If the Big Four become Three

The danger of a Big Four firm collapsing as a result of a damages claim is very real, according to a report by London Economics for the European Commission. The impact of one, let alone two, such collapses could cause chaos.

The report addresses the economic impact of auditors’ liability regimes, drawing on academic literature, surveys and interviews and covering all 25 European Union member states. Its 330 pages provide support for campaigners for some limitation on auditors’ liability, though the report stops short of recommending the best approach – whether an absolute cap (as in Belgium, Germany and Slovenia), a variable limit linked to the size of company audited or the audit firm (as in Austria and Greece), or proportionate liability. A one-size-fits-all approach is unlikely to be useful EU-wide, the report notes.

Dominant force
Big Four domination of large company audits is confirmed in the report, as are the challenges facing mid-tier firms that want to compete. The report states: “The selection of a Big Four firm is often viewed as safer because of the reputation of the Big Four firms and easier to defend should a problem arise down the road”. This attitudinal barrier, as well as structural ones, such as capacity and geographical spread, are not expected to be overcome by mid-tier firms quickly.

The infrequency with which companies change auditors is also highlighted. Over half the companies surveyed said their auditor had served them for more than seven years. Of those that had changed auditor, 12% did so in response to the demise of Arthur Andersen.

Of all switchers, 85% simply moved from one Big Four firm to another, while 13% changed from a mid-tier firm to a Big Four firm. Just 2% switched from Big Four to mid-tier. The most common reason for a change was consolidating several firms into one group auditor. Dissatisfaction with the quality of audit work and the price of audit services were not major reasons for switching.

In terms of the liability threat to firms, the report notes that from 1981 to 2003 the average annual cost of claims was £147m (in 2005 prices). As of 31 October 2005, firms were facing 28 claims in excess of £79m, of which 11 were in excess of £160m and five exceeded £785m. Liability insurance is proving costly and inadequate.

The report notes that commercial insurance available would cover “less than 5% of some of the large claims some firms face”. Should a firm have to pay out, once insurance cover had been exhausted, the report suggests partners in the afflicted firm might put up with an income cut of 15-20% for three to four years. It states: “The Big Four have suggested that anything in excess of this range would lead partners to leave in droves with a collapse of the firm very likely soon after”.

Join the queue
A reduction to a Big Three would “create very serious problems for companies whose financial statements need to be audited”, the report warns. They might have to queue for audit services. A major increase in the price of statutory audits would be required to restore the equilibrium between audit demand and supply. The adjustment period “could be stressful and challenging”, with many audits delayed. The capital markets could be affected as investors might have to wait longer for the release of audited annual accounts. The cost of capital could also be affected if the loss of one of the Big Four made investors lose confidence in capital markets. If two Big Four firms collapsed, the situation would be “dire”, the report says, with investor confidence falling significantly and the audit market adjustment to the shock being “chaotic”.

The report considers the impact of an increase in audit fees (which most audit firms do not believe fully reflect the riskiness of audits). It concludes that the cost of capital would be unlikely to feel much impact directly, even if audit fees increased sharply, as the share of audit fees in total operating costs is typically “very small”. Even a doubling or trebling of audit fees would have little effect on profitability.

Quality control
Although a majority of institutional investors are concerned that a limitation of auditors’ liability would affect audit quality negatively, the majority of companies surveyed consider the liability regime has no impact on quality. No group surveyed (auditors, companies or institutional investors) thought the cost of capital would be impacted by limiting auditors’ liability.

The report concludes that the costs of an unlimited liability regime may outweigh the benefits. On the other hand, a limited liability regime might help to open the market for large company audits to mid-tier firms.

However, the report contains a potential sting in the tail for finance directors. It notes: “Any limitation of the statutory audit liability will shift some of the liability risk to directors and officers of companies.”