Investor power at core of Competition Commission remedies

by Richard Crump

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26 Feb 2013

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THE BIG FOUR appear to have lost their way on who they work for, according to the findings of the Competition Commission's investigation into their dominance of the FTSE 350 audit market.

Of all the competition watchdog's observations about auditors' relationships with the companies they audit, the most stinging rebuke is that they are failing to serve their primary customers.

Auditors are appointed to protect the interests of shareholders, yet, according to the Competition Commission, too often their focus is on meeting the needs of senior management; the arbiters of whether their services should be retained. The agenda of the two parties are not always necessarily aligned.

By focusing on management interests over those of shareholders, auditors have created a "static market" in which too often audits fail to fulfil their intended purpose and meet the needs of shareholders.

The stickiness of audit tenures - 31% of FTSE 100 companies and 20% of FTSE 250 companies have had the same auditor for more than 20 years - has meant, so the commission's argument goes, that auditors have become too cosy with finance directors and compete to satisfy management. Their incentives are "misaligned".

The commission's findings, part of a provisional report into audit concentration in the large company market, were given short shrift by the Big Four. More than any of part of the commission's diagnosis about the "adverse effects" the Big Four's dominance has caused, or any potential medicine the commission might prescribe, it was the claim they have lost sight of their core function that drew the frostiest response.

"They just got that wrong," Simon Collins, chairman and senior partner at KPMG, tells Accountancy Age. "A lack of change [in auditor] doesn't mean you are too close to the finance director. There are not many audit committee chairs that would tolerate cosiness between auditors and FDs."

Collins was not alone in taking umbrage. Indeed, Ernst & Young, PwC and Deloitte all issued vehement rebuttals. "We categorically disagree that auditors typically place the interests of management over shareholders," was one typical response - from Deloitte's head of public policy and managing partner David Barnes.

Yet one would expect the Big Four to say that. Though that is undoubtedly the case, their mid-tier rivals - those companies most likely to benefit from any trimming of the Big Four's power - echoed the sentiment issued by their larger rivals. If, so they argued, auditors have departed from their core mission it is not the result of Machiavellian tendencies on the part of the Big Four.

"There are very few mechanisms for shareholders to get involved in the auditors' appointment," says Steve Maslin, head of external professional affairs at Grant Thornton. As a consequence investors have complained about being disconnected from the audit process.

"They want to be reconnected," says David Herbinet, head of public interest markets at Mazars. "Every time we put investors and audit committee chairs around a table they say they are missing regular contact."

Visibility

Among the remedies on the table - the commission has proposed seven in all - are moves to enhance shareholder/auditor engagement and strengthen auditor accountability to the audit committee. While shareholders vote annually on the appointment of the auditor, in practice they exert little influence over the choice of auditors and have little chance to engage.

To change the process of dialogue, the commission has suggested changing shareholder voting requirements to include an option to vote for holding a tender for external audit; requiring audit engagement partners to present to shareholders at AGMs and requiring audit committee chairs to hold a Q&A at AGMs on audit or financial reporting.

Additionally, the commission has suggested extending reporting requirements in either the audit committee's or auditor's report. It is no secret that investors are dissatisfied with the relevance and extent of reporting in financial reports, and the commission's proposals are in line with work already being undertaken by the Financial Reporting Council and IAASB as to how audit reports can be enhanced.

The FRC has already updated the UK's 20-year old corporate governance code with a host of changes that will encourage more informative reporting by audit committees, including on the process of appointing an external auditor and commenting on their effectiveness. According to auditors, visibility about the selection process and auditors' communication with committees has been lacking, rather than deficiencies in the process itself.

"We do a huge amount of work with audit committees," says Richard Sexton, head of reputation and public policy at PwC. "The Competition Commission has grossly underestimated the importance of that relationship."

Missing the point

Imposing some form of mandatory tendering of auditors could go some way to "shining a light" on the dialogue that goes on between auditors and committees. But only if there is a comply or explain provision. The commission has suggested tender periods of five or seven years, but unlike the FRC, which last year decided to force FTSE 350 companies to put their audits out to tender every ten years - or explain why they didn't - the commission believes such a provision would "undermine compliance" with the remedy.

By doing so it has missed the point, says KPMG's chairman. "Comply or explain shines a light on the audit committee. It is the membrane of governance between auditor and shareholder. Forcing them to tender would shed sunlight on their judgments."

Though Collins says KPMG has "no fear" of tendering, he remains opposed to the concept of mandatory auditor rotation, also being considered by the commission, and separately as part of audit reforms currently working their way through the European parliament.

The commission is considering rotation periods of seven, ten and 14 years, which it believes will increase companies bargaining power and increase competition between the auditors. The Big Four are united in their claim that enforced rotation is anti-competitive. The commission should take heed because some in the mid-tier agree.

"Mandatory rotation has been shown in practice and academic studies that it doesn't lessen concentration," says James Roberts, audit partner at BDO. "Mandatory tendering is the preferable route."

The mid-tier firms are not of one mind on this point however. According to Maslin at Grant Thornton, firms should "think several years down the track" as the requirement to tender or rotate could lead into advisory services.

"If you move towards frequent tendering and rotation it will encourage audit committees to form more meaningful relationships with a wider selection of firms," Maslin says. "They will not want firms on the tender list if they have no intention of appointing them. Likewise, firms will be reticent of tendering if they have no chance of winning."

Striking omissions

The commission's provisional recommendations are perhaps more interesting for what has been left out than for what has been included. For instance, it is doesn't suggest constraining non-audit service provisions or encourage the use of joint or component audit.

Both have been the subject of heated debate in Europe, particularly prohibiting the provision of certain non-audit services. Under the discussion in Europe is the black-listing of certain services, while other services would feature on a grey list, meaning they may be provided after approval of audit committee.

In its investigation, the commission found no evidence to suggest audit was a loss leader and that prohibiting the provision of non-audit work could undermine a means of facilitating switching from incumbent auditors, though it did recognise its potential to impair the independence of audit.

Herbinet for one is disappointed it was not included by the commission. "Non-audit is an interesting one we will take up with the commission. We think that will help to open up the market," he says.

He, and the rest of the profession, will get their chance to argue their case. The commission is considering suggestions for alternative remedies until 18 March, and will publish its final report by October. Then it will be down to Europe to take up the torch, though where the European Commission's investigation into the audit profession will end up is, after much to-ing and fro-ing, still up in the air.

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