Letter from the Chartered Institute of
Management Accountants (ADT 5)
1. The Chartered Institute of Management
Accountants (CIMA) is pleased to have the opportunity to present
evidence to the Select Committee on Economic Affairs of the House
of Lords in relation to its Call for Evidence on Auditors: Market
concentration and their role. CIMA, founded in 1919, is the world's
leading and largest professional body of Management Accountants,
with 172,000 members and students operating at the heart of business
in 168 countries.
2. Although the CIMA qualification does
not include auditing, our members have an active interest in the
effectiveness of audit as a consumer. CIMA members occupy senior
positions in many of the UK's largest public and private organisations
and have direct involvement in the selection of audit firms and
the work of auditors though various FTSE 350 audit committees
and boards. We have consulted with a number of these senior figures
in the UK and we thank them for their invaluable input. Despite
this, the views expressed in this evidence remain those of CIMA
3. Much has been said and written about
the causes of the financial crisis and we believe that this is
not a time for apportioning blame but rather for learning lessons
that reduce the likelihood of an economic collapse of this magnitude
reoccurring. It is the role of the board of an organisation to
deliver effective, entrepreneurial and prudent management that
can deliver long-term success. External reporting should allow
judgements to be made by third parties on whether this is happening.
It is the role of the audit report to express an opinion on whether
the financial statements present a true and fair view of the organisation's
affairs. Investors and regulators should act in a manner that
encourages organisations to act in their long-term best interests
and in the case of public interest organisations in a manner consistent
with the long-term public good.
4. We believe that there are several factors
driving audit market concentration: complexity of accounting standards,
the requirement for auditors with global reach, the reputational
risk of choosing an auditor outside of the Big Four and the significant
infrastructure investment required by a global audit firm. Despite
the degree of concentration, the audit market remains competitive.
However, any further reduction in the number of market participants
would significantly impair competition.
5. In our opinion, the audit process delivers
what is strictly required of it legally and by regulatorsit
tends to ensure compliance. There are a number of common misconceptions
about audit: it is not designed to detect fraud; it is not designed
or required to reveal that a company is undermining its own business
model and it cannot vouch that every fact and figure in a set
of annual accounts is correct.
6. At the present time the financial audit
is focussed on the financial statements. We believe that this
focus is unduly narrow. The front section of the Annual Report,
the narrative Operating and Financial Review (OFR), provides the
critical, forward-looking contextual information which is essential
to a proper understanding of the financial statements. There are
a number of initiatives underway which are seeking to improve
narrative reporting and we believe it is important that consideration
is also given to some form of audit assurance that covers the
process of generating the OFR.
7. We are very concerned about the increasing
reliance by auditors on the "management representation"
letter. Where there is material uncertainty it is only right and
proper that the auditor asks management to confirm the basis on
which the financial statements have been prepared and for the
auditor to make clear that they are relying on this statement.
There is a risk that management representations are been relied
upon in cases in which audit verification should be possible.
Auditors have a critical role to challenge the board but we do
believe that the management representation letter should also
set out the steps taken by the auditors to verify the statements
on which they have asked for management representation.
8. It is the purpose of good management
information to equip boards to manage in an effective, entrepreneurial
and prudent manner so as to deliver long-term success. We believe
that the role of audit should be extended to specifically cover
whether the information provided to boards is sufficient for the
board to determine the business model and adequately assess associated
9. There were many factors that led to the
financial crisis of 2008. Predominantly, we believe, that the
lightness of regulation and the pursuit of unsustainable business
models by boards were the most significant factors leading to
the crisis. We conclude that there was little more that audit,
as currently designed, could have done to prevent the crisis.
10. The regulation of the large audit firms
is now a global issue that requires international agreement for
effective change. The difficulties that this produces should not
be underestimated. However, the steps outlined above together
with an open dialogue between banks, regulators and auditors should
reduce the severity of future financial crises.
11. We attach responses to the detailed
questions contained within the call for evidence and look forward
to the opportunity to discuss these matters further with the Select
Committee on 19 October.
