Saturday, November 03, 2012

UK Competition Commission Finds International Audit Networks a Difficult Entry Barrier for Mid-Tier Audit Firms

There are a number of economic and strategic issues that membership of a large Big Four international audit network entails that may affect the level of competition in the market for the outside financial audit of public companies. As a barrier to entry, without a network with sufficient international breadth, it appears that a firm may be excluded from being invited to participate in audit tenders or being awarded the tenders of large international audit company clients. The Commission found that at least two-thirds of FTSE 350 companies require some level of international audit. It further found that the networks of the Big 4 appear to be somewhat more extensive and include international operations that are substantially larger than those of the mid tier audit firms. The Competition Commission is an independent public body which works with referrals from other authorities to ensure healthy competition between companies in the UK for the ultimate benefit of consumers and the economy.

The Commission found that there are also economies of scale in the Big Four international networks. By centralizing functions, there may be an avoidance of duplication of activity leading to a reduced resource requirement, and reduced costs. For example, if a global methodology and quality assurance program can be employed across a network, member firms will not have to perform as much work assessing each others’ competence when using each other to audit international subsidiaries.

For the majority of the large audit networks, the UK member firm (or an antecedent) has been providing professional services for at least 50 years and has had a link with the network since its formation. In the view of the Commission, the large, established networks may compete for and win the audits of large companies, with any success reinforcing the strength of the network and making it more attractive to potential future customers. Those without such a network are likely to be excluded from audit tender processes where there is expected to be a significant level of international audit work, and so the risk of any investment in network expansion is increased. Because of this shared heritage, said the Commission, it is not therefore possible to measure the impact of the network’s reputation on the domestic performance of most UK firms in a large established network.

The UK Competition Commission has become a significant player in the area of audit concentration. Recently, at a PCAOB roundtable on auditor independence, Nathalie Berger, Director of Audit at the European Commission, said that reports and findings of the UK Competition Commission will inform negotiations between the Commission and the European Parliament and the Council of Member States on pending legislation to mandate audit firm rotation.  Director Berger noted that the Commission sees support for mandatory audit firm rotation in the Council and in Parliament and will soon be entering into negotiations with those bodies with an eye towards passing final legislation.

The European Commission’s proposed legislation mandating audit firm rotation is currently before the European Parliament and the Council of Member States and some action is expected by year end. The Commission draft legislation includes mandatory audit firm rotation every six years for solo audits and nine years for joint audits.

Last year, with the blessing of the Financial Reporting Council, the UK Office of Fair Trading examined 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 decided that there are competition problems in the audit market that pass the statutory test for referral to the Competition Commission. 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.

The Office of Fair Trading 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.

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.