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

CHAPTER 3: Changes to the Legislative/Regulatory Framework Governing Audit

What has been done to increase competition?

28.  The dearth of competition in auditing is vividly illustrated by how rarely blue chip companies change auditors. A FTSE 100 auditor remains in place for about 48 years on average; for the FTSE 250 the average is 36 years. Nearly all these companies have Big Four auditors.[28] For example, Barclays has used PwC or its predecessors since 1896, and since 1978 as sole auditor.[29] These figures do not sit well with the view of the Big Four (paragraph 19 above) that the large firm audit market is highly competitive.

29.  The Financial Reporting Council (FRC) created the Market Participants' Group which issued 15 recommendations in 2007 aimed at reducing risk and bolstering competition in auditing.[30] Amongst these were recommendations that audit committees explain their choice of auditor; that shareholders take a greater interest in audit selection; and that the FRC promote understanding of audit quality. It was hoped greater transparency and shareholder engagement would lead to more choice in the audit market.

30.  The majority of these recommendations have been implemented but they lack teeth. Many recommendations are only guidance, which companies can all too easily ignore. For example, more than half of listed companies surveyed by the FRC ignored guidance that audit committees should provide information on frequency of audit tenders and on tenure of incumbent auditor. Even amongst those that sought to comply, the information was of little use in many cases. The FRC reported that "many ... failed to state exactly how long the relationship had lasted", only saying the auditor had been in place "for many years" or "a number of years."[31]

31.  Hence, as outlined in Chapter 2, the Big Four are as dominant as ever. Grant Thornton characterised the measures as "soft touch initiatives [that] have demonstrably not worked."[32] Even the FRC confessed to their "minimal impact on market concentration."[33]

32.  The Institute of Chartered Accountants in England and Wales attempted to defend the measures, suggesting that more time was needed for some recommendations to take effect.[34] But this was a minority view. Many witnesses argued that more action is needed to reduce market concentration. Mr Guy Jubb, Head of Corporate Governance at Standard Life Investments, said: "We are no longer comfortable with relying on market forces to create the resolution to this. We do believe that there has to be some regulatory or governmental intervention."[35] Baker Tilly argued: "It was commercially-led market mergers that caused the contraction and it will take positive discrimination in favour of potential competitors to now change it."[36] Baroness Hogg, Chairman of the FRC, said: "The time has come to consider more radical measures".[37]

33.  Attempts to introduce greater competition into the audit market have so far failed. Market concentration is as great as ever. The last set of recommendations from the Financial Reporting Council's Market Participants Group in 2007 lacked teeth. It has had no effect in lessening the dominance of the Big Four.

34.  Mr Edward Davey MP, Minister for Employment Relations, Consumer and Postal Affairs, at the Department for Business, Innovation and Skills, said of reducing market concentration: "There are some approaches that are quite regulatory, but we are not attracted to a very heavy-handed approach." He "would put a lot more emphasis" on less heavy-handed measures to do with "transparency and disclosure" in areas such as how a company chooses an auditor and how long a firm has had an existing auditor.[38]

35.  Measures envisaged by Mr Edward Davey MP, Minister at the Department for Business, Innovation and Skills, focus on transparency and disclosure. These echo the approach of the FRC Market Participants Group—an approach that has palpably failed. We were disappointed that the Minister is not more ambitious. We would expect exactly the same result for the measures he advocated to our Committee as the FRC's measures have had. It may be sensible to introduce these measures on their own merits. But they do not add up to a policy of creating greater competition and choice, of altering the current oligopolistic situation, or of addressing the risks of the Big Four coming down to a Big Three.

Possible measures

36.  We received many proposals for reducing market concentration. Witnesses' more radical proposals included limiting the market share of the Big Four as measured by the number of appointments held over a five year period.[39] A few witnesses said the authorities should consider breaking up the Big Four.[40] The FRC said the Government and competition authorities should make clear that in the event of one of the Big Four collapsing, the Big Three would be broken up.[41] Others suggested less radical measures such as joint audits and mandatory tendering of audit contracts to give non-Big Four firms more opportunities to compete. All proposals made to us are listed in Appendix 3. The main ones are discussed below:


37.  Joint audits—where two auditors sign off accounts—are required in France and, proponents argue, would give a foothold to non-Big Four auditors amongst large clients, if the requirement were specified appropriately.[42]

38.  Mr David Herbinet, Partner at Mazars which has a strong presence in France, said joint audits could make changing auditors easier by offering some continuity: "What you can do with a joint audit is stagger the appointments whereby you can change one of the two without putting the whole audit at risk."[43] Joint audits were well suited to banks because of their systemic risks, complexity and "the inherent subjectivity in their financial statements."[44]

