An appetite for greater choice

Increasing choice in the audit market is fast becoming the Holy Grail for capital market regulators across the globe, says Peter Williams

The latest bout of regulatory hand-wringing over the dominance of the Big Four audit firms recently came in the shape of consultation by the UK’s Financial Reporting Council (FRC) about how to tackle audit concentration.

The dominance of the Big Four in the UK large quoted company market is almost complete. In February 2007 no FTSE100 company had a non-Big Four audit; in the FTSE250 eight companies were brave enough not to be signed off by the Big Four. Even among the FTSE Small Cap the non-Big Four only have 15% market share. It is only when it comes to AIM does a reasonable spread appear and, in fact, the to-be-merged Grant Thornton/RSM Robson Rhodes entity should audit more AIM companies than any other firm.

One of the key recommendations of the interim report by the FRC’s Market Participants Group, published in April, was ‘to make investment in the supply of audit services more feasible’. The report goes on: ‘On the supply side, the Group believes that the principal responsibility for the decision to make this investment, and to secure appropriate sources of finance, rests with individual firms. The most important development would be additional investment by the existing non-Big Four firms or new firms in perceived and actual capabilities to audit public interest entities.’ The Group suggested that the FRC should promote wider understanding of the possible effects on audit choice of changes to audit firm ownership rules, subject to there being sufficient safeguards to protect auditor independence and audit quality.

What the provisional recommendation is suggesting is that if ownership and financing of audit firms is a barrier to entry it should be removed, subject to appropriate safeguards. A change in ownership rules would create an opportunity to increase investment in audit. At the moment firms of registered auditors must be managed and controlled by qualified accountants, and that means ownership of audit firms has to be at least 50% owned by qualified auditors.

So if the FRC’s suggestion happened more audit firms would be quoted on stock markets or owned by go-getting hedge funds. Or maybe audit firms could sell themselves to private equity, both to expand the business with the money these new heroes of capitalism would pour in, and to benefit from the experience and advice which is focused on driving growth. While quoted accountancy firms are rare but not unknown – step forward AIM-listed Vantis – to date there has been little appetite for the idea of outside investment, expertise or management to increase the competitive profile of audit firms.

Richard Bennison is a member of the UK board of KPMG. He says: ‘I have not heard articulated why outside capital would enable firms to suddenly get to the stage where they are able to offer choice at the top end of the market. The aim is to have firms that offer the choice that can compete at the FTSE100 level. To do that they need global networks with consistent methodologies and consistent quality of people, which is difficult to achieve other than over time. I don’t quite understand how the introduction of outside capital is going to help that.’

Perhaps, you might argue, a Big Four partner would say that. But Malcolm Ward, a member of Grant Thornton’s National Management Board and a former head of the firm’s London’s Audit Practice, also has his doubts. He says: ‘The case for outside capital depends on what you think you can do with the capital. The partnership model has worked over the last 100-odd years because the services we provide are based around the apprenticeship model. It is about a team of people working together and learning on the job. It is a robust model and it tends to persist.

‘It is not like an industry with huge plant or machinery that you have got to invest in. It is not a capital intensive industry, rather it depends on the knowledge in people’s heads.

‘If you look at the case for bringing external capital into that, the question would be what is your case/what is the story/what would you do with it?’

Ward argues that capital might be useful if you could achieve some sort of breakthrough such as transform your service capability, perhaps through a very large merger, or through investing in India or China, or making a strategic investment in technology. But he adds: ‘I am not entirely persuaded that it is the answer as far as audit is concerned. There are problems with bringing external capital in, to put it bluntly with the sharing of reward. In the partnership model, the stakeholders, the partners are used to sharing rewards with each other not externally.’ Bennison welcomes the idea of outside capital for those who think they need it, maybe for acquisitions of other practices, or to fund a big investment in audit methodology. But he adds: ‘The point of more choice is around having the depth and the breadth of skills and specialist that the largest clients demand. I’m not sure that it is about having money to invest, rather it is about a firm that can attract and retain the very best people to serve the largest and most complex clients.’ Firms cannot see the case for outside capital and they are reluctant to have private equity or institutional shareholders who would be demanding a large slice of the financial cake at the end of the year. They fear outside investment would drive away the very talent needed to make the business a success.

But while the larger firms may be unwilling or deem it unnecessary to embrace outside capital, there is evidence that smaller firms may not be so inflexible. In early 2007, UK-based Kato Consultancy surveyed independent firms with three to 20 partners. The survey found that four out of five of those firms would be willing to contemplate an AIM listing or bring in outside investors. Phil Shohet, Kato Consultancy director, said: ‘These firms recognise that they need to develop specialist service lines – whether that be corporate finance, insolvency or audit – and to do that they need outside capital to help them achieve those aims. We’re finding attitudes are changing dramatically in that size of firm.’ But the size of firm Shohet refers to isn’t going to impact the quoted company audit market.

And it is questionable what can make an impact on that market. Despite the best endeavours of the FRC, it may be factors other than regulation that determine who audits who in the years to come. At the same time as the FRC was publishing Choice in the UK Audit Market, Grant Thornton was acquiring RSM Robson Rhodes in the UK. After the merger Grant Thornton will still only be half the size of the smallest of the Big Four, Ernst & Young. But it is a step towards loosening the grip of the Big Four on UK large company audit mandates.

Audit-onlys

Market moves aside, other than a dramatic change of heart and culture in accountancy firms, there is one other scenario that might make outside capital a reality. Ward, expressing a personal rather than a Grant Thornton view, suggests external capital would work if there were audit-only firms. Ward says: ‘If you had audit-only firms then I think you would start to see a model concentrating on one activity, building market share and other forms of progression and reward. But so long as all of the accountancy firms have got models which depend on other non-audit services, I think external capital remains one of a lot of options.’

And audit-only firms are nowhere near a reality, or even on the regulators’ horizons. In the meantime, the fact remains that for accountancy firms capital raising is not a problem. As Ward puts it: ‘When we need capital we get it from our partners. We say, “Let’s have another 20 to 30 grand [per partner]”, and that is sufficient for our needs to grow our business quite nicely.’ Such funding is well-established, readily available and, above all, cheap.

Peter Williams is a journalist and a chartered accountant. He writes on accounting, financial reporting and auditing issues.