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

Memorandum by PricewaterhouseCoopers (ADT 32)

  1.  Auditors make an important contribution to the economic health of the nation through the role they play in corporate governance and the functioning of the capital markets by providing independent assurance on the financial statements of companies. Furthermore, the largest audit firms are important employers and developers of talent in their own right. However, we recognise that, in the aftermath of the recent financial crisis, stakeholders and policy makers are questioning whether auditors could make a greater contribution to the strength of the capital markets. The Committee's inquiry will be an important contribution to this debate.

  2.  In developing our evidence, we have reviewed the questions set out in the Committee's "Call For Evidence" and have concluded that they can be summarised as addressing the following broad topics:

    — The impact of concentration in the audit market (questions 1, 2, 3, 4 and 11).

    — The role of the auditor during the financial crisis and potential areas for future development (questions 5, 6, 7, 8 and 9).

    — The potential for conflicts of interest between audit and consultancy roles in multi-disciplinary firms (question 10).

    — The relationship between sound corporate governance and the external audit function (questions 12, 13 and 14).

  We address each of these issues below.

  3.  The issues addressed in this inquiry are complex and we note that many of the topics set out above are already the subject of detailed consultations in the UK and elsewhere. We will be responding to each of these consultations, where appropriate in conjunction with other firms in our global network. In particular, we believe it is important for any legislative action taken by the UK government or regulators to recognise the key requirement for the UK to remain competitive in a global environment.

  4.  We would be happy to provide further information in support of our evidence and to provide oral evidence at subsequent hearings if the Committee would find this helpful.


  5.  We believe that the audit market is an effective and competitive market. Since 2002, the auditing profession has made a significant number of changes to improve audit quality and to provide greater transparency around their own internal governance, partly in response to the recommendations by the FRC's Market Participants Group in 2007[17]. Some of these recommendations have only just been implemented and it is therefore too early to assess whether they have been effective in implementing both supply-side and demand-side measures to increase confidence in the profession. We believe that these initiatives should be monitored and their impact assessed before any further action is taken.

  6.  More immediately, action could be taken to make the audit process more transparent through better communication of the dialogue between audit committees and external auditors; and through more regular dialogue with stakeholders and regulators. At the same time we would welcome a wider debate about corporate reporting, focusing on a more integrated model that provides a more coherent, and less complex, picture of a company's performance and exposure to risk. Any such debate should include a discussion of the role that independent assurance can play in enhancing public confidence in the reporting model.


  7.  The introduction to the "Call for Evidence" states that "audit is dominated globally by the Big Four". This situation was created primarily by a process of consolidation during the latter part of the 20th century which reflected the needs of capital markets in both geographical spread and complexity, leading to the creation of five large global networks in 1998, subsequently reduced to four with the demise of Arthur Andersen. These mergers arose in response to market demands for audit firms with the necessary networks, people, methodologies and reputation to deliver quality audits for the largest multinational corporations.

  8.  In the context of the UK audit market, the concentration of audit appointments on the four largest firms is only true for the audits of companies listed on the main board of the London Stock Exchange. Below this level there is a wider range of firms supplying audits. For example, in February 2010 56.6% of the audit of companies quoted on the Alternative Investment Market (AIM) were audited by firms other than the largest four firms[18]. For this sector and for unlisted companies, the audit market remains highly fragmented.

  9.  The European Commission[19] acknowledged the importance of size when it determined that:

    "audit and accounting services to quoted and large companies form part of a separate product market: the necessity for such companies to have audit and accounting services provided by a firm with the necessary reputation in the financial markets (in the case of quoted companies), the geographic breadth to cover the companies' needs worldwide (in the case of multinationals), the depth of expertise in the particular sector (large companies in general and, in particular, regulated sectors such as banking and insurance) and significant resources (all large companies)| All these features are only provided by one of the large global audit and accounting networks".

