Which makes puzzling the reactions of the accounting firms to the provisional decision of the Competition Commission in the United Kingdom, that public company audits should be put out for mandatory re-tender every five years – which would halve the doubly permissive ten-year “re-tender or at least explain” promulgated last fall by the Financial Reporting Council.
The large firms complained that the five-year period is too short, while others argue that the provision is still too soft.
Considering the interests of the chicken and the pig, these reactions of both the Big Four and the next smaller firms seem wrong-footed. Regulators being masterful at failing to identify the likelihood of highly-disruptive unintended consequences – of which the statement of the Chairman of the Competition Commission’s Investigative Group, that “the audit function is too important to be left undisturbed for longer than five years” will likely prove an example -- here’s why:
Although there is no research or empirical evidence to indicate any causal relationship between lengthened auditor tenure and audit quality, there is wide and credible belief and research that the early years of an auditor-client relationship, on the steep slope of the learning curve, are fraught for issues of risk and irregularity.
So what is to happen in – say – years three and four, just ahead of the expensive and demanding re-tender process in year five.
A Big Four firm, prepared (and obliged) to invest both time and personnel, as either incumbent or outside competitor, would draw on its depth, from its broad client roster and its ranks of people and industry resources.
Indeed, an incumbent Big Four firm’s tactic would implement its obligatory engagement partner rotation in about year three -- providing that new partner with experience and seasoning, and selling its then-familiarized engagement leadership as a stability message in the re-tender competition in year five.
By contrast, a smaller firm would be hobbled in a five-year regime as either incumbent or as outsider. As incumbent, its profitability would have suffered – like a Big Four firm, to be sure -- from the first-time costs of a new engagement, against fee levels influenced by a multi-firm competition. Then, instead of benefitting from the stable middle years of a ten-year incumbency, firms would immediately face the costly defense of the engagement – against Big Four competitors assembling competitive proposal resources from available stock.
And as an outsider, a smaller firm – by definition lacking the “bench strength” in personnel and industry competence that only a Big Four’s roster of Footsie-350 clients provides – must, for each potential but very uncertain potential proposal target, find and marshal the people and invest the costs of proposing – not once but twice each decade.
Unhappy consequences can well be imagined for budget-cutting, ever-higher pressures of time and execution on engagement personnel, and threats to performance quality – with the associated prospects of audit breakdown and failure.
Defenders of the five-year timetable assert that the re-tender process could become routinized, and the costs therefore mitigated – an anodyne position that is wrong for two reasons:
First, the assumption is fragile. The pace of change in the global large-company environment will demand fresh, detailed and widely-researched attention every year. Attempted “off-the-shelf” proposal methodologies will obsolesce with the relentless speed of the business cycle.
Second, audit committees offered the easy default of incumbent retention would only be persuaded to change on the basis of compelling and well-customized advocacy. A box-ticking proposal process would only reinforce and increase an incumbent’s advantage.
In summary, five-year re-tender as proposed by the Competition Commission would portend these results:
- Even less auditor switching than under the FRC’s ten-year cycle.
- Mid-tier firms withdrawing from tenders for inability or unwillingness to sustain the impact on their personnel and their business models.
- Further intrusion of the Big Four into the client lists of the mid-tier firms, with resulting increase in the market concentration among that tetrapoly, based on their ability to deploy superior resources against uncertain defenses.
On top of all of this, the FRC’s ten-year rule seems already to be generating increased auditor switching – as I predicted last fall it might – with such large UK parcels reportedly to be passed as Unilever and the London Stock Exchange (both PwC), and PwC replaced by EY at both Land Securities and BG Group (here) – the discomfort of which no doubt being eased by PwC’s capture from KPMG of banking giant HSBC, the UK’s most lucrative audit engagement.
On the race-track of an August 13 deadline for comments, and with conditions in place not manifestly broken, Chairman Carstensen and her colleagues should re-think with care the warning to “be very careful what you wish for.”
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