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

Examination of Witnesses (Questions 114-151)

Mr David Herbinet, Mr Steve Maslin, Mr Simon Michaels and Mr Russell McBurnie


  Q114The Chairman: Good afternoon and welcome to the Economic Affairs Committee. This is the fourth hearing in our inquiry into Auditors: market concentration and their role. I have just one or two points to make before we start. Copies are available of the Members' entries in the Register of Interests and of declarations of interest relevant to this inquiry and one or two Members may declare something again today. Two Members of the Committee, Lord Currie and Baroness Kingsmill, are not taking part because of conflicts of interest.

  Can I welcome the four gentlemen from the various accountancy firms? Thank you all for coming and thank you very much for your very helpful written evidence. Before we begin with you, can I just make it clear for everyone else in the room that we are stopping at 4.45 pm for a quarter of an hour in private session, but mainly to enable us to set up the video link with Australia? Then we will be resuming at 5 pm with the Institute of Chartered Accountants in Australia, who are getting up at 4 am to attend this hearing.

  I would be grateful if you would speak loud and clear for the webcast and the shorthand writer. When we do have the questions we would be very happy, in order to save time, if one of you kicks off in answer and all the others simply agree. Don't all feel that you have to come in each time, but please do if you want to. Would anyone like to make an opening statement or shall we go straight into the questions? Good, thank you very much.

  My first question is a very general one to set the tone. We have had a lot of concerns and one of the reasons for setting up the inquiry was the domination of the Big Four, in terms of auditing. I'd like to ask you what you feel are the dangers in having the Big Four in such a dominant position in relation to present lack of competition. I refer to the comparatively rare testing of auditors, which has come through in some of your evidence; to the number of tendering occasions and the number of changes that are made, which are very few; and so on. Who would like to kick off with an analysis of why you feel this is a worrying situation?

  Mr Michaels: I'd be happy to kick off, if I may. The position we have at the moment is a market that is heavily dominated by four large firms. Those firms are very internationally focused and also domestically focused but they have a significantly high share of the market, particularly the top end of the market; the FTSE 350 is an example. Because the market is so concentrated I feel that, in the event that one of the Big Four were to exit the market, there is a risk of systemic failure with the profession being unable to provide the market with the services that need to be provided.

  So I get to the position that something needs to change and the market has tried to come up with market-led solutions for some time as a result of significant work that has been done over the last few years—that has particularly been led by the FRC and a group they formed the Market Participants Group. But that has not led to the market driving real change and, therefore, without intervention it's unlikely that that change is going to come about in at least the medium term and potentially the longer term as well.

  Q115  The Chairman: Does anyone else want to add to that?

  Mr Maslin: We share that view and would say that in order to effect change in the marketplace we do think that would take a little bit of time and, therefore, in our written submissions we've said we think the start place for changing the market structure would be the FTSE 250. If changes were brought about there over, let's say, the next three years that would provide a more solid platform for more firms to be able to challenge credibly in the FTSE 100 market.

  Mr McBurnie: I would agree with the comments and merely add that, in terms of the negative impact on what I would see in terms of auditor stagnation—lack of movement in that area in terms of the Big Four—is that what you get is a lack of added-value service from bodies who feel they don't need to go the extra mile to prove that they should have the audit again. One of the dangers of stagnation is a lack of a fresh pair of eyes over a set of numbers or over a business that is always useful in driving business forward and helping with the controlled environment in general.

  The Chairman: I think that is one of the reasons for our inquiry and you mentioned FRC. Clearly some of the solutions haven't really worked. So we'll be interested, in this session, to hear what solutions you have. Lord Tugendhat?

  Q116  Lord Tugendhat: Can I ask a supplementary to that? Do you regard the audit as a transaction between the auditor and the company that is being audited much like any other service that a company receives or would you regard an audit as a public good from which all citizens gain or lose?

  Mr Maslin: Shall I make a start on that? I think audit is a unique service and it's really incumbent on auditors to remember that their primary client is the investors as a whole. Therefore, while much of the interaction is with a company's management team and with its audit committee, the ultimate beneficiary of the assurance that derives from audit is the owners of that company—so the shareholders of that company—so we must always bear in mind that they are our primary client.

  Q117  Lord Tugendhat: Could I press you a bit further? I agree that the owners obviously have an interest, but surely not only the owners. The fact that a company's accounts are audited—obviously what I am saying applies with more force to bigger companies—is a matter of significance to the owners but it's also a matter of significance to the investment community as a whole and to the regulators in those industries that are regulated. Indeed, could one not argue that the investment community as a whole and the regulators rely on the audit to as great an extent as the owners of the company?

  Mr Maslin: I think it is a very fair comment, Lord Tugendhat, that there are other stakeholders that do place reliance on the audit and I think of particular relevance here is in the context of groups like the bank supervisor. One of the issues that our firm has spent a lot of time on since the financial crisis is working with the Bank of England to try and learn lessons from the financial crisis. Our view at the moment is that the biggest contribution the audit profession could make, coming out of the crisis, is to improve the way that we talk to the banking supervisor and that is why we have been spending time with the Bank of England.

  Lord Tugendhat: Thank you.

  Q118  The Chairman: This is a question we were going to ask you, so let's deal with it now. Would you like to say a bit more about that and where you are at and what you think the bank involvement should be?

  Mr Maslin: One of the things we have been trying to do with the Bank of England at the moment—I think it's been a very constructive discussion so far—is to think about the various ways in which it would be appropriate for the bank auditors to have formal and informal communication with the banking supervisor. That could be done in a number of ways. It could be bilateral and trilateral meetings that involve the individual bank audit team and the Bank of England. It could deal with specific issues with regard to specific banks and financial services companies.

