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


We list below measures put forward during the Inquiry aimed at reducing market concentration and/or improving audit quality. They are grouped according to the body which would be mainly responsible for implementing them.

These proposed measures are listed fully irrespective of whether the Committee agrees with them. Many are discussed in our report and some are the basis of our recommendations. Others we have not pursued further.

Addressed to Government

1. Transform the Audit Commission into a large audit firm, in alliance with a non-Big 4 firm

If the existing Audit Commission were kept together as a standalone entity, it would be the fifth largest audit firm in the UK. A strategic alliance with another mid-tier firm would enable it to access the corporate market as well as the public sector.

2. Develop the National Audit Office's private sector audit business

The size and credibility of the NAO, who are already empowered to tender for private sector audit business, in time could build another significant audit firm.

3. Remove the mandatory requirement for audit of mid-tier companies

Companies within the EC's small companies regime currently do not have to have an audit, but audit has been described as the lifeblood of the capital markets and as especially important for large companies. Leaving it to market forces to determine whether mid-tier companies or unlisted companies would choose to have an audit would be likely to damage audit firms outside the Big 4 who need to develop in order to widen choice in the audit market.

4. Limit auditor liability

Although the 2006 Companies Act allows contractual limitation of audit liability to be negotiated, this is rarely done for large company audits. Proportionate liability would mean the size of the auditor's potential liability would remain uncertain. A statutory cap on auditor liability would make it more attractive both for non-Big 4 firms to bid for large company audits and also for auditors to extend their audit assurance beyond the financial statements.

5. Change the ownership rules of auditing firms without risking audit quality

This would make it easier for firms to raise capital to expand into the market for the audits of the largest companies. The 8th EC Audit Directive limits external ownership to 49% and requires the majority of the management board of an audit firm to be approved EU auditors. Research indicates that the cost of capital in a partnership is considerably higher than in an external investment ownership model.

6. Introduce an alternative auditor appointment process for large companies

Auditors could be appointed by shareholder panels, by a regulator or by the audit committee (as in the US). A revised process could have the potential to address a number of concerns expressed to this Inquiry such as the concentration in the audit market, the infrequency with which auditors are currently changed and the perception that auditor choice is not currently sufficiently aligned to the interests of the shareholders to whom the auditors report.

7. Introduce a financial statements insurance approach as an optional alternative to the present audit

In view of the failure of past attempts to weaken concentration in the audit market, it has been suggested that a radical, innovative measure would be to introduce an alternative market to compete with the conventional audit market. Financial statements insurance would be such. Under the financial statements insurance approach (FSI), the audit committee (with the approval of its shareholders) could choose to approach an insurer to quote to cover the reliability of the statements which would otherwise be subject to a conventional audit. By arrangement, FSI could cover additional assertions made by management beyond those currently embraced by the conventional audit. As with other forms of insurance, the insurer would be likely to review the company and set conditions before providing the cover: this review might be done by the insurer's staff or by a firm of accountants chosen from a panel approved by the FRC. The insurance premium and the limit of the cover would be published. Then the insurer would appoint an auditor, also from the approved list, whose scope of work would be determined by the degree of risk that the insurer was willing to bear. If the company failed this audit, it would have two options for the following year: first, to revert to a conventional audit; or to renegotiate the FSI cover. When a claim was made against an FSI policy—for example, after investors sought compensation for losses allegedly caused by relying on misleading financial statements—it would be assessed by an arbitration process.

8. Lobby to ensure that measures taken by regulators of cross-border activities do not act as an effective barrier to using non-Big 4 audit firms

Ideally proposed measures should always be tested against this requirement.

Addressed to Competition Authorities

9. Place future limits on the market share of any audit firm

The number of appointments held could be limited over a five year period, monitored by representatives of regulators and investors. Compel the Big 4 to give up some market share.

10. Break up one or more of the Big 4

The Big 4 are global networks of national partnerships as are several other non- Big 4 firms. In the absence of coordinated international action, unilateral action by the UK could be a catalyst for wider change.

11. Eliminate covenants restricting choice of auditor

It is uncertain the extent of these. We have been told that they may on occasion even stipulate which of the Big 4 must be used. A lighter touch to action by the competition authorities would be for a Code to be drawn up between the British Bankers' Association, lending institutions, audit firms and regulators to address the issue.

12. Indicate clearly government policy and plans in the event of a Big 4 network collapse

This would need to cover how audit work is to be conducted in the short term and what long term structure is proposed for the audit market.

13. Make a clear statement that the government/competition authorities would break up a Big 3, and how this would be done

Choice is already grossly inadequate and it is generally accepted that the demise of one of the Big 4 from the audit market would create an intolerable situation.

14. Coordinate with competition authorities, in the EC and US in particular, to indicate in advance of failure of a Big 4 how they would be likely to respond

Cross-border contingency plans should be put in place to handle withdrawal from the market by one of the Big 4. To achieve this governments and competition authorities should engage first with the Financial Stability Board and then at G20 level to coordinate action that will lead to a plan being put in place. Arrangements would include developing a system to ring-fence healthy parts of a collapsing network.

