Investment firms caution against Big Four break up
Investors want to see improvements in audit quality and are concerned about the current dominance of the Big Four, but are holding back from calling for a break up of the largest firms or a ban on the supply of non-audit services, according to the responses made to the first stage of the Competition and Markets Authority (CMA) review of the sector
19 Nov 2018
In its response letter, Hermes Investment Management said that while it would not be averse to a de facto or actual break up the Big Four as a way of encouraging greater competition, this would not necessarily improve audit quality, which it cited as a critical issue.
The company said: ‘It may even have an adverse effect on audit quality in the short-term, which is why we suggest additional remedies such as strengthening the involvement of investors in audit procurement.’
Hermes Investment Management suggested that one of the core issues was the cross subsidisation of audit from consulting services, which it said ‘both distorts competition in the market and risks undermining the independence of the audit process through creating conflicts of interest’.
This mean it is almost impossible for auditing firms outside the Big Four to secure the audit contracts for FTSE 350 companies.
Hermes Investment Management suggested in its response: ‘Appropriate remuneration for auditing services provided would enable smaller – and non-compromised - firms to compete for contracts as cross subsidy would no longer be required.
‘It is our suggestion that the CMA request of the Big Four details of the profit margins made on contracts where both audit and consultancy services were provided. These should be broken down by service provided and datasets going back 5-10 years should be requested.’
It also wants to see audits better resourced with more senior staff who should challenge the information provided by management.
‘As a further check and balance, we also recommend increased scrutiny over the appointment of auditors. This could be achieved through meaningful consultation going beyond information sharing with major shareholders during the process, which is not currently standard practice,’ Hermes Investment Management said.
Standard Life response
In its response, Standard Life said it was ‘unrealistic’ to believe that non-Big Four firms can or want to take on complex audits. However, the insurer suggests that when there is an independence issue, a non-Big Four firm could be mandated either to undertake the related audit that causes the independence issue (eg, a pension fund) or undertake that part of the audit causing the independence issue (eg, modest IT support).
The company stated: ‘In the former situation, the non-Big Four auditors would be engaged directly in the normal way. In the latter situation, they could be engaged jointly by the company and the auditor that signs the overall opinion.
‘The audit committee would oversee that the independence issue is properly handled and the both the audit committee and the overall auditor would oversee the quality of the supporting firm’s opinion. The supporting firm would have a duty of care to the company and the overall auditor.
‘We anticipate that competition would be increased by around one-third.’
Standard Life also argued that shared audits (as opposed to joint where two firms take equal responsibility) has merit in overcoming conflicts of interest which would improve competition One method of encouraging shared audits would be to set annual targets for the Big Four. The targets could increase over time and ultimately be abolished as unnecessary.
This suggestion is picked up in the response from the Universities Superannuation Scheme Investment Management (USS), which pointed out that in France and North Africa, the financial statements are divided between two auditors.
USS said that whilst this indeed distributes market share more evenly, it is unclear whether it improves audit quality as sections of the financial statements are split between the auditors and they do not seem to review the sections audited by the other firm. In addition, the two auditors’ methodologies and materiality threshold can vary.
Its response argued: ‘However, if mid-tier firms were encouraged to participate, this solution could leverage the skills and capabilities of each firm, allowing mid-tier firms to be exposed to the technologies used by the Big Four.
‘In addition if the allocation of sections is changed every two or three years it would ensure the audit work is reviewed on a more regular basis. We would assume that peer reviewing improves quality if there is accountability at the end.’
In its response, Schroders emphasised the need to ensure any changes in the UK audit market reflected the requirements of those companies which operate on a global basis. Schroders pointed out that the requirement to change auditors, introduced by EU legislation and the CMA, has restricted the choice for large companies and public interest entities to only three firms, as the incumbent is not able to tender.
The company stated: ‘We believe that an internationally co-ordinated approach needs to be undertaken and that relevant auditing bodies need to determine the appropriate actions required to address the lack of competition, rather than encouraging companies to accept the additional risk associated with using a small or mid-tier audit firm for complex groups.
‘Additionally, an inconsistent global approach is likely to result in increased complexity and ambiguity in the rules and may lead to engagements being structured so as to avoid potential limitations in the UK.
‘This may allow companies to continue to source non-audit services from their external auditors outside the UK with no significant reduction in non-audit services provided by the external auditor on a global basis. This would restrict any potential benefit of a perceived reduction in independence conflict created by the provision of non-audit services.’
Schroders also indicated it is not in favour of the introduction of a market cap, which it said would restrict the choice of audit firms further in an already restricted market and may lead to the appointment of a firm that is inadequately skilled to perform the audit leading to a reduction in audit quality.
It offered some qualified support for the concept of joint audits, stating: ‘Although a joint audit model may create opportunities for non-Big Four firms to develop, we do not believe it is likely to result in an overall improvement in audit quality in the short term. It may however lead to greater inefficiencies, additional costs and should not be enforced until the firms are able to demonstrate the minimum capabilities required.’
Report by Pat Sweet