  There is another tier of useful communication where perhaps the bank would talk to the senior partner of the audit firm about general issues that are coming up in the financial services sector. There is at least a third tier, which probably would be a meeting between the banking supervisor and the large audit firms generally, where there could be some sharing of concerns and pressure points that have come up in bank audits and pressure points that the supervisor is aware of. So the audit firms can all go into the next audit cycle armed with that information, so that we're all sharing knowledge.

  What we've been doing with the bank is to see if we can just have a very simple dialogue framework that sets out what are the reasonable expectations of the various tiers of that discussion.

  Mr McBurnie: I think we probably need to differentiate between banks and other such very complex institutions in the way they are audited because I think, in terms of the financial structures that they have in place and some of the financial instruments they use, they are incredibly complex and they have, internally, people who are paid excessive sums of money potentially, but certainly large sums of money, to come up with these ideas. Are auditors and all audit firms capable of fully understanding them? Because you can't audit something if you don't understand it and we probably need to look very carefully at the expertise that audit firms have in looking at bank transactions and whether there needs to be special accreditation that is regulated by the ICAEW to look at these sorts of areas. When you think about how long it is going to take the Lehman's insolvency to be unwound, because it is such a mammoth beast, imagine having to audit that and whether people can understand that in order to give a proper opinion on those accounts.

  Q119  The Chairman: Do you think members of audit firms, in doing the audits, are still looking at this as systemic risk and all those sort of financial and banking implications?

  Mr Maslin: I think that's a fair comment. With regard to the banking financial services sector, there are very complex issues involved and it takes very specialist teams to consider those matters. Some of the specialists at the large audit firms are capable of dealing with those issues but it's certainly something that my firm would always be very careful of before taking on any new type of audit. It would only do so if it felt it had the appropriate skills and the appropriate depth of those skills. Clearly banking and financial services companies, the largest banks, are very complex beasts.

  Mr Michaels: Mr Chairman, can I come back on a broader point, and I'll also deal first with the point you raised there. One of the things that adds to some of the difficulties in the marketplace is simply the extent to which financial reporting has become so complex, particularly in relation to those financial institutions. While there is a public interest element in terms of the audits that are undertaken, there are gaps in perceptions around what is the role of audit. Other assurance could be provided to investors and it makes sense to also review how one might establish what the purpose of an audit really is and the nature of corporate reporting to reduce complexity. I think that is something we would favour being led, primarily by the FRC but also with significant input from the investor community. Without really understanding exactly what it is those investors need and want, additional levels of complexity are not really helping them make informed decisions about the risks that are being taken.

  There is also an argument, I think, for a greater level of disclosure in relation to some of the key areas and judgements that are being made, again to help investors understand the decisions that they are making. So I think there is a much wider piece in relation to the role of audit, and a much wider piece in relation to complexity of corporate reporting.

  I want to add just one more layer, if that's okay, which is the market is segmented in a number of ways. BDO focuses primarily on the mid-market. We have a lot of fully listed larger clients and we deal with that complexity as well. But intelligent auditing means that you have some businesses that are smaller caps or privately owned; that don't need the level of complexity or auditing that some of those larger, more complex, businesses need. I think there is pretty strong argument to have a fundamental review of what the market needs and wants and what is being provided by the profession.

  The Chairman: Thank you. Lord Tugendhat?

  Q120  Lord Tugendhat: Can I go a bit further down this road? We've received a lot of written evidence, as I'm sure you know, and, in their submission, Ernst and Young basically say that there is no reason why other people shouldn't be able to do the big audits; that it's a mistake to think that only the Big Four are able to do so. Would you feel happy if a major FTSE 100 company came along and asked you to tender for their audit and would you do it and would you feel that, if you did do it, you would stand a sporting chance of success?

  Mr Herbinet: Can I take this one? I think the answer to that question, from our point of view, is unequivocally "yes". The reason why I am saying "yes" is because we are already doing it. But let me take a step back. We understand that the prime concern of yours is the issue of systemic risk in the markets and the risk were a Big Four firm to fail. Therefore, we've looked a little bit more into this issue of systemic risk and, when you look at it in more detail, I think you come up with essentially three parts of the market where systemic risk is greatest: one is banks, two is other similar financial institutions and three is the FTSE 350 market.

  There are some interesting statistics on that, in that 95% of the UK market capitalisation is with FTSE 350 companies. Within that, 80% of the market capitalisation in the UK is with FTSE 100 companies. Therefore, if you are serious about addressing the issue of systemic risk, in our view it is in that segment of the market that something needs to happen because that is where essentially the value of British PLCs is. At present, only one-tenth of 1% of audit fees in the FTSE 100 is not earned by a Big Four firm; that's my friends from BDO. That is one-tenth of 1% of the fees in the market. Therefore, we think if a solution has to be found to reduce systemic risk it is in that market that we need to concentrate our efforts.

  That leads me straight into one of the questions that you may want to raise later on, on joint audit. Mazars, my firm, are already the joint auditors of Europe's third largest bank, which is BNP Paribas, and a number of other top European listed companies. If you look at our client base, 13 of our clients would feature in the FTSE 50 in the UK, i.e. would be among the 50 largest UK companies. This has been achieved through joint audits. So I think our view is that the FTSE 100 market is where, in our view, something needs to happen and we believe that there are ways to address this issue of systemic risk in this market.

  The Chairman: Lord Smith?

  Q121  Lord Smith of Clifton: We are really moving on here quite logically on what follows. We are talking about size and capacity. How much investment is needed for mid-tier firms to compete for audits of large companies and financial institutions and in what areas is investment most needed?

  Mr Maslin: May I pick this one up? Again, the way that our firm has looked at this question, Lord Smith, is to say that our recommendation is that if changes are made in the audit market structure, it's about building greater presence in a more vibrant audit market in the FTSE 250 and we would suggest starting there. But if you look at the average size and audit fee size in the FTSE 250—if you elect to move 20% of the audits away from the four largest firms to one or a collection of other firms—we estimate that that size of market would be about £25 million to £30 million. Certainly our firm and some others believe we have the cash reserves that we would be able to make the investment to serve the entirety of that market straightaway.

