Jump in auditor resignations points to a year of scandal

When an auditor resigns, it is a bad sign for the company. When there is an 80 per cent jump in auditor resignations, that is more than a bad sign for the market. Remember, auditors do not throw in the towel because they foresee a bad result, not during an economic downturn when every client matters. They throw in the towel when they smell trouble, fishy operations and book-cooking. In the past three months, there have been 54 auditor resignations, compared with 30 in the same period a year earlier. Given that the number of listed firms has remained stable, the rise is significant. That is about one resignation for each trading day. What is alarming is not just the number, but also the who, when and why behind the resignations (see table). Who are resigning? More than 42 per cent of the resignations come from the Big Three, compared with 23 per cent in 2007. Given their high reputation cost, the Big Three tend to be more risk-averse. When did they resign? More than 60 per cent of the tally resigned in December and January, just when audit work was about to begin. Since most companies have their annual result announcement scheduled before April 31, a responsible management will be reluctant to switch auditor at this time. In fact, for sizeable companies or conglomerates, the first phase of the audit process usually starts in August with the designation of the audit team, as well as distribution of audit plans. The audit normally begins in September. A last-minute switch is rare. That is why reappointments are mostly confirmed in June. For smaller companies, taking stock normally begins in late December and the management is supposed to hand over its internal accounts to the auditor in January. The audit work is done in February and March, leaving some time for debate on accounting policy. A change in auditor in January is not an easy call. Why are they resigning? The dominant explanations given are disagreement on audit fees and an annual review by the auditor of their clients. These account for more than 70 per cent of the resignations. Masked under these technical terms is a four-letter word: R-I-S-K. Let's look at the reasons. First, the fees. Sure, given the economic conditions, some managements may ask for a discount from their auditor while small audit firms are offering bargains. But there is an inbuilt inertia to getting a new auditor solely for the sake of price. This is because for limited savings (say several hundred thousand dollars), one will have to spend weeks or even months to get the newcomer to know the business and accounting system, as well as to agree on accounting policies. This is not to mention the negative signal an auditor's resignation carries. That is why when audit firms demanded a more than 20 per cent fee increase during the 2007-08 boom, no one seemed to care much, and there were not many changes in auditors. So it is hard to see why an extra two dozen firms have kicked the auditors out unless there is an overwhelming increase in fees. But it is hardly a time for fees to go up. The economy is depressed. New offerings have almost come to a stop. So has merger and acquisition activity. Then why would an auditor ask for an overwhelming fee rise? Did they locate new complexities that demand more auditing resources - say assigning a value to some currency swap contracts in such a volatile market? Or, did they simply want to scare the client off? 'A 50 per cent rise in fees is always a good way to get rid of unwanted client,' said a retired senior partner of the Big Three. 'This is face-saving for every party.' That brings us to the second explanation for resignations - annual review. Every winter, big audit firms study the professional risk, fees and resources involved in each client and decide which should go. Professional risk is not about expecting a client's profit-making business to turn to losses because of the economic downturn. 'Professional risk is about exceptionally high profit margins, complicated business structures or contracts; or whether the company can continue as an ongoing concern,' said the partner. These are easily exposed when the economic tide goes low. Of course, it is possible to minimise the risk with additional audit resources. But when the fees cannot justify that or the reputation cost is too high to bear, a resignation is the best way to 'cut loss'. The risk is more real with the establishment of the Financial Reporting Council. Instead of the Hong Kong Society of Accountants, the independent statutory council now has the sole responsibility and power of investigating professional negligence. The current economic plunge is the first since the council's establishment in December 2006. 'If a firm collapses, the [council] will certainly come after you,' said the partner. 'You want to stay away from troubles as far as possible.' Having read this far, you should have concluded that you will not need to go to the Che Kung Temple to draw a stick to tell what is going to happen in the Year of the Ox. It will be one dotted with scandals and anger.