Should the OFT Refer Problems in the Audit Market to the Competition Commission?

Sarah Jane Leake | Bloomberg Law

Statutory Audit: Consultation on the OFT’s provisional decision to make a market investigation reference to the Competition Commission of the supply of statutory audit services to large companies in the UK – Office of Fair Trading Consultation Paper OFT1357 of 29 July 2011

Earlier this year, the House of Lords Select Committee on Economic Affairs (Committee) published its much anticipated report on the audit market.1 In its report, the Committee made significant criticism of the “big four”2 firms’ domination of the market and argued that such a high degree of market concentration unfairly limits competition and choice. Concerned about the seriousness of the problem, the Committee called upon the Office of Fair Trading (OFT) to conduct a detailed investigation into the UK audit market, with a view to making a market investigation reference (MIR) to the Competition Commission (CC).

In May, the OFT announced that there were sufficient problems in the UK audit market to merit referral to the CC.3 In other words, the statutory test for referral, set out at section 131 of the Enterprise Act 2002, had been met: there were reasonable grounds for suspecting that there are features in the audit market that restrict, distort or prevent competition in the UK. However, before making a final decision on whether or not to make a MIR, the OFT wanted more time to explore with stakeholders whether or not appropriate remedies exist. After three months of liaison with industry, the OFT concluded that there is room to improve competition within the audit market, and announced its provisional decision to make a referral to the CC.

Section 169 of the Enterprise Act provides that before making a market investigation reference to the CC, the OFT must consult with those whose interests are likely to be affected by the reference. To this end, on 29 July, the OFT launched a consultation on whether a referral should be made.

The Audit Market

Under Part XVI of the Companies Act 2006 (CA 2006), a large number of companies are required to have their annual accounts externally audited. The auditor is required to provide an assurance that the firm’s financial statements provide a true and fair view of the company. Auditors therefore play a key role in maintaining public and investor confidence in companies and in the financial system as a whole.

In the OFT’s estimation, audit fees for FTSE 350-listed companies last year amounted to at least £600 million. While there are a large number of audit firms in the UK available to carry out statutory audits, few actually audit the largest companies in the country. These audits are undertaken almost exclusively by the “big four” firms.

In 2010, the “big four” collectively earned 99 percent of audit fees paid by FTSE 100-listed companies and 98 percent of the fees paid by FTSE 250-listed companies. The OFT suspects that concentration in the auditing of some specific industry sectors (e.g., banking) may be even higher.

For some time, the OFT has been concerned that the audit market for large companies in the UK is highly concentrated, with low levels of switching and sizeable barriers to entry, expansion and exit.4 In the wake of the financial crisis, at a time when the quality of audit is considered vital to market stability, the OFT argues that it is now appropriate to refer these problems to the CC.

Too Much Concentration, Too Little Competition

The OFT has identified a number of features, both individually and collectively, that prevent, restrict or distort competition in the audit market.

— Switching

Companies switch auditors very rarely. Research suggests that FTSE 100-listed companies switch auditors every 43 years, and FTSE 250-listed companies do so every 24 years.5 The OFT considers this indicative of limited competition and unfairly restrictive to new entrants to the market. The OFT has identified two key reasons for low levels of switching.

First, there is little incentive for companies to change auditors. Technical audit quality is becoming increasingly difficult to ascertain, particularly when subject to strict regulatory standards. In particular, concern has arisen that audit is now more of a rules-based, box-ticking exercise where less reliance is placed on auditor judgement. As such, audit is often wrongly perceived as a regulatory hurdle rather than something that can add value.

Secondly, companies are reluctant to change auditors because of the cost involved in doing so. According to PricewaterhouseCoopers, estimated switching costs are steep – typically between £500,000 and £1 million.

— Tendering

“The expense involved in the tendering process, as well as the dislocation, cost and quality risk involved in bringing in a new auditor,” commented PricewaterhouseCoopers last year, means that “large companies do not choose to put their audit out to tender very frequently.”6 In the OFT’s view, however, the lack of proper tendering limits the ability of firms outside the “big four” to compete for audit contracts.

— Bias for Size & Reputation

Size and reputation are the two most important factors borne in mind by companies when appointing auditors. In their view, engaging a large audit firm with an established reputation is more likely to satisfy investors.

While, according to the OFT, there is little difference in reputation between the “big four” firms, there is a larger difference in reputation between the “big four” and mid-tier firms. In consequence, mid-tier auditors struggle to compete, even where they offer better value or higher quality work.

— Bigger & Better?

Larger firms, without a doubt, are better resourced for auditing larger companies. Owing to their size, they possess a number of attributes that their mid-tier counterparts find difficult to acquire, including: greater experience in auditing complex businesses; sector-specific experience; extensive and integrated international networks; greater familiarity with the latest regulatory developments achieved through close connections with the relevant standard-setting bodies; capacity to provide non-audit services; and, ability to recruit high calibre talent.

Larger audit firms argue that they have developed many of these attributes to meet their clients’ demands in an increasingly international market. Smaller firms, however, inevitably find it difficult to develop these qualities because of the difficulty encountered in securing large audit contracts in the first place.

— Raising Capital

Smaller audit firms find it hard to raise money for expansion. According to the OFT, such difficulties are caused mainly by the requirements for a firm to be majority-owned.7 The firm’s ability to raise equity finance without restructuring is therefore severely limited, owing to the fact that a substantial number of partners/owners are not auditors themselves.

— Restrictions

Banks, when providing financing to companies, typically demand restrictive lending clauses requiring audits to be performed by one of the “big four” firms. This inevitably limits competition in the market. Both the OFT and the FRC have concluded that this issue merits further investigation.

The OFT identifies a multitude of other factors that limit companies’ choice of auditor, placing particular emphasis on multi-jurisdictional regulatory restrictions. Of particular significance to transatlantic companies is the U.S. Sarbanes-Oxley Act of 2002, which limits the ability of certain public companies to appoint auditors who already supply them with certain types of non-audit services.

Next Steps

The audit market is stuck in a vicious circle. Auditors with higher shares of supply can and do charge higher fees and, as a result of this, end up owning a greater proportion of the market.

There is widespread concern that concentration in the audit market will continue to grow unless remedial action is soon taken. This is especially relevant since, in reality, there is only a “big three” in the UK because Ernst & Young is not active. Should one of the “big four” leave the audit market, there would be an even greater degree of market concentration.

While it is up to the CC to determine the most appropriate remedy, the OFT concludes that there are two board categories of potential remedies available – those designed to remove barriers to competition and increase rivalry,8 and those intended to increase transparency and empower purchasers.9 In the OFT’s view, most, if not all, of the potential remedies are within the CC’s power to implement and could, where necessary, be supplemented by recommendations to the Government or the European Commission.

The consultation remains open until 9 September and the OFT anticipates being in a position to announce its final decision before the end of the year.