Will Big Four auditors become more powerful?
- 22 July 2013
- From the section Business
Company audits are the first line of defence for investors (any of us saving for a pension) against the management of businesses providing a rose-tinted view of their financial performance.
Those audits failed spectacularly to put up red flags of imminent danger for the big banks which collapsed in 2007 and 2008.
That failure was of course spectacularly expensive for everyone, and not just investors.
There has subsequently emerged a widespread concern that the market is dominated by too few auditors - just four for the biggest companies - and that those auditors have too cosy a relationship with management.
Those four (as if you didn't know) are Deloitte, Ernst & Young, KPMG and Pricewaterhouse Coopers.
And if you think their stranglehold on auditing is reminiscent of the powerful position of our big banks, you should think again. Because those four auditors dominate their market across the world, whereas RBS, Lloyds, HSBC, Barclays and (to a lesser extent) Santander are only immovably dominant in British retail banking.
Today the Competition Commission has come up with reform proposals which it hopes will end the alleged complacency in audits by forcing big companies (those colossi in the FTSE 100 index and middling ones of the FTSE 250) to hold competitions or tenders every five years to appoint an audit firm.
It also proposes measures to force auditors to feel more accountable to non-executive directors and investors and less to executives.
So, for example, the prime role in appointing the auditor, agreeing its fees and negotiating the scope of its work would be the audit committee of non-executives, who in theory feel a greater responsibility to protect investors' interests than execs do.
And the regulator of this industry, the Financial Reporting Council (or more precisely its audit quality review team), would assess the quality of the audit performance in each company every five years, and provide a grade - with the grade then being communicated to investors (in this context, think of the FRC as the equivalent of the schools' inspector and investors as the parents).
There would also be an annual vote by shareholders on whether audit committees are providing sufficient information on what they are doing in the annual report.
So what will all this do to the stranglehold of the Big Four auditing firms?
Well perhaps that will be loosened a bit by a prohibition on any stipulation in loan agreements that companies must employ one of them.
But only perhaps - because auditors at the big firms to whom I have spoken this morning are not quaking in their boots.
They don't expect a wholesale shift of their profitable business to smaller firms such as BDO, Grant Thornton and PKF, inter alia, for two reasons.
First, they don't think that companies and their investors will regard five years of engagement as auditor as a long time.
The point is that most FTSE 100 companies are huge, sprawling and international. It will take an auditor a couple of years just to get to know a typical business, such is the size and complexity of the modern firm.
So with compulsory retendering every five years, there will be a strong tendency to reappoint the incumbent.
Which is presumably why the FRC, the regulator, has imposed a 10-year retendering requirement (which will now be overridden if Monday's Competition Commission proposals are implemented).
Second, just the process of making a pitch to be auditor is massively expensive. Think about what an auditor needs to demonstrate about its competency, capabilities and knowledge to persuade a global corporate octopus like BP or HSBC to appoint it.
Because of those bidding costs, smaller auditing firms may not feel a great incentive to pitch for many big company audits.
Worse than that, the Big Four - with their huge incomes - are likely to bid aggressively to win the audits of the smaller FTSE 250 firms, where smaller auditing firms currently have contracts, as they too will be forced to retender every five years.
There is therefore a risk - as auditors have sardonically pointed out to me this morning - that these reforms could help the Big Four firms capture an even bigger share of the market.