Memorandum by BDO LLP (ADT 19)
We are writing in response to your call for
evidence on "Auditors: market concentration and their role".
We welcome your enquiry. The role of audit is,
and needs to continue to be, key in the operation of capital markets
which enjoy the confidence of investors. However, we believe that
there are substantial issues relating to market concentration,
to the conduct and scope of audit and to the underlying financial
reporting framework which could potentially threaten the stability
of those markets, and which thus require urgent attention. We
believe your enquiry presents a unique opportunity, in this rapidly
changing business environment, to re-examine the role of audit,
its conduct and market structure, and the financial reporting
to which it relates, afresh, with a view to setting a course for
the future which is fit for purpose.
Our conclusions are set out below. Detailed
responses to your individual questions numbered 1 to 14, are set
out as an appendix.
2.1. Market concentration has led to a small
number of firms having a very dominant position in the market.
There is no evidence to support that this dominance affects the
quality of auditing. There is evidence that it tends to increase
2.2. This market dominance is self-reinforcing
in an industry where size is taken as a proxy for quality. There
is a need for further examination of what quality in auditing
2.3. Domestic and international investors
want more choice in the audit market, as do other market participants,
including companies themselves.
2.4. There are steps that government and
other market participants can take to encourage competition, albeit
that firms themselves will have to make substantial investment
to compete in the market for the largest public companies.
2.5. There is a case for consideration of
direct shareholder engagement in the audit appointment and review
process for public companies.
2.6. Many UK companies currently subject
to audit requirements need not be so, saving considerable expense
at little risk, for example by increasing audit exemption limits
and abolishing the requirement for separate audits of subsidiary
2.7. The role of formal financial reporting
(and thus of audit) is diminishing in the public company arena
as annual accounts (the primary focus of the audit) become increasingly
peripheral in shareholder communications.
2.8. Financial reporting itself has become
overly complex, reducing its value to users of accounts, despite
its greatly increased volume. A process of review and deconstruction
is required, based on users' practical needs, both domestically
and internationally so that accounting standards continue to converge
worldwide, but not by default to the most complicated answer available.
2.9. There is a tendency to confuse the
purpose of audit, which is a precise statutory requirement, with
assurance more generally (of which audit is an example). There
is a growing demand for assurance over the identification and
management of risk in, for example, large financial institutions.
This is a legitimate demand, but not one that should be confused
2.10. The reduction in a statutory requirement
for so many companies to be subject to audit, and the demand for
wider assurance relating to, for example, risk or to communications
with shareholders other than annual accounts, will produce a need
for a tiered structure of assurance to be developed to meet users'
needs, appropriate to the size and complexity of businesses.
2.11. We do consider that there is merit
in the suggestion that, for public companies the section of the
accounts which deals with critical judgements be required to make
reference to matters which are the subject of discussion between
the auditors and the Audit Committee.
23 September 2010
Question 1: Why did auditing become so concentrated
on four global firms?
Concentration amongst the largest auditing firms
started in earnest in the mid 1980s and was largely complete by
1990, at which stage there were six firms remaining, which now
constitute the four largest industry participants.
The driving force behind these transactions was the
"merger mania" of the 1980s, which resulted in the largest
companies in the world being smaller in number, but larger in
individual size. Sheer size itself therefore became an important
component in being able to demonstrate that global coverage was
available in depth, in order that the needs of the largest clients
could be satisfied.
At the same time other firms, such as ourselves,
were concentrating on improving their international networks to
enable them to compete, by entering into arrangements with the
larger independent firms in each jurisdiction.
The outcome of this wave of activity was market
concentration in a relatively small number of firms, but there
remained a sufficient number of market participants such that
no particular firm dominated, nor was choice restricted to one
or two service providers in most instances.
In 1997 Price Waterhouse and Coopers & Lybrand
merged. The rationale for this merger was that the two firms feared
being left adrift by the four other largest firms. The competition
authorities, both in the UK and internationally, examined this
transaction, but to the surprise of many, allowed it to proceed.
It remains difficult to see how this merger was in the public
interest, given that it resulted in an immediate 42% market share
The subsequent collapse of Andersen and that
firm's absorption by Deloitte, again cleared by competition authorities
in the UK, led to the current position where the four largest
firms in the market hold an entirely dominant position.
The sheer scale of these firms does give them
an enormous advantage in auditing the largest public companies.
This is a consequence of the scale of resource that they have
and thus of perception of quality. It has also created a kudos
around their success which has become self reinforcingfor
example the mere use of the name "Big 4" is excluding
In reality other firms, such as ourselves, have
ambition and have a dedication to quality which results in substantial
investments in people, in service quality and in building international
networks of real resilience. These should reassure the investor
community of real alternatives to the largest firms.
