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

Supplementary memorandum by Baroness Hogg and Mr Stephen Haddrill, Financial Reporting Council (ADT 27)


  We are pleased to provide the Committee with this further letter following up on the issues that were raised in the course of our oral evidence on 9 November. This letter also responds to the Committee's request for further information on contingency planning on how to respond to the withdrawal from the audit market of one of the Big Four and issues concerning IFRS and the Companies Act 2006.


  The regulation of accounting and audit has evolved from a self-regulatory system and today it is the Financial Reporting Council (FRC) which provides oversight of the auditing, accounting and actuarial professions. We believe that further steps are necessary to strengthen the FRC's position as an effective, independent regulator.

  In order to facilitate this transition, the FRC needs increased powers to:

    — Gather information on failed companies to establish whether governance or audit failures were contributory factors;

    — License auditors of public interest entities; and

    — Investigate and discipline misconduct by auditors.

  Legislative change is also needed to enable the FRC to rationalize its current structure and ensure that information can be freely exchanged internally.

  In future we believe the FRC should have a greater capacity to be proactive in identifying and responding quickly to problems in capital markets. We currently have powers to monitor the quality of audit, and we review 300 sets of accounts each year. We also conduct investigations into potential misconduct by members of the accountancy and actuarial professions. However, we have limited powers to inquire into the accounting judgements of companies that have failed; our investigations into misconduct cannot compel evidence from, eg, directors who are not accountants and are very time consuming; and our audit inspections are established for the purpose of annual monitoring, and have insufficient powers for exploring urgent issues that fall outside our routine monitoring. This means that we are dependent upon the goodwill of the firms in helping us to understand whether there are any lessons to be learned in other areas, for example from the collapse of a number of companies supplying the public sector.

  We believe that additional measures could be taken to strengthen our independence and enhance audit quality:

Information sharing

  The FRC believes that better information sharing across our organisation and with fellow regulators, would benefit the market and help to spot and manage risks.

  There are currently restrictions on information sharing between some of the FRC's operating boards. For example, under current legislation the Financial Reporting Review Panel (FRRP) is unable to share information on companies whose accounts it may be investigating with the Audit Inspection Unit (AIU). We would ask the Committee to support legislation which will enable effective information sharing across the organisation.


  The increasing complexity of global business practice and enhanced investor expectations of the auditors of public interest entities require auditors to have a greater degree of expertise and experience to manage adequately the risks involved.

  We therefore propose an additional licensing regime for auditors of public interest entities. The need for this is shown by the evidence of the AIU's 2010 Annual Report, published in July 2010, which concluded that "the number of audits assessed as requiring significant improvement at major firms is too high" and among other firms a higher proportion of audits conducted required significant improvement. We believe a new regime for auditors of public interest entities should be provided by the FRC while the professional accountancy bodies should retain responsibility for the oversight of smaller firms.

  The ICAEW, in their letter to the Committee of 23 November about the audit inspection and monitoring regime, suggested that the existing regime could achieve our goals. It is correct that the Audit Registration Committee (ARC) has responded to individual reports made by the Audit Inspection Unit (AIU). However, the regime currently operates within very tight parameters. The AIU is restricted in the action it can request the ARC to take; its efforts to broaden the definition of what is a public interest entity have been challenged; as has its wish to undertake non-routine inspection work without seeking the ARC's permission.


  The current professional disciplinary regime is complicated and is not as independent or effective as it should be. At present the Accountancy and Actuarial Discipline Board (AADB) is required to consult with the relevant professional body before it can begin a disciplinary investigation. It has no statutory powers to obtain evidence.

  We believe that the independence of the process is compromised by the requirement placed upon the AADB to consult and seek the agreement of the professional bodies—this is the product of the previous self-regulatory system that we believe should now come to an end.

  To address this issue we therefore propose the clarification and streamlining of the AADB's discipline scheme. All disciplinary cases relating to public interest audits should fall to the AADB in the first instance.

  Where the market has been misled deliberately it is important that a robust sanctions regime is in place to deal with such behaviour. We are concerned that this does not exist at present and that the sanctions available to the FRC are limited, meaning that the most appropriate remedy is sometimes not available to us. We would therefore like a more tiered sanctions regime to be put in place which, accompanied by other changes outlined in this letter, would strengthen the FRC's independence and contribute to the better operation of the market.

  Taken together we believe these measures would significantly improve the accountability of the audit profession, strengthen the FRC's independence and put in place a robust sanctions and company investigations regime in the public interest.


