Thumbs down: Mandatory audit firm rotation proposal beginning to lose favour

The Competition Commission (CC) in the United Kingdom (U.K.) has rejected audit firm rotation as a remedy for improving competition in the U.K. market for statutory audit services for large companies.

The Competition Commission (CC) in the United Kingdom (U.K.) has rejected audit firm rotation as a remedy for improving competition in the U.K. market for statutory audit services for large companies. This means mandatory audit firm rotation has now been rejected on both sides of the Atlantic in recent weeks as a potential solution for concerns about audit. The question remains: how will this influence the outcome of measures being considered in the European Union (EU)?

The CC package includes mandatory tendering every five years, which is contrary to the 10-year retendering rule with a “comply or explain” provision recently issued by the U.K. Financial Reporting Council (FRC). The five-year period was chosen to make it consistent with the current rules for rotation of audit engagement partners to ensure their objectivity and independence.

The CC rejection of FRC’s audit firm rotation follows the decision by the U.S. House of Representatives to prohibit the Public Company Accounting Oversight Board (PCAOB) from requiring mandatory audit firm rotation for public companies.

Mandatory audit firm rotation remains under consideration in the EU where a committee approved a proposal for mandatory rotation every 14 years, with extension to 25 years in certain circumstances. The EU proposal is still working its way through parliament.

In Canada, mandatory audit firm rotation has not received support. Now that there is building rejection of rotation both in North America and Europe, hopefully the EU will take this into consideration in finalizing its proposals. The prospect of some jurisdictions requiring rotation while others don’t appears to be a recipe for chaos.

But if mandatory firm rotation is not the answer, will mandatory tendering work? The CC believes that requiring companies to put their audits out to tender every five years will encourage rivalry among audit firms by ensuring that “regular and well-informed assessments are made of whether a company’s audit service is competitive.” Others point out mandatory tendering has several disadvantages that will not enhance audit quality, such as:

  1. Using an arbitrary time frame for a change in auditors could cause hardship for a company if it would occur at an inopportune time (e.g., when a major transaction is occurring) and would not then be in the best interests of the company’s shareholders.
  2. The tendering process may be focused on audit fees rather than audit quality. Competitive pressure on fees in the audit market over time can negatively impact audit quality.
  3. Mandatory audit firm tendering would add time and costs for both management and the external auditor – even though the same external auditor may well be appointed. The company would also incur costs for educating new external auditors (if a new auditor is appointed) on the company’s operations, systems, business practices, and financial reporting processes. Shareholders indirectly bear these costs.
  4. The choice in a successor external auditor could be limited because providers of certain non-audit services to the company would be ineligible to be appointed as the new external auditor. Companies in specialized industries (e.g., financial institutions) or with a global footprint could be particularly affected by such a limited choice.
My own sense is that if I was an audit committee member forced to go through a tendering process every five years, I would be tempted to change auditors just to demonstrate that the process was worthwhile, regardless of the performance of the incumbent auditors.

There is growing support in Canada, and overseas, for the audit committee to conduct a periodic comprehensive review of the audit firm as the means of addressing threats from long audit tenure. This is because comprehensive review has a more direct focus on enhancing audit quality and likely costs less than either mandatory rotation or mandatory tendering. CPA Canada is working with various parties to develop guidance that will provide audit committees with the appropriate tools to conduct such a comprehensive review. This guidance may be available early in 2014.

Keep the conversation going….what is your reaction to the U.K. Competition Commission proposal for mandatory tendering? Will it benefit the financial reporting process?

Post a comment below; or email me directly.

Eric

Conversations about Audit Quality is designed to create an exchange of ideas on global audit quality developments and issues and their impact in Canada.

About the Author

Eric Turner, CPA, CA

Director, Auditing and Assurance Standards, CPA Canada

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