the future of auditing .. from the economist... an old but relevantpiece

[Miklos Vasarhelyi <miklosv@andromeda.rutgers.edu>]

The future of
auditing 

Called to account
Nov 18th 2004
 From The Economist print edition

The auditing industry has yet to recover
from the damage inflicted by an era of corporate scandals

NO ONE becomes an auditor because the job is adventurous. In recent
years, however, the profession has been really rather racy. Auditors have
been implicated in fraud after fraud. The Enron scandal brought down
Arthur Andersen, which had been one of the profession's five giant firms.
Now a scandal at Italy's Parmalat that was uncovered in late 2003
threatens Deloitte & Touche, another global giant, as well as Grant
Thornton, an important second-tier firm. And new scandals are still
emerging: most recently, financial manipulation was discovered at Fannie
Mae, America's quasi-governmental mortgage lender, and at Nortel
Networks, a telecoms-equipment group.

Investors depend on the integrity of the auditing profession. In its
absence, capital markets would lack a vital base of trust. So it is no
surprise that scandals have triggered changes in the profession. In
America it has seen self-regulation dissolved in favour of the Public
Company Accounting Oversight Board (PCAOB), in effect, a new regulator.
It has been deluged with new rules, restrictions and requirements as part
of the Sarbanes-Oxley act. In Europe the Eighth Company Law Directive,
which, among other things, deals with the auditing profession, is
progressing, albeit slowly, towards enactment. Britain's Office of Fair
Trading is in the midst of scrutinising its audit industry.

One consequence of all this change is that audits have become tougher.
The requirement introduced by Sarbanes-Oxley that auditors report to
independent non-executive board directors rather than company management
has reduced one overt conflict of interest. The certification of
financial reports by chief executives and chief financial officers has
focused minds. And the PCAOB has begun its inspections of audit quality
and internal controls at auditing firms. Its first, mostly reassuring,
reports were published in August.

Auditors themselves say they have toughened their standards and beefed up
internal controls. And checks-and-balances in the financial system have
been working better. Audit committees are taking their roles more
seriously and asking tougher questions of management and auditors;
activist shareholder groups, such as Calpers, are holding company
auditors to standards that are higher even than those required by law,
especially when it comes to their provision of non-audit services.
Auditors even have more business, thanks to the new rules they must
implement.

Yet despite this flurry of activity, behind the scenes there is a feeling
among auditors that they are still a long way from meeting all the
challenges they face. True, there are promising solutions to, say, the
problem of conflicts of interest. But leading auditors point to one
central concern: what, if anything, can be done to reduce the industry's
alarming concentration? That problem seems almost intractable.

The world's biggest companies rely for their annual audits on a tight
oligopoly of just four accounting firms. According to the General
Accounting Office, a congressional watchdog, the “Big Four”­Deloitte
& Touche, PricewaterhouseCoopers (PWC), Ernst & Young (E&Y)
and KPMG­audit 97% of all public companies in America with sales over
$250m. They audit more than 80% of public companies in Japan, two-thirds
of those in Canada, all of Britain's 100-biggest public companies and,
according to International Accounting Bulletin, they hold over 70%
of the European market by fee income.

This dominance raises two concerns. Is concentration stifling competition
and lowering the quality of audits? More alarming, if one of these firms
were to buckle, could the system cope with only a Big Three? “The dilemma
is that these firms are too important to fail­but there are mechanisms by
which they could fail,” says Paul Danos, dean of Dartmouth College's Tuck
Business School. “These are shaky foundations for financial
markets.”

The concentration of the audit industry is a relatively new phenomenon.
Until the Great Depression, company audits were voluntary. But as part of
the Securities Acts of 1933 and 1934, listed companies were required to
disclose audited financial information to the public. The franchise was
given to the private sector, and so the auditing industry was
born.

For several decades, hundreds of auditors plied their services to public
companies without much ado. A big change came in the industry in the
1970s, when rules restricting auditors from advertising and competitive
bidding were loosened, unleashing fierce competition­often on price as
much as audit quality. Around this time, audit firms began to move more
heavily into consulting, starting their transformation into
multi-disciplinary conglomerates peddling everything from legal and
strategic advisory services to the installation of computer
systems.

As listed companies grew bigger and more global, audit firms did too
through a series of mergers and acquisitions. By the 1980s, eight firms
dominated the American auditing industry. By 1998, this was down to five.
After the SEC's criminal indictment of Andersen in 2002 for obstruction
of justice in the Enron fiasco, the Big Five became the Big
Four.

Big,
bigger, biggest

There are arguments in favour of
such scale, at least where the world's biggest companies are concerned.
Unlike looser alliances of disparate accounting firms, which find it
difficult to monitor audit quality across countries, the truly
international audit firms spend piles of cash on common training,
internal inspections and the like, spreading the substantial costs for
these procedures across their relatively big capital bases.

