Memorandum by the Institute of Chartered
Accountants of Scotland (ADT 7)
The Institute of Chartered Accountants of Scotland
welcomes the opportunity to submit evidence to the House of Lords
Economic Affairs Committee inquiry on Auditors: Market Concentration
and their Role.
The Institute is the first incorporated professional
accountancy body in the world. The Institute's Charter requires
it to act primarily in the public interest, and our responses
to consultations are therefore intended to place the general public
interest first. Our Charter also requires us to represent our
members' views and protect their interests, but in the rare cases
where these are at odds with the public interest, it is the public
interest which must be paramount.
This is a global issue and is not restricted
to the UK listed company audit market.
We do not believe that there is a lack
of competition in the listed company audit market but rather that
the level of market concentration is not dissimilar to that found
in certain other sectors. However, we do believe that if the level
of competition was to contract further, for whatever reason, that
there would be a problem. We therefore believe that it is imperative
that a change to the auditor liability regime is made in early
course. Auditors should only be held accountable for their share
of the blame in relation to any successful negligence claim against
them and that is why we favour the introduction of a mandatory
proportionate liability regime.
An ICAS Working Group is currently considering
the role of the auditor and whether this needs to be developed
further. Recent research
has indicated that there is significant demand from the investment
community for at least some degree of external assurance on the
management commentary section of the annual report. The Working
Group's report is expected to be published before the end of the
year and we will send a copy to you as soon as it is finalised.
We do not believe that the level of competition
has any impact on the objectivity of the auditor.
We believe that the role of the audit
committee is already well established within the listed company
sector. It is our belief that it is the composition of the audit
committee and the diligence of its members which is key. We do,
however believe that there is a greater need for transparency
over the work of the audit committee. Current reporting requirements
on the work of the audit committee can often result in "boilerplate"
disclosures which add little to the stakeholder's understanding
of their role and their interaction with the external auditors.
The audit committee plays a critical role in challenging management's
judgements and more disclosure in the audit committee report could
further the transparency of both the external audit process and
the internal assurance processes within a company.
We believe the non-mandatory approach
to internal audit to be appropriate. However, we also firmly believe
that it is beneficial for listed companies to have an effective
internal audit function. In order for the internal audit function
to be effective it must have support at board level and not be
seen as a mere compliance related function.
It should be noted that there are various
different Government, regulatory and professional bodies currently
reviewing the role of the auditor. These include, but are not
limited to the following:
(i) the European Commission which is expected to
publish its Green Paper on Auditing, in October.
(ii) the Financial Services Authority/Financial Reporting
Council in their joint discussion paper 10/3 "Enhancing the
Auditor's Contribution to Prudential Regulation".
(iii) the Auditing Practices Board in its discussion
paper "Auditor Scepticism: Raising the bar".
(iv) the ICAS "Future of Assurance" Working
Group which comprises stakeholders from the investment community,
industry, academia, the media and the profession.
We would therefore encourage the Committee to
also consider the findings of the above consultations/projects
before finalising its recommendations.
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?
Accountancy firms are businesses and like other
businesses, firms have merged for similar reasons to mergers which
have taken place in other sectors. The current market position
arose over a number of years and as a result of various factors
which we outline below. It needs to be highlighted that this is
a global issue and is not unique to the UK listed company audit
A number of major industry sectors have only
4 or fewer major dominant players. This does not necessarily indicate
that a lack of competition exists eg the record industry in the
UK only has four major players, there are four main food retailers
in the UK, and the global private aircraft manufacturing sector
only has two. Whilst we appreciate that in certain niche sectors
entities may be restricted to less than four accountancy firms
from which to choose their auditor, the vast majority of listed
companies have access to greater choice. Additionally, for non
quoted companies there is plenty of choice in the audit market.
