The audit market: the FTSE needs you

If another failure on the scale of Andersen were to occur, the market would
be left with only three providers capable of auditing the most significant
companies and this would have a destabilising effect on investor confidence.

Financial statements provide crucial information on which investors base
their decisions.

Without confidence in these statements, investors would significantly reduce
their interest in the capital markets, security prices will fall and the cost of
capital will rise. If there was a prolonged and material rise in the cost of
capital, investment would decline, along with productivity, economic growth and
jobs.

In short this auditor concentration risk needs to be addressed.

Stock markets are a forum for raising capital – that is their primary
purpose. A crisis in confidence disrupts this process as seen in the last and
current bear markets. In 2002 and in 2008 investors effectively went on strike
and governments stepped in via the central banks to ease the ensuing liquidity
crisis.

To issuers another Andersen style failure could provoke a crisis.

First, these businesses are required to produce audited financial statements
on a regular and timely basis. This can only be achieved through an integrated
relationship with their auditor.

Second, because of the lack of alternative audit supply, to whom does the
issuer turn if their auditor disintegrates and its staff become tainted? In this
hypothetical case, could the remaining Big Three audit firms pull together the
staff and resources necessary, at short notice, to fill the void caused by the
exit of the fourth?

Step up

There are many small firms offering audit services, but very few who can
satisfy the needs of large listed companies. The fundamental problem is that
only a few firms are prepared to make the necessary investments to scale up
their operations to meet the requirements of multinational clients.

In a situation where the principle input is human capital, the partnership
model would seem to be the most appropriate. In order to have the capacity to
service an international client, however, audit partnerships must make
considerable investment in people and systems. The return on such investments,
which is uncertain, exceeds the investment horizon of partners, and hence rarely
occurs.

The partnership model finds it difficult to invest. The business is run for
cash generation on the human assets in hand, not for the present value of
possible future returns.

These dynamics become clear if one considers that the working life of a
partner could be 20 years, that most partners borrow to make their initial
partnership investment, and that the return of that investment is generally the
same amount again adjusted for inflation.

Therefore the partner has little interest in investing in assets for which he
will receive no benefit during the life time of his partnership.

This conservative approach becomes more acute when one considers that the
most influential partners will have only a few years left with the business.
Part of the solution to overcoming this inertia and to create additional audit
providers for the larger client market is to open the audit business to
non-audit capital – ‘the investor model’. This model could facilitate the
accumulation of resources enabling smaller firms to trade up and address the
needs of larger clients or possibly even fund new entrants to the market.

The main criticism of the investor model is that it would compromise the
independence and integrity of auditors. According to the Oxera report that
analyses the implications of audit market concentration, there is no example of
such a compromise occurring in the history of the audit business, or comparable
professions. It could be said that the existing safeguards in the 8th directive
on company law, which is targeted at maintaining investor confidence, with the
exclusion of clauses prescribing ownership and control, are adequate to protect
auditor independence.

While opening the audit market to non-audit capital is part of the solution,
another is harmonisation. Currently the European Union does not have common
agreement on auditor obligations and duties to clients and third parties, nor on
the enforcement of those obligations as they vary from state to state.
Harmonisation to a rigorous standard would significantly help in the development
of a single market for audit services. This is a necessary precondition, along
with access to non-audit capital, to integrating the market and encouraging the
emergence of new players.

Perception gap

Outside the work of the EU, investors and audit committees could do more to
inform themselves on the characteristics of audit firms. There is clearly a gap
of client perception versus reality in the structure of audit firms.

The large audit firms are generally organised into national partnerships,
with overseas affiliates and through an umbrella organisation, clients see
auditors as seamless global organisations. In reality, this is a franchise
structure, which is vulnerable to the failure of a national affiliate, with the
risk of liability spreading through the entire network. More should be done to
increase audit committee awareness of these structures.

So there are two crucial steps required to integrate the audit market and
encourage new players.

Firstly, the opening of the audit market to non-audit capital, and secondly,
the harmonisation of auditor: obligations, duties and enforcement across the
union. The latter is an important step to allow auditors to become fungible
across the EU, which is consistent with the aim of creating a single market.

These ideas would not change the concentration of the audit market overnight,
but over time they would permit the entry of new players to compete with the big
four, thereby reducing this form of systemic risk.

Committee decision

Audit committees should do more to avoid discriminating against mid-tier
firms. It is plausible that as smaller listed companies grow and become included
in the major stock indices, they acquire non-executive directors of increasing
status.

Through previous relationships with the larger audit firms, and a desire to
add value, these NEDs may push for a switch from an existing mid-tier auditor to
one of the Big Four on the basis of reputation and perceived risk reduction.
While this may add value to the share price, it is disruptive and costly to the
organisation and reinforces the position of the leading audit firms.

Given the current concentration at the top end of the audit market, is this
really a risk reduction exercise?

Charles Cronin is head of the CFA Institute Centre for
Financial Market Integrity, EMEA