UK Audit Market Concentration: The Problems

In this post I will examine the problems brought about in the UK audit market by the perceived lack of competition between the largest audit firms.

The Audit Market in the UK is dominated by the Big 4, and in recent years many people have raised concerns about this. Indeed, there have been numerous reports and studies looking at the issue, including the Oxera Report (2006) and the Financial Reporting Council’s (FRC) ongoing project.

The Big Four audit firms audit all but one of the FTSE 100 companies, and represent 99% of audit fees in the FTSE 350. Switching rates are low (around 2% on average for FTSE 100 companies), and competitive tendering does not occur frequently. (“Four better, four worse?”, Oxera, 2006)

The Problems:

High Barriers to Entry

Because of the sheer size of most large listed companies, and the current gap in size between the second tier of audit firms, there is a high barrier to entry into the market for auditing these largest companies.

• A lack of resources to audit the largest companies;
• Investment is particularly risky due to the high costs of scaling up to meet the resource requirements of auditing the largest organisations.

If barriers to entry remain high, at the current level, and investment into new or other firms, into this market remain risky, there will be little competition to rival the Big Four’s dominance.

Negative Perceptions

The Oxera report notes that reputation is a significant driver in the choice of auditor, “favouring the Big Four, whether this is based on real or perceived differences between the Big Four and mid-tier firms.”

Oxera also found that very few (<10%) large companies would even consider using a mid-tier firm, although a majority of those surveyed believed they were technically capable.

So from this statistic we can deduce that the audit committees of the UK’s largest companies are choosing audit firms not necessarily on price and capability, but also significantly based on the reputations of the audit firms amongst investors (institutional and private) and the general public. As the audit committees are aware of the large gap between real capabilities and perceptions.

Lack of choice:

For the very largest UK companies there is a real lack of choice of audit provider, especially in financial services. Because of the regulations surrounding audit and non-audit work for the same client and also auditing of close competitors, some have no realistic choice of alternative auditor in the short term future.

The biggest impactor on choice of auditor is the auditor independence rules, and combined with having just the Big Four results in a severe restriction on companies. Oxera found that this lack of choice has resulted in higher prices, and that due to the lack of alternatives these higher prices are able to stick and there is a lack of downward pressure on audit prices.

Big Four to Three Scenario:

The loss of one of the Big Four auditors would exacerbate the problems surrounding auditor choice, and may require regulators to make emergency changes to auditor independence rules. It would expand the number of companies impacted by the lack of choice down to the independence rules. And Significantly the loss of another large audit firm would probably have a significant impact on investor confidence in audits, which may ultimately impact on the UK’s capital markets with investors not trusting the audit reports and hence the published accounts of the UK’s largest companies.

In my next post I will look at the potential solutions to the problem.