What if the government insisted that every time you bought a tin of Heinz baked beans, you had to buy at least half a tin of Crosse & Blackwell ones too? You would have to explain to the grocery regulator why you chose Heinz, and if it thought that your choice was the wrong one it would mandate you to buy differently, publicly shame you and even take control of your grocery shopping as a punishment. You might not feel so great about it, but there’s no doubt that sales would rise for Crosse & Blackwell, who could then choose to invest the extra cash in improving its product, reducing its costs, or simply pay higher dividends.
The Competition and Markets Authority (CMA) is recommending this degree of intervention and forced joint-buying for the audit industry. The CMA report on the audit industry has many shortcomings; a lack of evidence, poor use of data, and a sharper ear to preferred interest groups. It clearly placed great weight on the views of politicians and investor corporate governance lobbies, but little weight on the views of companies and particularly not to chairs of audit committees;
“There are widespread public concerns about audit quality. While some Audit Committee Chairs (ACCs) and companies questioned whether there was a systemic and significant quality problem, the views of investors – the ultimate customers of statutory audits – were more supportive of our analysis that there is a persistent problem of variable or poor audit quality.”
The CMA suggested – without any evidence – that audit chairs were anyway likely to favour the Big Four if they had previously worked for them;
“The presence of ex-Big Four employees on Audit Committees is perhaps unsurprising given that the Big Four do employ a disproportionate share of financial professionals…However, it raises questions about whether Audit Committee members’ greater familiarity with the Big Four might lead them to favour Big Four firms when assessing audit tenders.” 1
Few would question that the audit market is too supply-side concentrated in only four companies. But the CMA is suggesting that the problem is demand-side driven. The purchasers of audit are making suboptimal choices, perhaps because audit chairs are just appointing their alma maters. The CMA also got itself into quite a spin trying to understand why ‘cultural fit’ was a helpful criterion for the selection of someone you are going to be working closely with for the next seven years, so it concluded that part of the problem is that audit committees are just looking for a friendly or compliant audit partner.
The CMA couldn’t quite persuade enough people that the choice of auditor should be taken completely out of the hands of the audit committee, but wants the regulator to; mandate minimum standards for the appointment and oversight of auditors; monitor compliance by audit committees; and issue reprimands to ‘non-performing’ committees. The CMA is silent on what those standards are, how the regulator will monitor them and how it can be sure that a regulator’s view will be superior to experienced directors working with the business and elected by shareholders.
The dual buying/joint audit remedy will increase cost and complexity for companies, but will also force revenue and market share towards smaller audit firms. This will, by definition, reduce market concentration. It may prove successful in increasing long-term audit competition if those non-big 4 firms seize the opportunity, or it may just be a long-term subsidy to possibly lower quality players, depending on how good the non-big 4 really are. In any case, the CMA has launched the project in the certain knowledge that it won’t be around to take responsibility by the time we know the ultimate outcome.
What worries me is the dismissive attitude that the CMA, regulators and politicians have for non-executives and the audit committee in particular. Independent non-executives are the key to our modern corporate governance, and yet the CMA wants audit committees to be supervised to an extraordinary degree. Auditor choice is to be mandated with joint audits and the process is to be reviewed by a regulator, who can ultimately take over the appointment decision. What would this say about the quality and integrity of our non-executives?
Even more concerningly, what does it say about the state of our regulators? Following the recent accounting scandals, regulators have lost faith in our basic corporate governance, whilst becoming more confident of their overriding wisdom. Most audit committees feel that the accounting scandals have demonstrated that the quality of regulation of audit firms is poor and needs to be drastically improved. But here we have regulators concluding that the answer is in fact more and wider regulation extended to audit committees.
Audit committees do need to face up to questioning, but it needs to be thoughtful. Do we expect audit committees to find fraud and accounting irregularities, if neither management nor auditors spot them? Do we expect boards to provide complete assurance that no company will ever go bust? How do we help boards to identify risks in their companies that might be signs of poor accounting practice or future financial instability? To help answer those questions, government needs to work with boards to understand better the issues, not just extend regulation and threats;
- Does the audit industry need more or just better regulation?
- Do we hold boards primarily accountable for running companies, or do we need to regulate them more?
- Do we trust non-executives to provide sufficient independent challenge on boards, or do we side-line them by regulating more?
- How do we help boards to identify and manage financial and accounting risks?
Otherwise we are back to the government deciding it knows best which baked bean is right for us.
1 This is a proposition that of course the CMA could have tested, but choose not to.