  So if we're talking about making a significant change in the FTSE 250 and then building a more stable platform to look at changing the structure in the FTSE 100, we don't think it's a question of lack of investment capacity. Our firm has signalled the fact that if there were a change in buying patterns in the FTSE 250 we would be prepared to invest more in that market.

  The reality is—and it's shown by, I think, the lack of success of the FRC in recent years—that typically buying patterns are such that it tends to be just four firms that are successful in that FTSE 250. So we really don't think it would require our firm to raise additional capital, even probably to get additional bank lending, to make a significant change in the FTSE 250. We would start there as a firm because we would be nervous about starting at the very largest companies in the FTSE 100 because we think that would give us a danger of an unstable business model where, too quickly, we could become dependent on one or two companies and we would not feel comfortable with doing that.

  Q122  Mr Michaels: If I could add, from BDO's point of view investment is not holding us back. We are a substantial international network. We audit one of the FTSE 100. We audit six of the FTSE 250. It is about us building our reputation, gaining the experience and getting the scale to be able to take on more of those opportunities which, as Steve Maslin has said, don't come around that often. So we don't see investment is the issue. The issues are much more, we think, around some of the institutional prejudice that exists there; that size and revenue in terms of size is seen as a proxy for quality and maybe that it's a safer bet to buy the Big Four rather than buying one of the mid-tier firms.

  Mr McBurnie: Can I just pick up on scale and expertise? From RSM Tenon's point of view we couldn't do a bank audit. We freely admit that; we do not have the expertise. I think it's very important that whatever comes out of discussions today and in the future ensures that what we don't do is force companies to have audits from people who aren't capable of doing the job properly, because that is the other end of the scale and a clear risk here. From our point of view, top 100 companies would probably be out of reach in terms of scale. While we would have the expertise to do ones that weren't bank-led or bank-related, I think—very much like my colleagues here—we would have issues in terms of the sheer scale and volume that a single job required. Investing in that and then potentially losing that audit and then having a surplus of staff would cause us issues.

  While we don't see our main competitors as the Big Four and our target market is not the top 100 or indeed the top 250, we see that mid-tier firms would relish, in certain cases, the opportunity to compete. But that has to be very real competition. There is no point in investing to be an also-ran; there is no point in investing just to knock the price down or cause price pressure on the Big Four. It has to be about real competition and if that is not going to be the case then I don't think firms would choose to invest.

  Q123  Lord Smith of Clifton: Do you think there is any likelihood of further mergers among mid-tier companies in order to up the threshold and the capacity or is that a leading question?

  Mr McBurnie: It would certainly be a potential shortcut for dealing with the perception issues in terms of scale. The biggest thing that the mid-tier firms have to get over is the perception issue; that is, the perception of the banks and the perception potentially of investors, of brokers, of audit committees and of finance directors.

  Mr Michaels: I don't think that a shortcut of merging mid-tier firms is an appropriate solution. If you combined the revenue value of firms 5 to 10, you don't reach the size of the smallest of the Big Four. It doesn't deal with your reputation as well. You get a collection of mid-tier firms. In fact the investment has to be more sustained, it has to be co-ordinated on an international basis and it really has to be about gaining the experience and the scale in a very measured way and building your reputation such that people feel comfortable making different buying decisions. I should say we also act in an advisory capacity, so a non-audit capacity, for about 30% of the FTSE 350. So the buying decisions are slowly starting to come through but we're taking a medium to long-term view because nothing is going to happen in that audit market for some time unless there is intervention.

  The Chairman: Lord Forsyth and then Lord Maclennan. Lord Forsyth?

  Q124  Lord Forsyth of Drumlean: I wanted to pick up on Mr McBurnie's point where you said you wouldn't be able to audit a bank and you wouldn't take on a bank audit. Is that because you wouldn't invest in the people and the expertise because you would have no chance of getting a bank audit? Isn't it a bit chicken and egg?

  Mr McBurnie: I wouldn't disagree; there is a chicken and egg situation there. I think what I'm talking about is our current capacity and where we are now, we couldn't do it.

  Q125  Lord Forsyth of Drumlean: That is not going to change, is it? If you think you have no prospect of getting into the banking market you're not going to recruit the people.

  Mr McBurnie: Absolutely. My next point really was that firms will invest if they see that there is potential for real competition and not being on a tender list for an audit to drive the price down, but if they have a real chance. You do have this "chicken and egg" thing. For example, we are trying to break into the market on large university audits and you will get audit committees coming back to you and saying, "Yes, we really liked your tender; yes, we thought you could do the job. But you do not have any experience of that area, so we're going to go with someone who has experience". Well, how do you get experience of that area unless you change the market?

  Q126  Lord Forsyth of Drumlean: Yes. Jut to follow up: the word "prejudice" was used; the prejudice in the market. Is it prejudice or is it just the old adage: no one was fired for buying Goldman Sachs?

  Mr Michaels: I used the word and I think there is an element of that, no one was fired for buying IBM. But also the NED community that services the FTSE 350 is very well networked with the Big Four. The FDs of those FTSE 350, inevitably would have been trained at the Big Four. So it is quite deeply ingrained and, therefore, to break through—which you can do—it just takes an awful lot of time to give people that confidence.

  Q127  Lord Forsyth of Drumlean: Sorry, you said most of them would have been trained. Are you suggesting it's patronage rather than prejudice; the old school tie?

  Mr Michaels: No, I'm not saying it's that explicit. I'm saying I think it's more subtle, I just think there is an understanding of how those businesses work, such that the comfort is there to buy those big brands from people they know and trust and that making the buying decisions outside of the Big Four—unnecessarily in my view and, I think, our view—is seen as a risky bet.

