No easy answers for breaking up Big Four in U.K.

The last time the U.K.’s Competition and Markets Authority attempted to break up what is widely referred to as an oligopoly of the audit market by the Big Four audit firms—EY, PwC, Deloitte and KPMG—its actions had the opposite effect. 

Auditor rotation and term limits introduced in 2014 forced an even greater concentration in the audit market, with 98 percent of the FTSE 350 now audited by the Big Four, compared to 95 percent prior to the change. Nevertheless, earlier this year, several parliamentary sub-committees tasked the CMA with deciding whether it needed to institute either a market study or a market investigation of the audit industry to try to increase options in the market. 

The CMA would neither confirm nor deny that it had held meetings with audit firms or representative bodies this month, though these meetings were confirmed by Dr. Nigel Sleigh-Johnson, the Institute of Chartered Accountants of England and Wales’ (ICAEW) Head of Financial Reporting, Audit and Assurance.

“The CMA is also meeting this month about whether to open a market investigation into the audit industry, but we don’t know whether they will make a decision this month,” he said. “The decision may be a market study, it may be a market investigation, possibly nothing; though we are expecting either a study or on investigation.”

In the meantime, the Financial Times is calling the situation the “big flaw.” Additionally, Shadow Chancellor John McDonnell has warned that, following the publication of a report into the industry by Prem Sikka, professor of accounting at Sheffield University, the Labour Party may call for the top four firms to be broken up. Grant Thornton supports audit appointments being made by a public sector body rather than by company audit committees, and Grant Thornton and BDO additionally want a ban on accounting firms offering any kind of consulting or advisory work to major audit clients. 

In contrast, Mark Weinberger, the global head of EY, was quoted as saying he didn’t believe anyone but one of the Big Four could audit the largest firms in the world precisely because they can offer an unmatched depth and breadth of expertise. 

And, finally, the Financial Reporting Council, the body that has authority over policing the industry, which is itself being investigated, has significantly increased the number of investigations and fines of auditors over the past two months.

Whatever the CMA decides to do, there is a good deal of consensus among the firms that this is a watershed moment, something the profession needs to address after a number of false starts in the past.
Dr. Nigel Sleigh-Johnson, ICAEW

Since the parliamentary select committee report into the Carillion failure in May, the ICAEW and representatives from the Big Four audit firms and mid-tier firms have met several times with the CMA. The CMA was interested in hearing about some of the discussions within the industry over further actions that could be taken to address the concentration of choice in the market. And the issue is choice, as one insider put it to CW: “The competition in the market is still huge. Ninety of the FTSE 100 audits have changed hands in recent years and most audit firms are participating in most of those bids. It’s not a competition issue, there is competition. It’s a choice issue.”

Another potential problem, according to insiders, is that there is also a dense concentration of fees at the top end of the market. The total audit fees for the FTSE 350 are around £1.2 billion (U.S. $1.57 billion), at least half of that earned from the 50 largest companies in the index. In the smallest 100 companies, the fees amount to only around £45 million. But it is the bottom of the market that would most easily be opened up to the second-tier firms; smaller, less complex, more domestic companies. However, that fee income is less attractive for a new participant, especially given the unlimited liability and a regime of stringent fines from the FRC. Thus, the profit on a £45 million revenue stream, with the need to recruit more talent and install costly infrastructure, is not going to be high. The problem still needs to be solved.

“We put together a large group of firms,” said Sleigh-Johnson “and also spoke to ICAS [the Institute of Chartered Accountants of Scotland], and had a number of discussions over the summer trying to work out whether there was consensus across the large firms—not just the top four, quite a bit wider than that—for change in the market, and what sort of measures might be taken to address that. 

“We were not trying to reach a view on the pros and cons of any of the potential solutions. A lot of them have been talked about before, and actions have been taken, by the U.K. regulators and by the CMA, to address the problem, but they haven’t had a very significant effect. 

“The discussions were very fruitful, with a lot of genuine interest from the Big Four and from several smaller firms in reaching a solution, which everyone agreed would have to entail a number of different measures. Following the discussions, we reported back to the CMA at the end of August that we had found some level of agreement over a package of measures that would likely be a mix of both voluntary and mandatory changes.”

CW interviews with Sleigh-Johnson, as well as with the heads of audit at some of the major firms, confirmed that there is considerable commitment to the public interest to make progress and cooperate with the regulators whatever they decide to do.

Asked about the comments of the EY CEO, Sleigh-Johnson said: “I’m sure there are different views within individual firms, and different views across different jurisdictions, but that’s why it’s interesting that we found this degree of consensus over recommending a range of reforms to the CMA among the Big Four, the next two largest firms, and a number of other smaller firms. I’m sure if you spoke candidly to partners in the U.K. or partners in the U.S., people working in audit, working in non-audit,” he continued, “you would get a range of different messages, different tone and a different level of anticipation of change. But something’s changed, and there is a widespread understanding that something needs to be done.” 