Also in theory, although this is perhaps more arguable in practice, big
firms can be tougher auditors because they are not overly dependent on
the profits they derive from a single client. They can also develop the
specialised expertise needed to audit increasingly complicated
clients­Citigroup and HSBC, for example, have banking activities spanning
derivatives trading to syndicated loans, spread across dozens of
jurisdictions.

The question facing the industry is how few
firms would be too few? In 2003, after the implosion of Andersen, the
General Accounting Office addressed this question at the behest of a
worried Congress. It found no evidence of collusion among the top firms.
Nor was there evidence that the audit profession's concentration hurt the
quality of big-company audits (although this is an inexact
exercise).

The real concern is not so much that four firms are too few, but that
four could fall to three. According to a report by Glass Lewis, a
research consultancy specialising in corporate-governance issues,
Andersen's collapse prompted approximately 1,300 firms to scramble to
find new auditors. Today the Big Four already have their hands full
dealing with the PCAOB's new rules. Cono Fusco, a partner with Grant
Thornton in America, says that a further collapse “could cause paralysis
in financial markets”, especially if it were to occur near the end of the
year when companies file their financial reports.

More importantly, a Big Three would almost certainly be too few to ensure
an adequate degree of competition in large-company audits. As it is, some
firms are already finding it tricky to comply with the PCAOB's new rules,
which restrict the provision of certain non-audit services by auditors.
This is particularly the case because of Section 404, a new rule that
requires public companies to have their internal controls, as well as
their financial reports, checked by an independent auditor.

Take Sun Microsystems, which has annual sales of $11 billion and operates
in 100 countries. It uses KPMG, Deloitte and PWC for work on internal
controls, valuation, tax and internal audit, while E&Y is its
external auditor. Trying to juggle these relationships is a
“time-consuming pain”, says Lynn Turner, a former SEC chief accountant
who sits on Sun's audit committee. Yet Sun is too far-flung for it to be
able to appoint a second-tier firm.

This problem is especially acute in certain industries. According to the
Public Accounting Report, an industry newsletter, the market share
of three of the Big Four firms (E&Y, KPMG and PWC) in the oil and gas
industry was 97.3% by revenue audited. In the casino industry, just two
firms (Deloitte and E&Y) audited 88.2% of the industry by the same
measure in 2004. Similar concentration exists in the air transportation,
coal and other industries.

Given this, regulators might feel constrained in how they respond to
sloppy or unscrupulous behaviour on the part of the Big Four. Almost
everyone agrees that Andersen's collapse made the financial system more
vulnerable. So far, regulators have dealt with those improprieties that
have come to light with narrow, targeted bans. For example, earlier this
year E&Y was handed a six-month ban on taking on new, listed clients.
It was found to have violated conflict-of-interest rules by forming a
business partnership with PeopleSoft, a software firm that was also one
of its audit clients. But who can say that another scandal on the same
scale as Enron or Parmalat will not surface? “The reality is that the Big
Four is very likely too big to fail. Regulators know this­and that is a
huge moral hazard,” says Jim Cox of Duke University.

A naked
option

The mountain of litigation facing the
profession as a whole, and the Big Four in particular, injects real bite
into these concerns. Neil Lerner of KPMG says there is an estimated $50
billion in claims outstanding against the Big Four. Settlements can be
enormous (see chart). And the worry is that even the likelihood of a big
payout could trigger a mass exodus of accounting partners, followed by
clients, then by more partners. “Andersen didn't die because of the SEC's
indictment per se,” says Mr Lerner, “but because its international
network unravelled. It was a death spiral.”

The cost of litigation and size of claims have mounted steadily over
decades, but in the post-Enron era both have “spiked like a hockey
stick,” says Bill Parrett, boss of Deloitte in America. Some 10-20% of
the Big Four's audit revenues are routinely funnelled into litigation
costs (settlements, insurance and the like), which are then passed on to
consumers. The Big Four have huge problems getting insurance,
particularly against unpredictable “catastrophic” risks. “Ten years ago,
there were 150 commercial insurers providing indemnity to the major
auditors,” says Tom McGrath, a senior partner at E&Y: “Now there are
ten.”

In theory, such pressure is a disciplining force on the profession. The
Big Four concede that they should pay something if they are to blame for
their part in accounting fraud. But ultimately, they argue, fraud is
perpetrated by company managers, not their auditors. Auditors claim they
bear the brunt of any financial damages sought because they have deep
pockets and are often “the last man standing”, says Sam DiPiazza, chief
executive of PWC. In effect, auditors have become the insurers of
financial statements, writing what Mr Fusco likens to a naked (ie,
unhedged) option: “You get unlimited exposure for a limited reward,” he
says. Critics see that as special pleading­after all, the whole point of
auditing financial statements is to give some form of guarantee that they
are credible.