The factors which have led to the current level
of concentration in the listed company audit market can be summarised
(i) Growth of multi-national companiesresponding
to customer needs
As companies began to expand their respective
operations beyond their domestic markets, professional accountancy
firms did likewise to enable them to provide the necessary services
to support their clients. This client driven expansion partly
explains the larger accountancy firms' initial international expansion
which was effectively driven by the needs of British and US based
multinationals for worldwide service in the 20th century. The
larger accountancy firms responded:
(a) by forming local partnerships in different
(b) by forming networks with local firms already
in existence in the particular jurisdiction concerned.
Even fairly recently, due to business demand,
auditors needed to establish operations in China, where there
was no established accountancy profession.
Linked to (i) above, is the need for an audit
firm to be able to satisfy itself in relation to the quality of
work undertaken, regardless of which jurisdiction the work is
performed. Where clients had sizeable operations in different
countries it was more difficult for audit firms to ensure the
quality of audit work in such jurisdictions where the audit of
some client affiliates (subsidiaries, associates etc) was undertaken
by firms not connected to the parent company auditor. The need
for the parent company auditor to ensure that firms in different
countries audited to the same standards resulted in the establishment
of networks to allow the sharing of knowledge, agreed methodologies,
training requirements and quality assurance etc. It also made
it easier to control the group audit when all significant affiliates
of the company were audited by a member firm of the network. In
this respect many clients would also rather only have to deal
with one firm auditing all of the group entities.
(iii) Barriers to Entry
Per the figures in Appendix 1, there is a substantial
gap between the revenue of the lowest of the Big Four firms and
the revenue of the next accountancy firm on the list. Therefore,
a fundamental change in the market or in the legal/regulatory
environment would be required to foresee a situation where a firm
not currently in the Big Four was to effectively challenge the
market share of even the lowest ranked Big Four firm. The barriers
to entry are substantial and are briefly summarised below.
Available Resources/ Breadth of Network
In relation to servicing multi-national companies,
not all networks have associate firms or sufficiently resourced
associated firms in all key jurisdictions. Many large corporates
therefore argue that only the Big Four firms provide the global
reach that is required to service their particular operations.
This will obviously depend on the nature and complexity of the
entity's operations and the number of jurisdictions within which
it operates, however, it is also not just the existence of a network
firm in a particular jurisdiction but also the quality of the
individual firms within that particular network which is key.
The auditors of large multi-national companies
are potentially exposed to legal claims the size of which could
threaten the very existence of the firm. In theory, the larger
the size of the firm the greater access it has to resources to
meet any such successful claim.
Depth of Specialism
On certain audits the depth of specialism required
eg for the audit of a major bank, is unlikely to be present in
sufficient volume outside of the Big Four firms.
The costs of having to comply with various different
regulatory regimes across the globe are a significant barrier
to entry for firms seeking to break into the listed company audit
(iv) Growth by Merger/Acquisition
Over the years many smaller firms have disappeared
as firms have merged for a variety of reasons. Up until 1989,
the audit market was dominated by the largest eight accountancy
firms. Following further mergers the market was left with the
Big Five which became four when Arthur Andersen collapsed due
to the reputational damage suffered following the demise of Enron.
(v) Economies of Scale
Undoubtedly, accountancy firms would have viewed
economies of scale as a potential benefit of a merger eg the savings
in costs in relation to developing methodologies, systems, technical
support, administration etc. However, significant costs had to
be incurred to merge the working practices and systems of the
2. Does a lack of competition mean clients
are charged excessive fees?
To the best of our knowledge there is no evidence
to suggest that clients are charged excessive fees. The Transparency
reports produced by the larger accountancy firms show lower levels
of profitability for assurance services than for other services
provided. The vast majority of listed companies are in a position
where they can instruct a number of audit firms and have the ability
to put the audit out to tender on an annual basis, if they so
wish. We do accept that in a few rare situations, conflicts of
interest may restrict the choice to less than four firms due to
the level of specialised knowledge required, particularly in certain
niche sectors. Developments in corporate governance and in particular
the increasingly important role of the audit committee also serve
to prevent firms charging excessive fees. ICAS produced revised
guidance in 2007 entitled: "Appraising Your Auditors".
