Auditors: Market concentration and their role - Economic Affairs Committee Contents

CHAPTER 2: Concentration in the audit market

11.  Concern about concentration of large-firm audit in the hands of the Big Four, and the impact on competition, choice, price and quality was our main motive in launching this inquiry.

How the Big Four evolved

12.  It took about 150 years from the beginnings of modern audit in Britain around 1850 to the emergence of the Big Four. Some of the founders' names, such as Deloitte, Price, Touche, Peat and Cooper, are still familiar. In the late nineteenth and early twentieth century, firms also grew in the United States and Europe. By the mid-twentieth century, there were large international groupings such as Deloitte, Haskins & Sells (UK/US, 1957), KMG (Netherlands/US/Germany, 1979) or Coopers & Lybrand (UK/US, 1957). But with many practitioners of various sizes and nationalities, including the international networks of the then Big Eight, the audit market still offered choice.

13.  The pace of concentration quickened in the 1980s and 1990s. The first mega-merger was between KMG and Peat Marwick (1987). In 1989, Deloitte, Haskins & Sells and Touche Ross came together. The same year, Ernst & Whinney joined with Arthur Young. In 1998, Price Waterhouse and Coopers & Lybrand combined. Not all these mergers were tidy, since the international networks are federations of national partners, some of whom went their own ways, but the entities they led to—KPMG, Deloitte, Ernst & Young and PwC—together with Arthur Andersen became the Big Five which dominated the world market in large firm audit. The collapse of Arthur Andersen in 2002 after the Enron scandal, and the absorption of its audit business by the others, meant that the Big Five became the Big Four. Consolidation was not impeded by regulatory intervention.

The large-firm audit market in the United Kingdom

14.  In 2010 the Big Four audited 99 of the FTSE 100 leading firms and around 240 of the next-biggest FTSE 250. They also had about 80% of the FTSE small capitalisation firm audits.[3] In some important market segments the degree of concentration is even greater: for example, only three of the Big Four audit banks in the UK. The Big Four are all the stronger because the next tier of accounting/audit firms are so much smaller: the audit revenues of even the smallest of the Big Four are nearly three times those of the largest second-tier firm.[4]

15.  The audit of large firms, in the UK and internationally, is dominated by an oligopoly with all the dangers that go with that. The oligopoly's power is underpinned by the fact that large firms are legally obliged to have their financial statements audited.

Why did the Big Four become so dominant?

16.  Witnesses put forward various reasons for the high degree of concentration in the audit market: Professor Michael Power, London School of Economics, said: "There is an element of concentration which may have to do with natural forces of economies of scale."[5] Mr John Connolly, Senior Partner and Chief Executive, Deloitte, said: "The degree of concentration in the audit market has arisen as a direct result of market forces and, in particular, the demand from investors for audit quality as well as appropriate capability to undertake complex audits across the world."[6] Mr Philip Collins, Chairman of the Office of Fair Trading (OFT), acknowledging that the OFT had not held a detailed inquiry into the audit profession, said: "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."[7]

17.  We also heard that a Big Four firm was seen as the safe choice by audit clients. Professor Power said: "I think audit committees go by franchise value alone and do not analyse audit teams."[8] Mr Timothy Bush, Investment Management Association nominated representative on the Urgent Issues Task Force of the Accounting Standards Board, said "there is a regulatory sense that big is best" and Dr Gunnar Niels of Oxera spoke of "the reputational advantages of having a Big Four as your auditor". Mr Jonathan Hayward, Director of Corporate Governance consultants Independent Audit, said: "No audit committee chairman of a FTSE property company … is particularly interested in changing to a medium-sized audit firm because there is lots of downside and no upside … in doing that."[9] In some cases reputational considerations have hardened into restrictive covenants or, as Ms Helen Brand, Chief Executive of the Association of Chartered Certified Accountants (ACCA) said: "Banks or organisations themselves are stipulating upfront that they will only employ a Big Four firm."[10]

18.  A self-reinforcing cycle has helped to consolidate the dominance of the Big Four. Factors include:

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 Anderson.

Does market concentration limit competition and choice?

