Capital Ideas Blog

The Big Four balancing act

By Francine McKenna

From: Blog

It’s a business model that can’t lose. Audit services are legally mandated, based on the generally accepted premise that third-party verification of financial reporting by public companies plays an important role in the proper functioning of the capital markets. Nothing else, no other service, can substitute for a clean opinion from a government-sanctioned public accounting firm.

Because of the prosecution of Arthur Andersen, the market for audits of multinationals consists, effectively, of only four global audit firms. Those four firms audit the overwhelming majority of publicly listed companies in the US and the EU.

Each audit firm is likely to be aware of the actions of the others and decisions of one audit firm often influence and are influenced by the decisions of the others. On the other hand, the stakes are high. Audit failures are often highly visible and can be quite costly to everyone involved. Litigation for negligence or malpractice against the largest four audit firms rarely goes to trial because of the danger that open court testimony about audit quality may affect future defense strategies for them all.

Current policy discussions in the US and the UK center on two events that would impact the supply of audit services globally and, therefore, likely the quality of financial information and costs to the capital markets. The first is the impact of further concentration in supply if one of the largest audit firms is disabled, either through litigation or sanction, and unable to provide audits to existing or potential clients for a period of time or even permanently.  

The second event is the proposal, actively discussed in the US and the EU, of a mandatory audit firm rotation scheme. A firm rotation mandate now seems unlikely in the US since the House of Representatives recently voted overwhelmingly to prohibit the industry regulator, the PCAOB, from imposing one. Even if the US Senate never acts, the message to the PCAOB is clear: No forced rotation will be allowed. Investors may want something different, but their voice is rarely heard in any number or in unison compared to the strong lobbying to maintain the status quo by audit firms and corporate executives.

The UK Competition Commission stopped short, for now, of mandating firm rotation, recommending only that companies put auditor contracts out to bid at least every five years. The FT reported that, in some cases, audit committees have forgotten how long it’s been since they last changed auditors. Tendering every five years is a more aggressive stance than the ten-year timeframe currently required by the UK industry regulator, the Financial Reporting Council (FRC). (In the US the average auditor tenure is approximately 28 years.)

Companies’ audit committees choose their auditor every year, theoretically, although the selection and retention process by most is less than transparent. Both UK proposals, however, leave it up to audit committees to ultimately decide if auditors should continue to serve. Data reveal a strong tendency to rehire the previous year’s auditor. Between 2008 and 2010, the probability of renewing an existing auditor relationship, according to Chicago Booth’s Joseph Gerakos and Chad Syverson, was approximately 95%.

In their new research paper, “Competition in the Audit Market: Policy Implications,” Chicago Booth Professors Gerakos and Syverson say an unexpected market exit of any of the Big Four audit firms would result in substantial losses in client companies’ expected “consumer surplus.” Consumer surplus is defined as companies’ value of purchased audit services in excess of the fees paid for them—that is, the net benefit derived from the audit services.

Gerakos and Syverson estimate that, conservatively, client companies’ consumer surplus, the total dollar amount client firms would have to receive in order to be indifferent to losing the ability to hire the exiting auditor, would be between $1.2–1.8 billion per year depending on which of the four auditors exits the market.

This loss represents only the direct effect of the loss of auditor choice. It does not account for the potential increase in audit fees that may occur as a result of less competition among the remaining auditors. In that case, moving from the Big Four to the Big Three, the authors estimate audit fees could increase between $0.3–0.5 billion per year, or as much as 5 percent of the $11 billion spent on audit fees alone in 2010.

The demise of Arthur Andersen affected auditor choice and, consequently, audit fees. Andersen’s exit reduced competition among the remaining four major audit firms and that created an opportunity for all remaining firms to increase fees. Andersen’s collapse is forever linked with the passage of Sarbanes-Oxley and changes in the demand for auditing services as a result of the requirement for reviews of internal controls over financial reporting under Section 404. Prior research implies the supply shock from Andersen’s exit alone, however, was industry specific. Audit fees went up more in industries where Andersen had a greater share of the market before its collapse regardless of whether the companies were Andersen audit clients.

Did Arthur Andersen charge lower prices and provide lower quality audits, resulting in greater fee increases for Andersen clients when they migrated to new firms? Prior research indicates Andersen provided audits of similar quality to audits provided by the other major audit firms, not necessarily better or worse. Audit fees, as previously mentioned, also went up in non-Andersen clients where Andersen had been the dominant industry player.

Another situation where a potential auditor exit would have a big impact is highlighted by the recent bribery accusations against top-ten global pharmaceutical company GlaxoSmithKline in China. GSK has an active internal audit program and conducted a 4-month investigation of the bribery claims in China earlier this year as a result of whistleblower reports. But GSK, and auditor PricewaterhouseCoopers, are seemingly gobsmacked by extensive Chinese law enforcement accusations that local executives used travel agencies to channel bribes to doctors and government officials.

PwC also audits Sanofi (jointly with EY), Novartis AG, and Merck. BusinessWeek says these companies also used the same travel agency under investigation by Chinese authorities in the GlaxoSmithKline bribery and corruption case. (Johnson & Johnson, part of this group of top-ten global pharmaceutical companies, is also a PwC audit client. In 2011 J&J settled Foreign Corrupt Practices Act allegations focused on business conduct in Greece, Poland, Romania and an investigation of a J&J subsidiary in the United Nations Oil for Food Program in Iraq. Roche and Astra Zeneca, KPMG audit clients, are also under scrutiny by Chinese officials in this latest crackdown.)

PwC, like all of the Big Four audit firms, actively defends against hundreds, if not thousands, of significant lawsuits, in particular right now for the failures of clients such as MF Global and Colonial Bank. PwC’s significant role in the failed OCC/Fed mandated foreclosure reviews was negatively portrayed in reports by legislators and media. PwC could be scrutinized by regulators at any time for missing repeated alleged illegal acts such as Libor manipulation, “rogue” trading, money laundering, energy market manipulation and mortgage servicing fraud at banking audit clients JP Morgan Chase, Barclays, and Bank of America, for example.

If five of the top ten global pharmaceutical companies or two of the top four US money center banks were forced to choose a new auditor as a result of significant litigation or government sanction event against PwC, the cost of such increased industry concentration could be enormous.


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