Audit choice: an open goal?

external audit cover

The Financial Reporting Council is looking at ways to increase choice in the
audit market, following concerns that the Big Four‘s stranglehold on the top end
of the market could hurt audit quality. It has come up with 15 proposals with a
final report due in October. But what are they and how will they affect FDs
choosing auditors?

1 The FRC should promote wider understanding of the possible
effects on audit choice of changes to audit firm ownership rules, subject to
there being sufficient safeguards to protect auditor independence and audit

Explanation: The regulator is trying to open up the ownership of
audit firms. Accountancy firms are generally required under law to be run by
qualified auditors. The FRC believes that private equity or other forms of
investment might ensure that there is greater choice.

Impact: Unlikely to have much impact for some time. If, and when, a
privately funded challenger did charge on to the scene, then FDs could decide
whether to switch.

2 Audit firms should disclose the financial results of their
work on statutory audits and directly related services on a comparable basis.

Explanation: Auditors should declare their profitability. This is
intended to encourage other types of investment to come to the market.

Impact: As with opening the market to private equity, it’s too early
to predict its impact. It’s worth noting that the

Big Four already tell us how profitable audit is. Only recently, Deloitte
said it had made £146m profit on audit revenue of £557m.

3 In developing and implementing policy on auditor liability
arrangements, regulators and legislators should seek to promote audit choice,
subject to the overriding need to protect audit quality.

Explanation: Audit choice should be important to regulators, but not
so important that it overrides quality.

Impact: Practically nil – it’s difficult to see what this adds to
the debate. The audit quality clause has clearly been added by Big Four
lobbyists whose argument is that audits are already excellent.

4 Regulatory organisations should encourage appropriate
participation on standard setting bodies and committees by individuals from
different sizes of audit firms.

Explanation: Bodies like the IASB should try and shed the image they
give of being dominated by Big Four alumni.

Impact: Could be significant. The standards-setters do have a
problem, with the allegation broadly accurate. This will cause a fuss, and
ideally some momentum towards accounting standards that are simpler, and do not
require the likes of a Big Four audit partner to understand.

5 The FRC should continue its efforts to promote
understanding of audit quality and should promote greater transparency of the
capabilities of individual audit firms.

Explanation: The FRC has been criticised for producing bland
statements about audit quality when inspecting the Big Four. It is up to the
Professional Oversight Board, an arm of the FRC, to say when a firm has made a

Impact: The POB is already implementing this by producing individual
audit reports. As far as FDs are concerned, this information will be invaluable.

6 The accounting profession should establish mechanisms to
improve access by the incoming auditor to information relevant to the audit held
by the outgoing auditor.

Explanation: KPMG suggested that incoming auditors should be able to
access the outgoing auditors audit files. That way, they can get up to speed
more quickly, and FDs and others will be keener to switch since it will be much
less hassle.

Impact: Potentially significant, but Ernst and Young has said that
changes to file access would have a ‘limited impact’ on choice as much
accumulated knowledge is not written down.

7 The FRC should provide independent guidance for audit
committees and other market participants on considerations relevant to the use
of firms from more than one audit network.

Explanation: This relates to calls for joint audits, which in France
have seen a much greater choice in the audit market.

Impact: Joint audits are a real hot potato. Mazars, which has huge
experience in France, is backing them. Big Four sources say that the move is a
recipe for trouble – Parmalat was joint audited, they point out.

8 The FRC should amend the section of the Smith Guidance
dealing with communications with shareholders to include a requirement for the
provision of information relevant to the auditor re-selection decision.

Explanation: Companies should say why they are re-electing their

Impact: This will have a very real impact on companies as it is yet
another regulation. Very few say why they are re-electing their auditor, and it
would be interesting to know why many favour the incumbent so often.

9 When explaining auditor selection decisions, Boards should
disclose any contractual obligations to appoint certain types of audit firms.

Explanation: There are fears from mid-tier firms that some potential
clients are told by their bankers or others to hire a Big Four auditor.

Impact: If that is the case, then this may stop it. The idea is to
flush out and expose institutional prejudices.

10 Investor groups, corporate representatives and the FRC
should develop good practices for shareholder engagement on auditor appointment
and re-appointments and should consider the option of having a shareholder vote
on audit committee reports.

Explanation: Directors choose the auditor, but audits are ultimately
conducted for investors and others, who should have role in deciding who the
auditor is.

Impact: There’s little evidence that more than a handful of
investors are interested in engagement on these issues, and suggestions that
investors might sit on the audit committee are perhaps impractical. Apart from
anything else, committees have inside information unavailable to the market.

11 Authorities with responsibility for ethical standards for
auditors should consider whether any rules could have a disproportionately
adverse impact on auditor choice when compared to the benefits to auditor
objectivity and independence.

Explanation: Auditors could be prevented from carrying out non-audit
work for their audit clients.

Impact: This could potentially open up some non-audit work to
others, but it is phrased very vaguely, since it could be contentious. Don’t
expect anything soon.

12 The FRC should review the Independence section of the
Smith Guidance to ensure that it is consistent with the relevant ethical
standards for auditors.

Explanation: As with (11), but for the FRC.

Impact: As with (11).

13 Regulators should develop protocols for a more consistent
response to audit firm issues based on their seriousness.

Explanation: There are worries that in serious cases of misconduct,
the market does not know whether the firm is likely collapse as a result.

Impact: This is more of a damage limitation issue for firms. It
won’t have an impact on other companies unless something goes seriously wrong at
their auditor’s firm.

14 Every firm that audits public-interest entities should
comply with the provisions of the Combined Code on Corporate Governance with
appropriate adaptations or give a considered explanation if it departs from the
Code provisions.

Explanation: The firms should be open and transparent with

Impact: The Combined Code tells companies to communicate with
investors about corporate governance, and ‘comply or explain.’ But as one Big
Four source says, in relation to the fact that Big Four partners already own
their firms, ‘who would we comply or explain to?’ May not make the cut.

15 Major public interest entities should consider the need
to include the risk of the withdrawal of their auditor from the market in their
risk evaluation and planning.

Explanation: Companies should have a contingency plan if their firm
goes under.

Impact: Not huge. Companies can hire another firm, as long as the
choice is there.

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