The Guide provides practical assistance to audit committees in
handling the responsibilities recommended by the FRC Guidance
on Audit Committees. In particular, the Guide helps audit committees
in their critical roles of monitoring the relationship between
company and auditor, overseeing the independence and objectivity
of the auditors and, when appropriate, selecting new auditors.
Additionally, surveys of audit fees in the FTSE
sector are regularly undertaken and the price charged for an audit
is specifically disclosed in the annual financial statements of
a company. Therefore, the fee charged for an audit is transparent
and companies can benchmark the cost of their audit versus that
of their competitors.
We would also like to emphasise that the audit fee
must be adequate to allow a full and proper audit to be undertaken
in accordance with auditing standards.
3. Does a narrow field of competition affect
objectivity of advice provided?
We do not believe that the existing field of
competition impacts on the objectivity of the advice provided
and we are not aware of any evidence to the contrary. Objectivity
is a state of mind expected of a professional and in our view
is not subject to improvement by increased competition.
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 with our response to the previous question
a key ethical requirement is for auditors to be objective. We
do not believe that the level of competition in the marketplace
is a factor in an auditor's ability to challenge his client.
5. What is the role of auditors and should
it be changed?
Role of Auditor
The role of the auditor is set out in sections
495-498 of the Companies Act 2006. This is summarised as follows:
The auditor's primary role is to report to the
company's shareholders on the truth and fairness of the company's
annual statutory financial statements. The auditor also has to
report on the consistency of the information contained in the
directors' report with that contained in the financial statements.
There are other related duties which can be found at the above
sections of the Companies Act 2006. For listed companies, the
auditor also has to report on whether the auditable part of the
directors' remuneration report has been properly prepared and
additionally review certain listing rules requirements.
Role of Auditorrecent developments
Questions have been asked in recent times as
to whether the role of the auditor is too narrowly defined eg
paragraph 221 of the report of the Treasury Select Committee (TSC)
"Banking Crisis: reforming corporate governance and pay in
published in May 2009 stated:
"We have received very little evidence
that auditors failed to fulfill their duties as currently stipulated.
The fact that some banks failed soon after receiving unqualified
audits does not necessarily mean that these audits were deficient.
But the fact that the audit process failed to highlight developing
problems in the banking sector does cause us to question exactly
how useful audit currently is. We are perturbed that the process
results in `tunnel vision', where the big picture that shareholders
want to see is lost in a sea of detail and regulatory disclosures.
Therefore, notably the TSC found little evidence
to suggest that auditors had not properly performed their duties
but questioned whether there was value in the audit. At a prestigious
ICAS event "The Aileen Beattie Memorial Lecture",
held in April 2010, none of the panelists which included a senior
investor representative and a FTSE 100 company executive, believed
that the statutory audit should be abolished and assurance needs
left to the market. They all expressed their support for the statutory
audit and the role it plays although it was recognised that the
auditor could be asked to do more in certain areas.
Recent research undertaken on behalf of ICAS
("Meeting the needs? User views on external assurance and
identified that there is significant demand for at least some
degree of external assurance on the management commentary section
of the annual report. This could therefore present an opportunity
for additional assurance to be provided by the auditor.
It would appear that there still remains an
expectation gap between what certain stakeholders believe that
the auditor is responsible for and what in fact his responsibilities
are. In our view, moves could be made to meet some of these expectations
but there are certain expectations which we do not believe can
be met. To progress this issue, ICAS established a "Future
of Assurance" Working Group earlier this year comprising
representatives from the investment community, academia, the media,
industry, regulators and the profession. The Working Group has
now met twice and it is anticipated that it will publish its proposals
before the end of the year. It is our intention to forward a copy
of the final report to you once it is finalised. Matters that
are being considered include the following:
(i) Could the auditor do more in terms of reporting
on "going concern"?
(ii) Should the auditor provide assurance on
the front end narrative section of the annual report?
(iii) Would a more informative and discursive
audit report be seen as beneficial?
