Statutory(Audit(Services(( Market(Inves4ga4on( · ACE $Conference$2014 ... UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated

Statutory Audit Services Market Inves4ga4on ACE Conference 2014: Parallel Session 1

Chair: Alex Baker 5 December 2014

Statutory Audit Services Market InvesEgaEon – ACE Conference 2014

Speakers •  Marie Clark, CompeEEon and Markets Authority •  Robin Finer, Financial Conduct Authority •  Caitlin Wilkinson, KPMG •  Dr Amelia Fletcher OBE, ESRC Centre for CompeEEon Policy

fingletonassociates.com 2


•  An audit conducted by an auditor under Part 16 of the Companies Act 2006

Statutory audit services

•  Those listed on the FTSE 100 and FTSE 250

Large companies


Background: auditors and audit services



Theories of harm

Unilateral market power of ‘Big 4’

Principle-‐agent problems CoordinaEon

Bundling Influence over regulatory bodies


Adverse Effect on CompeEEon (AEC)

RELEVENT FEATURES

•  Barriers to switching • Mid-‐Eer audit firms face barriers to entry, expansion and selecEon

•  Ability of execuEve management to influence external auditors in conduct and reporEng

•  InformaEon asymmetry between shareholders and audit firms

HOW THE AEC ARISES

• Weakening bargaining power outside tender process

•  Reinforcing current market posiEons and hindering emergence of new rivals

•  IncenEvise firms to compete to saEsfy demand not fully aligned with shareholders’ interests




Remedies

Mandatory tendering Changes to Audit Quality Reviews

(AQR)

ProhibiEon on loan agreement condiEons

Advisory vote on audit commidee

report

Strengthen accountability of auditors to audit

commidee

Financial Report Council to have ‘due

regard’ to compeEEon

Mandatory switching Further constraints on non-‐audit services

Joint or major audit component

Shareholder responsibility for

auditor reappointment

Independently resources risk and audit commidee

Fingleton Associates 33 Cavendish Square

London W1G 0PW

Office: +44 20 3730 9090 Email: [email protected]

fingletonassociates.com

Statutory Audit Service CC Market Inquiry

Robin Finer (FCA), formerly Economic Director CC Marie Clark (CMA), formerly Lead Economist CC 8

Content

9

●  What is a statutory audit? ●  Role of audit and market failures

●  Characteristics of audit

●  Theories of harm

●  ToH1 – audit firms have unilateral market power over client companies

●  ToH2 – principal-agent problems

●  Why this matters

What is Statutory Audit?

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The auditor must state clearly in the report: (a) whether in his or her opinion the annual accounts give a true and fair view;

(b) whether in his or her opinion the accounts have been properly prepared;

(c) whether the report is unqualified or qualified; and (d) whether there are any matters to which the auditor wishes to draw attention.

The auditor has a duty of reasonable care to the company as a whole in the interests of its shareholders.

Role of audit

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●  Response to principle agent problems in the management-shareholder relationship which arise where

-  misalignment of interests (hidden behaviour)

-  information asymmetries (hidden information)

●  Exacerbated by fragmented ownership. In particular: -  Free rider problems in monitoring

-  Conflicts of interest between larger/smaller shareholders

●  Audit provides -  shareholders with assurance on the reliability of the information required

to monitor management

-  management with a means of signalling to current and potential future investors the quality and reliability of the information.

Market failures in audit

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●  Audit is highly regulated (although some are carried our on voluntary basis). Requires:

-  Independent audit and publication of accounts

-  Audit is conducted in accordance with certain standards and principles

●  Reasons for regulation: -  Free-riding and adverse selection

-  Wider benefits(essential to effective corporate governance and efficient operation of financial markets)

-  Network benefits associated with common standards

Market failures in audit

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●  Audit supplements one P-A problem (shareholders-management) with another (shareholders-auditor):

-  Auditors better informed that shareholders

-  If managers influential in their appointment, may be incentives for auditors to be influenced by the management demand.

Requirement for an Audit Committee is recognition of this

●  Product characteristics: -  Bespoke (at least for FTSE 350)

-  Credence good for shareholders

-  Experience good for management/AC

Theories of harm

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●  TOH1: audit firms have unilateral market power over client companies ●  TOH2: principal-agent problems – whether there is a distortion of

competition arising from P-A problems

●  Link between these theories critical to our case

●  Investigated but not pursued: -  Non-audit services

-  Big 4 infiltration of regulatory bodies

-  Big 4 coordination

-  Big 4 predatory behaviour against Mid tier

ToH 1 - Framework

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●  Central to establishing ToH was understanding the relative bargaining position of firms and their clients.

