Will this lead to a big four audit market dominance?

External auditing (hereafter referred to as auditing) has evolved from a routine checking of the books of account to a vital part of the governance process of companies. Factors such as the volume of transactions, information technology, globalisation and the constant increase in the complexity and number of laws, regulations and standards governing entities and their auditors have all impacted drastically on the evolving role of the registered auditing profession. The corporate collapses, business failures and fraudulent financial reporting scandals of the late 1990s and early 2000s led to a very turbulent time and resulted in a credibility crisis for the auditing profession. One of the consequences of this was the demise of Arthur Andersen and the resultant decrease in the number of big audit firms from five to four. A further consequence was the drastic interventions by governments, regulators and the auditing profession itself, which have given rise to various and onerous new laws, regulations and standards that govern financial reporting and the auditing thereof. This is described as follows by Knechel, et al. (2007:xiii):

The period 2000 through 2006 has been a very turbulent time for the auditing profession, a period that witnessed numerous scandals and their aftermath (Enron, WorldCom, Parmalat), strident calls for changes in the way that auditors practise their profession, and regulatory initiatives that significantly change the way the profession is governed. Long-held attitudes and customary practices have been challenged and found to be deficient by the media, the investing public, and those charged with regulating financial reporting and auditing. Issues of auditor independence, the role of corporate governance, the responsibilities of management, the appropriateness of consulting services, and the overall professional obligations of auditors have all been discussed and debated by a broad array of interested groups and individuals. The theme linking these debates has often been ‘what is wrong with the auditing profession?’ and its close relative ‘what can be done to improve the auditing profession?’ As a result, this period has probably resulted in more substantive changes to the auditing profession than any other period in modern day business history.

The above developments also gave rise to the risk of a Big Four auditing firm domination of the audit market, and the possible effect that a collapse of one of these remaining firms poses to the effective functioning of the audit market.

1. Factors impacting on the external audit function
Various factors and circumstances impact on work of the registered auditors and their firms. These include:

• Fraudulent financial reporting and audit failures
Various corporate collapses occurred in the late 1990s and early 2000s many of which were the result of fraudulent financial reporting, and these resulted in significant losses for creditors and serious hardship for shareholders. Many of these business failures were also seen as audit failures, and the auditing profession stood accused of not performing its ‘watchdog function’ effectively and with objectivity.

Questions were also asked about the auditing profession’s ability to self-regulate, and governments responded by issuing new laws to regulate the auditor’s work. The auditing profession also implemented vigorous self-regulatory processes such as practice review, as well as other forms of auditor control, as discussed below. Lastly in this regard it is interesting to note the cynical comment that is sometimes heard that the auditors, through failure to perform their responsibilities with diligence and care, actually created more work for themselves and benefited substantially from their clients’ demise. This was voiced as follows by Whitehead (2007:54):

According to an article in the Wall Street Journal, the Big Four accounting firms KPMG, PricewaterhouseCoopers, Deloitte & Touche and Ernst & Young are more powerful than ever. The scandal that brought down US-based accountancy firm Arthur Andersen, gave rise to an increase in work generated by the stricter accounting and auditing standards in the Sarbanes-Oxley Corporate Governance Act. The increase in work combined with limited resources in turn delivered greater leverage for demanding and winning higher fees at the Big Four. So great is the demand that they are turning away work especially when the risks seem to outweigh the potential rewards.
• New legislation, regulations and standards
The response by governments and regulators to the corporate collapses and perceived audit failures gave rise to various new statutory requirements, regulations and standards that were aimed at strengthening the auditors’ independence and improving the quality of their work. Examples of these are the Sarbanes-Oxley Act in the USA, CLERP 9 in Australia and the Auditing Profession Act, Corporate Laws Amendment Act and Companies Amendment Act in South Africa.

