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

Memorandum by the Institute of Chartered Accountants in England and Wales (ADT 6)


  The Institute of Chartered Accountants in England and Wales (ICAEW) welcomes the opportunity to submit evidence in response to this House of Lords Economic Affairs Committee inquiry.

  ICAEW is committed to working with Government and regulators as well as wider market participants in order to help maintain economic confidence. Our 134,000 members work across every sector of the economy leading and advising organisations of all sizes. They include auditors, executive and non-executive directors, investors, regulators and wider market participants. By drawing on their collective expertise we are well placed to comment on the issues raised by the Committee.


  While it will take a number of years before the causes of the financial crisis are fully understood, evidence to date indicates that it was caused by a combination of sub-prime lending and a dramatic fall in property prices in the US. The collapse in confidence across capital markets that followed was fuelled by doubts about the viability of financial institutions holding significant assets that depended directly or indirectly on property lending or wholesale market funding.

  Concerns about the relative strength of the capital base of these institutions led to a meltdown in the liquidity available to them, which cumulatively resulted in a sharp contraction of funds available to the banking system generally and the ability of banks to provide credit to consumers and businesses. As financial institutions have come under pressure from regulators to restore capital ratios to prudent levels this has continued to limit the amount of lending that is taking place, resulting in a significant decline in economic activity.

  The speed at which all this happened was dramatic. A number of well known financial institutions were swept away, amalgamated or nationalised. Governments across the world were forced to underwrite failing industry sectors at a cost of many billions. Orthodoxies that governed economic behaviour over the previous decade were thrown into question. The real economy is only beginning to move from recession to fragile recovery.

  In these circumstances it is right that our financial systems be scrutinised. All market participants need to think hard about the lessons of the past two years and be prepared to take the necessary steps to ensure that the risk of this happening again is mitigated.

  The audit profession, which plays an integral part in the effective operation of capital markets and the wider economy, is no exception.

  The past 24 months have tested auditing reforms adopted in the UK after Enron as well as the work undertaken through avenues such as the Audit Quality Forum. The evidence to date suggests that in the main, auditors have been performing an important role with diligence in the face of challenging economic circumstances and that recent reforms are holding up well.

  Part of the auditors' contribution has been to challenge asset valuations, which has contributed to companies having to revalue their assets, in certain cases requiring a considerable reduction in values in order to give a true and fair view in accordance with the relevant financial reporting framework. These revaluations have contributed to the falling financial performance of banks, reductions in share price and criticism of their directors in general meetings of shareholders as well as the media.

  However, over the past 18 months ICAEW has been examining what lessons can be learnt from the crisis and how audit needs to evolve to meet changing market expectations. Our Financial Services Faculty has led on this work. Key recommendations are included in the report "Audit of banks: lessons from the crisis" which we have appended to this submission. In particular, we believe that improvements can be made in terms of the way risk is reported by banks. We also think there is a need for better dialogue between auditors and bank supervisors. To this end and at the request of the Bank of England we are participating in a Working Group to look at the flow of critical information on banks between the regulator and auditors.

  This House of Lords Committee inquiry is a timely and important contribution to the current debate. It builds on the Committee's June 2009 report into Banking Supervision and Regulation to which ICAEW also submitted evidence.

  Three key points inform our written submission:

    — This has not been an audit driven crisis and UK audit quality remains world leading.

    — The audit profession, along with other market participants, must nonetheless reflect on what lessons can be learned from what has happened over the past two years.

    — This has been a global crisis and reform proposals must therefore be capable of implementation across markets.

  UK audit firms belong to international networks and audit UK businesses that are international in their operations. We urge the Committee to ensure that hasty responses to the current crisis at the national level do not inadvertantly sow the seeds of a future crisis.

  ICAEW has been invited to give oral evidence to the Committee in October when we will be happy to expand on any of the points set out in this submission.


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.  The current concentration of firms providing audit services to the listed company sector has largely been driven by the behaviour and economic choices of these companies as well as the growth strategies of these firms.

