Attitudes differ
about the ingredients in a ham-and-eggs breakfast. To a chicken, it’s a matter
of interest. To a pig, it’s a matter of life and death. 

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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