Audit firms and Corporate Governance

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AUDIT AND CORPORATE GOVERNANCE

12 February 2014

Introduction

Audit firms have been under the spotlight ever since the collapse of Arthur Andersen in 2002. Lately, the competition commission (CC) had accused the so called “big four” as being too dominant and not meeting the shareholder’s needs. The 4 dominant accounting firms are PWC, Deloitte, Ernst and Young and KPMG. In a recent finding demonstrates, in 2010, the big 4 accounting firm were auditing 99 of the FTSE 100 leading firms and only three of the Big Four audit banks in UK. The Big 4 are dominating the market because the next tier of smaller accounting firms are much smaller in size and revenue, the audit revenues of even the smallest of the Big 4 are nearly three times those of the largest second tier firm (ParlimentUK). Therefore, the CC is now trying to encourage better competition within auditing firms by tendering and rotation of auditing firm in order for companies to have better bargaining power. The CC is encouraging companies to change and rotate auditors at least once in every 5 years. Auditing firm need to have more competition in the market and not monopolise in order to increase transparency, strengthening accountability and independence when conducting an audit.

Advantages of the Big 4 accounting firm dominating the market

Although the CC would want the auditing market to be more competitive, however the domination of the Big 4 firms does have several advantages. Auditing companies that have been in service with the same client for several years had developed an understanding and familiarisation within the auditor and the company that is being audited. Companies do tend to retain its existing auditors, especially the big 4 because, they are deemed to be more experience and resourceful as compared to mid-tier auditing firms. Audit quality is higher when audits are performed by firms that have industry expertise and by offices that are large, conditions that exits almost exclusively among big 4 firms (Newton et al 2013). Thus, because of familiarisation, the auditing company spent less time and man power when auditing a company as compared to a new auditor auditing a company. Therefore, if a company is required to change its auditors frequently, auditing companies and companies that are being audited will then incur a higher cost. Tony Cates, UK head of audit at KPMG, said: "Five year audit tendering will feel relentless to many companies, audit committees and investors who may only see audit quality damaged rather improved. Moreover, the commission estimate the cost to reform will be at least £30 million a year once it is up and running (Peston 2013). Having more accounting firms to switch from will cost the company to incur a higher expense and reduce the current standard of accounting as smaller accounting firms lack experience accountants.

Moreover, the dominance of the Big 4 has created certain degree of brand recognition among the market. Therefore is only logical for big companies that are listed in the stock exchange to appoint the dominated big 4 as their respective auditors. The dominance of big 4 has ensured that they have the capability to audit large companies and to keep their company private data. "The degree of concentration in the audit market has arisen as a direct result of market forces and, in particular, the demand from investors for audit quality as well as appropriate capability to undertake complex audits across the world”(ParliamentUK) . So the big 4 has clearly demonstrated that they have the capability and assurance to perform auditing to big companies and the big 4 act as a resourceful reliance to the users of financial statement. Moreover, the advantages of having good brand recognition allow the company to project their image as a global company. Consumers around the world are more likely to accept the big4 accounting firm as opposed to less dominated firm in the market. KPMG justify that they are now practicing in 150 countries around the world (Asher 2008).

The dominance of big4 have lead firm to very high revenue. Thus, big4 accounting firms do have the extra cash to spend on training its current employee to ensure quality is maintained throughout. Mid-tier firm are unlikely to spend on additional training for its employee as they are not capable to compete with the big4 in term of their spending power. A draft report demonstrates that accounting firm can improve the quality of audits through education and training program to ensure better sustainability (Ascher 2008). Therefore, with continue improvement and quality, big 4 firms will ensure continued quality.

Disadvantages of the Big 4 accounting firm dominating the market

Despite evidence that bigger firms do have the better expertise to perform a better audit, however, regulators have raised their concern that a less competitive market affects the quality of service that auditors provide to its clients. Auditor concentration reduces choice, induces complacency, reduce innovation, allow audit leniency, and decreases investor confidence (UK House of Lords, 2011). The domination of the big 4 has alerted the CC in questioning the quality of the audit work performs by the auditors and the independence of the accounting firm. The regulators are concerned that they are too dominant and do not always meet shareholders' needs (Peston 2013). The big 4 had been accused that since large companies have been reappointing the same auditors over again, and had developed a relationship between directors and auditors. Thus, a recent finding demonstrates that, audit firm ignore the interest of their primary shareholders which are the company’s shareholders and meeting the demand of the management instead. This is because, executive team decide if the firm would retain its service and as a result of that, competition focuses on factor that are not in line with shareholders demand (SkyNews 2013).

