By Ben Levenstein, head of UK equities, Universities Superannuation Scheme
Between late 2008 and 2010, 114 European banks received some form of capital injection from governments. Yet all these banks had clean audit reports, often just weeks before going cap in hand to the authorities. Something seems to be wrong with the audit process. We believe structural change is needed in the audit market to restore investor trust in financial statements.
As long term investors, we rely on companies’ audited numbers when taking investment decisions, and as a critical tool for holding executives to account. Auditor independence from company executives is essential to reassure shareholders that the audit is prudent and robust. We believe there are three structural problems that need to be addressed to protect auditor accountability to shareholders. To begin with, shareholders have minimal insight into the audit process. Too often we are told little about why auditors are selected or kept on. Likewise, the key discussions between the auditor, company executives and the audit committee (who are expected to represent shareholder interests) over critical assumptions and risks are rarely disclosed. This lack of transparency means that neither auditors nor audit committees are fully accountable to shareholders. To make matters worse, audit committees often delegate key aspects of audit management to company executives. Where executives are heavily involved in audit firm selection and remuneration, this introduces perverse incentives for the auditor.
Whom should the auditor serve: management or shareholders? Lastly, such conflicts of interest can be exacerbated by the desire of auditors to win lucrative non-audit service contracts from client companies. The incentive to avoid upsetting management threatens the independence and professional scepticism of the auditor, which are so vital to a robust audit process. We are not suggesting that all auditors are conflicted, or that all audits are of low quality. But we do believe that the structural flaws highlighted above raise risks to auditor independence to unacceptable levels. We are not alone in pointing to problems with audit. Regulators in the EU, US and the UK have all initiated reviews of auditors’ failure to ring alarm bells leading up to the financial crisis. Three key actions would strengthen auditor accountability to shareholders and help to mitigate the damaging conflicts of interest described above. First, audit committees and auditors need to be more transparent. Shareholders need to know the critical areas of debate between the auditor and the company, how these were resolved, and what steps are being taken to protect auditor independence. Second, audit committees should ensure that audit firms are rotated at regular intervals, with a maximum tenure of 15 years.
The current system of audit partner rotation, without a change in firm, does not ensure the requisite break with the past. Audit firm rotation should ensure regular and fresh challenge to past assumptions, and offer independent due diligence on the previous auditor. Third, audit committees need to set a limit on non-audit services provided by the auditor’s firm. Auditors seeking to win non-audit contracts from their clients are conflicted. Companies should be free to appoint the best possible service providers, but shareholders also need reassurance that the integrity of the audit is paramount. We suggest audit committees limit non-audit fees to no more than 50% of audit fees, and take remedial actions if this is breached. These three proposals are a package. We believe any implementation costs are likely to be manageable, and far outweighed by the heightened assurance investors would gain over auditor independence and, ultimately, the reliability of company accounts.
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