The United Kingdom’s Competition Commission has published its final report on the audit market, proposing that publicly listed companies put their audit contracts out for bid at least every 10 years.
The aim of the Competition Commission’s retendering proposal is to open up the U.K. audit market to greater competition beyond the Big Four firms and ensure that audits better serve the needs of shareholders in the future.
In a summary of its final report on the supply of statutory audit services to large companies in the U.K., the commission found that competition is restricted in the audit market due to factors that inhibit companies from switching auditors and by the incentives that auditors have to focus on satisfying management rather than shareholder needs.
The final report follows a provisional findings report that was published in February, as well as the provisional decision on remedies in July (see U.K. Commission Says Auditors are Not Serving Investors and U.K. Commission Recommends Mandatory Retendering for Audit Firms). In the July report, the commission had recommended a retendering period of every five years. The commission said the full final report would be published shortly. All information relating to the investigation can be found on the Competition Commission audit market home page.
The CC has set out a package of remedies in response to these findings which includes measures to improve the bargaining power of companies and encourage rivalry between audit firms; measures to enhance the influence of the Audit Committee; and measures to promote audit quality and shareholder engagement in the audit process.
The main measures proposed by the CC include a requirement that FTSE 350 companies must put their statutory audit engagement out to tender at least every 10 years. This differs from guidance introduced by the Financial Reporting Council in 2012 encouraging companies to go to tender on a “comply or explain” basis. Under the Competition Commission proposals, no company would be able to delay beyond 10 years, and the CC said it believes that many companies would benefit from going out to tender more frequently at every five years.
If companies choose not to go out to tender this frequently, a company’s audit committee would be required to report in which financial year it plans to put the audit engagement out to tender and why this is in the best interests of shareholders.
The Financial Reporting Council’s Audit Quality Review team should review every audit engagement in the FTSE 350 on average every five years, the Competition Commission also proposed. The Audit Committee should report to shareholders on the findings of any AQR report concluded on the company’s audit engagement during the reporting period.
The Competition Commission also called for a prohibition on “Big Four only” clauses in loan agreements that limit a company’s choice of auditor to a preselected list or category, although it will be possible to specify that any auditor should satisfy objective criteria. In addition, the proposals would require a shareholders’ vote at a public company’s annual general meeting on whether the audit committee reports in the company’s annual reports are satisfactory.
The commission also urged the adoption of measures to strengthen the accountability of the external auditor to the audit committee and reduce the influence of management, including a stipulation that only the audit committee is permitted to negotiate audit fees and influence the scope of audit work, initiate tender processes, make recommendations for the appointment of auditors and authorize an external audit firm to carry out non-audit services.
The commission also recommended that the FRC should amend its articles of association to include an object to have due regard to competition.
Open to Competition on a Regular Basis
“Our measures will deliver lasting change in a market where currently a major company putting its audit out to tender remains unusual enough to be a news story," said Laura Carstensen, who chairs the Audit Market Investigation Group at the Competition Commission, in a statement. "Instead, all this business will be open to competition on a regular basis. The introduction of regular and predictable tenders will benefit shareholders, who will also have a much greater say and knowledge of whether their needs as customers are being met. Instead of long, unchallenged tenures, which can reduce the appearance of objectivity and skepticism essential to an effective audit, there will now be far greater transparency and scrutiny. It will also open the door to other auditors who now have the chance to compete regularly for business and show they’re up to the mark. This will help them prepare for and counter any perceived lack of experience, resources and reputation which may have hindered them from winning FTSE 350 audit engagements in the past. In effect they will more frequently be able to compete on a level playing field.”
She noted that the Competition Commission had listened closely to the advice it had received from shareholders and the Financial Reporting Council on the retendering period and decided that 10 years was the “appropriate backstop period for mandating that the audit engagement be put out to tender,” as opposed to the five years in the July report.
