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

Supplementary memorandum by The Lord Sharman (ADT 41)



1.   Reforms to achieve fair and regular public tendering (perhaps once every five years) with independent oversight to provide opportunities for firms to increase their market share. Mazars in their written Evidence suggest the tendering might be 2-stage `providing for the submission of a short document at the first stage by a number of firms from which a shortlist would be selected for the final presentation.' Kingston Smith in their written Evidence suggest that at least one non-`Big 4' firm should be included in the tendering process.

  I think that this has merit, as I said in my evidence I would require Audit Committees to carry out a formal evaluation of their audit relationship every five years, and if it was decided not to tender, then to explain the reasons therefore in the Audit Committee report.

2.   Mandatory rotation of audit firms as in Italy (but, if specified inappropriately, mandatory rotation of all audits might compound the problem of market concentration if it led to `Big 4' firms supplanting `Mid-Tier' firms—not a problem if mandatory rotation limited to FTSE 350).

  I don't think that there is any evidence that this has improved matters in Italy. In the case of Singapore where it was introduced it has been reversed.

3.   Greater rotation of auditors (FSA)

  No comment.

4.   Transformation of the Audit Commission into a large audit firm.

  This has some attractions, particularly if its focus was on the public/private interface. The C&AG has since The 2006 Companies Act had the power to audit limited companies, so far I don't see much evidence of the moving outside the public sector, although I have always believed that there is a strong case for them auditing certain public interest enterprises eg The Big Four, who are audited by 2nd Tier firms.

5.   Removal of the mandatory requirement for an audit, leaving it to market forces. It has been argued that government intervention has stifled competition in the audit market and is responsible for the market concentration.[9] If this is so, then this Inquiry needs to be cautious about recommending measures which would entail further government intervention.

  I don't agree with this assertion, I can see no basis for it.


6.   Greater use of shared audits by leading listed companies.

  I can't see shared (as opposed to joint) audits working-the extra cost involved in the principal auditor reviewing and validating the work of the second auditor would make it economically unattractive.

7.   Mandatory requirement for joint audits (as distinct from shared audits) of large companies or just of large financial entities. Possibly mandatory joint audits with one of the two firms required to be a `non Big 4 + 2' `Mid-Tier' firm (Mazars evidence). With a joint (as distinct from `shared') audit, both audit firms provide the overall audit report and opinion, and the audit work would be required to be shared equitably in order to encourage the `Mid-Tier' firms to grow. Joint audits make it less likely that the auditors develop a too-trusting `cosy' relationship with the client. Mandatory joint audits would create `regulatory capital' for non-`Big 4' firms (Oral evidence on 07Dec10).

  Although I am not greatly in favour of joint audits, I think that they are expensive and inefficient, they have worked in the past and in other parts of the world. If they worked so as to open up the big four international networks to second tier firms this would be worth pursuing.

8.   A regulatory code of conduct promoting the use of non-`Big 4' firms: this might be as auditors of subsidiaries within large, public groups.

  I don't for the reasons set out in 6 above think that this is viable.

9.   Board's risk committee of large companies should be advised by someone who isn't the firm's auditor (another source of advice which would not require the same sort of global network and could therefore be provided by a non-Big 4 firm. A bit like a joint audit. (Baroness Hogg, 9th November).

  I support this for both the risk and the audit committees. The adviser does not necessarily need to be an audit firm.


10.   Placing limits on the market share of firms measured by the number of appointments held, say, over a five year period, monitored by representatives from regulators and investors (Grant Thornton's suggestion in their written Evidence to this Inquiry)

  This seems to me to be a classic competition solution (limit market share) I can't see why it would not work.

11.   Elimination of covenants restricting choice of auditor, which even sometimes stipulate which of the `Big 4' should be used.

  I'm not aware of this as a major issue, but I agree the proposal is sensible.

12.   The audit committee's report to explain why they considered the need to appoint a `Big 4' firm.

  This is a sensible proposal (see 1 above)

13.   According to Standard Life's March 2009 response to the EC's consultation on `control structures in audit firms and their consequence on the audit market', Standard Life considers another catalyst to accelerate access to international audit markets would be for boards and/or their audit committees [to] disclose when and how periodic formal evaluations of the internal and external auditors were undertaken and the key conclusions arising therefrom.

  Again sensible (see 1 above)

14.   Strengthen audit committees and require them to report/justify publicly their work and rationale re. audit and no-tendering decisions.

