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


Memorandum by Grant Thornton UK LLP (ADT 20)

  1.1  We welcome the opportunity to respond to the call for evidence.

  1.2  Grant Thornton UK LLP is a leading financial and business adviser operating from 28 offices. Led by 215 partners and employing nearly 4,000 of the profession's brightest minds, we provide personalised assurance, tax and specialist advisory services to over 40,000 individuals, privately-held businesses and public interest entities.

  1.3  Specifically in respect of public interest entities:

    — we audit 271 companies listed in the UK of which 186 are on AIM and 85 on main market;[9]

    — we work with one in six of the FTSE 100 in providing non-audit services;

    — we audit 25 local authorities as a chosen supplier to the Audit Commission including Manchester City Council and three London Borough Councils;

    — we are also a leading assurance provider to the National Audit Office; and

    — we publish the FTSE 350 Corporate Governance Survey.

  1.4  We are a member firm of Grant Thornton International Ltd, one of the world's leading international organisations of independently owned and managed accounting and consulting firms. Clients of member firms can access the knowledge and experience of more than 2,500 partners and 30,000 professional staff in over 100 countries and consistently receive a distinctive, high-quality and personalised service, wherever they choose to do business.

  1.5  Given our capabilities in the public interest sphere, we believe we are well placed to provide the Select Committee with our perspective on market concentration and the role of the auditor.

  1.6  We believe the questions posed by the Committee fall into two broad categories (i) market concentration and (ii) lessons from the financial crisis on the role of the auditor and we summarise our main comments on these two areas below:

2.   MARKET CONCENTRATION

  2.1  We are not aware of any evidence that the presence of four large firms has led to excessive fees being charged or had an adverse effect on audit quality in the markets that we serve. The current audit market structure is not viable in the long term, because the failure of another large firm would leave the market with too few firms and could lead to the exit of other firms. Market confidence would be significantly dented and the resulting market structure could create the further moral hazard that the remaining firms are perceived to be "too big to fail". This would reduce price competition and lessen the pressure to maintain audit quality.

  2.2  If this is accepted as a premise, in view of the international structures within which we and the other large audit firms operate, and absent global regulatory intervention, the only viable solution is forcibly to drive greater competition and choice as a medium term contingency plan. If one of the largest firms failed under the current market structure, an orderly transition would be difficult to effect and it is unlikely that people with requisite skills would choose to move to the next largest firms such as Grant Thornton and BDO, for example, because of differentials in partner remuneration.

  2.3  The soft touch initiatives promoted by the FRC have demonstrably not worked. While there is no "silver bullet", we believe that regulatory intervention could achieve meaningful changes in the structure of the audit market to widen and deepen participation beyond just four firms over, say, a five year period.

  2.4  For this reason, we are calling for the following:

    — a regulatory code of conduct or an unequivocal statement from investors promoting the wider use of firms outside the four largest; in the first instance this might be as auditors of subsidiaries within large, public listed groups;

    — placing tapered limits on the market share of firms measured by the number of appointments held over, say, a five year period, monitored by representatives from regulators and investors;

    — prohibition of contractual restrictions that prevent companies from appointing firms other than the four largest for audit and/or related services.

  2.5  There are helpful lessons which could be learned from the UK public sector audit market, where there is less institutional prejudice, audit quality is high and where there is a widespread view that audited entities receive value for money. In this market, independent appointments bodies monitor audit appointments, audit quality, value for money and tenders.

  2.6  The ultimate aim should be, within the medium term, to create a vibrant, competitive but sustainable market for large listed company audits since healthy competition is a long term driver of both innovation and quality. Both capital markets and audit quality would benefit in the long term were a more level playing field to exist between firms which are part of global networks.

  2.7  There is widespread concern that four dominant firms are too few, and in particular that the market is unduly exposed to systemic risk from the collapse of another large firm. This has led to studies on audit market concentration in a number of jurisdictions, including the UK, the EU and the US. We understand that in Japan following the withdrawal of the auditing licence from one of four largest audit firms, the regulators were forced to step in and oversee the creation of a new audit firm and effect a transfer of audits. This demonstrates that this is a tangible rather than purely an academic risk.

