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Audit probe holds back from serious reform

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22nd Feb 2013
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Update: The Competition Commission concluded that the domination of Big Four accountancy firms has an adverse effect on competition in the market for listed company audits.

The long-awaited provisional findings into the audit market was released at 7am on Friday 22 February and found a lack of effective competition that encourages corporate auditors to focus more on the interests of the managers who appoint them than the shareholders they are supposed to serve.

Recommended remedies

1. Mandatory tendering

2. Mandatory rotation of audit firm
3. Expanded remit and/or more frequent audit quality reviews
4. Prohibit ‘Big Four only’ clauses in loan documentation
5. Strengthen accountability to the audit committee 
6. Better shareholder-auditor engagement; and
7. Extended reporting requirements.
Source: Competition Commission remedy notice

The latest report is a major milestone in a 16-month probe that was set in train by a critical report from the House of Lords economic affairs committee in 2011. 

After poring over research documents, surveys and evidence from its own enquiries, the investigation team concluded that Big Four firms hold most of the big company audits, and that these organisations rarely change auditors.

"Essentially we identified two clusters of issues," audit investigation chairman Laura Carstensen told AccountingWEB. "The first was 'stickiness' and propensity of companies not to switch auditors and adverse issues that can result. And the second was to make sure auditors are more squarely aligned with what shareholders want."

The adverse effects of concentration of listed company audit work in so few hands include higher prices, lower quality and less innovation and differentiation than would be the case in a more open market.

This determination will come as little surprise to anyone who has worked in the profession or who has read the audit market investigation evidence published so far. If their conclusions are somewhat underwhelming, this is partly due to the project structure. With the initial findings now published, the investigation will move into its remedies phase, and seek feedback on proposals for regulatory reforms to address the audit market’s underlying problems (see box above).

Lack of competition also carries the risk of auditors being insufficiently independent from executives and insufficiently sceptical of their attempts to present the accounts in the best possible light. But when it looked into the potential for the provision of non-audit services to corporate audit clients, Carstensen's team did not find evidence of any problems.

She acknowledged the commonly held belief that "bundling" can compromise independence, but answered. "We didn’t find evidence, so our remedies didn’t address problem that we didn’t find."

The recommended remedies themselves hold few surprises, nor it might be said much to frighten the big firms. In several instances, they build on reforms and guidance that have already been put in place.

They start with mandatory rotation and tendering of audit work, either every five or seven years - with views sought on the advantages of seven, 10 and 14 years. A revision to the Combined Code for corporate governance effective from last October already requires FTSE 350 companies to put their audit out to external tender every 10 years, but the Competition Commission team concluded greater frequency of tendering may be required to address effectively the lack of market competition.

More frequent tendering should be mandatory, and the investigation team do not favour the "comply or explain" approach adopted by the current cod, "as this may undermine compliance with this remedy". In some instances, thought, the team can see a need for a mechanism
for the FRC to let companies off the requirement to switch auditor.

The recommendations also include "open book" tendering that would give firms pitching for the work access to the incumbent auditor's files to give prospective auditors a better understanding of the company’s control environment and audit issues.

Faced with evidence that finance directors frequently control the relationship with external auditors - and exert pressure to keep surprises away from audit committees - the Competition Commission wants to limit their role in selecting and appointing auditors to "the minimum necessary". The proposed remedy is to give responsibility for tendering and negotiating work and fees to audit committee chairs, making them "solely and unambiguously" the client of the audit engagement partner.

The suggestions to enhance shareholder-auditor engagement include propsals to let shareholders call for an audit tendering process. Audit engagement partners may also have to make presentations to shareholders at AGMs and hold open Q&A sessions on the conduct and outcomes of their audits.

Compared to these fairly minor adjustments, mandatory rotation forms the bedrock of the recommended remedies, yet critics have argued that it could end up strengthening the big firms’ monopoly of listed company audits if rotation just meant companies moved their audits from one Big Four firm to another every few years.

However Grant Thornton, the UK's number five accountancy firm, welcomed the findings and put out a statement this morning voicing hope that the probe would lead to "an appropriately balanced package of remedies" that would improve market diversity and assist firms such as Grant Thornton to accelerate their expansion in this market."

Carstensen made it clear that her team’s terms of reference did not extend to proposing a radical overhaul of the profession, and emphasised that the provisional findings were just one step of a continuing, and open consultation process.

“This is the Compettion Commission and the job we’re given is to idenitify if there is a competition problems and then to identify what remedy would be proportional to address those problems,” she said.

“I think we’ve come up with a number of novel points, particularly to give shareholders more visibility.

“Once you get a more contestible market with less security of tenure and more access for shareholders to express their demands, you should get from that process an adaptation of pricing, quality and service. We’re not in business as the Competition Commission to give anyone a leg up, but to open the door so people able to pitch for work get more opportunities to do so.”

Interested parties have until 21 March to submit their comments and alternative suggestions to the investigation. These responses will be collected and digested over the summer, with the final deadline for deciding any statutory action set for October 2013.