Sleigh-Johnson noted that there were different views between different firms; in addition to Grant Thornton’s support of an independent authority to appoint auditors, Mazars are very strongly in favour of joint audits. “Neither received universal support,” he said, “but they are on the table.”

Also in response to the comments from the EY CEO, a CW source admitted that the possibility of a mid-tier firm auditing any of the top 50 firms tomorrow was not realistic. “They are too complex, often in specialist industries like financial services,” he said, “and global in reach so you need a global network to be able to order them.” 

A modern audit draws on expertise from all over the Big Four firms, in pensions and valuation, for example, much of which is being drawn from outside the audit business. Mid-tier firms don’t currently have either the breadth or the depth of expertise for such an audit.

Sleigh-Johnson enumerated the main discussion points that had come from the meetings and that had been presented to the CMA. The first was market share caps, which, he said, might apply to different segments of the market, rather than a single percentage cap that applies to the whole of the listed market—the 80 percent cap most often touted in the press. “The cap might be different for the FTSE 100, or for the FTSE 250, or the rest of the listed market,” he said. “There might also be a different approach to very complex financial services companies and global businesses.” While a set of different market caps might seem more complex, it might, it was felt, also be more practical and acceptable.

In speaking to someone at one of the Big Four firms, CW sought an industry-side understanding of some of the proposals. It was felt that some of the potential solutions were fine in the laboratory, but more difficult in the real world. One of the difficulties of a market cap, for example, is, say a firm audits 92 companies in the FTSE 350, it would have to divest itself of 22 clients. How would you do that? How would you decide which of the 22 clients to divest and which firm would they move to? These difficulties also gave rise to the following scenario, which CW was told happens at least once a month in the bidding process. In a market where there are only four players, when an audit is out for bid, one of those players is off the table and one, or even two, of the other firms may be prohibited from bidding for the job because of conflicts of interest due to other work being done for the company. That leaves a company with a choice of one auditor, which is no choice at all. 

The concept of a shared audit has also been put forward. This is different from a joint audit, which would require both sets of auditors signing off on the accounts. Shared audits have different auditors auditing different parts of a group in various combinations. “This could be a way of accelerating the access of the challenger firms into the listed market,” said Sleigh-Johnson. Insiders agreed that a mid-tier firm might be called in to be a component auditor on a shared audit, and would be able to build skills that way.

There was also a suggestion that the Big Four firms could share skills, resources, technology and audit methodologies, which could be either short or long-term. CW asked a source how this might work in practice. 

“As well as needing the talent to execute one of these audits, you also need the infrastructure,” he said. Recognising that there might be commercial difficulties, it was felt that, rather than making the mid-tier firms go to the expense of building that infrastructure themselves, in pursuit of acting in the public interest, the Big Four might be prepared to share such resources.

“There was also agreement that the sanctions regime in the U.K. should be looked at,” said Sleigh-Johnson, “so that any sanctions become more proportionate and were not an unnecessary deterrent to challenger firms entering the market.” This change to the regulatory market is in the remit of the FRC, rather than the CMA.

Finally, and possibly most crucially, said Sleigh-Johnson, “there was widespread agreement of the need for buy-in from the demand side. In general, most believed this was as critical as anything else. A lot of these potential solutions,” he said “would involve some sort of restriction on the choice that audit committees could make. If anything was going to have a sustainable and significant effect, it would need the support of audit committee chairs.” 

Both the ICAEW and ICAS also spoke to the “demand side” in this process, and reported those findings back to the CMA as well. “Conversations are still ongoing with regulators and professional firms, and there’s a huge amount of interest outside the U.K. in all of the ideas that we have discussed.”

On this crucial demand-side question, CW’s source said: “Clients might say this is all very interesting that you’re having this conversation with yourselves but is there any point at which you are going to come and talk to us? I had an investor come to me,” he continued, “to say: if I see the signature of a non-Big Four firm on the audit and accounts it immediately raises questions in their mind as to why the company is not audited by the Big Four.

“That could just be a perception issue, but it is one that needs to be eradicated for this market to open up.”

From the demand side there is also the problem of why, when any audit costs will remain fairly constant, you would not want to buy what is perceived as the highest quality product. “The choice is not an economic one,” said CW’s source, “because mid-tier firms are not going to say that they’re going to do an audit for half the price. It would not be possible. Buyers are going to have to be made confident in the quality of the audit regardless of price.” 

While politicians and commentators might talk tough, the concentration issue gives some observers concern because they feel that auditors are too big to fail. The FRC can never be really tough because such action might cause a firm to fail, or simply decide it doesn’t want to do audits anymore and concentrate on other, more profitable parts of its business.

“The regulator is obsessed with the risk of creating a scenario where there is only a Big Three,” the source said. A market where there are eight players, it is widely held, would provide more variety, more reliability and less conflict of interest. The journey to get there, however, does not appear easy.