FEATURE Audit Survey

The Financial Director audit survey shows the Big Four has maintained its stranglehold on the audit market. But for how long? asks Richard Crump

Auditing the auditors

y the time you read this, the landscape of the audit market will likely have been subject to dramatic, tectonic change. The latest Financial Director audit survey shows the Big Four accountancy rms continuing to dominate the FTSE 350 audit market, while smaller non-listed companies mimic their larger peers in picking the best names available to vet their accounts. This is all set to change. The industry stands on the cusp of the most radical overhaul in its history. An investigation into the Big Fours concentration of the market is set to break their stranglehold of large-listed audits and potentially pave the way for smaller firms to make inroads into a previously closed market. At the time of writing, the Competition Commission is days away from delivering the preliminary ndings of a two-year investigation into a perceived lack of competition for FTSE 350 audits. While it is unlikely the UK competition watchdog will call for the most drastic measures that opponents of the Big Four have urged such as hiving o their audit practices into separate companies some form of mandatory auditor rotation is expected. Whether or not rms such as Grant Thornton, BDO and PKF will be able to
The Financial Director Audit Survey has been produced using FTSE 350 data provided by Manifest, based on disclosures in companies 2011/2012 annual reports, and independent research conducted by Financial Director. NMC Health plc & Bank of Georgia Holdings plc are new companies in the index with no data available; Investec plc has two auditors. Fees are reported individually therefore, they comprise two records instead of one. Constituents of the FTSE 350 are correct as of June 2012.
FTSE 100 highest audit fees Company HSBC Holdings Royal Dutch Shell Royal Bank of Scotland Lloyds Banking Group BP Aviva WPP Unilever GlaxoSmithKline Old Mutual Name KPMG PwC Deloitte PwC Ernst & Young Ernst & Young Deloitte PwC PwC KPMG

Audit fee 31,436,210 30,276,677 28,600,000 23,400,000 21,902,277 20,000,000 16,700,000 15,026,421 13,900,000 13,700,000

Audit-related fee 16,555,545 1,288,369 5,100,000 2,900,000 6,441,846 6,100,000 3,100,000 834,801 3,400,000 400,000

Non-audit fee 8,116,726 0 7,400,000 10,000,000 7,086,031 2,400,000 8,600,000 3,339,205 6,400,000 3,400,000

FTSE 100 lowest audit fees Company Hargreaves Lansdown Aggreko Admiral Group United Utilities ARM Holdings Capital Shopping Centres Group Randgold Resources Ashmore Group Wm Morrison Supermarkets Antofagasta Name Deloitte PwC KPMG KPMG PwC PwC BDO KPMG KPMG Deloitte Audit fee 100,000 160,000 200,000 200,000 261,000 350,000 385,557 400,000 400,000 429,027 Audit-related fee 6,000 521,000 0 100,000 555,000 40,000 0 0 200,000 428,383 Non-audit fee 0 217,000 300,000 100,000 259,000 972,000 0 500,000 700,000 443,843

penetrate the highest echelons of the company audit market as a result of the Competition Commissions ndings and recommendations, the toughening stance on audit tenures could well lter down to the relationships of mid-market nance directors and their auditors. Yet this is a debate for the future. At present the status quo remains. Out of the 349 FTSE 350 audits surveyed by Financial Director and Manifest see box for details of the data only 15 sets of accounts were vetted by companies outside of the Big Four. Between them, PwC, KPMG, Deloitte and Ernst & Young earned a staggering 663.3m in audit fees, according to companies 2011/2012 sets of accounts. Of the four, PwC is the undisputed leader, picking up 249.2m in fees, compared to its nearest competitor KPMG, which collected a distant, but nevertheless impressive 154m in fees from its audit clients. On the face of it, the Big Fours grip of the market is as iron-sted as ever. Yet

there is an important distinction that should be made between competition and choice, explains Ian Powell, chairman and senior partner at PwC. It would be better if there was more choice, but I dont think anybody should make the mistake in thinking there is no competition, Powell told Financial Director in an interview last year. Its ferocious. Every piece of work we do, whether on audit or consultancy, is hard fought and the pricing pressure at the moment is signicant. It strikes me that pricing pressure is a pretty good example of competition. Arguing about the distinction between choice and competition is more than mere semantics on the part of Powell. There is a case to be made about the competitive nature of current pricing in the audit market. In 2012, the total FTSE 350 audit market accounted for 669.4m fees, compared to 689.8m in 2009. And it is not only the Big Four that have experienced the pressure competitive pricing is perhaps

