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Cutting the Big Four down to size. By Rob Lewis

4th Jul 2007
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NooseThe Big Four have the audit market in a stranglehold. In the UK alone they perform a staggering 98% of large company audits: similar figures apply in the rest of Europe. So can the G8 economies keep them in line? Rob Lewis thinks not.

Fears over the incredible levels of concentration in the audit market are nothing new. Last year, the Department of Trade and Industry and the Financial Reporting Council (FRC) commissioned a joint survey into the matter, with damning results – choice was almost non-existent, wherever you look.

The Big Four have the tightest grip on Italy, where they command 99% of the market, according to figures from financial advisory firm Grant Thornton. Big four dominance in the UK comes a close second and the figure is also high in the US, Russian and Japan. Only in France is their position held in check, with 68% of the market.

Vive la France
Although joint audits are sometimes used in the UK and other countries, in France they have been a legal requirement since 1966, although it was a common practice long before then. The reasons are twofold. First, in France a defaulting auditor can only be replaced by a decision by the Court of Commerce. The second reason is to safeguard auditor independence.

The French joint audit system was not born out of a desire to open up the audit market. In fact, during the introduction of EU consolidation requirements in the 1980s, many French audit firms championed the joint audit system for the opposite reason: it kept the Anglo-Saxons out. Nevertheless, increased competition is exactly what it’s achieved. A study last year by leading European economic consultancy London Economics showed the only other European country to have such choice in the audit market is Denmark. And it also has obligatory joint audit?

A timely academic paper by the Universities of Missouri-Columbia, Paris Dauphine, Antwerp and Maastricht, published last November under the lead authorship of Jere Francis, dispelled much of the criticism commonly levelled at the joint audit system; specifically, that it was expensive.

“The audit fees of French companies are not significantly different form the fees of non-French companies that list in the US,” the paper said. “Preliminary evidence indicates the joint audit system is not necessarily costlier.”

Comparing how French and Belgian firms were priced by the Paris markets, the academics found evidence that suggested earnings under a joint audit regime are valued more highly. But implementing such reform in the UK would take considerable legislative change. Unsurprisingly, when the FRC’s Market Participants Group released its interim report on Choice in the UK Audit Market this April, it outlined six objectives, and none of them mentioned joint audit.

Six of one, half a dozen of the other?
Characteristically, the FRC has looked for a market solution. Its Market Research Group (MRG), composed of investors, bankers and partners from the mid-tier and Big Four firms, has outlined six key goals. To:

1. make investment in the supply of audit services more feasible;
2. reduce the perceived risks to directors of selecting a non-Big Four firm;
3. improve the accountability of boards for their auditor selection decisions;
4. improve choice from within the Big Four;
5. reduce the risk of firms leaving the market without good reason;
6. Reduce uncertainty and disruption costs in the event of a firm leaving the market.

Heavy-handed strategies such as a joint audit system are unthinkable, at least for now. “If the market isn’t going to work effectively then there may be cause for other actions,” says Paul George, director of the FRC’s Professional Oversight Board (POB).

“There were three overriding objectives: first of all, to improve choice generally in the marketplace. Secondly, there is no silver bullet and as any actions we may take in terms of increasing choice will take a number of years to take effect, you need to minimise the risk of the unnecessary – and I emphasise the word unnecessary – withdrawal from the market of one of the existing major players.

“If you then work out it’s neither possible to reduce or eliminate that risk entirely, you need to do some work on the third objective, which is to minimise the disruption and uncertainty should a big firm leave the marketplace.”

So the MRG’s goal was never simply to open up the audit market. Essentially, much of it is to mitigate the effects of having such a closed market, and reduce the damage if one of the Big Four get caught up in an Andersen-type scandal – although few would admit it. After all, it’s hard to imagine why any of the Big Four would want to pull their eminently profitable audit arms out of the market unless there was serious trouble on the horizon. George himself admits that the expression “unnecessary withdrawal” has never been specifically defined.

He also makes the point that while there may be too little choice at the top of the audit market, we will always need the big firms. There has been research by POB member Stella Fearnley and others which supports the common sense observation that big companies need big auditors. It’s easy to understand that audit firms which have too much revenue attributable to one client can be vulnerable to certain pressures.

“You need sufficient choice to drive quality, but you also want strong powerful auditors so they can reach objective opinions,” as George puts it.

It’s also worth remembering that people weren’t so worried about audit choice when the Big Four was a Big Seven, or a Big Six, or even a Big Five. If just one or two other firms could break into the FTSE market, would the issue resolve itself? “Absolutely,” George says. “The first aim of the project is to get to that situation.”

The young pretenders
Arguably, the mid-tier closest to gaining a FTSE foothold is Grant Thornton, especially considering its recent merger with Robson Rhodes. But Steve Maslin, head of external professional affairs, was quick to refute claims they were being groomed for a top slot.

“As much as anything, auditing works most effectively when there’s appropriate trust between auditee and auditor,” he says. “We don’t want to increase our presence in the market merely because we’re thrust on someone.”

At the same time, Maslin had to admit it would be “good for our business model” if people gradually looked beyond the Big Four firms. He wouldn’t mind a joint audit system either, although it would have to be because the market wanted it.

Many of the initiatives the FRC have implemented, or are considering implementing, are intended to help with the issue of audit choice. The new style ‘naming and shaming’ Audit Inspection Unit reports, allowing audit firms to raise external capital, and a European liability cap are all measures designed to increase competitiveness. But how effective will they be?

Jeremy Newman, a managing partner at BDO Stoy Hayward, the other firm that looks likely to increase its FTSE presence, has expressed scepticism, especially on the question of raising capital. “I cannot recall any investment decision we have declined to make because of a lack of available funds,” he blogs on his site. “Our bank would happily lend us a lot more than we borrow at present.”

According to Maslin, the reason the FRC want to make investment in the supply of audit services more feasible is not because they believe it will help an existing firm (Grant Thornton has had no financial problems with Robson Rhodes) but because it might encourage an entirely new entrant, such as a bank – although, he’s not particularly convinced either.

One of the biggest “invisible barriers” to market entry is probably perception. Newman has revealed how BDO pitched for a due diligence assessment and came in with a fee of £200,000. Meanwhile, the company’s Big Four auditor turned in a figure well over £600,000. In the end, the Big Four firm was simply told to bring that sum down to within 10% of BDO’s, which they promptly did, and won the contract. Demonstrably, the premium the market is willing to pay for a Big Four firm casts doubt over the likelihood of a market solution.

Investor power might go some way to compensating. After the Association of British Insurers put out a press statement last year, six of the UK’s largest institutional holders wrote to every single public company chairman, saying they would encourage all company that tested out firms outside the Big Four. But judging from the current state of affairs, audit committees have yet to bite. If one of the mid-tiers is not given a FTSE crown sometime soon, it looks like a major shake-up might be on the way.


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