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Emerald Group Publishing Limited
Copyright © 2007, Emerald Group Publishing Limited
Competitiveness of the audit services market
Competitiveness of the audit services market
The competitiveness of the market for audit services has been a focus of attention as a result of significant events like the large audit firm mergers and in particular, the collapse of Enron. These events have wide global implications for the accountancy profession. Studies have been initiated to understand the different dimensions of the competitiveness of the audit services market. In the USA, the Congress mandated in the Sarbanes-Oxley Act of 2002 that the General Accounting Office should study various aspects of the audit services market competitiveness (GAO, 2003). In the UK, the Chancellor of Exchequer and the Secretary of State for Trade and Industry set up a Co-ordinating Group on Audit and Accounting Issues to investigate regulatory arrangements for statutory audit and financial reporting (CGAA, 2003). In addition, the Office of Fair Trading has assessed the implications for competition of a cap on auditors' liability (OFT, 2004). At the time of editing this special issue, the Financial Reporting Council is consulting over the public interest issues that may arise from the existing competitive environment for audit services to large companies in the UK and how they might be addressed. Moreover, the European Commission has published a Recommendation to address auditor independence issues such as the provision of non-audit services to audit clients and the rotation of auditors (EU, 2002). These reports have raised many interesting questions in relation to the competitiveness of the audit services market.
The level of market concentration and audit prices are dependent on the degree of competitiveness of the audit services market. It is important to recognise that there are a number of “audit markets”. Broadly there is a listed market, an unlisted market, a not-for-profit market and a public sector market. The listed market is dominated by the Big Four accounting firms that are enormous compared to the mid-tier firms. Statistics for 2004 show that within the largest firms globally the Big Four had income of £8-10 billion whereas the next five firms had only £1-1.7 billion (Oxera Consulting Ltd, 2006). In staff terms the comparison is about 100,000 at the Big Four and 20,000 at the next five largest audit firms. This demonstrates the dominance and influence of the Big Four that may well have an effect on audit price.
Many people concern that the merger between Price Waterhouse and Coopers & Lybrand and that the demise of Arthur Andersen will reduce the competitiveness of the audit services market. Pong and Burnett (2004) found that in fact PwC experienced a reduction in its share of overall audit services market in the UK compared to that held by its constituent firms pre-merger. Indeed, Duxbury, Moizer and Wan-Mohamed showed that the effect of the merger between Price Waterhouse and Coopers & Lybrand has been to increase the relative attractiveness of non-Big Five audit firms. Their results suggest that the creation of the Big Four as a result of the collapse of Enron is more likely to strengthen rather than weaken the position of the remaining smaller firms. Similarly, Nagy and Cenker noted that in the USA the increased oversight and workload resulting from the Sarbanes-Oxley Act requirements has changed the nature of the external audit function to more compliance type work, and the environment has created much anxiety for the auditors. They found that the Big Four firms resigned from many of their smaller and riskier audit engagements, causing an increase in market share for the mid-tier firms.
In the 1980s, there was significant pressure put on the large audit firms in the UK, at that time the Big Eight, by the 100 Group of Finance Directors and others to restrict the cost of audit. Low-balling was an acceptable means of quoting for an audit in a competitive tender situation in that it was assumed that the audit team would be able to cross-sell other services at more lucrative rates. For many reasons the downward trend in audit fees ceased in the mid-1990s (Pong, 2004) and audit fees have risen steadily since then, particularly following the Enron crashes and the subsequent regulatory changes.
It is well recognised that audit price will be affected by the size of the auditee, the nature of its business and its international exposure. For example, financial services companies tend to have the highest audit fees whereas utilities and construction companies tend to have the lowest. Research results on the impact of merger of audit firms on audit fees have been inconclusive (Iyer and Iyer, 1996, Menon and Williams, 2001, Ferguson and Stokes, 2002, Pong and Burnett, 2006).
From the analytical work done by Oxera Consulting Ltd (2006) it would appear that the Big Four firms charge higher fees than the mid-tier firms. The report indicated that the Big Four audit fees were some 18 per cent higher than those in the mid-tier firms. We spoke to one mid-tier firm partner who indicated when his firm bided for an audit of a listed/AIM audit, his firm's bid was rarely the cheapest – often at least one of the Big Four would pitch lower. There was therefore the suspicion that the Big Four would be able to use their “protected” positioning in the audit services market of fully listed companies to price keenly in other market segments such as the AIM where there is more auditor choice. He also commented on the Oxera finding that the Big Four firms have tended in the last few years to seek fee rises in the order of 20-30 per cent and then settled for around 10 per cent by saying that if his firm proposed 30 per cent increases with their FTSE fledgling/Small Cap or AIM clients they would be “laughed out of court”. In his view in his sector of the market was price sensitive but did admit that their increases were usually above the headline inflation rate.