  2.8  Grant Thornton has a successful and well regarded business model and is now widely seen as the leading firm in the privately-held business and small listed company sectors. We are part of Grant Thornton International, a global organisation, which is responding to the market demand for more choice and has encouraged significant investment in its member firms. In terms of audit services, the global breadth and depth of our resources now means that Grant Thornton International member firms have the capability today to audit most large listed companies around the world. What holds us back is a misguided belief that big is better. The pervasive use of the term Big 4 inadvertently perpetuates the belief that there are only four global audit players with the capability to audit large listed companies. Despite the increasing evidence from independent audit inspections, the term Big 4 continues to be used as a short-cut for quality and it is this IBM effect (the perception of there being no recognisable upside to appointing a non-Big 4 firm but considerable perceived downside risk for individuals who make appointments) which remains the biggest barrier to entry for us in this market.

3.   THE ROLE OF THE AUDITOR

  3.1  We are proud of the role that audit plays in underpinning capital markets by providing investors and potential investors with confidence in the reported performance of quoted companies. We do, however, recognise the risk of the perception gap; the difference between what investors may believe an audit delivers compared with what is actually delivered. We would suspect that any perceived shortcomings in auditing in relation to the financial crisis are more likely to have arisen as a result of the current limitations on what constitutes an audit as opposed to failures to perform those tasks that presently are required as part of an audit.

  3.2  The Policy and Regulatory Group ("PRG") which represents the six largest UK firms on public policy issues, and which we chair, has made the following recommendations to the FRC:

    — a publication to be prepared by the ICAEW to raise awareness of what a modern audit entails and how auditors discharge their duties to ensure audited financial statements give a true and fair view;

    — the establishment by the FRC of a working group, including preparers, investors, auditors and BIS, to develop a framework which would enable large listed companies to provide enhanced and more relevant disclosures in areas such as the business model, risks, and management estimates and judgments; in due course these enhanced disclosures might encompass controls reporting and sustainability;

    — the establishment of a further group to develop a framework for the provision of assurance reports on these enhanced disclosures.

  We have also urged the FRC and BIS to consider safe harbour provisions for preparers and auditors who publish enhanced disclosures and assurance statements diligently.

  3.3  As a member of the ICAEW Financial Services Faculty, we support the Faculty's June 2010 Report on an enhanced role for the auditors of banks. Among the key policy proposals it contains are:

    — more frequent bilateral and trilateral meetings between the prudential supervisor and audit firms on both generic pressure points within the sector and bank specific matters;

    — specific, targeted reports to the supervisor by bank auditors, or another audit firm, on regulatory returns, control activities and governance;

    — views on how to establish a coherent framework which would enable banks to provide high quality disclosures on matters such as more detailed explanation of the business model and identification of key risks, a detailed going concern statement, a capital statement and benchmarking. These disclosures would be reported on by an auditor.

  3.4  Should, as has been proposed, a further working group be established to develop a framework for provision of assurance reports on the enhanced disclosures, then this could be designed in such a way to permit the involvement of a firm other than the statutory auditor to opine on these disclosures. We see no reason why the provision of this opinion need be restricted to the largest four firms and could see this as a possible method for delivering the benefits of multiple auditors to stakeholders, companies and audit firms seeking a foothold in the large listed market.

  3.5  On the following pages we provide brief answers to the questions raised by the Committee. In the interests of brevity, we have grouped some questions together and provided one response which addresses all the questions in that group.

  3.6  We commend the Committee for its interest in these vital areas of auditor concentration and the role of the auditor.

24 September 2010

APPENDIX

4.  RESPONSES TO INDIVIDUAL QUESTIONS

Question 1: Why did auditing become so concentrated on four global firms? For example, do economies of scale make it too difficult for smaller firms to compete?

