Auditors: Market concentration and their role - Economic Affairs Committee Contents

Memorandum by Professor Vivien Beattie: Glasgow University, Professor Stella Fearnley: Bournemouth University, and Tony Hines: Portsmouth University (ADT 1)


  1.1  We welcome the opportunity to submit evidence to the Committee on this very important subject.

  1.2  We have ordered our comments into four main areas:

    — Key points from our submission.

    — Summaries of outputs from our research, particularly relating to the role of auditors, audit quality, auditor/client interactions, financial reporting and audit market concentration.

    — Specific responses to the 14 questions posed in the Call for Evidence.

    — A brief summary of regulatory changes in the UK since 2002, which impact on auditing, financial reporting and governance is included as Appendix 1 as this provides background to our comments.


2.1.   Audit Quality

  Audit is a subset of financial reporting and in the UK context is already heavily regulated. Compliance with accounting and auditing standards is being achieved by a strong enforcement regime. Audit committees are viewed as having made a significant contribution to audit and financial reporting quality and the Financial Reporting Review Panel is believed to have to have similarly contributed to financial reporting quality. Achieving high levels of compliance may be viewed as good but our research also indicates that the audit process is becoming a compliance driven tick box regime, rather than one which considers the true and fair view, prudence (no longer part of the accounting model) and the economic substance of the financial statements.

  We suggest that a stronger emphasis needs to be placed on the auditors' overall view of financial statements in the context of substance over form, prudence and true and fair, rather than detailed compliance with the rules. We can see no case for further regulation of auditors under the existing UK regime.

  We suggest that the audit report could be reconsidered so that the auditor comments on the relative reliability of different items on the balance sheet and also whether all the liabilities are properly disclosed.

2.2.   The International Financial Reporting Standards (IFRS) accounting model

  Our research highlights serious concerns about the quality of the IFRS accounting model expressed by expert preparers, including listed company audit partners. We suggest that, in the drive to converge accounting standards with the US and achieve global convergence of accounting standards, policy makers and standard setters lost sight of the underlying quality of the standards being promulgated by the International Accounting Standards Board (IASB). Our research contains many complaints about excessive complexity and counter intuitive outcomes. In the banking context, fair value accounting and changes to a less prudent loan loss provisioning model undoubtedly contributed to the economic crisis. IFRS related matters were considered by expert preparers to have undermined UK financial reporting integrity. Concerns have also been expressed about the ability of non-accountants on audit committees and company boards to understand the IFRS accounting model.

  We do not believe that one set of global accounting standards is either achievable or desirable, as it allows the standard setter too much power and too little accountability. It is likely to be dominated by US interests under the current convergence objectives. We suggest that the UK should lead in recognising that global convergence is not achievable because of different cultures and legal frameworks and encourage other solutions, such as regional standard setting boards for the US, Europe and Asia. In the short term we suggest that the IASB concentrate on remedial action to the existing standards rather than promulgating any more.

  We are disappointed that UK policy makers and the accountancy profession have supported an accounting model that was known to be flawed. It is inconceivable that UK standard setters and regulators could have been unaware of the concerns and the excessive costs associated with the introduction of IFRS in the UK.

  We suggest that IFRS itself should include requirements for substance over form, the true and fair override and prudence.

2.3.  Competition and choice

  We have no evidence of lack of competition—rather there is a limitation of choice. However companies themselves are reluctant to change auditors because of the cost of doing so. There are a number of ways choice could be increased but most of these would require a significant intervention and this would have to be justified to the companies. Market-based solutions would be better if this can be achieved. One interesting finding from our research is that a significant number of AIM companies are audited by non-Big Four firms and this could be built on for the main market which is dominated by the large firms.

  However there remains a perception that audit firm size is a proxy for quality and smaller firms would have to show they can deliver the same quality in order to win the work.


  We carried out a major research study into the above areas in 2007-08. The research was funded by ICAEW Charitable Trusts and followed on from an earlier study carried out in the 1990s before the Enron scandal (Beattie, Fearnley and Brandt, 2001). The earlier study provided the basis for our evidence to the House of Commons Treasury Committee in 2002. The motivation for the 2007-08 research was to explore how the post Enron changes had affected the interactions between preparers and auditors of financial statements and their views on the effectiveness of the changes which had been introduced. The study comprised a survey and nine interview-based company case studies.

  In June 2007 we surveyed finance directors (FDs), audit committee chairs (ACCs) and audit engagement partners (AEPs) from UK listed companies and obtained a total of 498 responses (149 FDs, 130 ACCs and 219 APs) representing an overall authoritative response rate of 37%. This is the first academic research project to survey all three parties simultaneously.