19.  We heard conflicting views about the effects of the Big Four's domination of the market. Their own representatives argued that it was nevertheless competitive. Mr Ian Powell, Chairman and Senior Partner, PwC, said that the large firm audit market was "fiercely competitive" and that each tender was "ferociously fought" and that competition had affected prices.[11] Mr John Griffith-Jones, Chairman, KPMG, acknowledging that FTSE 100 companies very rarely switched auditors, argued that continuity and a fresh approach could be achieved by the same audit firm through frequent rotation of audit staff when new audit teams could still draw on the firm's corporate knowledge of the client.[12] Mr Ashley Almanza, Chairman of The Hundred Group (of Finance Directors of FTSE 100 companies), and Chief Financial Officer of BG Group, said: "We're content in general terms with the service provided and the competition that we observe in the market today."[13] He added: "Audit firms know that we have a choice and that very often is all you need to keep their pricing and the quality of their service honest."[14]

20.  Other witnesses thought the large firm audit market was not truly competitive and emphasised that tendering was rare: Mazars recalled research by Oxera published in 2006 by the FRC which indicated that "a FTSE 100 auditor can expect to remain in place, on average, for a period of 48 years".[15] Professor Vivien Beattie of the University of Glasgow said: "Concentration is sometimes even higher at sector level … sometimes in some sectors one of the Big Four has more than 50% of the market."[16] Mr Collins said: "We think that the market, as currently structured, may not operate in a way that works well for users".[17] Baroness Hogg, Chairman of the Financial Reporting Council (FRC) said that, despite the efforts of its Market Participants' Group "to explore ways of getting the market to work better … concentration is as great as ever … the time has come to consider more radical measures … we would now urge consideration of further actions at national and G20 level."[18]

21.  Some institutional investors believe the market is not competitive. Mr Paul Lee, Director of Hermes Equity Ownership Services, said: "The major concern is the lack of competition". Mr Guy Jubb, Head of Corporate Governance at Standard Life Investments, said: "It is not so much the competition issue but it is the lack of choice that is the area of particular concern … we are no longer comfortable with relying on market forces to create the resolution … there has to be some regulatory or governmental intervention."[19]

What if Big Four became Big Three?

22.  The market for large-firm audit could become even more concentrated if for any reason one of the Big Four withdrew. The demise of Arthur Andersen shows it could happen suddenly and unexpectedly. Legal liability is one area of risk: in the view of Professor Stella Fearnley, of the University of Bournemouth, "the risk obviously is a litigation risk."[20] Professor Power said: "I don't think we can rule out dramatic loss of franchise value, shock events."[21]

23.  Even witnesses comfortable with the present state of the market saw the prospect of a move from Big Four to Big Three as a step too far. Mr Almanza said: "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."[22] 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".[23]

24.  The Big Four themselves oppose any further concentration. Mr Connolly said: "I would be uneasy about it going down to three."[24] Mr Griffith-Jones said: "We need a regulator to prevent it getting any more concentrated than it is at the moment."[25] Lord Myners thought that concentration might already have gone too far and that in the end, if other approaches did not work, "there should be some action to 'trust bust'" because "everybody believes that it will be good to have more choice but nobody seems to be willing to be the first mover."[26]

25.  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]

26.  Most witnesses believe that the dominance of the Big Four limits competition and choice in the audit market. Ethically, audit firms are unable to accept work which would place them in conflict with other work for the same or other clients. This is a special problem in the UK banking sector, where only three of the Big Four are active. Banks' choice of auditor is sometimes limited by the need to avoid using a firm engaged by another bank.

27.  All witnesses fear the real possibility that one of the Big Four might withdraw leaving a Big Three (or even a Big Two, in the bank audit market). We agree. Loss of one of the Big Four would restrict competition and choice to an unacceptable extent. This is one reason for our recommendation of an Office of Fair Trading (OFT) investigation into the audit market.

3   ADT 24 (FRC). Back

4   FRC Professional Oversight Board, Key Facts & Trends in the accountancy profession, June 2010. Back

5   Q 6.  Back

6   Q 235.  Back

7   Q 174. Back

8   Q 8. Back

9   Q 84. Back

10   Q 80. Back

11   Q 242. Back

12   Q 244. Back

13   Q 292. Back

14   Q 305. Back

15   ADT 21. Back

16   Q 6. Back

17   Q 170. Back

18   Q 170. Back

19   Q 407. Back

20   Q 5. Back

21   Q 5. Back

22   Q 292. Back

23   ADT 42. Back

24   Q 238. Back

25   Q 236. Back

26   Q 486. Back

27   ADT 27. Back

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