  2.  When the audit committee of a listed company looks to appoint an auditor, what drives this choice is the need to ensure that the firm has the necessary breadth and depth of expertise. Those who appoint auditors should not be motivated by the need to ensure diversity in the audit market but the need to ensure auditors do the best job for their shareholders. From the perspective of the individuals who make these appointments there are incentives to gravitate towards an internationally recognised brand with the global reach that this brings.

  3.  While greater choice across the FTSE audit market is clearly something we would welcome what matters ultimately is that audit quality remains high.

  4.  This issue of market concentration has been looked at by the UK Government and the European Commission both of whom commissioned independent research[5] in this area. It was also examined by the Audit Quality Forum, whose work fed into a two year project undertaken by the Market Participants Group (MPG) of the Financial Reporting Council. The MPG identified a range of long-term, market driven steps that could be taken to increase competition and choice which are now being implemented. It is too early to assess the impact of these measures (the Audit Firm Governance Code for example was only introduced earlier this year) and they should be kept under close review. It is also worth noting that the European Commission is likely to revisit the issue in its forthcoming Green Paper on audit.

  5.  Economies of scale certainly create barriers to entry. The Oxera report made the point that "any new entrant would need to overcome perception barriers and demonstrate sector-specific skills, international coverage and high quality staff to win audits". This is not easy given the difference in size between the four largest firms and other major international networks. Other barriers also exist. For example, the European Union's Directive on statutory audit sets certain minimum control requirements for audit firms. These may prevent external capital providers funding a smaller firm as it seeks to become larger.

  6.  It is also important to remember that the current situation has arisen through market demand with the largest firms growing their audit services to meet the global needs of their clients. In many ways this process has been a success story for the UK economy as the UK arms of the dozen or so largest international network firms as well as many of the mid-tier practices have been at the forefront of driving quality, innovation and capability in this industry sector.

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

  7.  No. We are not aware of any evidence to support a claim that audit clients are charged excessive fees. While there are relatively few firms currently serving the listed company sector those that serve the market compete fiercely with each other on price as well as other differentiators. Competitive tendering or the threat of it across this sector ensures the firms are kept on their toes.

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

  8.  No. In our view the competitive structure of the current audit market does not have a significant bearing on auditor objectivity. Of far greater significance is the investment in training and development within the firms and the professional standards and ethical codes to which auditors must adhere, as well as the regulatory and oversight regimes that are currently in place to ensure that quality and objectivity are maintained. The learning and professional development students must undertake in order to qualify into the profession requires them to develop a range of skills in ethics, professional judgement and scepticism intended to ensure the objectivity of their work.

  9.  In January 2010 the FRC and ICAEW published the Audit Firm Governance Code. The Code applies to eight audit firms that together audit about 95% of the companies listed on the Main Market of the London Stock Exchange. For these firms, the Code sets a benchmark for good governance which other audit firms may wish to voluntarily adopt in full or in part and requires explanation for non-compliance. The Code sets out expectations of the role of independent non-executives in the firms' governance structures. It also codifies much existing good practice and references matters that audit firms must comply with as regulated professional partnerships.

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?

  10.  No. Again we would argue that the competitive structure of the current audit market does not have a significant bearing on auditor objectivity. Auditors are subject to significant independence requirements which are designed to protect objectivity and the ability to challenge and disagree with directors' opinions.

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

  11.  Auditors give shareholders confidence that financial information reported by a company is "true and fair". They do this by following a process whose standards are set and enforced by independent regulators. The role of auditors under UK law is explored in detail in the Audit Quality Forum publication Audit Purpose which is available on the ICAEW website at

  12.  An audit does not provide absolute assurance about the state of a company's financial health. The operation of a business involves judgements on a wide range of areas and this brings with it risk. No matter how strong financial reporting, auditing and corporate governance measures may be, they cannot eliminate bad business models or poor judgements by directors.