  Mr McBurnie: It's a whole raft of factors that add up to quite a barrier. So, is there a covenant in a banking agreement that says you have to go with a Big Four firm? Does the banking agreement say that they can say who your auditor should be and what is a bank likely to do? Well, they might say they want the safety of a Big Four audit. It's the attitude of investors or the perceived attitude of investors—"If I change from a Big Four audit and go to a mid-tier audit what will that say to the City?" It might say nothing, because everyone sitting in this row here believes that mid-tier firms are perfectly capable of doing audit there. But there will be audit committees and finance directors who sit back and have that conversation and it's breaking those barriers down.

  The Chairman: Lord Maclennan?

  Q128  Lord Maclennan of Rogart: Mr Michaels, in your initial answer to the Chairman's question, which was the broad question, you referred to the systemic risk or a risk of systemic failure. But it does seem to me that in your subsequent answers to the more particular questions you have been suggesting that there is really no short term way in which that systemic risk could be tackled because you—and, similarly, others—have said that companies such as yourselves don't want to scale up to the level at which you could spread the risk. I don't quite see what your—

  Mr Michaels: Let me clarify, if I may. The systemic risk point, in my mind, still stands. The other observations I've been making are that in my view things are unlikely to change and that systemic risk will not go away but it will be brought to the fore if one of the Big Four, for whatever reason, exited the market. I do think there are ways to accelerate progress and de-risk the market with intervention. I've mentioned the possibility of intervention.

  Q129  Lord Maclennan of Rogart: Are you speaking about regulation?

  Mr Michaels: I think the intervention could come in a number of ways. You have the regulators, you have investors and you have government as well. If I take the regulators to start with, you could get a situation where the regulators had more input into audit appointments within the FTSE 350. That would certainly help over a period of time to de-risk it if there was a wider choice in that marketplace. I think that is where the greatest concentration lies. If that was tied together with much tighter liaison with the audit committee chairs that ultimately have the responsibility for making those decisions, I do think you could start to de-risk the market more significantly and more quickly.

  The second point I would make in relation to regulatory intervention—as the point has already been made—is that there are restrictive covenants that exist in certain parts of the market in terms of undertaking some of the banking work. If those could be outlawed in some way, which would need regulatory intervention, that would open up buying ability. The third area—and, again, it has been mentioned already—is potentially approving networks or firms to undertake certain types of work so the market has confidence that the regulator believes those firms are capable of delivering.

  So in terms of the regulator, without burdening and bureaucracy, I think there are simple things that could be done. In terms of investors, the more investors are prepared to engage on auditor appointments and use their influence, accepting they're not a homogenous group—linking with audit committee chairs, again—I think there is more of a chance to de-risk the market. On government spending, again, a lot of government spending goes to the Big Four and widening that market out creates more opportunities. So I do think there are things that can be done to speed up change but if there isn't any intervention the market won't change in a hurry.

  The Chairman: We are going to have a round-up question towards the end, I think, about solutions and what recommendations you would make in that respect and we will come back to that later. Lord Hollick, did you want to come in at this point?

  Q130  Lord Hollick: Yes. I wanted to pick up on Mr Herbinet's comment that in Europe, and I think it was in France, you jointly audit companies that, if they were listed in the UK, would be part of the FTSE top 30. So you have the skills, the reputation, the heft if you like, and the experience that could be transferred to audit those companies in the UK or companies of similar size in the UK. As a result of that expertise, have you been invited to tender for the audit process in the UK for companies of that size?

  Mr Herbinet: I think one of the critical issues is that it is currently a very stagnant market. There has been some independent research carried out that shows that, on average, a FTSE 100 auditor can remain in place for 48 years—which means that they were appointed in 1960—and, on average, I think 70% of FTSE 100 companies have not had an audit tender for 15 years. So in that market, no matter which capability you have, you just don't have the opportunity of showcasing it.

  Q131  Lord Hollick: Do you think the practice of a joint audit is something that could be usefully introduced into the UK?

  Mr Herbinet: That's definitely our position, yes, and that's the position we've been putting forward for the last 10 years. We think that would bring significant benefits to addressing this issue of systemic risk. Very simply, in our view, this is the only proven mechanism that has reduced concentration in a major economy and in the segment of the market where systemic risk exists. We've put together a short paper on joint audits, which I would be happy to leave with you at the end, but if I may I will highlight a few of the key points that I believe would be worth further consideration.

  There are a number of misconceptions around joint audits. A joint audit is essentially two or more firms that express an opinion together on the financial statements of a group. The first misconception is that it is the audit being done twice by two firms; it is two firms working together to jointly form an opinion on the statements of the group. What they do is they look at the most complex and challenging audit issues together and, therefore, you have more input into the challenge and the scepticism the need for which has been highlighted by you.

  There are benefits and potential inconveniences of joint audits. In terms of benefits, I think I would just flag three points. One would be that you have the "four eyes" principle that is quite key to regulation, whereby you have more people looking at the complex issues. What that creates is a permanent and inbuilt quality control during the audit on a real-time basis and focusing on judgement more than on compliance. Point two, and it's a critical one for addressing systemic risk, is that it encourages new players to come into the market, because what you do is you offer visibility—the point that Russell was making earlier—offering the opportunity for a return on the investment that you make over the longer term.

  The third point is that it facilitates rotation of work and of firms over time. One of the issues that most large FTSE companies raise is that it's a major inconvenience to change auditors because they have to learn everything from scratch and some argue that when you change auditors you create an additional audit risk because a new auditor doesn't really know the business. What you can do with a joint audit is stagger the appointments whereby you can change one of the two without putting the whole audit at risk. So there are some clear benefits.

