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

Examination of Witnesses (Questions 152-168)

Mr Lee White and Mr Andrew Stringer


  Q152The Chairman: Good morning. Can you hear me all right?

  The Chairman: I think there is a two second gap between us speaking and you hearing. Mr White and Mr Stringer, thank you very much indeed for appearing in front of us, and welcome to our Economic Affairs Committee. We think this is probably the first time we've done a video link with Australia, so we hope that it works successfully. I'm not even looking at the camera, which I should be doing. So thank you very much indeed for that. The form is that we've a number of questions we want to ask you and I think you know the flavour of them. We will be taking it in turn to ask the question and the camera will pan to each Member who is doing it, but we do tend also to come in with impromptu questions. So I will try and control that at this end. Thank you very much also for your written evidence to us and we are very grateful for that. I would like to ask you whether you want to make any opening statement or go straight on to the questions.

  Mr White: I might just make a very brief opening statement and not really to re-emphasise what was already included in the written submission, my Lord, but really just to set a little bit of context from the Australian perspective.

  Very briefly, if we look across the Australian experience in the last five or six years, there have been about four significant changes to the public policy framework around auditing in Australia that I think we should just reflect on for one moment. Those four components are, firstly, the creation of government audit oversight, which is similar to what your UK FRC has been doing. Secondly, auditing standards became legally enforceable in Australia from 2006. Thirdly, there were a number of independence rules written into our laws for auditors, and fourthly was the creation and development of professional standards legislation and proportionate liability, which really is around the capping of liability for auditors. So in a very brief period of time we have seen—excuse me for a minute, I think our lights have just gone; my apologies. You have to keep moving occasionally here to keep the lights going. But those four changes have been very important in the auditing framework in Australia.

  Q153  The Chairman: Thank you very much for that. Your written evidence suggests that the Australian market for large firm audit is less dominated by the Big Four than elsewhere and certainly than here in the United Kingdom. Why do you think this is and is the Big Four market share in large firm audit a concern in Australia? We have just heard evidence before you from some of the second-tier firms and one of our starting points is that there is clear concern that if one more major audit firm disappears we really are in a risk situation. That is the concern here. Is that sort of concern shared in Australia or is your position different?

  Mr White: That last concern is certainly one that we do share, but let me set a little bit of context again from an Australian perspective. If we look at the listed market community in Australia, there are approximately 1,800 entities currently on the market. If we drew the ASX 200, the top 200 entities, that would account for in excess of 80% of the market capitalisation. So you can see in the spread of our listed markets we have 1,800 by number but most of the market capitalisation concentrated in the top 200. So that leads us to seeing that we have a lot of entities on the market that need auditing that are spread around Australia and, in some senses, the geographical spread of Australia has been one of our strengths to encourage audit firms to remain competitive within the market.

  One further element of that, my Lord, is certainly around Western Australia. So that is where we have a lot of the mining community and a lot of the junior miners that are listed on the market to try and raise monies, which may or may not be successful. So partly it is the geographical spread that has allowed our markets to have a little bit more healthiness than perhaps what you have in the UK. But the other element I would like to point out, which is something building from my opening remarks, is that the presence of the professional standards legislation and the proportionate liability arrangements in Australia have certainly been an element that our membership has said has allowed them to remain within the audit community and practising as auditors and if that strength wasn't in existence then perhaps they would have left the Australian market as well.

  The Chairman: Thank you. I am going to ask Lord Best to ask the next question.

  Q154  Lord Best: Could I preface my question by asking to what extent the Institute of Chartered Accountants in Australia is dominated by the Big Four in terms of your income as an Institute and in terms of the influence that the Big Four exert on your affairs?

  Mr White: It is a bit mixed. Certainly they are members; so individual partners and staff are members of the Institute. We have about 55,000 members all up. I couldn't tell you the proportion exactly but it wouldn't be a large element individually of that membership. They do contribute strongly in terms of assistance with some of the work that we're doing with the rest of our membership. So we will find leaders within the major firms who are giving time to share experiences with other colleagues within the profession and to assist in some education and training as well. So that would be their primary contribution. They do have representatives that come and exist on our governance boards at times as well.