Addressed to Regulators

15. Board risk committees for financial institutions and large companies exposed to systemic risks should receive independent advice from a party other than the entity's external auditors

This advice need not require the same sort of global network as might the external audit, and could therefore be provided by a non-Big 4 firm, which may in time provide them with opportunities to tender for the audits of some of these entities.

16. Require fair and regular public tendering of listed company audits

Perhaps once every five years, with independent oversight to provide opportunities for firms to increase their market share. At least one non-Big 4 firm to be included in the tendering process.

17. Achieve greater rotation of auditors

Greater, even mandatory rotation of auditors of FTSE 350 companies.

18. Require joint audits (as distinct from shared audits) of large companies or just large financial entities with one of the two firms being outside the Big 4 or outside the Big 4 + 2

With a joint (as distinct from 'shared') audit, both audit firms provide the overall audit report and opinion. The audit work would be required to be shared equitably to encourage the smaller audit firm to grow. Joint audits may make it less likely that any auditor develops a too-trusting 'cosy' relationship with the client, but would add to total audit costs.

19. Encourage greater use of shared audits by leading listed companies

'Shared', as distinct from 'joint' audits make it harder to assign full responsibility for the audit report on a group's results and arguably add to overall audit costs. A regulatory code of conduct could promote the use of non-Big 4 firms: this might be as auditors of subsidiaries within large, public groups.

20. Restrict auditors of large companies from undertaking non-audit work for their audit clients

The proportion of total fees earned for non-audit work has fallen over the past decade as sentiment has turned against using auditors for non-audit work. Nevertheless it can be convenient and cost-effective for clients to sometimes make modest use of their auditors in this way. Ethical standards for auditors are intended to address conflicts of interest: these standards could unequivocally bar auditors of large companies from providing tax advice and internal audit services of any sort to their audit clients, and limit the fee income from non-audit work to, say, 20% of total fee income from the client.

21. Require fees for 'audit related work' and 'extended audit work' to be reported by audit firms separately from fees for audit work

To discourage the apparent proportion of fees for work inessential to the audit from being understated.

22. Limit the proportion of audit fees a firm can receive from a single client

This would disadvantage small audit firms, and is already in place in the UK where total fees from a listed audit client, including audit of subsidiaries, should not regularly exceed 10 % of annual fee income or 15 % in the case of an unlisted client. There is a derogation for two years for unlisted entities if there are external quality control reviews but not for listed companies.

23. Establish an early warning system of significant threats to the operations of a Big 4 firm

We understand the FRC has agreed with the firms a protocol providing for the early warning of any significant threat to UK operations including—to the extent known—from overseas. An extension of this would be a contingency plan for the orderly transition of audit clients should a Big 4 firm exit the audit market for any reason.

24. Require large audit firms to formulate 'living wills' under regulatory oversight

Living wills for the largest audit firms would be intended to mitigate the risk of any exiting the audit market, and would set out how a firm would separate, under regulatory supervision, the good and failing parts of the business and would deal with funding issues.

25. Establish a resolution regime for the orderly wind-up of a failing large audit firm

The mechanism would need to be coordinated and agreed internationally.

26. Incorporate into, as appropriate, the FRC's Stewardship Code and into the FRC's guidance for audit committees more on accounting and audit

In particular that audit committees should report the rationale for audit tendering and auditor choice decisions, and the main issues the audit committee discussed with the auditors; and that investors should engage with their companies on these disclosures, as appropriate.

27. Assess all regulatory changes to ensure where practical they pass the tests that they neither add to the burden of the profession nor impact negatively on choice in the audit market

Because regulatory action should be in the public interest.

28. Seek to reduce the complexity of financial reporting and auditing standards

To better enable smaller audit firms to cope with the audits of large companies.

29. Take measures to eliminate the perception and/or reality of regulatory capture by the auditing regulation

This might entail a reduction in members of the accountancy profession who are members of regulatory boards, especially those who are or have been members of Big 4 firms or their antecedents; and making sure that chairs of regulatory boards meet generally accepted independence tests.

30. Intervene in the FTSE 250 audit market to achieve wider audit firm participation

If achieved, in the long term this would be likely to widen participation in the FTSE 100 audit market.

Addressed to Professional Firms

31. Appeal to the Big 4 as professional entities to put the public interest first and voluntarily break up their firms to form a Big 6 or Big 8

The quid pro quo for society ceding monopoly rights to practice and other privileges, is that professionals place the ideal of public service above other considerations. A clear ultimatum, time-defined, might be set for the Big 4'.

32. Encourage increased investment by, or mergers of, non-Big 4 firms to create one or more larger ones

Non-Big 4 firms argue that their access to additional capital to grow is not a problem, and it would be in the public interest for them to do so—especially to enhance their international networks.

Addressed to Companies

33. Report transparently on the basis for choosing or retaining an audit firm

Investors currently have little or no information on how an audit is awarded. The report on the audit committee would disclose when and how periodic formal evaluations of the external (and internal) auditors were undertaken and the key conclusions arising there from. Tendering or non-tendering decisions would be explained. The audit committee should hold discussions with principal shareholders every five years.

Addressed to Investors

34. Find a way of ensuring that the largest institutional investors act together to influence large companies to consider non-Big 4 firms

Investors told the Inquiry that they felt they were not influencing the choice of auditor sufficiently. The FRC could convene a group of large institutional investors to come up with audit market intervention initiatives.

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