It is also important to note that the actions
taken by the largest firms in creating such enormous practices
cannot now be replicated by othersthere are simply not
suitable merger candidates around the world to provide the stimulus
to growth by acquisition that the largest firms enjoyed. The finance
needed by individual partnerships to invest in creating similar
sized businesses in each jurisdiction around the globe is prohibitive,
even if the resources were available, and this is a powerful inhibitor
to other firms to challenge the very largest firms in size terms.
The market for audit services is unlikely to grow significantly
and therefore any real change in concentration is unlikely to
be achieved through normal market mechanisms alone.
Question 2: Does a lack of competition mean clients
are charged excessive fees?
There is a lack of comprehensive research on
the effect of the lack of competition in the UK audit market on
audit pricing, but what there is does suggest a direct relationship.
The Oxera Report on "Competition and Choice
in the UK Audit Market" published in April 2006, indicated
that the "Big 4" audit firms charged higher audit fees
on average than other firms, and quoted a differential of 18%.
A research paper,
published after the merger activity had completed, demonstrated
that the fees charged by the less expensive of the two merger
partners increased to be equivalent to that of the more expensive
merger partner over a short period.
Research by the London School of Economics estimated
a reduction of about 7% in audit fees of UK Listed and private
companies were there to be a 10% reduction in the market share
of the four largest firms.
Question 3: Does a narrow field of competition
affect objectivity of advice provided?
Question 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?
We have seen no evidence to suggest that the
objectivity of advice has been affected by the current lack of
competition in the audit market in the UK.
The level of objectivity, or otherwise, in auditing
is difficult to assess, as inevitably its only expression is in
the outcome of individual audits, and is consequently largely
a matter of conjecture.
Question 5: What is the role of auditors and should
it be changed?
The role of auditors has been determined by
statute and, in essence, has remained unchanged over a very long
period, albeit it has been extended through other regulation.
The 2006 Companies Act makes clear that the auditor's primary
function is to report on the company's annual accounts. In so
doing he or she is required to opine on the truth and fairness
of the profit and loss account and balance sheet of the company
or group, and additionally to state whether the directors' report
is consistent with the accounts. There may also be, in certain
circumstances, separate reporting on a corporate governance statement
and there are various other matters on which he or she must report,
such as for example, the existence of adequate accounting records.
The focus of the audit is therefore very much
on the annual accounts.
It is also relevant that the auditor's report
is addressed to the members of the company and specifically not
to any other stakeholders in the business.
We believe this remains appropriate for the
majority of UK companies, but that there are specific requirements
for reform, both to ease the costs and administrative burdens
on companies and also to strengthen responsible reporting and
Audits are for the benefit of the shareholders
of any company. We do believe that there is scope to look again
at the threshold requirement for an audit. Broadly companies turning
over more than £6.5 million per annum require auditing. We
believe that raising this threshold to £10 million will remove
a significant number of companies from what is increasingly an
onerous requirement. This would not preclude third party financiers
being able to ask for form of assurance, as part of the terms
of lending, and thus needn't be seen to erode confidence where
there are indications of significant risk for stakeholders other
than shareholders. Such a form of assurance could be similar in
scale and scope to an audit, but could be more tightly focussed
on the specific needs of the user. We do not contemplate it being
set in scope by statute.
We also believe that the requirement for audited
accounts to be prepared for subsidiaries (where those accounts
are consolidated into the accounts of another company) could be
abolished. A significant part of the audit cost and burden for
medium and larger businesses relates to the requirement to have
them audited to the same degree as stand-alone businesses, irrespective
of the relative importance of the subsidiary to the group of which
it forms part. In relation to this proposal most third party financing
of groups of companies are cross-guaranteed, such that the level
of risk in this proposal should be negligible. Again companies
could contract for special purpose assurance where stakeholders
require it, and, of course, that assurance need not be provided
by the primary group auditor.
By contrast, however, we do believe there is
a significant element of the private sector UK economy where audit
is not fulfilling the purpose for which it was designed. The largest
public companies no longer use annual financial statements as
the main conduit for communicating with their shareholders. Developments
in financial reporting over recent years, and notably the introduction
of International Financial Reporting Standards ("IFRS"),
together with the increasing sophistication in investor relations
by companies and their advisors, have led to an increase in direct
investor briefing and of dialogue between directors and shareholders.
Indeed this has been encouraged by proponents of better corporate
One of the consequences of this development
is that the preparation of annual financial statements, and by
extension their audit, has become a somewhat dry and compliance
driven exercise. Financial statements of larger companies are
now very difficult to understand and even more difficult to interpret.