  The governance structure of the Financial Reporting Council was significantly strengthened three years ago, reducing a large representational council to a Board of 16 members (currently consisting of a non-executive Chairman, the Chief Executive, 6 chairmen of the operating bodies and 8 independent non-executive directors). However, further changes under consideration for the coming year are intended to have the effect of increasing the majority of independent directors on the Board. These are selected to provide a wide range of skills and experience in business, investment institutions, the professions and policy-makers, including those affected by the work of the FRC. However, as the table below shows, there are no practising auditors on the Board, nor on the boards of the bodies responsible for auditor discipline.

BoardNo of members Current Big Four accountants or auditors Ex-Big Four accountants or auditors
FRC Board16 03
Accountancy and Actuarial Discipline Board (AADB) 1002
Professional Oversight Board (POB)11 02
Board for Actuarial Standards (BAS)16 00
Accounting Standards Board (ASB)10 31
Auditing Practices Board (APB)15 54
Financial Reporting Review Panel (FRRP) 2945
TOTALS10712 17

  There are specific rules in the FRC constitution pertaining to the AADB, which must always contain a lay majority, and the POB, where no board member can be a practising auditor and a majority of members must have been out of practice for at least five years.


  The FRC has been concerned for some time that the failure of one of the Big Four audit firms would have serious implications for the stability of the capital markets. The disorderly movement of partners and audit teams to other firms could result in companies not being able to produce audited reports and accounts on the timescales expected by the markets.

  The FRC has therefore put forward proposals aimed at addressing this issue and we have discussed our recommendations with both the Government and prudential regulators.

  The key issues that the FRC believes need to be addressed are:

    — The need for a clear statement that the government/competition authorities would break up a "Big Three";

    — A resolution regime and internationally agreed mechanism to ensure the orderly wind-up of a failing firm;

    — A system for ring-fencing healthy parts of the network; 

    — An early warning system of significant threats to operations; and

    — Living wills for accountancy firms.

  Tackling this issue will require action and agreement both internationally and across a range of UK regulatory bodies and competition authorities. The FRC has written to the Financial Stability Board (FSB) and recommends that the UK Government takes up the issue with the FSB with a view to it being discussed at G20 level in due course.

  The FRC does not believe that any of the Big Four should be seen as too big to fail. In particular, the taxpayer should not be expected to subsidise losses and regulators should not hold back from disciplinary action against misconduct. The value of audit depends wholly on confidence in its quality. Firms must not be disincentivised from the pursuit of quality by expectations of state protection.

  The Big Four are now global networks. This gives them resilience against the collapse of one part of the network. Resources can be transferred and loss of business need not be catastrophic. However, as audit business is dependent on client and investor confidence, the networks' strength can also be a source of vulnerability, as such loss of confidence in one country becomes contagious. The FRC believes that the networks are strong enough to survive a failure in most markets, but not in the US or probably the UK. The adequacy of response to a crisis is therefore of particular importance in both countries.

  Governments and regulators have liaised closely in the past if a network has been threatened to ensure any necessary action is co-ordinated and consistent. The international nature of the firms and of market confidence requires this. Such action has been specific to the cause of the problem.

  The success of such action depends on the authorities having enough time before failure becomes catastrophic. To that end, the FRC has agreed with the firms a protocol providing for the early warning of any significant threat to UK operations, including—to the extent known—from overseas.

  Such measures are valuable, but are not capable of ensuring against failure. Audit failure may have been so serious that the firm needs to close. Early warning depends on failing parts of the firm not keeping their problems secret from the network. News that damages confidence can have a very rapid impact, as seen in the wake of Enron.

  Governments and regulators do, therefore, need to be clear what their policy and plans will be if a network collapses. This needs to cover two major issues: how is audit work to be conducted in the short term and what long term structure is proposed for the audit market?

  More work needs to be done on devising a vision for a longer term structure ahead of a crisis. The audit market would face major challenges if it was shared between just three firms. Depending on which firm failed, there could be no competition for the business of large companies in some sectors, such as energy and insurance. In all sectors, conflicts of interest would arise between audit and non-audit business as the remaining three sought to pick up clients of the failed firm. We therefore believe that a market dominated by three firms is not desirable. However, in a crisis it could come about by default as the partners and teams of the failed firm would be rapidly recruited by the other large firms. To reduce the risk of this, we propose that the competition authorities, in the EC, UK and US in particular, should indicate in advance of failure how they would be likely to respond. A statement in advance that they would act to break up a Big Three would help to prevent this being created. We believe collaboration between Governments, competition bodies and audit regulators to consider market structure in the event of a major failure should be initiated.

