June 01, 2007

Governance Imperative: Auditor Choice

JULY MARKS THE completion of my 34th and last year as a partner at Grant Thornton, and the end of my 40 years in the public accounting profession. It also marks the fifth anniversary of the signing of the Sarbanes-Oxley Act of 2002. Much has taken place during my four decades in the profession, but the five years since the enactment of SOX have been the most dramatic. The accounting scandals and audit failures that rocked the capital markets and brought on the demise of Arthur Andersen in 2002 undermined confidence in financial reporting and seriously damaged the capital markets. It would be hard to overstate their impact.

Empowerment Redux
Perhaps the most significant change to emerge from the SOX legislation has been the vigorous empowerment of audit committees to fulfill their responsibilities. There is now more recognition of the special covenant among all stakeholders— audit committees, auditors, and investors. That covenant is fundamental to ensuring the underlying integrity of financial reporting and the capital markets, as well as to investor confidence.

SOX augured a paradigm shift in the audit profession generally and financial reporting particularly. Government regulators designed all of the SOX accountingrelated changes to shore up financial reporting, internal controls, and the oversight of external audits. New legal requirements, the threat of punishment, public outcry, elected official challenges, capital market pressures, mounting litigation, and increased director liability—all have led to a frenzy of activity and concern.

Unfortunately, not all of it has been efficient or effective. The communication between auditors, audit committees, and management has been strained. Companies complain about mounting costs and shrinking service. The expanded work SOX required was further compounded by an undersupply of capacity, especially among the four largest firms. Unable to meet the expanded workload, audit firms went through a triage of client retention, focusing on the largest and most profitable ones and either resigning from, or in some cases underserving, the rest.

At the same time, audit committees began to embrace their newfound legal authority to hire and oversee the external auditor. They wanted to select the firm they thought was best aligned with the needs of the company, and not just continue to work with the one they had inherited. Today, committees actively seek auditors that can provide the best combination of quality, service, value, and reach. Forward- thinking committees are now beginning to look beyond the Big Four and carefully consider the full continuum of audit-firm choice, including shifting to specialist firms for nonaudit work that technically may be audit-related.

Which begs the question, are there enough qualified auditing firms to choose from? This is a valid inquiry given the level of concentration of the Big Four. This concentration poses significant risks to the capital markets, a problem increasingly recognized by regulators and the accounting profession at large. Such concentration is neither desirable nor necessary. While for the most part only the Big Four have the capacity to serve the very largest multinationals, the reality is that for the vast majority of public companies, other qualified firms can and would do a superb job as their auditor.

In response to audit committees' growing demand for more choices, the accounting profession is reshaping itself. Larger firms are exiting smaller cities where they no longer have enough large multinational clients to maintain a profitable office, and smaller regional firms are taking their place. On a parallel track, we are seeing another round of consolidation, as the smaller national and regional firms merge to respond to these new opportunities.

Nonetheless, a major factor that causes resistance to this much-needed restructuring of the client/ audit firm universe is that auditor change is still perceived as a negative event in less-informed circles, particularly by those in the media and on Wall Street. We need to educate and encourage companies and other capital markets stakeholders to accept more audit firm choice and to be aware of the variety of logical reasons for making such changes. In certain cases where change is required, misperceptions in some segments of the capital markets still exist that constrain audit committee choice to the Big Four audit firms.

William McDonough, the former chairman of the Public Company Accounting Oversight Board, said that his agency was encouraging issuers to "really look for an audit firm that makes sense. There's been sort of a notion that rating agencies and maybe your lenders will think it's particularly spiffy if you're a small or medium-sized company and you deal with a Big Four firm. Frankly, I don't think that makes a whole lot of sense."

Avoiding Failure
If we do not continue to build a more broad-based public accounting profession able to audit public companies of all sizes, we run the risk of not having a sufficiently robust profession to absorb the shock of another large potential audit firm failure. This responsibility falls equally upon the markets, companies, regulators, and the auditing profession.

Although audit committees have increased their involvement in the audit process, investors are still not well-informed about committee activities, especially auditor changes. Currently, companies are only required to disclose whether an auditor was dismissed or resigned, whether there was a disagreement or reportable events, and whether prior audit reports contained an adverse, disclaimed, qualified, or modified opinion. In all other cases, investors are left to openly speculate as to why the committee made the change. Since less than 10 percent of those who switch auditors report these negative conditions, it is time to update out-of-date 8-K rules to provide more insight for investors and the markets.

We have the opportunity to create an environment where better-educated audit committees, with increased choices among qualified audit firms, beget more sophisticated buyers of audit services. Long-needed regulatory changes would encourage buyers of audit services to make more effective decisions.

And lastly, a reporting process that provides investors with the necessary insights into auditor change would reinforce that the sacred covenant between the audit committee and the auditor is protected and working on their behalf.