Their sheer complexity has made them a barrier to communication.
Consequently major communications between companies
and shareholders are not subject to the rigours of an assurance
process and directors are free to, within reasonable bounds, communicate
to the marketplace using figures that may suit their objectives,
and which will not be rooted in Generally Accepted Accounting
Practice ("GAAP"). The use of non-GAAP measures is widespread
and undermines comparability between companies, as well as introducing
uncertainty over their provenance.
It is beyond the scope of this enquiry to examine
the financial reporting framework and the various GAAPs that are
in existence (or planned), but we strongly believe this is an
area that needs to be re-examined, in the hope that annual accounts
will once again become an effective means of shareholder communication.
This is largely a matter of determining what information users
are actually interested in and of providing comparability and
However, in the interim, we do believe that,
for particular public interest entities, including the larger
financial institutions, there is a good case for requiring assurance
to extend to information contained within analyst briefings and
other market communications. This might further extend to an examination
of risk and its management for those financial institutions and,
potentially, for very large and complex businesses.
We believe that there is as yet no proven case
for mandating assurance over the existence and management of risk
outside the largest public companies.
Such a response needs to be scaleable and appropriate.
For example, it would not be applicable to most privately owned
companies and should not be onerous for smaller public companies,
such as to deter entrepreneurial companies from equity markets.
For the very largest, and for regulated businesses, it could involve
reporting to a range of stakeholders. Such an extension of responsibility
would require a re-examination of audit liability, so that risk
became proportionate with reward. We can foresee a tiered approach
to assurance being developed, meeting the needs of different markets,
and building on the work already undertaken in this area (for
example: ICAEW: Alternative to Audit, 2009).
Question 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
We are not auditors to any of the major banks
in the United Kingdom, and will therefore restrict ourselves to
comments which are perhaps of more general application.
This issue of "scepticism" in auditing
has recently been raised by both the Financial Reporting Council
and the Financial Services Authority in their recent paper dealing
with the role of audit and the banking crisis.
Reference is also made to a lack of professional scepticism in
the report of the Audit Inspection Unit ("AIU") of the
Financial Reporting Council ("FRC") issued in July 2010.
It is difficult to gauge the underlying evidence that there is
a lack of such scepticism, but it does seem to rest, in so far
as we understand the AIU report, on the same firm making different
judgements about a similar set of circumstances. The recycling
of this apparent lack of scepticism into the debate on auditing
banks smacks of a rather knee jerk reaction to the auditor's position
in the banking crisis.
The Treasury Select Committee Report
on the banking crisis acknowledged that auditors did do their
job, but that their duties, as currently stipulated, were largely
irrelevant to the crisis. If, for example, an institution is funding
long term assets with short term borrowing and that is being correctly
reported in annual accounts, then users of those accounts should
be capable of determining that was the case. Assuming that there
was no evidence at the time of viability risk in the short term,
it is difficult to see how auditors could have flagged up the
issue that, whilst the accounts were right, what they showed was
that the business was not a very bright one to be in, should short
term credit dry up. These sorts of judgements are the ones that
investors and analysts in particular, should be making on the
basis of the evidence that is made available to them. Similarly,
regulators have that evidence for the protection of depositors.
It may well be that the very complexity of financial reporting
is masking the key messages that accounts should deliver. It is
for users to make investment and other decisions. It is the auditors'
responsibility to make sure the required information is fairly
Question 7: What if anything could auditors have
done to mitigate the banking crisis? How can auditors contribute
to better supervision of banks?
As we have suggested above complex financial
institutions are particularly difficult to understand adequately
from the perspective of annual accounts. They are not easily dissectible
by segmental reporting, as many industrial businesses are, because
of the size and nature of their operations and the variety of
the underlying transactions. In particular this makes it difficult
to determine where risk arises and, unless volunteered, how it
has been addressed. This seems to us to be primarily a financial
reporting issue, rather than an audit issue.
We would commend the suggestion contained in
the paper from the Financial Services Faculty of the Institute
of Chartered Accountants in England and Wales ("ICAEW"),
published in June 2010, that banks confirm that they have dealt
with areas of judgement discussed with their auditors, and that
these are set out in disclosures related to critical accounting
estimates and judgements. Whilst there are always shades and tints
that can be applied by management to disclosures, which are a
matter for discussion and judgement with auditors, the inclusion
or not of these areas is a matter of fact and one on which auditors
can report if they are not satisfied. The judgement must, however,
remain those of the directors and be within their report and accounts
and not form part of the audit report. There would be merit in
considering the extension of this idea to public companies more
Question 8: How much information should bank auditors
share with the supervisory authorities and vice versa?