39.  But joint audits had plenty of critics. Mr Simon Michaels, Managing Partner at BDO, feared his firm would be "seen as being appointed as the poor relation of the Big Four to make up the numbers."[45] Professor Stella Fearnley, of the University of Bournemouth, added that a joint auditor could be another Big Four firm, so that market concentration would not be reduced.[46] Mr Charles Tilley, Chief Executive of the Chartered Institute of Management Accountants (CIMA), warned joint audits created the "risk of things falling through the cracks ... it can become a bureaucratic nightmare". Mr Iain McLaren, Senior Vice-President of the Institute of Chartered Accountants in Scotland (ICAS), and Mr Russell McBurnie, Finance Director of RSM Tenon, expressed similar views.[47] Some French companies had told the FRC that joint audits were a "nightmare", according to its Chief Executive, Mr Stephen Haddrill, because "auditors spend all their time passing the buck". Other French companies said auditors worked well together with benefits from two sets of eyes. Mr Haddrill said: "The evidence we've seen in the UK has been that it's been relatively inefficient in terms of the way the audit is conducted."[48]

40.  One suggested way to enhance competition would be to introduce mandatory joint audit where each audit firm signs off the audit report and opinion. The Committee is not convinced that this would deliver better accounts. It would certainly add bureaucracy and cost. It has only been applied in very few countries where the results do not amount to a resounding recommendation in their favour. But if it were promoted in the UK as a means to reduce market concentration, it should be on the basis that at least one joint auditor was a non-Big Four firm.


41.  As noted at paragraph 28, companies rarely change auditors. Many witnesses proposed mandatory tendering to give non-Big Four firms the opportunity to compete,[49] though some would exclude banks because of the specialist expertise required.[50]

42.  Other witnesses doubted that mandatory tendering, or the more radical suggestion of mandatory rotation after a fixed period, would work. Clients could simply switch Big Four auditors, with no effect on market concentration.[51] Some expressed concerns that changes of auditors not only increased costs but reduced quality in the early years of a new audit.[52] Mr Jonathan Hayward, director of corporate governance consultants Independent Audit, cited a study of the mandatory rotation regime in Italy which "concluded that the risks of audit failure in the early years, after a change, were greater than the risks of audit failure in the later years".

43.  Mr Paul Lee, Director of Hermes Equity Ownership Services, took the opposite view, arguing that audit quality improved as the new auditor put in more work.[53] The Office of Fair Trading (OFT) thought that any negative fallout from changing auditors could be lessened by outgoing auditors providing incoming auditors with information in a standard format.[54]

44.  The very long tenure of auditors at large companies is evidence of the lack of competition and choice in the market for the provision of audit services. A regular tender, with a non Big Four auditor invited to participate, should promote greater competition to the benefit of both cost and quality. We recommend that FTSE 350 companies carry out a mandatory tender of their audit contract every 5 years. The Audit Committee should be required to include detailed reasons for their choice of auditors in their report to shareholders.


45.  Shareholders mostly approve the board's recommendation on the appointment of auditors at annual general meetings with little or no discussion. Lord Myners said this was because investor apathy was endemic: "The average institutional investor has about as much interest in the companies in which it has invested its client's funds, as somebody buying a betting ticket on a 2.30 horse at Plumpton. Passionately interested in what happens for the next three minutes, but not much interested in what happens to the horse thereafter."[55]

46.  But a relatively small number of institutional investors play an active role in the companies where they hold shares. Mr Iain Richards, Head of Governance at Aviva Investors, defended his institution's record. They did "vote against a notable number of [auditor] appointments". But he added: "The difficulty is not enough of us do ... I think companies know that we are in such a small minority that they shrug their shoulders."[56] Lack of information was also cited as a reason for not challenging auditor appointments.[57] Mr Jubb suggested audit committees should discuss with principal shareholders every five years "the quality of service and other aspects surrounding the auditors."[58]

47.  Mazars suggested investor scrutiny might be strengthened by forming independent shareholder panels to choose the auditors. BDO recommended direct shareholder representation throughout the appointment and review process rather than only at the end.[59] Mr Steve Maslin, Partner at Grant Thornton, would like the Financial Reporting Council "to convene a group of the UK's largest institutional investors to get some focused action on the companies in which they invest—and that might be in the FTSE 250—to give a very strong signal to those companies to move more audits to firms outside of the Big Four."[60]

48.  There was wide support from witnesses for audit committee reporting to be more transparent about the rationale for audit tendering and audit choice decisions. There was also support for audit committees to report on significant financial reporting issues arising during the course of the audit, since the auditors' report cannot be relied upon to do so. Mr Davey said: "Maybe there is a role for further development of the relatively new Stewardship Code in this area. Is there a role for the FRC's guidance on audit committees to be looked at and possibly made mandatory?"[61] We infer that, if audit committee guidance were to become mandatory, the Department for Business, Innovation and Skills might support audit committees themselves becoming mandatory for listed companies.

