Next week the Competition Commission is due to publish its final report on its investigation into the market for statutory audit services. That report will reflect comments received by the Commission on its list of provisional remedies published back in July 2013 which, if implemented, could spell significant changes for FTSE 350 companies and their auditors.

Who are the Big Four and what do they do?

The giants of the audit world, the ‘Big Four’ – Deloitte, PwC, EY and KPMG – have dominated two-thirds of the global audit market for decades. Their role seems simple enough; to review a company’s accounts, determining whether they provide a fair and accurate representation of the company’s financial position.

During a time of heightened financial tension, the recession saw the unveiling of inaccuracies in some auditor’s reports, including some that failed to highlight the weaknesses of various banks that were close to collapse.  This, coupled with fears that the audit market is simply not competitive, sparked an investigation by the Competition Commission into the supply of statutory audit services.

Why might change be needed?

The investigation raised two key factors that combine to prevent, restrict or distort competition, and that threaten the independence of auditors, damaging the accuracy of their reports:

1.       Companies are just not willing to change auditor; they have either established comfortable relationships of mutual trust and confidence with their auditors (Marks & Spencer has engaged the same auditors since 1926!), or it costs too much to switch. According to the Competition Commission, this allows auditors to get away with charging consistently high fees.

2.       Shareholders have a very minor role in appointing an auditor, whilst the influence of the executive managers is strong. All listed companies are required to have an audit committee that is made up of non-executive directors and this committee is responsible for engaging auditors, and monitoring and reviewing the audit. However, the audit committee reports to the board. Auditors may therefore very easily lose their independence to the board, whose interests can be misaligned with the company’s shareholders. With little incentive to disclose the requested information to shareholders, auditors sometimes underperform.

The Competition Commission’s proposals

To keep auditors on their toes – and to foster competition outside the ‘Big Four’ – the Competition Commission published the following proposals in July 2013:

1.         FTSE 350 companies must put their statutory audit requirement out to tender at least every five years. This may be deferred by up to two years in exceptional circumstances.

2.         The Audit Quality Review team (the AQR) must review FTSE 350 audit engagement every five years on average, and the findings should be reported to the company’s shareholders.

3.         The AQR must also review and report on larger, mid-tier firms annually.

4.         Banks will no longer be able to restrict a company’s choice of auditor in loan agreements (often a common clause).

5.         Shareholders will have an annual advisory vote on the sufficiency of disclosures in the Audit Committee report section of the company’s Annual Report.

6.         The accountability of the auditor to the Audit Committee will be increased: only the Audit Committee will be able to negotiate and agree audit fees and the scope of audit work, to initiate tender processes and to make recommendations for the appointment of auditors.

A sensible move or a lot of fuss over nothing?

This could finally be what the audit services market has been waiting for: smaller firms may have a chance to develop their reputations and win big work; companies may benefit from reduced prices; and shareholders may be presented with a more balanced and accurate view of the inner-workings of their companies.

Or, the ‘Big Four’ could still rule, whilst companies are subject to unnecessary costs and hassle: the same auditors could be re-engaged post-tender, but only after companies have spent money on the process; where a new auditor is chosen, companies may resent the loss of a trusted advisor and the considerable amount of time required to train up a new firm; and, after all that, the reputations of the smaller firms may never develop to inject real competition into the statutory auditory services market.

Is this a rash regulatory reaction to the revelation of failures by auditors during the economic downturn? Or a much-welcome review of the systemic issues that are rife within a trusted system?  With the final report due out next week, watch this space…

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This blog is intended only as a synopsis of certain recent developments. If any matter referred to in this blog is sought to be relied upon, further advice should be obtained.