  10.  The relationship between audit quality and the relative size of the audit firm is acknowledged by the Audit Inspection Unit of the Financial Reporting Council[20] which stated that:

    "The AIU continues to find that a higher proportion of audits conducted by smaller firms require significant improvement. "

  11.  We are aware that some commentators are concerned that the practical restriction, at least in the short term, of a segment of the audit [and accounting] services market to four rival suppliers, may mean that the intensity of competition is reduced; and that, if this was indeed the case, it might result in outcomes inferior to those that would be expected in an effectively competitive market—lower efficiency, higher prices, less innovation and reduced quality.

  12.  We believe that these concerns are without foundation. There is intense competition between the four largest audit firms to win and retain the audits of large companies and these appointments are subject to independent governance. Such competition ensures that PwC and its competitors have every incentive to offer the quality global audits demanded by the large corporate clients, to be efficient and innovative, and to pass on the benefits to clients through the lowest possible prices. Delivering value to our clients whilst ensuring we do not compromise on the quality of our audits is the key priority of our own assurance business.

  13.  Critically, the reason why having four large firms competing for the supply of audits to the largest UK companies is sufficient to engender fierce competition is that the UK audit market is a "bidding" market. When choosing an auditor, large companies use a competitive tender process. It is recognised by economists and competition authorities that bidding markets have different characteristics from other markets, leading to intense competition even where there are relatively few suppliers.

  14.  In its investigations of the audit market when considering the merger of Deloitte & Touche and Andersen (UK)[21], and earlier the merger of Price Waterhouse and Coopers & Lybrand[22], the European Commission acknowledged the bidding nature of the audit market and how this imposed competitive constraints on the audit firms. In particular, it noted that:

    "launching an invitation to tenders imposes a competitive constraint on the incumbent auditor, often leading to a re-negotiation of the fees" and that "any of the Big Five could possibly win or loose (sic) a competitive tender, without any clear link towards its existing market shares".[23]

  15.  Because of the expense involved in the tendering process itself, as well as the dislocation, cost and quality risk involved in bringing in a new auditor, large companies do not choose to put their audit out to tender very frequently. There are other mechanisms for companies to ensure price competitiveness. For example, we are aware of situations where clients have used the statutory requirement for auditors to be reappointed annually as a tool in negotiations over the level of fees.

  16.  Furthermore, since the typical length of an auditor-client relationship can extend over many years, the incumbent auditor is aware that its competitors would make a serious investment in attempting to win over its client for what would be likely to be a long-term relationship. Competitive pressures are thus brought to bear on auditors, without the need for frequent costly tender processes which would themselves raise the costs of both the audit firms and their clients, without necessarily improving the quality of the audits provided.

  17.  That there has been no new entry since the five large firms became four is itself indicative that competition in the market is working successfully for the large company audit clients, and that the market is not sufficiently attractive to other potential suppliers of large audits in terms of the investment-risk-reward payoff to encourage investment. This is an indication that the market is working effectively, and that prices are not excessive in relation to the costs and risk of supply.

  18.  This pressure on prices leads to a need to ensure efficiency in the provision of audits. This in turn has to be balanced with the regulatory focus on the continuous improvement in audit quality. This was recognised in the AIU's 2010 public report on PwC[24] which stated:

    "The firm's strategy includes quality as one of its main priorities. The leadership of the firm and audit practice continues to focus on initiatives to improve or maintain audit quality, whilst also aiming to achieve efficiencies on audits. Although there is no evidence to suggest that this has detracted from the focus on audit quality, continued care is needed to ensure the emphasis on efficiency does not adversely affect audit quality. "

  19.  Following the collapse of Arthur Andersen in 2002, there have been a number of significant regulatory initiatives to improve the quality of audits, including the independent monitoring of auditors of public interest entities by the AIU and the development of rigorous ethical standards to ensure that auditors remain objective in their relationships with their clients. Further regulatory initiatives have addressed the need to provide additional transparency around the governance of audit firms, culminating in the adoption in the UK of an audit firm governance code[25] which incorporates the appointment of independent non-executives by the eight largest audit firms.

  20.  These initiatives are relatively new and it is too early to demonstrate how effective they are in developing market confidence in, and thus enhancing the competitiveness of, the next tier of audit firms. We believe that it would be helpful to monitor the implementation of these initiatives and to assess their impact before any further action is taken.


