CMA recommends major overhaul of U.K. audit market

“Legislation is needed to address both the vulnerability of the industry to the loss of one of the Big 4, and the current inadequate choice and competition,” said the CMA in its press release.

The CMA’s recommendations include: the separation of audit from consulting services, mandatory “joint audit” to enable firms outside the Big Four to develop the capacity needed to review the U.K.’s largest companies, and the introduction of statutory regulatory powers to increase the accountability of companies’ audit committees. The recommendations are distilled from the CMA’s December update paper, a major report from the Business Select Committee, and an inquiry by Sir John Kingman.

The announcement came too late in the day for the Institute for Chartered Accountants of England and Wales (ICAEW) to comment, nor have any of the Big Four released response statements, though they have already made their views known on the update paper. The Center for Audit Quality in the United States put out a statement almost immediately that questioned the effectiveness of the reforms and expressed concern over “unintended consequences, with the potential risk of lower audit quality, damage to UK competitiveness, and reduced resilience of the audit sector.”

“The Government now has three reports to hand. In large part, they come to similar conclusions. Conflicts of interest cannot be allowed to persist; nor can the UK afford to rely on only 4 firms to audit Britain’s biggest companies any longer. Early action will require legislation – hence the CMA’s proposals.”

Andrew Tyrie, Chairman, CMA

Regardless of objections, the CMA is recommending that its suggested changes be taken forward by the Secretary of State “at the earliest opportunity.” The changes will need concerted action by the government and will be overseen by the new regulator replacing the Financial Reporting Council—the Audit, Reporting and Governance Authority (ARGA). It also expects the changes to be complemented by the conclusions of the review by Sir Donald Brydon into the quality and effectiveness of audit.

“But,” says the CMA in its full report on the recommendations, “as Sir Donald himself indicated to the [Business] Select Committee, making progress with changes to the regulator and to the market need not wait for the final outcome of his review.”

The CMA describes the audit market as “fragile,” resulting from mergers that reduced a Big Eight to a Big Five and then to the Big Four with the meltdown of Arthur Andersen. It also expresses concerns that audit firms are less focused on audit. While there are already rules preventing the cross-selling of certain non-audit functions, the CMA feels that, with auditors benefiting from profit sharing, the conflicts of interest are too strong not to impact the quality of audit.

Its recommendations are intended to achieve the following objectives:

• Increase the effectiveness of audit committees across the FTSE350, ensuring that the selection and oversight of auditors is focused on quality—in the form of scepticism and challenge, as well as technical expertise;
• Increase long-run resilience and choice in the market; and
• Address the problems in terms of focus on quality, and choice, caused by the firms’ combined audit/non-audit services structures.

Concerns over joint audits are removed by the experience of France, where such is a requirement. This practice has reduced concentration of the largest audits in the hands of the Big Four and has not had “significant adverse consequences,” said the report. A small number of the largest and most complex companies will be exempted initially, as well as simple companies like investment trusts. It is the responsibility of the audit committee to make sure the work is equally shared and that it is not a “shared” audit, where the non-Big Four firm is clearly subordinate.

The audit/non-audit split envisaged by the CMA, it says, would only be fully effective if done internationally, but it recognises this is not in the U.K. government’s remit, so it recommends that at this stage the government put in place a split of “initially only the Big Four, but with the regulator able to add other firms in later years when they have grown to closer to the Big Four’s size.” However, it allows that they can be operationally split while remaining structurally intact, allowing them to preserve the elements of their multi-disciplinary practices. This will be achieved by the following, among other recommendations:

• 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;
• Separate financial statements for the audit practice, consisting of a profit and loss statement for the audit practice;
• Transparent transfer pricing, checked by the regulator, particularly for the use of non-audit specialists on audit; and
• A separate CEO and board for the audit practice.

Other possible measures are also recommended to both the government and ARGA. These include: remuneration clawback and deferral, liberalising audit ownership rules to allow for new entrants, changes to technology licensing, reducing notice periods and non-compete clauses so partners in Big Four firms could more easily join smaller firms, and consideration that audit contracts should have a fixed term of seven years.