Associated difficulties

Andrew Jordan looks at financial reporting and questions the future of accountancy practice-associated law firms following Sarbanes-Oxley

The only justification for the multi-billion dollar auditing and financial reporting industry is the need for clear and reliable financial information as the platform for creditor and investor protection.

It is remarkable how far this simple point became overlooked in corporate America, but it is now being rehabilitated with force.

Weaknesses in US financial reporting requirements were partly responsible for the recent corporate scandals, but those systemic failures are now giving rise to major changes to the structure of financial reporting in the US, through the Sarbanes-Oxley Act 2002.

This is a major piece of securities legislation, and its shock waves are going to ripple out across the Atlantic.

Companies which are household names in Britain have dual listings on the London and New York stock exchanges; companies listed on the NYSE or NASDAQ have important business operations in the UK; and global accountancy firms, now regulated by the new Public Accounting Oversight Board, dominate the auditing of UK listed companies.

Among many other provisions, the Sarbanes-Oxley Act has introduced independence requirements for auditors, which now prohibit accountancy firms from providing certain non-audit services to audit clients with a US listing.

Tucked into the blacklist is the provision of legal services.

A bad tempered debate has been ongoing for some time between the global accountancy firms and the Securities and Exchange Commission (SEC) about what impact the level of non-audit revenues could have on an auditor's impartiality.

The SEC had already introduced auditor independence rules in 2001, but the Sarbanes-Oxley Act tightens those rules in a number of significant areas.

Broadly speaking, the independence rule introduced by the SEC in 2001 prohibited auditors of publicly listed companies from providing US legal services to audit clients.

That prohibition will now extend to the provision of non-US legal services, either by the auditors themselves or their associates.

The fusion of law firms into multi-disciplinary practices never quite got off the ground in the UK, despite considerable pressure from accountancy firms that it should be permitted.

Instead, law firms became 'associated with' the leading accountancy practices.

The new pressures from the US will put the spotlight on these relationships.

Will the 'associated' law firms be allowed to provide UK legal services to US listed companies, or their UK subsidiaries, which are audit clients of their parent accountancy firms?

This issue could affect accountancy-linked law firms in two ways.

Firstly, it could deprive them of a line of revenue in the form of internal referrals from their accountancy parents.

Secondly, and potentially more seriously, where would it leave them if a similar rule were introduced in the UK for the audit of companies listed on the London Stock Exchange?

If the global accountancy firms see their relationships with law firms in the UK and Europe getting in the way of audit fees from some of the world's biggest corporations, there is only one way they can be expected to jump.

Equally, partners in law firms will not be happy if they find that an audit relationship in the US prevents them from working for a valued client.

Sarbanes-Oxley is a milestone enactment because it indicates the direction which future regulatory changes are likely to take.

As the underlying issues are essentially the same either side of the pond, it must represent a significant reversal of whatever momentum there was towards multi-disciplinary practices in the UK.

Andrew Jordan is a partner and head of corporate finance at Nelson & Co in Leeds