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
There is no specific evidence to answer this
question in the affirmative or the negative. The Financial Services
Authority and Financial Reporting Council have accused the auditing
profession of lacking "professional scepticism" in its
recent discussion paper
and the APB has published a paper
on this topic. However, the FSA/FRC paper does not contain any
specific evidence to substantiate this claim.
The auditor's role as stated above is to report
on the truth and fairness, or otherwise, of the annual accounts.
The auditor has to assess the assumptions and estimates made by
management. This assessment is conducted against the requirements
of the applicable accounting framework, with some accounting standards
requiring a greater degree of judgement than others. Where management's
judgement falls within the parameters of an accounting standard,
it is difficult for the auditor to argue that their judgement
is more appropriate than the judgement of management. Ultimately
management is responsible for the preparation of the financial
statements and they will naturally understand their own business
in greater depth than their auditors. The auditor's role is to
provide assurance that those financial statements are true and
fair against the applicable financial reporting framework.
7. What, if anything, could auditors have
done to mitigate the banking crisis? How can auditors contribute
to better supervision of banks?
First and foremost, the auditing profession
was not responsible for the banking crisis, as has been explained
in various reports which have been published since the crisis
eg the Turner Report.
"At the core of the crisis lay an interplay
between macro-imbalances which had grown rapidly in the last ten
years, and financial market developments and innovations which
have been underway for about 30 years but which accelerated over
the last ten to 15, partly under the stimulus of the macro-imbalances.
Given the role of the auditor as discussed above,
we are not aware of anything that auditors could have done to
mitigate the banking crisis. Going forward, improvements could
be made to the current regime by requiring regular meetings of
all the auditors of large financial institutions with the body
charged with monitoring financial stability.
8. How much information should bank auditors
share with the supervisory authorities and vice versa?
As one of the issues in the years leading up
to the credit crisis appears to have been the lack of meetings
held between the FSA and auditors, it is essential that greater
dialogue between these two parties is encouraged. It is therefore
crucial that plans are introduced for regular meetings to be held
to facilitate the sharing of relevant information where possible.
Note we stress the "sharing of information" as we believe
this has to be a "two-way" process and believe that
increased dialogue can assist both parties in discharging their
duties appropriately. Whist we have support for the concept of
the proposed default position proposed by the FSA/FRC. "Both
parties need to learn that, where there is a concern, the default
should be to share the information unless there are restrictions
that would prohibit this." we have concerns that there would
still possibly be situations where the auditor is not made aware
of something that might have a material impact on the audit. Therefore,
in our opinion the best way to facilitate the appropriate sharing
of information would be to introduce a reciprocal mandatory reporting
obligation on the FSA to that which auditors are currently subject
9. If need be, how could incentives to provide
objective and, in some cases unwelcome, advice to clients be strengthened?
We believe that there is no need to strengthen
the current framework in this respect. Auditors do provide objective
and on occasion unwelcome challenge to clients. Generally, the
unwelcome challenge will be acted on by the board of directors
rather than run the risk of having the audit report on their company's
accounts qualified. Additionally, improvements have already been
made to auditing standards and these will become effective for
accounting periods ending on or after 15 December 2010. Likewise,
revised ethical standards for auditors will become applicable
early in 2011.
10. Do conflicts of interest arise between
audit and consultancy roles? If so, how should they be avoided
Conflicts of interest can arise in certain situations
eg where audit firms provide non-audit services to their audit
clients. The extent of the conflict determines whether or not
the auditor is able to provide the service in question. Some threats
may be capable of being mitigated by the use of appropriate safeguards
by the audit firm eg use of different personnel etc whilst others
cannot be satisfactorily safeguarded and therefore the service
cannot be provided.
Following the aftermath of Enron et al,
the Auditing Practices Board was tasked with producing ethical
standards for auditors which audit firms are required to comply
with. The APB published its standards in late 2004 (revised 2008)
and they are one reason as to why the level of non-audit services
provided by auditors to their listed audit clients has decreased
significantly since 2001. The ratio of non-audit to audit services
peaked in 2001 at a level around 3.1. By 2008, the ratio had fallen
significantly to 0.7.
