Comment: The audit market needs more competition
Institutional prejudice prevents other firms from breaking into the Big Four’s business.
By James Roberts
The normally calm waters of the audit profession were becoming profoundly choppy at the end of March, as the House of Lords select committee on economic affairs issued its report on auditors: ‘Market concentration and their role’. Many of the headlines revolved around their Lordships’ rather trenchant comments on the audit of banks and this rather overshadowed the main thrust of the report. It concluded that the audit of large companies was dominated by an oligopoly of the largest four firms (PwC, Ernst and Young, Deloitte and KPMG), and that competition needed to be enhanced, particularly if one of the ‘Big Four’ were to withdraw from the market. Such a withdrawal is not a fanciful notion as the demise of Arthur Andersen, some ten years ago, demonstrated.
The scale of their domination is considerable – at the top end of the market they audit 99 of the FTSE 100 companies. In fact they dominate most parts of the audit market – large or small.
Is there anything necessarily wrong with that? The Big Four are packed with very good people and they are extremely well run. Although the House of Lords has suggested that auditing standards are slipping, largely as a consequence of an inexact financial reporting framework, there is no real suggestion that the quality or provision of audit suffers as a consequence of the oligopolistic nature of the market.
However, there is evidence that it does interfere with the normal working of market-based pricing. The Big Four always use the word ‘fierce’ when talking about competition. The select committee clearly found this a rather odd notion, in the context of the FTSE 100 companies changing their auditors on average once in every 48 years. The upshot of this, of course, is that twice a year there might be fierce competition over a very small portion of the market. I do find it difficult to extend that fierceness to the market as a whole.
A report by Oxera, Competition and Choice in the UK Audit Market, carried out in 2006, indicated that the Big Four audit firms charged higher audit fees on average than others in the market, and quoted a differential of 18%. Research carried out by the London School of Economics for BDO estimated that would be a reduction of about seven per cent in the audit fees of UK companies, were there to be a ten per cent reduction in the market share of the Big Four. This does seem to be a matter for some concern.
Although it is easy to argue about pricing statistics, albeit not very profitable, it is difficult to argue about choice. Audit is highly regulated and corporate governance is to the fore. Major audit firms need to be very alive to the concept of independence and conflict of interest. It is, therefore, likely that the largest companies will have relationships with at least three firms, covering audit, tax advisory services, corporate finance and a number of other areas. There has been a drive for separate provision of service and where only four firms dominate the market, it is quite clear that the choice of auditor amongst those firms might be as low as one.
One would have thought in this situation that other firms were available to the market. Indeed there are – my own firm has worldwide revenues in excess of $5 billion and is in more than 100 countries. The resources, the expertise and the international coverage are there to audit most of the companies in the land.
Is there then something there that prevents larger companies in general from extending their choice of auditor beyond the Big Four? I think there is and I would term it ‘institutionalised prejudice’. That does sound a bit sinister, but I’m not even sure it is a conscious effect. However, a large proportion of FTSE 100 finance directors are alumni of the Big Four and non-executive directors, who are the people who decide whether auditors work or not these days, have had relationships with these firms for most of their working lives. By their nature, non-executive directors are probably drawing to the close of fairly glittering careers and there is a substantial temptation for them to buy safe – the ‘IBM factor’.
There is a presumption in the audit market that size is equivalent to quality. This is something of a reaction to the difficulty one has in assessing the quality of an audit, which is effectively a binary product – accounts either show a true view or they don’t. However, the regulators have made public their reports on the technical quality of audits for some years now and one can’t drive a wedge between the Big Four and firms like us in terms of the reported quality.
It is for these reasons that the Lords have suggested a number of interventions in the market and have called for a referral of many of the issues to the Office of Fair Trading, and potentially the Competition Commission.
So what have the Lords suggested in addition to the OFT referral? They propose:
. Greater discussion between shareholders and companies of audit appointment and reappointments and the introduction of a requirement for audit committees to explain the basis for their decision making on auditor choice;
. The soon to be defunct Audit Commission should work in the private sector in such a way that it helps create a significant competitor to the Big Four;
. The Big Four firms should have ‘living wills’, so that the withdrawal of one would not undermine the market;
. FTSE 350 companies should have a mandatory audit tender every five years; and
. The government should make greater efforts to award public sector work to non-Big Four firms.
These are all changes at the margins of the competition issue, but they are welcome. The EU is also studying the issue at the moment and it will be interesting to see if they go along the same lines.
What is clear is that the audit market has been resistant to change for a very long time and that must now change. Audit underpins faith in capital markets, and if it is seen to be uncompetitive or cannot actually deliver, then the consequences could be profound. Apart from a desire for fair competition in the market, risk in the market demands change.
James Roberts is senior audit partner at BDO LLP.
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