Tuesday, May 17, 2011

Issue of Audit Concentration in Big Four Moves from Audit Regulators to Competition Authorities in UK

With the blessing of the Financial Reporting Council, the UK Office of Fair Trading will examine the issue of the concentration of financial statement audit in the Big Four, thereby taking the controversial auditor concentration issue to another level. The OFT has provisionally decided that there are competition problems in the audit market that pass the statutory test for referral to the Competition Commission. The OFT will discuss with interested bodies whether, in practice, potential remedies exist that could allow the Commission to resolve these problems.

Having explored ideas for addressing these issues through its Market Participants Group, it became clear to the FRC that the competition authorities are better placed than audit regulators to tackle competition concerns. FRC Chief Executive Stephen Haddrill said that the OFT will bring both expertise and a fresh perspective to an area of real importance to the future success of the capital markets.

Recently, a Parliamentary committee recommended measures to increase the ranks of the Big Four, noting that the audit of the financial statements of large companies in the UK and internationally is dominated by an oligopoly and that any move from the Big Four to a Big Three would create an unacceptable degree of market concentration.

In 2010 the Big Four audited 99 of the FTSE 100 leading firms and around 240 of the next-biggest FTSE 250. In light of this level of concentration, the Committee urged the Government and regulators to promote living wills for Big Four auditors. These would lay out all the information the authorities would need to separate the good from the failing parts of an audit firm so that disruption to the financial system from a collapse would be minimized. By setting out an orderly process of dismantling, reasoned the Committee, living wills should also help ensure that no audit firm was regarded as too big to fail

With a bow to the Committee’s report, the Office of Fair Trading said that it is concerned that the market for external audit services to large firms in the UK is highly concentrated, with substantial barriers to entry and switching. The OFT concluded that there are reasonable grounds for suspecting that there are features of the market that restrict, distort or prevent competition in the UK. A key consideration is whether there is a reasonable chance that appropriate remedies will be available to the Competition Commission. It will also be important to assess the relative benefits of action at international or UK levels. To consider these issues further, the OFT will therefore be conducting a number of roundtables and bilateral discussions with selected parties in May and June.

The OFT has been actively engaged in financial audit issues since 2002 and intends to remain engaged. The OFT recognizes that audit market concentration cannot be resolved effectively by a UK competition authority acting alone. The regulatory and supranational character of many of the discrete issues in this market means that, although certain improvements might be sought through regulatory intervention or legislative change,such changes would need to be international in scope and application to be successful. In this spirit, the OFT commented recently on a European Commission Green Paper on financial audit.

In its comment letter to the Commission, the OFT raised the specter that the existing high barriers to entry to financial audit, leading to high market concentration in the Big Four, could contribute to the risk of a wider, systemic failure whereby the failure of a company could have substantial negative effects on the wider economy. The limited choice of auditors and existing competition problems in the market mean that if one of the Big Four audit firms were to exit the market for auditing large companies, existing competition problems in the market could be exacerbated.

High barriers to expansion might make it difficult for smaller firms to step up to replace it. There might also be a short-term risk of some companies being unable to purchase audit services, leading to a loss of confidence in the financial status of large listed companies and high-risk companies and possibly among investors more generally.

The OFT told the Commission that joint audits potentially enable mid-tier firms to become active players in the large company sector and might also mitigate disruption in the event that an audit firm failed. However, possible downsides include a greater cost burden, greater complexity, and possible attempts by auditors to win a bigger role for themselves by discrediting the other auditors.

The OFT urged the Commission to consider a reduced form of statutory audit. As well as potentially reducing the burden on companies, reasoned the OFT, reducing the requirements of statutory audit might stimulate switching to smaller auditors that are able to undertake a more limited audit.