Q1. 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?
1. There appears to us to be several reasons
why auditing has become so concentrated on four global firms:
Complexity of accounting standards.
2. International financial reporting standards
(IFRS) are recognised as being complex. Proponents of IFRS cite
the growing complexity in basic business transactions but nevertheless
a significant amount of technical expertise is required by the
audit firms to adequately advise their clients. The Big Four firms
not only have more people in their technical departments but these
staff are exposed to similar issues in the dealings with other
multi-nationals. The prevalence of US GAAP and the need for advice
from experts in this field also drive large companies towards
a Big Four auditor.
3. Multi-nationals need access to high-quality
local accounting advice and audit firms outside of the Big Four
may find this difficult to provide across all necessary territories.
Companies often find it easier to negotiate audit fees based on
global coverage rather than adopt a piecemeal approach. Companies
that operate around the world need an external auditor with similar
coverage. It is vital that the auditor has a deep local presence
and is not totally reliant on "head office" transfers
for expertise. The clients who need coverage across the world
are a relatively small in number so cannot support a large number
of international audit firms; perhaps four or five.
4. Reputation, whether perceived or otherwise,
is also an important driver. As the 2006 Oxera report (Competition
and choice in the UK Audit Market) concluded, the Big Four benefit
from the so-called "IBM effect" ie "nobody gets
fired for buying IBM". In addition to the ability to perform
the technical audit and to provide global coverage, the Big Four
are also regarded as being better able to offer value-added services
on top of the audit and to provide insurance against catastrophic
risks and other reputational risks.
5. As a result of the need to offer a global
solution, the infrastructure requirements of a Big Four audit
firm are significant different and more complex than those of
a firm from the next tier. This gulf in the level of investment
is difficult to bridge and represents a major barrier to market
entry for the medium-sized audit firms.
Q2. Does a lack of competition mean clients
are charged excessive fees?
6. The Oxera report did find some evidence
that higher concentration led to higher audit fees, but it also
noted that audit committees tended to focus on quality and reputation
rather than price. It can also be difficult to separate the impact
of concentration rather than cost increases due to other factors
such as additional regulatory requirements.
7. On the other hand the greatest fees for
auditors can come from non-audit services and there is a concern
that some large company audits are done at a very low cost as
opposed to being at an excessive cost as a form of "loss
leader". This causes concern as it is likely to lead to the
audit firms seeking ways to cut costs and as such reduce the level
of assurance that they provide.
8. On the whole we believe that the audit
market remains competitive although any further reductions in
the number of global firms would be harmful to competition and
undesirable. Whilst there are some limits on the alternative audit
firms that an organisation could use, (due to independence, involvement
with competitors), we believe that most companies would have a
choice of capable firms should they decide to conduct a competitive
audit tender process.
Q3. Does a narrow field of competition affect
objectivity of advice provided?
9. From our experience, objectivity of advice
is not impaired by the narrow field of competition for auditors.
The larger audit firms generally have strong risk management and
agreed global interpretations of accounting and reporting requirements
that are not dictated by the wishes of any individual groups.
10. The fact that the audit firms also provide
non-audit services is not, in itself, necessarily a conflict of
interest in our view. The use of auditors for non-audit work should
only take place in limited circumstances and under close scrutiny
of senior management and the Audit Committee where their prior
experience of our business means they are best placed to deliver
the services required.
11. From a commercial point of view, as
the revenue from an organisation being audited becomes more significant
to an audit firm, the greater the potential risk of the objectivity
of advice being affected. Although, we do not have any evidence
that this conflict has affected any audit reports we believe that
it is essential that market regulators continue to monitor and
review this aspect.
Q4. 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?
12. This may well be the case but in our
opinion, for the reasons given in response to Q3, we would conclude
that auditors provide unbiased and professional advice even if
this is not welcome by clients.
Q5. What is the role of auditors and should
it be changed?
