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July 26, 2013

Analysis: Is five year retendering going to have the desired effect?

This week’s decision by the UK Competition Commission to introduce five year mandatory retendering for FTSE350 companies as part of its provisional final remedies report got a mixed reaction from the industry. While most mid-tier players believe the remedy will increase the number of tenders, and consequently dynamise the market, the Big Four have expressed surprise over the CC’s decision to lower the 10 year mandatory retendering provision only recently introduced by the Financial Reporting Council (FRC).

As the rejection of mandatory rotation of audit firms was the headline news following CC announcement, the question of whether five year retendering will have the desired effect on the market appears to have been left unanswered.

In a report explaining the provisional remedies, the CC said the Big Four and the mid-tier will now have "increased incentives to develop and expand their capabilities in order to win engagements" and that the five year retendering provision, coupled with the restriction on Big-Four only clauses, is likely to "encourage firms outside the Big Four to invest in the capabilities necessary to win FTSE 350 engagements, particularly those lower down the scale of complexity and international breadth".

In 2011, prior to the FRC’s introduction of the 10 year ‘comply or explain’ provision, 13 of the FTSE350 companies were audited by a non-Big Four firm, according to PwC UK data.In its extensive evidence gathering the CC also found that between 2007 and 2011 on average only 4% of FTSE350 companies put their audit out to tender each year. It also found the average number of participants in tenders was two.

Impact of the FRC changesFRC’s changes to the UK Corporate Governance Code have, however, already made some changes in the statutorily audit market since they were first announced in 2012. As several large corporates such as HSBC, Barclays, Schroders and Unilever have put their audit out to tender.

PwC UK head of regulatory affairs Gilly Lord says the market has already felt a significant impact from the FRC’s 10 year tendering regime.

"Over the past two years we’ve seen 36 tenders of FTSE350 audits. We think this year will see 50 and we’ll see another 50 the following year.""We’re surprised that the CC has suggested a shortening of the tender to five years, when the FRC’s regime is already having such a big impact," she says.

While the 5 year provision is likely to significantly increase the number of tenders in the market, the effects it will have on the mid-tier and their chances of winning FTSE350 audits is somewhat unclear.

BDO UK senior partner James Roberts says that it us up to the firm, "to make us better known in the market place". "To some extent this debate has done that itself and I would imagine there are relatively few companies that won’t open their doors to us to have a conversation, and then in the new world it’s up to us to demonstrate that we’ve got something they might want to buy".

When asked whether the five year retendering remedy will open the FTSE350 market to the mid-tier as opposed to only lead to rotation among the Big Four firms, Grant Thornton UK chief executive Scott Barnes said, "it is bound to have some kind of impact in terms of opening up the market". "It will create a mood of greater liquidity in the market, which you would imagine will have some impact. But the retendering remedy will have to sit alongside a willingness of companies to opt for firms other than the Big Four, if there is to be a big change. It will depend on buyer behaviour as much as it will on regulation."

Cost implicationsResponding to the 5 year provision, KPMG UK chairman Simon Collins says it, "not only undermines the fundamental ‘comply or explain’ principle of UK corporate governance, but also gives rise to a substantial incremental cost – far higher than the estimated £30m – and could have a highly disruptive effect on business".The firm’s UK head of audit Tony Cates adds: "Five year audit tendering will feel relentless to many companies, audit committees and investors who may only see audit quality damaged rather than improved, with the possible end result that the process of tendering becoming an empty box-ticking exercise, rather than a more meaningful, engaged exercise on a ten year basis."

Lord says the cost and time that companies will have to put into a five year tendering process will be "significant". Whether the five year tendering is sustainable, Lord says it is "theoretically possible" but adds "we would have to see how it works in practise to see if it’s having the desired effect".

While the cost of retendering could pose financial burdens on companies, the CC found during its investigation that following a switch, companies obtained a significant audit price decrease, which erodes over the subsequent two to three years.

Fees generally decreased in real terms the year after a switch and returned to the previous fee level in the third year after switching. The median company obtained a 17% fee decrease in the first year after switching and a 2% decrease (compared to the previous fee) in the third year.

Commenting on the cost companies may occur as a result of retendering, Roberts said: "At the moment [tenders] are so infrequent that when they do happen, it’s a huge great palava". "With the move towards a more structured, open-book basis, you’re actually going to get the unit cost of tendering right down. Both for the tenderer and the tenderee."

Surprises from EuropeWhile the debate around introducing mandatory rotation in the UK appears to have settled with the CC’s verdict, there is still a chance that at EU level audit firm rotation could be an option.

Lord says the important thing about CC’s announcement is that they have very clearly said they have concluded that mandatory firm rotation weakens competition.

"We think they’re absolutely right; mandatory firm rotation has an adverse effect on competition because it excludes one firm from the contest. So what I hope is that the CC’s very clear statement to that effect has an influence on the European debate as they consider whether to introduce mandatory rotation at a European level. "

Roberts says he is not sure what to expect from the EU.""It could be anything from mandatory rotation every 10 years to the whole thing getting kicked into the long grass, for all I know."

The European Parliament Economic Affairs Committee has passed on the revised EU audit reform document, which includes the suggestion of mandatory audit firm rotation every 14 years, to the European Council in April.

 

 

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