  The survey responses were followed up with nine company case studies where all three parties were interviewed about how they interacted with each other on financial reporting and audit matters, and their views were also sought on the effectiveness of the regulatory framework.


  Respondents to our questionnaire were asked to grade 36 factors affecting audit quality on a scale of 1-7. Factors 1-3 undermined audit quality, 4 was neutral and 5-7 enhanced audit quality (Beattie, Fearnley and Hines, 2010).

4.1  Factors undermining audit quality

  Factors considered to undermine audit quality were not related to the changes to the regulatory regime but to economic and competition issues, all of which had existed before the changes to the regime. These three factors are:

    — Management time and costs in changing auditors.

    — Budget pressures imposed by audit firms on staff.

    — Not Big Four audit firm.

  The response relating to not Big Four audit firm could be skewed as most of the respondents were either Big Four partners or were directors of companies audited by Big Four firms. Nevertheless, this confirms a widespread perception supported by many research studies that audit firm size is a proxy for audit quality.

4.2  Factors enhancing audit quality

  15 factors were considered by respondents to enhance audit quality and of these five related to the enhanced role of the audit committee including the top two factors:

    — Auditor required to communicate with the audit committee on all key issues associated with the audit and with ethical standards.

    — One audit committee member has recent and relevant financial experience.

  Four factors related to reputation damage for the firm/partner and the risk of regulatory action; three factors related to financial interests of the auditor and financial dependence of the audit firms on clients; three factors related to procedures within the firm to ensure quality; and Big Four audit firms were also considered to enhance audit quality. Again, the audit firm size responses may be skewed as most of the respondents were Big Four partners or Big Four clients.

4.3  How to improve audit quality

  We also gave respondents the opportunity to make comments about how audit quality could be improved. From the wide range of comments 117 were critical of the regulatory regime claiming it is driven by rules and box ticking and expressed concerns that this is detrimental to audit quality. This was attributed to the complexity in IFRS, the changed auditing standards and the audit inspection regime. Some believe that true and fair has been undermined. Both auditors and directors believe that the system has become increasingly compliance driven and auditors are now spending time ensuring compliance with standards rather than engaging with the business. Some directors and auditors believe that the current restrictions on non-audit services in Ethical Standard 5 (Auditing Practices Board, 2004) mean that auditors have less understanding of the business as they are less engaged with it.

4.4  The auditor/client relationship

  We also asked respondents if regulatory change had affected the nature of their relationship with their auditors/client. 267 respondents believed there was no change. 198 believed the relationship had changed and had become more formal, largely due to the increased focus on technical compliance and the move away from the business advisor role.


  Respondents reported a high level of financial reporting interactions mainly relating to ongoing problems with the changed accounting regime and other new requirements such as the Business Review although the new accounting regime dominates. The most frequently cited issues discussed and negotiated related to goodwill and fair values on acquisition, and there was little difference between the first and second years of the IFRS changeover (Beattie, Fearnley and Hines, 2008a). Thus the problems are of a continuing nature not just relating to the changeover. The 89 responses which came from directors and auditors in the financial sector showed a higher level of interaction in respect of financial instruments than the others. Not all companies are affected by the financial instrument standards. It is not possible from a survey to identify the precise nature of the interactions from survey responses.


6.1.   Factors improving financial reporting integrity

  We asked respondents for views on the impact of 14 recent and forthcoming changes to the regulation of financial reporting and auditing on the overall integrity of financial reporting using the same ranking as for audit quality. None of the items listed received a mean score of 5 or above but the three highest ranking scores were:

    — Financial Reporting Review Panel pro-actively reviewing published financial statements (4.94).

    — Enhanced role for audit committees in overseeing external auditors (4.80).

    — Introduction of regulation over the auditors of non-EU companies listed in the UK (4.76).

  The bottom two items (ranked between 3 and 4) related to the introduction of IFRS with the lowest rank given to Impact of IFRS on the true and fair view (3.35).

6.2  Narrative comments

  We received many comments from respondents on the above section of the survey. Many were critical of the impact of IFRS and fair value on the integrity of financial reporting (Beattie, Fearnley and Hines, 2008b; 2009a). They were also critical of the length and complexity of IFRS financial statements as well as some underlying principles. Apart from the IFRS factor, the main concerns, which also emerged from the audit quality comments, were the perceived move to a rules-based, prescriptive and compliance-driven framework where too much time was spent box ticking. Some commentators believed true and fair had been undermined by IFRS and others expressed concern about the possible downgrading of the stewardship objective of financial reporting under IFRS. Thus expert preparers did not believe that IFRS had improved UK financial reporting.