  21.  Following the financial crisis, all participants in the capital markets have a responsibility to reflect on the causes of the crisis and to examine the potential for changes in the way the markets operate in future. In this context, the role of the auditors was addressed by the House of Commons Treasury Select Committee[26] which stated:

    "We have received very little evidence that auditors failed to fulfil their duties as currently stipulated. The fact that some banks failed soon after receiving unqualified audits does not necessarily mean that these audits were deficient. But the fact that the audit process failed to highlight developing problems in the banking sector does cause us to question exactly how useful audit currently is. "

  22.  In response to this challenge, we are taking steps towards changing the role and responsibilities of auditors. [For example, we have committed to a closer working relationship with the banking supervisors and are actively participating in a number of other initiatives in conjunction with the FRC and the UK professional accounting bodies].

  23.  More recently, there has been a suggestion by the FSA and FRC in a joint discussion paper[27] that auditors may have been insufficiently sceptical in their audits of banks in the run-up to the crisis. We do not accept this assertion.

  24.  Professional scepticism is fundamental to what auditors do. It is defined in auditing standards[28] as "an attitude that includes a questioning mind, being alert to conditions which may indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence." Whilst practical application of this requirement is judgemental and will vary according to circumstance, it is hard to evidence. Scepticism is inevitably applied in real time and is a cultural and behavioural issue. To reinforce the culture of scepticism, we have a robust system of internal quality control reviews and consultation procedures. We believe that this is working. It is our experience that, in the vast majority of cases, audits give rise to changes in the financial statements prior to issuance.

  25.  It is the job of the auditor, as established by internationally agreed auditing standards, to challenge management's assertions and ensure that they are backed with evidence that is appropriate, supportable and capable of independent verification. It is not the auditor's job to develop alternative views and then try to persuade management to adopt them in preference to theirs.

  26.  As indicated above, however, the recent financial crisis has raised questions about the role of the auditor, particularly in the context of the audit of banks. We are already taking steps to address these questions. In the context of banks, we recognise that more regular bilateral and trilateral meetings with the supervisors of our audit clients will enhance both the supervisory and audit processes by encouraging greater dialogue and information sharing by all parties. We were active participants in the development of the proposals set out in the ICAEW Financial Services Faculty report[29] which also addressed the need for improved risk reporting by banks and the potential for increasing the level of assurance over these disclosures. We will continue to participate in developing more specific proposals in these areas in conjunction with other stakeholders.

  27.  More generally, we recognise that there is a need for significant improvements in corporate reporting and consequential changes in the role of the auditor. As a first step, we recognise that how auditors currently discharge their professional responsibilities is often opaque. To ensure investor confidence in company's financial statements we believe that it is essential that the audit process is made more transparent. One way to achieve this would be for audit committees to disclose more details about the dialogue between them and the external auditors. At the same time, there should be a wide-ranging public debate about the future of corporate reporting to identify ways in which the reporting model can be more integrated and less complex. This debate should include all stakeholders, including investors, government and regulators, and should incorporate a discussion of the role that independent assurance can play in enhancing public confidence in the reporting model.


  28.  The UK audit profession has operated for many years largely through the medium of multi-disciplinary practices providing a range of taxation, advisory and consulting services in addition to assurance services. It is important to recognise, however, that the growth of these other services is not dependent on the provision of non-audit services to audit clients.

  29.  Where non-audit services are provided to audit clients, there is an effective principles-based ethics regime requiring the analysis of the threats to objectivity and the application of appropriate safeguards. This has worked effectively both in the UK and elsewhere in the world. This regime recognises that there are circumstances where no safeguard can be established, resulting in strict prohibitions.

  30.  The effectiveness of this regime, combined with the key oversight role played by audit committees in considering and determining the appropriateness of the appointment to provide non-audit services, has been an important factor in increasing the level of independent scrutiny and thus increasing confidence in the regime. It was notable that very few respondents to the October 2009 consultation on the topic by the Auditing Practices Board[30] identified significant concerns about the effectiveness of the current system.

