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CMA calls for 'operational split' of audit market

24th Apr 2019
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Deloitte
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The axe that’s been hanging over audit finally looks set to fall after the CMA published its final report on the statutory audit services market.

While the audit market has been in the doldrums for a while, its nadir was likely the explosive collapse of Carillion. The Big Four raked in £71.6m for work relating to Carillion in the ten years leading up to its failure. At the time, MPs accused the firms of “feasting on what was soon to become a carcass”.

It was ultimately Carillion (and a slew of other high-profile company failures) that led the Competitions and Markets Authority to kick off its market review in October last year.

The now-published CMA report recommends a radical shakeup of the audit market. Namely, the separation of audit from consulting services, and mandatory ‘joint audit’ to foster greater competition from non-Big Four firms.

The ‘split’ proposal isn’t quite Sherman Act monopoly busting, though. “Given the difficulties with an immediate global structural split,” the report states, “the CMA is – at this stage – recommending an operational split of the Big 4’s UK audit work.”

That’s not a split into two distinct legal entities, but it will require “separate management, accounts and remuneration” for the two arms, including “a separate CEO and board” and “separate financial statements for the audit practice”. The proposal would also end profit-sharing between audit and consultancy.

Notably, this falls short of the “full structural split” called for by the Business, Energy and Industrial Strategy committee in its Future of Audit report.

At the same time, the CMA said mandatory joint audits would create more choice and market pressure for the Big Four. Currently, the barriers to entry for ‘challenger’ audit firms are substantial.

Last year, Grant Thornton said it would no longer bid for audit contracts from Britain’s largest listed companies, citing competition from the Big Four.

Under the CMA’s proposal, challenger firms will work alongside the Big Four in these joint audits and should be jointly liable for the results. There would be initial limited exceptions to the requirement for the largest and most complex companies. In addition, any company choosing a sole ‘challenger’ auditor should be exempt.

Company audit committees should also face closer scrutiny, according to the CMA report. “It is essential that audit committees choose auditors by seeking those likely to provide the most robust and constructive challenge to the accounting practices of their companies,” the body said.

The ubiquity of Big Four alumni on company boards has raised serious questions over how auditors are appointed and reviewed. The newly minted Audit, Reporting and Governance Authority (ARGA) should hold audit committees more vigorously to account, the CMA said.

“This may include ensuring that committees report their decisions as they hire and supervise auditors and that the regulator issues public reprimands to companies whose committees fall short of adequate scrutiny of their auditors.”

The final proposal is a baked-in, five-yearly review of progress by the audit regulator. The regulator should consider, in particular: “the merits of moving to independent appointment for auditors” and “whether to go beyond the operational split already proposed”.

The idea behind ARGA is that it will be substantially more robust than the soon-to-be-defunct FRC. ARGA can make direct changes to accounts rather than having to apply to a court to do so, make use of a wider range of sanctions in cases of corporate failure and publish reports into a company’s conduct and management. It can also investigate company directors, even if they aren’t a member of an accounting body.

As Prem Sikka, a long-time critic of the Big Four's audit stranglehold and professor of accountancy noted before, audit long enjoyed a uniquely insulated position compared to other industries.

“Anyone selling automobiles, food or medicines has to ensure that the product is fit for purpose and will not injure current or future consumers,” Sikka said, “but such considerations are absent from the audit industry. People have few, if any, rights against negligent auditors.”

Dr Ian Peters, chief executive of the Chartered Institute of Internal Auditors, welcomed most of the CMA’s proposals but expressed concern over joint audits. “We welcome the proposal to separate external audit from non-audit services to raise standards, eliminate potential conflicts of interest and ensure the independence of external auditors to reduce the risk of another Carillion style collapse.

“We are unconvinced about the CMA’s proposal for joint audits which risk becoming burdensome for business and there are big unanswered questions about how they would work. Joint audit is a sledgehammer to crack a nut and there are far better ways to raise external audit standards.”

The CMA’s chief Andrew Tyrie commented that the government now has no choice but to act. “The government now has three reports to hand. In large part, they come to similar conclusions.

“Conflicts of interest cannot be allowed to persist; nor can the UK afford to rely on only four firms to audit Britain’s biggest companies any longer. Early action will require legislation – hence the CMA’s proposals.”

Rachel Reeves MP, Chair of the Business, Energy and Industrial Strategy committee, echoed Tyrie’s urgency. “These findings, seen alongside our Committee’s report and the results of the Kingman review, show there is a clear consensus on how to restore confidence in the market.

“It’s now up to the government to deliver, by coming forward with legislation to ensure that audits provide what businesses, investors, employees, pension-holders and the public expect.”

Replies (2)

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By alan.rolfe
25th Apr 2019 09:11

The elephant in the room has been dodged by the CMA.

They still state that it is their "expectation that the audit business pays for the full cost of audit". This inherent conflict of interest could hinder impartial, high quality auditing.

It seems no one is willing to consider whether the parties relying on the audit (i.e. shareholders, pensions regulators, government, etc.) should pay the auditor, so that the auditor has to answer to them in the first instance.

By analogy, you wouldn't buy a house relying on a survey provided by the seller, the buyer expects to pay for an independent survey.

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By tedbuck
25th Apr 2019 10:53

I couldn't argue with alan.rolfe's principle but it is difficult to see how it could work in practice. Would the auditors be paid out of dividends? If so then the circle comes straight back to the Company.
What is really required for plcs is separation, i.e. the auditor just does the audit and is responsible to the shareholders and the Board of Directors. Surely that isn't too difficult.
Yes the audit cost would rise but other costs would presumably diminish. It might also be difficult to find auditors prepared to act for some Companies which would speak volumes to the shareholders.
The governing bodies would need to look carefully at the effect that changes would have further down the market where having a separate auditor becomes an expensive process which smaller entities could not afford.

Judging by the recent horror stories audits seem a bit pointless anyway as they certainly don't give shareholders much confidence. They really cannot pass judgement on the over-remuneration of Directors in plcs which has become a national disgrace, they don't find the black holes so what really is the point of them? If the Board or the management collude to hide stuff away from view what real chance does the watchdog have of finding it out? Even a bloodhound might be misled by a scented false trail. The real answer lies in a beefed up internal audit but who would control them?

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