49.  We recommend that:

i.  audit committees should hold discussions with principal shareholders every five years;

ii.  the published report of the audit committee should detail significant financial reporting issues raised during the course of the audit;

iii.  they should also explain the basis of the decision on audit tendering and auditor choice; and

iv.   the FRC's UK Corporate Governance and Stewardship Codes should be amended accordingly.

50.  Like the FRC's Market Participants' Group measures, the changes we recommend above should be marginally beneficial. But they would not deal with the fundamental issue of audit market concentration. Regrettably, with the notable exception of our investor witnesses, most shareholders appear to care little about a company's choice of auditor. It seems improbable that this apathy will soon be remedied. So measures which rely on shareholder engagement to help lessen audit market concentration are unlikely to be effective.


51.  The FRC argued that Government plans to abolish the Audit Commission might offer the opportunity for one or more non-Big Four auditors to take on its work. As a standalone entity, the Audit Commission would be the fifth largest audit firm in the UK, representing about 10% of the market.[62] Baroness Hogg said that if the Big Four picked up the work of the Audit Commission "that will be, at the very least, a big missed opportunity to increase the strength of work done by the non-Big Four firms."[63] Mr Maslin said that Grant Thornton "would be very enthusiastic under the right conditions to invest in taking a substantial part of the Audit Commission work."[64] If on the other hand the Audit Commission's work went to the Big Four, market concentration would increase.

52.  Preventing the Big Four from taking such work could however breach EU laws on public procurement. The FRC acknowledged that there were "practical difficulties that may need to be overcome to ensure the UK complies with European law relating to the procurement of public contracts but believe the prize of greater competition in the market makes this proposal worthy of further consideration."[65]

53.  Baroness Hogg told us that the expected abolition of the Audit Commission would provide an opportunity to increase competition and choice in the audit market if it formed the basis of a substantial new competitor to the Big Four. We recommend that the Government should work to encourage the emergence of such a competitor.


54.  BDO argued that for the types of projects where the Government tends to hire Big Four firms greater consideration should be given to smaller audit firms instead.[66] Asked about the Government's scope for ensuring more non-Big Four firms won public contracts, Mr Davey said: "In general, the Government is very keen at looking at how we procure goods and services and to see if that can be improved ... We want to encourage a very competitive market for procurement of Government services including audit."[67]

55.  The Government should make greater efforts, within EU procurement rules, to enable non-Big Four firms to win public sector work. This should include any work no longer undertaken by the Audit Commission.


56.  Restrictive covenants where companies are required by shareholders or banks to use one of the Big Four auditors are a barrier to choice,[68] as the Big Four plus BDO and Grant Thornton stated in a joint submission to the OECD: "In certain countries including the USA, UK, Germany, Spain and Finland we have encountered clauses or requirements in contractual agreements between companies and their banks or underwriters that state that only the Big 4 audit firms can provide audit services to the company. [This] can distort the market for audit services by excluding certain audit firms from competing in this market."[69] Mr Scott Halliday, Managing Partner, Ernst & Young, said: "Removing the only Big Four clause from any banking agreements would be a positive step."[70]

57.  Lord Sharman and Lord Smith of Kelvin doubted that restrictive covenants were common in the UK.[71] The FRC nevertheless recommends "a greater level of dialogue between the British Bankers' Association, lending institutions, audit firms and regulators to address the issue".[72] The OFT is considering the launch of a market study of restrictive bank covenants.[73] We consider that the OFT should conduct a market study of restrictive bank covenants. This would form part of the wider inquiry into the audit market which we recommend later in this report.


58.  Concerns about liability and insurance against claims for damages should a client collapse could deter non-Big Four accountants from auditing large listed companies. Auditors' liability can be limited by contract so long as the cap is "fair and reasonable in all the circumstances" and the client consents. The Association of Chartered Certified Accountants (ACCA) argues that more needs to be done as listed companies rarely consent, mainly because US authorities view such agreements as direct threats to audit quality. ACCA believes Germany has less market concentration than Britain because of a long-standing cap on auditors' liability.[74]

59.  But Mr Stephen Kingsley, Senior Managing Director at FTI Consulting, disagreed: "Lack of limitation clearly concentrates the mind." He argued that unlimited liability, had not, of itself, caused the collapse of any major firm, not even Arthur Andersen.[75] Mr Davey said the Government's "conclusion is that we shouldn't put a cap on [liability]. We have no plans to do so". He added: "Liability does drive quality of audit, and there is quite strong evidence from the academics in this regard."[76]

60.  Auditors' unlimited liability needs to be investigated to determine whether it deters non-Big Four auditors from taking on large listed clients. This too could form part of an Office of Fair Trading (OFT) investigation into the audit market which we recommend later in the report.