  4.1  At the end of the 1980s, following a period of radical change and significant growth in the profession as well as a series of mergers and acquisitions, the market started to refer, for the first time, to a Big 8. Grant Thornton made a decision to focus on owner-managed businesses, as that segment of the market where we could legitimately claim to be the leader. Following the advent of the Big 8 firms by the late 1980s, subsequent mergers within this group resulted in a Big 6 by 1989 and it was the combination of Price Waterhouse with Coopers and Lybrand in 1998 followed by the demise of Arthur Andersen in 2001 that saw six become four.

4.2  Grant Thornton has the global breadth and depth of resources to audit all but the very largest of the listed companies around the world. We believe that it is a common misconception that there are only four global audit players with the capability to audit large companies. In the large listed market, the biggest barrier to entry we face is not economies of scale but the relative strength of the brand names of the Big 4. This culminates in the IBM effect whereby few audit committees want to risk appointing a firm without such an established strong brand for fear of personal criticism for being out of step with market thinking. The point at which economies of scale would prove a bar to our competing is very high, perhaps the upper reaches of the FTSE 100. If there were genuine opportunities to grow our presence in the large listed market, we would invest further in this market.

  4.3  The significant differentials in partner incomes between the four largest firms and the next largest firms is a likely barrier to the partners from a collapsed firm joining such a firm, instead they would seek to join one of the three remaining largest firms leading to an audit market concentrated on just three large firms. This would create a further moral hazard to the detriment of capital markets since these three firms might be considered de facto to be too big to fail. To date, the soft-touch initiatives promoted by the FRC have demonstrably not worked, hence we are calling for direct intervention forcibly to drive greater competition and choice in the large listed audit market which we are confident would at least maintain audit quality.

  4.4  We submit that in order to protect capital markets from the inevitable chaos that would descend were four to become three, policy makers and regulators should give serious consideration to the case for regulatory intervention. The firm's current medium term strategy is to provide large corporates with advisory services in sectors where we can demonstrate credibility with a view to showcasing the global capabilities of our organisation such that we will in the future be invited as genuine contenders to tender for the provision of audit services.

  4.5  We encourage investors and policy makers to consider other markets where audit quality is high but concentration low, such as the public sector audit market in the UK. Notably this market exhibits the following features; periodic audit tenders, independent bodies which monitor quality and determine appointments and fees, and a broader audit scope to encourage bold assurance and value for money statements.

  4.6  Consultation should be sought as to whether there is support among investors for an independent body monitoring appointments and fees and/or the introduction of tapered, over a five year period say, restrictions on the market share of audit firms in order to reduce concentration in the large, public listed audit market and lessen the impact of any collapse of one of the largest audit firms. This should be supported by initiatives to encourage large, listed companies to explore the benefits of using firms other than the four largest to provide non-audit services and using multiple audit firms to carry out the audit work on groups, for example, using an alternative audit firm to audit components of the group. At the same time, intermediaries such as banks should be prohibited or discouraged from including contractual restrictions that limit audit or related appointments to the four largest firms.

Question 2: Does a lack of competition mean clients are charged excessive fees?

Question 3: Does a narrow field of competition affect audit 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?

Question 9: If need be, how could incentives to provide objective and, in some cases unwelcome, advice to clients be strengthened?

  4.7  We are not aware of any evidence that audit fees are excessive in the markets in which we operate. Audit fees are negligible in comparison with the market capital values of the audited companies. Nor do we consider that greater concentration has reduced audit objectivity or quality. All firms would recognise that reputational risk is so great that, like an airline, we simply cannot afford any crashes. For this reason, whatever the field of competition, no firm can afford to be anything less than fully robust in terms of the objectivity of the advice provided. This desire of audit firms to safeguard their own reputations is augmented by a strong, independent inspection process, the results of which are now published. We consider that these are adequate safeguards of audit quality and strong incentives to provide objective advice to clients even where it may be unwelcome. We and other firms have in place procedures to prohibit the acceptance of audits where we suspect that management are so-called "opinion shopping" or seeking to find alternative advisors who will sign up to a proposed accounting treatment that their current advisors have refused to endorse. We think that the FRC already has the tools it requires to ensure that we and the other large audit firms maintain a healthy degree of scepticism when conducting their work and that this remains the most effective regulatory approach.

