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

Memorandum by KPMG LLP (ADT 31)

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

  1.1  Independent reports from Oxera and London Economics to the UK Government and regulators and the European Commission underlined that the drivers to concentration were greater capacity/international coverage to serve global/complex organisations; technological innovation; need for industry knowledge/expertise to serve clients, reputation and liability risk. Concentration was exacerbated by the regulatory response to the problems of Arthur Andersen which led to its collapse.

  1.2  The market pressures continue today. The world's major companies continue to expand both through organic growth and consolidation demanding an ever increasing international audit capability. At the same time diverse national regulatory requirements continue to increase—including registration, annual returns, inspection, disclosure and ethical standards. This means significant investment in processes, infrastructure, expertise and technology but most importantly in people who are essential to quality. These factors create economies of scale which do help firms to expand and drive a virtuous circle with the best people joining those firms that are successful, reinforcing that success thereby attracting the best people.

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

  2.1  No. Cost is an important factor in the consideration of the appointment of auditors. A KPMG survey of Audit Committee Chairs puts cost as the fifth highest factor in the appointment of auditors behind issues like auditor communications, robustness and perceptiveness. In our experience when audits are put out to tender there is fierce competition, including on price, across all sizes of company. Even for those companies which do not go out to tender the audit fees are often benchmarked and in our view an appropriate balance is normally struck between cost and quality.

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

  3.1  No, we haven't seen any evidence that suggests that audit quality has declined since the consolidation to fewer large firms. Quality of opinion is paramount to the reputation of audit firms. This is backed up by rigorous training, strong ethics and enhanced by the multi-disciplinary nature of the UK profession.

  3.2  The Snyder-Myners Report, Professional Services Global Competitiveness Group in 2009 recognised the world leading position of the UK profession, "The UK accountancy profession is well respected and influential internationally. The resilience and strength of the UK multi-disciplinary model and the emphasis on judgement and principles are internationally recognised."

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

  4.1  No. Although it is possible that this may have happened, we have not seen any evidence that supports this argument. In our view the more important factors have been the profound and welcome changes to the profession in recent years—independent oversight, public reporting, the role of audit committees and the introduction of a code of governance for the major audit firms. These have all enhanced the independence of auditors and underpinned improvements in audit quality.

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

  5.1  The auditor is currently responsible for auditing the financial statements—prepared by management—to provide reasonable assurance to the investors that they are fairly stated in all material respects. The financial crisis has challenged all the key players in the global capital markets to re-examine their roles and effectiveness and the business reporting and the assurance framework should be part of this re-examination.

  5.2  We believe however that it is essential to retain the existing division of responsibilities—the company reports and the auditor provides assurances on those reports. Within that framework KPMG is keen to engage in the debate and find solutions that carry broad support. This might include expanding both the nature of assurance reporting and extending its scope beyond the financial statements and even perhaps beyond the annual report to other forms of corporate reporting. There might, for example, be some form of risk reporting for which auditors may not be the exclusive provider of assurance.We have also made suggestions as regards reporting to financial institution regulators in our response to the recent consultation paper from the FSA and FRC, we set out some of these ideas in our answers to question 7.

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

  6.1  In our experience auditors were sufficiently sceptical in the run-up to the financial crisis. We disagree with recent assertions to the contrary by some in the UK regulatory community. Such assertions of a lack of scepticism do not accord our engagement with regulators at the time. In any event, even if our view on professional scepticism was to be challenged we see no obvious connection with concentration.

  6.2  As the House of Lords Select Committee on Economic Affairs Report said in June 2009 "We have no evidence that bank auditors failed in their statutory duty to make 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."

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

  7.1  In our view whilst the auditors can contribute to an improved regulatory and micro-prudential regime, they could not themselves have "mitigated" the banking crisis. Banking as an industry is heavily impacted by the general economic environment and asset prices in particular. This environment is shaped primarily by politicians, policy makers and central banks across the world. The need for change in this area is also recognised. As the Governor of the Bank of England said recently "We let it slip|the crisis was caused not by problems in the real economy; it came out of the financial sector." We welcome the new focus in the UK on financial stability and better macro and micro prudential supervision—as auditors we stand ready to play our part in that.

  7.2  In the UK we support a new transparent and coherent process with a clear set of principles for a good working relationship between regulators, financial institutions and auditors. KPMG welcomes the debate that has been started by the FSA and the FRC on this and the parallel dialogue with the Bank of England. We have discussed in our response to the recent FSA and FRC consultation paper how a framework of dialogue between those charged with governance, auditors and regulators might work. The table below summarises our proposals.