  13.  In the wake of the financial crisis all market participants need to reflect on what lessons can be learned to help mitigate the risk of these events happening again. To this end ICAEW has recently published a set of recommendations for improving the audit of financial institutions, Audit of Banks: Lessons from the Crisis published in June 2010:

    Bank reporting

    Risk information is often presented in a piecemeal manner in bank annual reports, spread between the audited financial statements and the unaudited front sections. Banks need to focus on clearer presentation which allows users to understand the big picture, which is currently often obscured by the volume of detailed information. Summary risk statements are a potential way of providing this big picture. Auditors should be asked to provide assurance on new summary risk statements to provide confidence to readers of financial statements.

    Audit committees have an important role to play in supporting better reporting. Auditors play a key role in making sure audit committees are equipped with the information they need to perform their role. A guide to good practice in audit committee reporting would help improve performance.

    Auditor reporting

    Insufficient information is provided under the current framework about the work that underpins an audit. This makes it difficult for investors to assess the performance of bank auditors or to understand the key areas of challenge. To address this gap, banks should confirm that key areas of judgement discussed with auditors are set out in the critical accounting estimates and judgements disclosures in the financial statements. Our Financial Services Faculty is setting up a forum for investors and auditors to help make the audit more transparent. Auditors should also have more involvement in reporting on the front sections of annual reports. Their responsibilities for this are currently very limited.

    Dialogue with supervisors

    Regular exchange of information between auditors and bank supervisors enables both parties to perform their duties more efficiently and effectively. Dialogue between auditors and banking supervisors was not consistently good enough before the crisis, with the regulator not placing sufficient value on such dialogue. There have been improvements in both the frequency and quality of dialogue but this remains variable and is dependent upon the attitude of individual supervisors. Further improvements are needed, including improvements to promote greater consistency between supervisors and ensure that discussions are a two-way process for information sharing.

    Support for supervision

    Auditors and other external experts have particular skills that can support banking supervisors in performing their functions. Supervisors have the power to utilise these skills but have done so rarely, typically only where particular problems have been identified. There is scope for making greater use of external experts on a thematic basis, as part of supervisors' overall monitoring regime and as preventative or diagnostic measures.

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?

  14.  Notwithstanding concerns expressed recently by regulators we have seen no hard evidence to support claims that auditors were not exercising a high degree of professional scepticism in the run-up to the financial crisis whether as a result of a lack of competition or any other factor. Successive reports from the independent Audit Inspection Unit (AIU) have indicated that UK audit quality remains high.

  15.  The increased number of going concern qualifications and "emphasis of matter" modifications in audit reports over the past two years[6] suggests that auditors have continued to push back where they felt the need to do so.

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

  16.  Auditors were operating in the same environment as other market participants including regulators and Government and, like these other market participants, did not anticipate the systemic collapse in confidence across the capital markets that was fuelled by doubts about the viability of certain specific financial institutions. As the House of Commons Treasury Committee (TSC) concluded in May 2009 "we have received very little evidence that auditors failed to fulfil their duties"[7].

  17.  The banking crisis did however highlight weaknesses in the level of dialogue between auditors and bank supervisors. Meetings between auditors and the FSA were too infrequent, the range and quality of information shared by bank supervisors with auditors was limited, and the FSA had no obligation to share relevant information with the auditors. In hindsight, better channels of communication may have helped mitigate some of the effects of the crisis.

  18.  The need to improve the level of engagement has been acknowledged by the FSA and this has been improving since the start of the crisis.

  19.  Moving forward, auditors have an important role to play in better supervision of the banking sector. Auditors and other experts have particular skills that can assist banking supervisors in performing their functions.

  20.  As part of the improved dialogue between auditors and supervisors there needs to be a better balance of information shared. Currently there is a duty on auditors to report matters to the FSA which may be material to their supervisory responsibility but no corresponding duty on the FSA to share information with auditors that may be material to the audit. It would also be helpful for auditors to raise concerns with senior management within regulators if they consider the level of engagement from the supervisory team is inadequate.

  21.  To support the regulator in its supervisory work auditors could look at areas of risk in greater detail during the audit. Under section 166 of the Financial Services and Markets Act (FSMA), the FSA can commission a report to be prepared by a "skilled person" (s166 reports). Skilled persons include bank auditors. These reports could be used by the FSA on a thematic basis, or as a diagnostic and monitoring tool where the regulator is seeking to identify risks or problems in the system, or in assessing performance or compliance. The resulting exchange of information could be a powerful tool in the better supervision of banks.

