Auditors: EAC Report

Lord Currie of Marylebone Excerpts

Wednesday 14th March 2012 Grand Committee

[Lord Currie of Marylebone]

My Lords, in rising to speak in this debate on the Economic Affairs Committee’s report on concentration in the auditing market, I should start by declaring an interest as one of two non-executive directors at BDO. I will touch on that role and the experience that it has given me in some of my remarks. Because of that interest, although I am a member of the Economic Affairs Committee, I had to recuse myself from this inquiry. The loss was very much mine—my colleagues have clearly enjoyed a most interesting, wide-ranging and very rich inquiry and have produced an excellent report. I congratulate them, particularly our chairman, the noble Lord, Lord MacGregor. The report has been deservedly influential, with the very rapid adoption of its first key recommendation, of an OFT investigation of the auditing market, leading to a Competition Commission inquiry. We await the results of that inquiry later this year.

The appointment of independent non-executives to audit firms became mandatory in 2010 under the FRC governance code for audit firms. Under the code, the non-execs have a rather broad remit to look after the public interest in the activities of audit firms. Some of the points that have been made about the audit of banks bears very strongly on that role. Different firms have chosen different ways to incorporate their non-execs into the decision-making of their partnership governance arrangements. BDO saw advantage in non-execs rather earlier than its rivals. In 2008, it appointed me and my colleague Lesley MacDonagh, the former managing partner of the law firm Lovells. In contrast to the non-execs at other firms, we have been placed at the heart of BDO’s decision-making, sitting as part of the leadership team meetings. Lesley chairs those meetings, while I chair the firm’s risk committee. As such, we are involved in all the key strategic and operational decisions that drive the business forward. One could question whether such a central role in decision-making is not in conflict with the public interest remit given to us under the FRC code. I would strongly argue that that is not the case: public reputation is key to the success or otherwise of audit firms, as the unfortunate demise of Arthur Andersen demonstrated, so I see no conflict between the public interest and the successful development of the business.

In December, the FRC called a meeting of the independent non-execs across all the audit firms to monitor how the new arrangements code was working. It was welcome to hear that the non-execs of the big four saw as possibly the key public interest ensuring that four do not become three. As the report makes clear, the collapse, like Arthur Andersen, of one of the big four would turn an undesirably concentrated audit market into one where major companies faced no effective choice. It is therefore vital that none of the big four gets into difficulties that threaten its reputation and market standing. Were the worst to happen, regulatory intervention to prevent further market consolidation in those circumstances would be essential, however difficult.

My role as a non-exec of one of the leading mid-tier audit firms is rather different. The public interest imperative on us is to turn the four into five by enhancing the capacity and range of BDO, whether through organic growth or by mergers. BDO itself has grown to the size it has largely as a result of organic growth but also as a result of mergers, some large and many small. Small-scale mergers continue as small audit partnerships decide to join a stronger brand, and they are regular features of our leadership team meetings. They will undoubtedly continue as the flat-lining of the audit market induces further rationalisation.

My experience is that the directors of most FTSE 100 companies, and indeed many of those of FTSE 250 companies, underestimate the capacity and quality of what the leading mid-tier firms, such as BDO and Grant Thornton, can and do offer. It is a little-known fact that BDO is a $5 billion dollar business worldwide, operating in more than 120 countries but, as the report states, too few of the top companies look beyond the big four for audit services. The big four often claim to be the guardians of audit quality and to be the only ones who can undertake the audit of sophisticated businesses. Yet the AIU assessments of audit quality do not highlight any bright line between the quality of the big four and that of the larger mid-tier firms. What they show is that all audit firms experience occasional lapses of quality, but that quality is generally high and that there is little difference in standard between the big four and the mid-tier.

The large mid-tier firms would probably acknowledge that they do not have the capacity to audit all of the biggest, very complex and highly internationally diversified businesses—the global banks and the oil majors come to mind. That may be true, but I would make two points about it. First, as the report demonstrates very clearly—others have already alluded to this, particularly the noble Lord, Lord Lawson—the big four did not cover themselves with glory in their audits of the major banks. The FSA report of only last week pointed out that HBOS was able to conceal problem loans from its auditors, KPMG, in the run-up to its financial collapse, and KPMG raised no red flag over HBOS’s excessive risk taking. Secondly, if the major banks are exceedingly complex to audit, it is almost certainly the case that they are exceedingly complex to manage. Too big to fail goes hand in hand with too big to audit. The source of the problem is less the incapacity of auditors, big four or others, effectively to audit these complex businesses, but rather the incapacity of the human mind to grasp the complex interrelationships between these businesses. The answer is not bigger, more concentrated auditors, but rather less complex businesses that the human mind can understand and manage rather than delegating that to mathematical computer-based algorithms.

I would argue that the capacity and quality of the leading mid-tier audit firms, such as BDO and Grant Thornton, are not limiting their ability to acquire FTSE 100 and FTSE 250 companies, but rather it is market perceptions about them that constrain things. These perceptions should shift over time, were it not for the undoubted barriers to effective competition that the OFT investigation has highlighted and the Competition Commission is investigating, but there is no doubt that the quickest way to resolve such barriers is likely to be consolidation in the mid-tier part of the market. As I have already noted, the flat-lining of the audit market is providing a strong impetus to consolidation. I hope very much that the competition and regulatory authorities would not allow one of the big four to take over one of the mid-tier firms, since that would mean still more entrenched concentration. What could and should be allowed are mergers among the mid-tier businesses. That would help to create a still more viable alternative to the big four and should also help to overcome the perception that the mid-tier lacks capacity and capability.

However, we should not underestimate the difficulties that need to be overcome for such mid-tier consolidation to happen and to be effective. First, combining mid-tier firms will not automatically lead to a change in market perceptions. Secondly, most audit companies are partnerships, and there is no effective take-over mechanism for partnerships. Rather like universities, mergers happen only with the consent of both sides and, as for universities, this happy constellation does not often come around. Matters are made still more complex and difficult because we are talking about the merger not just of partnerships, but also, at some levels, of complex international networks of partnerships. Winning agreement for any merger of this kind is far from straightforward, even if the commercial logic is compelling. That is not to say that consolidation of the kind that I have been discussing will not happen, but it is to say that it is not assured. Without it, we are left with the current market position in which choice and competition are insufficient for FTSE 100 and FTSE 250 companies. Over time, continued investment and organic growth by the mid-tier companies could change the market structure, but that is a long-term outcome while market sentiments require something more urgent.

That leads me to the one area of this admirable report with which I take issue: its analysis of the case for changing the ownership rules for audit companies. Currently non-auditors are precluded from owning more than 49 per cent of the voting rights in an audit firm, as was the case for law firms until last autumn when the provisions of the Legal Services Act 2007, allowing alternative ownership structures—the so-called Tesco clause—came into effect. The Economic Affairs Committee did not see any immediate grounds for changing the law in respect of ownership, despite the strong advocacy of the FRC. It took this position in the light of evidence from BDO and Grant Thornton that they do not feel the need for greater access to capital to expand. I think the committee’s position on this is mistaken.

I would interpret the evidence from BDO and Grant Thornton somewhat differently. Within their preferred partnership model, they do not feel constrained by the availability of capital, but the partnership model undoubtedly places constraints on the strategic moves that these businesses can contemplate, as I can attest having sat through many strategic discussions. This is not in any way a criticism of their way of doing business, but it is to recognise that partnerships are only one way of organising audit business, or indeed any business. Given that, I think that there is considerable merit in allowing greater variety in governance: this would allow new entrants to come into the market with a corporate genetic structure different from the partnership model. That can only be good for greater choice and competition in this market. Indeed, not to do so could be seen as a form of professional restrictive practice, and that has fallen out of favour in almost every other area of business life. After all, we do not expect airlines to be owned by pilots or technology companies to be owned by nerds, although in the latter case some of them are, with great success. So I would argue strongly for the change in ownership rules that the committee turned its back on, but which are part of the European reform package proposed by Monsieur Barnier, and I would also note that BDO favours this change.

There is much else in this rich report that I have not commented on, and there is insufficient time for me to do so. They include: the very important weaknesses in IFRS; marking to market and marking to model which contributed to the financial boom and subsequent crisis; the need for risk committees; the much needed simplification of the regulatory landscape, which the noble Lord, Lord MacGregor, referred to; and the necessary enhancement of the powers and authority of the FRC that would come with that; the relationship between auditors and regulators; and much besides, but I have spoken long enough. I conclude by congratulating the noble Lord, Lord MacGregor, and my colleagues on the Economic Affairs Committee on producing such an excellent report. It has already achieved its key objective the form of the Competition Commission inquiry. This debate is merely a staging post. We must await what the competition gurus come up with. Let no one underestimate what is at stake. We cannot allow this critical market for corporate information to lack the choice and competition that we take for granted in all other walks of business life.