7 Oct 2019 01:17pm

Audit reform: time to replace rhetoric with analysis

The BEIS consultation on the Competition and Market Authority’s (CMA’s) proposals for audit market reform in the FTSE350 has recently closed.

Not surprisingly most of the few responses made public mirror the original submissions to the CMA’s own consultation on its provisional proposals earlier this year. Those seeking to resist real reform are faced with a challenge: the CMA has already considered their arguments ahead of its Final Report and, after a very thorough analysis, rejected them with only modest changes made. As evidenced by its rejection of the merger of two major supermarket groups, it is clear that the CMA is well able to withstand the heat of debate and form its views independently, without fear or favour.

In both its Update and Final Papers the CMA supported joint audit, with the later paper including some helpful modifications which address practical implementation issues. Joint audit lies at the heart of the CMA’s cohesive package of reforms for the FTSE350 audit market. It is the one proposal that would allow challenger firms to build up a significant market share, thereby providing the justification for making the substantial investment necessary over a number of years, whilst also creating a vibrant new market capable of adapting to meet the changing needs of stakeholders and serving the public interest. For decades we have lived with an audit market resistant to change and with no new entrants to any meaningful extent.

A key driver for audit market reform stems from the need to increase market resilience and avoid the systemic risk that would arise were one of the current largest players to leave the market for whatever reason. This is no theoretical risk. It is fewer than two decades since Arthur Andersen exited the UK market for a reason originating on the other side of the Atlantic. There is widespread agreement that if another one of the largest firms were to leave the market at present the result would be regulatory capture as well as systemic market risk as leading global companies would be left without an auditor. It is hard to imagine a bigger threat to audit quality.

There are three main options canvassed to address this risk; joint audit, shared audit or a market cap model. Joint audit in the form proposed by the CMA, with each FTSE350 audit involving at least one challenger firm, subject to limited exceptions, is the only remedy that will achieve the necessary objective within a reasonable timeframe.

Shared audit would keep challenger firms in a permanent subsidiary position with limited access to audit committees and with no significant record of auditing large listed groups. With this dynamic, the resistance to appointing challenger firms as group auditors would remain. Change in the share of FTSE350 group audits would consequently occur at a snail’s pace, and meanwhile the risk of a key player leaving the market with the ensuing turmoil would remain unaddressed.

So too with market caps and its more sophisticated variant, segmented market caps. Perfectly understandably, upon being told its market share is being capped any existing player will naturally seek to sacrifice its riskiest and least profitable audits in the first instance.

Substantial, and intrusive, regulatory intervention would be needed to stop this happening. As challenger firms would be appointed as sole auditors there would be a far more limited range of companies for which they could bid rather than if they were to be joint auditors, especially in the early years of reform. Shareholders in some companies would also find severe restrictions on their choice of auditor, with leading firms reticent to ‘spend’ their limited market share on them. To compound matters, these businesses would also face significant uncertainty as to whether their existing auditor would be willing to stay with them as this would depend on whether the firm was successful in tenders for more attractive clients.

By contrast, joint audit would allow shareholders in FTSE350 companies both to retain their existing auditor, who would continue to offer their opinion on the whole of the financial statements, and to choose which challenger firm to appoint alongside them. Joint audit, unlike shared audit, would provide the quality benefit of extra review by each joint auditor of the other’s work at modest additional cost. The direct costs of extra review, while not huge anyway, could be expected to be at least partially offset by expected fee reductions from the creation of a more competitive market. As joint auditors, challenger firms could both take on more audits in the FTSE350 for a given level of capacity and participate in audits at the upper end of the FTSE100 much sooner. It is the only model that could credibly allow challenger firms to build up a combined market share of, for example, 20% of the FTSE350 audit market by fees after around 5 years. This would mean that the collective market share of the challenger firms would be equivalent to the average share of the four largest firms: independent observers might well regard that as the minimum that is credible and acceptable.

Joint audit is the only one of the canvassed options for reform that has been tried and tested, and found effective for listed company audits in a G7 market for over half a century. It is not enough to call for audit reform repeatedly whilst seeking to undermine the means of achieving it. It’s time to replace rhetoric with analysis and to endorse the CMA’s recommendations.

David Herbinet is Mazars’ Global Head of Audit and Assurance