  7.1  Together and with others we have researched audit market concentration in the UK listed company sector for over 15 years (eg Abidin, Beattie and Goodacre, 2010; Beattie, Goodacre and Fearnley, 2003; and Beattie and Fearnley, 1994). The most recent study covers the period 1998-2003 and the entire population of domestic companies listed on the main or AIM[1] markets (1386 companies in 2003). In 2003, the Big Four held 68% of this market (based on number of audits) and 96% (based on audit fees). The difference in concentration figures is due to the fact that the Big Four hold more of the large company audits which have higher associated audit fees.

  7.2  PwC was market leader in 18 out of 34 sectors. In 20 sectors, the market leader had a share of over 50% (based on audit fees). In 11 sectors, a mid-tier firm held more that 2% of audit fees; in 2 sectors this was more than 5%.

  7.3  The complex dynamic of changes in audit concentration is analysed to reveal four distinct reasons for change: companies leaving the public market; companies joining the public market; companies changing auditor from/to the Big Four; and (for the audit fee measure of concentration) audit fee changes. The 8% reduction in Big Four concentration over the period based on number of audits from 76% to 68% was mainly due to their relatively low (51%) share of joiners (mainly smaller AIM companies). The 1% increase in Big Four concentration over the period based on audit fees from 95% to 96% was mainly due to their lower share of leavers from the market. Overall, there are more smaller audit firms acting for the smaller companies in the AIM market.

  7.4  Also evidence from our case study work (Beattie, Fearnley and Hines, 2011) indicates that smaller companies can prefer the more personalised attention they get from a smaller firm as they can be a more important client to that firm than if they were with a Big Four firm.

  7.5  It was also suggested that once a company grows above a certain size or has international subsidiaries, the non-Big Four firms do not have such effective global networks.


1.   Why did auditing become so concentrated on four global firms? For example, do economies of scale make it too difficult for smaller firms to compete?

  Business has become more global and such businesses need the scope (and scale) of global audit firms. Firms have also merged over time to become more effective and profitable. There was no regulatory objection to previous mergers but the demise of Andersen was not anticipated. The drive for global accounting standards and the complexity of the standards themselves plays to the strengths of the larger firms and increases the barriers to entry to the global market for smaller firms.

  Our studies into auditor changes in relation to changes in the population of listed companies reveal that, although almost half of new entrants to the market have a non-Big Four auditor, many change to a Big Four at a critical point in their growth, thereby maintaining concentration levels. New entrants to the market generally join the AIM market.

2.   Does a lack of competition mean clients are charged excessive fees?

  Despite high levels of concentration, we have no evidence that the audit market is characterised by a lack of competition leading to excessive fees. The fundamental problem is lack of auditor choice. Recent fee rises can be attributed to the additional work required by IFRS. Fees, although often agreed initially between the FD and AEP, go to the audit committee for approval. There is some evidence from our case studies that ACCs are less concerned about fee levels than FDs as they want to ensure a proper audit is carried out.

3.   Does a narrow field of competition affect objectivity of advice provided?

  We do not believe so. The ethical standards for auditors and the enforcement of ethical standards and ISAs along with audit committee involvement offer a robust framework for preventing this.

4.   Alternatively, does limited competition make it easier for auditors to provide unwelcome advice to clients who have relatively few choices as there is less scope to take their business elsewhere?

  As indicated above, any previous link that existed between these two issues has been broken by the strong enforcement within the regulatory regime.

5.   What is the role of auditors and should it be changed?

  We have already referred to auditing being a subset of financial reporting and therefore the quality of the accounting and auditing standards and the enforcement regime under which auditors are required to work will determine the quality of the final outcome.

  The role of auditors in the UK was, under UK Generally Accepted Accounting Principles (GAAP), to provide independent assurance to shareholders that the accounts prepared by the board of directors comply with law and regulation and give a "true and fair view" of the company's performance over a period and its financial position at the period end. The true and fair view override has effectively gone under IFRS (Nobes, 2009), to be replaced by "give a true and fair view, in accordance with IFRS as adopted by the European Union". The true and fair view has to some extent been restored under the 2006 Companies Act but it is not yet clear whether this will make a significant difference. The principle of "substance over form", part of UK GAAP (ASB, 1994) has gone from IFRS as has the principle of prudence. We argue (Beattie Fearnley & Hines, 2011) that the true and fair view override and the principles of substance over form and prudence should be brought into IFRS itself.

