An eagerly anticipated report on the auditing market from the United Kingdom’s Competition Commission found that the audit market is not serving shareholders and suggested as a possible remedy the mandatory rotation of auditing firms.

The report could play an influential role in the ongoing deliberations in the European Union and the U.S. over whether or not public companies should be required to rotate their auditing firms on a periodic basis or at least put the auditing work out for bid every few years.

In provisional findings published Friday, the U.K. Competition Commission found that competition in the audit market is restricted by factors that inhibit companies from switching their auditors and by the tendency for auditors to focus on satisfying management rather than shareholder needs. This is the Competition Commission’s provisional conclusion in its investigation into the supply of statutory audit services to large companies in the U.K.

The Competition Commission is now looking at possible ways to encourage greater competition through mandatory tendering and rotation of auditing firms. Other alternatives include increasing information and transparency with more frequent reviews and extended reporting requirements; and strengthening accountability and independence by giving audit committees and shareholders greater control of external audit.

In its notice of possible remedies, the commission said it is exploring the following possible combination of remedies:

• mandatory tendering;
• mandatory rotation of audit firm;
• expanded remit and/or frequency of the audit quality review team (under the auspices of Financial Reporting Council) reviews;
• prohibition of “Big Four only” clauses in loan documentation;
• strengthened accountability of the external auditor to the audit committee;
• enhanced shareholder-auditor engagement; and
• extended reporting requirements.

“We have found that there can be benefits to companies and their shareholders from switching auditors but too often senior management at large companies are inclined to stick with what they know, particularly when it is difficult to compare with the alternatives and the incumbent auditors are in a strong position to hold on to the business,” said Laura Carstensen, who chaired the Competition Commission’s Audit Investigation Group.

The commission considered whether the market conditions are conducive to coordination or that Big Four firms engage in tacit collusion; that they bundle audit and non-audit services together in order to raise barriers to expansion to other firms; that they target the customers of mid-tier firms with particularly low prices; or that they are able to exercise undue influence over the formation of regulation or on regulatory bodies through their extensive alumni networks. To date, the commission has not identified sufficient evidence to support these other theories of harm.

The report acknowledged that companies find it difficult to compare possible alternatives to their existing audit firm. Many companies prefer continuity and face significant costs in switching auditors. Thus, they are reluctant to change auditing firms and lack bargaining power with their auditors. The Big Four dominate the market in the U.K., as they do in the U.S. for major public companies, and many alternative firms find it difficult to show that they have sufficient experience and reputation to win the audit engagements of FTSE 350 companies.

In addition, while auditors are appointed to protect the interests of shareholders, who are therefore the primary customers, too often the focus of auditors is on meeting the needs of senior management who are key decision takers on whether to retain their services. Competition then focuses on factors not aligned with shareholder demand.

The commission found that 31 per cent of FTSE 100 companies and 20 per cent of FTSE 250 companies have had the same auditor for more than 20 years, and 67 percent of FTSE 100 companies and 52 percent of FTSE 250 companies for more than 10 years. The commission noted that the lack of competition is likely to lead to higher fees, lower quality and less innovation for companies and a failure to meet the demands of shareholders and investors.

“Whilst we accept that most audits are performed diligently and understand that those involved are behaving rationally in response to their incentives, auditors tend to focus on management interests over those of shareholders,” said Carstensen. “For example, management may have incentives to present their accounts in the most favorable light whereas shareholder interests can be quite different. Shareholders play very little role in appointing auditors compared to executive management—and despite the presence of audit committees and other safeguards—audit firms naturally focus more on meeting management interests. The result is a rather static market in which too often audits don’t fulfill their intended purpose and thus fail to meet the needs of shareholders."

The commission found that companies face significant hurdles in comparing the offerings of an incumbent auditor with those of alternative suppliers other than through a tender process. It is difficult for companies to judge audit quality in advance due to the nature of audit. Companies and firms invest in a relationship of mutual trust and confidence from which neither will lightly walk away as this means the loss of the benefits of continuity stemming from the relationship.

Company management face significant opportunity costs in the management time involved in the selection and education of a new auditor.

Mid-tier audit firms face both experience and reputational barriers to expansion and selection in the FTSE 350 audit market. Auditors have misaligned incentives, as between shareholders and company management, and so compete to satisfy management rather than shareholder demand, where the demands of executive management and shareholders differ, the commission found.

Auditors face barriers to the provision of information that shareholders demand, in particular, from the reluctance of company management to permit further disclosure.

“It is clear that there is significant dissatisfaction amongst some institutional investors with the relevance and extent of reporting in audited financial reports,” said Carstensen. “This needs to change so that external audit becomes a more genuinely independent and challenging exercise where auditors are less like corporate advisors and more like examining inspectors.”

The commission plans to take into account proposals for the audit market that are currently being discussed by the EU and how its package of remedies may interact with the U.K. proposals. The commission expects to work closely with the Financial Reporting Council, the relevant regulator for audit and financial reporting.

The U.K. Office of Fair Trading referred the market to the Competition Commission for investigation in October 2011. The CC plans to publish the full provisional findings report early next week and invite responses on the report and possible remedies before issuing its final report later this year. It is required to publish its final report by Oct. 20, 2013.

“It will undoubtedly be challenging to change a long-standing and entrenched system, but our proposals will look to create a situation where tendering and switching become the norm, and where greater transparency and information increase both contestability of the market and the ability of shareholders to judge the service they are getting,” said Carstensen. “We also want to increase their influence—and that of the audit committee—over the choice of auditor. We now want to explore which combination of these proposals will be most effective in addressing the factors that inhibit competition and move towards a situation where auditors compete over the quality of service they provide to shareholders.”

For more information on the investigation, visit the audit market home page.