The Competition and Markets Authority has issued an update in its market study into the audit sector, which was launched in October.
The concerns and proposals the CMA has now announced touch on some of the key aspects of how the market for large company audits works, and if taken up have the potential to fundamentally change the sector going forward.
What issues has the CMA identified?
The update notes a number of concerns the CMA has with how the audit market operates, including the dominance of the so-called "Big 4" audit firms _ PwC, EY, Deloitte and KPMG. The CMA notes that these firms conduct 97% of FTSE 350 audits between them, but at least 75% of their revenues come from non-audit services such as consulting. The CMA expressed concerns that these factors result in limited choice for companies and a weaker incentive for firms to deliver high quality audits.
The CMA also noted a potential misalignment of incentives in companies choosing their own auditors, with evidence that some companies' selection of auditors is too reliant on factors, such as 'cultural fit' or 'chemistry', that may not necessarily identify who will conduct the most robust audit or be most likely to challenge the company's management.
What does the CMA suggest?
The CMA is now consulting on proposals to change the law on how audit firms operate. The measures proposed include:
- Requiring auditors to focus solely on audit services and not on other services such as consulting, possibly through requiring structural break-ups of existing firms but more likely by requiring audit and non-audit businesses to be split into separate operating entities with separate management, finances and remuneration. This is intended to preserve the advantages of firms being able to call on the expertise of their related advisory businesses, but ensure auditors focus on and are rewarded only for their audit activities.
- Introducing regulatory oversight of the appointment of auditors by audit committees, to ensure they are acting independently of management, are prioritising quality and willingness to challenge over price and 'cultural' factors, and are not biased against firms from outside the Big 4. This is as an alternative to auditors being appointed entirely independently of the company in question, which the CMA notes might be legally and practically difficult but does not rule out.
- Introducing more competition and reducing the barriers to 'challenger' firms, by requiring all FTSE 350 companies to appoint two audit firms jointly, at least one of whom must be a non-Big 4firm. This is intended to allow challenger firms to develop experience and credibility with larger clients, building their offering so it presents better competition to the Big 4, while also allowing for a cross-check on quality. If joint audits did not work, the CMA proposes a market share cap instead, which would limit the number of FTSE 350 businesses that could be audited by the Big 4.
- Peer review of audits by the regulator which could essentially amount to an audit of the auditors.
The CMA appears determined to see change in the audit market, noting that if the proposed actions would not have the desired results (including if difficulties are identified at consultation stage that could not be overcome) it would revisit the more drastic alternatives such as structural break-ups, independent appointment of auditors and a market share cap.
It is important to note that the CMA's proposed remedies at this stage would require primary legislation, which would of course require the UK Government to both adopt the proposals and then find time for the legislation in a busy (and at present Brexit-dominated) Parliamentary timetable. The Government has established a new review, under the outgoing chair of the London Stock Exchange, to build on the CMA's recommendations and those of Sir John Kingman's review of the Financial Reporting Council, the current industry regulator.
In the meantime the market study has another nine months to run. The sector may therefore face more CMA scrutiny and proposals for intervention, particularly if the CMA were to move on to a full market investigation. In that case the CMA would have greater scope to impose remedies without legislation, in the form of binding orders. While the full range of current proposals could not be implemented via orders, the CMA's powers following a market investigation are extensive, and include the ability to order the break-up of businesses.
The CMA's consultation is open for responses until 21 January 2019, with consultation questions and a format for responding available at section 6 of the CMA's update paper. If you are an audit firm, an audited company or simply an interested party, and would like assistance understanding the CMA's proposals or responding to this consultation, we would be delighted to help.