The United Kingdom’s Competition Commission has issued a provisional decision recommending that companies put their auditing work out for bid every five years to promote competition in the audit profession.
The closely watched decision comes amid efforts in the U.S. and the European Union to expand competition in the audit industry, which is largely dominated by the Big Four accounting firms. The Public Company Accounting Oversight Board, the European Commission and the European Parliament have been considering both mandatory audit firm rotation and mandatory retendering, such as the kind recommended by the U.K. Competition Commission. It would apply to publicly traded companies in the FTSE 350 and the retendering could be postponed an additional two years, for a total of seven, under "exceptional circumstnaces." The Competition Commission said it would not recommend mandatory audit firm rotation or "switching." However, it is recommending a ban on Big Four-only clauses in loan documentation.
The provisional decision that the Competition Commission announced Monday included a list of remedies it is considering introducing when it publishes a final report on the supply of statutory audit services to large companies in the U.K. that it plans to release in October.
In a summary of its provisional decision on remedies, the CC has put forward a package of measures to promote competition and to ensure that competition is directed towards satisfying the demands of shareholders. The remedy package 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 shareholder engagement in the audit process.
In its provisional findings report published in February, the CC said that competition was restricted in the audit market due to factors which inhibit companies from switching auditors and by the incentives that auditors have to focus on satisfying management rather than shareholder needs (see U.K. Commission Says Auditors are Not Serving Investors).
The main measures the CC has proposed are as follows:
• FTSE 350 companies should put their statutory audit engagement out to tender at least every five years. Companies may defer this obligation to go out to tender by up to two years in exceptional circumstances. There will be a transitional period of five years before the measure comes into full effect.
• The Financial Reporting Council’s Audit Quality Review team should review every audit engagement in the FTSE 350 on average every five years. 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.
• A prohibition on Big Four-only clauses in loan documentation (that is, clauses that limit a company’s choice of auditor to a preselected list).
• A shareholders’ vote on whether audit committee reports in company annual reports contain sufficient information.
• 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 and agree audit fees and the scope of audit work, initiate tender processes, make recommendations for appointment of auditors and authorize the external audit firm to carry out non-audit services.
• The FRC should amend its articles of association to include a secondary objective to have due regard to competition.
The CC said it has decided against bringing in measures requiring mandatory switching of auditors, further constraints on audit firms providing non-audit services; joint audits; shareholder or FRC responsibility for auditor reappointment or independently resourced risk and audit committees.
“This is a comprehensive set of measures that will ensure that shareholders are better served by a more competitive market for statutory audit which is more responsive to their requirements,” said Audit Market Investigation Group chairman Laura Carstensen in a statement. “More frequent tendering will ensure that companies make regular and well informed assessments of whether their incumbent auditor is competitive and will open up more opportunities for other firms to compete. A more dynamic, contestable market will reduce the dangers that come with overfamiliarity and long, unchallenged tenures. We have found that tender processes are thorough, fair and transparent processes which produced effective competition—but we need to see more of them. We think that a five-year period is an appropriate period to subject the engagement to scrutiny and challenge—and it is also aligned with existing FRC guidelines on rotating the Audit Engagement Partner, making it an appropriate time to put the service out to tender.
“The audit function is too important to be left undisturbed for longer than five years,” Carstensen added. “Audit provides a vital role in providing assurance to shareholders on the reliability and accuracy of corporate reporting and an audit market in which shareholders can have increased confidence will have benefits for the economy more widely. Whilst there are costs involved in going out to tender, we think that they are outweighed by the benefits of a more competitive market in which shareholders can have increased trust. Audit committees have a vital role in ensuring that the external audit is effective. We found that finance directors often have considerable influence over the audit relationship in practice despite the formal authority of audit committees. We are therefore proposing measures that increase the influence and responsibilities of the audit committee.
“We would also like to see the FRC build on the valuable work it has carried out in recent years in reporting on and promoting audit quality,” Carstensen added. “Public reporting of AQR grades, alongside recent FRC initiatives to improve information on the audit process, will help shareholders assess the performance of auditors and the key judgments underpinning the audit process, and will promote engagement with companies.
“We gave careful consideration to other measures, including mandatory switching, but we think that the measures that we have provisionally chosen will be the most effective and proportionate way to address the problems we have found,” Carstensen noted. “We do not see a competition problem with audit firms retaining business if they do a good job—but they will have to demonstrate this on a regular basis.”
The Competition Commission said it is aware that its proposed package of remedies may be affected by measures currently being discussed by the EU. However, there are as yet no definitive EU proposals, and it has therefore proceeded on the basis of the evidence produced by its own inquiry.
The Legal Affairs Committee of the European Parliament voted in April to require public companies to change audit firms after up to 14 years, which could increase to 25 years if safeguards are put in place (see European Parliament Committee Votes for Audit Firm Rotation). The full European Parliament is expected to take up the draft law later this year.
In the U.S., the PCAOB issued a concept release in August 2011 proposing mandatory audit firm rotation as one way to improve audit firm independence and held a series of roundtable meetings across the country last year to gauge sentiment from accountants, investors, academics, business leaders and other groups (see PCAOB Hears Input on Auditor Independence and Firm Rotation). After hearing a series of objections to the concept, the PCAOB has not yet formally said what decision it would make. There was little support among either auditing firms or business groups for the proposal, although some consumer advocates, academics and investor groups favored it. Congress has become involved at the urging of business groups, and earlier this month, the House voted overwhelmingly to approve a bill prohibiting the PCAOB from imposing mandatory audit firm rotation (see House Approves Bill Banning Mandatory Audit Firm Rotation). But it is unclear whether the Senate will take up the bill.
The Institute of Chartered Accountants in England and Wales said it was concerned about the five-year retendering recommendation. “Whilst there is a desire for greater competition and choice in the audit market, whether or not tendering on a five year basis will help achieve this is open to question,” ICAEW chief executive Michael Izza said in a statement. “Regular tendering is good business practice, but we need to be mindful of the regulatory burden. There needs to be a balance between the costs and resources required from both businesses and firms when tendering and the desired outcomes. It is therefore disappointing that the Commission has decided on more frequent tendering than that now required on a comply or explain basis by the Financial Reporting Council, which has not had a chance to embed yet. We have expressed concern in the past that mandatory audit firm rotation would have unintended consequences in terms of quality, cost and competition. The Commission's decision not to adopt this reinforces this message. ICAEW has long supported a ban on Big Four-only clauses in contracts so it is encouraging that the Commission has included this as one of its proposed remedies.”
The CC will publish the full provisional decision on remedies shortly and consider all responses before publishing its final report. It is required to publish its final report by Oct. 20, 2013. Any interested party is invited to respond to the provisional decision on remedies in writing by Aug. 13, 2013.
To submit evidence, they can email email@example.com or write to:
Audit Market Investigation
All information relating to the investigation can be found on the Competition Commission audit market home page.
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