  At the point of crisis, the authorities need to act to preserve market confidence consistent with their longer term vision. If, as we believe, that vision should not foresee the creation of a Big Three, the failing firm will need to be kept as a viable operational entity until new arrangements for handling its work are put in place. Under current legislation, this is not easy to achieve. Partners and employees cannot be forced to stay with the firm, nor can clients.

  Finally, whilst public authorities need to plan their actions, we believe the firms' own plans also need to be developed fully. The concept of living wills could be borrowed from the financial services sector. These would set out how a firm would segregate, under regulatory supervision, how good and failing parts of the business will be separated and funded.

  It is vital that cross-border contingency plans are put in place and to achieve this we recommend that the Government engages first with the Financial Stability Board and then at G20 level to coordinate action that will lead to a plan being put in place.


  The FRC has studied carefully the issues raised in your letter and we hope that the following response will help to clarify the Committee's understanding of the issues relating to IFRS and the Companies Act 2006.

  The FRC has consulted BIS and shares its view that the adoption of IFRS was in conformity with the Companies Act 2006 because:

    — The use of IFRS for the consolidated accounts of all groups listed in the EC was expressly mandated by the EC in 2002.[45]

    — In addition, the EU gave individual Member States the right to decide whether to require the use of IFRS for the preparation of individual accounts of listed companies and their subsidiaries, and for any other companies. Following a consultation in 2002,[46] the UK Government resolved to permit the use of IFRS by such companies.

    — The necessary changes to the legislation to reflect these, and other, changes to the UK legislation came into effect on 12 November 2004.[47]

  We would also like to address the underlying concern that IFRS resulted in financial statements that showed a higher profit (or smaller loss) than would have been the case under UK GAAP.

  Whilst it is right that the introduction of IFRS led to certain situations where profits could differ from those under UK GAAP, it is not the case that IFRS would always result in a higher profit than UK GAAP. So, for example, while the UK GAAP requirement to amortise goodwill would result in a reduction in profit as compared to IFRS, in contrast the effect of discounting financial assets carried at amortised cost when there is evidence that there has been an impairment loss under IFRS would result in a lower profit than under UK GAAP.

  The FRC has consulted with BIS and shares its view that the introduction of IFRS did not give rise to breaches of sections 830 and/or 831, Companies Act 2006.

  Those sections prescribe the manner in which a company must determine the profits that it has available for distribution. They provide that the profits as shown by a company's financial statements should be the starting point for determining the profits available for distribution. They then provide for various adjustments to be made to take account of a number of factors. Once those adjustments have been made, it is for the directors of the company to decide the amount of any dividend to be paid to shareholders.

  Directors make such decisions:

    — in the light of the company's "realised profits" as defined by section 853(4), Companies Act 2006. The method of calculating profits regarded as realised "in accordance with principles generally accepted at the time when the accounts are prepared" is set out in "Guidance on the Determination of Realised Profits and Losses in the context of Distributions under the Companies Act 2010[48]; and

    — having regard to their fiduciary duty to act in the best interests of the company.

  In summary, whilst the accounting framework determines the calculation of the profits shown in the financial statements, the decision as to the amount of any distributable profits to be paid to shareholders by way of dividend is determined by reference to the company's realised profits (as defined in accordance with section 853(4), Companies Act 2006).

  The FRC shares BIS' view that, for these reasons, changes are not required to either IFRS or to the Companies Act 2006 in order to reduce any possibility of illegality.

  The FRC has urged the IASB to learn lessons from the financial crisis and a number of changes have been made as a result, for example to standards on the accounting for financial instruments. Other standards that have been reviewed, and where the FRC has been active in influencing proposals, include insurance accounting and leasing.

  I understand that the Committee has invited Roger Marshall, interim chairman of the ASB, to give evidence to the inquiry on 18 January on the effect of changes to accounting standards and he would be delighted to expound further on these points.


  In our oral evidence to the Committee on 9 November we set out several specific proposals to expand choice in the audit market which we feel it would be helpful to expand upon.

Audit Commission

  We believe that the abolition of the Audit Commission provides an opportunity for one or more non-Big Four firms to expand into that market and grow significantly. This could be the catalyst to encourage a fifth big player in the audit market. If the existing Audit Commission was kept together as a standalone entity, it would be the fifth largest audit firm in the UK. A strategic alliance with another mid-tier firm would enable it to access the corporate market as well as the public sector.

