ABSTRACT
The Economic Affairs Committee's inquiry into Auditors:
market concentration and their role aimed to look into
two main issues:
- the dominance of the Big Four and its effects
on competition and choice; and
- whether traditional, statutory audit still meets
today's needs.
As the inquiry unfolded, the Committee also focussed
on two other important issues:
- the effect on audit of the adoption of International
Financial Reporting Standards (IFRS); and
- how banks were audited before and during the
financial crisis and what changes there should be, including in
auditors' relationships with financial regulators.
This report addresses all of these issues.
Identification of the shortcomings of the large-firm
audit market is easy enough. It is clearly an oligopoly with all
the attendant concerns about competition, choice, quality and
conflict of interest. It gave no warning of the banking crisis.
The narrowness of the assurance it offers is much criticised.
Its regulatory structure, in the UK and internationally, is complex
and unclear.
Yet investors, regulators and commentators regard
rigorous and reliable external audit as an essential underpinning
of business and the capital markets which finance it, in Britain
and elsewhere. The assurance offered by audit is especially needed
in the case of banks, with their attendant risks and where loss
of confidence can imperil the financial system. The importance
of audit is recognised by the legal requirement that medium and
large-company financial statements should be audited and by the
size and prosperity of the audit business, which is dominated
in Britain and globally by the Big Four: Deloitte, Ernst &
Young, KPMG and PricewaterhouseCoopers.
The Big Four's domination of the large firm audit
market in the UK is almost complete: in 2010 they audited 99 of
the FTSE 100 largest listed companies, which change auditors every
48 years on average. In bank audit in the UK there is only a
Big Three, since Ernst & Young are not active. This report
highlights the risk that one of the Big Four might leave the audit
market, leading to an even greater and wholly unacceptable degree
of concentration unless preventive action were taken.
The Committee's concerns about the Big Four's oligopoly
of large firm audit were intensified by their failure to give
warning of trouble in the run-up to the financial crash. Clearly
bank auditors cannot express concerns openly about banks' finances
without undermining confidence and risking a run. But the Committee
was highly critical of the fact that, as our evidence revealed,
confidential dialogue between auditors and bank regulators had
fallen away before the financial crisis so that there was no pooling
of information or concerns which might have given warning or allowed
some action to mitigate the worst effects. This failure to maintain
dialogue seems to the Committee a dereliction of duty.
The Committee also heard evidence that audit standards
had been lowered by the adoption of International Financial Reporting
Standards (IFRS). These became mandatory for EU listed companies
in 2005 and are intended to pave the way towards common accounting
standards around the world including the US. The Committee heard
that IFRS were more rules-based than previous national standards
and leave less scope for the auditor to exercise prudent judgment
and as necessary to override a box-ticking approach in order to
reach a true and fair view of a given financial statement.
The Committee considers that good audit is essential
to business and finance. It welcomes the Financial Reporting Council
(FRC)'s efforts to improve competition and choice in the audit
market and to streamline the regulatory framework but shares the
FRC's view that they have not led to any great improvement. The
Committee recommends several measures which should be of benefit
in reducing the dominance of the Big Four but concludes that these
in themselves are unlikely to be enough.
The Committee makes three main recommendations:
- first, a detailed investigation of the large-firm
audit market by the Office of Fair Trading, with a view to an
inquiry by the Competition Commission so that all the interrelated
issues surrounding concentration, competition and choice can be
thoroughly examined in depth and in the round. The Committee recognises
that the global reach of the Big Four and of their clients goes
beyond the scope of a national competition authority. But when
London is both the incubator of at least some of the Big Four
and one of the world's leading financial centres, it seems right
for the UK to take a lead;
- second, that prudence should be reasserted as
the guiding principle of audit;
- third, the new framework of banking supervision
should provide for bank audit to contribute more to the transparency
and stability of the financial system, in particular through two-way
dialogue between auditors and supervisors about the financial
health of banks.
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