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

Memorandum by Mr Stephen Kingsley (ADT 13)

This note offers views on some of the issues raised in the Call for Evidence published by the Select Committee.

  1.1  A little background. Four firms currently dominate the auditing business globally and, between them, would appear to have over 250,000 employees dedicated more or less exclusively to audit and assurance, generating approximately $46 billion in fees. These figures are based on data drawn from the firms' websites. Auditing is a thus big and costly business. Unquestionably, stakeholders in the corporate sector, whether investors, lenders, employees, tax authorities or regulators, need to be able to rely on the financial information that they receive. So, when analysts and others look at financial information provided by corporates, they need to believe that what they are looking at is complete, accurate and fairly presented. The notion that an outside expert has examined this information with these criteria in mind ought to give them the comfort which they seek. The question is—does it? Put another way—we all want to see truth and fairness in corporate reporting, but is external auditing an effective way to achieve this objective? Just as importantly, even if external assurance is thought to be a good thing, is a legally-mandated rules-based system operated by what is essentially an oligopoly of four global firms the best way of delivering it?

  2.1  What is the purpose of auditing? Statutory auditing seems to have become formalised in early English company legislation which, by creating joint stock companies, recognised the separation of management and ownership of businesses, and allowed external capital to be provided by people who would have no direct line of sight to the business that they were funding. To compensate for this, the concept of the mandatory statutory audit emerged as way of providing assurance to shareholders as to the truth and fairness of management's account of the way in which their money had been put to use. This concept has been developed over the years so that we now have reports and accounts, accounting principles, and a persistent attempt to create some global consistency in the way companies account and report on their operations so as to mirror the globalisation of the market for corporate capital. The statutory auditor has played a key role in this process and, almost everywhere, is a mandatory element in the corporate reporting process.

  2.2  Indeed, their role and responsibility has been widened as the reach of regulation has itself widened. For instance, financial institutions have detailed regulatory reporting responsibilities which often require the intervention of external auditors. Furthermore, the supervisors often rely on external auditors to perform inspections.

  2.3  There are, or arguably should be, stakeholders in the audit process other than shareholders and regulators. A case could be made for the formal stakeholder group to include lenders, creditors, employees and the tax authorities.

  3.1  Does auditing meet these needs? Does the status quo drive companies and their auditors to do the right things? External auditing involves the transfer of responsibility for the accuracy and completeness of financial information from management to an independent expert. But the transfer is not complete, as a quick scan of a typical audit report will confirm. The extent to which responsibility is transferred and, therefore, the extent of auditor liability for errors and omissions, is a grey area. From time to time, this gets to be tested in the courts. Most often, however, it is settled behind closed doors—which means that the uncertainty persists. There is also uncertainty about who is entitled to rely on information signed off by statutory auditors. The result is confusing—both for the audit firms and for stakeholders.

  3.2  As accounting and reporting rules have proliferated, compliance with these requirements has become both technical and challenging. Managements understandably consult with the auditors on such matters since they are the experts. Equally, it should be understood that this is accounting and not auditing—and there is a big difference. Two problems arise. First, there a clear potential for conflict here since the auditor now "owns" the answer rather than checking it. Secondly, the burden of compliance with these requirements is such that the balance between ensuring compliance and "real" auditing is now likely to be wrong.

  3.3  Where management has put together a comprehensive and accurate set of financial information and where "there is nothing to hide", external auditing is relatively straightforward and is unlikely to add a much value External auditors are really needed when management does have something to hide, and where the truth has either been massaged or masked. Unfortunately, auditors are near-defenceless where management is intent on deceit and is sufficiently competent to cover its tracks. Indeed, the extensive caveats in their contracts and their reports tend to support this.

  3.4  Management may feel that the auditor can and should be blamed when accounting and reporting issues surface. We should remember that it is management's responsibility to prepare financial information—as audit reports make very clear—so management really needs to be fixed with the responsibility of any material errors, particularly if these are deliberate. The very existence of the external auditor helps to blur responsibility for external reporting.

  3.5  Corporate accidents—frauds and insolvencies—often result in assertions that the audit "went wrong", and thus lead to action against the auditors, mainly because they have deep pockets. When this happens, audit firms act as de facto insurance companies and yet, ex ante, do not operate like insurers. If they did, they would likely be much more differentiated about the audits that they did, the scope of their work, and what they charged.

  3.6  The result of all of this is the so-called "expectation gap". This is the difference between what auditors think they do and what outsiders think auditing means—and the debate about it has been going on for at least the last four decades. If anything, the gap has increased over that time.

  4.1  Perhaps the concept of auditing is flawed and should be debated? Some of the preceding arguments might suggest that the concept of auditing is inherently flawed and that the perhaps 150 year-old experiment with statutory auditing should be closely examined. Why has this debate not taken place, despite the unsatisfactory status quo? External auditing provides a valuable "tick in the box" for all kinds of users—analysts, rating agencies, shareholders, bankers, trade creditors and tax authorities to name but a few. Changing what has become a globally accepted regime would require agreement from the key jurisdictions (US, EU, Japan)—and that is unlikely to happen any sooner than the emergence of a contender to challenge the domination of the Big Four. Instead, much of the debate around statutory auditing tries to deal with two different problems—the lack of competition to the Big Four and auditor liability. Whilst it might be interesting to introduce more firms into the global auditing game, I doubt that it would change the dynamics that I have described. In any case, given the enormous barriers to entry, introducing a new competitor would be a real challenge. As for auditor liability, lack of limitation clearly concentrates the mind and does not seem to, of itself, have led to the collapse of any major firm—including Arthur Andersen. At best, it seems to be a peripheral part of the problem.

