Competition Commission backs away from mandatory rotation in preliminary report on audit market

Out-Law News | 24 Jul 2013 | 2:50 pm | 3 min. read

The Competition Commission (CC) has decided against forcing companies to rotate their statutory auditors regularly and has signalled that they should instead put their auditing needs out to tender at least every five years.

It has published a summary provisional report on the remedies it is considering introducing (8-page / 135KB PDF) when it publishes its final report on the supply of statutory audit services to large UK companies this autumn. The CC has already come to the provisional conclusion that competition in the statutory audit market, which is dominated by the so-called 'Big Four' firms, is constricted.

However competition law expert Guy Lougher of Pinsent Masons, the law firm behind Out-Law.com, said that the CC's apparent "change of heart" put it "on a potential collision course with legislative proposals currently being discussed at an EU level, where very serious consideration is being given to a requirement that auditors be periodically switched".

"The audit companies involved in the CC's review can be forgiven feeling a real sense of frustration that, having been heavily embroiled in the CC's market investigation into the audit market which began in October 2011, they still have another battle to win - this time at the EU level," he said.

"The CC's change of heart on remedies also illustrates well the complexity and demanding nature of its market investigations. It currently has two years in which to undertake such investigations but, with effect from April 2014, the Competition and Markets Authority will generally be expected to complete market investigations within an 18 month timetable. It remains to be seen how achievable that revised timetable will be in practice," he said.

The 'Big Four' auditors are PwC, KPMG, Deloitte and Ernst and Young; and between them they earned 99% of the auditing fees paid by the top 100 companies by share capital in 2010. The Office of Fair Trading (OFT), UK's consumer protection and competition regulator, referred the market to the CC in 2011, citing concerns about lack of choice, low levels of switching and substantial barriers to entry.

The CC published its provisional findings in February. As part of its investigation, it found that companies were reluctant to change auditor as they found it difficult to compare alternatives, preferred continuity and faced significant costs when doing so. In addition, auditors tended to focus on meeting the needs of senior management rather than shareholders, meaning that competition tended to focus on factors that were not aligned with shareholder demand, it said.

The remedies recommended by the CC in its provisional decision are designed to improve the bargaining power of companies and encourage rivalry between audit firms, as well as to promote shareholder engagement in the audit process, it said. Among its proposals are a prohibition on clauses in loan documentation issued by banks that limit a company's choice of auditor to one of the Big Four, and the introduction of a shareholders' vote on whether audit reports contain enough information.

The CC has proposed requiring companies to put their audit requirements out to tender every five years, although companies would be able to defer this obligation by up to two years in exceptional circumstances. It has also proposed tougher regulatory oversight by the Audit Quality Review (AQR) Team at the Financial Reporting Council (FRC), and additional measures to strengthen the accountability of external auditors to the company's audit committee rather than management.

"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," said Laura Carstensen, chair of the CC's audit market investigation group. "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 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. 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," she said.

The CC said that it was "aware" that its proposals could be affected by ongoing work at EU level, but said that as there were "yet no definitive EU proposals" it had "proceeded on the basis of the evidence produced by our inquiry".

It has encouraged feedback on its provisional remedies, and will consider all responses before publishing its final report by 20 October, it said.