Wheel of Fortune: The Audit Fees Survey 2014

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IT HAS BEEN a signal year for auditors and the finance directors and audit committees of the FTSE 350 companies they audit. Landmark rulings by the UK Competition Commission and an influential group of European politicians have forever changed the relationship between Britain’s largest companies and the firms that vet their accounts.

In practice, the new guidelines will mean increased competition among auditors for the most lucrative contracts, more frequent tendering – and eventually rotation – undertaken by audit committees, a curtailing in the provision on non-audit services and a diminishing influence for finance directors in the appointment of auditors.

Though the changes have yet to take hold – so far, only a handful of companies have switched or tendered their audits in light of the new rules – businesses may already be starting to benefit from a more competitive environment. According to Financial Director’s latest FTSE 350 audit fees survey, total fee income across the indices fell by 8.2% to £978m from just over £1bn in last year’s survey, while fees charged for non-audit work dived by 40% to £171m from £290m.

Reductions in non-audit work, always a thorny issue for the independence of auditors, may be less about new market guidelines and more about depressed activity for transactional work such as mergers and acquisitions and initial public offerings. But non-audit fees are expected to fall in future surveys as new rules currently making their way through the European political system will clamp down on this more than ever before.

Cap in hand
The Competition Commission and EU rules, endorsed last October and in January of this year, respectively, bring to an end years of wrangling and politicking over the shape of the large-listed audit market.

First, the competition watchdog requires Britain’s largest listed businesses to tender their audit contracts every ten years, while those that tender less frequently than five years will be required to report in which financial year the audit engagement will be put out to tender. This aligns the rules with guidelines adopted by the Financial Reporting Council (FRC) and signifies a retreat from the former highly contentious five-year tender period.

Similarly, the EU rules, agreed during trilogue discussions between the Lithuanian EU Council presidency and the European Parliament – and subsequently endorsed by the European Parliament’s legal affairs committee – required companies to change their auditors every ten years, with the option of extending the period by a further ten years if tenders are carried out, and by 14 years if the company being audited appoints more than one firm to carry out the audit.

Rotation is only part of it. The Competition Commission rules also restrict the close personal relationships between auditors and finance directors in favour of handing audit committees more formal powers to set and agree audit contracts.

For instance, only the audit committee is permitted to negotiate and agree audit fees and the scope of the work, initiate tender processes, and make recommendations for the appointment of auditors, while the ability of shareholders to hold audit committees to account has been strengthened with the inclusion of a shareholders’ vote on whether audit committee reports in company annual reports contain sufficient information.

The EU has taken a more draconian approach in that it requires a 70% cap on the fees generated for non-audit work, while certain non-audit services, such as tax advice and services linked to financial and investment strategy have been banned altogether in a so-called black list. The list of prohibited services, which proved one of the most contentious issues among EU member states, is designed to limit conflicts of interest in instances where auditors are involved in decisions affecting the way companies are managed.

At a high level, the law says that banned services include certain tax, corporate finance, risk and valuation services. Tax, in particular, is a lucrative non-audit service for incumbent auditors. According to the survey, FTSE 350 companies paid out £56m in tax advice and £50m in tax compliance fees in the last financial year.

However, the rules are open to interpretation. “There are loopholes in the way that the law is written and in its scope, but we are hearing that audit committees will look to the spirit of the law,” says Nick Jeffrey, director at Grant Thornton International.

For instance, £45m was paid for work on corporate finance transactions. It is a decidedly grey-area question whether this falls foul of the black list, which bars services linked to the “financing, capital structure and allocation of the audit client”. As a result, audit committees will need to be more precise about how they disclose the nature of transactions and the advice they receive from their auditors.

Many firms and companies could also be hit by the 70% cap. Based on this year’s figures, 101 companies paid more than 70% of their audit fees for non-audit work. However, in some instances these figures will include work now banned under the black list, while the cap – much like fair play rules introduced by football’s governing body – relates to fees earned over a period of three or more consecutive financial years.

So the £683,000 charged by KPMG for non-audit work conducted on behalf of A G Barr – 778% higher than its £82,000 audit fee – wouldn’t necessarily come under the cap, as £566,000 of the fees related to assurance work performed on A G Barr’s proposed merger with Britvic.

Clearly, though, accounting firms will become more strategic in how they bid for audit work, while audit committees will be working closely with firms to determine the value of non-audit services to the business versus the value of the audit itself.

Getting strategic
The increased frequency with which audit contracts will come onto the market means firms will have to look closely at services they already provide to prospective audit clients. When audits rarely, if ever, came up for tender, conflicts of interest from big strategic projects were unlikely to arise.