There has been a decrease in the amount of dialogue
between regulators and auditors of financial institutions over
recent years, which has not been helpful, but has largely been
a function of the regulatory framework. Both the joint paper on
prudential regulation by the FSA and the FRC and the ICAEW publication
referred to above support greater interaction between regulators
and auditors. We support this development.
Question 9: If need be, how could incentives provide
objective and, in some cases unwelcome, advice to clients be strengthened?
The only sanction available to auditors, other
than resignation, is to modify their report through qualification
or inclusion of an emphasis of matter. This is very much the "nuclear
option" and therefore is not proposed lightly. There are
normally a whole range of discussion issues relating to the treatment
and presentation of items in the annual accounts, as far as public
companies are concerned, that are the subject of a difference
of view or nuance between management and the company's auditors.
Inevitably these are dealt with through a process of negotiation
whereby the most important of these are dealt with by the Audit
Committee, should they not be resolved earlier.
As suggested in our response to question seven
above, these could form part of the discussion in the annual accounts
relating to critical accounting estimates and judgements. Whilst
it could be argued that reference in the annual report to matters
discussed by the auditors with the Audit Committee might lead
to a drive by financial management, in particular, to restrict
those matters discussed at the Audit Committee, we believe that
it could be an effective tool and one that auditors would be robust
enough to make good use of and which investors would be reassured
Question 10: Do conflicts of interest arise between
audit and consultancy roles, if so, how should they be avoided
The ethical standards, issued by the Auditing
Practices Board, have provided an environment where auditor independence
is regulated and where fewer non-audit services are being provided
to audit clients than was hitherto the case. This position is
sometimes distorted by the unfortunate way in which annual accounts
disclose fees for non-audit services, which can cause confusion.
There are a number of services which are effectively extensions
of the audit (such as reporting on bank covenants) but which do
not appear to be at all related in the way that they are disclosed.
This is currently being considered by the Auditing Practices Board.
For private companies, and in particular those
where there is no real public interest element, the implication
of restricting further non-audit services would be to increase
the number of suppliers and to put upwards pressure on pricing.
This does not seem welcome in the absence of any evidence of independence
For larger, public interest companies the anecdotal
evidence from chief financial officers is that it is always easier
to ask a firm other than the auditors to carry out additional
work, because of the independence considerations and the consequent
need for an extended dialogue with the Audit Committee. The latter
are there, at least in part, to ensure that independence is in
place and, when the general direction of travel is to increase
the level of governance and the standing of Audit Committees,
it seems unfortunate to take over part of their role through legislation
We suspect that more conflict arises from a
desire to retain the audit appointment, than from the provision
of other services. This highlights the anomalous position that
auditors work for shareholders but are, in effect, judged by management.
For public companies this could suggest some intervention is required
in the auditor appointment and review process. Both mandatory
audit firm rotation and "quota" limits on client numbers
seem to us to be directly anti-competitive. Direct shareholder
representation in the appointment and review process would be
welcome and would seem an appropriate response to both national
and international investor concerns over audit choice.
Question 11: Should more competition be introduced
into auditing? If so how?
More competition in the market for many of the
audit of the largest companies is desirable. The Oxera report
demonstrates concern amongst companies with the lack of auditor
choice, particularly in the largest companies. The US Government
Accountability Office ("GAO") estimated that half of
those companies who felt they had a choice of three or fewer auditors
felt they had insufficient choice.
Domestic and international investors want more choice. Companies
themselves wants more choice, but the potential market opportunity
is inhibited, as we have referred to above, by the practical difficulty
for market entrants in being able to invest sufficiently to enter
the market and hold sensible market share.
This will be particularly exacerbated if one
of the four largest firms were to exit the market for any particular
reason. Such a situation could lead to high risk companies being
unable to find a suitable auditor, independence rules becoming
inoperable and price increasing (which Oxera considered might
be in the region of 14%). Such a scenario would have a disproportionately
higher effect on competition and concentration than previous mergers
or withdrawals from the market. There has been no international
consensus on liability reform, rendering it largely inoperable,
leaving failure of one of the firms as a distinct possibility.
Alternatively, suggestions have been made that audit firms be
effectively treated as being "too big to fail" and thus
get support through some other manner. This seems particularly
unfortunate in the light of the recent banking crisis, and we
believe that a contingency plan should be put in place to cover
the eventuality of the failure of one of the largest firms, which
might include short-term measures to direct a widening of supply,
to avoid a further significant increase in market concentration.