  Agreed (see 1 above)

15.   Break up of one or more of the Big 4.

  If this were to be considered (again a classic competition measure) it needs to be looked at by reference to audit market share and not the total size of the firms measured by say revenues. It could be achieved in the context of 10 above by requiring divestment of audits to 2nd tier firms.


16.   Relaxing the limit to the amount of outside capital of an audit firm (currently set at less than 50% by the EC). Ownership rules of auditing firms need to be changed (FRC—9 November).

  I think that this would be helpful.

17.   Increased investment by, or mergers of, non-`Big 4' firms in order to create one or more larger ones (Mr. Ashley Almanza, Hundred Group and BG in oral evidence on 07Dec10).

  I think 16 would be necessary which I think is desirable.

18.   `Second-tier' firms must be encouraged to invest more (to enhance their international networks, etc) (Lord Sharman's oral evidence—14th December).

  I think 16 would be necessary which I think is desirable.

19.   Defection of a large number of specialist bank auditors from a `Big 4' firm to a `mid-tier' firm.

  I would leave this to the market, if 16/17/18 were to be achieved then the environment for this to happen would have been created. This should include specialist auditors in any field.

20.   A workable mechanism for the limitation of auditor liability, so that the risks of auditing large entities do not outweigh the benefits. Possibly a cap on auditor liability (as in Austria, Germany, Greece) and also the introduction of proportionate liability.

  This is highly desirable, and is already viable as a result of The 2006 Companies Act. I am not in favour of a cap as opposed to proportionate liability, nor I suspect would Institutional Investors be either.


21.   Alternative appointment processes for auditors, eg involving shareholder panels, or appointment by regulator.

  These could be viable, but I believe that any move to disenfranchise the shareholders in the process is wrong.

22.   The audit committee to appoint the auditors, as in the US under Sarbanes-Oxley and report in some detail their decision (E&Y witness).

  This works but UK law requires appointment by the shareholders in general meeting, this can be achieved by the audit committee recommending to the AGM the appointment and explaining the reasons therefor.

23.   Introduce a financial statements insurance approach as an optional alternative to the present audit.[10]

  An interesting concept which would need to be explored with say Lloyds of London to see if the market would be willing to underwrite such risks.


24.   Reduce complexity of financial reporting and auditing standards to better enable smaller audit firms to cope with the audits of large companies.

  Given where we are I don't see this as viable.

25.   Narrow the scope of the annual audit, so that companies can get other advice from other firms, so allowing mid-tier firms to compete better.

  I think that this would be a retrograde step, we need broader assurance including looking forward not more narrow assurance.

26.   Consistency/alignment of the regulatory framework globally would help, but may be insufficient (Shell: oral evidence, 7 December 2010).

  This is desirable but won't be the solution.

27.   Make sure that regulators of cross-border activities do not act as an effective barrier to using non-`Big 4' audit firms.

  This is a valid aim.

28.   The regulator should be less burdensome of the profession (Q50 of transcript of 19 October 2010 session—answer by Mr. Hodgkinson of ICAEW: `Oblige regulators to consider how regulation affects availability of choice. Make it a criterion for regulatory action because it is clearly of public interest.')

  I don't agree. By contrast with other regulators, the FRC has not in my opinion been overly burdensome.

29.   The regulator needs a contingency plan for orderly transition of audit clients if a Big 4 firm fails (Mr. Ashley Almanza, Hundred Group and BG in oral evidence on 07Dec10).

  I agree.

30.   Develop living wills for the largest audit firms to mitigate the risk of any exiting the audit market (Deloitte witness).

  Again I agree


31.   Find a way of ensuring that the largest institutional investors act together to influence large companies to consider `Mid-Tier' audit firms, as `they usually get the changes they are looking for'

  This would be desirable, they have and continue to be very effective on remuneration issues. Perhaps shareholder committees is one way forward.

32.   The FRC should convene a group of large institutional investors to come up with audit market intervention initiatives.

  It will be interesting to see what they come up with.


  33.   Ignore the present system and build an alternative in parallel, alongside the present system.

  Great in theory, but where do you start and what sort of a system would you seek to build?

34.   First, work to reduce market concentration in FTSE 250 audits so as to build a sustainable platform for the `Mid-Tier' firms to be able later to compete effectively for FTSE 100 audits.

  This would be good in process terms but the 2nd tier need to understand that The FTSE 100 is the aim.

9   Benedikt Koehler, (2006): `Audit Market Failure', in Economic Affairs, journal of The Institute of Economic Affairs. Back

10   Joshua Ronen, (2010): `Corporate Audits and How to Fix Them', in Journal of Economic Perspectives, Spring, vol. 24, no. 2, pps 189¸210. Back

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