Call to relax 51% rule on audit firm ownership

Reform of the audit market should focus on relaxing audit firm ownership rules, to permit new capital to enter the market to increase competition rather than breaking up the Big Four audit firms

At the same time there is a risk the remedies proposed by the Competition and Markets Authority (CMA) ‘will cause more harm than good’, according to former head of the Financial Reporting Council (FRC), Paul Boyle.

Boyle, who headed the the audit regulator from 2004 to 2009, is now arguing for liberalisation of the ownership rules in a paper for the thinktank, the Centre for the Study of Financial Innovation (CSFI).

While he agrees with the CMA’s view that there are problems with audit quality, choice and market resilience, Boyle argues the competition watchdog’s proposals for tackling these ‘involve a substantial increase in the scope and intensity of regulation’.

‘Some of the remedies directed at quality are either unlikely to achieve their aim or might only do so at disproportionate cost – costs that will ultimately be borne by shareholders for whose benefit audit is intended to operate,’ Boyle said.

His preferred option is to relax the ownership rules by eliminating the requirement that at least 51% of the voting rights in a firm must be controlled by qualified auditors.

To protect the quality of audits performed by non-auditor-controlled (NAC) firms, additional safeguards would be implemented.

Boyle says the requirement for audit firms to be majority-owned by qualified accountants has created a high barrier to entry in the market for large-company audits, and claims the current restrictions are anti-competitive.

Widening the potential for new entrants will improve audit market resilience, Boyle argues. There will be more credible competitors at the top end of the market, making it easier for clients of a failing audit firm to appoint a satisfactory replacement. Second, an externally funded firm could be more easily recapitalised than one financed solely by its partners.

Using examples from the airline and pharmaceutical industries, Boyle counters concerns that relaxing ownership rules introduces the risk of interference in audit judgments by non-auditors, who may be motivated by profit rather than audit quality, or may have a conflict of interest regarding the firm's clients.

He suggests measures to address the issues could include limits on the maximum percentage (say, 30%) that could be owned by a single non-auditor shareholder; tighter governance; prohibitions on auditing some clients; and a declaration from shareholders of no interference.

Boyle suggests that the most appropriate source of new capital would be institutional investors. He points out that the ‘role of the statutory auditor is to work in the interests of shareholders to increase their confidence in the reliability of a company’s financial statement’. Other candidates would be technology firms or a user-owned mutual.

The CMA dismissed the option for changing the ownership rules in its initial assessment of the audit market. Boyle analyses the CMA’s current six proposed remedies and is critical of the suggestions for regulatory scrutiny of audit committees,  joint audits, caps on the Big Four’s market shares and the separation of audit from non-audit, all of which he claims fail either by aggravating lack of choice or by cutting across the multi-disciplinary business model, and as such are unlikely to be effective.

He is particularly critical of the way the CMA proposes to strengthen the role of audit committees, saying the premise is that directors ‘cannot be trusted to act in the interests of shareholders’, calling into question the entire corporate governance regime.

Boyle said: ‘It is surprising the extent to which the CMA has concluded that the solutions to problems in the audit market are best addressed by regulating, restricting and imposing further costs on the clients.’

He does support measures to support challenger firms, such as a tendering fund, and the need for a market resilience regime echoing prudential regulation of banks.

Andrew Hilton, CSFI director, said: ‘This is an important paper on an important subject, by an authoritative voice. I very much hope that it prompts a wider debate on an issue that has profound implications for UK plc.’

CSFI report, Making the Audit Market Work: the case for liberalising ownership

Report by Pat Sweet

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