Meeting Type ObjectiveAttendees Timing
Micro prudentialCovering culture, risk appetite, business model, what can go wrong, key judgements and decisions, effect of macro prudential issues Tri-lateral: Regulators, Audit Committee and Auditors Semi-annual
Micro prudential"Safety valve" meeting between auditor and regulator Bi-lateral: Regulators and AuditorsAnnual or as required
Micro prudentialDiscussion of key accounting judgements and disclosure Tri-lateral: Regulators, Audit Committee and Auditors Pre-issuance of financial statements—could be expanded to half year/quarterly reports
Micro prudentialCross border regulator issues Tri-lateral: Relevant Regulators, Audit Committee and Auditors Annual
Macro prudentialFSA and auditors market issues—may require hot topic sub groups to continue discussions Large audit firms and regulatorsQuarterly
Macro prudentialFinancial Stability Board/G20 agenda Large audit firms and regulatorsSemi Annual
SupervisoryPerformance of audit firm (see comments on monitoring arrangements below) Audit firm, FRC and FSAAnnual

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

  8.1  We do not believe that there should be any significant limitations on the client information that could be shared between regulators and auditors and financial institutions as part of the trilateral process that we advocate.

  8.2  The difficulty is in filtering and identifying the key issues from such a volume of information. This requires a structured reporting framework and communication mechanism setting out what information is required, when and in what format. This whole area might benefit from a code of conduct or a set of protocols which formally recognises the respective roles and responsibilities of all the different parties.

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

  9.1  We believe the incentives are already very strong. It is critical to the reputation and hence success of the audit firms that they provide objective advice, which in some cases will be unwelcome to clients. This is supported by clear ethical and professional standards and is an area on which the FRC already has a clear focus with their central objective of market confidence in high quality financial reporting and corporate governance.

  9.2  Audit committees also play a key role in this dialogue and we have commented on their role further below.

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

  10.1  In our view the issue is more one of perception than reality. We fully accept however that it is important to deal with this perception, but we believe this is best achieved through the triple lock of strong corporate governance; a clear Code of Ethics and the threats and safeguards approach. In addition, the recent agreement to a Code of Governance by the larger UK audit firms and the appointment of independent non-executive directors will further reinforce the public interest nature of the profession. The APB has been looking at reforms of non-audit services and in July 2010 published the results of consultation and reported that the "overwhelming view" was that there should be no outright prohibition of non-audit services but further consultation on stronger guidance to audit committees; extension of the threats and safeguards approach and a specific look at a small number of service areas like restructuring advice. KPMG support this approach whilst agreeing with the view of the Synder-Myners Report that "strong provision of other services like tax advice is critical to the competitiveness of the corporate sector."

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

  11.1  Our Joint European Chairman John Griffith-Jones wrote in the FT 15 September 2006, "We agree that in an ideal world there would be more than four `big' audit firms. Greater realistic choice for companies can only be a good thing|.the solution lies in the creation of a successful fifth firm not the destruction of the existing four."

  11.2  In the UK the FRC—through a Market Participants Group reporting in 2007 set out 15 recommendations to increase choice in the audit market whilst maintaining quality and independence eg a code on corporate governance for larger firms and guidance to audit committees re use of larger firms. In Europe, Commissioner McCreevy studied a variety of reforms and recommended in 2008 that there should be liability reform across the EU to improve choice and competition. These approaches which "encourage" rather than "require" and consider, for example, cost/benefit and regulatory burden are consistent with the emphasis of the new UK Coalition Government.

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

  12.1  The internal auditor is only one, albeit important, way in which the directors and management control a company. The range of companies and their activities is in our view too great to set any general mandatory internal audit requirements. In addition, within the regulated financial sector the FSA already review whether the level of internal audit within individual institutions is appropriate.

  12.2  As regards the relationship between internal and external auditors this is governed by the International Standards on Auditing which in our view strike an appropriate balance between the desire to prevent unnecessary duplication (and hence inefficiency) with the need for the external auditor not to rely unduly on a function which is by definition not independent. These arrangements are subject to both company review (Audit Committees) and regulator oversight (AIU inspections and APB review).

13.   Should the role of audit committees be enhanced?

  13.1  In the UK Audit Committees have a powerful role and we have not identified any areas which need enhancing. The UK Corporate Governance Code (which defines the role of the audit committee) and the associated FRC Guidance for audit committees is kept under regular review by the FRC and already goes well beyond the recent requirements introduced by the EC Statutory Audit Directive. It was last updated in 2008 in response to MPG recommendations to require disclosure of how the audit committee reached its recommendation re the appointment of the auditor (including information on tender frequency, tenure of the incumbent auditor and any contractual obligations that restrict the audit committee's choice).

  13.2  However, it is key that investors in particular have confidence in the those appointed as their agents and we remain open minded as to how this might be enhanced for example through being more involved in the selection of non-executives.

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

  14.1  In our opinion the knowledge gained during an audit and the experience auditors have through auditing many businesses ensures they are well placed to promote good corporate governance (both in the round and for their audit clients). EU Directives (and International Auditing Standards) require external auditors to report to the audit committee (or others charged with governance) on key matters identified during the audit including deficiencies/weaknesses in internal control.

  14.2  Audit firms have taken the lead in promulgating good governance practice. For example, long-before Sir David Walker's recommendations stressed the importance of training and development for non-executive directors, KPMG set up the Audit Committee Institute (now operating in 30 countries) to provide complimentary guidance and a variety of resources designed to assist audit committee members (and other non-executive directors) update and refresh the skills and knowledge which are essential to their role. This is a serious commitment with around 50 seminars, workshops and other colloquium provided each year in the UK.

28 September 2010

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