30 | nancialdirector.co.uk | March 2013

Level of importance for FDs when assessing audit quality

Efciency of audit process Reliability of audit report Knowledge of sector and business Communication skills Ability to spot mis-statements Independence of the rm Degree of challenge by auditor Project management skills Scepticism exhibited by auditor Added value services Innovation
0.0 0.5 1.0 1.5 2.6 2.49 2.43 2.21 2.0 2.5 3.0 3.5 4.0 3.7 3.63 3.51 3.5 3.4 3.32 2.98

Ernst & Young

Innovation

4 3

Independence of the rm Knowledge of sector and business Reliability of audit report

Added value services

Project management skills Scepticism exhibited by auditor Efciency of audit process Importance of factor for an audit Average top 5 accountancy rms

Degree of challenge by auditor Communication skills Ability to spot mis-statements Average Ernst & Young

even more telling, the lower down the food chain you go. One senior audit partner at a top ten firm described the pricing environment as brutal, just brutal, when speaking to Financial Directors sister title Accountancy Age. He is not alone in believing so. There have been accusations of price-cutting, lowballing and dumping business the act of offering work below cost with a partner at a top 20 accountancy firm telling Accountancy Age the environment is the most challenging I have ever seen.
FTSE 250 highest audit fees Company Investec Balfour Beatty Man Group Phoenix Group Holdings TUI Travel ICAP Invensys Mondi Logica Rentokil Initial Name Ernst & Young Deloitte PwC Ernst & Young PwC PwC Ernst & Young Deloitte PwC KPMG

A number of rms are nding it extremely dicult. We have seen margins go down across board, she said. The preponderance of the Big Four among the FTSE 350 only BDO, Grant Thornton and PKF have any clients in the index should come as no surprise. It has ever been thus. More interesting is the fact that they dominate the market for smaller company audits as well. According to research conducted by Financial Director, the Big Four hold a 39%

Big Four dominance

Audit fee 6,114,000 5,100,000 4,031,952 4,000,000 4,000,000 3,400,000 3,400,000 2,754,844 2,600,000 2,600,000

Audit-related fee 1,740,000 500,000 214,513 500,000 1,000,000 1,100,000 300,000 166,960 200,000 400,000

Non-audit fee 1,541,000 800,000 634,522 2,200,000 2,000,000 500,000 2,400,000 500,881 700,000 200,000

FTSE 250 lowest audit fees Company Personal Assets Trust Edinburgh Dragon Trust Herald Investment Trust Murray Income Trust BlueCrest AllBlue Fund Aberforth Smaller Companies Trust Fidelity European Values JPMorgan American Investment Trust Monks Investment Trust Blackrock World Mining Trusts Name Ernst & Young KPMG Ernst & Young Ernst & Young Ernst & Young Ernst & Young Grant Thornton Deloitte PwC Ernst & Young Audit fee 14,000 15,000 18,000 19,000 19,299 20,000 20,000 21,000 22,000 23,000 Audit-related fee 0 5,000 0 0 0 0 0 0 0 6,000 Non-audit fee 12,000 4,000 0 4,000 5,824 2,000 1,000 8,000 1,000 0

