Audit Commission's demise may see Big Five emerge

WHILE THE AUDIT COMMISSION BRACES for the executioner’s axe, accounting firms are clamouring to step into its shoes. But the question of who will inherit the kingdom remains uncertain, with Big Four, mid-tier and smaller accounting firms all in the running and arguing that they should have a share of the commission’s considerable hoard.

Last month, commission staff released a consultation document on the future of the body – a crisp 43-page document which resembles a final will and testament.

In the “issues paper” the commission explained how the government might divide its work and responsibilities after its demise in 2012.

However, within the pages is a warning: a “free market” for auditors of public bodies will do more harm than good resulting in struggling local councils and public authorities paying through the nose.

A free market is exactly what large accounting firms want, and in that aim they have the most powerful of allies – the government.

“I want to see the commission’s auditing function become independent of government, competing for future audit business from the public and private sector,” local government secretary Eric Pickles said in August.

At stake is about £184m in audit revenue, a huge sum by any measure. By contrast, the UK’s fifth largest accounting firm, Grant Thornton, earned £136m from audit in the last year.

The Audit Commission represents the largest purchaser of audit services in the UK and has used this market position on behalf of public bodies to secure the best deal for taxpayers.

Famous five

The commission, at present, outsources 30% of its audits to a handful of accounting firms with dedicated public-audit departments. The remaining work it handles in-house. There are only five accounting firms which compete for these public contracts: Deloitte, Grant Thornton, KPMG, PKF and PwC.

Without the commission to bulk-manage audit tendering, a wholesale market for auditors could end up increasing costs for councils and other public bodies, costs which might then be passed on to the public. The commission negotiated a £30m reduction in costs over the next five years, however, without a volume discount, these savings are likely to be lost.

The number of firms the commission outsources to has been steadily shrinking since the commission was established in 1983, when there were 15 firms. The situation has led to a concentrated market with five firms holding the required expertise to audit public bodies. If the commission’s work is put out to tender in a free market it will be these firms, in the short term, that will benefit. New players could emerge, but are unlikely. Building expertise in this specialised area takes time and effort, and new entrants will need to invest considerably to bring their departments up to scratch.

Further complicating the picture is the existence of some 9,800 small public bodies, which may require an audit but can barely afford to tender or pay the auditor.

These bodies, among them internal drainage boards, larger local councils, charter trustees, port health authorities and a number of

joint committees, have an annual turnover of £1m or less. The commission has operated a proportionate “limited assurance” model for these bodies.

Bodies with income and expenditure below £200,000 use a “basic” audit, while larger bodies receive an “intermediate” audit.

Smaller still, there are some 1,200 public bodies with expenditure below £1,000, where the audit is conducted free of charge. For 1,900 bodies with expenditure above £1,000, but below £5,000, the fee is £50.

The total fees for this sector amounts to about £2.5m – just over 1% of the commission’s income.

These smaller audits are not cost-effective for audit firms in an open market. The commission had to cajole and create a secondary market with firms, including BDO, Clement Keys, Mazars and Moore Stephens, being awarded regional contracts for a bundle of audits in a geographical area.

Without the commission to manage this market, audit firms are unlikely to take on this work. The commission has itself warned: “It is unlikely the efficiencies of scale that are essential to the viability of the limited assurance regime for small bodies could be sustained [after the commission is scrapped]”.

“There is a real risk that the skills and experience of current audit suppliers would be lost, as it is unlikely that they would wish to be appointed to individual councils other than on a very selective basis,” the commission said.

Under one proposal these bodies may have to subscribe to an “independent examination” model currently used as a cost efficient audit-variant for charities.

Another option is for smaller, local accounting practices to pick up the work, however, with limited experience of local government accounting and without the commission to maintain consistency the UK market could be left with inconsistent standards across the country.

But there is more at stake than just public accounting standards. There are fears within the UK’s reporting regulator, the Financial Reporting Council, which oversees the functioning of the audit industry, that the abandoned work of the

Audit Commission will be carried off by the Big Four accounting firms, further entrenching their oligopoly of the UK audit market.

Aggressive tendering, com­bined with an ability to undercut competitors, could see the firms triple their existing revenue from public audits, especially from larger public bodies like councils.

Rising from the dead

The FRC is fighting further consolidation of creating a free market for auditors. Instead it has proposed an imaginative solution – the creation of a new audit firm, like a phoenix, out of the ashes of the Audit Commission.

Commission staff would retain their audit work and bid competitively for public sector work. Under this idea, the top-six accounting firms would be forced to compete with a private sector Audit Commission, with an existing contact base, expertise and reputation in the public sector.

However, this might only serve to create another monopoly dominated by a newly created Audit Commission or, in other words, another “too-big-to-fail” entity.

It would also do little to erode the Big Four’s stranglehold in the private sector. Only accredited “responsible individuals” (RI) can audit private companies. Audit Commission auditors however use alternative qualifications that limit them to the public sector.

Some, within the big accounting firms, suggest the commission would be unable to competitively tender. The large audit firms have vast experience competing for audit work, in contrast to commission staff who have little experience on the tendering side. In a pitched battle for public sector work, the honed pitching skills of the big accounting firms may trump their former public sector colleagues.

One alternative being discussed at the FRC is a partnership between a privatised Audit Commission and an existing non-Big Four firm. The most likely contender by size would be the UK’s fifth largest firm Grant Thornton. However even here there remain great challenges.

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The Audit Commission’s current workload eclipses Grant Thornton’s audit revenues by more than £50m. The structural challenge in absorbing the commission’s staff are potentially insurmountable and would take years of integration.

A final alternative is to allow non-Big Four firms preferential bidding rights for public entities, however, this would place the government in the bizarre situation of enforcing a type of negative-discrimination against Big Four firms.

Despite this, there is some tentative support for this approach outside the FRC.

Michael Izza, CEO of the ICAEW, said in a statement that if a model was adopted that saw the National Audit Office take on an oversight role over a private sector regime, such an arrangement “has the potential to create greater competition and choice within the audit market and could be a real opportunity for accountancy firms outside the Big Four”.

The decision will largely fall to the Communities and Local Government department (CLG) which is currently drawing up recommendations to take to government in the 2011 legislative year.

Legislation needs to be drawn up to cement the new structure, with new laws needing to pass through Parliament next year.

Commission staff are not quite counting the months until their doors close forever, but the end is within sight. What remains uncertain is who will inherit the new kingdom.