Audits to be put out to tender

Competition Commission to investigate audits of large UK companies

FTSE 350 companies may be forced to have part of their audit work done by a non-Big Four firm, and to put their audit work out to tender on a regular basis, as part of a package of measures designed to broaden the UK market for audit services and to improve competition between firms. These and other measures will be considered by the Competition Commission over the next 18 months or so, after the Office of Fair Trading (OFT) last week referred to the Competition Commission the market for the supply of statutory audit services to large companies in the UK.

For nearly ten years, the OFT has had a “watching brief” over the UK audit market, and has finally decided to ask the Competition Commission to carry out a full investigation of the market and of the potential measures that could be taken to improve competition. The OFT is particularly concerned that the audit market for large (i.e. FTSE 350) companies is very concentrated (nearly all FTSE 350 companies are audited by one of the Big Four); that such companies only switch auditor very infrequently (FTSE 100 companies are calculated to switch auditors every 43 years on average, and FTSE 250 companies every 24 years), and put their audit work out to tender only infrequently; and that there are substantial barriers preventing other firms entering the market for large audits.

Features of the market identified by the OFT as preventing, restricting or distorting competition include:

•             There is little incentive for companies to switch auditor. In part, this is because it can be difficult for clients to discern differences in the technical quality of audit work.

•             Substantial management and audit committee time is required to tender for and select a new auditor and to bring a new auditor up to speed. There is also the potentially higher risk of a new auditor making mistakes.

•             It is difficult for mid-tier and smaller firms to develop the necessary attributes such as reputation, experience, expertise and resources to undertake large audits because of the difficulty of securing large audit contracts in the first place – a potential vicious circle.

•             It is difficult for mid-tier and smaller firms to raise capital to expand. This is partly because firms are required to be majority-controlled by chartered accountants, and because firms are almost invariably structured as general partnerships or limited liability partnerships, which cannot have their shares admitted to trading on a UK market.

•             Banks sometimes require borrowing companies to use a Big Four auditor – either by means of an express contractual requirement or implicit, softer encouragement.

•             Some companies’ choice of auditor is constrained by other factors such as overseas regulation; rules on banking relationships; conflicts of interest; and internal policies of audit firms.

The Competition Commission will now conduct a public inquiry and reach its own conclusions about whether any feature of the audit market prevents, restricts or distorts competition and what remedies, if any, are appropriate based on a detailed assessment of the benefits and costs of the potential remedies.  It has a maximum statutory period of two years (until 20 October 2013) to complete its investigation.

The OFT’s Market Investigation Reference gives broad details of a number of possible remedies that the OFT has discussed with audit firms, companies and other stakeholders. Taking into account the OFT’s comments, and other issues that are likely to arise, we consider that the remedies most likely to be recommended by the Competition Commission are (in descending order of likelihood):

•             FTSE 350 companies will be required to put their audit work out to tender on a regular basis.

•             They will also have to make public (e.g. in their annual reports) more information about the process for tendering and appointing auditors.

•             Auditors’ professional bodies should work to standardise as far as possible the procedure for an outgoing firm to hand over to a new one, including the form and content of information that should be passed on.

•             Audit work for a large company should be split between auditors from different firms – either through a joint or split audit process. This could mean the audit of a FTSE 350 company being split between a Big Four and non-Big Four firm.

•             Banks should not be permitted to include covenants in facility agreements that require the borrower to use a Big Four firm.

•             The appointment of auditors to a FTSE 350 company should be made subject to shareholder approval, or perhaps an “advisory vote” like the directors’ remuneration report.

•             Rules should be changed to make it easier for audit firms to raise capital from external investors.

It does not appear likely that the Competition Commission will require audit firms to be split up, or will require mandatory rotation of auditors, although these measures cannot be ruled out, especially if they are proposed at a European level. The European Commission published a Green Paper on audit earlier this year, and is expected to make legislative proposals by the end of 2011, although it is not yet clear what form they will take. The Competition Commission will feed the results of its investigation into the European process.

Reproduced by kind permission of Law-Now –

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