In May 2009, Treasury Select Committee
"We strongly believe that investor confidence,
and trust in audit would be enhanced by a prohibition on audit
firms conducting non-audit work for the same company, and recommend
that the Financial Reporting Council consult on this proposal
at the earliest opportunity. "
The APB consulted late 2009/early 2010 on whether
audit firms should be prohibited from providing all non-audit
services to their listed audit clients. ICAS specifically set
up a Working Group, comprised of representatives from the investment
community, industry, academia and the profession to respond to
the consultation. The Working Group also sought the views of leading
investors and directors of listed companies and issued its paper
Out of approximately 150 responses to the APB's consultation,
only three were in favour of a complete prohibition being introduced.
Therefore, the overwhelming message was that there should not
be a complete prohibition on audit firms providing non-audit services
to their listed clients. Additionally, the vast majority of respondents
supported the "threats and safeguards" approach adopted
by the APB in its standards. The APB however has taken the opportunity
to make proposals which could further tighten up the types of
the non-audit service that the auditor can provide. This consultation
does not close until 23 October.
11 Should more competition be introduced
into auditing? If so, how?
ICAS supports the work undertaken by the FRC
in raising the matter of limited choice in the audit market for
listed companies, although we appreciate the limited impact that
the proposals of the Market Participants Group have had to date.
It is important that this is kept to the fore and the debates
over the last year have certainly focused more attention on the
issue. The ICAS view remains that the overriding priority in the
short-term is to ensure that all of the big four firms remain
in existence. In this respect we believe that reform of the current
liability regime is urgently required. In 2007, the previous Government
appeared to accept the argument for removing the "unlimited
liability" regime for auditors. However, the optional contractual
system put in place has had no impact on the market. There are
no quick or easy measures, however, that can be put in place to
bring forth another "very large auditor" and, of course,
the issue is made more difficult as it goes beyond the UK.
Other than legislation to introduce a fairer
liability regime as indicated in our response in August 2006 to
the FRC's initial consultation about choice in the UK audit market,
we believe that this issue in general should be left to market
forces. Market based measures are more likely to effect gradual
and sustainable improvements than regulatory changes, which may
have unintended consequences. We do not support regulatory intervention
to artificially increase competition in the audit profession.
As noted above the listed auditing market is not unique, there
are a number of other industry sectors where the market is dominated
by four or in some cases fewer major players. The possibility
also exists that a new large accountancy firm might enter the
market from one of the rapidly developing economies eg China or
We have long argued that developing and implementing
proportionate liability should assist in increasing auditor choice
and that this should not be at the expense of audit quality. Companies
need access to quality audits at a reasonable cost but there is
a high risk attached to auditing multinational companies, which
is due to the auditor being exposed to potentially very high claims
compared to the profits of the auditing unit concerned and this
acts as a deterrent to new entrants to the multinational market.
12. Should the role of internal auditors
be enhanced and how should they interact with external auditors?
It should be realised from the outset that the
roles of internal audit and that of the external auditors are
entirely separate. The role of the external auditor as noted above
is enshrined in legislation whereas there is no statutory requirement
for any size of company to have an internal audit department although
the majority of large listed companies do so. The role of the
internal audit function is determined by those charged with governance
of the organisation. Indeed the UK Code on Corporate Governance
which listed companies are required to apply on a "comply
or explain" basis implies that companies complying with the
Code should have an internal audit committee in the accountability
section of the Code.
C.3.5 The audit committee should monitor
and review the effectiveness of the internal audit activities.
Where there is no internal audit function, the audit committee
should consider annually whether there is a need for an internal
audit function and make a recommendation to the board, and the
reasons for the absence of such a function should be explained
in the relevant section of the annual report.
We believe this non-mandatory approach to internal
audit to be appropriate. However, we also firmly believe that
it is beneficial for listed companies to have an effective internal
audit function. In order for the internal audit function to be
effective it must have support at board level and not be seen
as a mere compliance related function.
