AUDITORS too often focus on satisfying senior management of companies, who play a key role in deciding whether their services are retained, rather than the shareholders whose interests they are appointed to protect, the Competition Commission has found.
The commission said that competition in the audit market was restricted by the tendency towards this focus and by factors inhibiting companies from switching auditor.
It also highlighted the difficulties which accountancy firms outside the "Big Four", a grouping which comprises KPMG, Deloitte, PricewaterhouseCoopers, and Ernst & Young, have in winning audits of the top 350 publicly quoted companies in the UK.
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Issuing provisional findings of its market investigation into the supply of statutory audit services to large companies in the UK, the commission yesterday said the lack of competition was likely to lead to higher-priced and lower-quality audits, and a failure to meet shareholder demands.
The House of Lords Economic Affairs Committee in 2011 accused auditors of complacency in the run-up to the financial crisis.
The commission, an independent public body, said the external audit must become "a more genuinely independent and challenging exercise, where auditors are less like corporate advisers and more like examining inspectors".
It added: "Although auditors are appointed to protect the interests of shareholders, who are therefore the primary customers, too often auditors' focus is on meeting the needs of senior management who are key decision-takers on whether to retain their services. This means that competition focuses on factors that are not aligned with shareholder demand."
The commission cited mandatory tendering of audits every five or seven years, and rotation of audit firms every seven, 10 or 14 years as possible remedies to the lack of competition it identified.
It revealed it would also consider prohibition of clauses in loan documentation stipulating a company must be audited by a Big Four firm as a condition of its borrowings.
A commission spokesman cited "template leveraged loan documentation" containing a clause requiring the use of a Big Four firm. While noting nobody had to use this documentation, or include the clause, he added that these were "quite widely used".
The commission acknowledged the scale of the task of reforming the audit market.
It said: "It will undoubtedly be challenging to change a long-standing and entrenched system, but our proposals will look to create a situation where tendering and switching become the norm."
Laura Carstensen, chairwoman of the commission's Audit Investigation Group, said: "Whilst we accept that most audits are performed diligently and understand that those involved are behaving rationally in response to their incentives, auditors tend to focus on management interests over those of shareholders.
"For example, management may have incentives to present their accounts in the most favourable light, whereas shareholder interests can be quite different."
She added: "Shareholders play very little role in appointing auditors compared to executive management – and despite the presence of audit committees and other safeguards – audit firms naturally focus more on meeting management interests.
"The result is a rather static market in which too often audits don't fulfil their intended purpose and thus fail to meet the needs of shareholders."
The Institute of Chartered Accountants of Scotland (ICAS) said mandatory rotation was "not the silver bullet" for increased choice in the FTSE-350 company audit market.
ICAS technical policy director James Barbour questioned whether mandatory rotation would "merely result in the work being reallocated amongst the Big Four firms".
He welcomed the commission's move to ban contractual clauses requiring that an audit must be undertaken by a Big Four firm. But he took issue with the commission's view that auditors too often focused on the needs of senior management.
Mr Barbour said: "The suggestion that auditors are more concerned with retaining clients than working in the public interest and in the interest of investors does a disservice to the rigorous work and high level of professionalism of audit professionals."
Ernst & Young said it disagreed strongly with the commission's statement that the audit market was not serving shareholders.
Highlighting the challenges accountancy firms outside the Big Four faced in trying to win the audits of FTSE-350 companies, the commission said: "Audit firms outside the Big Four, which dominate the market, find it difficult to show that they have sufficient experience and reputation to win the audit engagements of FTSE-350 companies."
It also said that, because companies find it difficult to compare alternatives with their existing auditor, prefer continuity and face significant costs in switching, they are reluctant to change auditor and so lack bargaining power.
The commission found 31% of companies in the FTSE-100 top flight and 20% of mid-capitalisation groups in the FTSE-250 index had had the same auditor for more than 20 years. It found 67% of FTSE-100 companies and 52% of FTSE-Mid 250 constituents had had the same auditor for more than 10 years.