●  Framework: -  Credibility of a threat to switch:

§  Availability of outside option

§  Search costs

§  Switching costs

§  Balance/risks in relation to potential gains and costs

-  Risks to firm of losing a client:

§  Ability to manage the risk

§  Cost to firm and partner of losing a client

ToH 1: Evidence

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●  Survey evidence on behaviours, motivations and attitudes ●  Statistics on frequency of tendering and switching, tenure fees, costs

of conducting audits and inputs

●  Characteristics of the clients for more/less profitable engagements

●  PwC econometric analysis of effect of switching on audit fees. ●  Tender processes and the costs involved

●  Often competing interpretations – necessary to consider the most plausible explanation in the circumstances

ToH2 - Framework

17

Board

Shareholders

Audit Committee

Auditor

Board comprised executives (CEO, CFO, etc) and NED’s. AC comprises NEDs but CEO/CFO usually attend meetings. Directors have fiduciary duty to act in the interests of the company. AC has particular responsibility to ensure interests of shareholders are protected in relation to financial reporting and internal control.

ToH2 - Evidence

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●  Understanding of the following: -  process for initiating and conducting a tender;

-  the role of management/AC and shareholders in the conduct of audit, tenders and appointment;

-  the information available to management, AC and shareholders on the conduct of the audit.

●  Survey of ACC on role, information and resources.

●  Views of investors

●  FRC findings

Findings – features giving rise to AEC

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●  Barriers to switching: -  Significant opportunity costs in management time involved in selection

and education of new auditor;

-  Loss of expertise and knowledge with change in auditor;

-  Experience good – difficult to accurately assess in advance benefits a tender process and switching would bring.

●  Executive management able to influence external auditors in how conduct and report audit

●  Information asymmetry between shareholders and firms – shareholders have little information regarding conduct of audit

Why this matters

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●  Takes us back to role of audit and market failures in conduct of audit

●  Essential to effective corporate governance and operation of financial markets

●  As shareholders do not have the information to identify ‘bad apple’ any doubts risk undermining trust in audits (credence good for shareholders)

●  Consequences – nicely summarised by OECD

OECD Statement

21

effective corporate governance system, within an individual company and across an economy as a whole, contributes to providing the confidence that is necessary for the proper functioning of a market economy. As a result, the cost of capital is lower and firms are encouraged to use resources more efficiently, thereby underpinning growth. When this trust is undermined, lenders and investors are said to lose their appetite for risk, and shareholders to sell their equity, resulting in lost value and reduced availability of capital. The principles of corporate governance of transparency and accountability are said to be crucial to the integrity and legal credibility of our market system.

Appendix – B2E

22

●  Mid Tier firms have reasonable share of AIM and unlisted market/public sector

●  Some Big 4 firms not active in all sectors

●  Institutional preference for Big 4 - experience and global spread key.

●  Virtuous circle: demonstrable experience of FTSE 350 audit enhances reputation and chances of gaining additional FTSE 350 clients.

●  Low levels of tendering and switching and the difficulty of predicting the timing of such opportunities hindered the ability of firms to investment in building experience

UK Competition Commission inquiry into Statutory Audit

Services Caitlin Wilkinson

5 December 2014

24 © 2014 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

Agenda


■  The statutory audit product

The implications of competition on quality

■  Competition on audit quality

■  Implications for market structure

Mandatory tendering and mandatory rotation

■  The CC’s aims from the mandatory tendering remedy

■  Bargaining outside of tender events

■  Barriers to entry and expansion

■  Evidence on audit outcomes

Conclusions



What is a statutory audit?

In the UK, the Companies Act 2006 requires an audit firm to:

a) Determine whether the financial statements provide “true and fair view” of the company’s financial position and prepare in accordance with relevant reporting requirements; and

b) report on the Director’s Report and (for listed companies) the auditable part of the Remuneration Report and the Corporate Governance Statement.

To do that for a FTSE350 company, an audit firm must get to grips with a huge amount of complexity...