61.  The FRC believes that changes to the ownership rules—which are set at EU level and preclude non-auditors from holding more than 49% of the voting rights in an audit firm—would "make it easier for firms to invest to allow them to expand into the market for the audits of the largest companies".[77] The Government is pressing for changes to the EU ownership rules.[78] The EU is considering whether the ownership rules should be relaxed, according to a Green Paper from Mr Michel Barnier, the Commissioner for Internal Market and Services.[79]

62.  Surprisingly, BDO and Grant Thornton—the largest non-Big Four auditors—say they have no need for greater access to capital to expand. Grant Thornton said they would not need to raise additional capital to expand into audit of the FTSE 250 listed companies, now dominated by the Big Four. Mr Michaels of BDO declared: "Investment is not holding us back."[80] The OFT suggested that there was a deterrent to investment by audit firms: "Investment may not be attractive to older partners due to the limit that retirement imposes on the period in which they can receive a return."[81]

63.  The ABI argued that liberalising ownership rules could enable non-auditors to help recapitalise an audit firm on the brink of collapse.[82] Mr Davey, the BIS Minister, said the Government might examine this option,[83] as an alternative to the further market concentration which would result from a takeover by another Big Four firm.

64.  The leading second-tier audit firms have told us that their scope for growth is not constrained by any problems of access to capital. So we see no immediate grounds to change the law to lift limits on shareholdings by non-auditors in audit firms, especially since such a change would carry the risk that auditors might become less independent. The OFT should also examine limits on share ownership as part of its investigation.


65.  In his review of corporate governance in UK banks and other financial industry entities, published in November 2009, Sir David Walker recommended that "the board of a FTSE 100-listed bank or life insurance company should establish a board risk committee separately from the audit committee. The board risk committee should have responsibility for oversight and advice to the board on the current risk exposures of the entity and future risk strategy, including strategy for capital and liquidity management, and the embedding and maintenance throughout the entity of a supportive culture in relation to the management of risk alongside established prescriptive rules and procedures."[84] It could be argued that such risk committees, composed largely of non-executive directors but with expert advice, might have prevented or at least mitigated some of the decisions taken by these institutions which led to the financial crisis.

66.  The assessment of risk, whether by separate risk committees or as part of the audit committee, is becoming a more prominent feature of corporate governance not only in the banks and financial institutions but also in other major companies where appropriate. As the Walker report said: "This seems a welcome development in particular in the light of recent experience, much of which can be characterised as marking a failure by boards to identify and give appropriate weight to risks on which they had not previously focused." The report also suggested the use of a "high-quality source of external advice."[85]

67.  In its evidence to us, the FRC wished to encourage banks and other systemic institutions to use non-Big Four firms as a source of advice to these risk committees. The FRC argued that this would give such firms an exposure to large companies they might not otherwise have access to and might in time provide them with the opportunity to tender for the audits of some of these entities. Baroness Hogg argued that such risk committees—reporting to the board about the levels of risk facing different parts of the business and how these can be contained—should be advised by a firm other than the company's auditors, and that such a measure might enable non-Big Four auditors to enter the big company market.[86] Mr John Connolly, Senior Partner and Chief Executive, Deloitte said: "I think the concept of independent advisers advising risk committees is a good one. If that was adopted, I think that is a good change."[87] Mr John Griffith-Jones, Chairman, KPMG agreed that the auditor should not be the risk committee's adviser but added that nonetheless "auditors have an important potential role to play around the risk area."[88] Lord Sharman said: "I have found ... that the appointment of an independent advisor to both the audit committee and the risk committee, separate from the external auditors, separate from the internal auditor, and separate from anybody else in the organisation ... is particularly helpful." When asked, "How general is it?" he replied, "I suspect it's not very common." [89]

68.  Whether such risk assessment is done by a separate risk committee or as part of the audit committee work, we can see considerable benefits in expert external advice being increasingly used. It should not be provided by the firm's own auditors. It will increasingly involve the use of specialist advice and experience quite distinct from that involved in audit work and could provide an opportunity for non-Big Four firms to build up such expertise and as an entree to FTSE 100 companies.

69.  We strongly support the development of separate risk committees in banks and major financial institutions. Other large companies should institute them where appropriate. Such committees will increasingly require specialist skills and external advice. This advice should not be provided by the firm which is the company's auditor. Providing it could open opportunities for non-Big Four accountancy firms to enter the large company market in a way which they have found difficult to do.

70.  We believe that every bank should have a properly constituted and effective Risk Committee of the Board. It should be one of the duties of the external auditor to ensure that this is done, by making clear that if it is not, the auditor will say so in a qualification to the accounts. This is best dealt with by rules made and guidance issued by the FRC rather than by being made a statutory requirement. Reference should however be made to it in legislation on the relationship between financial supervisors and auditors, to which we return later in the report.

