Risk & Economy » Regulation » Tackling big four dominance

Worried about the dominance of the Big Four audit firms and the impact on
choice, quality and cost, the Financial Reporting Council established the Market
Participants Group last October to suggest possible actions that are largely
orientated towards increasing the likelihood of major ‘public interest entities’
selecting non-Big Four auditors.

In an interim report published in April 2007, the working group made 15
recommendations on which it is now consulting:

The recommendations
1. The FRC should promote wider understanding of the
possible effects on audit choice of changes to audit firm ownership rules
subject to there being sufficient safeguards to protect auditor independence and
audit quality.

The report says that non-Big Four auditors have not complained publicly that
the current ownership laws restrict their ability to raise the external capital
that might be necessary to make a step change in their capabilities. But it is
possible that the rules could in future prove restrictive to existing or new
audit firms. Moreover, the European Commission is investigating the audit firm
ownership rules and is expected to report later this year.

2. Audit firms should disclose the financial results of
their work on statutory audits and directly related services on a comparable

Clearer, more consistent information may be necessary so that other firms can
decide whether it is economical to make the necessary investment to go after the
Big Four market.

3. In developing and implementing policy on auditor
liability arrangements, regulators and legislators should promote audit choice,
subject to the overriding need to protect audit quality.

The Companies Act 2006 allows a contractual cap on auditor liability (subject
to shareholder approval), but whether this will be enough to encourage new
entrants to the audit market may depend on whether the professional liability
insurance market opens up to major audit firms again.

4. Regulatory organisations should encourage appropriate
participation on standard setting bodies and committees by individuals from
different sizes of audit firms.

Non-Big Four firms say there are misconceptions about their capabilities, in
part because audit members of regulatory standard setters come predominantly
from the larger auditors.

5. The FRC should continue its efforts to promote
understanding of audit quality and should promote greater transparency of the
capabilities of individual audit firms.

While the onus is on audit firms to make the market aware of their
capabilities, the report says there is a need to ensure that such information is
as accurate and comparable as possible.

6. The accounting profession should establish mechanisms
to improve access by the incoming auditor to information relevant to the audit
held by the outgoing auditor.

The revised EU Statutory Audit Directive requires outgoing auditors to
provide incoming auditors with all relevant information, but there is no
agreement yet on how to achieve this in practice.

7. The FRC should provide independent guidance for audit
committees and other market participants on considerations relevant to the use
of firms from more than one audit network.

The Hundred Group of Finance Directors said in the FRC’s 2006 discussion
paper that a revision to auditing standards might be desirable to make it easier
to appoint joint auditors.

8. The FRC should amend the section of the Smith
Guidance dealing with communications with shareholders to include a requirement
for the provision of information relevant to the auditor selection

As some companies use the same auditors for decades, there ought to be more
openness in the audit committee report about how auditors are selected.

9. When explaining auditor selection decisions, boards
should disclose any contractual obligations to appoint certain types of audit

Non-Big Four firms provided evidence that professional advisers and banks
have recommended or even required the appointment of a Big Four auditor – advice
that they say is poorly informed and inappropriate.

10. Investor groups, corporate representatives and the
FRC should develop good practices for shareholder engagement on auditor
appointment and reappointments and should consider the option of having a
shareholder vote on audit committee reports.

While, nominally, shareholders vote at the AGM on the reappointment of
auditors, in practice, there is little discussion before the vote.

11. Authorities with responsibility for ethical
standards for auditors should consider whether any rules could have a
disproportionately adverse impact on auditor choice when compared with the
benefits to auditor objectivity and independence.

There is concern that UK and, especially, US rules to preserve auditor
independence act to restrict auditor choice.

12. The FRC should review the Independence section of
the Smith Guidance to ensure that it is consistent with the relevant ethical
standards for auditors.

Some companies are thought to take an excessively strict interpretation of
the Smith Guidance, thereby preventing providers of non-audit services from
being considered for the group audit.

13. Regulators should develop protocols for a more
consistent response to audit firm issues based on their seriousness.

There is concern that an Andersen-style collapse could be an unnecessary
result of a future Enron-style problem.

14. Every firm that audits public interest entities
should comply with the provisions of the Combined Code on Corporate Governance
with appropriate adaptations given a considered explanation if it departs from
the Code provisions.

Audit firms should explain not only how their UK operations are governed, but
also their international networks.

15. Major public interest entities should consider the
need to include the risk of the withdrawal of their auditor from the market in
their risk evaluation and planning.

Major companies, especially those using a Big Four firm, should consider what
they would do in the event of the “withdrawal” of that firm from the audit

The Market Participants Group Interim report can be found at
Click on ‘About the FRC’, then click on the ‘Audit choice project’ tab.