The audit market isn’t serving shareholders.
That’s the UK Competition Commission’s provisional finding following a yearlong investigation of the statutory audit market. The Commission’s possible remedies, which include mandatory tendering and rotation, increased auditor accountability to the board and engagement with shareholders, and restrictions intended to address the dominance of the ‘Big Four’ audit firms, suggest that one of the coziest corners of the UK corporate world may be due for some fresh air.
Interested parties are invited to comment on the possible remedies (PDF) by March 18, and on the provisional findings by March 21.
The Commission found that auditors have misaligned incentives and tend to satisfy management rather than shareholder interests. This may reflect the strong influence that management, rather than the board or audit committee, have over auditor selection and fee approval. Suggested remedies include changing voting requirements to empower shareholders, requiring auditors to appear at AGMs, and giving audit committees increased power over fee negotiations, tenders, and approval of non-audit services.
Duration of service is another issue of concern, as over half of FTSE 350 companies have not changed their audit firm for over ten years, with the tenure at more than 20% of such issuers extending beyond two decades. Directly referencing recent non-binding Financial Reporting Council guidance that tenders be made every ten years, the Commission states that “a greater frequency of tendering may be required”, suggesting mandatory tenders every five or seven years as a standard. As the tender process does not necessarily lead to a change in auditor, the Commission also suggests a mandatory change of audit firm after five, seven or ten years, or every two tender periods.
In addition to encouraging competition for each issuer’s audit, the Commission seeks to encourage competition amongst auditors themselves. Noting that the “overwhelming majority” of FTSE 350 issuers rely on one of the ‘Big Four’ auditors, the Commission suggests prohibiting restrictions on the use of non-Big Four firms in loan contracts. In addition, more frequent and extensive quality review and extended reporting requirements could provide shareholders and issuers with more information about audit quality, and in turn reduce barriers to switching firms.
Several potential remedies that the Commission is not considering include restrictions on non-audit services by the main audit firm, or making shareholder groups or the FRC responsible for auditor appointment. The final report is due by October 2013.
While the FRC’s recent guidance on tendering was a welcome addition to the UK Corporate Governance Code, we are encouraged that the Commission is considering further regulation, including mandatory requirements. Given the critical importance of financial disclosures, as evidenced by recent accounting scandals, this may be one area where the UK’s traditional non-binding, comply-or-explain model does not go far enough to protect shareholder interests.