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
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
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. KEY POINTS
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
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
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 competitionrather
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
3. OUR RESEARCH
THE UK REGULATORY
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.
4. FACTORS AFFECTING
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
Budget pressures imposed by audit firms
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
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
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
6. THE IMPACT
6.1. Factors improving financial reporting
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. RESEARCH INTO
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
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
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,
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
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
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
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
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 offeredour studies do not
address internal audit.
13. Should the role of audit committees be
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
3 October 2010
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REGULATORY CHANGES IN THE UK SINCE 2002
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
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