  Q155  Lord Best: Okay. Your evidence notes that there has been a reduction in the number of audit firms, and indeed the number of registered auditors, and you imply that this is because of the more onerous regulations. Has that, in itself, led to an increase in the market share from the big firms because they can cope with all the heavy regulation? So on balance do you think these auditing rules have gone too far, become rules focused neglecting underlying principles, and have themselves led to a greater concentration in the hands of the Big Four firms?

  Mr White: Okay. There are a few elements to that question. The implication that you've raised is one that we would certainly say that's what we were implying. So those changes that I made reference to in my opening remarks about the introduction of government oversight and inspection and also that the auditing standards in Australia having the force of law, did lead to certain auditors in Australia saying in our markets, "This is too hard now to participate in this market. We will withdraw and do other things as accountants, other than auditing". So, in some senses, that was a concern for us but we also saw that it was a natural evolution; that as thresholds continue to increase and expectations of auditors increase, then perhaps some who no longer wish to do this in a part-time capacity would leave. So that's what we've seen in recent times in the Australian market.

  But where we saw people leave was perhaps at quite the small end of the registered company auditor community and we didn't really see that work flowing up or concentrating into the major firms. In some senses that work flowed up into the next layer above those firms and perhaps then also assisted some of what we might call the mid-tier firms; but in Australian terms that would be the next 20 firms underneath the Big Four. We did also see, my Lord, in that grouping of the 20 firms underneath the Big Four, some consolidation or aggregation of those firms. So we started to see some greater concentration in mid-tier firms arising from this need of trying to keep up with regulations and focus as well.

  The final part of your question was about whether auditing rules have gone too far—and I will use that phrase of auditing rules as not being just about auditing standards. We think in Australia at the moment there is probably a fairly good balance. We would reach out and say we in the community all have one goal and that goal is the delivery of high quality auditing for the consumers of those services. So we think the combination of the government oversight, the legal enforceability of the auditing standards, together with the presence of professional standards legislation and the capping of liability, have all brought about the right components for a rigorous framework.

  Mr Stringer: If I could add something to that. The question about the auditing standards being heavily rules-based and neglecting the underlying principles is misplaced, but the standards that we have are very much principle-based and scalable to all sizes of entities and, from the Institute's perspective, one of the core objectives is to make sure we make available tools to enable smaller practitioners, in particular, to remain on top of the standards.

  The Chairman: Thank you. Lord Forsyth?

  Q156  Lord Forsyth of Drumlean: You referred in your written evidence to the regulator's focus on audit quality. Has that come about because there have been cases of inadequate audit quality?

  Mr White: The regulator's focus on the audit quality has been in existence pretty well since the creation of their oversight function in 2005. The regulator puts out onto the public record, fairly regularly, an aggregated report of their findings. Through that work they have not really identified any systemic issues that are threatening audit quality in Australia, but they have identified areas of focus for practitioners to continue to develop and improve on in the work that they're doing.

  In recent times the regulator has spoken quite publicly—and we have supported the regulator on this—about the current level of discounting, for want of a better word, of audit fees in the Australian community. That is coming not from the regulator having seen evidence of deficiencies in audit quality at this point; rather, it is coming, and rightly so, from the regulator looking forward and saying, "I am concerned that significant discounting of audit fees could potentially lead to a compromise in audit quality in future years". So the regulator is really on the front foot in saying, "You, the audit community, need to be very careful here that, in striving to win or retain work by heavily discounting fees, that is a business decision you can take but you need to be careful you do not end up compromising audit quality".

  The Chairman: Thank you. Lord Tugendhat, do you want to come in on the same point?

  Q157  Lord Tugendhat: This is a supplementary to that point. In this country it has been increasingly the case that the relationship between the board and the auditors is conducted by the audit committee and that the main relationship is that way. First of all, is that equally the case, do you think, in Australia? Secondly, do you feel, in terms of audit quality, that the concentration on the audit committee has created problems and that if the board as a whole had more access to the auditor that would lead to a wider coverage of issues and questions?