Should audit remain mandatory?

71.  Audits are mandatory for most companies except the smallest for which the burden and benefits are deemed disproportionate. There is a case for reduced mandatory audit requirements, while enabling companies to opt for more detailed audits to reassure investors. This could provide opportunities for non-Big Four auditors. The OFT said: "Reducing the requirements of statutory audit might stimulate switching to smaller auditors that are able to undertake a more limited audit. Doing this might also reduce auditor liability for errors and hence auditors' risk of failure."[90]

72.  Independent Audit argued for the removal of the requirement for an audit. It would then be for boards to take responsibility for their financial statements, perhaps also opting to have them audited.[91] Mr Davey said: "The Government believes, there is a strong case for taking away the mandatory requirement for an audit from medium-sized companies."[92] If enacted, this change would apply to 32,385 companies.[93] (A company is classified as medium-sized if it meets two out of the three criteria set by the EU: turnover between £6.5m and £25.9m; total assets from £3.26m to £12.9m; and 50 to 250 employees.[94])

73.  However, most shareholders and lenders would insist on full audited accounts for listed companies. Professor Michael Power of the London School of Economics saw a more widespread removal of the requirement for audit as "just simply unthinkable for a whole range of institutions at the moment."[95] Investors also outlined the importance of audits. Mr David Pitt-Watson of Hermes said: "Audit and accountancy are absolutely fundamental to the integrity of our capital markets and the good governance of our companies." Mr Richards of Aviva said: "The fact that we have an audit is valued by investors."[96]

74.  We raised with witnesses the scope for financial statements insurance drawn to our attention by business consultants Z/Yen[97] and also proposed by Professor Joshua Ronen of New York University's Stern School of Business.[98] One attraction of this is that it would create a parallel market to compete with the existing audit market that has proved resistant to widening choice. Under this system, companies could opt to seek insurance for their investors against losses caused by below par financial statements, as an alternative to the existing audit regime. The insurer would assess the company to determine the risk and then set a price for offering such insurance. It is hoped auditors would want to build a strong reputation to make sure that insurers hired them; and the interests of the insurers, who would want to pay out as few claims as possible would be aligned with shareholders. Mr John Connolly of Deloitte dismissed financial statements insurance as containing "a lot of very impractical features". He suggested it would be costly and availability of insurance cover against audit failure would be limited. He said: "There is not enough insurance in the insurance market to cover the market capitalisation of a single FTSE 100 company, let alone the whole market, so I do not know why there is the view that this insurance would exist."[99]

75.  In order to lower regulatory costs, there is a strong case for some reduction in the audit requirement on smaller companies. This is unlikely to reduce audit market concentration, since the audit requirement would remain in place for the large listed companies where the Big Four predominate.

Should auditors give broader assurance?

76.  We heard much evidence that audits should change to be more useful to investors. The Institute of Chartered Accountants in Australia wanted 'closer to the event', more up-to-date assurance.[100] ACCA argued for widening audit's scope from financial statements to embrace risk management, corporate governance, and the business model.[101] CIMA believe auditors should also offer some form of assurance on the narrative operating and financial review.[102] Mr McLaren of ICAS said that assurance on these lines would be to a standard of 'balanced and reasonable' rather than 'true and fair'.[103] BDO saw a case for listed companies assurance, especially for large financial institutions, to extend to analyst briefings and other communications with investors.[104]

77.  Independent Audit argued for the rules and regulations concerning narrative statements, such as reviews of business operations in companies' annual reports, to be further developed to close the "expectations gap" between what the general public want auditors to do and what they actually do in terms of providing assurance. Audits of narrative reports should give a qualitative commentary rather than a yes or no 'binary' opinion. But even Independent Audit warned that audit firms "are much less well-equipped to form a view on the subjective and sensitive topics that lie outside the financial statements."[105]

78.  Mr Ashley Almanza, Chairman of The Hundred Group (of Finance Directors of FTSE 100 companies) and Chief Financial Officer of BG Group did not support any widening of auditors' assurance because "whatever product they produced, would have to be so heavily qualified I query whether investors would get real value."[106]

79.  Investors and others demand that audit should provide broader, more up-to-date, assurance on such matters as risk management, the firm's business model and the business review. This additional assurance would help the audit to meet the current expectations of investors and the wider public. Any widening of auditors' assurance would radically change their role. Again the OFT should address this issue as part of its broader review of the workings of the audit market.

Should auditors do less non-audit work and internal audit?