If the provisional findings contain few surprises, the material gathered during the investigation should hold some interest for students of the internal practices of firms at the top end of the market, including:

  • Summary of provisional findings
  • Notice of possible remedies
  • A survey into the strength of competition for audits at FTSE350 companies that found that they put tenders out and switch auditors infrequently, and as a result have little evidence to assess the value they are getting for the fees paid; 40% of these companies would not consider an auditor other than one of the Big Four firms,
  • Responses to investigation working papers 
  • independent reports commissioned from outside. , but does not give many clues as to which way the enquiry will go with its recommendations. The FTSE 350 survey, for example, 
  • The majority of FTSE 350 companies surveyed did not consider their choice of auditor to be limited to the Big Four firms, this was the case for around 40%.
  • A study of inertia and conflicts of interest published last October that found 66% of finance directors/chief financial officers surveyed had previously worked for one of the Big Four audit firms, and around 60% of audit committee chairs.
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Replies (7)

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By Steve-EBL
19th Feb 2013 13:04

Audit Lottery System

I think stakeholders will benefit from some increased objectivity whilst auditing large companies financial statements.

Some massive companies globally have gone unexpectedly bust over the last decade or so, overseen by esteemed auditors, so there is no doubt there is a problem.

We are all stakeholders, whether it be with ensuring they pay the correct amount of corporation tax (fake provisions and accruals are rife), or for example if the man on the street is investing either directly or through pension schemes.  Of course employees, if the directors are being wreckless, they need replacing and not surviving by tweeking the books until its too late.

I think a firm of qualified accountants that has competence and resources to fulfil an audit should once approved, join my proposed audit lottery scheme idea, a bit like ERNIE (new acronym meaning pending) they would be randomly assigned to a 3 year engagement; dependant (a bit like a dating website) on meeting clients specified key requirements, and perhaps even stating if a menage a trois would be considered. 

If generally all audit firms are competent, and all auditors are members of ICAEW and such, what has anyone got to hide (except their wealth).

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John Stokdyk, AccountingWEB head of insight
By John Stokdyk
22nd Feb 2013 11:12

ICAEW: 'Don't undermine audit'

ICAEW chief executive Michael Izza released the following statement on the morning the Competition Commission provisional findings were published:

“This report, in reinforcing the importance of audit to maintaining confidence in capital markets, is a timely reminder that it can only be effective if wider shareholders as well as investors and management engage effectively with the auditors.

“Whilst the Competition Commission has found no evidence of anti-competitive behaviour amongst the Big 4 firms, it has identified a number of areas where more can be done to increase competition and choice in the audit market for the UK’s largest companies.

“It is important to see this report in context. The UK audit and accounting sector is a significant success story which not only contributes over 1% of GDP in its own right but helps support businesses of all sizes across every economic sector driving employment and growth.  The accountancy profession is also the biggest single employer of graduates in the UK and a great British export.  

“It is therefore critical when looking at how these measures are implemented, that they do not undermine or destabilise what is such an important sector for the UK economy. They also need to be seen in an international context and be consistent with proposals currently being considered in Europe. 

“Increasing market choice will only be possible if audit committees - who are responsible for appointing auditors - recognise that there is huge quality and talent to be had outside the big 4 accounting firms.”

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By WhichTyler
22nd Feb 2013 17:07

Hmm...

“Increasing market choice will only be possible if audit committees - who are responsible for appointing auditors - recognise that there is huge quality and talent to be had outside the big 4 accounting firms"

And 60% of audit ctee chairs were from Big 4 firms...

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By carnmores
23rd Feb 2013 13:14

its called a cartel

and with good reason - we need to find ways to ways to examine the role of audit in a modern economy - sending out young people with very little training and ask them to fill in what is effectively a manual is not a sound process. fast growing and or high risk companies, as identified, need to be subject to more rigorous scrutiny - here is an overwhelming need for independent audit panels

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By carnmores
23rd Feb 2013 13:35

PS

is Izza the most frequent self justifier there is?

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By N.Krishnaswamy
14th Mar 2013 14:46

Aduit rotation

 

 

 

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Replying to johngroganjga:
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By N.Krishnaswamy
14th Mar 2013 14:57

The best way out to require audit by joint auditors, the  nubmer of joint auditors being decided  depending on the size of capital or turnover or gegraphical access so that branch audits are always done bya different auditor thatn the mainstatutoryauditors. This will creat more widespread exposure to all sizes of firms foir audit expericence and to grow  intheir exoertise. In India for all public sector companies, the auditor general suggests the auditor  for units of each area and mnostly local audit firms so that expenses on travel and other outgos are reduced. In the case of public sector banks, threeto five audit firms are appointed as statutory adutors and the aduits of branachs are alllotted to the local auditor firs os certain size depening on the size of the  advances of the branches. The statutory auditors divided maong themselves the varius areas of audit and discussmaong themseles and the management collectively onaudit points arising out ofthe audit before finalised the aduit and the audit report with various notes and qualifications are issued as reqruied under the regulations of the central bank. It is working well for th epast more than fifty years now. Whynot adot the same in UK also?  

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