1. This submission is made by the Office of
Fair Trading (OFT), the UK's consumer and competition authority,
whose mission is to make markets work well for consumers.
3. The OFT considers that competition in the
market for audit services in the UK may be limited. Some aspects
of the audit market giving rise to this concern include companies'
lack of clear incentive to switch auditors; the focus on established
reputation in companies' choice of auditor; high switching costs;
the established competitive advantage of the "Big Four"[20]
over mid-tier auditors;[21]
the limited choice of auditors to appoint; and the difficulties
mid-tier firms face in raising funds to finance expansion.
4. The OFT considers that these aspects of the
audit market may explain low levels of switching of audit contracts;
very high market concentration, with high and stable market shares
for the Big Four being maintained at least as far back as 2002;
and potentially high fees. The OFT also notes that there are significant
concerns about the systemic risk arising from the potential impact
of an audit firm failing.
5. Audits enable stakeholders such as investors,
lenders and trading partners to assess the reliability of a company's
financial statements. If this is not done effectively, they may
be deterred from doing business with that company, in which case
companies would be likely to face less favourable terms of trade,
including higher costs of obtaining finance.
6. Higher audit fees or higher financing costs
are likely to feed through to higher prices for consumers. Weak
competition may also contribute to a risk of wider, systemic failure
in the audit market. Moreover, barriers to expansion might make
it difficult for mid-tier firms to step up to replace one of the
Big Four firms if it were to exit the market unexpectedly.
7. Given that competition may be limited, there
are a number of changes that may have the potential to increase
competition in the market. OFT's preference would be for changes
to be delivered through the market. Market-led solutions ultimately
result in the right incentives being harnessed so as to deliver
the best outcomes for consumers. However, certain improvements
may also be sought through regulatory or legislative change, at
least in the short term. The nature of the audit market is such
that changes may have to be international to be successful.
8. The OFT is the UK's consumer and competition
authority. The OFT's aim is to make markets work well for consumers.
It performs this role by deploying a variety of tools at its disposal
including the enforcement of consumer and competition laws and
advice to policy makers where wider government policies affect
competition and markets.
9. In 2002, the OFT considered whether a market
investigation or Competition Commission referral would be appropriate
for addressing competition concerns following the Enron affair
and subsequent collapse of the audit firm Arthur Andersen. In
November 2002, the OFT stated:
10. Since then, the OFT has provided advice
to Government on the implications for competition in the audit
market of proposals to permit auditors to limit their liability
by way of negotiated caps[23]
and contributed to the UK's submission to the OECD roundtable
on competition and regulation in auditing and related professions
in June 2009.[24]
In addition, the OFT has, since 2002, liaised, and will continue
to liaise, with the Department for Business, Innovation and Skills
(BIS) and the Financial Reporting Council (FRC) in relation to
concerns regarding this market.
11. A recent report by the FRC indicated that
a number of recommendations intended to result in the audit market
working more efficiently and to increase audit choice in the UK
had been implemented but had been largely unsuccessful. The FRC
found that "there is limited evidence that the recommendations
have had a significant impact on market concentration and the
risks arising from that concentration".[25]
12. In addition, in preparing this submission,
we have met with four of the largest providers of audit services
(BDO, PwC, Deloitte, and Grant Thornton), providing them with
an opportunity to tell us their views and experiences of the market
for auditors.[26]
However we have not shared this document with them.
14. This submission addresses the concern that
competition in the audit market may be limited and may deteriorate
in the future. Therefore, it relates primarily to three questions
posed in the call for evidence from the Select Committee on Economic
Affairs:
15. In addressing these questions in particular,
the remainder of this submission is presented in the following
three sections:
16. For the purpose of this submission, the
relevant market is the provision of external audit services to
large companies. This may be taken to mean FTSE350 companies.
However, there may be separate markets defined more narrowly than
this, for example by reference to FTSE100 companies and/or according
to particular sectors that have more complex audit requirements,
such as banking and insurance.
17. The OFT considers that competition may be
limited as a result of the following six aspects of the audit
market:
18. The OFT considers that the aspects described
above could result in the following three potential market effects:
19. The OFT considers, therefore, that weak
competition in this market may mean that audits cost companies
more than is necessary, with the possibility that the market does
not operate as efficiently as possible and that the value added
by audits is not maximised.
