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

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 price.

  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 actually means.

  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 companies.

  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 with audit.

  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 for PWC.[1]

  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 reinforcing—for example the mere use of the name "Big 4" is excluding in itself.

  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 others—there 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,[2] 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.[3]

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 governance.

  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 governance.

  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 balance.

  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 factor?

  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.[4] 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[5] 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 stated.

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"),[6] 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 generally.

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 by.

Question 10: Do conflicts of interest arise between audit and consultancy roles, if so, how should they be avoided or mitigated?

  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 failure.

  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 or regulation.

  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.[7] 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.[8] This failure to engage suggests to us that some more radical change is required.

  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 be enhanced?

  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 compromised.

1   Oxera, Competition and Choice in the UK Audit Market, 2006. Back

2   K.P. McMeeking et al, The effect of audit firm mergers on audit pricing in the UK, 2005. Back

3   Kittsteiner and Selvaggi, Enterprise LSE, Research Report-Concentration, Auditor Switching & fees in the UK Audit Market, April 2008. Back

4   Financial Services Authority & Financial Reporting Council, Enhancing the auditor's contribution to Prudential Regulation, 2010. Back

5   House of Commons Treasury Committee, Ninth Report of Sessions 2008-09. Back

6   ICAEW, Financial Services Faculty, Audit of Banks: Lessons from the Crisis, June 2010. Back

7   GAO, Audits of Public Companies, 2008. Back

8   FRC, Choice in the UK Audit Market, Fifth Progress Report, June 2010. Back

previous page contents next page

© Parliamentary copyright 2011