  A number of criticisms have been made. The first one is that it's French and I hope that we can rise above this at a time when we are combining our efforts in the Armed Forces. Factually this is wrong. It's like rugby; joint audit was not invented in France but it has found the soil to grow and develop in France. The second criticism is that it's very expensive. There is simply no evidence to support that criticism. The third criticism that we hear most often is that it's a race to the bottom in terms of audit quality. Again, it's anything but that because you have more people looking at the complex issues. Probably the best answer to that challenge is that most Big Four, all Big Four, are very happy to put their name on the same audit report as Mazars, on the companies that we audit with them. So they clearly have no issue there in terms of quality.

  There is an interesting recent report that was produced by the French equivalent of the CBI—and that report was produced with the audit firms, including the Big Four—that concluded that the practice of joint audit brings more benefits than inconveniences. That included business, Big Four and key stakeholders in the market.

  Q132  The Chairman: Is it mandatory anywhere else other than in France?

  Mr Herbinet: It is mandatory in South Africa where they put this in place after the last major banking crisis in the mid-1980s.

  The Chairman: Lord Best?

  Q133  Lord Best: Am I right in thinking that Mazars do more than half of all of the joint audits in France? More than half; is it getting on for 60% of all of the joint audits are done by your firm in France?

  Mr Herbinet: In France my firm audits 30% of the CAC 40 in a joint audit capacity and, within these joint audits, I think you will have a balance of work allocated to one or the other firm. On balance, my firm would probably do between 30% and 50% of the overall work on that audit.

  Q134  The Chairman: We were going to ask you about joint audits in particular. I think we've probably covered that now but if there's anything else you would like to add to it please do submit another paper to us.

  Mr Michaels: Could I just add one thing, which is a slightly alternate view? We're not equally sold on joint audits. This isn't clearly a homogenous group that has a consistent view. I haven't done the analysis on the cost piece nor the efficiency piece, but I wouldn't want to be in a market where we're seen as being appointed as the poor relation of the Big Four to make up the numbers, frankly. I think what I'd rather do is try and find a more permanent solution. So, although I can see how that work could be helpful in some regards and might be able to reduce the risk—I do accept that point—I don't see that it necessarily is as permanent a solution as we might need.

  The Chairman: Quite quickly, because we must move on.

  Q135  Lord Forsyth of Drumlean: Before we leave that, just following up on that point and perhaps I am being stupid, but I thought the whole argument for joint audit was that it would create more diversity in the marketplace. If you are doing such a big proportion of the CAC business, why is that not working? The argument for joint audit is that it will give more firms, as I understood it, an opportunity to come into the market so there is less domination. But you've just described the French market where you are very big and where there doesn't seem to be that diversity. So why is that not working?

  Mr Herbinet: I would look at the market in a slightly different way. In that market you have the Big Four, you have my firm, but you have, through joint audit, the opportunity for other firms to come and establish themselves. Practically, at this point in time, Steve's firm, Grant Thornton, is making very significant progress in the French market through joint audit. Simon's firm, BDO, before their previous firm was acquired by Deloitte, had a significant presence in the French market in key joint audits. So what this brings in a market is the opportunity for a firm to really go for it and make the investment and establish themselves in the market as a key player. You have many firms constantly coming into this market.

  Q136  Lord Forsyth of Drumlean: So you wouldn't say the difference is you have a Big Five instead of a Big Four?

  Mr Herbinet: No, I don't think so. I think it creates a much more open market.

  Mr McBurnie: Can I just say, as a representative of mid-tier and also a finance director of a main listed company, I tend towards Simon's view that we would not be in favour of joint audits. I cannot see how they cannot be more costly and inefficient, because it just seems the logic must be that. I also worry about responsibility falling between cracks and between firms in terms of the way the work is divided up.

  The Chairman: There are a lot of other questions we want to ask you, so I think we must move on. Lord Maclennan, the fourth one, on the capital point.

  Q137  Lord Maclennan of Rogart: One of you said £25 million might be enough to enable the firms to compete with the Big Four. Is that a considered view?

  Mr Maslin: Yes. What I said is if one looks at the average—the average audit fee in the FTSE 250 is around about £600,000. To get down from a concentration, at present, of about 96% to 80% would involve a shift of only about 40 audits but that would be quite a significant change in the audit market. That suggests that the total amount of fee shift would be about £25 million to £30 million and, as Mr Michaels has said, our two firms would have the cash resources to be able to invest in the entirety of that market shift. But we would only make that investment if there was a change in buying patterns and we felt there was a realistic opportunity of being successful in winning those appointments.

  Q138  Lord Maclennan of Rogart: What would stimulate the change in buying patterns, as you put it?

  Mr Maslin: If I were to leap ahead to possibly the last question, we think there would be a lot of merit in the FRC convening a group of the largest UK institutional investors to take more of a top-down look at the audit market rather than what happens at the moment, which is that audit procurement decisions are a whole bunch of bottom-up decisions. We think that situation works relatively well in the UK public sector market where you have much lower levels of concentration and demonstrably high levels of audit quality.

  I was interested in the comment of a very well respected fund manager from Schroders, albeit in a slightly different context, who made the point that if the largest UK institutional investors act together in the companies in which they invest, they tend to get the change that they're looking for. We think it would be a very interesting model to look at; for the FRC to convene a group of the UK's largest institutional investors to get some focused action on the companies in which they invest—and that might be in the FTSE 250—to give a very strong signal to those companies to move more audits to firms outside of the Big Four. Virtually all of the FTSE 250, firms like ours have the international reach, the investment capacity and the audit quality as measured by the public reports of the inspection units, to do high quality audits in those areas. We think that is a model that would be worthwhile examining.

  Q139  Lord Maclennan of Rogart: The existing investors or partners would not be concerned about the dilution of their stake if that external investment took place?

  Mr Maslin: In terms of our firm?

  Lord Maclennan of Rogart: Yes.

