"The Big Four's domination of the large firm audit market in the UK is almost complete: in 2010 they audited 99 of the FTSE 100 largest listed firms, which change auditors every 48 years on average. It is clearly an oligopoly with all the attendant concerns about competition, choice, quality and conflict of interest. It gave no warning of the banking crisis."

The UK's House of Lords has delivered a damning indictment on the role of auditors and shareholders at the end of their 8 month investigation into the causes of the financial crisis. Auditors are accused of a "dereliction of duty" and investors criticised for their apathy: “Most shareholders appear to care little about a company’s choice of auditor."

According to some of the shareholders who have been active in the HoL inquiry, the report itself  "offers an unusually rich and frank review of the issues on the audit market and role of auditors in the crisis".  Although there is some disappointment that the report did not go as deeply into some areas as had been hoped (enhancing the audit report itself or defining the purpose of audit more clearly) the three main recommendations were warmly welcomed. In brief these are:

• A detailed investigation of the audit market by the Office of Fair Trading (OFT)
• Prudence to be reasserted as the guiding principle of accounting/audit; and
• Auditors to contribute more to transparency and stability, not least through formal two-way dialogue with supervisors.

Evidence given by Tim Bush, former Hermes fund manager and member of the Urgent Issues Task Force of the Accounting Standards Board was prominent throughout the report. Tim has been particularly concerned by the the conflict between IAS39 and the Companies Act 2006 which requires accounts to be prepared prudently. Tim is backed by accounting academic Professor Stella Fearnley who said that IAS "substituted neutrality for prudence".  Iain Richards of Aviva Investors added weight to Tim's concerns noting that "the True & Fair View has been characterised as being evidenced by compliance to the standards, particularly  by standard setters".

UK shareholders mostly approve the board’s recommendation on the appointment of auditors at annual general meetings with little or no discussion. Lord Myners attributed this to endemic investor apathy noting that: “The average institutional investor has about as much interest in the companies in which it has invested its client’s funds, as somebody buying a betting ticket on a 2.30 horse at Plumpton. Passionately interested in what happens for the next three minutes, but not much interested in what happens to the horse thereafter.”

The Stewardship Code may yet nudge so-minded shreholders and the Code could be beefed up to cover audit issues according to suggestions put forward by Edward Davey MP, although the report strikes a somewhat gloomy note suggesting "It seems improbable that this apathy will soon be remedied..."

Key Findings

The full report is available Here>> with supporting evidence Here >>

Thanks go to Iain Richards of Aviva Investors for putting together the following executive summary of the report.

Summary of the Conclusions and Recommendations

There was no single cause of the banking meltdown of 2008-09. First and foremost, the banks have themselves to blame…. But we conclude that the complacency of bank auditors was a significant contributory factor. Either they were culpably unaware of the mounting dangers, or, if they were aware of them, they equally culpably failed to alert the supervisory authority of their concerns.

Competition

• The audit of large firms, in the UK and internationally, is dominated by an oligopoly with all the dangers that go with that.
• Most witnesses believe that the dominance of the Big Four limits competition and choice in the audit market.
• Attempts to introduce greater competition into the audit market have so far failed.
• The last set of recommendations from the FRC's Market Participants Group in 2007 lacked teeth and had no effect.
• Measures envisaged by Edward Davey (BIS Minister) echo an approach that has palpably failed and were disappointing
• Loss of one of the Big Four would restrict competition and choice to an unacceptable extent.
• The very long tenure of auditors is evidence of the lack of competition and choice in the market

OFT

• OFT should conduct such an investigation into the audit market in the UK, with a view to a possible referral to the Competition Commission.
• The OFT should conduct a market study of restrictive bank covenants.
• Auditors' unlimited liability needs to be investigated to determine whether it deters non-Big Four auditors from taking on large listed clients (could form part of an OFT investigation)
• No immediate grounds to change the law to lift limits on shareholdings by non-auditors in audit firms (OFT should examine this)
• The OFT should address whether audit should provide broader, more up-to-date, assurance on such matters as risk management, the firm's business model and the business review as part of its broader review of the workings of the audit market.
• The OFT should examine whether any other non-audit services should be banned

Government

• The Government should work to encourage the emergence of a substantial new competitor from the abolition of the Audit Commission
• The Government should make greater efforts, to enable non-Big Four firms to win public sector work.
• The Government and regulators should promote the introduction of living wills for Big Four auditors.
• The regulation of accounting and auditing should be rationalised
• The wider powers sought by the FRC would go some way to simplifying and streamlining matters for audit.