Drivers of complexity of a statutory audit

FTSE350 companies, their operating models and their systems of controls, reporting and governance are extremely complex – all of which an audit firm must understand in-depth:

■  Number of countries where FTSE350 Co operates ■  Growing importance of emerging, less developed, markets

Geographic diversity

■  Number of units/entities ■  Separate (local) reporting requirements ■  IFRS and Different GAAPs

Reporting complexity

■  Different year ends ■  JVs ■  Regulatory reporting

■  Commercial arrangements (business/ contracts) ■  Tax structuring (operational, financing) ■  Operational

Operational complexity

■  Legal versus management reporting mismatch ■  Non-standard systems ■  Centralisation of transaction processing (offshoring and/ or outsourcing) ■  Accounting

Accounting complexity

■  Values ■  Politics/ personal agendas ■  Organisational behaviours

Cultural complexity


Client

An audit requires more than just auditors

■  Services that are an implicit part of the audit

■  Client expectations

The implications of competition on quality


Audit firms have to compete on quality

Companies get, and expect significant value from an audit, including: ■  the credibility / reputation of the audit firm; ■  a deep understanding of the business; ■  challenge to management; ■  value-adding views/ reporting on systems and processes; ■  efficiency.

Audit firms also face substantial risks from “getting it wrong” and damaging their reputation: ■  loss of clients; ■  substantial regulatory fines on the firm or the individual partner; ■  loss of talent/ staff; ■  liability claims; ■  potential for disastrous consequences (a la Andersen).

Audit firms must compete on quality


Providing high quality requires investment

■  Quality is a key parameter of competition in the audit industry.

■  Competition on quality means that to remain competitive, firms must invest in:

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Overall firm-wide capabilities, e.g.: •  a global network; •  IT software; •  staff recruitment and training; •  staff depth (“bench strength”); •  technology and audit methodologies; •  sector expertise; •  quality assurance processes. These investments involve fixed, sunk costs

Client-specific capabilities, e.g.: •  FTSE350 companies are very

complex; •  Providing high quality requires

substantial investment in learning about the individual client’s business, processes, controls, complexities, etc;

•  “learning by doing”. Audit clients also themselves make investments in getting their auditor “up to speed”.


Implications for market structure

Concentration Fixed, sunk cost investments are crucial for delivering high quality audit services for FTSE350 companies. Competition for market share means the natural market outcome is one with few, high quality suppliers.

The level of concentration of audit firms serving the FTSE350 is a result of competition to provide

high quality

Switching rates Substantial relationship-specific investments on the part of both audit firms and clients are required throughout any FTSE350 audit engagement. Frequent switching would be inefficient as the value of these investments would be lost.

Switching rates among FTSE350 audit clients are efficient and the result of competition to provide

high quality

Evidence on mandatory switching and mandatory tendering


The CC’s views on mandatory switching and mandatory tendering

■  The CC considered mandatory switching of audit firm but decided not to impose it, in part because it would reduce competition.

■  The CC imposed a remedy of mandatory tendering every 10 years (having originally proposed 5 years), which it said would:

■  increase companies’ bargaining power;

■  reduce barriers to entry and expansion.

(NB: 10 year tendering on a “comply or explain basis” – i.e. a company has to tender its audit or issue a letter explaining why it hasn’t – already required by the Financial Reporting Council)

Did the CC’s evidence demonstrate that these two benefits would arise from mandatory tendering?

What are the benefits/ costs of mandatory tendering over and above ‘comply or explain’?


Will mandatory tendering increase companies’ bargaining power?

■  Competitive pressure exerted on audit firms through bilateral negotiations throughout the life of an audit – i.e. not limited to tenders.

■  Outcome determined by the strength of each party’s outside option. We agreed with the CC that:

FTSE350 company’s outside option includes costs of tendering and cost of switching, including loss of relationship-specific investments. Audit firm’s outside option includes lost profit from the audit PLUS substantial costs of lost value of relationship-specific investments; reduction in experience/ sector knowledge; reduced ability to win/ retain other clients; damage to reputation for quality.

What evidence is there that companies get better outcomes through a tender than through these bilateral negotiations?

But key differences: On the evidence: CC thought companies could not judge quality outside of tenders– we disagreed (see evidence on ACCs’ ability, survey evidence, # ACCs sitting on other boards, provision of non-audit services by rival audit firms). On the economic theory: No clear link between uncertainty and competitiveness of negotiated outcome.


Will mandatory tendering reduce barriers to entry/ expansion?

Mid-tiers have very limited presence in FTSE350:

What evidence is there that mandatory tendering will improve outcomes for FTSE350 companies by reducing barriers to entry/ expansion?