Question 5: What is the role of auditors and should it be changed?

  4.8  We do recognise that there is a compelling case for the role of the auditor to be enhanced for some or all listed companies as well as banks. We are actively promoting debate with investors and other stakeholders on this and other topics.

  4.9  The Policy and Regulatory Group ("PRG") which represents the six largest UK firms on public policy issues, and which we chair, has made the following recommendations to the FRC:

    — a publication to be prepared by the ICAEW to raise awareness of what a modern audit entails and how auditors discharge their duties to ensure audited financial statements give a true and fair view;

    — the establishment by the FRC of a working group, including preparers, investors, auditors and BIS, to develop a framework which would enable large listed companies to provide improved and more relevant disclosures in areas such as the business model, risks, and management estimates and judgments; in due course these enhanced disclosures might encompass controls reporting and sustainability;

    — the establishment of a further group to develop a framework for the provision of assurance reports on these enhanced disclosures.

  We have also urged the FRC and BIS to consider safe harbour provisions for preparers and auditors who publish enhanced disclosures and assurance statements diligently.

  4.10  As a member of the ICAEW Financial Services Faculty, we support the Faculty's June 2010 Report on an enhanced role for the auditors of banks. Among the key policy proposals it contains are:

    — more frequent bilateral and trilateral meetings between the prudential supervisor and audit firms on both generic pressure points within the sector and bank specific matters;

    — specific, targeted reports to the supervisor by bank auditors, or another audit firm, on regulatory returns, control activities and governance;

    — views on how to establish a coherent framework which would enable banks to provide high quality disclosures on matters such as more detailed explanation of the business model and identification of key risks, a detailed going concern statement, a capital statement and benchmarking. These disclosures would be reported on by an auditor.

  4.11  These recommendations would further enhance users' understanding of the entity's results and state of health.

  4.12  Should, as has been proposed, a further working group be established to develop a framework for provision of assurance reports on the enhanced disclosures, then this could be designed in such a way to permit the involvement of a firm other than the auditors to opine on this report. We see no reason why the provision of this opinion need be restricted to the largest four firms and could see this as a possible method for delivering the benefits of multiple auditors to stakeholders, companies and audit firms seeking a foothold in the large listed market.

  4.13  At the same time, we would caution that the existing arrangements remain appropriate for the vast majority of our smaller listed companies. Therefore any expansion of the audit scope beyond banks and the large, sophisticated listed companies may need to be weighed carefully to ensure that it is proportionate for those smaller, less complex businesses and does not unduly increase the compliance burden for them without providing any additional assurance to stakeholders.

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?

Question 7: What, if anything, could auditors have done to mitigate the banking crisis? How can auditors contribute to better supervision of the banks?

Question 8: How much information should bank auditors share with the supervisory authorities and vice versa?

  4.14  We believe that there should be free and open, two-way communication between the prudential supervisor and bank auditors. We accept that this will require the audit firms, as well as the supervisor, to educate their people to ensure that this dialogue is both full and frank such that it is a meaningful and productive as possible and we are committed to doing this.

  4.15  We are aware that the FSA and FRC have raised questions around professional scepticism by audit firms and we are participating in that debate. At present we do not believe that firm conclusions have been reached, and we would simply reiterate our belief that healthy competition is a long term driver of innovation and quality. We note that the FSA has reported that even where it disagrees with judgments made by preparers, and accepted by auditors, it has found no cases where it believes the 2007 (pre-financial crisis) financial statements prepared by banks and large financial institutions failed to give a true and fair view. In our responses to the FSA, we have made the point that the FSA should make greater use, than was the case around 2007, of skilled persons ("Section 166") reports on selected governance and other issues at regulated financial services companies and that in many of those cases it would be more appropriate for a firm other than the auditor to carry out those reports. This is one way in which greater competition might be promoted.

  4.16  Grant Thornton was the first firm to call for publication of the results of independent audit inspections. If there is evidence of examples of inadequate professional scepticism we believe the FRC should be robust in dealing with them, including reporting the firm publicly where necessary. If such a case were felt to involve a Grant Thornton audit, we commit to dealing with the matter and any training needs robustly. If there are examples at other firms we do not believe we should be tarred with a broad regulatory brush.