In South Africa, the new Auditing Profession Act was seen to give effect to Government’s intention to ensure that the auditing profession performed its monitoring function and that it could be held accountable for any future corporate bankruptcies (Laschinger, 2006:40). The Auditing Profession Act provided much stricter requirements regulating registered auditors and audit firms and more stringent reporting requirements for reportable irregularities. A consequence of this was that 885 reportable irregularities were received by the Independent Regulatory Board for Auditors (IRBA) during the eight months from 1 April 2006 (when the Act became effective) to 22 November 2006, as opposed to 88 in total for the previous 15-month period ending 31 March 2006 (IRBA, 2006:6). The Act expanded the practice review requirement of individual registered auditors to that of audit firms, with the result that every registered auditor performing the attest function and every registered audit firm would receive a practice review by IRBA at least once every five years. These new requirements were all aimed at improving the quality of audits, but consequently also gave rise to increasing costs for the profession. Grant Gelink, CEO of Deloitte South Africa, said the following on the subject: “the review process is an excellent idea and the committee is very thorough having gone through the files of our biggest clients and inspected our regional offices … (But) it is costly and time consuming, taking more than two months and likely to cost the firm more than R1m” (Temkin, 2006:1-2).

Similarly, the International Federation of Accountants (IFAC) issued new auditing standards that introduced a new risk-based audit methodology and more stringent documentation and reporting requirements. Garth Coppin, technical partner of Ernst & Young South Africa, is of the opinion that this gave rise to a 30% to 40% increase in audit fees, which he attributes to legislative and audit standard changes (Temkin, 2006:1).

The new regulations, requirements and increased legal exposure of auditors are also often criticised and blamed for harming the auditing profession’s ability to attract and retain staff (Laschinger, 2006:40). Allen Blewitt (ex-CEO of ACCA) concurs:

The auditing profession stands to lose most of its members by 2013 due to overregulation in the light of corporate scandals worldwide. Only the big four auditing firms (PricewaterhouseCoopers, Deloitte, KPMG and Ernst & Young) will be viable in the next several years. Sheer numbers of audits are dropping. Legislators do not understand the auditing profession. When they regulate the profession all they see is red tape. The regulators have a blinkered view of audit (Temkin, 2008).

Lastly, it should be noted that an aspect that was heavily debated in South Africa at the time of drafting the various pieces of legislation, namely, mandatory audit firm rotation, was abandoned in favour of audit partner rotation after five years.

• Audit costs and audit fees
The cost of performing audits has increased significantly over the past number of years. This is attributed to factors such as the drastic increase in staff salaries, professional indemnity insurance, increasing technology costs, as well as the impact (discussed in the previous section) of changing audit methodologies and new accounting standards, which are time consuming to understand and to audit (Kana, 2006:35; Sehoole, 2006).

At the other end of the scale are the clients who are often reluctant to accept increases in audit fees in excess of inflation. According to Kana, this forces auditors to do extra work without being paid for it, which in the long run will affect the firm’s ability to retain such clients. The dilemma that auditors face because of higher costs and lower fees is reflected in the following remark by Moore (2003:1-2) in the CPA Journal:
Efficiency is one thing, but audit fees have been so drastically reduced by factors such as bidding and price competition that firms have been forced to think of ways to reduce the time spent working on audits. Accountants are under pressure to fit the expenses of the job into the fees they can charge. Many of the firms involved in the continuing high-profile accounting scandals had their work papers done by firms that easily passed peer review. The auditors probably did their jobs efficiently, but didn’t have the luxury of thinking about what might be wrong. Auditing fees should be high enough so that auditors can think on the job instead of quickly and mindlessly doing paperwork that will pass inspection.

King II recognised this and, warning against management’s practice of putting audit fees under pressure, stated that audit fees should be set in a manner that will ensure an effective external audit, and added that the targeting of audit fees as a means of cost saving should be discouraged (IoD, 2002:125).
• Staffing, training and transformation
Auditing firms in South Africa, like their counterparts in overseas countries, are experiencing significant shortages of trainee accountants and qualified staff. South African auditing firms have the added challenge of transformation and targets to deal with. Accordingly, there is a high demand for staff amongst auditing firms, and especially as regards attracting and retaining black trainees and accountants (Anonymous, 2005:1; Anonymous, 2008:58-60; Laschinger, 2006:40; Mabotja, 2003:10). This shortage of auditing staff has driven up salary costs, and consequently audit costs and audit fees.