  Our objective in making a recommendation in this area is to ensure that the audit market does not become concentrated still further as a result of the Government's decision to abolish the Audit Commission. We recognise the practical difficulties that may need to be overcome to ensure the UK complies with European law relating to the procurement of public contracts but believe the prize of greater competition in the market makes this proposal worthy of further consideration.

Banking covenants

  The FRC echoes concerns that have been raised by auditors from mid-tier accountancy firms that restrictive bank covenants could contribute to audit market concentration and restrict choice. We recognise that in essence the issue is a commercial one although we believe there is sufficient anecdotal evidence to require a further investigation in to this issue.

  The Lending Standards Board (which replaced the Banking Code Standards Board) is currently consulting on the Lending Code. However, the Code applies only to private individuals and micro-entities and so is not an appropriate vehicle for addressing the bank covenant issue. In the absence of a similar Code for larger entities, we would urge a greater level of dialogue between the British Bankers' Association, lending institutions, audit firms and regulators to address the issue as soon as possible.

Risk committees

  The FRC would encourage banks and other systemic institutions to use non-Big Four firms as a source of advice to their risk committees. This would give such firms an exposure to large companies they might not otherwise have access to and may in time provide them with the opportunity to tender for the audits of some of these entities.

Ownership rules

  The FRC believes that serious consideration should be given to amending the current rules on audit firm ownership which would allow audit firms to access external capital.

  In principle we believe that it should be possible to change the current rules governing the ownership of audit firms without risking audit quality. Alternative ownership structures, including the possibility of raising capital from external sources, have the potential to make it easier for firms to invest to allow them to expand into the market for the audits of the largest companies. Research carried out by Oxera has indicated that the cost of capital in a partnership was considerably higher than in an ownership model which allowed for external investment.


  The FRC meets with market participants regularly to discuss their concerns and identify issues that need to be addressed. This engagement intensified following the collapse of Lehman Brothers in September 2008. During 2008 the FRC held two meetings with market participants, and a further two meetings were held in 2009. Typically, these meetings involved: companies, corporate treasurers, auditors, investors and business organisations. These formal meetings are held in addition to ad hoc meetings held throughout the year.

  The FRC issued guidance to the market in 2008 in response to concerns in the market that auditors would find it difficult to sign off the accounts of a large number of companies as going concerns because of the state of the credit markets.


  In our oral evidence we suggested that the audit process should be capable of providing an early warning signal to the market—something that was not delivered in either 2006-07 or 2007-08. We believe that the market is capable of providing more signals and the creation of a Market Participants' Group comprising regulators, auditors, finance directors and investors would enable warnings to be identified and discussed by the market. These issues could be addressed through market information, guidance or regulatory action. The FRC would be well placed to convene such a group and we would welcome the Committee's support for such a proposal.


  The FRC believes that company boards have a responsibility to encourage a culture of professional scepticism by auditors. The Committee requested further details on the work the FRC has undertaken to encourage auditors to demonstrate appropriate professional scepticism. We attach as an Appendix a discussion paper which we published in August 2010, along with another paper published jointly with the FSA and which deals with the financial sector specifically. We are currently analysing the responses to these consultations and will announce the outcomes in 2011.

  The Audit Inspection Unit's 2010 annual report also called on auditors to exercise greater professional scepticism particularly when reviewing management's judgements relating to fair values and the impairment of goodwill and other intangibles and future cash flows relevant to the consideration of going concern.

  We hope this supplementary submission is helpful to the Committee. As we say in our written evidence, we stand ready to play our part in implementing policies that will both enhance competition and quality in the audit market. We look forward to the Committee's analysis and recommendations.

22 December 2010

45   Regulation (EC) No 1606/2002 of the European Parliament and of the Council of 19 July 2002 on the application of international accounting standards (the IAS Regulation). Back

46   International Accounting Standards "A Consultation Document on the possible extension of the European Regulation on International Accounting Standards", DTI, dated 30 August 2002. Back

47   SI 2004 No 2947 The Companies Act 1985 (International Accounting Standards and Other Accounting Amendments) Regulations 2004. Back

48   ICAEW Technical Release-Tech 02/10. Guidance on the determination of realised profits and losses in the context of distribution under the Companies Act 2006. Available at: This guidance is issued following public exposure and independent legal review. Back

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