But the unintended consequence of litigation run amok, argues the
profession, is that audit quality is worse. Accounting rules are
increasingly interpreted prescriptively rather than based on broad
principles that are seen as too fuzzy to hold up in court. Auditors
themselves, fearful of lawsuits, are inclined to adopt a “check-the-box”
approach, adhering strictly to accounting rules rather than exercising
(necessarily subjective) judgment. And the looming threat of litigation,
argues the profession, hurts the recruitment and retention of the best
and brightest talent. “Who wants to be a partner in a firm that faces
billions of dollars in lawsuits?” asks one company boss.

The cap
doesn't fit

Arguably the litigation problem
worsens the issue of industry concentration, because only auditors with
deep pockets can afford to take on the risk of making a mistake with a
large public company. The Big Four point out that some European countries
have caps on auditor liability. As a consequence, they say, there is
significantly less concentration in these markets, an outcome they seem
willing to contemplate. In Germany, for example, where auditor exposure
is capped at €4m ($5.2m), 67 of the biggest 300 listed companies are
audited by firms outside the ranks of the Big Four. In Greece, where the
audit cap is set, bizarrely, at five times the salary of the president of
the Supreme Court, 27 of the 60 companies listed on the Athens stock
exchange are audited by firms outside the Big Four.

But these arguments have failed to sway regulators in America and
Britain, where auditor-liability reform is most debated. Britain's Office
of Fair Trading recently considered and rejected auditor caps, saying
that it found little evidence that caps encouraged competition or would
do anything to reduce the risk of the collapse of a Big Four firm.
Indeed, caps might make concentration worse, since they would help the
Big Four, who are already most exposed, more than smaller outfits. As for
recruitment, figures show that, in America at least, the number of
students taking accounting courses has risen sharply since the scandals
at Enron and WorldCom were uncovered.

Can anything be done to shore up the audit profession's latent
instability? Ideally, the market would self-correct. “Where profits are
to be made, you should find new entrants,” says Peter Wallison of the
American Enterprise Institute, a think-tank. But the barriers to entry in
the audit of the biggest companies are exceedingly high. Building huge
international networks is difficult and expensive. And legal rules in
many countries mean that audit firms have to be partnerships, so cannot
raise funds on the capital markets.

Regulation is another big barrier. The cost of doing public audits has
increased dramatically, stretching capacity thin. As an indication of
increased regulatory costs, E&Y's Mr McGrath says that so far this
year, his firm has spent nearly 400,000 man-hours on training and
education on Section 404 alone. “Given how expensive it is to comply with
the new regulations in order to do audits of public companies, and the
significant downside from litigation, why would a smaller firm want to
take this on?” asks Mr Wallison.

Even the next tier of international firms­BDO Seidman, Grant Thornton and
MRI­admit that they do not have the capacity to audit the world's biggest
companies. Nor do they feel much inclination to do so. These firms are
already thriving by auditing middle-sized firms, which, they are quick to
point out, encompass many Fortune 500 companies. BDO, for
instance, currently audits sub-Fortune 100 international companies
such as Barnes & Noble, a bookstore chain. Grant Thornton in America
says its cut-off is around the level of the companies towards the bottom
of the Fortune 250 list.

Second-tier accounting firms have made some progress. According to the
International Accounting Bulletin, the eight largest mid-tier
firms gained 122 clients from the Big Four in the first seven months of
this year; only nine companies went the other way. But that barely
affects concentration. Mergers among the second-tier accountants could
speed things up, but a recent General Accounting Office study found that
even a merger of the next four or five biggest firms would not create a
fifth big firm that could compete well with the Big Four.

Without a viable market solution, some wonder if more drastic action
might be needed. Mr Danos of the Tuck business school, believes that the
Big Four should be forced in some way to become six or eight firms, by
government mandate if necessary. His fear, shared by many, is that should
another Big Four firm collapse, there is a real risk that the government
would take over audits and that financial markets would suffer long-term
harm. Indeed, some say a continuation of the current state of affairs is
leading towards a creeping nationalisation of the industry. “We have
become a highly regulated industry and this will only continue,”
complains one audit-firm boss.

Rotate
and restrict

Rather than a radical move such as
a break-up, some suggest that smaller reforms could help second-tier
firms grow into bigger ones over time. Mr Cox of Duke University suggests
two possibilities: mandatory rotation of entire audits rather than the
more limited rotation just of individual partners as is now required in
America; and sharp limits on the provision of non-audit services. “These
types of changes will lead to a change in competitive structure,” he
predicts, encouraging smaller firms to develop pockets of expertise where
they can compete with the Big Four.

Others believe that caps or other restrictions on allowable market shares
for the Big Four in certain segments (especially middle-market companies)
would help the second-tier accounting firms to grow. But many second-tier
firms find the idea of restricting clients' choice unpalatable,
particularly since these restrictions would yield a viable fifth big
competitor only over many years, if at all. Auditors have been good
(perhaps too good) at helping their clients solve tricky problems. So
far, at least, their own industry's concentration looks like a challenge
too far.

Miklos A. Vasarhelyi
KPMG Professor of AIS
Rutgers University
Director Rutgers Accounting Research Center
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