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Opinion: the CMA on the future of audit

19 February 2020: the Government now has four reports to hand about audit, all calling for sweeping change. Will Hayter, Senior Director at the Competition and Markets Authority (CMA), takes stock and sets out the test of successful reform.

The unthinkable has a habit of happening. Gordon Brown thought he had consigned boom-and-bust to the history books. Alan Greenspan believed he had ushered in a new golden age of great moderation. Yet some of the oldest banks in the world hurtled towards failure under their watch.

For those in the business of selling trust, a single scandal can sink a global corporation. A firm that once said there was "not enough money in the city of Chicago" to make it sign off on flawed accounts, shredded evidence along with its reputation as the auditor of Enron. The scandal took less than a year to destroy Arthur Andersen, one of the then Big Five, with nearly a century of history behind it.

We all depend on good audits to know how our employer, savings and pensions are doing. Yet when it comes to policing our most important companies, there are only four auditors to choose from. If a choice of four didn’t seem bad enough, conflicts of interests and mandatory rotation often whittle the list down to two or even just one. Therefore, the problem we face is not just one of choice. The current setup is also a threat to the resilience of the entire system, in the event of a firm collapsing or withdrawing. The Big Four are too few to fail.

That is why the CMA investigated the sector last year in our audit market study. The proposals we made would go a long way towards solving the two core issues that threaten the market and produce too many poor audits: conflicts of interest and the dominance of the Big Four.

The operational split we recommended takes care of the first problem by making the audit practice independent and realigning its culture and incentives towards delivering quality. It ends cross-subsidies and profit sharing between audit and consulting, including for the remuneration of partners. It is good to see a growing consensus behind it.

The regulator needs to be given new powers to impose and enforce the split. If the firms are prepared to take matters into their own hands and separate their operations more quickly, so much the better. But even then, legislation is still needed as a fall-back.

Most people also recognise the second problem, although there is disagreement on the solution. The CMA concluded that, on balance, the best way forward was stopping companies from appointing the Big Four to act as sole auditors. We recommended that, for all but the biggest and most complex companies, audit committees should be able to choose between appointing a challenger firm jointly with a Big Four or appointing a challenger alone. For the most complex clients, we recommended a system of in-flight peer review by a challenger auditor.

There is no perfect solution and plenty of trade-offs. Take market share caps. A cap would allow the challengers to audit large companies too, but it also presents a competition paradox. Until it is lifted, the cap works by reducing choice – the opposite of what it aims to achieve in the long run.

We are against a hands-off cap based on market shares because it risks the Big Four cherry-picking good clients and leaving difficult cases to the challengers. Some might say such a cap looks more like a cartel than a competition remedy, and we should be sceptical of solutions that the incumbents favour. On the other hand, a well-managed, dynamic cap that prevents cherry-picking might work. Managed competition is, however, difficult to design and requires a lot of regulatory involvement. The FRC would have to rise to the challenge.

There may well be variants of what we put forward that do the job. One could be to limit the appointment of Big Four firms acting as sole auditors to one term. On the next term, companies would be required to appoint a challenger, alone or on a joint basis. This system would deliver a 50% cap on the Big Four acting as sole auditors, while preventing cherry-picking and retaining maximum choice for companies.

Our report rejected shared audits – instead of joint audits – as a solution. The distinction between shared and jointÂť may sound trivial, but in fact it makes a world of difference. A shared audit is carried out with one firm taking overall control and responsibility for the audit. The second firm performs a support act, directed by and reporting to the main auditor. In other words, the Big Four keep most of the fees and all of the status.

Since then, some have explored enhancing shared audits as another option. There may be potential in this idea, if the enhancements add up to something approaching what joint audits would achieve. For example, the challenger firm should be responsible for auditing large, complex parts of the business, and the audit partner should report directly to the company. In short, enhanced shared audits could work as long as they put the two auditors on a near-equal footing.

There is then a range of options for the Government to choose from. We should all judge the solution by one overriding test: will it create a resilient market where there are more than four firms capable of auditing the largest companies, a market that rewards quality and punishes poor performance through loss of business? If the answer is no, the CMA may eventually be forced to revisit the question.

Those in the industry and elsewhere who pay lip service to the need to go from four to more should not doubt the CMA’s resolve. If they continue to oppose or undermine solutions that retain choice for audit committees, perhaps in time we should look again at the direct appointment of auditors in order to build resilience and drive up quality.

There are now four reports to hand, all recommending vigorous action. There is unlikely to be a better time for it.

To read ICAEW’s resources in this area, please click here.