Audit quality is also an important competitive dimension of audit firms. Accountancy Age (23 February 2006) recently reported that in some competitive tendering situations the competing audit firms were being asked to put their audit costs estimates in sealed envelopes so that audit committees making the selection could make their initial choice based on the quality of the tender rather than cost. Such a selection process has long been used by the some aid agencies when selecting consultants to carry out projects overseas. It would seem that both the auditors and the auditees are in agreement that the lowest price is not the best reason for selecting an auditor with whom you are going to have to work with for a number of years. Glyn Barker, UK head of assurance at PricewaterhouseCoopers, was quoted (Accountancy Age, 23 February 2006) as saying:
We are seeing a gradual shift in focus from price to quality, with come clients choosing firms on quality grounds then negotiating around fees if they feel the need to. Quality should be the critical factor
Chia, Lapsley and Lee found that during the Asian financial crisis in the mid 1980s, the large firms have increased their market shares. A possible reason is that during the crisis, it was important for companies to provide credible financial statements. In this respect, the large firms were able to provide better quality audits. They showed that large audit firms were able to constrain earnings management of managers of such companies.
The corporate governance culture that has developed over past decade has focussed on the need for effective audit, internal and external, and for it to be properly overseen by the audit committee of non-executive directors. As a result the non-executives need to feel that the audit service is effective and reliable. As the Chief Executive of a FTSE 250 building company we spoke to said:
While a keen eye is kept on audit pricing – as with all costs – the overriding influences in today's corporate world are undoubtedly governance and concerns over reputation – corporate and individual ... non-executive directors are very aware both of the high standards of governance expected and of the consequences of any reputational blemish ... add to this a “blame culture” and increased litigiousness and you have an environment in which there is a risk of their being a positive incentive to ask the auditor to extend their work programme – as much with a view to have been seen to have taken action as in the belief that the work will turn up anything substantive
We can also learn from experience in countries other than the UK and the USA. Both Gonthier-Besacier and Schatt, and Piot look at the audit services market in France. While there have been debates in implementing the requirement of appointing joint auditors in the UK, this practice has been carried out in France for sometime. Piot analysed auditor concentration between 1997 and 2003. He found that since the merger, PricewaterhouseCoopers did not gain any market share. Barbier Frinault, formerly associated with Arthur Andersen, lost market share as a result of Enron. Furthermore, the result of his analysis is contrary to our expectation that the increase in auditor concentration during the period was accompanied by more frequent joint-auditing arrangement among the large firms. Instead, evidence suggests that there was a reluctance of the large firms to carry out joint audits together. Gonthier-Besacier and Schatt found that audit fees charged under a joint audit by two Big Four firms was lower than that of any other joint audit arrangements. They suggested that this could be a result of a more balanced sharing of qualifications and skills, as well as potential risk, between the two firms.
There is still certainly a lot to learn about the competitiveness of the audit services market. The purpose of this special issue is to raise the awareness of the importance of this area. As a final note to the special issue, we are delighted to include a keynote speech by Professor J.P. Percy which was made at the National Auditing Conference in the UK in 1996. Professor Percy was formerly senior partner of Grant Thornton, President of the Institute of Chartered Accountants of Scotland and Chairman of The Accounts Commission for Scotland. His speech looks at the changes in the auditing profession in the last 15 years and it provides valuable insights where auditing research is necessary.
Ian MarrianVisiting Professor at the University of Edinburgh
Chris PongSenior Lecturer at the University of Edinburgh
CGAA (2003), “Review of the regulatory regime of the accountancy profession”, Final Report to the Secretary of State for Trade and Industry and the Chancellor of the Exchequer, January, Cottage Grove Athletic Association, Cottage Grove, MN.
EC (2002), “Statutory Auditors' independence in the EU: a set of fundamental principles”, Commission Recommendation, May, European Commission, Brussel.
Ferguson, A. and Stokes, D. (2002), “Brand name audit pricing, industry specilisation, and leadership premiums post-Big-8 and Big 6 mergers”, Contemporary Accounting Research, Vol. 19, pp. 77-110.
GAO (2003), “Public accounting firms, mandated study on consolidation and competition”, Report to the Senate Committee on Banking, Housing, and Urban Affairs and the House Committee on Financial Services, July, General Accounting Office, Washington, DC.
Iyer, V. and Iyer, G. (1996), “Effect of Big 8 mergers on audit fees: evidence from the United Kingdom”, Auditing: A Journal of Practice & Theory, Vol. 15, pp. 123-32.
Menon, K. and Williams, D.D. (2001), “Long-term trends in audit fees”, Auditing: A Journal of Practice and Theory, Vol. 20, pp. 116-36.
OFT (2004), “An assessment of the implications for competition of a cap on auditors' liability”, July, Office of Fair Trading, London.
Oxera Consulting Ltd (2006), “Competition and choice in the UK audit market”, prepared for Department of Trade and Industry and Financial Reporting Council, April, Oxera Consulting Ltd, Oxford.
Pong, C.K.M. (2004), “A descriptive analysis of audit price changes in the UK 1991-95”, European Accounting Review, Vol. 13 No. 1, pp. 161-78.
Pong, C.K.M. and Burnett, S. (2006), “The implications of merger for market share, audit pricing and non-audit fee income: the case of PricewaterhouseCoopers”, Managerial Auditing Journal, Vol. 21 No. 1, pp. 7-22.