Structural/Practice reforms

• The Committee is not convinced that a mandatory joint audit would deliver better accounts. But if pursued at least one joint auditor should be a non-Big Four firm.
• FTSE 350 companies should carry out a mandatory tender of their audit contract every 5 years.
• There is a strong case for some reduction in the audit requirement on smaller companies, but not for larger, listed companies

Auditor-Regulator dialogue

• Adequate and timely dialogue between bank auditors and supervisors is of the first importance
• Paucity of auditors and regulator meetings pre-crisis was a dereliction of duty by both
• Code of Practice proposed by the BoE and FSA while welcome does not go far enough – a statutory obligation is required.
• Mandatory Quarterly meetings and general duty to call ad hoc meetings when warranted.

IFRS

• On convergence the risk of the lowest common denominator prevailing should be recognised
• IFRS is more rules-based than UK GAAP.
• By limiting auditors' scope to exercise prudent judgment, IFRS is an inferior system which offers less assurance.
• IFRS also has specific defects, such as its inability to account for expected losses.
• The weaknesses of IFRS are especially serious in relation to bank audits.
• the Government and regulators should not extend application of IFRS beyond the larger, listed companies.
• Continued use of UK GAAP should be retained, so that the basis of a functioning, alternative system remains in place
• As it revises banking regulation, the Government should bear in mind the importance of accounting standards
• A prudent interpretation of IFRS as applied to banks should be promoted incl. sober valuation of financial instruments.
• At present IFRS permits recognition only of incurred losses, not expected losses, but it is essential that banks put aside reserves in good times to provide against downturns (would have the incidental advantage of reducing the scope for banks to pay bonuses on the basis of profits struck without taking account of possible losses).

Auditors

• The profession, regulators and the Government should all seek ways to defend and promote the exercise of auditors' traditional, prudent scepticism
• The Government should reassert the vital role of prudence in audit in the UK, whatever the accounting standard, and emphasise the importance of the going concern statement
• We do not accept the defence that bank auditors did all that was required of them, which appears disconcertingly complacent.
• the Big Four carried out their duties properly in the strictly legal sense, but we have to conclude that, in the wider sense, they did not do so.
• It cannot (or at least should not) be taken for granted by auditors that banks in difficulties will be bailed out and this should not be a decisive consideration in making the 'going concern' judgment.

Non-audit services

• A complete ban on non-audit work is not justified.
• Auditors should be banned from providing internal audit, tax advisory services and advice to the risk committee for that firm.
• OFT to examine this further

Audit Committees

• The Audit Committee should be required to include detailed reasons for their choice of auditors in their report.
• Audit committees should hold discussions with principal shareholders every five years;
• The audit committee report should detail significant financial reporting issues raised during the course of the audit;
• Audit committees should explain the basis of the decision on audit tendering and auditor choice;
• The FRC's UK Corporate Governance and Stewardship Codes should be amended to reflect the above recommendations

Risk Committees

• Strongly support the development of separate risk committees in banks and major financial institutions.
• Risk committees will increasingly require specialist skills and external advice, but not from the auditor.
• Failure to have a properly constituted and effective Risk Committee should result in auditor qualification to the accounts.

Shareholders

• With the notable exception of our investor witnesses, most shareholders appear to care little about a company's choice of auditor. It seems improbable that this apathy will soon be remedied.
• Measures which rely on shareholder engagement to help lessen audit market concentration are unlikely to be effective.

Other matters not fully addressed

The inquiry has not been able fully to address all the highly complex issues which may stem from market concentration. These include: 

1. Lack of choice;
2. Higher fees than in a more competitive market;
3. Lower quality; and
4. The huge risks involved if one of the Big Four left the audit market.