U.K. regulators recommend shake-up in audit market

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The United Kingdom’s Competition and Markets Authority has released the final version of a long-awaited report on changes in the audit market, recommending separation of audit from consulting services, mandatory “joint audits” to enable firms outside the Big Four to develop the capacity needed to review the U.K.’s largest companies, and the introduction of statutory regulatory powers to increase accountability of companies’ audit committees.

The report suggested that legislation is needed to address both the vulnerability of the industry to the loss of one of the Big Four and the current inadequate amount of choice and competition in the audit market.

The CMA’s recommendations come after extensive discussions with audit firms, investors and major U.K. companies for an update paper it issued in December. The suggestions also take account of recommendations in a major report from the Business Select Committee and an inquiry into regulation.

“People’s livelihoods, savings and pensions all depend on the auditors’ job being done to a high standard,” said CMA chairman Andrew Tyrie in a statement. “But too many fall short — more than a quarter of big company audits are considered substandard by the regulator. This cannot be allowed to continue. 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 U.K. 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.”

The report recommended that auditors should focus exclusively on producing the most challenging and objective audits, rather than being influenced by their much larger consultancy businesses. Given the difficulties with an immediate global structural split, however, the report recommends at this stage an operational split of the Big Four’s U.K. audit work. The CMA pointed out this would require separate management, accounts and remuneration: a separate CEO and board for the audit unit; separate financial statements for the audit practice; an end to profit-sharing between the auditing and consulting practices, and promotions and bonuses based on the quality of the audits.

The report also calls for “joint audits” between the Big Four and smaller auditing firms to provide more choice and competition for the audits of big businesses, but acknowledged the barriers to entry for “challenger” audit firms are currently large. The CMA recommended mandatory joint audit to increase the capacity of challengers to increase choice in the market and thereby increase audit quality. It said the challenger firms should work alongside the Big Four on these joint audits and should be jointly liable for the results.

The report also said there should be initial limited exceptions to the requirement, based on criteria set by the regulator, focused on the largest, most complex companies. On top of that, any company choosing a sole “challenger” auditor should be exempt.

Audits of exempt companies would be subject to rigorous, real-time peer reviews commissioned by and reporting to the regulator. The joint audit requirement would remain in place until the regulator determines that choice and competition have improved enough to address the vulnerability of the market to the loss of one of the Big Four.

“The U.K. is recognized as having a strong history in the fields of corporate governance and accounting,” said CMA chief executive Andrea Coscelli in a statement. “Our recommendations, along with improvements to regulation and clarifying the purpose and scope of audits, will ensure the U.K. strengthens its position.”

The report also calls for more involvement by the audit committees at companies, pointing out that it’s essential for audit committees to choose auditors by seeking those who are likely to provide the most robust and constructive challenge to the accounting practices of their companies. The CMA recommended that regulators should hold audit committees more accountable, ensuring 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 report said the regulator should review the effects of these changes periodically, initially five years after full implementation of them. It should consider the merits of moving to independent appointment for auditors; whether to go beyond the operational split already proposed; and how to fine-tune the joint audit remedy to adapt to market developments.

The CMA’s final report, and further information relating to the market study, are available on the audit market study case page.

In the U.S., the Center for Audit Quality reacted to the report. "We recognize that other countries around the world have different regulatory, governance and capital markets systems,” said a statement Thursday from the CAQ. “For instance, while we support objectives to increase choice and competition in the UK audit market, we believe some of the reforms being proposed could lead to unintended consequences, with the potential risk of lower audit quality, damage to U.K. competitiveness, and reduced resilience of the audit sector. In addition, in today’s rapidly evolving global business environment, it is more important than ever that the full breadth and depth of audit firms' subject-matter expertise, supported by the multidisciplinary business model, continue to serve as a crucial foundation for delivering the highest quality audits. These skills enable auditors to fully understand and evaluate the broad array of business risks necessary to execute high-quality audits that meet the needs of investors and strengthen confidence in our capital markets.”

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