13. The efficient allocation of capital is fundamental
to the capitalist economic model. Financial audit is an important
element in this allocation process. But it is only one part and
there is a limit to what should be expected from an audit. The
scope of the auditwhat it does, what it can do and what
it is not meant to doseems to be greatly misunderstood
by the general public, investors and others. An audit is not designed
to detect fraud, although it often does, nor is it designed to
identify poor business models or management teams. Its purpose
is to allow the audit firm to express an opinion on the truth
and fairness of the financial statements published by the audited
organisation. This is not an exact science; it is a process, governed
by auditing guidelines and standards, which provides the audit
firm with the information needed to form a view on the accounts
prepared by the management team and approved by the directors.
14. That is not to say that the audit process
could not be improved. The International Federation of Accountants
(IFAC) have for some time been investigating the elements of the
business reporting system. As well as considering corporate governance,
financial reporting and the usefulness of financial reports, IFAC
also investigated the audit of financial reports. The basis of
the project was a global research study, in which 74 IFAC member
bodies from 59 different countries and jurisdictions, including
all major economies, participated. The results from the study
were published in February 2009 IFAC in an Information Paper entitled
"Developments in the Financial Reporting Supply ChainResults
from a Global Study among IFAC Member Bodies" (available
15. The study built upon previous work by
the IFAC team which had identified a number of recommendations
with regard to the audit of financial reports, these were:
Continue to focus on independence, objectivity
and integrity for auditors
Converge to one set of global, principles-based
Ensure consistent use of auditing standards
and safeguarding of quality within audit firms
Improve auditors' communication, both
with the client and with external stakeholders
Consider limited/proportionate liability
Remove barriers that limit choice of
16. The study found that the extent to which
their earlier recommendations had been addressed varied from country
to country. Of all the recommendations with regard to the audit
of financial reports, most progress was reported on the continued
focus on independence, objectivity, and integrity for auditors,
closely followed by further convergence to one set of global,
principles-based auditing standards and a more consistent use
of auditing standards and quality control within audit firms.
17. Attempts to change the regulation of
audit firms are difficult to implement due to the international
nature of their operations which often means that cross-border
agreement is necessary for any change to be effective.
18. Returning to a UK context, the Financial
Reporting Council (FRC) earlier this year published its fifth
progress report on the implementation of the recommendations of
the Market Participants Group (MPG) and on other UK and international
developments relevant to choice in the audit market.
19. CIMA, in our response to the fifth progress
report, made substantive comment on 15 of the recommendations
made by the MPG, which we regard as the most important.
The FRC should promote wider understanding
of the possible effects on audit choice of changes to audit firm
ownership rules, subject to there being sufficient safeguards
to protect auditor independence and audit quality.
Audit firms should disclose the financial
results of their work on statutory audits and directly related
services on a comparable basis.
Regulatory organisations should encourage
appropriate participation on standard setting bodies and committees
by individuals from different sizes of audit firms.
The auditing profession should establish
mechanisms to improve access by the incoming auditor to information
relevant to the audit held by the outgoing auditor.
The FRC should provide independent guidance
for audit committees and other market participants on considerations
relevant to the use of firms from more than one audit network.
The FRC should amend the section of the
Smith Guidance dealing with communications with shareholders to
include a requirement for the provision of information relevant
to the auditor re-selection process.
Investor groups, corporate representatives
and the FRC should promote good practices for shareholder engagement
on auditor appointment and re-appointments.
Regulators should develop protocols for
a more consistent response to audit firm issues based on their
Every firm that audits public interest
entities should comply with the provisions of the Combined Code
on Corporate Governance with appropriate adaptations or give a
considered explanation if it departs from the Code provisions.
20. Although the FRC should be commended
for the openness of its reporting of progress on implementation
of the recommendations of the MPG, it is disappointing to see
that progress on only one of the recommendations listed above
can be categorised as even "Moderate" whereas four rank
as "Limited" and four as "None". Progress
in this respect is determined by the degree of impact on the associated
risks. Whilst it is clear that the FRC has undertaken a considerable
amount of work and that the benefit of some of its changes has
yet to influence the progress measurement metric, CIMA calls on
all market participants to re-double efforts to act upon all 15
recommendations in as timely a manner as possible.