  Mr White: The first question is that the audit committee presence in Australia has been an evolving practice. Currently in Australia we have some requirements for the top 300 listed entities to have an audit committee. Now, that audit committee can be just simply the full board or it can be a sub-committee of the board. But, my Lords, you can see, again, over a fairly short period of time that the importance of the audit committee in the governance structures of companies in Australia has grown in importance quite substantially and will continue to do so. Why are we seeing that? Because you're seeing a mechanism which brings together independent directors, management, external auditors, internal auditors, and I think we're certainly trying to encourage the practice and the thinking of the audit committee to be much broader than perhaps it previously was. In Australia, perhaps only a few short years ago, the audit committee was only focused just on the financial statements and its breadth now is expanding quite substantially.

  The second component to your question was about the dynamics between the board and the audit committee and how easily that works in the Australian environment. I'd have to say to you it is a little bit mixed. We would certainly see some experiences where the audit committee engagement with the auditor is, in our opinion, first rate but that audit committee then also assists the board quite substantially in its deliberations as well. But in other senses we are perhaps not seeing that performance as strongly as we would like.

  But we certainly would come and reach out and say that we think there is a future for the audit committee to continue to build on what we have as a very good foundation. But the risk in Australia at the moment is whether the liability for an individual existing on the audit committee is potentially much stronger than if that individual just remained on the board, if that makes sense. There is a sense that being on an audit committee, particularly if you are an individual with a level of financial acumen, trained financial acumen, you might start to be carrying more personal liability than if you remained on the board and that potentially can lead to the right sorts of people not being on the audit committee.

  The Chairman: Lord Hollick?

  Q158  Lord Hollick: How might auditors expand their role into reporting on risk to a client's business model and its scope to fail? For instance, might auditors start to provide assurance on narrative content within annual reports including the director's corporate governance assertions, risk management assertions and other narrative assertions?

  Mr White: Thank you. We are very confident and optimistic that the role of the auditors does need to expand. We believe that the relevance of audit in remaining simply a retrospective examination primarily of financial statements is important, but still seems to be losing its relevance with a lot of the business community and analysts and so on. We feel that auditors being involved in some prospective work—looking at perhaps prospective figures or risk-to-business models—is the right way for the audit function to move. To answer the first part of your question, we feel it would come from perhaps the audit committee or the full board making disclosures in the annual report outside of the financial statements about these risks to the business model and then for the auditors to provide a level of assurance but not necessarily the type of assurance they would in a normal statutory audit report. So the disclosure would first come from the organisation. Then the onus would be on the auditors to look at that type of disclosure on the key business risks and then to offer their opinion on that.

  Q159  The Chairman: I think this is a very interesting point and I notice that in your written evidence to us you had three themes and the first one was future of audit and you did stress this point when you said that auditors are well placed to be involved with the reporting on risks to the business model and the potential for that model to fracture. That's getting away from the traditional role and skills of the auditors in many ways and I wondered whether you think that this presents a new challenge to auditors—the need for new skills and wider skills—and also whether clients would be prepared to pay for that extra service?

  Mr White: We're quite passionate around this and the reason we're passionate is that we feel, at least in the Australian environment, that this relevance of audit is starting to wane and we need to really think about how it can substantially contribute back into the capital markets. The implications, some of which you've captured there in your questions, are where we're thinking as well, my Lord. Certainly the first one around the skill sets and the experience of auditors will need to change. The mind-sets of approaching and thinking about risks to a business model auditors do to some degree now, as part of their work, but I think that we're taking this to a very different level. So we, as a professional body, will need to demonstrate our leadership in building it into our core education programmes and training. So I think there's a large piece of work there that if you're going to change the model you need to make sure your profession has the right skills and experience. I think we're coming from a good foundation there but I think there's much more to be done around how that could be improved.

  The pricing element is really a very interesting question and the pricing element comes back to this core function around the relevance matter. At the moment in Australia, as I indicated, there is a degree of quite substantial discounting of audit fees going on. To some purchasers of the audit that means or it feels like audit is just a commodity that you can take off the shelf and anyone can buy. What we're trying to think about is making sure that the relevance and the value proposition is clearly understood. In doing that, if we can get the value recognition of audit to be improved, then I believe you will get the pricing to flow through as well.

  The Chairman: Thank you. Lord Smith wants to come in on this one and then Lord Tugendhat.