80.  There has long been concern about conflict of interest if an external auditor also provides other services to the same client. Under the current rules certain work for an audit client is prohibited—anything that would involve auditing one's own work, acting in a management capacity or acting as an advocate for an audit client. Some services such as advice on tax issues and acquisitions may only be provided by partners with no knowledge of their colleagues' audit for the same client[107]—the Chinese wall. But accountancy firms are generally free to offer consultancy services to their audit clients, although listed companies disclose in annual reports fees paid to auditors for consultancy work. Northern Rock was a case in point. In addition to auditing Northern Rock, PwC received some £700,000 in 2006 in consultancy income from Northern Rock. The House of Commons Treasury Select Committee referred to this as an apparent conflict of interest.[108]

81.  Earlier, in 2005, a former Chief Economist of PwC joined the Northern Rock Board as an independent director and the following year was appointed to its Audit Committee. She resigned from the committee after one meeting following concern expressed by PwC but rejoined early in 2007.[109] Northern Rock and their auditors were subject to conflict of interest criteria in both the US and the UK. Although this arrangement does not seem to have breached the letter of US or UK criteria, PwC is to be commended for focusing on their substance rather than their form. We note however that compliance with the UK's Corporate Governance Code is at the discretion of companies, unenforced by regulation.

82.  Professor Kevin McMeeking of Exeter University stated that prohibition of all consultancy advice to audit clients was "the only failsafe solution" to avoiding the potential for conflict.[110]

83.  Dr Sarah Blackburn of the Chartered Institute of Internal Auditors said "internal audit should not come from the external auditors of the company" and that "it's useful to have more than one source of assurance and more than one point of view."[111]

84.  Mr Timothy Bush, Investment Management Association nominated representative on the Urgent Issues Task Force of the Accounting Standards Board, raised concerns about companies receiving tax advice from their audit firm: "I would be concerned where there's a skeleton in the cupboard that the auditor isn't incentivised to uncover, and I think some tax planning can tie companies in knots for years, and if that is audited by the same firm that advised on the tax planning, then you're going to have a real problem."[112]

85.  Accountancy groups, unsurprisingly, believed the current rules require at most minor tinkering.[113] They also saw benefits in staff acquiring wider experience. Mr Ian Powell, Chairman and Senior Partner, PwC said of auditors working in non-audit parts of the firm: "As they move back into audit practice, they are much better auditors because of the quality of the training and the experience that they've had."[114] Baker Tilly entered one proviso: if the client could create systemic risk to capital markets—such as a large bank—then auditors should face stricter rules in what non-audit services they could supply.[115]

86.  Accountancy groups saw no demand to prevent accountants from supplying other services to their audit clients.[116] For smaller companies it may be cheaper to get non-audit advice from their auditors than from elsewhere.[117] ACCA cited figures from listed company accounts showing that the ratio of non-audit to audit fees has fallen from 191% in 2002 to 71% in 2008[118], still a high figure.

87.  We are not convinced that a complete ban on audit firms carrying out non-audit work for clients whose accounts they audit is justified. But we recommend that a firm's external auditors should be banned from providing internal audit, tax advisory services and advice to the risk committee for that firm. We also recommend that the Office of Fair Trading should examine whether any other services should be banned from being carried out by a firm's external auditors.

Big Four to Big Three?

88.  As outlined in Chapter 2, there is always the possibility that for whatever reason one of the Big Four might leave the audit market. Mr Almanza said that going down to the Big Three would be "an unwelcome change".[119] The OFT said in such circumstances "existing competition problems in the market could be exacerbated".[120] Some companies, especially in riskier industries, might not be able to obtain audit services in the short term. This could trigger a loss of confidence in financial statements among investors.[121]

89.  Any move from the Big Four to a Big Three would create an unacceptable degree of market concentration. Choice and competition in the audit market would be seriously undermined.

90.  Mr Almanza recommended that the authorities should have a contingency plan for the orderly transition of clients to another auditor if one of the Big Four collapsed.[122] Mr Graham Roberts, Finance Director of British Land, writing in a personal capacity, argued that auditors should draw up 'living wills', similar to those proposed for banks, which would detail how a failing institution could be wound-up with the least possible disruption to the financial system.[123] The FRC also advocates 'living wills': "These would set out how a firm would segregate, under regulatory supervision, how good and failing parts of the business will be separated and funded."[124]

91.  By setting out an orderly process of dismantling, living wills should also help ensure that no audit firm was regarded as too big to fail. Even without living wills the FRC is keen to dispel any idea that the Big Four are too big to fail: "We would not moderate our actions to protect a firm from failure but it is of concern that some believe such a risk exists."[125] The FRC advocates a global contingency plan for a Big Four collapse by governments and regulators in the UK, EU and US, with two main strands:

  • Conduct of audit work in the short term;
  • Long term structure for the audit market.

The FRC recommends that in the first instance the Government should ask the Financial Stability Board—the global organisation that coordinates national financial authorities and standard setters—to examine the issues, "with a view to it being discussed at G20 level in due course".[126]

92.  We recommend that the Government and regulators should promote the introduction of living wills for Big Four auditors. These would lay out all the information the authorities would need to separate the good from the failing parts of an audit firm so disruption to the financial system from a collapse would be minimised.

