The emergence of evidence that clauses in some UK banking covenants require companies to use only a Big Four accounting firm for their auditing needs – not a mid-tier or other player – has added fuel to the wider philosophical discussion around the way the audit world operates and the value it brings to business.
Finance directors’ concerns have been exacerbated by the association some of those firms have with a number of high-profile and controversial cases of accounting errors or trickery – and by increasingly sceptical regulators. On top of investigations by the Financial Reporting Council (FRC) and the Accountancy and Actuarial Discipline Board (AADB), the House of Lords is now conducting its own review of the major audit houses and will report its recommendations in the autumn.
The restrictive nature of clauses that require companies to use the auditor prescribed by the lender – acknowledged by FDs to exist, though few are willing to be identified discussing it – gives more weight to the ongoing conversation around whether companies that are forced to use the Big Four are getting value for money. FDs tell Financial Director that the value in a Big Four auditor is its global reach and reputation but add that, this aside, they are not convinced it provides any additional value for money on a service level that a mid-tier firm could not.
Is it right that lenders can force their clients to use a cherry-picked panel of the already most dominant auditors? “I don’t know,” says the global head of planning and reporting at one very high-profile FTSE-100 company, who asked to remain anonymous. “But the headlines usually involve the Big Four being in trouble from inadequate audits… you rarely read a story where there are problems in the wider auditing community.”
He thinks the clauses are a legacy from the time when the Big Four was the Big Eight. “It is difficult to find real choice in competitive tendering for audits,” he says. When one of his group’s holding companies recently tendered out its auditing requirements, several second-tier firms and one Big Four firm applied. When there was no banking covenant that stipulated the business should go to a Big Four firm, they went for a mid-tier provider, but not because it was cheaper.
“The second-tier firms were initially more competitive in pricing, but this did not preclude the Big Four accounting firm from reducing its price,” he says. “In the end, we went for a second-tier firm because we want to contribute to the success of those firms, so that hopefully one day they can match the Big Four. We do look for ways to use second-tier firms.”
But the power of brand still compels. “Banks will seek to de-risk any deals they do and the perception is that a Big Four auditor on the mandate is a shortcut to quality,” says Katherine Lee, former FD at YouGov and now an investor relations consultant to FDs. “I agree to a certain extent, but acknowledge that the BDOs and the Grant Thorntons of this world offer a similar service at a reduced fee. Probably, for companies outside the FTSE-100, these auditors understand their business better.”
KPMG is the only Big Four firm that responded to Financial Director’s enquiry as to whether the profession believes such restrictive clauses in banking covenants are fair and offer the best service for business. “Everyone would feel happy if there were five big firms,” a KPMG spokesperson says. “We’re not trying to block competition.” The British Bankers’ Association declined to comment.
Many are concerned that there could be an audit firm crisis off the back of the banking crisis – a worry not assuaged by the House of Lords’ investigation. There is a very real fear that Ernst & Young (E&Y) is vulnerable to massive litigation for its alleged role in the collapse of Lehman Brothers. In mid-June the AADB announced that it was investigating E&Y’s role as an auditor at the investment bank in the months leading up to its implosion.
Of course, many FTSE-100 companies employ all four of the major accounting firms in one way or another. “If one of the Big Four goes down, it becomes three, and when it comes to auditing it represents a very big problem,” says Gillian Lees, a spokesperson for the Chartered Institute of Management Accountants.
Indeed, this very issue is being investigated by the FRC. In early June its chief executive Stephen Haddrill announced that it would develop proposals to increase competition in auditing. This follows the failure of recommendations made three years ago that aimed to do precisely that – though these came at a time when people were not asking the big questions of the audit industry they are now – including making boards more accountable to shareholders and reducing the perceived risks to directors who choose a non-Big Four auditor. The findings will be looked at closely by business secretary Vince Cable who, before and after entering government, suggested he was in favour of reviewing the dominance of the Big Four and the leading law firms. The European Commission is also looking at auditor choice.
Prem Sikka, professor of accounting at Essex Business School and a vocal commentator on these issues, says that it is often shareholders who lose out when banking agreements force companies into a severely restricted process of auditor choice. “Banks as a major creditor can insist on things, but there are other stakeholders whose interests are not taken into account: shareholders, employees, taxpayers, the State and trade creditors,” he says.
For many, the issue is the way in which UK companies are required to appoint the auditors through the audit committee and then a shareholder vote. “I raise this issue every year with the Association of Chartered Certified Accountants [ACCA],” says Sikka. “When it comes to a vote on the auditor, I want to know who exactly does the work, how many students do it and how many hours they spend. I’m asked to vote on something and the information I get is zero.”
Chas Roy-Chowdhury, head of taxation at the ACCA, believes simply that the onus is on second-tier accounting firms to prove they can deliver quality of value above and beyond the reputation of the Big Four. “Firms need to show that the quality of work is uniformly good, irrespective of the size of the firm,” he tells Financial Director. But the feedback from the industry is that the work of those firms is already extremely highly regarded.
The power of reputation may be at play in the covenants as well as in the market more generally. But as soul-searching on the value of audit continues, FDs of companies that have traditionally felt the pressure to retain a Big Four auditor are reviewing that decision.
“Sometimes the Big Four’s reputation is more perceived than real,” Louisa Burdett, chief financial officer at the FTSE-100 publishing company FT Group, tells Financial Director. “Often in the case of auditors, you are relying on the fact that there are wise heads behind the teenagers they send out.
“But just because it is a Big Four firm doesn’t mean there are not other wise heads out there. The issue of quality in auditing is central to the process of tendering and getting value for money. Who opines – and at what point – that BDO, for example, is good enough or
wise enough to become one of the inner circle?”
The UK’s imminent exit from the EU that may now put the audit committee to the ultimate test
Audit tendering has turned from good practice to legal practice under the EU audit reforms
Businesses will have to think more strategically about where they can source those non-audit services in the future
The FRC has raised concerns that the FTSE 350 audit market remains highly concentrated among the Big Four despite high levels of tendering and rotation