The skills requirement of auditors has also undergone significant changes over the last number of years. Nowadays auditing staff face many new challenges, and in order to overcome these they should be schooled and trained in techniques that surpass traditional accounting and auditing procedures. These include, inter alia, computer skills, communication and presentation skills and professional and business ethics. All of these aspects involve costs, affect the firm’s recruiting, training and retention of staff, and ultimately impact on the audit fee.

• Auditor independence and the provision of non-audit services
The provision of non-audit services by auditors to audit clients has had a significant impact on auditors’ independence and the profitability of their firms. Usually these non-audit services are very profitable and sought after, with the resultant effect that in the past auditors were tempted to succumb to management pressures on external audit issues in order to retain the audit engagement, and so to provide the very profitable non-audit services. The various regulations issued and legislation passed since Enron, as well as the various corporate governance codes, now all include stringent rules that either prohibit, or strictly control, non-audit services rendered by auditors to their audit clients.

• The audit expectation gap and auditor litigation
The audit expectation gap, being a difference in opinion or understanding among the participants in the financial reporting process as to what are management’s duties and responsibilities regarding the financial statements, as opposed to those of the auditor, still exists and poses a very real threat to auditors. With the changing business environment, new laws and regulations and the ever increasing occurrence of fraud, auditors are often blamed for not detecting fraud, errors or non-compliance with laws and regulations – responsibilities that reside with management. Such misunderstandings not only result in a loss of confidence in the auditing profession, but also often give rise to lawsuits against audit firms, resulting in legal fees and productive management and auditors’ time lost in the litigation processes.

2. Risk of Big Four audit dominance
It would therefore appear that the challenges facing the auditing profession are enormous, and conventional wisdom would suggest that the only ones capable of tackling them head-on are the Big Four firms, due to their size, the extent of knowledge- and information-sharing implicit in their global network, and the resultant economies of scale. But is this situation, real or perceived, to the benefit of the auditing profession and, in fact, South Africa’s economy?

Market dominance by the Big Four is not only of concern in South Africa. Both the Financial Reporting Council in the United Kingdom and the European Commission have expressed concern in this regard. A report arising from the so-called 17 May 2006 Directive, which examined “the impact of the current liability rules for carrying out statutory audits on the European capital markets and on the insurance conditions for statutory audits and audit firms, including an objective analysis of the limitations of financial liability”, reached the following conclusions, which are important for the purposes of this article.

• The study, which focuses on the economic impact of the auditors’ liability for statutory audits, shows that the market for statutory audits of large and very large companies is highly concentrated and dominated by the Big-4 networks. Moreover, the structure of this market is unlikely to change much in the coming years.

• This is because middle-tier firms face a number of barriers to entry into the market. Such barriers are reputation, capacity and breadth of their networks, and the exposure to unlimited liability in most EU Member States combined with very limited professional insurance availability.
• As a result, over the foreseeable future, middle-tier networks are unlikely to become a major alternative to the Big-4 networks or a substitute for a failed Big-4 network.

• In light of the number of large actual or potential claims outstanding, the risk of an award or settlement in excess of the tipping threshold is far from nil, and one of the major Big-4 networks could possibly fail as a result.

• The adjustment to a situation in which one of the Big-4 networks fails is unlikely to be smooth. But, the long run consequences are likely to be limited provided the overall statutory audit capacity does not fall significantly. Among the various economic sectors, financial institutions may find such a situation particularly difficult, as their statutory audits are viewed as more risky and require special expertise and skills which, on the whole, only Big-4 firms have. In this regard, it is noteworthy that, in some EU Member States, two Big-4 firms dominate the market for statutory audits of financial institutions.

• The situation is likely to be much more dire if a second Big-4 network fails shortly after the first one. Investors’ confidence will in all likelihood be seriously affected and the adjustment to the new situation is likely to be difficult, especially if statutory audit capacity shrinks as a result of these events.