  31.  An analysis of the annual reports of major listed companies indicates that there has been a significant reduction in the proportion of non-audit fees to audit fees in recent years. At the same time, audit firms have recorded significant growth in revenues from services to clients where they are not the auditor, illustrating that this growth has not been generated from their audit client base. Consequently, we do not believe that the continued growth of multi-disciplinary firms represents a conflict of interest with, or a threat to the objectivity of, the audit services provided by the same firms.

  32.  In contrast, we believe that the ability of auditors to operate within the framework of multi-disciplinary practices is important for the following reasons:

    (a) A profitable growing firm is in a better position to invest in the continuous improvements in audit quality necessary to allow it to respond to the increasing demands of business, shareholders and regulators.

    (b) The existence of a range of skills and breadth of experience within an audit firm allows for greater insight into market issues and can significantly augment audit quality, particularly in the audit of complex business transactions. This was acknowledged by the AIU in their 2009-10 Annual Report which stated[31]:

"The increasing use of internal specialists, especially by the major firms, to evaluate valuations performed by client specialists and to assist in the audit of other complex audit areas such as taxation and pension balances contributes to improving the quality of audit evidence obtained in these areas. "

    (c) Multi-disciplinary practices have a significantly enhanced ability to recruit and retain the highest quality professionals. A working environment where employees have the ability to learn and develop skills beyond audit and accounting is more attractive to recruits.

    (d) Secondment opportunities to work in specialist areas, such as valuation and business recovery services, provide auditors with new skills and they return to audit better equipped to challenge management and to apply the level of professional judgement necessary in today's complex financial reporting environment.

    (e) Profitable, growing multi-disciplinary firms are less dependent on the fees from any one individual audit client. As a result they are better able to deal in an objective and unbiased way with potential conflict with management over issues that arise in the course of the audit.

    (f) The co-location of other professional services with a regulated audit business ensures that the culture of objectivity and professionalism pervades all of the firm's activities.


  33.  The key organs of corporate governance are the board of directors and the audit committee which set the tone for the organisation as a whole. As such, their relationship with the external audit function is important to ensure public confidence in UK companies. Internal audit is intentionally an internal function of a company which is established to respond to the needs of management.

  34.  Audit committees have a vital role to play in promoting sound corporate governance and in challenging management. There is already provision for dialogue between the audit committee and the external auditor but we recognise that external investors would welcome greater insight into the nature of that dialogue. Audit committee reports to investors currently focus primarily on procedural issues but they could be expanded to address the significant issues raised by the auditor in their report to the audit committee. This could embrace the significant risks of material miss-statement in the financial statements, alternative accounting treatments and the principal matters of judgement discussed with the audit committee and would provide stakeholders with greater insight into the external audit function and the way in which the audit committee is discharging its role.

24 September 2010

17 Back

18   Fifth report of the Financial Reporting Council on Choice in the Audit Market, June 2010. Back

19   Case No COMP/M.2810-Deloitte & Touche/Andersen UK, Merger Procedure Article 6(1)(b) Decision, Commission of the European Communities, 1 July 2002. Back

20   AIU 2009/10 Annual Report, 21 July 2010. Back

21   See 1 above. Back

22   Case IV/M.1016-Price Waterhouse/Coopers & Lybrand, Commission Decision of 20 May 1998. Back

23   Deloitte & Touche/Andersen UK, see footnote 1. Back

24 (section 2.2 page 9). Back

25 Back

26 (para. 221 page 77). Back

27   Financial Services Authority & Financial Reporting Council Discussion Paper DP 10/3 "Enhancing the Auditor's Contribution to Prudential Regulation", June 2010. Back

28   International Statement of Auditing (ISA) 200, para 13(l). Back

29   Institute of Chartered Accountants in England & Wales Financial Services Faculty "Audit of Banks: Lessons from the Crisis", June 2010. Back

30 (para. 2.4 page 10). Back

31   Financial Reporting Council Audit Inspection Unit 2009/10 Annual Report, 21 July 2010. Back

previous page contents next page

© Parliamentary copyright 2011