  Mr Maslin: That's what I'm saying. We wouldn't need to dilute the ownership stake of the partner. We have the cash reserves to make that level of investment and we've demonstrated that we've been prepared to make investments of that size. Three years ago we invested about £40 million acquiring Robson Rhodes to increase our size and we're on public record as saying that we would be very enthusiastic under the right conditions to invest in taking a substantial part of the Audit Commission work, which currently runs to several hundred million pounds. We're very happy to make those levels of investment but we will only do so if we think there are realistic opportunities of that getting a payback in terms of winning a reasonable number of appointments, but we are able to do it without diluting a partner.

  The Chairman: Mr Michaels?

  Mr Michaels: If I could just build on that point, if I may. Equally, lack of investment isn't an issue; lack of capital is not an issue. But we've had support from investors, very visible support, previously. When we roll the clock back to when the Oxera report was done for the FRC and the DTI on competition and choice in the audit marketplace a number of investors—and I have the letter here—sent a note to a particular business that they don't believe there is an issue with appointing a non-Big Four firm. So I think in that sense the investor community are generally supportive and I think more engagement and more intervention on their part, with some encouragement, might bring about some reasonable change as well as in the other areas.

  The Chairman: Lord Lipsey?

  Q140  Lord Lipsey: I can see all the advantages to your firms of broadening out this market but I would like to try and get a finger on the advantages to the people who I suppose this Committee, in a sense, represent who are investors, the firms themselves, and the wider public interest. Is this really about price—you have a conflict in your evidence because BDO says the Big Four monopoly does push up prices, Grant Thornton in their evidence say there isn't any evidence that it does—or is it about quality? Is it about radical new approaches to audit? What are the advantages for Joe Public in widening this market out so you can get more business?

  Mr Maslin: Shall I lead on that? The start point I think of all of these discussions is that audit quality must be maintained and Mr Michaels' firm and my own have consistently over a long period called for publication of the results of the independent audit inspection into the large audit firms because we would only wish to compete in any market on the basis of quality. I think the FRC missed an opportunity in December 2009 in not doing a better job of publicising the results of the respective levels of quality of firms such as ours in comparison with the largest four. So the start point must be that quality is at least maintained and we believe in the longer term you need a vibrant audit market to drive quality innovations.

  I think, in terms of the public interest benefit elsewhere, we've never particularly seen concentration as our issue. Our firm will grow very significantly and if there are not opportunities to grow in the FTSE market we will find other areas of the market and other businesses to grow. Over a long-term period it's investors in this country and regulators around the world that have recognised the risk of forced exit of one of the largest firms. The policy proposals we've put forward might be argued as having some self-interest there but we think there are practical measures that would go some way to addressing those concerns that have been raised by other stakeholders, by regulators and investors. Does that help to answer your question?

  Q141  Lord Lipsey: Yes. I think your answer is, "We will produce very good quality". I suppose the difficulty with the quality argument always is assessing it; whether a company can assess it, an investor can assess it. It's very hard for a layman to know what is a good audit and what is not a good audit, isn't it?

  Mr Maslin: Again, that is why—I'm sure Mr Michaels has the same view—we were very frustrated in terms of the way the AIU findings on the firms in 2009 were presented. One of the things that the AIU does is to publish a table grading the individual quality of the files that it has inspected and over the last two years it has inspected, I think, something like 183 large audits of what it calls the major firms. Within that table, Mr Michaels' firm and mine, in December 2009, were the two firms that didn't have any audits criticised as requiring significant improvement. I'm not complacent and I'm sure Mr Michaels isn't complacent about that and we will have files criticised in future. But we thought there was a real opportunity there for the FRC to demonstrate that audit quality isn't confined to four firms. What it actually did was present those findings in a way that has enabled many commentators to think that any firm outside of the Big Four doesn't have the capability of producing quality. It was very frustrating to us.

  Mr Michaels: The other aspect to build on, taking on some earlier points, is in a way it's a shame but there's not a lot of evidence to say that investors assess audit quality in whichever form. I think maybe it's time that they did because if they took more interest in that again it would help.

  The other point that I made earlier, about revenue or size being seen as a proxy for quality, is a consistent frustration because there's a feeling that is where you get your reputation from. Our global network has revenues of $5 billion, yet we're not seen as big enough to service some of those largest companies. It seems ridiculous. So it's going to take some time and I think the more effort that can be put into articulating what quality really is and how that is recognised in the market such that it starts to influence buying decisions, the better. But I think we both go back to the point, and others as well, where we've said that without some sort of intervention the market is not going to find that solution in a hurry itself.

  The Chairman: Lord Hollick?

  Q142  Lord Hollick: Staying with the question of quality for a moment, one of the things that the Institute of Chartered Accountants said to us was that the audit has become largely an audit of compliance. It has ceased to have, or it has much less than it used to, the question of judgement around the quality of the accounting, the quality of the business model, and obviously this goes to the problems of some of our financial institutions. In a world where the audit process itself has become compliance, how do you differentiate yourself? How do you win business when it would appear that it is being robbed, denuded if you like, of its original purpose of giving a true and fair and prudent view?

  Mr Maslin: I think different firms would clearly respond to that in different ways. In our firm one of the things we try to do to differentiate ourselves is to think about the way we're delivering services, which is very much to try and focus specifically on what are the needs of an individual audited entity rather than saying, "There is a generic Grant Thornton way of delivering an audit and that's what you get". Certainly we've had some very favourable feedback in terms of audits that we have won from some very large companies. I think it goes too far to say that there are no judgements in the modern audit and certainly when I ran our audit practice for seven years there were at least four occasions when, as a result of judgement disagreements with some of Grant Thornton's largest firms, we decided that we would resign, and sometimes in very public situations, from those situations. So I think it goes too far to say that there are no judgements exercised.

