APPENDIX 3: LIST OF MEASURES RAISED IN
EVIDENCE TO IMPROVE CHOICE, COMPETITION AND QUALITY IN THE AUDIT
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
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
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
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
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
policyfor example, after investors sought compensation
for losses allegedly caused by relying on misleading financial
statementsit 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
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
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
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 includingto the extent knownfrom
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
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
Because regulatory action should be in the public
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 soespecially to enhance their international
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.