60. The Power of Four

The auditing profession is dangerously concentrated

WHATEVER you might think if your accounts have ever been qualified, audi­tors are only human. And hu­mans tend to exploit their power. So it is understandable that Britain's accounting watch­dog revealed last week that in­vestors and the finance directors of the country's big compa­nies worry about the dominance of the big four auditing firms - Deloitte, Ernst & Young, kpmg and Pricewaterhouse-Coopers (pwc). This is not a uniquely British problem: ac­counting is a global profession - and it needs a global solution. Audits are vital to investors, who need trustworthy ac­counts if they are to allocate capital efficiently. It is everyone's business to have confidence in what they do. Past doubts have centred on the conflicts of interest when an auditor earns large fees for selling tax advice or consultancy. And there have been welcome moves to save auditors from such temptations.

The worries that emerged this week were about choice. If one of the big four international accounting firms collapsed, some large quoted companies might be stuck without an alter­native. Many companies even now have only three to choose from, because they buy non-audit services from one of the big four. Since audit firms tend to specialise by industry, some companies have no choice at all. The darker version of this theme is that the four will use their power to hold sway with litigators, regulators and standards setters. On the one hand, they dominate the profession's official bodies; on the other, they cannot be too severely sanctioned for fear that four might become an even more dominant three.

It is not an idle threat. The profession is in this pickle only because Andersen, the auditor of Enron and WorldCom, col­lapsed in 2002 after its conviction (later overturned) for ob­struction of justice. Since then Japan's financial regulator has suspended the audit licence of pwc's Japanese arm for two months and Ernst & Young's American arm was banned in 2004 for six months from taking on new public-company au­dit clients for reckless and negligent conduct. It is hard to avoid the suspicion that Ernst was allowed to keep its existing clients for fear of the consequences if they were taken away. One of the reasons American prosecutors did not indict kmpg last year for its part in a case of massive alleged tax fraud may have been to avoid the risk of another Andersen-like collapse.

Imbalance sheet

Everyone has his own fix for this mess. Least appealing is one of the auditors' own proposals, that the state protect them by capping their liabilities if they are sued for damages. Aca­demic research suggests that similar legislation in America has led auditors to cut corners and take risks. Others think the best solution is to help the second-tier accounting firms audit the big companies. The trouble is that smaller firms would invest in gaining expertise only if they had a good chance of being appointed. But, without a reputation, firms' appeal is limited. The best way to ensure independence (and weaken the stranglehold of the big auditors) is compulsory rotation: cli­ents should be required to appoint a new firm every seven years or so. Bring in that change and four big auditors would not seem too few. Meanwhile, regulators have no business giving big firms an easy ride just because they fear what will happen if they do what is right. If one of the big four collapses, so be it. Then the moment for drastic remedies will be at hand and the remaining big three should be split up.