Every few years significant concerns are expressed about the market for external audit services, which is dominated by the Big Four firms. Typically, these concerns are triggered by a corporate collapse (most recently, Carillion) which prompts questions like “where were the auditors?”
These individual cases are regrettable, and have led to more demanding corporate governance codes, more extensive disclosures by companies and more prescriptive regulation of auditors—but cases continue to occur.
However, the most important problem with the audit market is the persistent one-way ratchet of ever-greater consolidation: Big Eight, Six, Five, Four. Although the market was able to absorb the collapse of Arthur Andersen, a withdrawal of one of the Big Four would have both rapid and serious consequences. Many clients of the Big Four buy consulting and advisory services from the other three, which means that they would be ineligible for appointment as independent auditors.
The probability of the withdrawal of one of the Big Four is higher than generally believed. The relevant probability is of the withdrawal of any of the Big Four, and the probability is increased because of the global nature of the firms. This was an issue in Texas, which created difficulties in the UK. And the risk will persist for as long as we only have four major firms.
Absence of new entrants
One significant feature of the audit market has been the absence of new entrants, in striking contrast to many other markets (such as airlines) in which well-funded new players have had a material impact on customer choice and on the behaviour of existing firms. Arguably, the last new entrant of scale into the audit market was Arthur Andersen in 1913.
The one-way ratchet of consolidation, coupled with the absence of new entrants, has reduced choice for companies (and their investors), reduced incentives for innovation and increased the risk of regulatory authorities “pulling their punches” when it comes to sanctioning firms. The Big Four are “too big to fail”.
Unfortunately, as organisations that are dependent on reputation, the Big Four are vulnerable to rapid collapse. There was a “run” (of clients) on Arthur Andersen, which was as rapid as the “run” (of depositors and buyers of securitised mortgages) on Northern Rock. And the intervention tools used to keep Northern Rock and other banks on life support are not available to respond to the impending collapse of a Big Four firm. The Big Four are also “too fragile to save”.
Previous attempts to address the issue, notably the Competition Commission’s inquiry in 2011-2013, have failed. The Commission’s principal recommendation of more frequent audit tendering has done nothing to solve the problem and has, arguably in the light of Grant Thornton’s recent announcement, reinforced the dominance of the Big Four.
The main reason for the absence of well-funded new entrants is the current ownership rules, which require the majority of voting rights in audit firms to be owned by qualified auditors. This is the audit equivalent of a rule requiring that qualified pilots had to be majority owners of airlines. Had the pilots of Easyjet and Ryanair needed to fund their own planes, then those two dynamic new entrants would literally not have got off the ground.
Unintended consequences
The audit firm ownership rule has a valid rationale: the undesirability of non-auditors exerting improper influence on audit opinions. However, the rule was introduced decades ago when there were many large audit firms and no independent audit regulators. It has had unintended consequences and there are alternative means of addressing the concern of improper influence.
We should eliminate the current audit firm ownership rule but require firms that are funded by non-auditors to implement additional safeguards against improper influence. These could include limiting the percentage that any individual investor might own, requiring a board consisting of a majority of independent directors to state publicly that the procedures to safeguard audit independence have operated effectively. And of course externally funded audit firms would be subject to the same standards and inspections as existing firms.
So, where would the capital come from? Ideally from the same source as other commercial ventures: institutional investors. Indeed, long-term investors might have a particular interest in supporting new audit firms as they have the greatest exposure to the “too big to fail” risk. This proposal would be more effective than forcing the Big Four to separate their audit and non-audit practices, which would still leave only four major audit firms.
No doubt this proposal has some imperfections, but the test is not perfection—rather, it is whether this proposal can help to reverse the audit market concentration ratchet.
Paul Boyle was the first CEO of the Financial Reporting Council and is now chairman of the whistleblowing charity, Public Concern at Work.