Audit market not serving shareholders
22 Feb 2013
Competition in the audit market is restricted by factors which inhibit companies from switching auditors and by the tendency for auditors to focus on satisfying management rather than shareholder needs. This is the Competition Commission’s (CC) provisional conclusion in its market investigation into the supply of statutory audit services to large companies in the UK.
In a summary of its provisional findings published today, the CC states that because companies find it difficult to compare alternatives with their existing auditor, prefer continuity and face significant costs in switching, they are reluctant to change auditor and so lack bargaining power. Audit firms outside the ‘Big 4’, which dominate the market, find it difficult to show that they have sufficient experience and reputation to win the audit engagements of FTSE 350 companies.
Additionally, although auditors are appointed to protect the interests of shareholders, who are therefore the primary customers, too often auditors’ focus is on meeting the needs of senior management who are key decision takers on whether to retain their services. This means that competition focuses on factors that are not aligned with shareholder demand.
The CC 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 per cent of FTSE 100 companies and 52 per cent of FTSE 250 companies for more than ten years. The CC adds that the lack of competition is likely to lead to higher prices, lower quality and less innovation for companies and a failure to meet the demands of shareholders and investors.
The CC is now looking at possible ways to encourage greater competition through mandatory tendering and rotation; 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.
Laura Carstensen, Chairman of the Audit Investigation Group, said:
‘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.
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. For example, management may have incentives to present their accounts in the most favourable 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 fulfil their intended purpose and thus fail to meet the needs of shareholders.
It is clear that there is significant dissatisfaction amongst some institutional investors with the relevance and extent of reporting in audited financial reports. 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.
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. 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.’
The main points the CC has found are 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 firms face 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.
- Auditors face barriers to the provision of information that shareholders demand (in particular, from the reluctance of company management to permit further disclosure).
The CC also considered whether the market conditions are conducive to coordination or that Big 4 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 CC has not identified sufficient evidence to support these other theories of harm.
In its Notice of possible remedies, the CC is exploring the following possible combination of remedies:
- mandatory tendering;
- mandatory rotation of audit firm;
- expanded remit and/or frequency of Audit Quality Review team (under auspices of Financial Reporting Council (FRC)) reviews;
- prohibition of ‘Big-4-only’ clauses in loan documentation;
- strengthened accountability of the External Auditor to the Audit Committee;
- enhanced shareholder-auditor engagement; and
- extended reporting requirements.
The CC will take into account proposals for the audit market currently being discussed by the EU and how its package of remedies may interact with those. The CC expects to work closely with the FRC, the relevant sectoral regulator for audit and financial reporting.
The Office of Fair Trading referred the market to the CC for investigation in October 2011. The CC will 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 20 October 2013.
In carrying out its investigation, the CC has:
- surveyed company Finance Directors (FDs), Chief Financial Officers (CFOs) and Audit Committee Chairs (ACCs) that were purchasers of statutory audit services (343 FDs/CFOs interviewed and 264 ACCs);
conducted a follow up survey with 71 ACCs;
- conducted case studies of ten FTSE 350 companies (37 in depth interviews with FDs, CFOs, ACCs, Audit Engagement Partners and Investors);
- held hearings with the six largest auditors, four other auditors and other interested stakeholders including the FRC, Association of British Insurers, the Investment Management Association, the National Association of Pension Funds, Association for Financial Markets in Europe, Hermes and Professor John Kay;
- received written submissions from audit firms, investors and other interested parties including members of the public;
- commissioned a review of academic literature by Professor Vivien Beattie;
- instructed Cardiff Business School to assist in analysing the prevalence of ‘Big-4-only’ clauses in loan documentation;
- constructed a public data set, with the cooperation of the parties, to capture an accurate record of publicly available information for FTSE 350 companies from 2001 to 2011 and for Top Track 100 companies from 2006 to 2011; and
- issued detailed information requests to the main parties and client data requests to all UK firms that audited a FTSE 350 or Top Track 100 company in the period 2006 to 2011—15 firms in total
All information relating to the investigation can be found on the audit market home page.
Any interested party is invited to respond to the notice of possible remedies and provisional findings report in writing by Monday 18 March and Thursday 21 March 2013 respectively.
To submit evidence, please email email@example.com or write to:
Audit Market Investigation
Notes for editors
1. The CC is an independent public body, which carries out investigations into mergers, markets and the regulated industries.
2. The members of the audit market investigation group are: Laura Carstensen (Group Chairman and CC Deputy Chairman), Carolan Dobson, Barbara Donoghue, Richard Farrant and Robin Mason.
3. Under the Enterprise Act 2002, the OFT can make a market investigation reference to the CC if it has reasonable grounds for suspecting that competition for the supply or acquisition of certain goods or services is not working effectively.
4. In its investigation, the CC is required to decide whether ‘any feature, or combination of features, of each relevant market prevents, restricts or distorts competition in connection with the supply or acquisition of any goods or services in the United Kingdom or a part of the United Kingdom’. If so, then there is an adverse effect on competition and the CC will also consider whether this is resulting in a detrimental effect on customers such as higher prices, lower quality or less choice of goods or services. The CC will then decide whether the CC should introduce remedies to tackle the adverse effects on competition or detrimental effects on customers or whether the CC should recommend action be taken by other bodies to remedy the adverse effects on competition, and if so, what actions or remedies should be taken. If the CC finds that there is no adverse effect on competition, the question of remedies will not arise.
5. The Enterprise Act 2002 requires the CC to consult the main parties on its proposed decisions and it will also publish notice of its provisional findings on the CC website as required by its rules. Full details on the CC’s guidelines for market investigation references are available on the CC website:
6. Enquiries should be directed to Rory Taylor or Siobhan Allen or by ringing 020 7271 0242.