In addition, another disadvantage when the market is dominated by the big 4 is when a public listed company which seek public accounting service, they will be face a tight oligopoly. Both tight oligopoly and a dominant firm market structure allow the Big 4 accounting firm to use their market power either partly or through collusion to their advantage. This is because, when one firm have the dominant position in the market, the result may be price leadership. The firms with lower market shares will not have the choice but to simply follow the price changes that is set by the dominant firm (Pai and Tolleson 2011). Therefore, by having little competition which results in a dominant market, such as the Big 4, the accounting firms will then have the power to dictate the price of the accounting fee. Furthermore, a journal article also argued that when like-minded managers operate in the same industry and band together they usually engage in manner that are damaging to the public interest. Adam Smith that demonstrates that when small numbers of large competitors associated with an oligopoly have the market to influence price and to pass risk on to other, especially to smaller entities (Pai and Tolleson 2011). Thus, it is important for the auditing market to remain competitive for companies to achieve fair auditing fee because the standard economic theory suggests that consumer make economic decision based on cost or efficiency.

Next, another disadvantage of the dominance of the big 4 is that, the current market share for accounting firm carries too much of a risk involved if one of the big 4 leave the audit market. The market could not afford any of the big 4 to be insolvent which result the big 4 to reduce to big 3 or probably 2. The exclusion of Arthur Andersen has impacted the accounting market negatively. The systematic risk refers that the reduction of the big 4 will cause even more problem in the market such as major disruption to financial market and thousands of large business (Huber, 2011). Hence, it is important for the market to be dominated by more than the commonly known big 4 to ensure better competition and to avoid the risk of another accounting firm to be insolvent. Many agree that restrict choice and competition to unacceptable extent. The Association of British Insurers also claim that the remaining big 3 do not have the capability to absorb a failed big four firm (ParlimentUK).

Conclusion

The domination of the big 4 still raised many concern within the public and the CC. However, having a tight oligopolistic market does allow big 4 to maintain a global brand that is recognizable around the world that ensures client the highest quality. In spite of this, the CC is still concerned that the market is too dominated by the big 4 and will affect quality and price leadership in the market. Therefore, it is important for CC and governments to intervene to investigate the pro and cons of having a dominated big 4 accounting firms in the market.

(1472 words)

Work Cited:

Ascher, B 2008, “The Audit Industry: World’s Weakest Oligopoly?’, The American Antitrust Institute, AAI Working Paper No. 08-03, viewed 29 January 2014.

House of Lords 2011, ‘Auditors: Market concentration and their role’, Authority of the House of Lords London: The Stationery Office Limited, Volume 1:Report, viewed 28 January 2014.

Huber, N, 2011, ‘Big Four break-up threat’, AccountancyAge, viewed 28 January 2014.

Newton, N, Wang, D, & Wilkins, M 2013, 'Does a Lack of Choice Lead to Lower Quality? Evidence from Auditor Competition and Client Restatements', Auditing, 32, 3, pp. 31-67, Business Source Complete, EBSCOhost, viewed 27 January 2014.

Pai, K, Tolleson, T, 2011, ‘The Capture of Government Regulators by the Big 4 Accounting Firms: Some Evidence’, ASBBS Annual Conference, viewed 27 Janaury 2014.

ParlimentUk, ‘Concentration in the audit market’, ParlimentUK.com, viewed 29 January 2014.

Peston, R 2013, ‘Audit Market Competition Plan Unveiled’, BBC News Business, viewed 27 Janauary 2014.

Peston, R 2013, ‘Will Big Four Auditors Become More Powerful?’, BBC News Business, viewed 27 January 2014.

SkyNews 2013, ‘Big Four Accountants “Dominating Market”’, SkyNews HD, viewed 27 January 2014.

Tolleson, T, & Pai, K 2011, ‘The Big 4 Accounting Firms: Too Big To Fail?’International Journal Of Business, Accounting, & Finance, 5, 1, pp. 56-66, Business Source Complete, EBSCOhost, viewed 27 January 2014.

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