UK Audit Market Subject to Competition Commission Investigation
Sarah Jane Leake | Bloomberg Law
After months of consultation1 arising out of high-level parliamentary scrutiny,2 the Office of Fair Trading (OFT) now has confirmed its decision to refer the market for the supply of statutory audit services to large companies in the UK to the Competition Commission (CC) for investigation.
In line with the statutory test for referral, set out at section 131 of the Enterprise Act 2002, the OFT considers there to be reasonable grounds for suspecting that there are features in the audit market that restrict, distort, or prevent competition in the UK.
While a number of respondents to the OFT’s recent consultation argued that the OFT’s investigation was too limited in scope, the OFT maintains that the OFT stage is “not intended to be a deep and prolonged investigation in which every avenue is exhaustively looked at . . . . That is for the CC stage.”3
The Importance of the Audit Market
Audit is vital to the country’s financial health. A large number of companies are required to have their annual accounts audited, pursuant to Part 16 of theCompanies Act 2006, for the primary purpose of providing assurance to shareholders and the wider investment community that a company’s financial statements represent a true and fair view of the company. As auditors therefore play a key role in ensuring an efficient allocation of capital, it is important to ensure that the market for audit is sufficiently competitive, and that it can deliver the most efficient outcomes in terms of price, quality, and innovation. This is particularly important considering the size of the market – audit fees for the FTSE 350 in the UK amounted to over £600 million last year.
Current concentration in the UK audit market stifles competition. The “big four” – PricewaterhouseCoopers, KPMG, Deloitte, and Ernst & Young – last year earned, collectively, 99 percent of the audit fees paid by FTSE 100 companies, and 98 percent paid by FTSE 250 companies. Current levels of concentration could increase further in the event of failure of one of the “big four” firms. As such, the OFT is concerned that firms outside the “big four” face substantial barriers to entry, especially in terms of gaining the experience necessary to establish their reputation further and win big company audit work. In its view, therefore, these barriers restrict competition in the supply of statutory audits to large companies in the UK.
Issues Preventing, Restricting, or Distorting Competition
The OFT has identified a wide array of factors that are to blame for preventing, restricting, or distorting competition in the audit market.
The main issue is the rarity with which companies switch auditors. Data collected between 2002 and 2010 indicates annual average switching rates of 2.3 percent for FTSE 100 companies and 4 percent for FTSE 250 companies. On this basis, the annual switching rate of FTSE 100 companies is every 43 years, reduced to every 24 years for FTSE 250 companies. Furthermore, there is little incentive for a company to switch auditors. Substantial financial resources, not to mention time, is required to put a new audit out to tender and help bring a new auditor up to speed. Switching auditors also can prove a costly affair. A number of leading academics, during the parliamentary inquiry, emphasised that companies “are reluctant to change auditors because of the cost in doing so.”4 In PricewaterhouseCooper’s estimation, switching costs for the audited company easily can amount to £1 million. While this is not a large sum in the overall context, it is nonetheless a cost that need not be incurred if the client is satisfied with the existing auditor’s quality of work. Moreover, companies are likely to have been particularly reluctant to change auditors over recent years, when financial reporting regulations have been subject to significant change and financial conditions have been difficult.
Other problematic issues identified include:5
- Size: when choosing an auditor, many companies focus unduly on size and reputation. In their view, appointing a large audit firm with a well-established reputation will more likely satisfy investors. However, larger audit firms undoubtedly possess certain attributes necessary for auditing larger companies, including: greater experience in auditing large and complex businesses; sector-specific experience; more extensive and integrated networks across the globe, including branding, common audit methodologies, and quality standards; capacity to provide non-audit services; and, ability to attract and retain the best talent.
- Raising capital: for small firms, avenues for raising capital are limited. This is primarily due to the requirements for a firm to be majority-owned. Given that a substantial number of partners/owners are not auditors themselves, a firm’s ability to raise equity finance without restriction is limited.
- Restrictive covenants: commonly, banks include requirements in lending agreements for listed companies to use one of the “big four” audit firms. Such restrictions, without a doubt, limit competition in the market. There is general consensus that some form of action should be taken, either to remove these requirements in their entirety or, where they are justified, to make them more transparent.
Referral to the Competition Commission
The UK’s Financial Reporting Council has welcomed the OFT’s decision to make a market investigation reference. In its view, audit regulators do not have the necessary tools at their disposal to address effectively concentration in the market. Furthermore, voluntary action by market participants is just not enough – even on a “comply or explain” basis. In its view, the problem of market concentration is best dealt with by a competition authority. While the CC is due to investigate the issue in more depth, the OFT stresses that it is not concerned with anti-competitive conduct that might be in breach of the Competition Act 1998 – the issues at hand do not relate to the conduct of any individual market participants.
Restricting competition in any sector is likely to produce adverse effects on customers. It can limit choice, drive up prices, and stifle innovation. Market stability is also at risk – particularly should one of the “big four” ever fail.
The European Issue
Last year, the European Commission launched a consultation seeking views on how the audit market within the EU could be improved.6 Similarly, it identified market concentration as a barrier to healthy competition and a proponent of systemic risk. Having held a high-level conference earlier this year on the subject, the European Commission now is preparing draft legislation on an array of issues applicable to the audit sector across the EU.
The OFT sees no merit in waiting for the outcome of the European Commission’s work. Instead, given the UK’s leading position in the global audit sector, the CC’s focused inquiry should run in tandem with the EU process. In the OFT’s view, there are valuable cross-overs and synergies between both projects that will further enlighten both Commissions. Moreover, the CC’s inquiry may reveal idiosyncrasies particular to the UK sector, in which case the Government then would be able to develop supplementary measures to address specific problems not addressed at EU level.
Building on the OFT’s work to date, the CC will commence its own investigation, with a view to determining what remedial action might be taken in order to open up competition in the UK audit market. According to the OFT, there are two main types of remedy available to the CC – those that address barriers to entry and the level of competition between suppliers, and those designed to increase transparency and empower purchasers.
While the CC has until 20 October 2013 to publish its findings, it aims to complete its investigation within a shorter timeframe. In addition to analysing the OFT’s work, the CC is inviting further submissions on the issue from all interested parties, before formally setting out the scope of the investigation in the form of an issues statement. Interested parties are urged to submit their feedback to the CC by 11 November 2011.
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