  4.17  We have raised a concern that the FSA, the current prudential supervisor in the UK, operates within certain legal constraints that it believes limit the amount of information it may share with the auditors of a bank or other financial institution. If so, we believe it would be timely for such legal constraints to be re-examined.

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

  4.18  Indisputably conflicts of interest can arise between audit and consultancy roles. In our experience the existing principles already result in the decline of appointments that would result in a genuine conflict of interest. Those that remain are largely a matter of perception, and this view has been echoed by a number of large UK institutional investors we have spoken with. We would not support any further prohibitions on non-audit services provided by auditors since we believe that this would likely result in additional costs to companies for little or no benefit.

  4.19  We do, however, support robust mechanisms to preserve both the appearance and actuality of auditor independence and specifically the IFAC Code of Ethics which is accepted by a large number of countries around the World. In the UK, the Ethics Standards which govern the ability of audit firms to provide non-audit services to their audit clients and the Smith Guidance which governs the way audit committees of listed companies oversee provision of other services by their auditor are monitored by the AIU. We are satisfied that the current guidelines are sufficient for these purposes provided all firms honour the principles of the standards and do not seek to treat them as rules which can be bent to permit undertaking assignments that may in fact be contrary to the principles of the standards. We support the recommendations of The Institute of Chartered Accountants of Scotland that audit committees of listed companies should provide clearer information about their policies to avoid conflicts of interest arising and reasons for involvement of auditors in providing substantial non-audit services.

Question 11: Should more competition be introduced into auditing? If so, how?

  4.20  We believe that it is of paramount importance that more competition and choice be introduced into the large, listed audit market in order to mitigate the catastrophic damage that could be caused by the collapse of four into three large firms. We are calling on policy makers and regulators to consider regulatory intervention. We suggest examination of other markets (such as the public sector market in the UK) where audit quality is high and concentration is low and consideration of the following:

    — a regulatory code of conduct or an unequivocal statement from investors promoting the wider use of firms outside the four largest; in the first instance this might be as auditors of subsidiaries within large, public listed groups;

    — placing tapered limits on the market share of firms measured by the number of appointments held over, say, a five year period, monitored by representatives from regulators and investors;

    — prohibition of contractual restrictions that prevent companies from appointing firms other than the four largest for audit and/or related services.

Question 12: Should the role of internal auditors be enhanced and how should they react with the external auditors?

Question 13: Should the role of audit committees be enhanced?

Question 14: Is the auditing profession well placed to promote improvement in corporate governance?

  4.21  Internal audit is an important aspect of a company's governance and risk management. It is the responsibility of management to put in place a system of internal control appropriate to the size and complexity of the business and internal audit plays an important role by enabling management to monitor both the design and operation of internal controls. We believe it is essential that there is no blurring of the lines between internal and external audit but instead a full and open dialogue between internal and external auditors.

  4.22  We believe that audit committees have a key role in bringing about the enhanced disclosures we have suggested in our covering letter. We are proposing that listed company financial statements should include an audit committee report which provides clear disclosures on the business model, risks and critical management judgments and estimates and that the auditor or another audit firm provides a fairness opinion on that report. A framework for the provision of this additional assurance will need to be agreed so that the responsibilities of management and the auditor are clearly defined and understood by all parties.

  4.23  The auditing profession is well placed to promote improvements in corporate governance. Providing assurance over governance statements and advising on this subject are at the heart of the skill set of large audit firms. It is already a part of the audit of a listed company, since the auditor is required to report on parts of the Governance Code. Many of the large audit firms have substantial specialist teams that deal with governance advice. For example, Grant Thornton has produced the FTSE 350 Corporate Governance Survey which sets out a seven year trend of compliance with the Governance Code by the UK largest listed companies and our specialists were consulted last year by Sir David Walker and the FRC in their respective reports on governance reform.



9   Source: The Hemscott Rankings Guide May 2010. Back


 
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