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U.K. Panel Suggests Rotation to Improve Audit Quality

Tammy Whitehouse | February 22, 2013

Audit firms and public companies in the United Kingdom are too interdependent, restricting the objectivity and skepticism that is meant to protect shareholder interests, according to the U.K. Competition Commission, which studied the audit market at the request of the U.K. Office of Fair Trade.

In a provisional report, the commission says it is looking at possible ways to encourage greater competition through mandatory tendering and rotation, increased information and transparency with more frequent reviews and expanded reporting requirements, and greater accountability and independence by giving audit committees and shareholders greater control over the external audit. The commission says 31 percent of the top 100 public companies in the United Kingdom and 20 percent of the top 250 have had the same audit firm for more than 20 years. It raises a concern that lack of competition can lead to higher prices, lower quality, and less innovation, not to mention a failure to meet the intended objective of protecting shareholder interests.

In the United States, the Public Company Accounting Oversight Board has studied extensively whether it should adopt some system of term limits or mandatory rotation for audit firms as a way to inject greater objectivity and professional skepticism into public company audit work. The board has heard heavy criticism to its initial concept release floating the idea, and even board members have expressed doubt that the board can gather the evidence and support it needs to establish a mandatory rotation requirement. 

The U.K. commission says the audit market, dominated by the Big 4, is restricted by factors that inhibit companies from switching auditors. Those factors also give auditors reason to focus more on satisfying management's needs than those of shareholders. The study concludes that companies find it difficult to compare alternatives with their existing auditor, they prefer continuity, and they face significant costs in firing and hiring auditors. As a result, their reluctance to change auditors diminishes their bargaining power.

On the audit firm side, auditors know it is management, not shareholders, who make the decision on whether to retain or replace the firm, so they tend to focus on meeting the needs of management over shareholders. That means competition among audit firms focuses on issues that are not necessarily aligned with shareholder needs, the commission says. Even further, audit firms outside the Big 4 find it difficult to demonstrate they have enough experience and reputation to win audit engagements with public companies, especially when companies are under loan covenants that require them to employ a Big 4 firm.

The commission says it is exploring several possible remedies, including mandatory tendering of audit contracts, mandatory rotation of audit firms, more frequent audit quality reviews, prohibition of “Big 4 only” clauses in loan documentation, greater accountability of the external auditor to the audit committee, enhanced engagement of auditors with shareholders, and increased reporting requirements. The commission will also take into account similar study and exploration at the European Union.

“It will undoubtedly be challenging to change a long-standing and entrenched system,” said Laura Carstensen,chairman of the commission's Audit Investigation Group, in a statement. “But our proposals will look to create a situation where tendering and switching become the norm, and where greater transparency and information increase both contestability of the market and the ability of shareholders to judge the service they are getting. We also want to increase their influence, and that of the audit committee, over the choice of auditor.”