolution in the ways that audits are organized and carried out is inevitable. In a recent speech, John Griffiths-Jones, joint chairman of KPMG Europe, recognized “a defining moment for the audit profession” said of the need for debate at the European level “I have to say, I agree. In fact I positively look forward to it.”

External regulation by the CSSF

So not only auditors will be affected. For example, a challenging move from self-regulation by the audit profession to external regulation by the CSSF is in its first year.  Under the reforms, the CSSF could be required to take on vastly increased responsibilities for controlling and reforming the audit profession at a time when it is already stretched. Not all of the proposals will be enforced. Reversing the mergers that created the Big 4 seems impossible. The first big merger between Peat Marwick and KMG to create KPMG occurred over 20 years ago. Following the collapse of Arthur Andersen, national practices merged with different firms in different countries or regions and it’s difficult to see how this process could possibly be reversed. However, simply raising such possibilities illustrates the Commission’s ambition. Any measures taken will bring challenges for the Luxembourg economy, its regulatory model and institutions and international image.

Barnier Green Paper

The Barnier Green Paper is open for comment until 8 December 2010 followed by a conference on 10 February 2011 to examine the reactions. Discussions among the interested parties and lobbying will certainly water down the most radical proposals in the Green Paper. But the Commission is determined to bring in changes and even the least contentious proposals involve major changes for the audit profession. Facing previous reforms, the audit profession was usually able to speak with one voice as the interests of all firms of all sizes were similar and lobbying efforts were broadly successful. In the past, the Commission was broadly sympathetic to the auditors; the Big 4 was seen as part of the solution rather than part of the problem. (Barnier’s predecessor as Commissioner for Internal Markets and Services, Charlie McCreevy, is himself a Chartered Accountant). This time is different. Many proposals target changing the balance between the Big 4 and the smaller firms. The non-Big 4 have a huge amount to gain from the proposals and won’t fully endorse the position of the Big 4. The background of the financial crisis lends urgency of the Commission’s initiative sand makes reforms inevitable. This apparently dull Green Paper could produce the most dramatic changes in the auditing profession for decades and another challenge for Luxembourg’s institutions.