Gary Gensler Has an Auditing Problem

Bookmark

Gary Gensler has a jumbo to-do list as he settles into his role as chair of the U.S. Securities and Exchange Commission. Here’s an important addition: Prevent high-earning audit partners from being beholden to the managers of the clients whose accounts they scrutinize.

The independence of auditing is central to the proper functioning of markets. It’s a key principle underlying the 2002 U.S. Sarbanes-Oxley Act that was introduced in the wake of the Enron scandal. The aim is to prevent executives dodging scrutiny by meddling with the audit process. While rules vary by country, the general approach is to have a subset of the board form an independent audit committee that oversees the work of an external auditor. For example, SOX, as the U.S. regulation is known, says this committee should be “directly responsible” for hiring and firing the auditor and setting the fees.

The primacy of the audit committee in theory addresses the potential conflict in the arrangement: the fact that the external audit firm has an economic incentive to retain what is often a highly lucrative contract. If a company’s audit committee is calling the shots, the auditor will be judged on the quality of the accounts. But if the executive managers get involved, they may prefer an auditor who doesn’t rock the boat.

Unfortunately, management can and does still influence the selection of audit firms and the individual partners who work on the numbers — even if audit committees have final sign-off.

The U.K.’s 2019 anti-trust probe of the accounting profession warned that management played a “significant role” in the audit tender process. “Chemistry” with the executives was even used as a selection criteria.

It’s the same story in the U.S.

“The audit committee often delegates responsibility to the management. Then the decision comes back to the audit committee for ratification,” says former SEC Chief Accountant Lynn Turner, who penned a white paper on reform last year. “Firms often will propose a new partner, who will be interviewed with the management team. They put forward people who'll get on with management.” 

Where there’s an opportunity to influence the choice of lead partner, management teams have a vested interest in nudging the audit committee to pick individuals who come over as agreeable and like-minded. Chosen in such circumstances, that person is inevitably in a position of implicit gratitude to management.

SEC rules appear to guard against favoritism by requiring that the lead partner is “rotated” at least every five years. But if management gets to influence the choice of successor, with the audit committee merely rubber-stamping the selection, the dynamics are perpetuated. Moreover, a client may be able to force an early rotation in the event of disagreements. The risk is the unscheduled change gets glossed over as a personality issue, even when it may involve a more substantive accounting dispute.

Doubtless the average audit committee takes its responsibilities seriously, and the audit profession includes robust partners who stand up to their clients. SOX is widely regarded as a success. But that doesn’t mean oversight can’t be improved. The economics and personal dynamics put a lot of pressure on individual partners to keep management happy. In the background, the risk of being booted off a well-paid account, or losing it for the firm and getting sidelined, loom large.

One reform would be to make it explicit how and when audit committees can involve executive management in audit firm and partner selection — if at all. Another would be to require formal disclosure if partner rotation happens early, with both sides providing separate written explanations to the regulator. 

These moves could go in tandem with strengthening the financial acumen and resources of the audit committee.

Even then, greater punishments for lapses in independence would also help. Anup Srivastava, Canada research chair in accounting at the Haskayne School of Business at University of Calgary, is wary of placing expectations on audit committees that are too high, given the competing demands on their time and attention, and the challenges of keeping up with changing accounting standards.

“There should be materially significant financial penalties, reputational impact and temporary disbarment from the profession, to act as deterrent against future misdemeanors,” he says.

Having a regulator appoint the auditor would deal with the conflicts once and for all. This was floated in 2018. Perversely, the U.K. investment community nixed it despite it being clearly in their interest.

As things stand, the U.K. is proposing that its accounting supervisor imposes additional requirements on audit committees relating to auditor selection. Consultation as to precisely how is ongoing. It’s critical the government follows through. The fallout from the collapses of Greensill Capital and Wirecard AG should focus minds.

As for Gensler, the issue should matter a lot. He was a senior advisor to U.S. Senator Paul Sarbanes, the co-architect of SOX. Now he’s in a great position to ensure the regulation truly works as intended.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Chris Hughes is a Bloomberg Opinion columnist covering deals. He previously worked for Reuters Breakingviews, as well as the Financial Times and the Independent newspaper.

©2021 Bloomberg L.P.

BQ Install

Bloomberg Quint

Add BloombergQuint App to Home screen.