  Q160  Lord Smith of Clifton: Yes please. With regard to your second point, you were talking about mission creep on the part of the profession—the analysing business models and so on and just move away from just retrospective analysis of past finance—surely this needs to be delineated very carefully, because you are almost getting a sort of professional imperialism there. What is left to the board? If you have your auditors doing the business model and doing the retrospective analysis who, apart from the salesmen in the company, are doing anything?

  Mr White: Understood. I would fully agree and support your phrase that we need to very careful in the delineation. We believe that clearly the responsibility for the organisation rests with the management and obviously the board of directors. So, in the earlier comment that I made, the disclosure around the business model and the risk to those business models needs to, first and foremost, come from the organisation. So that information would then be what the auditor would need to reflect on. Now, that is where you're going to have to be very careful about whether there is new information that the auditor wishes to then introduce and how would that occur. But I haven't taken that as far in my thinking as perhaps where you're asking me to, but I certainly do support the issue around the delineation.

  The Chairman: Lord Tugendhat?

  Q161  Lord Tugendhat: Some of your most important companies in Australia are in the mining business and the most important market for the mining business is increasingly China. Doing business in China and being dependent on China gives rise to risks and hazards and unexpected eventualities that don't necessarily apply in other markets. Now, in the light of what you were saying and what Lord Smith said about mission creep, do you think that there are aspects of the business of companies in China that, in practice, are very difficult indeed for auditors to assess?

  Mr White: I might need a little bit more information there to understand the question. If I could perhaps at least offer up a first comment and then perhaps pass back to you, my Lord. Certainly the Australian economy at the moment is very reliant on our exports of our mining industries and certainly to China. We think it's been a very substantial component to why we were able to weather the GFC as an economy stronger than others. Are you alluding to the idea that there would be subsidiaries of Australian companies in China and how do you then get the audit assurance around those countries?

  Q162  Lord Tugendhat: Yes. I mean China is a very different place from OECD countries and Japan, of course, is an OECD country. So the more involved in China your biggest companies become the more there is an element of the unknown and uncertainty in the business environment, which both the management and the auditors have to consider.

  Mr White: I agree wholeheartedly. I suppose we could think of some other jurisdictions outside of China as well. That comes back to then the auditors discharging their responsibilities in a robust way and they have rules and points of focus that they need to deal with in what we would call group audit situations. In dealing with countries where potentially there is some level of greater risk, then the onus is really on the auditor to do what is required above and beyond perhaps the norm between an Australian and an English environment to making sure that they're getting the right level of audit evidence to support their opinions around that Chinese subsidiary, or any other country for that matter.

  I think an important element in this as well is how the regulatory frameworks are building up in each country and, again, how government regulators are starting to exchange information as well. Now, again, China is perhaps a little bit further away than some of the more western countries in these discussions but you can see this as being an important element to assist audit quality as things develop over time, too.

  The Chairman: Lord Lipsey?

  Q163  Lord Lipsey: Can I ask about limited liability? It is allowed in the United Kingdom but, on the whole, it's not been taken up; perhaps because there is a suspicion in many minds that it is auditors trying to get out of paying up when they mess up. But you appear to have felt that it has brought benefits in the Australian system. I wonder if you could expand on them and, in particular, might I ask does it apply across the board in Australia or only where it is agreed between the company and the auditors?

  Mr White: Let me just give a little bit of the Australian dynamics because I think the Australian model is quite different to what may have been introduced into the UK. As I understand it, in the UK your laws were modified to allow two parties basically to contract together about limiting liability and, therefore, you have this discretionary element to the arrangements. That is quite different to what we do have in Australia and I would have thought, without being derogatory in any way, the English model may be working against certainly some smaller audit firms or even mid-tier who might be wishing to engage with some significantly larger clients who then might be putting pressure on them to not go down the route of contracting out around liability.

  The Australian example or the Australian context is that it's mandatory. So anyone who is holding an Auditing Practising Certificate is required, under legislation, to hold minimum levels of professional standards capping. Therefore, while I think I heard some reference to saying, "Well, this is just the auditors getting out of situations", the drivers of this in Australia were quite different. The drivers in Australia were that the insurance markets for professional services pretty well dried up in the earlier part of this decade and, therefore, it was seen that legislation was required to bring the insurance back into a level of supply.

