U.K. regulator considering mandatory audit firm rotation

A much awaited summary of provisional findings of the U.K. Competition Commission (CC) stated that companies are reluctant to change auditors because they have difficulty comparing alternatives with their existing auditor, prefer continuity, and face significant costs in switching auditors.

In addition, the provisional findings, released Friday, stated that instead of protecting investors’ interests, auditors often focus on meeting the needs of senior management who are the key decision-makers on whether to retain their services.

Officials with Big Four firms disagreed with that assessment.

“We are very clear that we report to the shareholders and engage with the audit committee as their representatives,” PwC Head of Reputation and Public Policy Richard Sexton said in a news release. “We believe that the Competition Commission [has] grossly underestimated the critical role that audit committees play in protecting the interests of shareholders.”

The CC published a notice of the following “possible remedies” for companies that may be listed on the London FTSE 100 and FTSE 250 indexes:

• Mandatory tendering.
• Mandatory audit firm rotation.
• Expanded remit and/or frequency of reviews by the Audit Quality Review team under the auspices of the UK’s Financial Reporting Council (FRC).
• Prohibition of “Big-Four-only” clauses in loan documents.
• Strengthened accountability of the external auditor to the audit committee.
• Enhanced shareholder-auditor engagement.
• Extended reporting requirements.

While pondering its final actions, the CC also is taking into account proposals for the audit market that are being discussed by the European Union. The European Commission also recommended audit rotation and other reforms in November 2011, but the European Parliament has yet to decide whether to act on them.

Audit firm rotation has been a topic of frequent discussion among regulators in many jurisdictions since the start of the global financial crisis. But while there has been significant debate over the issue, resistance to mandatory rotation has been strong.

In the United States, the PCAOB has been studying the audit firm rotation issue since it issued a concept release on Aug. 16, 2011. But no action has been taken, and PCAOB member Jay Hanson has said there are many obstacles that make the implementation of mandatory audit firm rotation by the PCAOB unlikely.

Decision due in October

The CC will publish its full provisional findings report this week and will solicit comments and possible remedies before issuing its final report, which is due by Oct. 20. Comments on why the provisional findings should or should not become final are due March 21, while comments on the possible remedies are due March 18. Comments can be submitted by email to auditors@cc.gsi.gov.uk.

Laura Carstensen, chairman of the CC’s audit investigation group, said it will be challenging to change a long-standing and entrenched system. But she said the CC’s proposals will attempt to make changing auditors the norm and increase the influence of shareholders and the audit committee over the auditor.

“We have found that there can be benefits to companies and their shareholders from switching auditors, but too often senior management at large companies are inclined to stick with what they know,” Carstensen said in a news release.

The CC found that 31% of FTSE 100 companies and 20% of FTSE 250 companies have used the same audit firm for more than 20 years. In addition, 67% of FTSE 100 companies and 52% of FTSE 250 companies have used the same audit firm for more than 10 years.

The overwhelming majority of such audits are performed by one of the Big Four firms (Deloitte LLP, Ernst & Young LLP, KPMG LLP, or PwC LLP), although some FTSE 350 audits are performed by other firms, according to the CC.

Big Four firm officials disagreed with some of the CC’s findings.

“We believe that competition between audit firms is healthy and robust, and that the evidence supports this,” Ernst & Young said in a news release. “We also are focused first and foremost on audit quality—it is our primary responsibility and directly in the interests of the shareholders of the companies we audit.”

David Barnes, Deloitte UK’s head of public policy, cautioned that audit quality is a critical consideration as the CC considers taking action.

“Although we understand why mandatory tendering and rotation have been raised as potential remedies that may help the perception of competition, we are concerned that the importance of continuing to increase audit quality risks being ignored in this debate,” Barnes said in a news release.

Simon Collins, chairman and senior partner of KPMG in the U.K., said KPMG does not support the CC’s suggestions regarding mandatory tendering or mandatory rotation.

“The FRC has only just introduced tendering every 10 years on a ‘comply or explain’ basis, and this is already having a significant impact,” Collins said in a news release. “We supported this measure, as we believe it fits with the corporate governance framework in the U.K. and reinforces audit committee oversight of the external auditor. Arbitrary, preset periods will do the reverse and potentially damage audit quality, and forced rotation will undermine rotation and actually reduce shareholder choice.”

The AICPA has written a comment letter to the PCAOB saying that mandatory audit firm rotation may hinder audit quality. The Chartered Institute of Management Accountants (CIMA) also opposes mandatory audit firm rotation.

—Ken Tysiac (ktysiac@aicpa.org) is a JofA senior editor.