share of the overall audit market. Based on responses from 188 nance directors, nancial controllers and group treasurers 88% of whom were from non-listed companies the ve most popular auditors by response were KPMG, PwC, Grant Thornton, Deloitte and Ernst & Young. That the ve largest rms in the UK ll the top ve slots is to be expected. Of interest is that Grant Thornton, which vets the accounts of six FTSE 350 businesses, garnered more responses than Deloitte and E&Y. Steve Maslin, assurance partner at Grant Thornton, has previously taken issue with claims that the mid-tiers diculty in tapping the market was not a sign of barriers to entry but simply reects the will of the market. This result goes some way to bearing that out. We will invest and deliver high-quality work and value for money where we have a realistic opportunity to win work and there are no barriers to entry. That is not currently the case in the FTSE audit market and will not be the case for the foreseeable future without regulatory intervention, Maslin told Accountancy Age. Speaking to Financial Director about the results of the survey, Maslin adds: Grant Thornton is the clear audit market leader on AIM and government audit and, on various measures, has come out in the past as one of the top three auditors to large, privately held businesses. These market segments already recognise the firms strength in quality, service and price it is really only the FTSE 350 that has lagged behind.
March 2013 | nancialdirector.co.uk | 31

FEATURE Audit Survey

Grant Thornton
Innovation Added value services

4 3 2

Independence of the rm Knowledge of sector and business Reliability of audit report

KPMG
Innovation

4 3

Independence of the rm Knowledge of sector and business Reliability of audit report

Added value services

Project management skills Scepticism exhibited by auditor Efciency of audit process Importance of factor for an audit Average top 5 accountancy rms

Degree of challenge by auditor Communication skills Ability to spot mis-statements Average Grant Thornton

Project management skills Scepticism exhibited by auditor Efciency of audit process Importance of factor for an audit Average top 5 accountancy rms

Degree of challenge by auditor Communication skills Ability to spot mis-statements Average KPMG

Other strong performers outside of the Big Four included BDO (4%), RSM Tenon (3%), Sarey Champness (3%) and Baker Tilly (2%). Nevertheless, the attraction of a big-name auditor remains whether the customer is a multinational company with complex accounts or a more simplistic mid-market business. Part of that is based on perception. Big Four names carry weight with audit committees and lenders that have been known to insert clauses into agreements requiring the borrower to use a Big Four auditor. The Big Four also prove attractive to FDs and audit committees because of their ability to deliver non-audit services in areas such as tax, compliance and transactional advice. Divinia Knowles, the nance director of Mind Candy, the company behind childrens game Moshi Monsters, recently explained that the companys changing corporate structure necessitated the adoption of a Big Four auditor. The company brought in the big guns as auditors in 2011 when PwC replaced GSM & Co. Subsequently, Mind Candy moved its reporting from UK GAAP to IFRS, and saw its audit fees increase threefold. Like many FDs surveyed by Financial Director 47% of respondents use their current auditor for tax advice - Mind Candy wanted a big name to deal with big tax issues. Despite being classed as an SME, Mind Candys corporate structure is relatively complex. With US employees and an increasing number of product lines, Mind Candy now operates with three US
32 | nancialdirector.co.uk | March 2013

companies and two in the UK. Our tax overhead is quite complicated, because we have all these products that attract dierent taxes in terms of digital products and then withholding taxes of consumer products. It got to a point where we needed PwC they have oces everywhere, Knowles told Financial Director. The provision of non-audit services to audit clients remains a lucrative but thorny issue for the accountancy profession. The importance of non-audit services as a secondary revenue stream is not in doubt. FTSE 350 auditors collected 289.7m in non-audit fees last year, while for Grant Thornton and PKF it proved to be even more protable with their pure audit business. Grant Thornton, the fth-largest UK accountancy rm, picked up 1.7m in non-audit fees, compared to 1m from its audit work, while PKF earned 101,000 compared to 86,000. But when it comes to large company audits, particularly banks the audits of which were largely responsible for the instigation of the Competition Commission investigation there are questions of a conict to answer. In a recent Lords committee hearing, Lord Lawson suggested the provision of non-audit services was a case of the tail wagging the dog. Grilling members of the Big Four who appeared before the Commission on Banking Standards in January, Lawson suggested that providing consultancy services to audit clients was

