The UK's Audit Market - Case Study Example

Auditing Table of Contents Introduction 3 The prevailing situation in UK 3 The risk associated with low competition in UK audit market 4 Steps takenby regulators 6 Conclusion & recommendation 7 Reference 9 Introduction With time, the number of corporate fraud cases is increasing in international market. The matter of question is how companies can manipulate the financial information in spite their financial data being audited by some of the reputed auditing firms (Big Four). The auditing firms that know as “Big Four” are quite renowned and have a sound market image but such cases of frauds raise question on the efficiency of these firm. Why these firms fail to detect the misconduct done by the client companies; also why not the government has taken these cases seriously. Today majority of the large corporations prefer to hire the Bid Four auditing firm and thus the mid tier auditing firms have a very small role to play in the contemporary audit market. Therefore, the matter of concern is “whether lack of competition in the audit is responsible for such poor performance of these Big Four?” The prevailing situation in UK In Britain “the Big Four” accountants have a strong market share in the audit market. Despite the effort given by the regulators, there is no significant increase in the degree of competition. The “Big Four” accountants are Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers. As per the latest data published by Hemscott, more than 95 percent of the FTSE 350 firms and 63 percent of total UK listed companies are being audited by the ‘Big Four”. From last four years, Financial Reporting Council (FRC) is taking initiative to increase competition in the audit market by expanding the number of choice of firm but it hardly succeeded. As compared to the moderate or small firms, the large public firms listed in FTSE 100 rely more on the big audit institutes. Among all the FTSE 100 listed companies, only Randgold Resources, a well known mining group is audited by BDO. As per the large companies, actually the quality of the service that is provided by these “Big Four” makes them an attractive accountant to be hired. However, partner of Grant Thornton, the fifth largest auditing firm in UK pointed out that the small auditing firms do possess the ability to handle account of large companies. It was also said that actually the UK banks are responsible for such poor competition in UK’s audit market (Spence, “Big four maintain hold on UK audit market”). These banks ask the companies to audit their financial statements by the “Big Four” while developing the lending agreements. It has reported that a simple banking covenant of £270m agreements restricts Amedisys to choice the “Big Four” and thus the possibility of hiring a mid tier auditing firm got obsolete. The case of Amedisys is one the only examples that reflect how the banks are responsible for reducing the competition in the UK’s audit market. In 2006, offeyville Resources had a $1 billion agreement when it accepted KPMG of the “Big Four” as the independent auditor. A research conducted by Grant Thornton’s US branch highlighted that in last few years almost 220 companies were restricted by the banks hire only the “Big Four” as the independent auditor (Christodoulou, “Restrictive bank covenants keep the Big Four on top”). The risk associated with low competition in UK audit market No doubt the UK audit market lacks competition because almost all the large companies listed on FTSE 100 are audit by one of the “Big Four”. Such high concentration on the ‘Big Four” has increased dependency of the large public companies on these firms. If one compare the fee changed by the “Big Four” against the mid tier accountants, the difference can be clearly pointed out. For a FTSE 100 listed company, the average fee charged by Deloitte clients is £4,751k, by Ernst & Young clients is £4,882k, KPMG clients is £5,291k and by PricewaterhouseCoopers clients is £6,375k. However, BDO Stoy Hayward clients pay only £464k as auditor’s fee (Financial Director, p.44-46). Such a large deviation in the fee reflects the risk of high auditing fee charged by the “Big Four”. According to the information revealed by Oxera, high concentration in the audit market has resulted in hike of auditor’s fee. While conducting the research it has also been found that there exists degree of price sensitivity among the clients but they pay more attention towards the quality of the audit and thus agree to accept high audit fee (Department of Trade and Industry and Financial Reporting Council, “Key finding of this report”). According to the research, if the market share of the “Big Four” declines by 10 percent, there will be fall of 7 percent in the audit fee (Sukhraj, “Big Four-only audit clauses should be banned”). At present the “Big Four” are responsible auditing 99 percent of the public companies listed in FTSE 100 and thus the degree of dependency is high on these audit firms. Apart from the auditing, these firms also provide value-added services to its clients. This is one of the causes that make “Big Four” an all time favourite. However, if any one of these four auditing company collapse, it will result in harsh impact on the security market of UK and whole of the economy may suffer (Peterson, “Market Concentration of the Big Four Audit Firms: The Feasibility of a Suggested Trade -- Divestiture for Liability Limitations”). The role played by Arthur Andersen in the fraud