Thursday 7 March 2019 8:54 am

A market cap is the quickest way to inject some competition into audit

Scott Knight is head of audit at BDO

As you read this, the Kingman review, the Competition and Markets Authority review, the Brydon review, and the Business, Energy and Industrial Strategy Select Committee are all scrutinising the audit profession following a series of high-profile scandals.

Failures such as Carillion, BHS, and Patisserie Valerie present very different problems, but each case rightly led to the question: “where were the auditors?”, quickly followed by “did they shout loudly enough?”

It is not the role of the auditors to stop companies from going bust or prevent poor business models from running into trouble. But it is their role to flag the warning signs so investors don’t suddenly find that they are taking risks they didn’t know about.

Audit has a critical role in our capital markets and there are some fantastic instances of companies being pressed to make disclosures, write-downs and provisions due to auditor intervention.

But these are outside of public view. Our successes are private but our failures are very public, and the string of recent scandals has eroded trust.

Restoring that trust is critical, but a quick look at the structure of the market reveals why so many believe that audit is a rigged game: a lack of competition and transparency.

Most listed companies in the UK use one of the Big Four auditing firms – about 98 per cent of FTSE 350 businesses have their books vetted by PwC, KPMG, Deloitte, or EY. The regulator has argued that conflicting commercial interests are rife, with this small band of firms supplementing their audit work with lucrative non-audit services. Unhelpfully, the rules on what additional work auditors can do are complex and poorly understood.

While increasing the number of players in the market will not automatically prevent failures, it will both improve quality and alleviate the public’s concerns that audit is a cartel that serves business rather than society.

I have heard some stakeholders say that the so-called “challenger” firms outside the Big Four don’t have the capability or capacity to audit large listed companies. To misquote Jeremy Bentham, this idea is simply nonsense upon stilts. FTSE 350 companies are increasingly recognising that a firm’s size is not a proxy for quality, and this progressive trend must continue.

So what can be done to inject more competition? Numerous options are on the table, each being considered by the various reviews, but one practical solution stands out: the introduction of a cap on the number of companies that any one firm can audit.

A market in which no single firm could audit more than, say, 70 FTSE 350 clients could be successfully implemented within just a few years.

There would be limited disruption, and UK businesses would quickly have a much more competitive and dynamic audit market where quality was the dominant factor in choice.

This should go hand in hand with a new attitude to regulation. The best intervention, as articulated in the Kingman review, is enhanced regulatory oversight by a beefed-up watchdog.

A reinvigorated regulator could instate more stringent requirements on auditors to interrogate finance directors’ judgments – and should be given extended powers to do so. This will challenge the public’s perception that the audit market is free to mark its own homework.

There are other ideas out there, and these should of course be fully considered. But my concern is that, for all the noise about the need for reform, an inability to agree upon a solution following extensive consultations could leave us with no meaningful change at all.

We will only be able to restore trust when the public can see a real transformation in the market.

There is no silver bullet. A package of remedies overseen by robust regulation is required. And, while the current review structure is thorough and welcome, it must not be used to slow the pace of change. The audit profession has a limited window of opportunity to demonstrate its relevance – or else risks being side-lined.

 

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.

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