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

  22.  As a guiding principle, bank auditors should be prepared to disclose anything to bank supervisors and vice versa. How this can be achieved in practice is something ICAEW is currently working on with the Bank of England, the FRC, the FSA and the major audit firms.

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

  23.  There are already very strong incentives for auditors to be objective. They report in accordance with independently set standards on the truth and fairness of financial statements, adhere to rigorous independence and ethical requirements and are subject to regulatory oversight. All of these requirements act as a check and balance on the professional judgement that they exercise. In recent years the AIU has also reported annually on the quality of individual firms, providing another important incentive for auditors to be objective.

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

  24.  Yes. Conflicts of interest are one of a number of potential sources of threats to auditor independence which arise as a result of self-interest, self-review, advocacy, familiarity and intimidation. These threats are dealt with through effective disclosure as well as a regime of safeguards, selective prohibitions on consultancy services and, crucially, review by the audit committee, which is central to UK corporate governance.

  25.  There will be always be specific circumstances where the provision of non-audit services is unacceptable and ICAEW believes the current framework should be kept under constant review. However, there is no evidence that the provision by auditors of non-audit services to listed entities that they audit has actually compromised audit quality and we do not believe that the provision of these services diminishes audit quality. Our understanding is that the overwhelming majority of respondents to the current Auditing Practices Board (APB) consultation on non-audit services see the current regime as largely effective and reject outright prohibition of non-audit services as proposed by the TSC in favour of better disclosure provisions.

 (a)   Should more competition be introduced into auditing? If so, how?

  26.  As a general principle we support greater choice in the audit market. We also believe the current industry structure is the result of market dynamics which would limit the effectiveness of any direct market intervention. Market based measures such as those set out by the Market Participants Group of the FRC should prove most effective and durable over time.

 (b)   Should the role of internal auditors be enhanced and how should they interact with external auditors?

  27.  Yes. Internal auditors should have a leading role within an organisation in providing assurance on the management of risk. The remit of internal audit should, in theory, be very wide-ranging across all parts of an organisation. Although its role is set by the board, the audit committee and management, in practice what internal audit can actually achieve is limited by resources and expertise. Their work should be focused on areas of greatest risk within the organisation which often go well beyond financial risks and controls.

  28.  The relationship between internal and external auditors is established by standards for external auditors. It is good practice, even if external auditors decide not to use the work of internal auditors, for there to be good communication between the two functions. Internal audit can be a useful source of information about the risks and controls within the organisation and how management are addressing these issues. However, external auditors do need to remember that internal auditors are responsible to companies and not investors and be mindful of this distinction.

 (c)   Should the role of audit committees be enhanced?

  29.  Yes. Audit committees have a vital role to play in terms of promoting good corporate governance and in challenging management. Their responsibilities have evolved over time and been considered again by the Walker Review on Corporate Governance in Financial Institutions, and also by the recent wider review of corporate governance conducted by the Financial Reporting Council. In particular we would support more information being made available by audit committees about their discussions with auditors, to provide evidence that auditors are performing their duties with due rigour, to ensure wider stakeholders are better informed about the way in which audit committees handle their governance responsibilities and to provide greater clarity around the nature of the judgements the company has made in the accounts.

 (d)   Is the auditing profession well placed to promote improvement in corporate governance?

  30.  Yes. Although it is for companies themselves to determine their governance structures, auditors are an integral part of the corporate governance process and have a duty to report matters of significance and provide challenge to management's critical accounting estimates. This normally happens through the audit committee.

  31.  ICAEW has established a working party that will publish guidance in early 2011 to strengthen the consistency and quality of communication between auditors and bank audit committees. This will improve corporate governance in banks, as it will enable audit committees to better challenge executive directors on accounting judgements and estimates and financial statement presentation.

24 September 2010

5   Oxera Report and London Economics Report. Back

6   Deloitte research. Back

7   Treasury Committee Report: "Reforming corporate governance and pay in the City", 15 May 2009, paragraph 221. Back

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