As a global issue, this would need a high degree of consensus
amongst major economies.
The FRC's Market Participants Group ("MPG")
reports produced since Oxera have sought to produce recommendations
for increasing choice in the audit market, reducing the risk of
a firm leaving the market and mitigating uncertainty and disruption
that might arise as a consequence. Whilst there has been a number
of useful initiatives in a number of areas (such as the introduction
of the Audit Firm Governance Code in January 2010 and the publication
by the FRC of the Audit Quality Framework), the impact of all
this on competition and choice has been and will continue to be
negligible without real action. For example, the FRC's Guidance
to Audit Committees, issued in October 2008, included a number
of detailed recommendations. The MPG found that, from 129 reports
subsequently published, only 29 companies addressed information
on frequency of audit tenders, 49 provided information on the
tenure of the current auditor and just seven included reference
to the risks of auditor withdrawal from the market.
This failure to engage suggests to us that some more radical change
The pre-eminence of the four largest firms is
largely based on continually reinforced market views which equate
size with quality. The audit market is one where quality is ill
defined and therefore difficult to benchmark.
This myth is reinforced by the language that
is used by virtually all market participants. The use of the terms
"Big 4" and "Mid-Tier" are in themselves unhelpful.
We would encourage all market participants, including Government
and its related bodies, to use the phrase "major firms"
to cover any that participate in the audit of public interest
entities. That term at least does not preclude "promotion"
and "relegation" in the normal commercial to and fro.
This should lead on to the elimination of overtly anti-competitive
actions, such as the much reported inclusion of "Big 4"
only clauses in banking agreements.
The domination of the "Big 4" firms
of the four largest firms is replicated in the public sector.
We believe Government should encourage wider market participation
and should start doing this "at home".
Without these signals it is difficult to see
how firms other than the four largest will be encouraged to make
the sort of investments, at considerable short-term financial
cost, to ensure that there is a competitive position that is acceptable
going forward. External financing and ownership models are unlikely
to be effective. The payback period on such investment is likely
to be too long term to attract external investors.
Question 12: Should the role of internal auditors
be enhanced and how should they interact with external auditors?
The role of the internal audit is one that can
only be approached on a company by company basis. The different
complexity, control and business environments and sizes of companies
will be determinants of what they require to ensure that they
have the necessary assurance. It would be wrong to mandate a level
of internal audit work from outside any company.
External auditors have been, and are, encouraged
to make use of the work of internal auditors and we do not believe
that any changes are needed to the current guidance in this area.
Question 13: Should the role of Audit Committees
Audit Committees have become an important element
of the way Boards of public interest entities work and, often,
appear to have taken over a higher level of responsibility from
the Board as a whole, than perhaps they should have done. In particular
we do not believe that Audit Committees should also be responsible
for risk (and nor do we necessarily think separate risk committees
are a good idea). Risk is the flip side of the coin of opportunity
and is therefore a facet of every aspect of every business. This
seems to us to be a matter for the whole Board.
For many public companies in the UK, largely
outside the FTSE 350 the real issue is whether the Audit Committee
gets sufficient support from the Board. By and large they will
have one independent non-executive director with appropriate experience,
who will be the chair and who, in practice, has to largely deal
with all matters that are reserved for the Committee. Where there
is other than an excellent relationship between the Chair of the
Audit Committee, the Finance Director and the Chairman, the audit
chair can be a difficult one on which to sit.
Question 14: Is the auditing profession well placed
to promote improvement in corporate governance?
The quality of corporate governance in any company
is more closely related to the culture of that company than it
is to the governance procedures it has in place. However there
are best practices in governance. Auditors, because of their relationships
with a number of companies, are in a good position to advise on
best practice and this would seem a natural thing for them to
do, although it is a service that might best be sourced by other
than one's own auditors, in that at least partially one would
be advising on the governance of one's own relationship, and would
potentially lead to the appearance at least of independence being
1 Oxera, Competition and Choice in the UK Audit Market,
K.P. McMeeking et al, The effect of audit firm mergers
on audit pricing in the UK, 2005. Back
Kittsteiner and Selvaggi, Enterprise LSE, Research Report-Concentration,
Auditor Switching & fees in the UK Audit Market, April 2008. Back
Financial Services Authority & Financial Reporting Council,
Enhancing the auditor's contribution to Prudential Regulation,
House of Commons Treasury Committee, Ninth Report of Sessions
ICAEW, Financial Services Faculty, Audit of Banks: Lessons from
the Crisis, June 2010. Back
GAO, Audits of Public Companies, 2008. Back
FRC, Choice in the UK Audit Market, Fifth Progress Report, June