Tail wagging the dog

an area of potential conict of interest, and added that a disparity between the protability of audit work and consulting services was a cause for concern as we have the tail wagging the dog because audit is a critical function that is in the public interest. However, the Big Four denied one service was inherently more protable than the other and, in any case, there are already a number of checks and balances that govern the work auditors can do for their clients to prevent clear conict. If there was a tax judgment that was dependent on an accounting treatment where the amounts were material, we couldnt give tax advice related to that, said John Preston, PwCs global tax policy leader, while Jane McCormick, head of KPMGs tax and pensions practice in the UK, added that nancial institutions have tended to limit the consulting work they give to auditors. Very often, it is simply more trouble for a nancial institution to use its auditor to give tax advice than it would be just to hire one of the competitors, she said. Nevertheless, John Cullinane, tax partner at Deloitte, suggested that the profession would be comfortable if an iron rule was imposed to prevent auditors providing tax consulting to clients. However, non-audit work presents a likely entry route for nonBig Four rms into the market for FTSE 350 audits. As Maslin explains, it is dicult to make a case for being able to deliver big company audits unless the company has some

previous experience of dealing with the rm. Companies realise there is no point putting us on a future audit tender list unless we already have a meaningful business relationship, eg. through advisory services initially, and many are talking to us already about how best we can establish that relationship, Maslin says. No less thorny for the profession, and for nance directors and audit committees, is the idea of companies being forced to a compulsory switch of auditors. It is widely expected that the Competition Commission will demand some form of mandatory auditor rotation when it delivers the preliminary ndings of its investigation. Pressure is being brought to bear on this issue from all sides. A separate investigation into audit quality being conducted by the European Commission, based on proposals laid out by internal markets commissioner Michel Barnier, suggests companies should be forced to switch auditors. European policymakers remain heavily divided on the issue. British MEP Sajjad Karim, the rapporteur steering the bill through the European Parliament, published a working paper on behalf of the parliaments legal aairs committee which suggested mandatory auditor rotation should only have to take place every 25 years. Watering rotation rules down to 25 years the commission initially called for six years may be seen as a sop to the Big
What is the length of your audit tenure?

Swings and roundabouts

26% 44%

30%

Less than ve years Six to ten years More than ten years

Four, the cabal of rms most likely to lose out by the enforcement of strict rotation rules. However, Karim says it should not be seen this way. Leaving the market as it is will not be an option. The end conclusion I came to is that neither is it a healthy situation that we deliver on a political path where we do something because we need to be seen to do so, nor is it that we maintain the status quo. I dont want that to be seen as the eventual outcome, he told Accountancy Age in an interview. Karims ideas on audit tenures have proved to be a divisive issue. Shortly after Karim produced his working paper, German MEP Jrgen Creutzmann, member of the European Parliaments committee on industry, research and energy, produced a report that called for audit tenures to last no more than seven years as it would render the selection process more transparent and give the audit committee more choice. Creutzmann was not the only one taking pot shots at the proposals. Ahead of the publication of Karims report, a collection of the largest investors in Europe ganged together to urge the EC to push ahead with tougher audit reforms. Signatories of a joint letter sent to the EC included Euroshareholders, a group of about 30 European national shareholder associations, the investment arm of Legal & General and the Universities Superannuation Scheme. High on their agenda is that auditors need to rotate every six years, although this could be extended to nine years if there are joint audits, with a cooling-o period of four years. But big questions remain over whether mandatory rotation will improve competition, or for that matter improve audit quality. Powell at PwC doesnt think it will. That removes competition, Powell said. You have immediately taken covenant out of the equation. You might have a fantastic audit team doing a fantastic job, and they have to be eliminated. Powells answer is what you would expect the leader of a Big Four rm to say. Yet his views are shared by those in the mid-tier. It is quite interesting to see mandatory rotation come up as an answer ... academic studies show it doesnt increase competition, James Roberts, audit partner at mid-tier rm BDO, said ahead of the

Who is your auditor?

