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

Letter from Ernst & Young (ADT 30)

  We welcome this inquiry from the House of Lords Economic Affairs Committee as an opportunity for an open dialogue with Parliament, regulators and the general public about the issues. We are pleased to submit evidence in response to it.

  Ernst & Young is one of the largest global professional services organisations. We provide audit, accounting, tax, corporate finance and other business advisory services to businesses of all sizes in all sectors; not just financial services. Our UK activities are overseen by the Institute of Chartered Accountants in England & Wales, with further supervision over certain parts of our business by the Financial Reporting Council (FRC), its Operating Bodies and the Financial Services Authority (FSA).

  In preparing our evidence, we consulted with other member firms in the Ernst & Young network.

  We attach a two-page summary and an eight-page Appendix in which we set out our answers to the Committee's specific questions.

  For further information or to discuss this submission, please contact Andrew Hobbs, Director, Regulatory & Public Policy, using the contact details above. We would also welcome further conversations with you and the Committee's advisor Professor Chambers. We would be happy to elaborate on any of the points made in this letter at the forthcoming oral evidence session.


Competition and choice

  1.  The UK market for audits of large listed companies is highly competitive. That said, we recognise that concentration of auditor choice is an important issue. Ideally, there should be more choice in the large listed company audit market. As we have consistently said, we are in favour of promoting the capability of the mid-tier audit firms through market-based initiatives that remove any barriers to entry or expansion that may exist. We do not share the perception that only the Big 4 networks have the depth and reach to participate in the market for large listed company audits.

How has Ernst & Young responded to the crisis?

  2.  Like many others, we have used the financial crisis to consider how we can improve what we do as well as to consider the role of our profession as a whole. Here are a few key examples relevant to the Committee's inquiry.

  3.  To provide the highest quality audits, we believe we need to be as globally integrated as possible. Thus we have continued to move forward to integrate our organisation internationally. This is enabling us to be more effective at identifying accounting, risk and reporting issues and communicating with clients about them. We also continue to review our own internal processes to identify areas for improvement. For example, we have continued to integrate our financial services practice, have enhanced our (independent) engagement quality reviews, and deployed scarce specialist skills across boundaries.

  4.  Independent non-executives will join Ernst & Young's Global Advisory Council, the highest global governance body in the Ernst & Young organisation, to advise on the public interest aspects of Ernst & Young's decision making, risk management and stakeholder dialogue.

  5.  Since the crisis began we have contributed to UK initiatives to develop policy affecting corporate governance, financial reporting and the audit profession, including the Walker Review, UK Corporate Governance review, audit firm governance, FSA regulatory reform and the FRC's various guidance on going concern.

What needs to change?

  6.  All stakeholders need to reflect on the crisis and challenge the status quo. The audit profession is no exception.

  7.  Global coordination is a necessity, not a luxury, in today's interconnected and interdependent markets. Regulators and standard-setters need to continue to work together to achieve global consistency. Effective audit oversight is an important part of this. With more than 140,000 people working in more than 140 countries, Ernst & Young would welcome much greater connectivity and coordination between national audit oversight bodies. In financial reporting, the lack of progress in achieving a single set of high quality global accounting standards has been particularly disappointing.

  8.  Strong corporate governance is fundamental to a company's health and to the well-being of our economy. Seeking to strengthen the corporate governance framework holistically, rather than focussing on some of its individual components, should be at the heart of any proposals for change.

  9.  We have also turned our minds specifically to the question of corporate reporting and auditing. Financial statements are prepared by companies and the accounting judgments are the responsibility of management and the directors. They are a historic snapshot of a company's financial health. A statutory audit is an examination of a company's financial statements carried out in accordance with independently prescribed auditing standards. After the audit is completed, the auditor issues an audit opinion which is published as part of the financial statements. It states whether or not the financial statements show a true and fair view of the company's business operations and financial health during the period covered. It is designed to provide reasonable (not absolute) assurance that the company's financial statements are free from material misstatement.

  10.  Except for the going concern statement, the audit does not provide any assurance about a company's future performance because financial statements are backward-looking.

  11.  We believe the current reporting and auditing model delivers significant value to users. In light of the crisis, some stakeholders have questioned this value. We are always open to any positive change that enhances stakeholder confidence and which improves audit quality. We would support the following enhancements:

    (a) Strengthening audit committees so they are better placed to challenge management, auditors and their respective judgements. Such strengthening would also better equip them to support the auditor's dealings with management.

    (b) Better reporting by audit committees and/or auditors about the existing value of audit and how auditors discharge their professional responsibilities.

