The Big Four firms face an operational split between audit and consulting services, and mandatory joint audits of large listed companies, as a result of the Competition and Markets Authority’s (CMA) final report on the UK audit market, reports Accountancy Daily.
The competition watchdog has stopped short of calling for a full break-up of the sector’s biggest firms, citing concerns about the global nature of the firms and the impact of the UK taking a unilateral approach to audit reform.
The recommendations are intended to address what the CMA described as ‘serious competition problems in the UK audit industry’, and are the result of its own consultation and outreach activity, as well as consideration of the Kingman review on the future of the audit regulator, the Financial Reporting Council (FRC) and the BEIS select committee inquiry into the audit market.
The CMA says rapid legislation is required to address both the vulnerability of the industry to the loss of one of the Big Four firms, and the current inadequate choice and competition across the market, which is dominated by four players – PwC, Deloitte, EY and KPMG.
It has made three recommendations to the government – splitting the Big Four firms on an operational basis, mandatory joint audit except in the case of the largest audits and greater oversight of audit committees – and is calling for swift action to change current legislation to establish the new framework.
The watchdog expects the government to take the recommendations seriously and move to introduce legislation and give the regulator more powers of oversight. Secretary of state for business, Greg Clark, called for the CMA review last autumn following growing concern about the audit market, lack of competition and a succession of audit failures, and he has subsequently told the BEIS committee that he was committed to making the changes to audit governance.
Although some of the measures would require legislation, the CMA says that the underlying framework would have to be shaped and governed by the replacement governance body for the FRC which is yet to be set up – the Audit Regulation and Governance Authority (ARGA).
The lack of competition in the market for listed entity audit means that the CMA has taken a radical approach, calling for mandatory joint audits, with equal parity for audit firms, and rejected criticism from Big Four firms that this would dilute the market and not create more competition from challenger firms. It also accepted that any changes would take time to implement as firms responded to the new dual audit requirements.
The watchdog also expressed serious concerns about long-term market stability with the risk of one of the Big Four collapsing, as happened in 2001 when then Big Five firm Arthur Andersen was brought down over the Enron scandal.
It wants to protect against the collapse of one of the current Big Four, which would arguably dilute competition further.
The CMA said that ‘the impact of failure of one of the large firms on competition would be mitigated if it were possible to prevent the failed firm’s audits from moving to the remaining three large auditors. For example, if the failed firm’s audits and partners could instead be moved to one of the challenger firms (or shared between a number of them) then the concerns about the impact on choice would be significantly diminished’.
Recommendation: audit split
Regarding the Big Four’s operational models, the CMA says auditors should focus exclusively on producing the most challenging and objective audits, rather than being influenced by their much larger consultancy businesses.
However, it acknowledges there are difficulties with an immediate global structural split. At this stage, the CMA is recommending an operational split of the Big Four’s UK audit work.
This will require separate management, accounts and remuneration: a separate CEO and board for the audit arm, populated by a majority of independent non-executives.
The CMA argues that by keeping the firms structurally intact while operationally separate, this recommendation will allow the firms to preserve the elements of their multi-disciplinary practices that they prize most highly: the ability for audits to draw on non-audit expertise from staff with a shared brand; and attracting recruits with the potential to carry out different types of work across audit and non-audit.
The key elements of the operational split are likely to embrace no profit-sharing between the audit practice and the non-audit practice, with audit partner remuneration linked to the profits of the audit practice only. There will be separate financial statements for the audit practice, consisting of a profit and loss statement for the audit practice, along with transparent transfer pricing, checked by the regulator, particularly for the use of non-audit specialists on audits.
The audit practice should also include audit-related services, such as various regulatory reporting requirements that regulators regard as being best carried out by companies’ auditors.
The CMA says the audit board should be responsible for all remuneration and career progression decisions within the audit practice, and these should be strongly linked to audit quality, with the audit board setting and overseeing quality standards.
As suggested by the BEIS select committee, a ‘cooling-off’ period could be introduced after the end of an audit, during which the firm would not be allowed to carry out any non-audit work for the company concerned. This should be considered by the regulator, in the context of its existing review of its ethical standard.
The CMA warns that if it proves impossible to complete an operational split that delivers the expected improvements – for example if the firms found ways to erode the separation – then the government should consider a structural division between audit and other activities.
Recommendation: mandatory joint audit
The CMA’s second recommendation is designed to remove the barriers to entry for ‘challenger’ audit firms in the FTSE 350. The watchdog says mandatory joint audit will increase the capacity of challengers, increase choice in the market and thereby drive up audit quality.
There should be initial limited exceptions to the requirement, based on criteria set by the regulator, focused on the largest and most complex companies. In addition, any company choosing a sole ‘challenger’ auditor should be exempt.
Audits of exempt companies may be subject to rigorous, real-time peer reviews commissioned by and reporting to the regulator. Currently this is the FRC, although this body is going through a transition into the new Auditing, Reporting and Governance Authority (ARGA) recommended by the Kingman review.
The CMA said it had rejected an alternative proposal, for shared audits, on the grounds this would result in the smaller firm being very clearly subsidiary to the bigger, and would be less effective in achieving resilience and choice in the market. It would also present a risk to audit quality because the second auditor would not sign the audit report, and would not be jointly liable, as with joint audit.
Key elements of the new approach will be a requirement for most FTSE 350 companies to appoint joint auditor, with at least one joint auditor a non-Big Four firm. The regulator should establish criteria on which companies may need initially to be exempted, covering a small number of the largest and most complex companies; companies with very simple, single-entity accounts such as investment trusts are also likely to be candidates for exemption.
The CMA says the introduction of joint audit should be gradual, enabling adaptation over time, as suggested by the BEIS select committee; companies should make the transition to joint audit no later than when their next tenders arise (rather than all companies in scope having to make the change immediately), but could do so earlier if they choose.
Audit committees should ensure that the work of each of the two joint auditors is substantial and relatively equal, starting with each audit firm ordinarily receiving at least 30% of the audit fee. No changes should be made to the existing UK audit liability framework, meaning that the joint auditors will have joint and several liability for the engagement.
The joint audit requirement will remain in place until the regulator determines that choice and competition have improved enough to address the vulnerability of the market to the loss of one of the Big Four.