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Competition Commission report. It would have to include some form of mandated involvement of non-Big Four rms. UK reporting regulator, the FRC, last year decided to force FTSE 350 companies to put their audits out to tender every ten years or explain why they didnt while not requiring them to rotate. Maslin says the FRC rules had been helpful, but called for the commission to go further. The FRC proposals could be bolstered with some form of backstop rotation period, he says. Yet something needs to be done to encourage switching among the largest companies. Research carried out as part of the Competition Commission inquiry, which surveyed more than 600 CFOs, nance directors and audit committee chairs, found little desire among respondents to change auditors. According to the survey, FTSE 350 companies have used the same auditor for an average of 11.3 years, while 59% have not changed auditor for at least ve years. More than a third of companies were found to have used the same Big Four auditor for more than 11 years, with 14% using the same rm for more than 20 years. However, in instances where companies had switched their auditor, more than half
March 2013 | nancialdirector.co.uk | 33

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FEATURE Audit Survey

Which of the following non-audit services do you use your current auditor for?
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to take the hint. Already some of the largest companies Schroders and BG Group to name but two have recently switched auditors, a consequence of a shift in attitude towards the hitherto cosy relationships companies enjoyed with their auditors. So maybe the market is competitive, after all. PwC certainly didnt waste any time in claiming that to be the case on losing the BG audit to Ernst & Young. James Chalmers, PwCs UK head of assurance, said: We operate in a ercely competitive market where all participants win and lose audits. We are committed to delivering high-quality audits for the benet of our clients and their shareholders. Imposing competition for competitions sake is not an end in itself. The aim, on which auditors and nance director both agree, is to improve audit quality. Because, while price is undoubtedly important, quality matters. But how do nance directors judge audit quality? And what elements of the audit process are more important than others? Regulators seem to think a lot of it boils down to better auditor dialogue with audit committees, and more extensive communication through the auditors report that accompanies annual reports. For instance, auditors will be required to warn investors about risks within the companies they audit as part of a step change in the way audit reports are structured, proposed by the FRC in February. In response to criticism that auditors reports are uninformative, the reporting watchdog has launched a consultation to extend their scope to include a commentary of the risks of material misstatement identied by the auditor. As part of the changes, which could force auditors to ag risks that dier from those disclosed by company directors, auditors will be

What is the fee your company paid for its last statutory audit?

39%

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experienced a reduction in cost and 64% reported an improvement in audit quality. When switches have been made, the Big Four has mopped up almost all of the business on oer. According to the research, 97% of all switches made by FTSE 350 companies in the last ve years have been to, or within, the Big Four. But outside of the FTSE 350 audit tenures are much shorter. According to Financial Directors research, 44% of companies current auditor has had a tenure of less than ve years, while 30% reported tenures of between six and ten years and 26% revealed that tenures has lasted more than ten years. Despite the stark gures, traction is already being made in this area. Finance directors and audit committees are starting
FTSE 350 auditor fees Auditor BDO Deloitte Ernst & Young Grant Thornton KPMG PKF PwC Total Clients 8 89 64 6 81 1 100 349 Audit fees 1,979,480 137,146,448 126,000,200 1,029,309 153,981,748 86,000 249,179,185 669,402,370

Audit-related fees 22,000 18,953,683 20,708,382 8,000 42,130,044 13,000 27,609,602 109,444,711

Non-audit fees 793,820 72,614,890 46,043,577 1,712,399 54,456,081 101,000 113,978,270 289,700,039

Total 2,795,300 228,715,021 192,752,021 2,749,708 250,567,873 200,000 390,767,057 1,065,260,160

34 | nancialdirector.co.uk | March 2013

1 0k or les s 1 0k -2 5k 2 5k -5 0k 5 0k -1 00 1 k 00 -2 50 2 k 50 -5 00 k 5 00 -1 m 1 m5 m 5 m1 0m Ov er 1 0m

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required to explain how they applied the concept of materiality which relates to the importance of transactions, balances and errors contained in the nancial statements and summarise how the audit scope responded to company risks. The FRC proposals build on a raft of suggestions published by the IAASB in June last year aimed at improving the auditors report. In addition to improving corporate reporting in a general sense, the various initiatives aim to force auditors to provide greater transparency about signicant matters in the nancial statements, as well as the conduct of the individual audit. The changes will no doubt make the auditors report more interesting as well as insightful. The one-page report has, at times, been derided for being an unremittingly dull description of how the auditor has discharged its duties which, couched in standardised wording, sheds no light on subjective matters in nancial statements. David Herbinet, audit partner at Mazars, hopes that providing more information will improve the perception and visibility of audit quality and go some way to repairing the battered reputation of audit that was the result of failings in the audit of public

