Vinita Mithani 2 Nov 2018 09:49am

More audit competition: who loses out?

Without a change in the contractual set up, an increase in audit competition may not benefit shareholders

Caption: Greater competition reduces the power of the supplier

The Competition and Markets Authority has recently launched a review into the audit market with the view to increasing competition. However, the audit market for public interest entities (PIEs) is a peculiar one in terms of the nature of the auditor/client relationship, and needs to be properly understood if we are to correctly assess the impact of greater competition in this particular market.

It is generally accepted that greater competition in any market ensures better outcomes for customers/clients in terms of both service and price.

As we are aware from the recent auditing and accounting scandals, many external auditors have already been providing the ‘best outcomes’ for their clients – except they perceive their clients to be the directors of the companies, the very individuals whose assertions they are meant to be reporting on.

Auditors of public interest entities (PIE) do not generally have a direct relationship with their true clients: the shareholders of the company, which tend to be a large number of unconnected entities/individuals, and even the larger institutional shareholders like pension schemes do not tend to have a significant enough interest in any one company to develop a direct relationship with the external auditors.

Of course, one would expect that auditors could be more easily dismissed and new ones appointed if there were greater competition in the market; but who normally proposes such changes? It is the directors themselves. Shareholders tend to remain in the dark about the deep secrets of an organisation until the organisation declares a state of emergency, at which point changing auditors is usually the least of the shareholders’ worries.

Directors are unlikely to propose changing the auditors if the auditors are happy to rubber stamp the directors’ assertions. The only scenario one can envisage where directors would be voluntarily proposing a change of auditors is if the latter put up an effective challenge to the directors, and that is precisely what we want to avoid. The greater the audit firm options available, the easier it would be for unscrupulous directors to effect a change in auditors when they begin to feel threatened.

Indeed independent and competent audit committees were meant to break this link between the auditors and management, but research evidence suggests that audit committees perform a ceremonial function, and that management remain the dominant party in the decision making processes surrounding auditor removal and appointment.

Greater competition reduces the power of the supplier, but because of the unusual nature of the service provided in this market and the contractual set up, reduced auditor power is unlikely to be what everyone is striving for, quite the opposite: one needs to be able to empower auditors to challenge directors without fear of being dismissed.

Grant Thornton has recently voiced the need for a fully independent procurement process.

Only if auditors are appointed and remunerated by an independent regulatory body can we truly free auditors of their relentless battles between safeguarding their income stream and also safeguarding shareholders’ and the public’s interests. Eliminating this core conflict for auditors is essential to ensure quality audits, something that all other regulation has been failing to achieve.

Greater competition in the audit market will indeed work very well but only with a changed contractual set up, where the company whose financial statements are being audited ceases to be a client of the audit firm, and where the independent regulatory body contracts with the auditor instead, as any evidence of low quality audit work will then allow the regulatory body to change audit firm easily.

Vinita Mithani is a lecturer in Accounting at Middlesex University