  Now, why was that incredibly important? Partly for the auditors but partly for the consumers of the audit services. You needed consumers to have confidence that the people they were dealing with had appropriate insurance sitting behind them. So it's an important component of consumer protection. The other part of the Australian scheme that works is that by being given the limited liability the auditor profession and practitioners have to demonstrate how they are improving their risk management and how they are improving the delivery of audit quality in order to see that level of giving, in order to bring the insurance components in.

  My Lord, I give just a little bit of further context here and I apologise—and it is starting to sound like I am more like a lawyer than an accountant, which is my training. The other element important to this in the Australian environment has been around proportionate liability. So, again, in earlier years we didn't have clarity in our laws around proportionate liability and that was more under the joint and several implications, which again meant that auditors, at times being the last man standing, were seen to carry too much of a burden in proportion to perhaps the directors or others involved in whatever financial difficulties there were.

  So the introduction of proportionate liability was a very important element to strengthening our audit profession and community. It meant basically auditors bore a proportionate amount of responsibility to what the courts felt they were responsible for. So the two elements that have contributed a lot to strengthening the Australian framework were the introduction of compulsory professional standards legislation, the capping of liability, together with the proportionate liability as well.

  The Chairman: Thank you. Lord Maclennan?

  Q164  Lord Maclennan of Rogart: There is increasing interest in a continuous assurance approach to audit. We wonder if the necessary software and systems might be so costly as to strengthen the audit market position of the Big Four firms. Might it be, impractical for smaller audit firms to develop software to monitor their client systems on a continuing basis?

  Mr Stringer: Perhaps I can respond to that. We believe, as we said in our submission, that the move towards continuous assurance is something that will happen perhaps as supplementary to, rather than replacing, the historical model that we currently work with. The question of whether there will be this large barrier to entry for the smaller firms is something that we do not believe is necessarily so. There will likely be a cost element but the underpinnings for that are in place already. The underlying technology is called XBRL and that is currently available at little or no cost. So, to go the additional step, we don't see that as a major hurdle.

  Mr White: What we would say is that with the development of continuous assurance you have two elements, my Lord. You have the technology element, which Mr Stringer has just referred to, but you also have the methodology side. Therefore, methodology, the major firms and certainly some of the mid-tier firms spend a lot of their time and energy in making sure they have a robust methodology and that's their own intellectual property and that's great. We, as a professional body, need to make sure that we're able to also assist practitioners with their methodology who mightn't be able to invest in it as substantially as others can. We will certainly be carrying that commitment through as the continuous assurance starts to be developed up in the auditing regime. So this continuous assurance was certainly another element we feel is certainly part of the future of the auditing and the investing community as well.

  Mr Stringer: If I could just add to that as well. A consequence that we can see of the emerging field of continuous assurance is the tighter integration of the external audit function and the greater use of the internal auditors as well. That might be something to be welcomed. There are obviously implications for all of us in how that moves forward.

  Lord Maclennan of Rogart: Thank you.

  The Chairman: Lord Smith?

  Q165  Lord Smith of Clifton: Yes. Gentlemen, we see from your evidence, when we're looking at this issue of conflict of interest between auditing and consultancy and providing other services, that the ICCA members follow a "threats and safeguards" approach to manage this potential conflict of interest. While it is broadly similar to the UK approach, while both may deal with what you call the real conflict of interest, how can we deal with the perceived conflict of interest that forms at least part of the expectations gap? And, on this, we have heard from other witnesses that they maintain Chinese walls and things like that. Well, I don't know about the Antipodes but in this part of the world Chinese walls are very permeable.

  Mr White: And, with no disrespect to our major trading partner now, yes, they're probably a bit vulnerable down here too, my Lord. It's really tough with the perception. It is really tough. It's like you and I could both be looking at a similar set of circumstances and I might be okay with that and you might just have a very different view. So it is a little bit that each individual will have a slightly different view in their own perception. But where I would reach out and say, "How do we tackle the perception issue"—because it's as strong as the real, no doubt about that—perhaps comes back to the conversation we've already had with some of the other Lords here today, which is around the future positioning of the audit committee.