21. The audit as currently designed focuses
on the financial statements and in particular on the historic
financial position of an organisation at a point in time. Income
or net profit for the period in question is largely determined
by the difference between the opening and closing audited balance
sheets. This is, undoubtedly, an important building block for
an efficient allocation of capital but is only one element of
22. CIMA believes that it is the role of
the Board to deliver effective, entrepreneurial and prudent management
that can deliver long-term success. Internal reporting should
ensure that Boards are provided with the information set needed
to operate in this way. We believe that there may be a role here
for auditors to comment on whether the board is provided with
sufficient information to be able to determine the business model
and assess the associated risks.
23. Audited external reports should allow
judgements to be made by third parties on whether this is happening;
and investors and regulators should act in a manner that encourages
this type of business approach.
24. We firmly believe that the top slice
of information regularly reported to boards should form the basis
for narrative reporting that supplies the necessary contextual
information, including environmental and risk information, needed
to help explain the financial position, performance and prospects
of an organisation through its annual report and accounts.
25. Such narrative reporting is typically
featured in the front section of annual reports. The effectiveness
and completeness of this type of reporting varies considerably
from company to company and, although there is a legal underpinning
of minimum content through the Business Review legislation, we
believe that there is scope to increase the mandatory requirements
in this area. The Department for Business, Innovation and Skills
(BIS) is currently consulting on a mandatory Operating and Financial
Review (OFR). The OFR requirements specify the type of information
that should be provided in the narrative section of an annual
report. At this point in time the Accounting Standards Board has
published voluntary guidance on the OFR and we intend to support
the BIS proposal to make this guidance compulsory and to extend
its provisions in the area of social and environmental disclosures.
26. There is a role here for the audit profession
to provide some form of assurance over the disclosures in an OFR.
We accept that the level of rigour applied to the audit of financial
statements is not applicable to the "audit" of information
in an OFR as it is more subjective and opinion based but nevertheless
the audit profession should be challenged to offer an opinion
on the contents of the OFR. We accept that this might raise substantial
liability issues for auditors which may not be resolvable especially
as liability protection would need to be global in nature. In
which case we would like the audit profession to consider what
assurance could be given over the process within the organisation
used to generate the narrative report and its compliance with
OFR requirements / guidelines.
27. In summary, we believe that the role
of audit is largely undertaken with a high degree of professional
competence by highly trained individuals. A number of recommendations
have already been made that would enhance the audit function and
we have highlighted those areas that we feel should be concentrated
on to ensure that progress to date is turned into effective change.
We believe that there is a need for consideration of a system
of assurance from independent auditors on the OFR which would
require an extension to the scope of the audit, recognising that
this might require some form of liability protection for auditors.
28. We recognise that audit is only one
part of the mechanism for efficient market allocation of capital
and emphasise the integral part that effective narrative reporting,
such as the OFR, should play in this allocation. CIMA has a history
of making positive contributions in this area. Together with PricewaterhouseCoopers
(PwC) and Radley Yeldar, we established the Report Leadership
initiative in 2005, with the aim of challenge thinking on corporate
reporting. Through a number of publications the group presented
simple, practical, yet effective, ways to improve narrative and
financial reporting. Further work is still planned for this group.
In addition, we have recently joined with PwC and the think-tank
Tomorrow's Company to investigate the cultural and behavioural
barriers to the effective development of corporate reporting which,
we anticipate, will provide some interesting results.
Q6. 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
29. Much has been written and said about
the role of the various market participants in the economic collapse.
Overall, we believe the issue was an over-lightness of regulation
rather than a failure of audit. As Mervyn King, governor of the
Bank of England, speaking at the Trades Union Congress on 15 September
said "Before the crisis, steady growth with low inflation
and high employment was in our grasp. We let it slipwe,
that is, in the financial sector and as policy-makers"
30. The overreliance in the financial sector
on regulatory regimes, centred on the minimum capital requirements
under Basel and the risk weightings applied to loan books, particularly
in relation to property lending and especially because they were
often based on short term loan loss experience models which only
captured activity during the unusually prolonged upside of the
Q7. What, if anything, could auditors have
done to mitigate the banking crisis? How can auditors contribute
to better supervision of banks?