  I mentioned the work stream we had with the Bank of England earlier on but a second work stream with the bank and with the FRC goes to this issue as to whether more colour around judgements and the quality of judgements that are made by auditors and the volatility of valuations that are inherent in values in the balance sheets could be provided in the financial statements and the auditors could be responsible for giving some sort of statement on the fairness and reasonableness of those disclosures around judgements. I think there is a pressing need coming from investors for that type of disclosure. Interestingly, I think that that would help audit firms to compete on the basis of quality because the quality and robustness of our challenge to management and audit committees would become a matter of public record.

  Mr Michaels: You talk about differentiation. One of the areas that we focus on very heavily is the service quality plus technical quality as well. So, while we put an awful lot of investment into the methodology on an international basis, into the IT, into the training, we also put a huge amount of investment and time into the service experience that our clients get because we think that is a way of differentiating and building an overall impression of quality that goes beyond the pure function of an audit.

  There is another piece as well that I alluded to earlier, which is that I think again there is a wider debate to be had about the purpose of audit and the complexity of that corporate reporting and really asking investors what it is they need and want from the market, not assuming it means extending audit services. It is about looking at the wider level of assurance that can be provided to the market and what is appropriate for the relevant companies that are either investing or providing services to those businesses, where they seek to place a reliance on what is being produced by the profession.

  The Chairman: We are covering a lot of ground but we have only another just under quarter of an hour and there are some other questions we want to move on to, but you're being very helpful. Lord Moonie?

  Q143  Lord Moonie: Thanks, Chairman. I should declare an interest at this point that I'm the chair of an audit committee of a company whose audit is carried out by BDO. Just in passing, I assume that you don't think that the size affects the quality of the audit, the size of the company doing it.

  Mr Michaels: The size of the company doing the audit work?

  Lord Moonie: Yes. It is not aligned with quality?

  Mr Michaels: No. As I said before, I think it's a red herring but the perception is that it is an issue.

  Q144  Lord Moonie: What effect does lack of choice in the market for large firm audit have on audit price and quality? Are there any other effects?

  Mr Michaels: Yes. In our submission, the Oxera study that was done for the DTI and the FRC in 2006 did suggest that, following the PricewaterhouseCoopers merger in the late 1990s and following Andersen's exit from the market in the early 2000s, price did increase. BDO also funded an independent study by the LSE a few years ago that said that a 10% reduction in concentration in the market would lead to a 7% reduction in price. It's very difficult to say that is the case until you're there doing it but certainly there is a suggestion that price, in our minds, would be impacted. There is no suggestion, however, that the concentration in the market leads to a lack of quality.

  Mr McBurnie: I've benchmarked prices because I've had to make decisions about who does our audit and the Big Four are quite simply more expensive, pound for pound, in terms of doing the job than other mid-tier firms. We do need to be careful about balancing price with quality. Audit cannot become a commoditised service. If it is too cheap there is the risk that it is not done properly and one of the jobs of the audit committee is to make sure that a proper price is being charged for an audit. So, for example, I see my job as a finance director potentially to beat up my auditors on price but the audit committee has an overview on that price and signs off on it and it says, "Is that job being done at a reasonable price to ensure that they can do the job that they need to do properly in terms of coming to their audit opinion?"

  In terms of choice, the other impacts—not just on price and on quality but more on the service side, which we've already sort of discussed—is the fact that if you have stagnation, if you have lack of movement, if you have a firm doing the same audit for 48 years, what sort of onus is there on that firm to provide the value-added services; to look at the financial accounting controls and report on them, which they should be doing as part of their job, if they don't need to in order to maintain that audit? It's those sorts of areas. It's the value-added; it's the fresh pair of eyes; it's that sort of thing that you don't get if you have the same audit firms doing the same audits over and over again.

  Q145  Lord Best: Isn't it true that you have chosen one of the Big Four to be your auditor?

  Mr McBurnie: That is correct. However, let's be clear who I think our main competitors are. They are the mid-tier firms. Therefore, I use a Big Four firm because we don't compete with the Big Four. I know people can talk about independence but I put it to you that if Tesco sold audits, Sainsbury's wouldn't buy one from them.

  The Chairman: Lord Forsyth?

  Q146  Lord Forsyth of Drumlean: I'll resist the temptation for once. I think I know what the answer to this question is going to be. Some people have suggested that internal audit should be mandatory for UK-listed companies rather than explain why you don't have internal audit procedures, if that is the case. What do you think about that?

  Mr McBurnie: I think for the right size of firm internal audit should be mandatory. I wouldn't put it for all companies. You might say it's the top 100, it's the top 250, but it has to be internal audit that is written very clearly with clear guidelines: what are they going to report on, what are they going to do and a framework within which they work very closely with the external auditor as well in order to get the best value from it?

  Mr Maslin: Could I offer a variation on that view? It comes back to the concept of the FRC perhaps convening a group of leading institutional investors to look at audit appointment issues but audit issues more generally. I note earlier this week there was a study released by Deloitte in which a number of internal auditors of large companies expressed some concern that their internal audit functions weren't as well resourced as they would like.

  I think it's easy to have a regulatory intervention that says, "Do something, have an approach" and someone can tick off a box and say, "Okay, we never used to have an internal audit function. We now have a part-time person doing internal audit". I think a more effective way of looking at concerns around internal audit and all sorts of other governance issues would be to get a dialogue going so that if there were a concern like that it could be assessed and evaluated by institutional investors together and if they felt there was a weakness in the market they could bring pressure to bear on the companies in which they invest to bring about improvements.

  Mr Michaels: I agree. I wouldn't make it mandatory. I think the FRC guidance is adequate and I think it depends on the complexity of the business and the need for the appropriate checks and balances to be provided rather than should be driven by the regulator.

  Lord Forsyth of Drumlean: That wasn't the answer I was expecting.

