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Auditing the auditors – Big Four still under fire. By Alan Shipman

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10th Jul 2007
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GunAlthough its latest quality report finds signs of progress and no major lapses in 2006-7, the Financial Reporting Council (FRC) remains determined to break the Big Four domination of large company audits. This article reviews the reasons for the FRC’s concern, arising from research conducted in 2006 on which industry consultation was launched last October. A follow-up will look at proposals for reform drawn up by the FRC’s invited panel in April, and the likely outcome of wider industry consultation now under way.

The quality of auditing in the UK remains ‘fundamentally sound’, according to the 2006/7 Audit Quality Inspections public report. Issued at the end of June by the Financial Reporting Council (FRC), this is based on the inspections of a sample of audits, mostly of large companies, by the Council’s Audit Inspection Unit.

Arriving two months after the FRC’s critical follow-up to last year’s negative assessment of concentration in the auditing market, the report will provide some relief to its dominant Big Four players: Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers. But it will not end regulators’ efforts to loosen the grip of these auditing giants, which amounts to a stranglehold on signing-off the accounts of top companies, according to research the FRC commissioned last year with the Department of Trade and Industry (DTI). This suggested that large companies’ universal tendency to stick with the Big Four is not due to any measurable superiority of standards, and that the cost of audits has risen as the choice of auditors has narrowed.

In April the FRC announced that its annual auditing standards report would start to identify individual firms if they merited criticism – interpreted in the financial press as a threat to “name and shame” those whose quality falls below the standards set by its Professional Oversight Board. While the 2006/7 audit of the auditors stops short of such public revelation, it shows a slow rate of progress that will not lessen the FRC’s determination to help smaller firms break into the market for the biggest corporate accounts.

The past year’s progress – sure, but still slow
As last year, the Audit Inspection Unit (AIU) carried out full visits to the Big Four, and the five next largest auditors: Baker Tilly, BDO Stoy Hayward, PKF, Grant Thornton and Robson Rhodes (before the last two completed their merger on 2 July). For the first time, it also made briefer inspections of seven smaller firms. This expansion of the survey raised the number of big-company audits reviewed to 103 (67 by the Big Four) in 2006/7, from 77 (60 by the Big Four) in 2005/6 and just 27 (all Big Four) in 2004/5.

The AIU pronounces itself “satisfied” with the way firms are implementing IFRS and recognising “significant progress” in the implementation of past recommendations, and acknowledges a rise in the overall quality of documentation in audits submitted for inspection. Areas in which recommended actions had been taken, generally with sufficient speed, included raising the emphasis on audit quality in company strategy and communication, linking it to staff and partner appraisal, creating and revising standard forms to improve the quality of documentation, and finalising a policy for rotation of key audit partners.

However, this year’s observations lead inspectors to warn for greater vigilance against the possibility of auditors checking accounts with the same software they have supplied to help clients compile them. They cite as unacceptable one company’s practice, of classifying the redrafting of notes to a client’s accounts as “providing accounting advice rather than accounting assistance”, concluding that this “created a significant self-review threat.” In some other cases, they were “not satisfied with the approach taken to testing of internal controls.”

There is also a general warning to check more closely the quality of other inputs to a large group audit – particularly other auditors (even if these are well-known network firms), and specialists in such areas as fair valuation, pension valuation and derivatives accounting. Although the inspectors accept that calling in such specialists can raise audit quality, they “have observed a tendency for audit teams to take less ownership over the areas covered by the specialists, and to accept the work undertaken without adequate review,” despite the high cost of mistakes in these areas.

Continuing concern about key judgements
While happy with audit documentation in general, the AIU finds “no clear improvement in the sufficiency of documentation to support key audit judgements.” It points out that the consequent difficulty in later reconstructing the rationale for such judgements can impede the on-the-job training of new audit staff, as well as the conduct of quality inspections.

The inspectors’ demand for “ongoing improvement” in the timeliness and depth of audit documentation will put many accounting departments under pressure for a clearer paper trail when the auditors next call. The AIU also notes that “further work is required by all firms” to implement fully the ISAs (UK and Ireland), especially in the areas of fraud and audit risk where these differ most from the ISAs (International Standards on Auditing) most currently use, issued by the International Auditing and Assurance Standards Board.

With competition for skills causing increased movement of specialist staff between companies, the inspectors also draw attention to rules regarding conflict of interest. Attention is drawn to the case of a partner of one of the inspection firms who left to become finance director of a major audit client – to illustrate the importance of ensuring, before such a crossover, a two-year separation from the hiring firm’s audit ‘chain of command.’

