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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