In concentrated audit milieu what is the role of competition law?

The regulatory scrutiny the South African audit profession has come under as a result of the state capture scandal is not without precedent. During the 1980s the eight major audit firms that existed at the time consolidated through a series of mergers to form five firms.

Then, in 2002 the collapse of Enron led to the demise of Arthur Andersen, its auditor, which was broken up and sold to other large auditors the world over. In SA, this was to KPMG, while in other countries it was to Deloitte, EY or PwC.

Then came the global banking and financial crisis of 2008, which led to renewed interest in both the question of competition in the audit sector as well as the part that should be played by auditing companies in preventing company failures and economic downturns.

The objective of an audit is to express an independent opinion as to whether the company’s financial statements are a true and fair reflection of its financial health and are prepared in accordance with the law.

Potential investors will inevitably take into consideration the credibility a clean audit gives to a company’s financial status, as reflected in that company’s financial statements. Confidence in the operation of capital markets depends, at least in part, on the credibility of the opinions and reports issued by auditors.

The question now arises to what extent competition law intervention could assist in preventing audit failures in future and thereby strengthen the South African economy.

There are potential concerns from a competition law perspective when considering the way the audit profession operates:

High barriers to entry and expansion. Specific knowledge is required to operate an audit firm, there is significant cost involved in attracting and training staff and it is accepted that the existing size and reputation of an auditing firm plays a crucial role in a company’s choice of auditor;

High concentration. There are only 4,000 qualified audit professionals in SA and four big firms dominate the sector; and, lastly

The audit profession is subjected to extensive regulation that sets out how an audit should be conducted.

These characteristics suggest that the competitive landscape of the audit profession might prevent, restrict or distort competition.

Where there is a restriction or distortion of competition, adverse effects can occur in the supply of audit services to businesses and the economy in general.

Inevitably, a negative impact on the competitive landscape will subsequently lead to several detrimental effects on customers.

The above said, the fear always remains that should one of the big four firms with international representation fail in SA and exit the market, this could represent a systemic risk to the wider economy.

In addition, it might induce the regulator with auditor oversight to protect the four largest firms — for example, through tailored interventions in their favour.

Such an outcome is the converse of what a competition regulator would wish to achieve, in that interventions of this nature are likely to increase barriers to entry. Furthermore, a risk presents itself that the failure of an audit firm could result in higher concentration, lower investor confidence, market instability and risk to the financial system.

THERE WAS A CALL TO SCRUTINISE THE CLOSE RELATIONSHIPS BETWEEN COMPANY EXECUTIVES AND THEIR AUDITING FIRMS

Adverse effects that could result from a distorted competitive landscape might cause lower levels of audit quality and innovation and higher costs. At the same time, it should be recognised that excessive and burdensome audit quality procedures could also lead to higher costs, which would also negatively affect the consumer and the competitive landscape, as well restrict the expansion of smaller firms.

There could also be a suboptimal level of regulation in the market. Underregulation may facilitate entry by new competitors, but it could in turn result in lowerquality services.

The above is a clear indication that when considering the impact of competition law on the audit profession, a number of issues that affect far more than just the professional body and how an audit is conducted should be considered.

UK accountancy watchdog the Financial Reporting Council recently called for the Competition and Markets Authority to scrutinise the close relationships between company executives and their auditing firms.

While SA’s Independent Regulatory Board for Auditors is looking at the profession as a whole and conducting a number of more targeted investigations, this might be an opportune time for it to cooperate with the competition authorities and in so doing formulate a clear position on the necessity for a competitive, dynamic audit profession and market in SA.