March 30, 2011

The UK House of Lords’  Economic Affairs Committee recently issued a report on it’s inquiry into Auditors’ market concentration and their role, to better understand the dominance of the Big Four and its effects on competition and choice; and whether traditional, statutory audit still meets today’s needs.

And the report is a tough, no-nonsense look at the UK audit market, confirms its huge market concentration, berates the Big Four firms for their lax role in the financial crisis and proposes some alleviating recommendations.

The UK audit market, the report says is “clearly an oligopoly with all the attendant concerns about competition, choice, quality and conflict of interest.”

Further, it (the firms) gave no warning of the banking crisis, and moreover, “Its regulatory structure, in the UK and internationally, is complex and unclear. “

But is it necessary and critical to investors, regulators and commentators.

And there are very interesting facts: “The Big Four’s domination of the large firm audit market in the UK is almost complete: in 2010 they audited 99 of the FTSE 100 largest listed companies, which change auditors every 48 years on average.” In the UK financial sector, there is even less choice – only Big Three, since Ernst & Young are not active.

And the report criticizes the firms’ failure to sound the alarm in the run-up to the financial crash, in that”confidential dialogue between auditors and bank regulators had fallen away before the financial crisis so that there was no pooling of information or concerns which might have given warning or allowed some action to mitigate the worst effects. This failure to maintain dialogue seems to the Committee a dereliction of duty. “

And the Committee has 3 main recommendations:

1. 1. A detailed investigation of the large-firm audit market by the Office of Fair Trading, with a view to an inquiry by the Competition Commission so that all the interrelated issues surrounding concentration, competition and choice can be thoroughly examined in depth and in the round.
2. 2. Prudence should be reasserted as the guiding principle of audit
3. 3. A new framework of banking supervision should provide for bank audit to contribute more to the transparency and stability of the financial system

And then the committee poses a question, often unasked and more frequently unanswered: Why did the Big Four become so dominant?

(1) Economies of scale

Natural forces support  economies of scale. High concentration is due to market forces: investors demand audit quality and appropriate capability for complex audits across the world. And no one was really looking at this  – Mr Philip Collins, Chairman of the Office of Fair Trading (OFT), saying “It is a market in which we have a keen interest but it is not a market in which we felt it appropriate, in the last seven or eight years, to conduct a detailed review because other things had been happening.

(2) Safe choice

Seen as safe choice by audit clients, since Audit committees go by franchise value alone and do not analyse audit teams. Many say, “there is a regulatory sense that big is best” and “the reputational advantages of having a Big Four as your auditor”. And change to a new medium-sized audit firm has lots of downside and no upside. And finally, banks or organisations themselves are stipulating upfront that they will only employ a Big Four firm.

(3) Other factors: i.  the internationalisation of business; ii.  the scale of investment and capital required in an audit firm;  iii.  economies of scale in audit; iv.  a semi-captive market; v.  non-interventionist competition authorities; vi.  the perception that big is best; vii.  the reputational assurance of using Big Four auditors; and viii.  the fall of Arthur Andersen.

And then the reports poses another key question – What if Big Four became Big Three?

It would be quite disastrous as  they find out – the market for large-firm audit could become even more concentrated. Companies say, “Big Four to Three firms I think would be regarded by most large companies in the UK, certainly by our company, as an unwelcome change.” The Association of British Insurers (ABI) also suggested that the remaining Big Four might not in any event have the “necessary … firepower to absorb a failed Big Four firm”.

The Big Four themselves oppose any further concentration. Deloitte’s Mr Connolly said: “I would be uneasy about it going down to three.” Mr Griffith-Jones said: “We need a regulator to prevent it getting any more concentrated than it is at the moment.

Regulators:  The FRC is clear that a Big Three would not be acceptable. It emphasises “the need for a clear statement that the Government/competition authorities would break up a Big Three.”[27]

In the end they conclude, while it may be intolerable to have the Big Four, a loss of one of the Big Four would restrict competition and choice to an unacceptable extent.

The whole report is an excellent read, the Committee exposes without fear, speaks without obfuscations and asks (and tries to answer) tough questions. In this, it is a strong report, with candor not generally seen in this area. Perhaps a similar report for all the developed economies are in order. http://www.publications.parliament.uk/pa/ld201011/ldselect/ldeconaf/119/11902.htm#evidence

But the key issue is, despite the Lords blasting the Big Four firms, what is to be done with the recommendations, and how will it impact the market. The challenge is the very large number of factors which favor concentration and very few that favor even competition. That makes the climb for the non Big Four that much harder, and for the foreseeable future (unless some catastrophic event), things are likely to see only small changes over time. Unless, of course, the paradigm itself shifts quickly, and that no one can really forecast today.

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