done by Enron or Ernst & Young’s negligence in the case of collapse of Lehman Brothers highlight the risk associated with high concentration on “Big Four” and poor competition in audit market (Inman, “Auditors role in Lehmans collapse unites opposition in calls for reform”). Steps taken by regulators The regulators have already taken several steps to minimise the concentration over “Big Four” by enhancing the degree of completion. In September 2009, three consultations relating to auditor firms have been launched by the International Organisation of Security Commissions (IOSCO). These consultations are as follows: “Exploration of non-professional ownership structure for audit firms” “Transparency of firms that audit public companies” “Auditors communications” (Financial Reporting Council, p.7) The main aim of these consultations is to improve the transparency in functioning of the auditors and to motivate high degree of completion. Before these consultations, the regulator in UK has introduced several other amendments in the regulations to improve the competency in audit market. In the paper submitted to House of Lords committee, The FRC has suggested that degree of competition can be increased in UK audit market if the commission’s audit practice can be acquired by the small firms. If the government abolishes the “Audit Commission” soon the competition may increase among the auditing firms (Hinks, “Audit Commission work should be denied to Big Four”). To compete with the “Big Four”, the mid tier audit firms has to expand their scales and should strength themselves. To motivate the enlargement of mid tier auditing firm, the government agreed that the firms can raise the capital from the market and thus these firms can introduce required change in their ownership structure. According to the research conducted by Oxera, employee-owned form of ownership in the audit firm will result in increase in rate of return. However, considering the high risk, the investors will ask for high rate of return and thus the cost of capital high will be quite high (Oxera, 2007, p.iii-iv). Again the concept of independence of the audit firm, the client firm should not have any relation with the audit firm. Therefore, if the outside companies start investing in these audit firms, their choice of client base will go on reducing. This is one of the reason that the mid tier audit firms are not much enthusiastic to accept expansion of ownership (Sukhraj, “Choice words from audit watchdog fail to impress”). Vince Cable has announced that the regulators will take all possible steps to increase competition in the audit market and this decision has given light of hope to the fifth and the sixth auditing firm in UK. The banks will be asked to overcome covenants that restrict companies to audit their financial statements only by the “Big Four”. However, it might take some more time to change the prevailing situation in UK’s audit market. Conclusion & recommendation Like many other international markets, the UK audit market is highly concentrated and the degree of competition is too low. At present more than 63 percent of the total UK companies are being audited by these “Big Four”. Thus, the mid tier audit firms has very less opportunity to participate in this industry. Basically, the banking policies and the regulations motivate the large firms to hire these “Big Firm”. However, such a situation is quite risky for the whole corporate market. Therefore, soon some changes should be introduced to overcome this risk. The government should provide an option to the small audit firms to merge and to gain the required capability to handle auditing of large firms. Even, the banking covenants for the “Be Four” should be removed. The main reason for high reliance on “Big Four” is their strong market image. If the mid tier firms can improve their market image, companies may ask non-Big Four firms to audit their financial reports. The government can ask the companies to rotate the independent auditors on regular basis and on an alternative basis the non-Big Four should be hired as per the rule. All these may assist in minimising the high degree of concentration and poor competition in audit market of UK. Reference Christodoulou, M. Restrictive bank covenants keep the Big Four on top. June 17, 2010 Accountancy Age. . Department of Trade and Industry and Financial Reporting Council. Key finding of this report. April 2006. Competition and Choice in the UK Audit Market. . Financial Director. FTSE-100. 2009. The 2009 Audit Fees Survey. . Financial Reporting Council. International Development. October 2009. Choice in the UK Audit Market. Fourth Progress Report. . Hinks, G. Audit Commission work should be denied to Big Four. October 15, 2010. Financial Directors. . Inman, P. Auditors role in Lehmans collapse unites opposition in calls for reform. March 15, 2010. Guardian News and Media Limited. . Oxera. Impact on access to capital. October 2007. Ownership rules of audit firms and their consequences for audit market concentration. . Peterson, J. Market Concentration of the Big Four Audit Firms: The Feasibility of a Suggested Trade -- Divestiture for Liability Limitations. January 18, 2010. Re:Balance. . Spence, A. Big four maintain hold on UK audit market. March 01, 2010 The Sunday Times. . Sukhraj, P. Big Four-only audit clauses should be banned. April 30, 2008. Accountancy Age. . Sukhraj, P. Choice words from audit watchdog fail to impress. May 29, 2008. Accountancy Age. . Read More