A harbinger of things to come could be the recent case of Unilever, which under Anglo-Dutch listing rules was forced to replace PwC as its auditor. KPMG won the bid but, more importantly, EY did not pitch for the work because it was already a strategic supplier to the business. In this instance, the tender process left little time for EY to address any independence issues associated with its pre-existing Unilever work, unlike a decision not to bid for the audit being driven by commercial pressures.

At least EY was able to discover the conflicts before pitching for the work. In the case of Schroders, KPMG was less fortunate when it successfully won the chance to vet the accounts of the FTSE 100 fund manager. Having been confirmed as the new auditor in January last year, PwC was quietly ushered back in two months later after KPMG revealed its appointment would conflict with other interests.

Nevertheless, firms are actively planning for the new environment. “In the last 12 months, we have made plans and decisions as to whether there are companies we will look to target,” David Barnes, audit partner at Deloitte, told sister title Accountancy Age in October.

Deloitte is hardly alone in gearing up for the new environment. Indeed, Mazars’ UK head of public interest markets, David Herbinet, says the firm has set up a number of initiatives to “build relationships and credibility” – such as its Centre for Audit Committee & Investor Dialogue, launched last year with three institutional investors.

Most important for firms that want to build relationships with prospective clients is the requirement that audit committees announce when they intend to tender. “Clearly, that disclosure is extremely useful,” Herbinet said.

Tony Cates, head of audit at KPMG, agrees the five-year disclosures will give firms a “line of sight” and make the announcements “more crisp”. “They can be a bit vague,” he says. “Now you have to really allocate resource and target those companies.”

To a certain extent, companies in the FTSE 350 have already started to disclose their intentions in their annual reports – National Grid, for instance, announced in its latest report that it would tender the audit by the time of its next audit partner rotation, currently scheduled for March 2015.

And the work involved is hardly negligible. When Schroders put its audit up for tender, the process comprised 28 interviews with Schroders management for each firm, written proposals and a presentation to the audit committee and management.

Changing hands
But the costs to companies should not be overdone. At a minimum of ten years, the time scales involved are still fairly long. However, a flurry of activity is expected in the short term. David Sproul, Deloitte’s senior partner and CEO, has suggested that “something like 45 FTSE 100 audit tenders will come out within the next three years”.

Cates at KPMG expects most companies will “go early” and hold a tender process before the ten-year period is up. James Roberts, BDO’s audit partner, agrees with Cates that waiting until the end of the cycle will be “too risky” because of the potential for unforeseen events – such as the finance director resigning – and that most tenders will take place in years seven and eight.

“Everyone will need to think more strategically and go and self-select when they don’t want to play,” Roberts says, adding that he expects BDO to build on its TMT and retail sectors, among others. “It is quite important that we say, ‘This is an area we are focused on and do well in’, and spend money, and get the right people in.”

Indeed, over the last 12 months a slew of audits have changed hands – most recently Vodafone. In February, Britain’s second-largest listed company replaced its auditor for the first time since listing on the stock market 26 years ago, appointing PwC in place of Deloitte, which earned £8m in audit fees, as well as £1m in audit-related fees and £400,000 in non-audit fees last year.

The 13 tenders to have been completed since the last audit fees survey was published in March 2013 have accounted for £69.8m in audit fees and £103.9m when non-audit and audit-related fees have been taken into account. Of those tenders all but two have changed hands – one of which was PwC retaining Schroders. The other notable exception is Standard Chartered. By retaining its audit of the FTSE 100 bank, KPMG – which has held the work for 40 years – secured a piece of work that earned it about £9m last year.

The UK rules only require a tender process to be conducted, rather than enforcing a switch, so Standard Chartered was under no obligation to replace KPMG – and with its finance director Richard Meddings stepping down, the timing may not have been the most suitable to change even if it had wished to do so.

No statement was issued by the bank over its decision, so any insight into the thinking behind its decision will be postponed until its annual report is published in the spring. Interestingly, Standard Chartered’s approach to the audit, and subsequent reticence to issue a statement on its process, contrasts with that of British Land.

A day before Standard Chartered’s announcement, British Land revealed Deloitte would be replaced by PwC as its auditors after more than ten years with the firm. Indeed, the property investor went so far as to explain in its announcement to the stock exchange, saying that Deloitte had been told not to bother with the expensive business of retendering for the work because of the longevity of its appointment.

Pricing power
Another question on the lips of finance directors will be whether they can make savings. Increased competition should mean increased purchasing power. Helpfully, one can look to China for an indication of what might occur.