How is that consistent with CC’s view that under current levels of concentration: ■  generally companies have a choice of alternative suppliers within the Big 4? ■  competition in the tender process is strong with mid-tiers only participating in

1/3)?

CC concluded there were barriers to entry / expansion (from lack of experience) that contributed to a lack of competition.


Do outcomes for audit customers show that mandatory tendering will deliver benefits? (1) Audit quality

■  Case study companies generally expressed a positive view of quality, though some thought quality could be better;

■  AQRT (independent audit quality review team) said 14 / 167 audits reviews in 5 years required ‘significant improvement’;

■  AQRT acknowledged improvements in audit quality over time;

■  AQRT notes emphasis placed by Big 4 audit firms on internal quality control systems;

■  AQRT shows audit quality is higher for FTSE350 than non-FTSE350 companies;

■  Declining number of claims against audit firms and premiums paid out since 2002.

What is an appropriate benchmark for a ‘competitive’ level of quality?

In our view this evidence did not show that companies got worse outcomes without a tender.


Do outcomes for audit customers show that mandatory tendering will deliver benefits? (2)

Margins following a switch:

Fees following a switch: ■  The median audit fee falls following a switch – but does not control for audit scope. ■  The median audit fee does not fall following a tender.

Our view: this analysis did not show outcomes less competitive without a tender

Engagement profitability plateaus after 5 years – does not continue to increase with length of tenure.

Profitability of an engagement increases in first 5 years - CC recognised consistent with additional work required in early years.

Conclusions


Conclusions on economic analysis

Some of our overall views on CC’s economic analysis

1.  CC recognised that quality was a key aspect of competition – but not clear that the CC applied the right ‘competitive benchmark’ for quality.

2.  CC didn’t fully recognise the ‘endogeneity’ concentration and switching rates:

•  Concentration measures not informative when companies compete through fixed, sunk cost investments

•  Low switching is an efficient equilibrium outcome when there is a lot of ‘learning by doing’

3.  CC accepted the bargaining framework and recognised that competitive pressure exists outside of tenders – but some issues in the detail of the analysis of outside options.

© 2014 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

The KPMG name, logo and “cutting through complexity” are registered trademarks or trademarks of KPMG International.

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

ACE 2014: Parallel Session 1 The UK Competition Commission’s Audit Services Market Investigation

Amelia Fletcher Centre for Competition Policy

Key competition facts – broadly agreed v  There is significant concentration and high barriers to entry

Ø  ‘Big 4’ audit firms account for >95% of FTSE 350 firms’ audits and >99% of fees.

Ø  ‘Mid-tier’ firms find it hard to compete for FTSE 350 audit work, other than in some specific sectors (eg real estate).

v  Even within Big 4 there is very little switching Ø  Average annual switching of 2.4% and around of half of this due to

mergers/move into FTSE 350.

Ø  So only around 1% due to desire to get better value.

Ø  Also very little tendering.

Further key facts – broadly agreed v  Price is a secondary consideration in choice of auditor. Quality is more

important. Ø  Asymmetric information means that it can be hard to assess the true quality of

different offerings. Ø  Much current switching occurs in response to poor current quality.

v  There are reasonably high costs of search/tendering (mainly time) v  There are also high costs of switching, in particular in terms of:

Ø  Cost (mainly time) of educating a new auditor: This cost is higher for larger and more complex companies.

Ø  Loss of benefits from continuity in client-auditor relationship: Can reduce efficiency of audit process, increase risks of poor technical audit quality, reduce potential for additional commercial insights, goes against desire to portray stability and continuity.

So far, so apparently bad…but… v  Audit firms are keen to keep existing clients, due to ongoing profitability of

relationship (which in turn reflect sunk upfront costs of investing in relationship and benefits of continuity).

v  When customers do go out to tender, the Big 4 firms typically bid vigorously to try and win the business.

v  Thus, customers in a good position to negotiate better deals without going out to tender. Ø  Indeed, CC found evidence of such renegotiation to get lower fees or

changes in audit scope. Plus average prices and hours have fallen in recent years (evidence apparently ignored!)

v  In this context, and given sophisticated big buyers, might low switching rates simply indicate happy customers?

Last year, I promised equations! v  Case raises an interesting research question (I think!):

Ø  If buyers can improve their deal by threatening to go to tender… Ø  …is this any worse than the competitive market outcome?

v  Very simple model:

Ø  One customer only, who must buy a unit of audit. This customer is initially allocated to Firm 1.