FEATURE Audit Survey

interest entities in the lead-up to the banking collapse of 2008. The view is shared by respondents to Financial Directors survey, who rated the reliability of the auditor report as the second most important quality, with communication skills coming in fourth. Top of the list was eciency of the audit process, which also garnered the most written responses from those surveyed. An ecient and cost-eective service is key for my company and its 100-odd shareholders. We changed from a mid-tier rm six to seven years ago and the fee is still less than heretofore, said one respondent. Respondents were less bothered by their auditors exhibiting much professional scepticism, contrary to the views of the FRC. Last year, the watchdog published a discussion paper that urged auditors to be cynical and pragmatic in their approach to audits, while auditors have been regularly pulled up by the FRCs Audit Inspection Unit (AIU) for a distinct lack of scepticism. More needs to be done to promote the appropriate exercise of professional scepticism, in particular in relation to the level of challenge of managements explanations, the AIU said in a typical report last year. Despite this, scepticism was the third least important quality expected by nance directors from their auditors. Only product innovation and the provision of value added services scored lower.

Recurring gripes

Not all nance directors were happy with their auditor, with one respondent going so

far as to say they are an unnecessary evil and are a parasitic inuence on innovation. That response represented the most extreme view, but there were some familiar and recurring gripes that cropped up. Chiey, auditors cutting back on the time devoted to the audit and giving audits over to junior accountants. An overreliance on juniors, and a lack of continuity of service amount audit management makes for a frustrating relationship much of the time, said one respondent. Another respondent mirrored this view: The use of young audit trainees does not give a good impression. Our audit spread over many weeks with changes in personnel meaning we supplied the same information or explanation more than once. It appears they have a point. Audit hours have become a contentious point, with the FRC warning that rms have been cutting costs by o-shoring certain audit procedures, delegating work to junior sta and using more checklists, as well as other eciency measures. In its annual report into the professions performance, the FRC warned competition between firms could damage audit quality as practices try to increase the volume of audits they can perform. An example in PwCs report said it had launched its Audit Transformation programme to improve audit quality. However, the guides issued appeared to focus on improving efficiency by reducing audit hours. The FRCs Audit Inspection Unit warned it

should ensure that there is no adverse impact on audit quality as a result of its initiatives to improve audit efficiency in the light of competitive pressures. The most critical response came from one FD who questioned the value of the service they received from their auditor. The field work takes a minimal amount of time and is not particularly focused. The standard of reports including financial statements is extremely poor and requires significant correction. I feel that across the audit industry standards have dropped considerably both in terms of technical advice and client service, the respondent said. There have been several instances where I have queried their technical advice on both accounting and disclosure (at this firm and also my previous Big Four auditors) and their advice was incorrect on fairly basic points. This does not give me the confidence that their advice would be correct on more complicated queries when I would be looking for more guidance. Auditors need to start to prove themselves as valued advisers. With the UK regulators and European policymakers set to reform the audit industry though the nal terms are still to be set the lesson is clear. The reforms must deliver an enhanced service and improve audit quality for nance directors, audit committees and investors. If the reforms fail to achieve this, then the past two years of arguing will have been a waste of time and eort.
4 Independence of the rm

PwC
Innovation

4 Independence of the rm 3
Knowledge of sector and business Reliability of audit report

Deloitte
Innovation

3
Added value services

Knowledge of sector and business Reliability of audit report

Added value services

Project management skills Scepticism exhibited by auditor Efciency of audit process Importance of factor for an audit Average top 5 accountancy rms

Degree of challenge by auditor Communication skills Ability to spot mis-statements Average PwC

Project management skills Scepticism exhibited by auditor Efciency of audit process Importance of factor for an audit Average top 5 accountancy rms

Degree of challenge by auditor Communication skills Ability to spot mis-statements Average Deloitte

36 | nancialdirector.co.uk | March 2013