    (c) New high quality disclosures to help companies provide a fuller picture of their financial position, business model and future viability. Enhanced assurance over these disclosures would also be required. The key objective should be specific reporting which avoids boilerplate language. Liability risks present challenges to this objective. Safe harbours for management, audit committees and auditors should be explored.

    (d) We also support a greater role for auditors in prudential regulation. This would include a regular dialogue between bank auditors and supervisors to share in both directions as much information as possible relevant to their respective roles; and in carrying out their prudential responsibilities, supervisors could make more and better use of auditors and other external experts using targeted risk based reporting.

  12.  In 2006 the global CEOs of the six largest audit networks including Ernst & Young published a vision paper1 which explored many of these issues. It highlighted increasing globalisation and the growth of emerging markets. It recognised that auditors could only contribute to the stability and strength of capital markets in this new world if corporate reporting and auditing standards were global; if independent audit oversight bodies became more formally coordinated; and if the large audit networks continued to improve the consistency of audits across the different countries in which they operate. This included enabling audit networks to integrate more closely. We continue to believe these are essential drivers of audit quality.

  13.  In the UK alone, policy initiatives are already underway in relation to many of these issues. Ernst & Young is pleased to be actively involved in all of these debates. We recognise the vital importance of ensuring there is a robust framework for corporate governance, corporate reporting and auditing that meets the developing needs and expectations of our stakeholders.

27 September 2010



  For more information about our organisation, please refer to our UK transparency report.[4] It provides insights relevant to the Committee's specific questions.

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

  1.  Concentration through consolidation has been driven mostly by the staggering growth in number, size and reach of multinational companies, the need for scale to build effective global networks to audit these companies, increasing litigation risk and the demise of Andersen in 2002. A 2006 Oxera report on competition and choice in the UK audit market[5] provides more detail.

  2.  The audit market for large listed companies in the UK is concentrated among the Big 4 audit firms. Outside this, the UK audit market is much less concentrated. As at September 2010 Ernst & Young's share of FTSE350 audits stands at 17.4% (61 audits). Our share of FTSE100 audits stands at 18 audits.

  3.  Only the very largest global companies require the geographic reach and industry specialisation of the Big 4. However, there is a widespread misconception that only the Big 4 networks have the depth and reach to participate in the market for listed company audits. As we have consistently said, we are in favour of promoting the capability of audit firms outside the Big 4 through market-based rather than regulatory initiatives

  4.  By way of a specific example, the six largest global audit networks including Ernst & Young recently wrote to the OECD arguing for the removal of Big 4 only clauses in loan agreements. We do recognise though, that in the short to medium term, it will be difficult for audit firms who do not already have the capability to enter the market for large listed companies for a number of market-driven reasons including: (i) significant investment required for market entry; (ii) the long investment horizon; (iii) liability risks; and (iv) audit client inertia.

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

  5.  No. The largest audit firms are extremely competitive. Auditors are subject to reappointment by management and the shareholders every year, during which process audit fees are negotiated. The company can choose to switch auditor if satisfactory terms cannot be agreed.

  6.  Listed companies also run competitive tenders for both audit and non-audit services. However, companies do not change their auditor very often because running tenders and changing auditors is costly. It takes time for auditors to build up knowledge of the company and to form strong relationships with the audit committee, both essential factors in ensuring audit quality. When audit tendering does occur it is highly competitive, and the incumbent is typically retained in only a third of cases.

Does a narrow field of competition affect objectivity of advice provided?

Alternatively, does limited competition make it easier for auditors to provide unwelcome advice to clients who have relatively few choices as there is less scope to take their business elsewhere?

  7.  We do not accept the premise that there is limited competition. In any event, in our experience, concentration in the UK audit market is not linked to the objectivity of advice. Objectivity is driven by personal qualities, reputation, professional training, industry codes of ethics, ethical and independence standards, auditing standards, and continuing professional development; not to mention positive reinforcement in the workplace, including tone from the top. At Ernst & Young these drivers are supported by a detailed system of internal quality control.[6]

  8.  The UK is also recognised as a global leader in the regulation and oversight of the audit profession. The drivers of objectivity are reinforced by independent oversight, disciplinary schemes, and potential civil and criminal liabilities.

  9.  Ernst & Young's client acceptance and continuance policy establishes a rigorous process for determining whether to accept a new client or continue with an existing relationship. This policy is fundamental to maintaining quality, managing risk, protecting our people and meeting regulatory requirements. A company's propensity to "opinion shop" or to exert unreasonable pressure on its auditors is a highly relevant factor to client acceptance and continuance.