Ø  Firm 1 chooses how good a deal value to offer (value V1)

Ø  There are n other possible suppliers, and the value of the deal offered by each is exogenous, and randomly drawn from a uniform distribution on [0,1].

Ø  The customer can only observe the deals offered by others if it tenders, at cost x. If the customer then switches, this costs y.

3 Stage game v  Move order:

Ø  Stage 1: Firm 1 decides what value V1 to offer. For exogenous reasons, it wishes to retain the consumer ‘at any cost’.

Ø  Stage 2: Customer decides whether to go out to tender, at tender cost x. If it tenders, it learns the values of the other deals on the market Vj. (If not, it simply sticks with Firm 1).

Ø  Stage 3: If it has tendered, the customer decides whether to switch to a new provider, at switching cost y.

Stage 3 – To switch or not to switch? v  Stage 3 decision:

Ø  Customer will switch only if there exists a supplier j, such that:

Vj > (V1 + y)

Ø  The likelihood that of this occurring is given by:

L = (1 – (V1 + y)n)

Stage 2 – To tender or not to tender? v  Stage 2 decision (now assume n = 1 for simplicity):

Ø  Customer will go to tender if the expected gain from doing so exceeds the tender cost x.

Ø  Expected gain conditional on later switching = (1 - (V1 + y))/2

Ø  So overall expected gain = L × (1 - (V1 + y))/2

= (1 - (V1 + y))2/2

v  Or more formally:

Ø  Overall expected gain = ∫𝑉↓1 +𝑦↑1▒ [𝑉↓𝑗  − ( 𝑉↓1 +

y)] 𝑑𝑉↓𝑗  = (1 - (V1 + y))2/2

Stage 1 – How to keep a customer? v  Stage 1 decision:

Ø  Firm 1 will offer as good a deal as it takes to keep its customer, by preventing it from going to tender.

Ø  In order to do so, Firm 1 has to set V1 such that the customer’s overall expected gain from going out to tender is no higher than the tender cost x.

Ø  That is, it will maximise V1 subject to the following constraint:

x ≥ (1 - (V1 + y))2/2

Ø  Thus, it will set V1 at:

𝑉↓1 =1−𝑦−√2𝑥 

v  One of the CC’s remedies was a mandatory tendering remedy. This requires FTSE 350 companies to carry out a formal tender for their audit firm no less frequently than every 10 years.

v  How does this fit into the model? It effectively removes Stage 2, because the customer is forced to tender.

v  This changes Stage 1 too. To be certain of retaining the customer within a formal tender, the supplier has to set V1 such that it is no lower than the maximum possible Vj (= 1) minus switching cost y. That is:

𝑉↓1 =1−𝑦

v  Given that the customer also pays the tender cost x, this means that, under compulsory tendering, the customer overall receives:

𝑈↓1 =1−𝑦−𝑥

The mandatory tendering remedy

v  Under compulsory tendering, the value received by customers is:

𝑉↓1 =1−𝑦−𝑥

v  Under the original model, without compulsory tendering, the value received by customers is:

𝑉↓1 =1−𝑦−√2𝑥  v  Since √2𝑥 > 𝑥, for all relevant x, customers are better off with the compulsory

tendering remedy! That is, real competition is better than ‘negotiation in the face of a threat to tender’.

v  Clearly this model is highly simplified and stylised. But does it contain a core truth? Probably.

Comparison: Is the remedy good?

v  There is, though, a further interesting factor here (not in model). Ø  In a tender, it seems likely that an incumbent audit firm may have a

competitive advantage (‘toe-hold’) over its competitors. Ø  In such situations, the Bulow, Huang and Klemperer (1999) problem

can arise, viz. no one bids because it is obvious who will win. This in turn means that incumbent firms can win despite offering poor deals. Competition doesn’t work!

Ø  In fact, there is currently strong bidding. But is this because, today, if a customer switches this may signal dissatisfaction with its current supplier, and thus no advantage?

Ø  Will this change with mandatory tendering? And if so, is there a risk that the Bulow, Huang and Klemperer problem emerges?

Addendum: Unintended consequences?

ACE 2014: Parallel Session 1 The UK Competition Commission’s Audit Services Market Investigation

Amelia Fletcher Centre for Competition Policy

Statutory Audit Services Market Inves4ga4on Discussion and quesEons

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Statutory(Audit(Services(( Market(Inves4ga4on( · ACE $Conference$2014 ... UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated