UK: In The Event Of A Big 4 Failure What Are The Opportunities For Mid-Tier Audit Firms?

The Companies Act 2006 received the Royal Assent yesterday including the provisions enabling auditors in the UK to limit their liability by contract with their audit clients, Click Here to view related article.

However, by the end of 2006, the European Commission is scheduled to table a report for the European Parliament in respect of statutory audit liability within the 25 European Member States. To assist in the preparation of its report, the European Commission has commissioned a detailed and important study by London Economics which has recently been published. The study addressed the following issues:-

• The economic impact of different audit liability regimes within the European Union

• The insurance market for audit liability

• The likely impact if one or more of the Big 4 audit networks was to disappear

• The various ways in which audit liability can be limited

The report included the results of an extensive survey programme of both auditors and their client companies, together with institutional investors; these results provide some clear pointers for the future development of this market. The purpose of this article is to identify the principal conclusions of the study and to look, in particular, at the implications for the major audit firms in the United Kingdom outside the Big 4.

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The Companies Act 2006 received the Royal Assent yesterday including the provisions enabling auditors in the UK to limit their liability by contract with their audit clients, click here to view related article.

However, by the end of 2006, the European Commission is scheduled to table a report for the European Parliament in respect of statutory audit liability within the 25 European Member States. To assist in the preparation of its report, the European Commission has commissioned a detailed and important study by London Economics which has recently been published. The study addressed the following issues:-

• The economic impact of different audit liability regimes within the European Union

• The insurance market for audit liability

• The likely impact if one or more of the Big 4 audit networks was to disappear

• The various ways in which audit liability can be limited

The report included the results of an extensive survey programme of both auditors and their client companies, together with institutional investors; these results provide some clear pointers for the future development of this market. The purpose of this article is to identify the principal conclusions of the study and to look, in particular, at the implications for the major audit firms in the United Kingdom outside the Big 4.

In 1986, there were the 8 key audit firms - by 2002, they had become the Big 4. The report shows just how highly concentrated the audit market is for large and very large companies: the Big 4 hold 90% of the audit mandates for banks and insurance companies on regulated markets on stock exchanges across the European Union; they also hold 67% of the audit mandates for non financial companies which is a less pronounced, but still very heavy concentration.

The most important cause of this concentration is thought to be changing client needs over the years rather than, for example, the demise of Arthur Andersen. The audit of major companies requires extensive geographical spread and specialist skills and knowledge which the Big 4 are perceived to have. Given that the trends which have brought about the high levels of concentration are set to continue, what are the barriers to entry for audit firms wishing to try and compete in this market?

"Reputation" is viewed as the single greatest obstacle to entry to the market currently dominated by the Big 4; simply put, the Big 4 are perceived to be a "safer bet". Audit client inertia is also a significant factor and surprisingly audit clients change auditors infrequently; of those companies which participated in the survey, more than half had had the same auditors for more than 7 years.

Specifically from a United Kingdom perspective, a survey by Oxera showed that, in 2004, only 1% of FTSE 100, and 2% of FTSE 250 companies changed auditors that year. The most frequent reason given for making a change was the appointment of a group auditor rather than any dissatisfaction with the audit service being provided, or the price being charged. In terms of market concentration only 2% of the firms moved from a Big 4 firm to a mid-tier firm; the vast majority moved to other Big 4 firms.

So, given that geographical spread, capacity and detailed specialised knowledge are viewed by audit clients as significant barriers to entry to the market, is consolidation the answer? To put this question into context, it is worth noting the difference in size between the largest mid-tier firms and the smallest Big 4 firm; even a merger of the three next largest mid-tier firms would produce a firm considerably smaller than the smallest Big 4 firm. In any event, the survey indicates that there is only limited appetite for consolidation between mid-tier firms in the short to medium term. Merger is not, therefore, likely to prove to be a means by which competition in the market will be increased.

The study concludes that audit firms have been faced with a declining availability of coverage in the insurance market at the higher end of the scale and have also experienced significant increased costs of reinsurance for captives which have been established. Against that background, and with considerable assistance from Aon, the study has analysed the historic and current claims experience across the UK and European Union for audit negligence claims. The conclusion is that the Big 4, together with the two largest mid-tier networks, face a number of potential and actual claims which could result in a settlement or award which will "vastly exceed both the available insurance cover and the firm’s own resources"; in particular, 16 claims or potential claims, exceed €160 million and 5 exceed €785 million (or US$ 1billion).

With the assistance of information provided by the Big 4 networks, the authors have sought to identify the "tipping point" for a judgment or settlement which would threaten the existence of one or more of the Big 4 firms. The calculation made takes into account all available insurance coverage (including that which may be provided by captives) and then, on the basis that such an award or settlement will certainly exhaust those resources (given that commercial insurance could only cover 5% of the larger claims currently in existence), the reduction in income which the partners in the firm would be prepared to tolerate for a limited number of years in order to fund the award or settlement. This element has to be for a period, and at a level, which would not cause partners to leave in large numbers with the result that the firm failed in any event; it is suggested that a reduction of 15-20% in income over 3-4 years is the likely limit of tolerance. Given that the Big 4 firms themselves are of varying sizes, the "tipping point" range was from €170 million to €255 million at the lower end and €365 - €540 million for the largest firm.

As the authors so aptly conclude, the risk of failure of a Big 4 firm is "far from nil"; this is further emphasised when it is recognised that €540 million (i.e. the highest "tipping point" ) represents less than 0.3% of market capitalisation of the largest UK company audit client by market size and less than 0.25% of the turnover of the largest UK turnover i.e. the point at which the largest Big 4 firm would fail is but a small fraction of the size or earning power of the largest UK audit clients.

If a Big 4 firm did fail (and notwithstanding all the serious difficulties which would inevitably arise on a number of fronts, including disruption to both audit clients and markets), the survey responses indicate that, provided the audit staff from that failed firm stayed in the audit market so that audit capacity was not reduced, then the audit clients of the failed firm would be most likely to move to one of the remaining Big 3. There would be only limited scope for mid-tier firms to acquire clients.

The mid-tier survey respondents were, however, optimistic about the prospects of increasing their market share. There were some grounds for such optimism in this respect from the analysis of the migration pattern of EU audit clients from Arthur Andersen. Whilst the largest companies moved to one of the Big 4 firms, only 61 out of 208 smaller companies (i.e. with a turnover of less than €10 million) did so. So far as the large audit clients are concerned, the mid-tier firms would have to decide whether they were prepared both to invest in acquiring the necessary capacity to compete for them, and also to assume the liability risk which the conduct of those audits carries given that, at the moment, there is exposure to unlimited liability in most EU states.

After completing a comprehensive review of the different legal and regulatory regimes for audit liability which pertain in the various EU Member States including this weeks UK legislation, the study concludes that whilst a limitation on auditors’ liability would reduce the risk of Big 4 failure, whichever form of audit liability limitation is put in place, the key issue will remain the level of financial exposure faced by audit firms. This is particularly so given the different systems which currently pertain and it is recognised that a "one size fits all" approach for audit liability within the European Union will not be appropriate.

It will not be straightforward to achieve a level of exposure (in terms of hard cash Euros) which will strike the necessary balance so as to encourage mid-tier firms to attempt to compete in the market currently dominated by the Big 4 firms and yet be high enough to continue to give the necessary incentive to the Big 4 to concentrate on audit quality in the face of increased competition.

There are no easy solutions to the issues regarding audit liability within the European Union with which the European Parliament is seeking to grapple; important developments within both the United Kingdom and Europe are set to take place during 2007 and will continue to be covered on LawNow. Group A firms in particular, are likely to be monitoring progress closely and giving careful thought to their aspirations for the audit market for large companies.

This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq

The original publication date for this article was 09/11/2006.