  10.  Auditors and accountants are highly regulated; ethics is integral to the sector and ingrained in its qualifications and working practices. At Ernst & Young, our culture of ethics and integrity is embedded in our training programmes and internal communications. As part of our approach to professional values, our employees are expected to follow a strict Code of Conduct.

  11.  The requirement to maintain independence and objectivity is one of Ernst & Young's ten principles of quality and risk management which apply globally across our organisation and against which our people are evaluated and rewarded.

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

  12.  Auditors play an essential role in the functioning of the global capital markets and add value to the roles played by other stakeholders such as preparers, investors and regulators. We are committed to promoting and enhancing transparency to instil confidence in financial markets. Transparent financial information facilitates the allocation of capital to its highest and best uses, which in turn drives economic growth and rising standards of living.

  13.  Financial statements are prepared by companies and the accounting judgments are the responsibility of management and the directors. They are a snapshot of a company's financial health at a particular point in time. A statutory audit is an examination of a company's financial statements carried out in accordance with independently prescribed auditing standards. After the audit is completed, the auditor issues an audit opinion which is published as part of the financial statements. It states whether or not the financial statements show a true and fair view of the company's business operations and financial health during the period covered. It is designed to provide reasonable (not absolute) assurance that the company's financial statements are free from material misstatement.

  14.  Except for the going concern statement, the audit does not provide any assurance about a company's future performance because financial statements are backward-looking.

  15.  Independent assurance of that information by the external auditor builds trust among stakeholders that the information can be relied on, thereby instilling investor confidence. Independent research, recently published by Maastricht Accounting, Auditing and Information Management Research Center (MARC)[7] provides strong support for this.

  16.  We believe the current reporting model delivers significant value to those who use it. However, the audit profession and other market participants need to reflect on the crisis and challenge the status quo. Working with professional bodies, regulators, investor groups and the audit profession, we have been developing our thinking on how corporate reporting and audit for all companies may be enhanced. Our views are as follows:

    (a) There is a need to increase awareness of how auditors discharge their professional responsibilities.

    (b) A coherent framework needs to be developed to enable listed companies to provide high quality disclosures that provide a fuller picture of their financial position and future viability. This would include better (not necessarily more) information about business models and the risks to it; internal controls; and management judgements and estimates. Such enhanced reporting will likely also require assurance.

    (c) The key objective should be specific reporting which avoids boilerplate language. New disclosures by companies about their business should be meaningful and auditors should provide assurance statements which provide better information about what the auditor has done. Unfortunately liability risks present challenges to the objective. Safe harbours for management, audit committees and auditors should be explored.

    (d) To maximise the benefit for all stakeholders, these improvements need to take place within an internationally consistent framework which includes a single set of high quality global accounting standards.

Were auditors sufficiently sceptical when auditing banks in the run-up to the financial crisis of 2008? If not, was the lack of competition in auditing a contributory factor?

  17.  While Ernst & Young audits many banks outside the UK, we did not audit any of the major UK headquartered banks during the crisis. Our UK perspective on this question is therefore limited by this fact.

  18.  A challenging mindset is a key driver of audit quality. Accordingly, the application of professional scepticism is a fundamental auditing requirement. It is important that we have an open discussion about the concept because it will enhance stakeholder understanding of and confidence in the auditor's work. We therefore welcome the Auditing Practices Board's paper on the topic.[8]

  19.  Concerns about professional scepticism in the audit of banks have been raised by the FSA in its joint Discussion Paper with the FRC[9] and more generally by the Audit Inspection Unit of the Professional Oversight Board (AIU) in its latest round of reporting. We have seen no evidence which suggests there is a pervasive lack of scepticism in the audit profession. Moreover, as shown by successive AIU reports the fact remains that the quality of listed company audits in the UK is good. We recognise that improvements can always be made and Ernst & Young continues to make significant investments in training and processes to achieve this.

  20.  There is also room for new and alternative ways for auditors to better demonstrate the application of scepticism to investors and regulators. In this regard, we believe that a professional judgment framework for preparers and auditors, which encourages a critical, reasoned, rigorous, thoughtful and deliberate approach to decision-making, would strengthen financial reporting and audit quality and contribute to the exercise and demonstration of professional scepticism.

  21.  We do not believe that audit market concentration has any impact on professional scepticism. The key drivers of objectivity and professional scepticism, including the significant reputational, regulatory and financial risks for auditors, exist regardless of the number of market players.