  4.2  Issues of competition. It is received wisdom that competition is a "good thing". It should ensure that customers get fair prices, high quality goods and services, and benefits from innovation. On the face of it, the market in statutory auditing of large corporates is a four-firm oligopoly. As a result, there is only one company in the FTSE100 which is not audited by the four firm group. Others can comment better than I on whether customers are damaged in consequence. It is clear, however, that it will be really difficult to widen market access. There seem to be a number of simple reasons for this:

    (1) Audits change hands very infrequently.

    (2) Much of the selection process is in the hands of Big 4 alumni who, apart from anything else, are possibly loath to deal with what they see as an unknown quantity.

    (3) An enforced break-up of the Big $ is likely to prove practically very challenging.

    (4) The aspirant firms, of which there are perhaps one or two, have neither the experience, personnel or footprint to deal with many of the complex international companies.

  4.3  It may therefore be more pragmatic to "accept" the oligopoly and to introduce some new thinking into the way it operates.

  What can be done to improve the status quo? Here are three ideas:


  5.1  The culmination of an auditor's work is the audit report. Whilst audits may be a mandatory requirement for listed companies and regulated financial firms in most jurisdictions, the wording of the audit report is something which is largely left up to the profession. This, in my view, has a number of undesirable consequences:

    (a) The length and complexity of wording of the reports has increased.

    (b) The reports contain somewhat arcane phrases like "true and fair" (in the UK) and "presents fairly" (in the US) the precise meaning of which is not clear to most readers and which has all too often had to be tested in the courts.

    (c) It leads to "box ticking".

    (d) The gap between what we all think auditors do and what they think they do is allowed to persist.

  5.2  It is worth focussing on this last point about reporting. The latest manifestation of the problem is in the report by Mr Valukas on the demise of Lehman. One easy step that could be taken to increase usefulness and close the expectations gap starts by recognising that auditing is a public service and that what auditors say about their work is a matter of public interest. It should follow that users, via the relevant authorities, should state what they want auditors to say in their reports. What the reports could say about the accounts might include comments about:

    (1) Accuracy and completeness.

    (2) Compliance with applicable accounting and reporting standards.

    (3) Whether they "make sense".

  5.3  This last point is both new and key. Accounting and reporting standards have been, and will continue to be, arbitraged by exploiting loopholes or inconsistencies. Indeed, the larger the rulebooks, the likelier this is to happen. This is not to say that this happens all the time or that everyone does it, but it does happen. It can lead to accounts being technically compliant but nevertheless not making much sense in terms of reflecting reality. Insisting that auditors say whether or not the accounts make sense would lead to better balance between the application and application of judgement, and should serve to make their work much more useful.

  5.4  As is inevitable with any system founded in statute, and in line with developments in other areas of society, external auditing has become increasingly based on rules rather than principles, reducing the need to apply judgement and experience, to the possible detriment of quality.

  5.5  There is a further point here. Standards governing both accounting and reporting have, particularly over the last few years, become more and more complex. The process of standard setting, whilst not controlled by the large accounting firms, is certainly capable of being influenced by them. The increasing complexity seems to have led to a position where, for many companies, the accounts are becoming incomprehensible to most readers. Perhaps worse yet, some of the more recent developments in accounting standards are controversial and seem to have unintended consequences—fair value accounting comes easily to mind in this context. This suggests a rethink and perhaps a move back towards simplicity.


  5.6  Accounting is, in some senses, the reconciliation between corporate imperative and economic reality. The auditor's role in this process is to ensure that this reconciliation is fair and follows the rules. Managements, quite understandably, sometimes get caught on the wrong side of this reconciliation and seek to take evasive action. Part of the answer may be to make more serious the consequences of being detected. There continues to be a significant blurring of the line between the respective responsibilities of management and auditor. It is normally the case that an auditor stands little or no chance in the face of management intent on deceit. If this position is accepted, then the response needs to be a more rigorous and unambiguous treatment of managements who deceive.


  5.7  There are some fundamental differences between auditing and everything else that the firms do. This is because auditing should not be about advice; it should exclusively be about an objective assessment of someone else's work. Moreover, the real client is not the enterprise being audited or its management; it is the external stakeholder group—shareholders, creditors, regulators and so on. The audit committee is an attempt to enfranchise this group but is unlikely to do so effectively. In a very real sense, auditing is a public service and the organisations that deliver such a service need a culture which corresponds. The rest of what the firms do is, for the most part, not like this, and requires a different culture. Managing these two cultures within the same organisation is, in my view, a serious challenge and one which, if not handled properly, creates the risk of conflicts of interest. This in turn can dilute the healthy scepticism with which auditing should be conducted and the consequent willingness to deliver "bad news". This line of argument might point towards the mandating of "audit only" firms.


  6.1  Stephen Kingsley worked in the financial services practice of Arthur Andersen for thirty years, latterly as head of the firm's global practice. He is currently a senior managing director in the London office of FTI Consulting, a global expert services firm. He is also a non-executive director of the Co-operative Financial Services Group. The views expressed herein are those of the author.

September 2010

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