31. It is not the auditor's role to question
strategy and to the extent that the banking crisis was caused
by unsustainable business models then there was little more the
auditor could have done. However, we do believe that there is
a risk that the sheer complexity of accounting rules and liability
concerns may have led to a reduction in the level of professional
scepticism applied to the audit of financial statements to be
replaced too often by a tick-box mentality. This view is supported
in the FSA and FRC joint discussion paper "Enhancing the
auditor's contribution to prudential regulation" in which
questioned whether auditors "paid adequate attention to indicators
of management bias" and told auditors to "challenge
Q8. How much information should bank auditors
share with the supervisory authorities and vice versa?
32. The primary responsibility of an auditor
is to the shareholders of the company being audited and satisfying
this responsibility is unlikely to require significant exchange
of information with the supervisory authorities. However, the
audit of certain organisations, which would include banks, might
well be regarded as of general public interest. We support an
open dialogue between banks, their auditors and the Bank of England
which may require auditors to share information relating to financial
stability with the supervisory authority. If auditors' responsibilities
were increased in this way then the issue of legal liability to
shareholders for equity losses arising as a result of disclosure
to supervisory authorities would need to be addressed.
Q9. If need be, how could incentives to provide
objective and, in some cases unwelcome, advice to clients be strengthened?
33. We have no evidence that advice to clients
is not objective even if that advice is likely to be unwelcome.
There possibly needs to be a strengthening of the relationship
between the auditors and the audit committee and Chairman, for
example through regular private sessions with the audit committee
Q10. Do conflicts of interest arise between
audit and consultancy roles? If so, how should they be avoided
34. We have no evidence that such conflicts
do arise. However, to the extent that they might then the systems
in place to maintain the quality of audit, including the work
of the Audit Inspection Unit of the FRC, need to be maintained.
Q11. Should more competition be introduced
into auditing? If so, how?
35. The capitalist market model depends
upon healthy competition and it is difficult not to agree that
more competition would be a good thing. However, it is not easy
to see how this might be achieved.
36. If one believes that company boards
act in the best interests of their company then the fact that
all of the largest UK companies are audited by firms from the
Big Four tells us that they are unwilling to move towards the
next level of audit firms and, as such, are likely to be sceptical
about moving to a new entrant to the market especially if that
entrant came about artificially.
Q12. Should the role of internal auditors
be enhanced and how should they interact with external auditors?
37. Internal and external audit are distinct
but complementary to each other and CIMA believes that both are
extremely important. Good internal audit, which could be outsourced
to an external audit firm, might have helped during the recent
economic crisis because it would have reported on the adequacy
of internal controls and risk issuesbut if a bank was pursuing
an unsustainable business model, it is not clear how much influence
they could have had.
38. There are valuable synergies to be gained
from a strong relationship between internal and external auditors
such as reliance by external auditors on internal audit transaction
Q13. Should the role of audit committees
39. The UK Corporate Governance Code is
comprehensive in terms of the role of the audit committee. It
is notable that the recent review of the code did not result in
enhancements to the audit committee role; but the new code has
a heightened focus on the whole board's responsibility for risk.
40. The audit committee should adequately
discharge its responsibilities in a professional and challenging
manner but this should not reduce the sense of responsibility
of the whole board to the entire published corporate report.
Q14. Is the auditing profession well placed
to promote improvement in corporate governance?
41. The auditing profession is well placed
to provide advice on how governance might be improved. However,
it remains the responsibility of the Board to ensure adequate
corporate governance based upon the FRC's UK Corporate Governance
Code. The FRC and its subsidiary bodies have an important role
to play in monitoring company reports and in our opinion this
process appears fit for purpose.