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

  22.  We support the Committee's findings from its 2nd Report of Session 2008-09:

    "We have seen no evidence that bank auditors failed in their statutory duty to make a going-concern judgement on their clients. Bank auditors should not be required to make a more general judgement on the quality of their clients' strategies. In any event, it is unlikely that auditors would be more able than financial supervisors to identify structural problems in the financial sector".[10]

  23.  Audits are focused on individual entities. However, the risks giving rise to the financial crisis were market-wide and not confined to a single entity or geography. Accounting standards and the audit profession played an important role in bringing some realities of the banking crisis into sight quickly. Although painful, this enabled investors, management, creditors and policymakers to recognise problems or opportunities on a timely basis so they could make informed decisions and take appropriate corrective actions.

  24.  The financial crisis presents all stakeholders with an opportunity for positive change. In this regard, auditors and prudential supervisors are examining how auditors might contribute to better supervision of banks. In June 2010, the ICAEW published its report on how the audits of banks might be enhanced.[11] It provides a good explanation of how auditors might contribute to better bank supervision. We support its recommendations including the increased use of section 166 reports and increased interactions between prudential supervisors and auditors. On 29 June 2010 the FSA and FRC published a Discussion Paper on the topic.[12] If the Committee would like a copy of our response, please let us know.

  25.  The six largest UK audit firms have recently joined a working group comprising representatives from the FSA, FRC, ICAEW and chaired by the Bank of England. Its purpose is to consider how the relationship between auditors, firms and regulators can be more clearly defined to permit more useful and comparable disclosures about judgment issues and the sensitivities around material valuations. The working group will also seek to define ways in which the relationship between auditors and prudential regulators can be enhanced in practical terms.

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

  26.  Regular exchange of information between auditors and bank supervisors enables both parties to perform their duties more efficiently and effectively. We therefore welcome the FSA's new consultative approach and the recent improvements in both the frequency and quality of dialogue. Ernst & Young now meets with the FSA and the other five large audit networks on a regular basis. This year the FSA has sought meetings with us on a bi-lateral basis every six months. We meet with individual supervisors about certain individual institutions around twice a year.

  27.  There is still room for significant further improvement. In particular, discussions between the FSA and auditors must be a two-way process for sharing as much information as possible. This includes information about individual entities and market-wide information held by prudential regulators. In the short term, the FSA needs to find ways within its legal constraints to notify auditors of relevant concerns, with a review of the current legal constraints in the long term.

  28.  Tri-lateral engagement (FSA, auditor, financial institution) is equally important. The FSA should also increase its interactions with audit committees.

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

  29.  The existing drivers of objectivity explained in paragraph 7 of this Appendix provide a good platform for the provision of objective advice to clients. In many ways the most important driver of objectivity is talented professionals. For this reason, regulators need to help ensure that the audit profession continues to be able to attract and retain talented individuals with the requisite diversity of skills.

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

  30.  Conflicts of interests, which can arise between the provision of audit and non-audit services to the same client, are just one of a number of potential threats to auditor independence. The UK regulatory regime adopts a "threats and safeguards approach". This provides that such threats can be managed by audit committee oversight, transparency, the implementation of safeguards and in some cases prohibitions.

  31.  Responses to a recent APB consultation indicate that there continues to be widespread stakeholder confidence in this approach.[13]

  32.  Audit firms operate in a highly regulated environment with strong independence requirements both for audit firms and individual auditors, who also subscribe to robust ethical codes. Audit firms also have to operate a strong system of independence controls and are subject to significant independent oversight. That said, we accept there can be situations where it would be inappropriate to provide certain non-audit services to an audit client.

  33.  Greater transparency about the nature and amount of non-audit services auditors provided to audit clients should address any remaining perceptions among some stakeholders that objectivity and independence is impaired by their provision. We seek to achieve this through our transparency report, as well as statutory public disclosures, which outline revenues attributable to different segments of our firm. This information provides companies and investors with the relative size of the non-audit practice as compared to the audit practice.

  34.  There also needs to be better disclosure in company annual reports of the audit committee's policy on non-audit services together with clearer information of how non-audit services are categorised (many non-audit services are actually integral to the audit) plus additional guidance for audit committees. In 2010, we were pleased to assist the Institute of Chartered Accountants of Scotland to develop recommendations[14] for the FRC and the Department for Business on this issue.

  35.  It is worth noting that the majority of our non-audit services are provided to non-audit clients. They made up 62.4% of our UK revenue for the financial year ended 2 July 2010 as opposed to 13.4% of total UK revenues for non-audit services provided to audit clients. Assurance services for audit clients made up the remaining 24.2%.

  36.  Auditors at multi-disciplinary firms can further increase their business acumen and technical skills by working at non-audit clients. The opportunity to develop multi-disciplinary skills encourages the recruitment and retention of high quality professionals; an essential component in audit quality.