Referral to the Office of Fair Trading

93.  In 2002, when the large-firm audit market became concentrated in the hands of the Big Four following the collapse of Arthur Andersen, the OFT conducted a preliminary inquiry into whether to launch a full-scale competition investigation of audit. It decided not to do so, nor to refer the matter to the Competition Commission—usually the next stage in any full-scale competition investigation. The OFT explained its decision: "We have not found evidence to suggest that [audit] firms have acted to prevent, restrict or distort competition. Nor have we had complaints that they may be doing so." The OFT considered that the time was not right for further investigation, while great changes were taking place in the audit market, and concluded: "Our approach is to keep the market under review and to examine any competition implications of regulatory proposals that may arise from current reviews of audit and accountancy services." [127]

94.  The Big Four continue to strengthen their position by using their financial muscle to acquire significant parts of the home and international networks of next-tier firms. There have been several notable acquisitions in recent years in, for example, France and Brazil. These takeovers limit the scope for smaller competitors to develop international networks. The effect seems anti-competitive.[128]

95.  Lord Myners told us that if other measures to increase choice in the audit market did not work then as a last resort "one has to consider whether there should be an OFT reference and whether ... there should be some action to 'trust bust'".[129]

96.  Most other witnesses opposed breaking up the Big Four. ACCA said it could have unintended consequences such as one of the Big Four leaving the audit market altogether; it argued that as things stood there were enough reputational incentives for auditors to offer objective advice and maintain high standards.[130] Independent Audit thought that any benefits would be uncertain, since market pressures for scale and consolidation were unlikely to abate. They also drew attention to the difficulty of breaking up the Big Four given their international networks beyond UK regulators' reach.[131] Yet the UK is a relatively important player in the audit world. Reforms in the UK might in the FRC's view be "a catalyst for international developments and debate."[132]

97.  The Committee believes radical approaches are needed to solve the many problems with the audit market. Any industry in which four firms share the total market (one with 40%, the others with around 20% each)[133], has to be one where choice is clearly restricted. As Lord Sharman put it: "Anybody who chairs a major company, or sits as chairman of an audit committee of a major company, cannot fail to be concerned about the lack of choice. It's not a lack of choice among four; quite often it comes down to the fact that you only have two that you can possibly appoint."[134] Mr Philip Collins, Chairman of the OFT, said: "We consider that the competition in the market for audit services to large companies may be limited, as a result of barriers to entry and expansion, switching costs and limited choice in firms. We observe low levels of tendering and switching, high concentration and some evidence of high fees. There may be other effects of a lack of competition, such as low quality and lack of innovation … High concentration may also contribute to a risk of systemic failure in the audit market. Barriers to entry might make it difficult for mid-tier firms to step up to replace one of the Big Four firms if it were to exit the market. Thus we think that the market, as currently structured, may not operate in a way that works well for users."[135]

98.  In this report we have recommended a number of measures to reduce the dominance of the Big Four in the large firm audit market. But within the time and the resources available to us, we have not been able fully to address all the highly complex issues which may stem from market concentration. These include:

i.  lack of choice;

ii.  higher fees than in a more competitive market;

iii.  lower quality; and

iv.  the huge risks involved if one of the Big Four left the audit market.

A thorough review of the issues in depth and in the round is overdue. We recommend that the OFT should conduct such an investigation into the audit market in the UK, with a view to a possible referral to the Competition Commission. Its findings would need to take full account of the international dimension, but the UK could give a lead internationally by undertaking such a review.

28   ADT 21 (Mazars). Back

29   Email from Barclays' public affairs department, 11 March 2011.  Back

30   Financial Reporting Council PN199, Final report of Audit Choice Market Participants Group published, 16 October 2007. Back

31   Financial Reporting Council, Choice in the UK Audit Market-Fifth Progress Report, June 2010. Back

32   ADT 20. Back

33   ADT 24. Back

34   ADT 6. Back

35   Q 407. Back

36   ADT 53. Back

37   Q 170. Back

38   Q 504. Back

39   ADT 20 (Grant Thornton),ADT 41 (Lord Sharman). Back

40   ADT 64 (Prof Kevin McMeeking), Q 111 (Dr Gunnar Niels). Back

41   ADT 27. Back

42   ADT 21(Mazars). Back

43   Q 131. Back

44   ADT 21 (Mazars). Back

45   Q 134. Back

46   Q 20. Back

47   Q 77, Q 136. Back

48   Q 231. Back

49   ADT 62 (Kingston Smith), ADT 26 (Office of Fair Trading), ADT 1 (Professor Beattie et al), Q 418 (Mr Paul Lee).  Back