  In the longer term a much wider review of the role of auditors in reporting to shareholders annually is needed given the changes in shareholder mix and behaviour and the interests of other stakeholders. We expressed our concerns about stock lending in our submission to the Treasury Committee (Beattie Fearnley and Hines (2009c)

6.   Were auditors sufficiently sceptical when auditing banks in the run-up to the financial crisis of 2008? If not, was the lack of competition in auditing a contributory factor?

  A debate on auditor scepticism emerged in the UK in 2010 (FSA/FRC, 2010; APB, 2010). The specific issues where greater scepticism is called for in the AIU (2010) annual report are fair values and the impairment of goodwill and other intangibles and future cash flows relevant to the consideration of going concern. The appropriate current level of scepticism is considered to be an enquiring mind. We have no evidence from our research of a lack of scepticism. Even if there was, we would not characterise the problem as a lack of competition (a structural issue), rather the regulatory regime is the problem, ie the move towards a compliance driven tick box model of financial reporting and auditing, and the loss of substance over form, prudence and the undermining of true and fair.

7.   What, if anything, could auditors have done to mitigate the banking crisis? How can auditors contribute to better supervision of banks?

  Increasing regulation because of a financial scandal may help to prevent a repeat of the scandal which caused the increase in regulation. However ex post regulation is often driven by psychological biases such as the need to find a scapegoat (Hirshleifer, 2008), and generally fails to prevent another scandal with different attributes. This has recently manifested itself with the banking crisis following on so soon after the major changes to the regulatory regime post Enron and the search for scapegoats, including auditors.

  Regulatory change is also costly and can have adverse unintended consequences. To repeat what we said in our submission to the UK Inquiry into the Banking Crisis (Beattie, Fearnley and Hines (2009d): "We suggest that, unless there is incontrovertible evidence of auditors failing to comply with law and regulation in their audits of the banks, there is no case for introducing more regulation into the audit process itself".

  Many concerns were expressed by our survey and interview respondents about the quality of IFRS and the IASB's US convergence objectives. We believe that quality in accounting standards has been subordinated by the global ambitions of the standard setters (on which critical decision no public consultation was held). In our submission to the House of Commons Treasury Committee in 2008 (Beattie Fearnley and Hines, 2009c) we articulated our concerns about the accounting model, global convergence, and the governance of the IASB. Since this submission in 2008 our concerns about the feasibility of global convergence have increased rather than diminished and the problems of superimposing a US based accounting model on countries with different underlying legal regimes (5, 2006) are becoming more apparent. The full impact of the accounting deficiencies on the banking crisis are emerging, particularly the impact of mark to market accounting and the restricted loan loss provisions required by the IFRS accounting model.

  Although auditors had no duty under IFRS to report on the lack of economic substance in bank accounts during the bubble, they must have noticed that the accounting model was producing dysfunctional results and that the structure of bank balance sheets was radically changing with the growth of derivative trading. Although the prudential supervision of banks is not the auditors' responsibility, as the true experts in accounting, the accountancy profession would have greatly served the public interest by articulating in public their concerns about the accounting model.

  There has been a disconnect between the views of the expert preparers applying the IFRS accounting model as reflected in our research findings and the UK public policy stance taken by accountancy professional bodies and the Financial Reporting Council, all of whom seem to have given primacy to US convergence and support of the IASB over concerns about the quality of the accounting model.

  Going forward, we suggest that the UK should take the lead in publicly challenging the global convergence plans for accounting and recommend that the IASB abandons this scheme, and issues no more standards until it has cleared up the problems in the existing ones. We also suggest that the UK should lobby for reconsideration of standard setting. The IASB is trying to serve too many masters and subsequently serves none effectively.

  One possibility would be to consider the establishment of regional boards such as US, EU and Asia and which would be more able to meet the needs of those they serve.

  We also suggest consideration be given to changing the audit report to cover individual items on the balance sheet as opposed to a report on the financial statements as a whole. This would expose the degree of reliance a user could place on specific assets and liabilities whether on or off the balance sheet in order to expose problem valuations and off balance sheet liabilities. This would have exposed some of the problems about the reliability of some of the assets in the banks' balance sheets.

  If the audit product becomes a totally tick box compliance based activity then its own value to shareholders, other users and auditors themselves will be diminished. The question of audit purpose has already been raised by the House of Commons Treasury Committee.

8.   How much information should bank auditors share with the supervisory authorities and vice versa?

  Auditors should be required to communicate concerns on any issues concerning the stability of banks and the public interest to an independent regulatory body.