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

  37.  The terms audit concentration, audit competition and choice are sometimes used interchangeably when they refer to different issues. Audit concentration is a small number of audit firms, such as the Big 4, performing audits for one particular market (eg FTSE100); audit choice means the number of audit firms available for companies to choose; and competition refers to a fair contest for market share among any number of audit firms.

  38.  A robust, competitive, listed company audit market positively impacts on audit quality and innovation. It is therefore in the best interests of investors and the capital markets.

  39.  There continues to be healthy competition in the audit market but we recognise that there could be greater choice. We therefore welcome sensible efforts to increase choice in the listed company audit market and support recommendations that might help to increase choice without compromising audit quality. Regulators and other capital market participants should encourage market-based initiatives to encourage auditor choice of the kind identified by the FRC's Market Participants Group.[15] Imposing solutions that are not market-based are likely to lead to unintended consequences.

  40.  The risk of catastrophic liability for auditors of large listed companies can serve as a barrier to entry for some of the smaller audit firms. Catastrophic liability itself could create further consolidation in the larger listed company audit market. Policymakers need to take steps to ensure that choice is not further eroded by the disappearance of one of the remaining audit networks.

Should the role of internal auditors be enhanced and how should they interact with external auditors?

  41.  Consistent with our view that policymakers need to examine the governance framework holistically, options for enhancing the role of internal audit should also be investigated. This is particularly relevant in financial institutions where failures in organisation-wide risk management were a key factor contributing to the crisis. In this respect, we support the prevailing FSA view that internal audit in financial institutions should focus on systems of governance, risk management and internal controls. We would support stronger reporting lines by the Head of Internal Audit to the Audit Committee Chair with a dotted line to the CEO/CFO rather than the CRO. There is also a need for internal audit to shed its traditional image as a monitoring role. It should be seen as a function that rigorously audits an organisation's policies and processes to ensure they are properly implemented and effective.

  42.  Internal and external audit serve different purposes. They have different responsibilities, different accountabilities and are independent of each other. Nevertheless the roles are complementary at times. It is important they are aligned when planning their respective work to avoid duplication of effort and to maximise the total assurance that they provide.

Should the role of audit committees be enhanced?

  43.  Yes, this is extremely important. High quality reporting requires audit committees, as representatives of shareholders, to be strong, dedicated and thoroughly engaged.

  44.  Audit committees could be strengthened by looking at: (i) their composition; (ii) their experience, skills and training; (iii) their resources; (iv) greater audit committee accountability for the selection and oversight of auditors; (v) better audit committee reporting about the financial reporting process; (vi) more regular meetings between audit committees, boards and auditors; (vii) auditors reporting to the shareholders' meeting; and (viii) better engagement between investors and audit committees.

  45.  Enhancing the audit committee's role will help reinforce auditor independence and support the auditor in exercising professional scepticism. Stronger audit committees will be better placed to challenge management, auditors and their respective judgements. Such strengthening will make them better equipped to support the auditor in their dealings with management.

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

  46.  Yes. By way of an example, Ernst & Young has extensive financial reporting and corporate governance knowledge and experience, gained across all markets and geographies. In order to promote best practice in corporate governance, in the UK we operate programmes such as the Independent Director Programme and the Audit Committee Chair Forum. Internationally, Ernst & Young convenes a series of audit committee leadership networks in conjunction with Tapestry.[16] Their purpose is to promote positive change in corporate governance, improving the performance of audit committees and enhancing trust in financial markets.

  47.  We also believe firms like Ernst & Young have an opportunity to be exemplars of good governance. Strong governance has been fundamental to the integration of our organisation and to strengthening our ability to provide consistent, high quality service worldwide. In recent years we have embraced many changes to audit firm governance such as independent regulation and the separation of management and governance functions.

  48.  In January 2010, the FRC and ICAEW issued the Audit Firm Governance Code. Its purpose, whose origins preceded the financial crisis, is to promote confidence and choice in the UK audit market and provide a benchmark of good governance.

49.  At Ernst & Young, we see the publication of the Code as a real opportunity. Over the past few years, we have moved to integrate our organisation and strengthen our ability to provide quality audits. For us, much of our ability to do this depends on strong governance and tone from the top. For these reasons, for the first time we will appoint independent non-executive representatives will join our organisation. They will join our Global Advisory Council, the highest global governance body in the Ernst & Young organisation. Their role will be to advise on the public interest aspects of our organisation's decision making, risk management and stakeholder dialogue.

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