  So in Australia if we can see the evolution of the audit committee developing, then the engagement of the external auditor in other activities outside of just the statutory audit really needs to be tested by an independent third party. To me, the right independent third party falls back to being the audit committee. So if the audit committee can clearly communicate to its stakeholders and shareholders that they have continually considered the relationship between the external auditor and any other services that auditor might be providing, notwithstanding they might be legally allowed within the frameworks within Australia, I think that goes a long way to helping deal with and tackle some of these perceptions.

  My advice to our membership is always very much focused, first and foremost, on perception rather than reality. While I may have some members at times who come to me and say, "But, Lee, we can deal with this, it's appropriate", I always say, "But how would you feel if this was on the front page of the Financial Review?", which is like your Financial Times. "If it was on the front page of the Financial Review, would you feel comfortable with being able to explain that perception?" I think that's always a really simple way to keep them focused on making sure that's first and foremost in their thinking.

  The Chairman: Thank you. Lord Tugendhat?

  Q166  Lord Tugendhat: Well, we've come quite a long way down the question list. If I could ask you this question. If you could introduce one measure to improve competition and choice in the Australian or the global audit market, what do you reckon it would be?

  Mr White: I have been thinking about this question, because it's quite a good one. I will probably, if I'm allowed, talk about two measures. First, I probably have already made enough representation around this, but it wouldn't be from an Australian perspective, it would be from a global one. It would involve saying if we could try to have alignment of the legal structures around the capping of legal liability and proportionate liability, I think that alignment would go a long way to assisting audit quality; because that's the goal that we are striving for.

  I think the second element would be that we need to be very careful that the growth of regulation cross-border activities does not become a barrier to auditors wishing to remain or at least join the audit profession. By that I mean that in Australia we have made mention that we have government oversight; the UK has the government oversight through the FRC; America has the PCAOB and so forth. What we are experiencing in Australia now is the visit from different audit regulators other than the home regulator.

  So, for example, the United States has been an audit regulator that comes to the Australian community and conducts oversight of Australian firms. So, if it is not managed carefully, as more countries develop audit oversight, you're going to have layer upon layer upon layer of regulators from different countries all visiting audit firms and firms will just say, "This is too hard", and will lead to a greater concentration of audit firms. So I reach out to regulators to make sure that they can try and align their work as sharply as they can.

  Q167  The Chairman: I was interested that you put the capping of liability first. I was going to ask you, if you hadn't mentioned it, where you would rate it but you have already dealt with that. Can I just ask you one question about it, though? I think I heard you say that this would, in particular, help to deal with quality and I just wondered to what extent you would also say that it would help very considerably to introduce more competition and make it easier for the non-Big Four to break into the big market?

  Mr White: Let me clarify my reflections there, my Lord. Certainly the first is around the quality and we agree with that. The second is we have certainly had direct feedback from our membership to say that they would not have remained in audit practice in Australia unless professional standards legislation and proportionate liability had been introduced. So it was very clear to us, particularly as you started to go down in size of firms, that this was a really important piece for them to remain competitive. Has it assisted firms come in? Very unclear for me to say that but I certainly can say it has been a very important component to preventing greater concentration in the Australian market.

  Q168  The Chairman: Well, I think it is a very interesting note for us to end on; unless there is anything else you would like to say?

  Mr White: I'll ask Mr Stringer as well whether he did. Mine would be to say thank you very much for the opportunity. We share the passion and the focus of our British friends around audit quality and so thank you for the opportunity to present our views. And we look forward to the tour around the Ashes and we look confident that we will remain successful in that sphere, my Lord.

  The Chairman: Are you going to say anything, Mr Stringer?

  Mr Stringer: I would just like to echo Mr White's comments and thank you again.

  The Chairman: I won't comment on the controversial last point.

  Lord Tugendhat: I was in Melbourne, down in Australia, when you won 5-0 last time. I think hope springs eternal, but we have a better team this time.

  The Chairman: Can I also thank you very much, not only for the interest you have taken in our inquiry and for the evidence you've given us, but for the very helpful dialogue we've had today. We're particularly grateful to you for doing this at such an ungodly hour, from your point of view. So thank you very much indeed for your help.

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