Report on audit reform delayed

Lucy Mair discusses why the audit market being investigated and how the industry is likely to change

Last year the Competition Commission began investigating the dominance of the UK's audit market by four companies: Deloitte, Ernst & Young, KPMG and PwC, known as the "Big Four". The investigation was sparked by complaints that they have an unfair stranglehold on the audit market and the suggestion that poor-quality auditing played a role in the financial crisis.

The watchdog was due to publish its initial findings this November, but it has delayed its results until the new year, with a final report not expected until August 2013. However, the EU is preparing its own reform plans under British MEP Sajjad Karim, who will publish the final amendments to the European reform plans on 11 November.

What is an audit?

An audit is an assessment of a company's financial records and procedures, and sometimes other aspects of its operations. The objective of an audit is to assess whether or not the company's financial records give an accurate view of its financial position. So, an audit may check that the company's financial records agree with those held by its bank, that its assets and investments have been correctly valued in its financial statements, and that its financial procedures are efficient and comply with all relevant regulation.

The most common form of audit is an external audit, which is carried out by an independent organisation, such as a professional services firm. Most medium and large UK businesses, public sector organisations and charities must be audited by an external body annually. However, organisations also often choose to undertake continuous internal audits to ensure that they are both operating efficiently and prepared for their external audit.

Why is reform needed?

In the UK the Big Four professional services firms audit all but one of the FTSE 100 companies, and together they also audit the majority of the FTSE 350. The monopoly has arisen through a combination of strong historic relationships between these firms and their clients, and the fact that many large organisations are required to use a Big Four firm by their investors. However, smaller firms in the audit industry and regulators argue that the monopoly stifles competition, which in turn has driven up the price of audits and pushed their quality down.

As a result of longstanding relationships between companies and professional services firms, it has also been suggested that some auditors were not sufficiently rigorous in their analyses of the financial records of banks and other financial institutions before the financial crisis. The lower quality of auditing and cosy relationships between audit firms and the management of their clients has been blamed in part for the significant losses sustained in the wake of the financial crisis.

Finally, when an external audit is conducted it's important that it is independent and unbiased. However, because the Big Four professional services firms also offer a range of consulting and advisory services, the potential for a conflict of interest is huge.

What reforms have been suggested?

To re-introduce competition, and a system of checks and balances, the EU has put forward proposals to introduce mandatory joint audits of large corporates, which will require Big Four firms to share work with their smaller rivals. These proposals are expected to be echoed by the Competition Commission when it publishes its findings next year.

EU proposals have also suggested that auditors regularly rotate to prevent them from becoming too close to their clients. Plans put forward by EU commissioner Michel Barnier last November recommended that audit tenures last no longer than six years. But when the final amendments to the proposed reforms are published next month, the maximum tenure could be anything up to 25 years. Karim argued in a recent working paper that quality audits depend on a strong relationship between the audit firm and the client, and that the quality of the audit procedure should be put before increased competition in the market.

To guarantee independence of external auditors, the Auditing Practices Board in the UK already restricts professional services firms from offering advisory services to their audit clients. The EU initially proposed more stringent measures to prevent audit firms from providing non-audit services. This could shake up the business model of the Big Four professional services firms, but little detail on these proposals has been provided so far and it is likely that they will be watered down before entering EU law.