The report concluded by proposing that some form of limitation of liability for auditors be introduced, and this was subsequently followed by the European Commission Recommendation of 5 June 2008, which recommended and proposed various ways in which this limitation could be achieved. The main purpose of the recommendation is to encourage the growth of alternative audit firms in a competitive market. The recommendation is made in response to the increasing trends in litigation and lack of sufficient insurance cover facing the auditing profession in Europe, and has as its aim the protection of European capital markets by ensuring that audit firms remain available to carry out audits on companies listed in the EU.

But what of the situation in South Africa? While it may be true that only two of the top 40 companies listed on the Johannesburg Securities Exchange (JSE) are not audited by the Big Four, the recent Listing Requirements issued by the JSE to accredit firms to audit listed companies may help to address the perception that the medium firms are unable to service these top companies, and the attaining of accreditation by them will not only open the market and create more competition, but will also send a signal to the market that they have the expertise and resources to handle these possibly complex audits.

However, if South Africa is to achieve true competition and avoid the total dominance of the audit market by the Big Four, we need to follow the example of the European Commission, and introduce some form of liability protection for auditors. This will allow the firms to take on the more complex auditing assignments with expanded responsibilities that their clients are demanding, and will remove a hitherto barrier for the medium-sized firms to take that step up.
3. Conclusion
The challenges facing the auditing profession are both complex and many in number. However, given the rigour of the education and training process, the rigour of the qualification process, the technical competence of auditors, their multidisciplinary knowledge and experience, and a process of continuous learning and development, there is no doubt that the auditor will be able rise to the challenge and succeed.

1. Knechel, R.W., Salterio, S.E. & Ballou, B. (2007). Auditing Assurance & Risk. 3rd edition. Canada: Thomson South Western.
2. Whitehead, R. (2007). Do corporate failures create more opportunities? CEO, 6(9): 54.
3. Laschinger, K. (January 2006). Regulation impracticalities. Accounting & Business: 38-40.
Independent Regulatory Board for Auditors. (IRBA). (November/December 2006). Reportable Irregularities. Irbanews: 6.
4. Temkin, S. (7 April 2006). Auditors generally welcome new law despite concerns about education roles. Business Day,
pages 1-2.
5. Temkin, S. (28 April 2008). Auditing braces itself for exodus. Business Day. Available from: http://www.businessday.co.za/articles/article.aspx?ID=BD4A743612. (Accessed 28 April 2008).
6. Kana, S. (11 May 2006). Opwindend, uitdagend of albei? Finweek, page 35.
7. Sehoole, I. (2006). Accounting profession arming itself for a tough few months. SAICA. Available from: http://www.saica.co.za/resources/Showitem.asp?Item=415&ContentPageID=330 (Accessed 2 May 2006).
8. Moore, R.D. (July 2003). Reflections on audit reform. The CPA Journal. Available from: http://www.nysscpa.org/cpajournal/2003/0703/nv/nv6.htm (Accessed 2 June 2006).
9. IoD Institute of Directors. (IoD). (2002). King II Report on Corporate Governance, Institute of Directors in Southern Africa. Johannesburg.
10. Anonymous. (4 December 2005). Black CAs need to be grown, not poached. Sunday Times, page 1. Available from: http://www.sundaytimes.co.za/Articles/TarkArticle.aspx?ID=1797150 (Accessed 2 May 2006).
11. Anonymous. (12 June 2008). Vaardigheidstekort ‘n bedreiging. Finweek: 58-60.
12. Mabotja, S. (23 April 2003). Stryd om erkenning. Finansies & Tegniek, page 10.
13. 17 May 2006 Directive of the European Parliament and the European Council, report by London Economic (2007).
14. Commission of the European Communities, Commission Recommendation of 5 June 2008 (2008).

Ben Marx CA(SA), BCompt (Hons), MCompt, is a Professor of Auditing at the University of Johannesburg. Jan Dijkman, BA LLB, LLM, H Dip Tax, ADL, CFP, is a Certified Ethics Officer and Project Director: Ethics and Discipline at SAICA.