20. Audits enable stakeholders such as investors,
lenders and trading partners to assess the reliability of a company's
financial statements. If this is not done effectively, they may
be deterred from doing business with that company, in which case
companies would be likely to face less favourable terms of trade,
including higher costs of obtaining finance. Higher audit fees
and higher financing costs are likely to feed through to higher
prices for consumers.
21. The limited choice of auditors and high
barriers to expansion for mid-tier audit firms mean that if one
of the Big Four were to exit the market, existing competition
problems in the market could be exacerbated. There might also
be a short-term risk of some companies being unable to purchase
audit services, leading to a loss of confidence in the financial
status of high-risk companies and possibly among investors more
generally. Thus the existing high barriers to entry, leading to
high market concentration, can be seen as contributing to the
identified risk of wider, systemic failure in this market. Moreover,
barriers to expansion might make it difficult for mid-tier firms
to step up to replace one of the Big Four firms if it were to
exit the market unexpectedly.
22. If indeed competition in the audit market
is limited, there are a number of issues to consider before determining
what changes to the market could lead to the most effective outcome.
These considerations cover regulatory change, changes in ownership
arrangements and planning for the possible failure of one of the
Big Four.
23. We make two key observations in relation
to these issues. Firstly, the OFT's preference would be for changes
to be delivered through the market. The OFT considers that market[41]
solutions ultimately result in the right incentives being harnessed
so as to deliver the best outcomes for consumers. However, the
OFT recognises that certain improvements may also be sought through
regulatory or legislative change, at least in the short term.
Secondly, we recognise that many of the potential solutions will
require action on an international level if they are to be wholly
effective.
24. The issues to consider in relation to different
types of possible changes to the market are discussed below.
25. Under the broad heading of regulation of
the audit market, the OFT has considered a number of specific
changes that could be contemplated, such as:
— Changes to the minimum requirements
of the statutory audit.[42]
We consider that it is worth exploring whether the level of detail,
scope[43]
or materiality[44]
required of statutory audits should be reduced. Companies could
then choose whatever methods (in addition to the statutory audit)
were necessary to enable them, investors and any other bodies
using the accounts (for example companies wishing to trade with
them) to assess the company's financial position with the level
of confidence that is appropriate for their particular purposes.
Thus they might, for example, commission audit firms or consultancies
to provide a more thorough audit or whatever assessments of particular
aspects of their operations, for example the performance of particular
assets, divisions or products were thought necessary.
As well as potentially reducing the burden on companies,
reducing the requirements of statutory audit might stimulate switching
to smaller auditors that are able to undertake a more limited
audit. Doing this might also reduce auditor liability for errors
and hence auditors' risk of failure. Despite evident risks around
such a change, the OFT considers that these must be balanced against
the compelling possible gains that would result from shifting
the requirements and incentives of companies when selecting auditors.
Such a regulatory change could result in companies being more
motivated to ensure that the potential value added by audits is
maximised.
26. Another issue to consider is whether some
form of change in the rules governing the ownership arrangements
of audit firms might be beneficial. Audit firms currently have
to be majority controlled by auditors which limits the scope for
new investment and hence expansion of mid-tier firms.
27. In the event that less interventionist changes
are not successful in bringing about an increase in competition
and a reduction in systemic risk in the market, attention might
turn to whether direct intervention is called for in order to
shift the market to a new equilibrium. However, it is necessary
in all such cases to ensure that any such response is at most
targeted "micro-surgery" rather than potentially more
drastic intervention in order to avoid the risk of undermining
competition in the long run.
28. In addition to the issues to address before
determining what interventions should be used to achieve the most
effective market outcome, it may also be appropriate to focus
attention on what could be done to mitigate harm if any of the
Big Four firms were to leave the market. In this regard, the OFT
is considering undertaking further research and analysis vis-a"-vis
potential competition issues in concentrated markets where there
may be a risk of systemic failure, where any such failure could
cause significant harm to the UK economy. Our interest in such
markets is distinct from other regulators who do not have a competition
focus. Our interest is not on assessing the level of systemic
risk as such but in assessing whether such markets currently deliver
what consumers want on competitive terms that present good value
to consumers and, more broadly, to the wider economy. Any such
work, if undertaken, would likely consider what, if any, appropriate
solutions may be available.
29. This submission has explained that the OFT
considers that competition in the market for audit services in
the UK may be limited. It has presented a number of issues to
be considered in determining appropriate changes to the market
that could increase competition in the market and thereby possibly
reduce the systemic risk of failure of one of any of the Big Four,
with the resulting significant impact of this on companies and
consumers.
