Competition Commission stops short of requiring Mandatory Rotation of Auditors

by K&L Gates LLP
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Introduction
As part of its ongoing investigation into the UK audit services market, the Competition Commission ("CC") has provisionally decided on a package of remedies that will require FTSE 350 companies to put auditing contracts out to tender at least every five years, encourage shareholder engagement in the audit process and ban "Big-Four-only" clauses in loan agreements. However, in a move welcomed by the top accountancy firms, the CC has declined to impose a mandatory rotation of audit firms.

The CC’s Investigation
The CC has been conducting its market investigation since October 2011, although the audit services market had already been under scrutiny for many years - for example the Office of Fair Trading conducted a provisional investigation following the collapse of Arthur Andersen and Enron concluding in 2002. The CC's February report [1] had found that the dominance of the largest accountancy firms (the "Big Four") is protected by the difficulties of comparing alternative services and the cost of switching auditor. The CC also expressed concerns that auditing contracts were protecting the interests of company management rather than those of shareholders.

Remedies
The CC has found that when tender processes do take place, they are thorough, fair and transparent and produce effective competition but that more are required. The Financial Reporting Council has already imposed a 10-year tender rule but the CC hopes that more frequent tendering will ensure that companies make regular and well-informed assessments of their auditor. Under the CC's proposal, the five-year tender requirement will be extended to seven years in exceptional circumstances.

The other primary measures proposed by the CC are as follows:

  • the Financial Reporting Council’s Audit Quality Review (“AQR”) team should review every audit engagement in the FTSE 350 on average every five years. The Audit Committee should report to shareholders on the findings of any AQR report;
  • “Big-Four-only” clauses in loan documentation should be prohibited, which would encompass all clauses that limit a company’s choice of auditor to a preselected list;
  • shareholders should vote on whether Audit Committee Reports in company annual reports contain sufficient information;
  • measures should be introduced to strengthen the accountability of the external auditor to the Audit Committee and reduce the influence of management, including a stipulation that only the Audit Committee is permitted to negotiate and agree audit fees and the scope of audit work, initiate tender processes, make recommendations for appointment of auditors and authorise the external audit firm to carry out non-audit services.

Some more dramatic measures were rejected by the CC, including requiring companies to change auditors periodically and limiting auditors' ability to provide other financial services. Laura Carstensen, chairman of the audit market investigation group, commented, "We gave careful consideration to other measures including mandatory switching, but we think that the measures that we have provisionally chosen will be the most effective and proportionate way to address the problems we have found. We do not see a competition problem with audit firms retaining business if they do a good job - but they will have to demonstrate this on a regular basis.”

Nevertheless, some argue that even the CC's proposed remedies go too far and are excessively costly. The UK head of audit at one of the Big Four commented, "Large, global companies are inescapably complex; when these businesses put their audits out to tender it creates a substantial burden and the process can take up to two years of preparation." The CC estimates that the cost to the industry of these reforms will be less than £30 million a year once it is up and running, but the Big Four argue it will be “far higher” than that.

What happens next?
The proposals will be open to public comment until 13 August 2013. The CC's indicative timetable states that it hopes to publish its final report during September 2013 and its statutory deadline falls on 20 October 2013. In any event, if the CC proceeds with the proposed five-year tender obligation, there will be a five-year transitional period before this requirement takes effect.

The audit industry was widely criticised during the financial crisis for not doing enough to flag up concerns about company balance sheets and not scrutinising banks' books in enough detail. These concerns have resulted in the European Union also considering action in this area. It seems likely that, if approved, the EU initiative will go farther than the CC, for example in proposing mandatory switching of auditors every 10-25 years and potentially imposing curbs on their ability to provide advisory work.

Notes:
[1]   Its provisional findings announced on 22 February 2013.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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