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

Memorandum by Independent Audit Limited (ADT 12)

  1.  Thank you for your invitation to give evidence to the Enquiry of the Select Committee on Economic Affairs into the above topic.

  2.  Independent Audit Limited provides clients with independent assurance and advice on matters relating to corporate governance, risk management and compliance assurance, ranging from board and audit committee effectiveness to the effectiveness and value for money of their external audits. We have expertise in financial statement auditing but do not undertake such audits ourselves.

  3.  Concentration of the audit market on the Big Four firms is most apparent in certain sectors, particularly listed companies and financial services organisations. The audit market for private companies, especially smaller ones, is very different, with much more competition, and is not addressed by this paper.

  4.  There has been no systematic evidence of audit failure relating to the recent financial crisis and in our view it is mistaken to seek to blame individual auditors for not having helped to prevent it. It is true that they did not seem to see it coming, but sadly they were not alone in this. Very few people saw the crash coming, and even those who did could not predict its timing. Auditors fell into the same trap as most of the rest of us, including those charged with economic policy and regulation of the financial services industry. And while it is true that audited accounts failed to draw attention to the stresses building up in the financial system, this is a failing not of individual audits but of the system within which audits are performed.

  5.  Criticism of auditors for their role in the financial crisis, or rather their absence of role in preventing it, seems largely to arise from a difference in expectations between those of the critics and those of the profession. Some of the critics seem to look to auditors to protect society from the ravages of capitalism, and their views, although usually expressed with eloquence and vigour, are perhaps better considered in a forum other than the present one.

  6.  A more significant, albeit sometimes less dramatically communicated, body of criticism originates from people who do not wish to change the nature of economic society but whose expectations are that audit will increase their understanding of management effectiveness, financial strength and business model resilience. The audit profession generally fails to meet these expectations and it is not immediately obvious to those outside the profession that this is because the expectations are fundamentally unreasonable. Once again, however, this is not the fault of individual auditors but of the system within which they have to operate.

  7.  The system of audit is characterised by a number of very distinctive features, which are to a large extent interdependent. These include:

  7.1.  "Clean" audit opinions have very low information value. Most of the words in them are standard boilerplate and are devoted to explaining what the auditor has not done and cannot be held responsible for.

  7.2.  The words in a clean audit opinion are usually identical regardless of the degree of risk in the financial statements and the extent of rigour in the audit. They contain nothing to identify a good audit that has licked poor accounts into shape so that they have come to deserve a clean opinion. A qualified audit opinion has higher information value than a clean opinion but is not evidence of a more rigorous audit.

  7.3.  The most significant piece of information in a clean audit opinion is the name of the audit firm. In the absence of any other information about audit quality, readers trust well-known brands.

  7.4.  Many investors show little interest in the technical relevance of the audit, instead acting as if much the most useful thing to them is their ability to sue the audit firm for very large or even unlimited amounts in the event of the company's accounts proving to have been misstated. This, together with a presumption of quality, leads them to favour the big brands.

  7.5.  The same predisposition can be seen in lenders, whose practice, if not their official policies, is often to require borrowers to appoint one of a short list of large audit firms. The evidence for this is largely anecdotal but there seems little reason to doubt that it occurs.

  7.6.  The widespread perception that investors and lenders favour the large audit firms discourages audit committees from appointing smaller firms. For an individual audit committee there is little to be gained by taking the risk of departing from the safe option.

  7.7.  In the same way, the widespread perception that the Financial Services Authority has a preference for large audit firms means that financial services organisations have a marked tendency to play safe. While the FSA has no official policy of favouring the large audit firms, it does little or nothing to dispel the widespread perception to the contrary, nor to encourage greater competition in this sector of the market.

  7.8.  Auditing standards impose a largely similar process on all audits. While the firms make brave marketing efforts to differentiate their audit services, underneath the decorative trimmings each must employ much the same approach as required by the various professional and regulatory bodies who govern their practices.

  7.9.  The economic model of the profession is that a small number of partners profit from work carried out by a much larger number of employees. A high proportion of an audit firm's staff are trainee or recently qualified accountants. They have knowledge of accounting standards and audit process but little experience of business and even less of management. Rules aimed at increasing the public's perception of auditor independence have had the side-effect of restricting auditors' wider experience.

  7.10.  Auditing standards reflect this state of affairs and are translated by the audit firms into methodologies which can be completed by inexperienced staff under the supervision of a smaller number of experienced auditors. The process required by auditing standards is one which places a very high premium on the completion of satisfactory documentation as evidence that an audit has been completed and this is reflected in the firms' and the regulators' approaches to quality assurance.