9.   If need be, how could incentives to provide objective and, in some cases unwelcome, advice to clients be strengthened?

  We do not believe that there is such a need. We believe the enforcement regime with regard to auditors is sufficiently strong. It is the accounting model which requires attention.

10.   Do conflicts of interest arise between audit and consultancy roles? If so, how should they be avoided or mitigated?

  Concerns about non-audit service provision by the incumbent auditor have always been largely a perception problem, with no robust evidence that auditor independence is compromised (Beattie and Fearnley, 2002). We do not believe that significant conflicts remain following recent restrictions (Beattie, Fearnley and Hines, 2009b).

11.   Should more competition be introduced into auditing? If so, how?

  Although highly concentrated, the market appears to function in a competitive manner based on analysis using industrial economics. The problem lies in lack of choice. If it is considered to be in the public interest to reduce concentration, this could be achieved by: (a) breaking firms up; (b) restricting the number of main market listed company audits any one firm can undertake; (c) expanding the role of the soon to be defunct Audit Commission or the National Audit Office as a fifth big firm to engage with the private sector; (d) encouraging mergers between the larger non-Big Four firms; (e) insisting on joint audits for listed companies; (f) introducing compulsory audit firm rotation or tendering requiring regular tenders including non Big Four firms.

  However, any major intervention would require legislation or at least regulatory change and a very careful cost benefit analysis. The international impact would be critical as market share varies between countries and the reaction of the auditee companies about enforced change could be very negative. Imposing significantly more cost and disruption on the corporate sector is unlikely to be welcomed given the concerns expressed by our survey respondents about the cost of auditor change.

  The situation remains that audit firm size is viewed as a proxy for audit quality, thus a Big Four firm is a safe appointment for an audit committee to make.

12.   Should the role of internal auditors be enhanced and how should they interact with external auditors?

  No response offered—our studies do not address internal audit.

13.   Should the role of audit committees be enhanced?

  Their role already seems very well developed. We are not sure what form further enhancement would take. We have concerns that the complexity of IFRS may be damaging the effectiveness of the audit committee as only those members with an accounting qualification and recent experience of IFRS are able to engage effectively on accounting issues.

14.   Is the auditing profession well placed to promote improvement in corporate governance?

  Corporate governance is a matter for companies. We have no evidence that the current regime is not working. Going forward, auditors would always be able to contribute to suggestions for improvement.

3 October 2010


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  Because of the importance of the US capital markets to the UK economy, the UK regulatory framework was reviewed after the Enron collapse and the demise of the audit firm Andersen and but other changes not related to Enron were also introduced. The Enron scandal focussed on financial reporting and auditing problems and the changes therefore concentrate in these areas.

  Key changes include:

    — Revisions to the Combined Code for Corporate Governance (Financial Reporting Council (FRC), 2005) [renamed the UK Corporate Governance Code in 2010] which operates on a comply or explain basis. The role of the audit committee's engagement with auditors was more clearly defined to include approval of fees and non-audit services and closer engagement with the audit process.

    — The responsibility for setting auditing and ethical standards for auditors was transferred to the Financial Reporting Council (FRC). Since then the Auditing Practices Board (APB), a subsidiary body of the FRC, has adopted International Standards of Auditing (ISAs) ahead of any EU requirement to do so (but with limited changes to fit with UK law). ISA 260 (Auditing Practices Board, 2004) lays down the level of engagement auditors should have with company audit committees; Ethical Standard 5 (APB, 2004) restricts the non-audit services that auditors can provide the client companies.

    — The Professional Oversight Board (POB) was established under the FRC to oversee the activities of the UK accountancy professional bodies and, via the Audit Inspection Unit (AIU) carry out independent inspections of public interest audits and firms. The AIU issues public reports on its inspections and, recently, individual reports on the major audit firms (those auditing more than 10 entities within the AIU's scope, of which there are currently nine) have been published. In its most recent annual review, the AIU reveals that many audits require "significant improvement" and calls for greater scepticism (AIU, 2010).

    — The Financial Reporting Review Panel (FRRP) changed its way of working to carry out pro-active compliance reviews of company financial statements. The FRRP previously been a predominantly reactive body;

    — An EU Regulation in 2002 required all EU listed companies to prepare their group accounts under IFRS for December 2005 year ends onwards.

1   The Alternative Investment Market (AIM) is the London Stock Exchange market for smaller companies that wish to go public. The admission criteria are less onerous than for the main market. Back

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