Auditors: Market concentration and their role - Economic Affairs Committee Contents

Supplementary letter from Mr Robert Hodgkinson, Institute of Chartered Accountants in England and Wales (ADT 8)

  I write in response to the request made by Lord Lawson at the Committee's session on 19 October 2010. At the end of the session, Lord Maclennan asked "If there were one measure you would propose that would most assist in widening choice in the audit market, what would it be?" I replied "Oblige regulators to consider how regulation affects availability of choice. Make it a criterion for regulatory action because it is clearly of public interest."

  Lord Lawson requested a brief note on what I was proposing and how it would work out in practice. I summarise these matters below and also take this opportunity to set out the various actions that ICAEW is taking to follow-up on our Financial Services Faculty's report "Audit of banks: lessons from the crisis", which Lord Lawson referred to earlier in the session.


  All regulators involved in the audit market should be required to consider the consequences of their actions on the public interest objective of increasing choice in the audit market.

  My proposal is that audit regulators should include the issue of choice in their regulatory principles. Where relevant, they would consider choice in each aspect of their work such as framing new or revised regulations and standards, or reporting on monitoring and enforcement activities.

  In so far as practical application is concerned, I suggest that at the outset of a piece of work the regulator would formally determine whether the output might affect the availability of choice in the audit market because of its impact on potential providers and purchasers of audit services. If it might do so, then the regulator's internal processes would require the regulator to confirm that in deciding on a course of action it had given full consideration to the impact on choice in the audit market. There would also be reference to choice in the impact assessments that accompany the regulator's output.

  One benefit of this suggestion is that future inquiries into choice in the audit market would be better informed about practical experience of trade-offs between choice and other public interest issues, including audit quality.

  It may help the Committee if I provide a little background to this proposal.


  Choice in the audit market is, in the first instance, currently driven by company boards and their audit committees who choose who should be put forward for appointment as auditor by shareholders. As a possible result of the work of your Committee and that of the European Commission, shareholders may in future take a more active interest in the appointment and reappointment of auditors. One consequence of increased scrutiny from shareholders might be that audit committees are even more attracted by the perceived safety of choosing one of the four largest firms. Against this backdrop it will be very challenging to widen the listed company audit market.

  Over the past few years the Financial Reporting Council (FRC) has undertaken specific work to try to actively influence choice. In particular, its Market Participants Group (MPG), whose membership consisted of investors, companies and audit firms, published a report in October 2007 report entitled Choice in the UK Audit Market. Of the report's 15 recommendations:

    — 12 focussed on increasing choice of auditor for public interest entities;

    — two were about reducing the risk of an audit firm leaving the market without good reason; and

    — one sought to reduce uncertainty and disruption costs in the event of an audit firm leaving the market.

  Of the 12 recommendations on choice, some looked at supply-side measures intended to encourage firms other than the four largest to offer audit services to large public interest entities. Other recommendations referred to demand-side measures, including making boards more accountable to shareholders and reducing the perceived risks to directors of choosing a smaller audit firm. In the period between October 2007 and June 2010, the FRC published five progress reports on the 15 recommendations. In their written submission to your Committee, the FRC states that the majority of the MPG's recommendations have been implemented but to date have had minimal impact on market concentration.

  However, in addition to these specific initiatives to help widen choice, the FRC and its subsidiary boards undertake many on-going, broader activities such as framing new or revised financial reporting, auditing and ethical standards and reporting on monitoring and enforcement activities. In my opinion, the outputs of these broader activities are very likely to influence the perceptions of, and the choices made by, audit committees and shareholders as well as audit firms. My proposal seeks to address this matter. Audit regulators need to consider the consequences of all their relevant actions on perceptions of key participants in the audit market.

  Currently the words "choice", "concentration" and "competition" do not feature in the FRC's document "Regulatory Strategy: Our Role and Approach" (Version 4) dated April 2009. By way of contrast, the Financial Services Authority (FSA), in pursuing its functions under the Financial Services and Markets Act, is required to have regard to additional matters that it refers to as "principles of good regulation". There is a competition principle which states "The need to minimise the adverse effects on competition that may arise from our activities and the desirability of facilitating competition between the firms we regulate." The FSA states that one of the aims of its principles is to avoid unnecessary regulatory barriers to market entry or business expansion. It goes on to note that competition and innovation considerations play a key role in its cost-benefit analysis.

  Thus, my proposal is that relevant regulators (particularly the FRC) should include the issue of choice as one of their principles for regulation and ensure that, where relevant, it is considered in each aspect of its work not just in relation to the specific recommendations of the MPG.


  Finally, I would like to take this opportunity to follow up on my oral comments to the Committee by summarising a number of initiatives ICAEW is undertaking as a result of our report "Audit of banks: lessons from the crisis", which Lord Lawson referred to in the session on 19 October 2010. We:

    — have established the Financial Services Faculty Auditor-Investor Forum to highlight and discuss key risks across the financial services sector. The Forum will meet for the first time on 22 November 2010 with the aim of promoting wider understanding of the key areas of focus of auditors of financial institutions in the upcoming reporting season and potential difficult issues in preparing annual reports, including any systemic risk concerns. This should promote greater confidence that auditors will be considering and addressing these issues;

    — have established a working party to develop good practice guidance for communication between auditors and audit committees in financial institutions. The objective of this initiative is to provide better information to audit committees and to encourage better disclosure by audit committees about their dialogue with auditors. We aim to publish draft guidance before the end of 2010 and final guidance after the next reporting season; and

    — have assisted the Bank of England and the FSA in establishing a working group to examine and revise protocols for dialogue between auditors and supervisors. This will look at both the information that auditors should share with supervisors and the information that supervisors should share with auditors.

  We believe that each of these initiatives will promote important incremental improvements that can be made relatively quickly. While there may be debates to be had on more fundamental changes to auditor responsibilities, such wider changes can be complicated by potential unintended consequences which mean that they take much longer to agree and implement.

  I would be happy to brief Lord Lawson and any other members of the Committee on the matters covered in this letter or any other matters arising from your inquiry if that would be useful.

28 October 2010

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