  7.11.  Documentation tends to become an end in itself (an assertion supported by academic as well as much anecdotal evidence) and is not necessarily well correlated with what constitutes an effective audit.

  7.12.  The purpose of a financial statements audit is defined by law and regulation in very circumscribed terms, being to give an opinion on whether the financial statements give a true and fair view and comply with accounting standards. Much of the public expectation of audit lies beyond this tightly defined and largely historical purpose, and is therefore doomed to disappointment unless auditors choose to go beyond their remit. From the individual auditor's point of view there are few good reasons to so do, and many very good reasons not to. Liability is the most obvious one, but it is also the case that while audit firms are very well equipped to examine compliance they are much less well equipped to form a view on the subjective and sensitive topics that lie outside the financial statements remit. This is especially the case where the opinions have to do with uncertain future events of which a global liquidity crisis is the most extreme recent example.

  7.13.  Financial statements are essentially backward-looking and contain only limited information about other matters for which there is public demand. Information about the risks inherent in a business model, for example, is largely forward-looking, and to the extent that it is to be found in an annual report it will be in the narrative section which is not subject to audit.

  7.14.  Accounting standards have become much more complex and prescriptive. Although enthusiasts and the uninformed pronounce that IFRS is principles-based rather than rules-based, this assertion defies common sense. No statement of principles should be measured in thousands of pages.

  7.15.  IFRS can introduce a high degree of subjectivity into financial statements through accounting procedures that sometimes require a great deal of estimation, so audit judgement is required in relation to detailed calculations. However, the self-referential declaration that a true and fair view is achieved through compliance with these standards serves to reduce professional judgement in relation to the overall picture. Whether the accounts are "right" is reduced to compliance with the rules.

  7.16.  Regulators and lawyers generally attach considerable importance to documentary evidence of compliance with standards. Audit firms seek defence in documentary evidence of completion of audit steps or by reference to accounting standards which relieve them of responsibility for outcomes. Not unreasonably, there is a very strong defensive motivation to avoid taking positions which can be only unreliably defended by reference to subjective notions such as "right and wrong", "true and fair" or "professional judgement".

  7.17.  An increasing proportion of time spent by auditors is spent on checking compliance with the increasingly voluminous accounting standards and documenting the audit process. This contributes to the cost of audit without necessarily providing a great deal of real value.

  7.18.  Knowledge of how these complex standards are elsewhere applied is a commercial asset to audit firms, and one which increases in value with scale. Larger firms have much more valuable knowledge of practice, as well as the capacity to commit more resources to specialist technical roles. Any new entrant to the audit market would need to invest very considerable amounts in acquiring this knowledge and developing technical expertise.

  7.19.  The increasing burden of regulation on audit firms and the commercial benefit of scale in accounting expertise together create a strong rationale for yet further consolidation in the audit sector, while discouraging fragmentation and increased competition. The reason consolidation is rarely seen in practice is that, as private partnerships, audit firms are usually reluctant to give up their independence.

  7.20.  It is sometimes argued that increased competition could be introduced through forced fragmentation—breaking up the large firms. This would be immensely difficult to do within the existing system (for example, how do you break up a large UK firm into pieces that can function effectively without also breaking up its international network, which is not within the UK's power?). And given that all the other pressures within the system are for scale and consolidation, it is not self-evident that forced fragmentation would have a net beneficial outcome.

  7.21.  Audit firms compete very vigorously when audits are put out for tender. However, for what are usually good reasons this happens only rarely. A change of auditors might bring a fresh point of view but it also brings ignorance, and there is some evidence that the temporary disadvantage of the latter outweighs the equally temporary advantage of the former. In years when there is no tender, the fact that there is limited market competition is largely irrelevant since price is set by negotiation, usually using the previous year's fee as a reference point.

  7.22.  When an audit is put out for tender, the audit firms will compete vigorously on price and on quality of service to management, but not in practice on the quality of audit. Because of the role of auditing standards and regulation, their differentiation over the quality of the audit service is restricted to peripheral matters and "froth" which clients usually disregard.

  7.23.  Some aspects of service to management are disguised as contributors to audit quality. The most significant of these is the large, well-integrated international network. This is something that multinational clients appreciate, since it simplifies the management of the audit process and gives access to useful resources that can be deployed when and wherever the need arises, within the constraints of the auditor independence rules. It would in fact be perfectly possible to conduct a quality audit of a multinational company without such resources but this would be contrary to the presumptions of auditing standards, the economic interests of the international networks of audit firms and the convenience of management. Instead, the presumed need to have such a network is allowed to remain a very significant barrier to entry into the large company audit market.