Interaction with External Auditor
The matters which the external auditor should
consider in situations where a client has an internal audit function
are set out in International Standard on Auditing (UK and Ireland)
610 "Using the Work of Internal Auditors"
" (a) To determine whether, and to
what extent, to use specific work of the internal auditors; and
(b) If using the specific work of the
internal auditors, to determine whether that work is adequate
for the purposes of the audit. "
In determining whether the work of the internal
auditors is likely to be adequate for purposes of the audit, the
external auditor shall evaluate:
(a) The objectivity of the internal audit
(b) The technical competence of the internal
(c) Whether the work of the internal
auditors is likely to be carried out with due professional care;
(d) Whether there is likely to be effective
communication between the internal auditors and the external auditor.
The standard basically adopts the principle
that it is for the auditor to decide to what extent he wishes
to rely on the work undertaken by the internal audit function
which at least to some degree will be determined by the nature
of the work performed during the period by the internal audit
function and the auditor's assessment of the quality of that work
and independence of internal audit within the organisation. In
our view this position is appropriate. We note that the International
Auditing and Assurance Standards Board is currently revising this
standard but we do not believe that the revision will alter the
fundamental principle that it is for the auditor to decide to
what extent he wishes to rely on the work of internal audit. We
also support the function of internal audit as a mechanism for
providing assurance within a company and as a basis for the directors
to prepare their financial statements with confidence.
13. Should the role of audit committees be
We believe that the role of the audit committee
is already well established within the listed company sector.
It is our belief that it is the composition of the audit committee
and the diligence of its members which is key.
We do, however believe that there is a greater
need for transparency over the work of the Audit Committee. Current
reporting requirements on the work of the Audit Committee can
often result in "boilerplate" disclosures which add
little to the stakeholder's understanding of their role and their
interaction with the external auditors. The Audit Committee plays
a critical role in challenging management's judgements and more
disclosure in the Audit Committee Report could further the transparency
of both the external audit process and the internal assurance
processes within a company.
14. Is the auditing profession well placed
to promote improvement in corporate governance?
Auditors can provide a mechanism for improving
corporate governance. In isolation it is difficult to envisage
how effective an audit firm could be in this respect without support
from the other constituent parts ie the directors and the shareholders.
Auditors are ideally placed to make recommendations to those charged
with governance in relation to weaknesses in the governance framework
in place within an entity but ultimately such recommendations
need to be acted on by the company.
24 September 2010
APPENDIX 1 GLOBAL
REVENUES OF THE 6 LARGEST ACCOUNTANCY FIRMS FOR YEARS ENDING 2009
|PwC (1)||Deloitte Touche
|KPMG (4)||BDO (5)
ICAS (2010), Meeting the needs? User views on external assurance
and management commentary, Back
ICAS (2007), Appraising Your Auditors: A Guide to the Assessment
and Appointment of Auditors, Back
House of Commons Treasury Committee (2009), "Banking Crisis:
reforming corporate governance and pay in the city", Ninth
report of Session 2008/9 HC 519, 15 May, The Stationery Office
ICAS (2010), Aileen Beattie Memorial Event-"Should Statutory
Audit be Dropped and Assurance needs left to the Market", Back
ICAS (2010), "Meeting the needs? User views on external assurance
and management commentary", Back
FSA/FRC (2010) Discussion Paper 10/3: "Enhancing the Auditor's
Contribution to Prudential Regulation", Back
APB (2010, Discussion Paper, "Auditor Scepticism: Raising
the Bar", http://www.frc.org.uk/apb/publications/exposure.cfm Back
FSA (2009), "The Turner Review-A regulatory response to the
global banking crisis", Back
House of Commons Treasury Committee (2009), "Banking Crisis:
reforming corporate governance and pay in the city", Ninth
report of Session 2008/9 HC 519, 15 May, The Stationery Office
ICAS (2010), "The Provision of Non-audit Services by Audit
firms to their listed company clients", Back
APB (2009)), International Standard on Auditing (UK and Ireland)
610 "Using the Work of Internal Auditors", Back