Opinion
26 Nov 2015 03:00pm

Assessing audit rotation’s impact on quality and cost

Robin Freestone, the former chief financial officer (CFO) of Pearson, discusses the impact of audit rotation

The CFO's view

It’s probably fair to say that most CFO's were initially unenthusiastic about proposals to mandate tendering and rotation of their plc. external audit service:

While they acknowledged the argument that a plc. that had employed the same audit firm for many years (some over 100 years) could be accused of complacency or even lethargy, they refuted suggestions that independence was being compromised by such longevity. They cited the requirement that an audit partner had to rotate every five years – as well as the fact that the average plc. CFO's tenure was similar – as evidence that cosy relationships could not develop and they worried about the workload in tendering and the subsequent reduction in expertise when a whole new audit team arrived on site.

It was, however, difficult for CFO's to refute the legitimate perception that the guardian of the company's finances should be prepared to seek competitive bids for a significant Corporate cost on more than an occasional basis. They cited alternative, but less transparent ways, of keeping audit fees down, akin to settling things in the corporate equivalent of going behind the bike sheds.

There was also a wide held belief that the large and mid cap audit market was too concentrated in the hands of the Big Four and that regular tendering would allow smaller, mid tier audit firms to penetrate the plc. large and mid cap market. CFO's expressed scepticism, based on capability and geographic reach outside the Big Four.

So, although still in the early stages of the new rotation requirements, it’s fair to ask the question; who was right? The sceptical CFO community, or the guardians of best buying practice and champions of competition and public perception?

The experience so far:

Audit tendering and rotation

As shown in a 2015 FTSE 100 audit fees survey (published by Accountancy Live, November 2015), nine constituents had changed their audit firm in the last 12 months, with significantly more indicating they will tender over the next 2 years.

In addition, some 13% of the FTSE 250 are expected to have tendered in 2014/5 with a majority choosing to rotate. Much of this was however before the UK requirements had been fully finalised and there is a belief that this percentage will also increase significantly from 2016- 2018.

Audit Fee trends

In the same 2015 survey, the FTSE 100 audit fee market grew 1.1% to £534m compared to a 1.7% increase in the 2014 survey. As the constituency of the FTSE 100 does not remain entirely stable over a two year period; Company's tend to grow (bringing more entities into audit scope) and exchange rates can be a factor, it is difficult to isolate pure inflationary pressures, but it appears that the overall FTSE 100 audit fee market is not seeing significant price inflation.

However when the audit fees for the 9 FTSE 100 Companies who changed auditors in the past year are assessed, the overall increase for them was 4%. Intriguingly there was a wide range of outcomes within the 9, with some double digit increases and reductions. Is it possible that Audit Chairs, who are now more influential in the tender process, are that little bit less focussed on the cost of the audit than their Executive colleagues?

Audit quality

The definitive view of audit quality comes from the FRC's annual report on audit quality arising from their inspection of auditors. In their 2014/5 report, published in May 2015, 54 FTSE 350 Company audits in the prior 12 months had been subject to FRC review, a 50% increase on the coverage in 2013/4. Of those reviewed this year, 67% were assessed as either good or requiring only limited improvement, up from 60% on a year earlier and continuing the trend seen since 2011/2.

There is little doubt that audit quality overall is improving, although it would be interesting to see data arising from the FRC reviews in the first year of a new audit firm, to see how quickly incoming auditors reach the required standard.

Big Four concentration

It was always optimistic to believe that firms outside the Big 4 would quickly break into the FTSE 100 audit market, even if they wanted to (which some doubted). Mid tier audit firms always suggested that a break through would take time and that they were more focussed on selling other services into the FTSE 100 market, which indeed appears to be happening. Within the FTSE 100, all rotations to date have been just that; rotations between the Big Four.

Of greater relevance is what has happened in the FTSE 250 market over a longer period. Data from Deloitte suggests that since 2012 the number of non Big Four audit firms present in the FTSE 250 market has actually shrunk, from 13 to 10. The biggest winners? None other than KPMG (up 11) and PWC ( up 3); we appear to be headed in the exact opposite direction desired, if indeed reduced Big Four concentration was an objective of increased tendering.

Summary

It's early days in the brave new world of audit tendering. The data to show the impact it’s having is so far limited and inconclusive. However the direction would seem to favour higher quality, even if it comes at higher cost, with Audit Chairs tending to prefer Big 4 firms. Whether rotation has been influential in delivering that higher quality or whether the work of the FRC's inspection unit has been the key driver, we can only speculate. Some CFO's, however, are likely to remain unenthusiastic, or even sceptical, about the benefits of rotation for a little while longer.


Robin Freestone is the former CFO of Pearson and former chair of the 100 Group


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