  8.  This is far from an exhaustive list of distinguishing features of audit market, but it is enough to show the nature of the systemic problem with audit. Auditing and accounting standards; the business model of audit firms; the liability regime; the individual interests of investors, lenders, management and audit committees: these and other features all work together to give us an system which favours consolidation and discourages innovation and competition, and whose output is increasingly what might be labelled as "compliance" with a reporting regime which meets the public's expectations to only a partial extent.

  9.  The audit partners and staff who work in this system are, with only rare exceptions, conscientious, diligent and highly skilled professionals who seek to make the system work, and are rewarded for doing so. It is no criticism of them to observe that the system fails to achieve what those outside the system would like it to achieve. In fact, criticising auditors or individual audits undertaken within the present system distracts attention from the real issue, which is the inadequacies of the system.

  10.  Of the separate features of the system summarised above, there is no single one which dictates its overall character, nor is there a clear-cut chain of cause-and-effect. The different features fit together and support each other, and the system functions as a whole. Consequently, it is hard to see how incremental adjustment to individual features will succeed in making significant change to the system. Reform of the liability system and control of restrictions in bank covenants are probably the most immediately helpful things that could be done, but even these are removal of barriers rather than positive inducements to change.

  11.  Moreover, there is a long history of unsuccessful attempts to improve the situation from within. For example, the "expectations gap" between what the public want and what auditors do has been around for as long as auditors can remember. Despite the profession's heroic efforts to educate the public to want less, the gap remains. And attempts to improve regulation by doing more of the same have made things better in some respects and worse in others.

  12.  The regulation of audit and accounting is increasingly international and the features of the audit system described above are broadly similar in all major jurisdictions. This provides a further constraint on the UK's ability to achieve significant change through adjustment of the present system. So while it might be tempting to suggest, for example, that matters could be improved by a transformation of audit regulation, this would be at least a lifetime's work if it had to be done on the international stage.

  13.  When the system of audit is looked at in the round in this way, if leads to the conclusion that if, as a society, we wish to see audit move away from compliance and contribute more to economic stability by increasing public understanding of and confidence in matters such as the quality of management and the sustainability of business models, and if we wish to see a market which encourages rather than discourages new entrants and innovation, we must consider radical options that could be implemented in the UK without needing international agreement. For example, any or all of the following:

  13.1.  Leave the financial statement audit regime largely untouched and consistent with international practice, thus avoiding getting drawn into international dispute. Meanwhile, in recognition of the fact that the expectations gap relates largely to qualitative and forward-looking information, develop the requirements for narrative reporting by UK listed companies and other public interest entities, with a view to reducing, if not closing, the gap. This narrative reporting should be audited, but not by the financial statement auditor. The audit's output should be a long-form report giving a qualitative commentary, rather than a "yes or no" opinion. Liability should be much restricted to encourage effective communication around difficult issues for which there is often no clearly right or wrong answer. Regulation should focus on ensuring that the quality of this review was apparent through the content of the report. This framework would create a new market in which innovation and specialist smaller firms would be able to flourish, so long as the visible quality of their work justified it.

  13.2.  Remove the statutory requirement for companies to have a financial statements audit and instead increase the requirements for boards to explain how they have ensured that they are giving a good statement of account to their shareholders. One of the problems with audit is that the duty of auditors is to report to the shareholders on the board's statement of account but they are in practice appointed and overseen by the board (the principal/agent problem). Without a statutory audit to muddy the waters, shareholders should increase their emphasis on the accountability of directors. In many cases, this could be expected to result in boards choosing to appoint auditors for their own protection. Auditors would thus be appointed by the beneficiaries of their work, who would also be those best placed to monitor its quality. If investors felt strongly enough about it, they could form a shareholders' committee to appoint and manage auditors on behalf of all shareholders (with audit fees to be paid by the company and reported in the same way as dividends, and liability negotiated under contract). This proposal would have the additional benefit of mitigating the consequences if a large audit firm were to withdraw from the market.

  13.3.  Distinguish the audit of consolidated accounts for shareholders from the local audits of statutory accounts of subsidiaries, by prohibiting the group auditor from acting as the auditor of all but the most material subsidiaries. This would have two benefits: it would remove a barrier to entry by taking away the perceived need to have a well-integrated international network, and it would force the auditor to address a multinational company's financial reporting by reference to how well it is managed in the context of the risks arising from its business model, rather than on its compliance with accounting standards around the world

  14.  This is far from a complete review of the wide range of topics covered in your request for evidence, but we hope it is sufficient to make the case that improving our system of audit will not be achieved by tweaking it. It has been tweaked at regular intervals for decades and the outcome is always to make the present system work better on its own terms. If we wish to make it work well on different terms, terms which are better fitted to the present needs of society, then we need to be willing to think outside the present system.

24 September 2010

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