Last year saw the results from the first wave of companies forced to rotate their auditors in what is an important step for Chinese corporate integrity. According to The Big Four and the Development of the Accounting Profession in China, a book by Professor Paul Gillis, a former PwC partner and an accounting expert at the Peking University school of management, fees in China have fallen as a consequence.

No audit contract went to a firm outside the Big Four but audit fees dropped significantly. The data is, as yet, incomplete but Gillis’ initial work shows that the Agricultural Bank of China switched from Deloitte to PwC with the fee falling 12% to RMB115m (£11.57m). Meanwhile, the Bank of China swapped PwC for EY with a 31% cut in the fee to RMB148m (£14.89m). Other banks won similar fee reductions.

According to Gillis, smaller local firms may have backed away from tempting offers to tender for the audits: “The Chinese government and some regulators went to the second-tier firms and asked them to propose on some of the companies that were being rotated. I know of at least one circumstance in which one of the firms that was requested to propose on banks refused to do so.”

But Gillis also believes the cut in audit fees will put pressure on the Big Four’s ability to deliver quality. Defining what audit quality represents is now the burning issue for firms and business.

The code
Since the revised corporate governance code was issued in September 2012, there has been a lot of debate regarding the way that boards, and audit committees, might approach the changes to the contents of annual reports.

A number of these changes focus on the section of the annual report that deals with audit committee matters, and are effectively mandatory for the current reporting season. The code, and its associated audit committee guidance, has been revised to include provisions for FTSE 350 companies to put the audit out to tender at least every ten years and the FRC is encouraging companies to say what they intend to do with regards to the audit contract.

Committees are now being encouraged to report the process through which they have assessed external audit effectiveness, rather than just to state at present whether or not they do consider it to be effective. The element that many committees will find most burdensome is that they are required to provide information surrounding significant financial reporting issues and the way that these have been addressed, and to say how they have discharged their duties.

In addition to the above, the new requirement for boards to state that the annual report, taken as a whole, is “fair, balanced and understandable” will most often fall upon the audit committee in the first instance. All in all, audit committees are under greater scrutiny than they ever have been and that trend is only likely to continue.

In this context, BDO released its third annual review of audit committee reporting, ‘Waiting is the Most Difficult Bit – an Analysis of Audit Committee Reporting, 2013′.

Although it also looks at audit committee reporting for AIM companies, the most striking feature of the survey was that, overall, there was no appreciable increase in the quality of listed company audit committee reporting between the annual reports of 2013 and 2012. There has been surprisingly little anticipation of the revised code in the disclosures and in the descriptive material surrounding audit committee conduct.

“Overall, we were surprised, and a little bit disappointed, that companies had not used 2013 to advance audit committee reporting along the road to fuller disclosure in 2014,” BDO audit partner James Roberts wrote in an article for Financial Director.

The report focused heavily on relationships and communication with the external auditor, and gave lots of information regarding non-audit services and independence. However, little was said about the relationship and communication with internal audit and the absence of disclosure of the focus of their activities was very apparent.

Practically speaking, there is a number of simple things that companies can do to improve communication in all these areas without creating more of a reporting industry.

Presentation is important and audit committee reports that are laid out with clear headings, using charts and boxed presentations, will create a more friendly environment in which a user can absorb the report. The use of questions and answers is an easy way to lead the reader through and to put matters into context.

A new landscape
Over the last 12 months the likes of HSBC, Marks & Spencer, Hargreaves Lansdown, Land Securities and FTSE 250 groups Cairn Energy and Henderson Group have all switched audit firms as result of the new landscape, and as an expression of good corporate governance. PwC appears to be doing the best, retaining one and winning six, including the £29m audit of HSBC – the second-highest fee in the survey.

The mid-tier firms have yet to make any inroads into the market because of the changes. They might have hoped to win an audit such as British Land, worth £500,000 and fairly simple when compared to the likes of HSBC.

Compared to last year, Grant Thornton’s total fees – audit, non-audit and audit-related – fell 41%, though the firm does now audit a FTSE 100 business in the form of Sports Direct, which entered the index last year. BDO managed to increase its fees by 55% to £4.3m, though this can be attributed to its merger with PKF.

Clearly, it is early days, and audit committees, auditors and finance directors are getting to grips with new formats and environment. The likes of GT and BDO are playing the long game and don’t expect to pick up many top-level audits in the immediate future.

So for now, the Big Four appear to retain a monopoly on the market. Therefore, despite all the changes, it may be that the FTSE 350 audit market remains much like the ship of Theseus. The auditors may all have to be replaced but the market – at least for the time being – remains fundamentally the same. ?