Wednesday, October 27, 2010

UK Audit Overseer Says Market Forces Alone Will Not Move Auditor Choice Beyond the Big Four

The UK regulator of financial statement audit told a parliamentary committee that market forces alone will not expand global audit choice beyond the Big Four and that regulation will be needed on auditor concentration. In a prepared submission to the Economic Affairs Committee, the Financial Reporting Council expressed concern that the highly concentrated market for audit services in the Big Four and a litigious market, especially in the US, poses a risk that one of the Big Four could fail, resulting in severe disruption to global capital markets as investors lose confidence in the financial statements of the firm’s audit clients. The FRC also said that there is an expectation gap between the actual scope of an audit and public perception of the information an audit should reveal. This gap was particularly evident in much of the commentary following the financial crisis, with many people querying how a financial institution could have received an unqualified audit report only to collapse a few months later.

The market for the audits of the largest companies is highly concentrated, noted the FRC, with the Big Four auditing 99 percent of the FTSE 100, and with similar levels of concentration in the US and most other developed countries. The FRC believes that market perception is the main barrier to the expansion of non-Big Four firms into the audit market for large public companies. While mid-tier firms may not have the resources to audit the very largest companies, noted the FRC, they are quite capable of auditing a far broader range of companies than is currently the case.

One negative result of audit concentration is the potential for moral hazard as the largest firms consider they are too big to fail and judge that regulators will be reluctant to take enforcement action against them if that action has the potential to result in the firm leaving the market. Also, there is a lack of auditor choice for large companies, particularly those in certain industries where only two or three firms are judged to have the appropriate expertise to act as auditor. If the company uses another large firm for other services, such as corporate finance, it may find itself without an effective choice of auditor in the short term due to independence restrictions. In the FRC’s view, there is also a lack of innovation in audit, with all large firms offering a virtually identical product. Regulatory restrictions on the scope of audit, independence rules and the format of the audit report offer only a partial explanation for this lack of innovation. Similarly, the FRC found little indication that the large audit firms attempt to compete on quality.

The FRC does not believe that the Big Four should be preserved at all costs, and regulators and legislators should not be afraid to take action against a Big Four firm if it is warranted. The FRC would not wish to preserve a firm from commercial failures, but would prefer to see action after failure to prevent the market becoming dominated by just three firms.

With regard to audit expectations, the FRC observed that there have been suggestions from various market participants, including some audit firms, that there would be value in widening the scope of audit and in extending reporting requirements beyond shareholders to include bodies such as regulators. Recently, the European Commission issued a Green Paper on audit suggesting this type of auditor scope. Early feedback suggests that auditors could validate a wider range of risk-related information on financial institutions and engage more closely with regulators.

Corporate governance also plays a significant role, emphasized the FRC. Boards must ensure that the corporate culture and environment encourages open dialogue with the auditors at all levels. Auditors and individual partners should not fear removal if they challenge management assumptions. Audit committees have primary responsibility for the appointment, reappointment and removal of external auditors, noted the FRC, and should also review annually the effectiveness of their audit arrangements, including the experience, expertise, resources and independence of the audit firm. Audit firms have told the FRC that effective audit committees are a powerful driver of audit quality and that there has been an improvement in the overall effectiveness of audit committees in recent years

Finally, the FRC urged audit firms to do more to promote auditor skepticism, Application of appropriate professional skepticism is vital, reasoned the FRC, since auditors must be prepared to challenge management’s assertions or they will not be able to confirm, with confidence, that a company’s financial statement gives a true and fair view. The audit oversight body therefore looks closely at the evidence of skepticism during its inspections and, if concerned, will seek an improved approach by the firm. The regulator also pays attention to whether recruitment, appraisal and promotion policies reward personnel for delivering high quality audits, including displaying appropriate skepticism in their audit work.