50   ADT 62 (Kingston Smith). Back

51   Q 418 (Mr Iain Richards), Q 420 (Mr Robert Talbut). Back

52   Q 329 (Mr Robin Freestone), Q 418 (Mr Iain Richards). Back

53   Q 418. Back

54   ADT 26. Back

55   Q 488. Back

56   Q 427. Back

57   Q 418 (Mr Robert Talbut), Q 433 (Mr Paul Lee). Back

58   Q 430. Back

59   ADT 21 (Mazars), ADT 19 (BDO). Back

60   Q 138. Back

61   Q 504. Back

62   ADT 24 (FRC), ADT 1 (Professor Beattie et al), Q 515 (Mr Richard Carter).  Back

63   Q 192. Back

64   Q 139. Back

65   ADT 27. Back

66   ADT 19. Back

67   Q 506. Back

68   ADT 4 (ACCA), ADT 20 (Grant Thornton), ADT 62 (Kingston Smith). Back

69   OECD Policy Roundtables (2009), Competition and Regulation in Auditing and Related Professions, Submission by Regulatory Working Group of the Global Public Policy Committee of six major accounting networks, page 248 Back

70   Q 236. Back

71   ADT 71 (Lord Smith), ADT 41 (Lord Sharman). Back

72   ADT 27. Back

73   ADT 49. Back

74   ADT 4 (ACCA), ADT 53 (Baker Tilly), ADT 7 (ICAS), ADT 62 (Kingston Smith), ADT 69 (Professional & Business Services), ADT 41 (Lord Sharman). Back

75   ADT 13. Back

76   Q 550. Back

77   ADT 27. Back

78   QQ 519-521. Back

79   European Commission Green Paper COM(2010) 561, Audit Policy: Lessons from the CrisisBack

80   QQ 121-122. Back

81   ADT 26. Back

82   ADT 42. Back

83   Q 505. Back

84   Sir David Walker, A review of corporate governance in UK banks and other financial industry entities, Final recommendations, 26 November 2009.  Back

85   Sir David Walker, A review of corporate governance in UK banks and other financial industry entities, Final recommendations, 26 November 2009. Back

86   Q 194. Back

87   Q 246. Back

88   Q 256. Back

89   QQ 365-367. Back

90   ADT 26. Back

91   ADT 12. Back

92   Q 522. Back

93   Q 523.  Back

94   UK Government Response to the European Commission's Green Paper on Audit, 8 December 2010. Back

95   Q 23. Back

96   Q 404. Back

97   ADT 74. Back

98   Joshua Ronen (2010), Corporate Audits and How to Fix Them, Journal of Economic Perspectives, Volume 24, Number 2.  Back

99   Q 260. Back

100   ADT 23. Back

101   ADT 4. Back

102   ADT 5. Back

103   Q 69. Back

104   ADT 19. Back

105   ADT 12. Back

106   Q 322. Back

107   ADT 24 (FRC). Back

108   Treasury Committee, 5th Report (2007-08): The run on the Rock (HC 56-I). Back

109   Northern Rock 2005 and 2006 annual reports. Back

110   ADT 64. Back

111   Q 380. Back

112   Q 100. Back

113   ADT 4 (ACCA), ADT 19 (BDO), ADT 53 (Baker Tilly), ADT 29 (Deloitte), ADT 6 (ICAEW), ADT 7 (ICAS), ADT 31 (KPMG), ADT 32 (PwC), ADT 69 (Professional & Business Services). Back

114   Q 250. Back

115   ADT 53. Back

116   ADT 4 (ACCA), Q 71 (Mr Iain McLaren and Mr Robert Hodgkinson). Back

117   ADT 4 (ACCA), Q 71 (Mr Robert Hodgkinson). Back

118   ADT 4 (ACCA). Back

119   Q 292. Back

120   ADT 26. Back

121   ADT 4 (ACCA), ADT 26 (OFT), ADT 24 (FRC). Back

122   Q 343. Back

123   ADT 38. Back

124   ADT 27. Back

125   ADT 24. Back

126   ADT 27. Back

127   Office of Fair Trading, Competition in audit and accountancy services-A statement by the OFT, 22 November 2002. Back

128   International Accounting Bulletin, E&Y acquires Terco Grant Thornton, 3 August 2010; Le Monde, Deloitte and BDO Marque & Gendrot to merge (translation), 25 July 2006; Les Echos, KPMG SA takes over Salustro Reydel (translation), 24 March 2005.  Back

129   Q 486. Back

130   ADT 4. Back

131   ADT 12. Back

132   ADT 24. Back

133   Financial Reporting Council, Choice in the UK Audit Market-Fifth Progress Report, June 2010. Back

134   Q 400. Back

135   Q 170. Back

previous page contents next page

© Parliamentary copyright 2011