UK Audit Market Concentration: The Solutions

In this second post on UK audit market concentration I want to look at the potential solutions to the problems I outlined in my first post.

The three main problems brought about by the severe concentration in the UK audit market are as follows:

• High barriers to entry;
• Negative Perceptions;
• Lack of Choice.

What to do about the UK audit market has been the subject of numerous studies, the Financial Reporting Council (FRC) have an ongoing project looking at solutions to the problems, and that is upon what my solutions are based.

The Solutions:

Break up the Big Four:

One argument (McMeeking, 2006) is for audit regulators to mandate the break-up of one or more of the Big Four. Doing this will broaden the choice available to the largest companies, solving one of the biggest issues. However this solution would require the agreement of audit regulators across the world, given the global nature of the Big Four firms. Also the favour with which this sort of solution is viewed will depend greatly on the concerns held by the local regulators, for instance the UK Auditing Standards Board have few urgent concerns because audit quality remains high, this might not be true in other markets.

Raise awareness of capabilities:

As part of the FRC’s ongoing project, the FRC Market Participants Group (2007) found that:

“The FRC should continue its efforts to promote understanding of audit quality and the firms and the FRC should promote greater transparency of the capabilities of individual firms.” (FRC Market Participants Group, 2007)

The general idea being to obtain greater transparency on individual audit firm’s audit capabilities and resources, hopefully leading to a situation where audit committees are no longer reliant on reputation and branding of audit firms in making their choices, as there are no systemic differences in audit quality between Big Four and mid-tier firms (Grant Thornton cite Kyla Gillan and Lynn Turner).

It might also be possible for mid-tier firms to become specialists in certain industries, providing a viable alternative to the Big Four within these sectors.

Greater regulation for Big Four:

McMeeking (2006) proposed that legislation could be introduced which would open up the audit market to other suppliers (i.e. National Audit Office, Audit Commission). With the biggest change being the introduction of an “auditor of last resort” which would guarantee that all firms could turn to an independent auditor, this would have a beneficial impact on the stock market as the risk of there being no independent auditor available is removed.

However: “direct regulatory intervention […] has not been accepted by the OFT or the government.” [Beattie, V. and Goodacre, A. and Fearnley, S. (2003)]

Another regulatory option is to introduce compulsory auditor rotation periods, which might encourage audit committees to look beyond the Big Four, thereby having the dual benefit of increasing auditor independence and competition in the market.

Change Perceptions:

Oxera (2006) concluded that unless perceptions of the non-Big Four audit firms changed, entry into the FTSE 100 and FTSE 250 audit markets would require uneconomic levels of investment.

How this might happen is difficult to answer, but ultimately I think it is the only long-term solution. But it might be easier than it looks… could audit committees be seeing a problem (investors want only Big Four) that doesn’t exist? Peter Montagnon, the ABI’s Director of Investment Affairs, said: “It is important that companies approach this choice with an open mind. Investors are content for companies to choose an auditor from outside the Big Four, if this suits their circumstances.” [Montagnon (2006)]

Merger between mid-tier firms:

Finally, a solution to the issue is for mid-tier firms to merge, creating audit firms comparable on scale to the Big Four. This is obviously a very real possibility, as the Big Four have shown. However, merged mid-tier firms may get to a comparable size but the perceptions (stigma, possibly) might stick, so audit committees may still stick to the current Big Four.

Conclusions:

My personal favourite solution is a free-market one, without imposed regulations, but with assistance from the regulator bodies such as the FRC in reviewing and publishing, in a transparent fashion, the capabilities and resources of all audit firms, not just the Big Four.

It is a very tricky problem to overcome, luckily in the UK there are no real concerns over audit quality and so the need for solutions is not so urgent. Although some critics would argue that auditors are complicit in the current economic downturn, in particular within financial services, but I personally think this is significantly down to the expectations gap evident within the general population.

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.