Big Four still on probation after market power exposed
The FRC has tightened its watch on the Big Four since the extent and effects of their domination were confirmed in research it commissioned from consultancy Oxera, published in April 2006. This established that they now audit 97% of FTSE-350 firms, and that “the near 100% combined market share of the Big Four in auditing large companies is not regarded as healthy for competition or choice.” Oxera found that many companies in their sample had little or no alternative, at least in the short term; and that in any year only 4% of UK listed companies change auditor, dropping to 2% for the FTSE-100.

Even if the Big Four’s service is not measurably better than smaller firms’, their clients are likely to pay more for it. Oxera’s 2006 report “found evidence that higher concentration has led to higher audit fees,” with its econometrics suggesting that a steady rise in UK audit fees since 1995 is due to growing concentration as the Big Six distilled to the Big Four, as well as to rising accounting complexity and regulation making big audits a more labour-intensive job.

Some research even suggests that, unless regulators get tough at the top, corporate clients may end up paying more for an inferior service. If the Big Four start to believe they are ‘too big to indict’ then there is less to stop their standards slipping, argues George Washington University law professor Lawrence Cunningham. In a recent Columbia Law Review article, Cunningham argues that this ‘moral hazard’ has worked against the auditing improvements intended by Sarbanes-Oxley.

The law has, in recent memory, caught up with those guilty of the most egregious auditing errors. But successive mergers, and Arthur Andersen’s demise in the wake of WorldCom and Enron, have continued to shrink large clients’ choice. And having already escaped partners’ formerly unlimited liability through the formation of LLPs, auditors have been permitted under last year’s Companies Act to negotiate more specific liability limitations with clients - a practice into which the FRC, on accountants’ request, last week set up an independent enquiry chaired by former judge Anthony Colman, which will report for consultation document later this year.

Battling the ‘IBM effect’
Last year’s report found evidence that the Big Four have come to dominate big company audits as much because of their perceived reputation as because they do better quality work. The latest quality audit does little to dispel the suspicion that most large companies stay with the household names because it carries the least risk to their reputations. There is concern that switching to a smaller auditor will result in being taken less seriously, or seen as having something to hide.

This fear of the lesser-known persists despite the Big Four, with the biggest clients, being involved in some of the most-reported quality lapses. Although they can claim this is the inevitable result of taking on the most difficult cases, the household names cannot escape unwanted regulatory attention:

  • PwC last week agreed to pay $225m to settle a class action by shareholders of fraud-struck conglomerate Tyco, and was fined $5bn in 2002 by the Securities & Exchange Commission (SEC) for irregularities in 16 other US audits

  • KPMG, though called into troubleshoot after the Enron scandal had brought down Arthur Andersen, had its own run-in with the SEC over the way it allowed Xerox to bolster its sales figures with equipment leases

  • Deloitte has been investigated for the way it helped iSoft to compile revenues before it became the troubled software group’s auditor last year

  • Four Ernst & Young partners were charged in May for illegal use of tax shelters, though the US Inland Revenue Service stopped short of prosecuting the firm as a whole

    While such incidents recur, it will take more than this year’s relatively clean bill of health from the Quality Inspections report to get the Big Four off the hook. But the size gap that has now opened up between the Big Four and the middle tier means that, however good a job the smaller players can do, a change of rules and some tilting of the playing field will be needed before they can break into the biggest audit market.

    Next steps
    In April 2007, a year after its consultants’ critical verdict, the FRC published a review of the findings by its Market Participants’ Group, which was asked to address the options for tightening safeguards against Big Four complacency and widening choice beyond them. It is now receiving comments on these ideas from the wider financial community, including the Big Four, other auditors, the companies that use their services and the shareholder interests that rely on their good faith. In a follow-up article, we’ll assess the Group’s report and the initial reactions, looking ahead to the increasing pressure you’re likely to come under to make a competitive transparent selection of auditors, and the strategies the regulators will use to give you greater choice.

    Alan Shipman is editor of AccountingWEB's sister site, FinanceWeek.co.uk

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    By petestar1969
    11th Jul 2007 15:30

    YAWN!!!!!!!!!!!
    Wow, sorry, got about a quarter of the way through and started to doze off.

    I'm so glad I no longer work for an audit firm.. more hassle than its worth.

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