“Whilst we think many companies would benefit from a greater frequency of five years (and that an increasing proportion would benefit from going to tender as the period since the last tender process lengthens), we have accepted that requiring this in all cases could dilute the benefits we all want to see,” said Carstensen. “However, in keeping with the greater responsiveness to shareholders we are promoting, companies will be required to spell out when they next intend to hold a tender process if five or more years has elapsed since the last one. This remedy will be supported with other measures that will empower shareholders and also shift influence to audit committees, so that they can perform their role more effectively in ensuring external audit works well. The FRC has done valuable work in recent years in assessing audit quality and we feel that extending this and making it more transparent will further serve the cause of shareholders.
‘If audits and auditors are regularly being called to account, by being answerable to shareholders and assessed on quality and can be contested by other companies, that will address the concerns we’ve expressed,” Carstensen added. “We do not think that mandatory switching would add to that, when an auditor will already have to prove its worth in a competitive tender process run by the audit committee in order to retain the business. Mandatory switching would also reduce choice at such tender processes.’
The Competition Commission plans to now work towards drawing up an order for those elements of the remedy package it can require and make recommendations for the others. It is expected that these will come into force from the last quarter of 2014.
Moves in U.S. and Europe
In the U.S., the Public Company Accounting Oversight Board has also been considering the concept of mandatory audit firm rotation, or at least mandatory retendering of bids for outside audit work, every few years, while a committee of the European Parliament have also voted for mandatory firm rotation, but no definitive requirements have been adopted yet (see European Parliament Committee Votes for Audit Firm Rotation).
The PCAOB issued a concept release two years ago on auditor independence and audit firm rotation, but has heard mostly negative responses on the idea of requiring companies to rotate their auditing firms or put their audit work out for retendering after a certain number of years.
“After more than two years of studying the issue, which included extensive outreach and analysis, we have not found evidence that would allow for generalizable conclusions about the impact of auditor tenure on audit quality that would justify a one-size-fits-all requirement for mandatory audit firm rotation,” said PCAOB board member Jeanette Franzel in a speech Tuesday at a conference of the National Association of Corporate Directors. “This result is consistent with academic research that also is inconclusive on the impact of auditor tenure on audit quality. This lack of generalizable evidence on auditor tenure and independence does not in any way alleviate the need to evaluate auditor tenure and its relationship to independence and audit quality in individual cases. And that is where the audit committee comes in. Due to the potential risks of long auditor tenure that could manifest in individual situations, audit committees must be vigilant in overseeing auditor independence and determining whether a potential rotation of auditors or retendering of the audit would be beneficial, given the facts and circumstances of their company's situation.”
The U.K. Competition Commission said it is aware that its proposed package of remedies may be affected by measures currently being considered by the European Union. However, there are have been no definitive EU proposals yet, the commission has therefore proceeded on the basis of the evidence produced by our investigation. The CC will be able to amend its remedies, if necessary, in the light of any agreed EU measures, it pointed out.
The full final report will be published shortly. All information relating to the investigation can be found on the audit market home page.
Michael Izza, chief executive of the Institute of Chartered Accountants in England and Wales, commended the U.K. Competition Commission for heeding the advice of constituents to extend the recommended retendering term from five to 10 years.
“The Competition Commission has listened to feedback from the business and regulatory communities about the additional costs and disruption five-yearly retendering would cause,” he said in a statement. “The requirement to tender every 10 years is more in line with the recently introduced 10-yearly tendering on a ‘comply or explain’ basis by the Financial Reporting Council, which has already seen signs of more frequent tendering taking place. At a time when economic recovery is still hanging in the balance and businesses need to focus on driving growth, this is the right decision. However, it is regrettable that the commission did not have full faith in the FRC’s requirement.
“We do not think that five-yearly mandatory tendering would have increased choice,” Izza added. “Instead what is required is for those that buy audit services to recognize that real quality, as well as niche expertise, also exist outside the largest professional service firms. We would urge businesses to do a broader survey of firms and the capabilities available before determining which their preferred suppliers are for audit and non-audit services.”
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