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February 27, 2013

CC report explains provisional findings

Last week’s summary of the provisional findings into the statutory audit market concentration by the UK Competition Commission (CC) has been backed up by the release of a 297 page report explaining the CC methodology and findings.

The overall verdict by the CC last week was that the audit market is restricted by factors which inhibit companies from switching auditors, and by the tendency of auditors to focus on satisfying management rather than shareholder needs.

The CC also said that until the end of its consultation, the final report expected in the autumn, it is to consider remedies such as mandatory tendering and rotation, increased transparency with more frequent audit reviews and extended reporting requirements, and the strengthening accountability and independence by giving audit committees and shareholders greater control of external auditors.
The CC said in its report that the low level of switching auditors is not linked to any large investment that the mid-tier needed to make, however the CC concluded that potential customers looked for a substantial track record of experience of auditing FTSE 350 companies when selecting auditors.

"In our case studies the interviewees (all FDs or ACCs of FTSE 350 companies) generally had much better awareness of the capabilities of the Big Four firms than they had of the Mid Tier firms," the CC report reads.

The CC said that Deloitte, KPMG and PwC all submitted that weaker market awareness of mid-tier firms was driven by mid-tier firms’ less significant efforts to target larger companies.

"However, this is a ‘chicken and egg’ situation. If mid-tier firms do not believe they will win FTSE350 audits they have no commercial rationale to invest more in marketing to FTSE 350 companies. If companies are not aware of mid-tier firms’ capabilities then they are unlikely to invite them to tender."

The CC investigation found that the tenure of existing auditors was longest among FTSE 100 companies. An auditor was appointed for more than ten years at 67% of FTSE 100 companies, 52% of FTSE 250 companies.

"We also found that 31% of FTSE 100 companies had audit engagements exceeding 20 years compared with 20% of FTSE 250 companies."
The report also said that the CC was not able to reach a conclusion on whether audit firms were making profits above competitive levels.

"This was on account of difficulties in valuing capital employed; the intangible nature of the asset base in this market; difficulties in cost allocation (as firms offered both audit and non-audit services); and difficulties in identifying costs due to the partnership ownership structure. However, we found that the risk-reward balance offered to audit partners was attractive; and on balance it appeared to us that audit was a relatively attractive service line whose risks were not unusually high, when compared with other service lines," the CC report reads.

Shareholder needs
The CC report also elaborates on one of its main findings with regard to shareholder needs.

"It appeared that shareholders, despite their legal rights, played very little role in any decision to appoint an auditor, while in contrast executive management was very influential," the CC report said.

The CC said it found that both shareholders and management have an interest in the auditors detecting issues likely to lead to a material misstatement of accounts.

"We considered that each might have different incentives when it came to reporting the findings of those investigations, and in how issues requiring judgement were treated. In particular, we found that at times executive management had incentives to manage reported financial performance to accord with expectations and present accounts in an unduly favourable light. We found that, in general, shareholders would have no such interest."

The CC goes on to say that it has provisionally concluded that while most of the time audits were performed diligently and with appropriate challenge, any loss of audit objectivity or scepticism in conducting a given audit would not easily be detectible, and so it was possible that such loss of independence occurred without being known by shareholders.

"We provisionally found that the loss of independence arose because competition between audit firms was on the wrong parameters, as audit firms responded to demand from executive management and not demand from shareholders, which is a restriction or distortion of competition."

The summary issued last week provoked mixed opinion in the profession with the Big Four opposing some of the main findings and potential remedies such as mandatory rotation and the mid-tier welcoming the CC’s tone and recognition of some of the issues.

Related articles
UK audit market not serving shareholders: CC provisional findings

CC audit chairman comments on "radical suggestions"

CC provisional findings split the profession

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