Accounting: Playing low-ball

The Big Four say they welcome the idea of more audit choice for large
companies. But do they mean what they say? After all, the concept of greater
audit choice for big business implies that the top firms would lose audits,
market share and profit.

In this debate, the subject of low-balling has always been the elephant in
the corner: something that is really obvious, but which is never properly
discussed. The ultimate purpose of predatory pricing is to sell goods or
services at artificially low prices with the intent of driving competitors out
of the market, or to create a barrier to entry into the market for potential new
competitors. If other firms cannot sustain equal or lower prices without losing
money, they go out of business. The predatory pricer then has fewer competitors
or even a monopoly, allowing it to raise prices above the level that the market
would otherwise bear. Audit choice and low-balling are two sides of the same
coin.

It is not in the interest of any of the major players to want to open up the
question of predatory pricing. The Big Four audit firms don’t want to discuss
it, nor do finance directors. So the audit trail on low-balling goes cold. While
some accept low-balling as an absolute fact of life, others deny that it ever
happens.

Certainly, the documented evidence on low-balling is rare, but every few
years there is a low-balling tale or accusation from someone who ought to know.
And this keeps alive the idea that absence of evidence does not equate to
evidence of absence. The latest explosion came from Jeremy Newman, managing
partner of BDO Stoy Hayward, who is leading a sustained assault on the Big Four.
A clearly exasperated Newman has put into the public domain the story of a due
diligence job for which his firm quoted. Despite the fact that the maximum fee
level that BDO Stoy Hayward asked for was a third of the initial price of the
company’s auditors, the work eventually ended up being performed by the i
ncumbent for around 10% more than BDO Stoy Hayward’s top quote.

It is tempting to dismiss the tale as an example of a canny finance director
using a different supplier as a stick with which to beat the incumbent – and
presumably favoured auditor – into providing the service at a more reasonable
price. Or is it, as Newman suggests, predatory pricing designed to force out his
firm from competing in certain segments of the marketplace? Significantly,
Newman also claims that the Big Four firms are increasingly targeting the
clients of BDO Stoy Hayward – and presumably the other second-tier firms – by
promising significantly reduced fees, which the incumbent is forced to at least
match, or risk losing the work. Even smaller independent firms feel the threat
of low-balling. These independents find their biggest clients – significant
private companies, but not quoted entities – are regularly targeted by the Big
Four.

One way in which the incidence of low-balling could decrease would be if
clients made it clear that being the auditor gave a professional firm no
advantage when it came to bidding and winning other work. The downside of that
step is, why should FDs bother? It’s convenient to work with professionals who
know about your business and can swiftly start to do the task required of them.

The BDO complaint on low-balling has to be seen in the wider context of the
overall trends in the audit market. Jeremy Newman chose to release his tale
about low-balling at the time that the Financial Reporting Council – among other
roles, the UK’s audit regulator – is consulting on audit concentration (see
www.financialdirector.co.uk).

Part of the recommendations of the Market Participants Group should have an
impact on the possibility of low-balling. For instance, the recommendation that
audit firms disclose the financial results of their work on statutory audits and
directly related services on a comparable basis should ensure relevant
information emerges over time about audit firms’ current pricing policies. In
particular, this may start to illuminate the issue of cross-subsidisation of
audit services by non-audit services. The Association of British Insurers
suggested to the FRC at the start of its consultation on audit choice in 2006
that there is a risk that large firms, which can afford to sustain such
subsidies, can use this device to create a barrier to entry by smaller firms.
While companies and shareholders don’t want to be overcharged for poor-quality
audit services, the ABI described it as “simple common sense” that a fair price
for audit is a prerequisite for the maintenance of both choice and quality.

The question at the heart of the debate on increasing choice in the audit
market is how hard the Big Four firms are prepared to fight to hold on to the
market share they have carefully gathered over the years, both through merger
and through organic development. All the evidence suggests the answer to that
question is easy: very hard indeed.