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

CHAPTER 7: Conclusions and Recommendations

168.  The audit of large firms, in the UK and internationally, is dominated by an oligopoly with all the dangers that go with that. The oligopoly's power is underpinned by the fact that large firms are legally obliged to have their financial statements audited. (para 15)

169.  A self-reinforcing cycle has helped to consolidate the dominance of the Big Four. Factors include:

i.  the internationalisation of business;

ii.  the scale of investment and capital required in an audit firm;

iii.  economies of scale in audit;

iv.  a semi-captive market;

v.  non-interventionist competition authorities;

vi.  the perception that big is best;

vii.  the reputational assurance of using Big Four auditors; and

viii.  the fall of Arthur Anderson. (para 18)

170.  Most witnesses believe that the dominance of the Big Four limits competition and choice in the audit market. Ethically, audit firms are unable to accept work which would place them in conflict with other work for the same or other clients. This is a special problem in the UK banking sector, where only three of the Big Four are active. Banks' choice of auditor is sometimes limited by the need to avoid using a firm engaged by another bank. (para 26)

171.  All witnesses fear the real possibility that one of the Big Four might withdraw leaving a Big Three (or even a Big Two, in the bank audit market). We agree. Loss of one of the Big Four would restrict competition and choice to an unacceptable extent. This is one reason for our recommendation of an Office of Fair Trading (OFT) investigation into the audit market. (para 27)

172.  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. (para 33)

173.  Measures envisaged by the Minister, Mr Edward Davey MP of 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. (para 35)

174.  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. (para 40)

175.  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. (para 44)

176.  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. (para 49)

177.  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. (para 50)

178.  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. (para 53)

179.  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. (para 55)

180.  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. (para 57)

181.  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. (para 60)

182.  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. (para 64)

183.  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. (para 69)

184.  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. (para 70)

185.  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. (para 75)

186.  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. (para 79)

187.  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. (para 87)

188.  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. (para 89)

189.  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. (para 92)

190.  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. (para 98)

191.  The regulation of accounting and auditing is fragmented and unwieldy with manifold overlapping organisations and functions. This is neither productive nor necessary. Other professions have only one regulator—medicine for example under the General Medical Council. The wider powers sought by the Financial Reporting Council would go some way to simplifying and streamlining matters for audit. But further impetus needs to be given to rationalisation and reform. We hope and expect that the profession will provide that impetus. In the absence of rapid progress, we recommend that the Government stand ready to impose a remedy. (para 110)

192.  Obvious benefits should flow from global adoption of common accounting standards for a global economy. But there is a corresponding risk that the lowest common denominator will prevail. So all concerned need to insist on the highest possible standards of rigour, clarity and quality of accounting and audit. (para 129)

193.  We accept that standards for use in many countries need clear rules which all can apply. It follows that IFRS is more rules-based than UK GAAP. But we are concerned by evidence that, by limiting auditors' scope to exercise prudent judgment, IFRS is an inferior system which offers less assurance. IFRS also has specific defects, such as its inability to account for expected losses. The weaknesses of IFRS are especially serious in relation to bank audits. (para 130)

194.  We recommend that the profession, regulators and the Government should all seek ways to defend and promote the exercise of auditors' traditional, prudent scepticism. The Government should reassert the vital role of prudence in audit in the UK, whatever the accounting standard, and emphasise the importance of the going concern statement. (para 131)

195.  Achieving general agreement on IFRS could be a long and uncertain process. In the meantime, we recommend that the Government and regulators should not extend application of IFRS beyond the larger, listed companies where it is already mandatory. Continued use of UK GAAP should be permitted elsewhere, so that the basis of a functioning, alternative system remains in place in case IFRS do not meet their aims. (para 132)

196.  As it revises banking regulation, we recommend that the Government should have the importance of accounting standards at the forefront of its mind. It should promote a prudent interpretation of IFRS as applied to banks. This would include sober valuation of complex financial instruments. At present IFRS permits recognition only of incurred losses, not expected losses. So it is essential that banks put aside reserves in good times to provide against downturns. This would have the incidental advantage of reducing the scope for banks to pay bonuses on the basis of profits struck without taking account of possible losses. We recognise that a fully satisfactory outcome depends on international negotiation and believe that the Government should give a lead. (para 133)

197.  There is a particular—and particularly serious—problem with the auditing of banks which has to be faced. An auditor who encounters a problem which might, in the ordinary course of events, justify a published qualification to the accounts, might understandably be reluctant to insist on this in the case of a bank. They might fear that to do so could cause a collapse of confidence and a run on the bank, to the detriment of the shareholders and, quite possibly, of the wider public interest. While this problem cannot be entirely avoided, we recommend in paragraphs 164, 165 and 167 how it can best be minimised. (para 140)

198.  We do not accept the defence that bank auditors did all that was required of them. In the light of what we now know, that defence appears disconcertingly complacent. It may be that the Big Four carried out their duties properly in the strictly legal sense, but we have to conclude that, in the wider sense, they did not do so. (para 142)

199.  It cannot (or at least should not) be taken for granted by auditors that banks in difficulties will be bailed out by the authorities and the taxpayers. We do not accept therefore that this should at any time be a decisive consideration in making the 'going concern' judgment. (para 144)

200.  Adequate and timely dialogue between bank auditors and supervisors is of the first importance. It is essential not only to enable the auditors to audit more effectively and the supervisors to supervise more effectively, but in particular to overcome the problem caused by the understandable reluctance of auditors to qualify banks' accounts. (para 155)

201.  We regard the recent paucity of meetings between bank auditors and regulators, particularly in a period of looming financial crisis as a dereliction of duty by both auditors and regulators. (para 161)

202.  We welcome the Code of Practice proposed by the Bank of England and the FSA for the relationship between the external auditor and the supervisor. But in the light of the regrettable backsliding of the years 1997-2007, and of the manifest importance of this issue, we believe that a Code of Practice does not go far enough. A statutory obligation is required. (para 164)

203.  This might take the form of a mandatory quarterly meeting, at the highest appropriate level, between the supervisory authority and the external auditor of each bank whose failure might, in the view of the supervisory authority, pose a systemic risk. There might be a further requirement for either side to initiate a meeting between the regular quarterly meetings should information come to light which might warrant such a meeting. (para 165)

204.  There was no single cause of the banking meltdown of 2008-09. First and foremost, the banks have themselves to blame. As our predecessor Committee found in its report on Banking Supervision and Regulation in 2009, the supervisory system put in place in 1997 proved unfit for purpose. But we conclude that the complacency of bank auditors was a significant contributory factor. Either they were culpably unaware of the mounting dangers, or, if they were aware of them, they equally culpably failed to alert the supervisory authority of their concerns. Our recommendations are designed to address these failings and thus make a repetition less likely. (para 167)

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