  The Chairman: We're coming to the big mop-up question, I think. Lord Best?

  Q147  Lord Best: I chair an audit committee that uses BDO and I chair another organisation that uses BDO for its internal audit. So I declare that interest.

  The big question is what is the one single measure that each of you would suggest in order to widen choice in the audit market? Perhaps you could set that in the context of the fact that the consultation that goes on with the profession through the Financial Reporting Council, the FRC, is almost entirely with people who have a self-interest, a vested interest, in the outcome of that consultation. I think about 85% of those consulted are in the profession themselves. But, even with that backdrop, what would be your suggestions for change to give us more choice in the audit market?

  Mr Michaels: I don't think there is a silver bullet that solves this in one go but I do think this is a once-in-a-generation opportunity, if you like, to grasp the nettle and do something about it. For me that single issue is around intervention, around the regulators, around investors and around government as well in terms of spending. Building on that point of intervention, I think, without it becoming bureaucratic, there is an awful lot you can do to speed up the de-risking of the market and creating more choice for investors and making sure absolutely that the market is providing them with what they need and want as opposed to a solution that isn't necessarily appropriate for their means.

  Mr Maslin: I would go back to something I've said a number of times, which is that the ultimate user of audit services is the investor community and that's why I quite agree, Lord Best, that the valid views here are from the investor community, not from Grant Thornton and other audit firms. But I do think there is a role for a strong steer to be given to the FRC to convene a grouping of large institutional investors to take on some of these issues and I think that would be the most effective way of getting the market and the investor community to bring about change in the audit market structure for the companies in which they invest.

  The Chairman: Mr Herbinet.

  Mr Herbinet: I was a member of the market participant group that the FRC put together to try and come up with market-led solutions and we are where we are today with very little impact from the recommendations made. So I would totally agree that regulatory intervention, in my view, is needed as part of a programme of reforms. If you ask me to select one measure I don't think anyone here would be surprised that I would recommend joint audit; in particular for banks and other listed companies posing a systemic risk to the market, the economy and society at large. All firms will be looking at it and all stakeholders will be coming at it with an element of self-interest. I think it's down to people like you to assess whether the recommendations would have an impact on this issue of systemic risk.

  Mr McBurnie: I would tackle the audit committees, because that's where the decision-making in terms of audit choice lies. I would strengthen the role of the audit committee. I would ensure that members of the audit committee had proper and clear qualifications in order to be able to do their job properly and I would insist that there was greater transparency. So there should be some words in the audit report that forced the audit committee to report on performance review of the auditors, retendering timetable, pricing, reasons for their choice of auditors, what work they undertook with audit planning, the work undertaken to review what the auditors did as part of the audit committee, review of key judgemental areas affecting the figures, why they've chosen not to retender the audit. That has proven to work in the public sector because by having a very open tendering process you can have audits based on quality assurance rather than just price and perception.

  Mr Michaels: May I make one more observation, a very short one, which is that there is an EU Green Paper out at the moment on audit policy, which I'm sure you're aware of? I think the solutions that one might seek to impose in the UK, given the international nature of business and given the international nature of the investor committee as well, it's going to be very important that they are, where possible, done on a much more co-ordinated basis; much as certainly we would like to see the UK taking the lead in that.

  Q148  The Chairman: Can I just come back to the tendering point? There has been increasing pressure in the last 10 to 15 years, in corporate governance to retender in all sorts of areas—financial advisers, in the pension world, actuaries and so on and so forth—and there is a fairly standard process for a lot of us now in doing that every five years. You've mentioned that a lot of firms haven't changed their auditor in over 48 years. Do you think that retendering should be made compulsory?

  Mr Michaels: No.

  Mr McBurnie: No, but I think—

  Q149  The Chairman: Would you like to get it more consistent?

  Mr McBurnie: What I would like to see is a very open decision-making process on why they decided not to retender. I don't think you should force a company to retender and go through a process if they have the right set of people doing the right job. That seems to me to be creating bureaucracy for bureaucracy's sake.

  Q150  The Chairman: You're putting a heavy weight on the chairman of the audit committee then to take the view instead.

  Mr Michaels: Yes. I think the linkages with the investor community are absolutely vital to make those decisions but the point I would just add to it is there is a study, which we would be more than happy to share with the Committee, that says that mandatory rotation compounds the concentration issue. This is because, while audits are put out to tender, those that are done so by the non-Big Four firms are generally sucked up by the Big Four and it's very difficult for the non-Big Four to win them back. So I wouldn't favour mandatory rotation in that sense and I will share the research so you have that as a reference point.

  The Chairman: I would be grateful if you would let us have a note on that. That would be very helpful.

  Mr Maslin: If I could say very quickly that more regular tendering is necessary clearly to effect change in the audit market but, of itself, if there is no change in the buying behaviours as a result of that, then I don't think it gets us anywhere. So I agree with Mr Michaels.

  The Chairman: Lord Forsyth?

  Q151  Lord Forsyth of Drumlean: It is a slightly rude question but is it the fear that you would lose business to the Big Four if there was such a process? Is that part of the thinking behind it?

  Mr Michaels: I would build on the point Steve Maslin made, which is unless the buying patterns are going to change on a permanent basis mandatory rotation could be a one-way ticket. So I think there's a combination of factors in it.

  Mr McBurnie: My view is based on what the company is doing, what is best for them, because it makes no difference to our firm at all whether there is mandatory rotation in the top 100 and 250 because it's simply not a market we're competing in against the Big Four. So we have nothing to gain or lose, as it were.

  The Chairman: Gentlemen, you have given us a fascinating afternoon with a different perspective, which is exactly what we expected and you've certainly fulfilled our expectations. So thank you very much indeed for coming.

  We will now adjourn for 15 minutes and then be on the line to Australia, and it will be an open session at 5 pm. Thank you.

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