ساختار بازار حسابرسی، هزینه و انتخاب، در یک دوره تغییرات ساختاری: شواهد از بریتانیا - 1998-2003

This paper presents evidence on audit market concentration and auditor fee levels in the UK market in the crucial period of structural change following the PricewaterhouseCoopers’ (PwC) merger and encompassing Andersen’s demise (1998–2003). Given the current interest in auditor choice, analysis is also undertaken at the individual audit firm level and by industry sector. There is evidence of significant upward pressure on audit fees since 2001 but only for smaller auditees. Audit fee income for top tier auditors (Big 5/4) did not change significantly while the number of auditees fell significantly, consistent with a move towards larger, less risky, clients. A decomposition analysis of the aggregate Big 5/4 concentration ratio changes over the period identifies the impact of four distinct consumer-based reasons for change: leavers; net joiners; non-par auditor switches; and (only for the audit fees measure) audit fee changes. Andersen’s demise markedly reduced the level of inequality among the top tier firms but PwC retained its position as a ‘dominant firm’. On switching to the new auditor, former Andersen clients experienced an initial audit fee rise broadly in line with inflation, with no evidence of fee premia or discounting. They also reported significantly lower NAS fees, consistent with audit firms and auditees responding to public concerns about perceptions of auditor independence. There is no general evidence of knowledge spillover effects or cross-subsidisation of the audit fee by NAS. The combined findings provide no evidence to indicate that recent structural changes have resulted in anticompetitive pricing; the key concerns remain the lack of audit firm choice and issues concerning the governance and accountability of audit firms.

Rising audit market concentration has attracted the interest of regulators, market participants and academics for many years, especially since the audit firm mega-mergers of the 1980s and 1990s which reduced the global Big 8 to the Big 5. During that period, there was a general concern (based on the predictions of classical micro-economic theory) that excessive concentration would reduce competition, leading to an increase in the price of the services provided by the auditor (Financial Times, 1997). Paradoxically, there was also concern, based on observed market behaviour, regarding excessive competition and low-balling (e.g. CAJEC, 1992). From an industrial economics viewpoint, high seller concentration can both harm consumers and also benefit them through, for example, economies of scale and scope. Although concerns about the so-called ‘mega-mergers’ on competition were raised, in general the regulatory conclusion was that the mergers would be unlikely to substantially lessen competition (Goddard, 1998 and Thavapalan et al., 2002). A further major shock to the system of financial reporting and auditing arose when the US energy giant, Enron, failed in 2001. This event, along with other financial scandals in the US, led to the passage of the Sarbanes-Oxley Act in 2002, which instituted reforms designed to restore confidence in corporate governance. Given the global nature of capital markets and further scandals in Europe (e.g. Parmalat), there have been moves to adopt Sarbanes-Oxley style reforms throughout Europe and elsewhere (Oxley, 2007 and Quick et al., 2007). In June 2002, Andersen, one of the top five audit firms in the world, was convicted of obstruction of justice for shredding documents related to Enron.1 As a result, the firm lost its auditing license in the US.2 In August 2002, the firm ceased business and, in the UK, was acquired by Deloitte & Touche, reducing the number of big accounting firms from five to four. In the US, the Andersen business was dissolved and former Andersen clients switched to other, mainly Big 4, audit firms. This event sparked further intense debate, which is ongoing, about competition and audit quality in the audit market (e.g., EC, 2002, EC, 2008, OFT, 2002, GAO, 2003, Oxera, 2006, Oxera, 2007, FRC, 2006a, FRC, 2006b, FRC, 2006c, FRC, 2007a, FRC, 2007b, FRC, 2009 and US Treasury, 2008) and provides motivation for the present study. Immediately following Andersen’s demise, in the US the General Accounting Office (GAO) studied the effect of consolidation but found no evidence of impaired competition (GAO, 2003). Prior to Andersen’s acquisition, the EC also examined the possible impact of the acquisition, concluding that there was no danger of the creation of a single dominant firm since Andersen and Deloitte were the smallest of the Big 5 firms (EC, 2002). More recently, the GAO has updated its report on audit market concentration, concluding that, in 2006, the Big 4 continue to dominate the large company market segment while concentration has eased in the small and mid company market segments (GAO, 2008). Additionally, the US Treasury received a final report from the Advisory Committee on the Auditing Profession (2008), a body set up by the US Treasury in 2007. One of the principal topics considered by the committee is audit market competition and concentration (the others being human capital and firm structures and finances). The report makes six recommendations in relation to this topic, including the reduction of barriers to entry for small auditing firms.3 In the UK, a report on competition and choice in the UK audit market was commissioned by the UK Department of Trade and Industry/Financial Reporting Council (Oxera, 2006).4 This was followed by discussion papers on choice in the UK audit market and promoting audit quality (FRC, 2006a, FRC, 2006b and FRC, 2007c) and by reports on choice (FRC, 2007a, FRC, 2007b and FRC, 2009). Stakeholders expressed a strong preference for market-led solutions to the problem of restricted choice in the market for audit services to public interest entities in the UK and proposed a package of 15 recommendations designed to lessen concentration over the medium term. These recommendations require action by all market participants including audit firms, investors, companies, regulators and legislators.5 Academics have also investigated the impact of Andersen’s dissolution on concentration, with Beattie et al. (2003) predicting that the acquisition would increase the Big 4’s UK listed clientele to 72.8% of all audit clients (96.3% in terms of audit fees). In terms of individual firm market share, it was projected that Deloitte would become the third largest audit firm in the UK, accounting for 19.2% of the total market (based on audit fees). However, as the EC and Beattie et al. (2003) studies were based on pro-forma figures, there is no published study that documents the actual impact of Andersen’s dissolution in the UK. Further, since these studies cover only a very short period of time, the extent of change in concentration in the UK listed company audit market in recent years is not yet fully documented. This is especially true for the period following the Price Waterhouse and Coopers & Lybrand merger in 1998. To our knowledge, the only UK study that offers a detailed investigation of audit market concentration among the entire population of listed companies during the 2000s is Beattie et al. (2003). Previously, studies undertaken by Briston and Kedslie, 1985, Moizer and Turley, 1987, Moizer and Turley, 1989, Beattie and Fearnley, 1994 and Peel, 1997, 6 and Pong (1999) jointly cover the period from 1972 to 1995. 7 The study by Pong and Burnett (2006) examines the years 1997 and 2001. Figures reported in recent studies commissioned or produced by regulators ( Oxera, 2006, POB, 2006, POB, 2007, POB, 2008 and FRC, 2007b) offer limited insights into the structure of the market, due to restricted samples or the use of measures based on only number of audits. Recent academic studies are also based on restricted samples: McMeeking (2007) reports on the FTSE 100 while McMeeking et al. (2007) report on 309 listed companies in 2002. The present study seeks to provide answers to the following specific research questions with respect to the UK domestic listed company audit market during the crucial period of structural change 1998–2003: 1. Have audit fee rates changed significantly during the period? 2. What was the aggregate level of audit market concentration following the PricewaterhouseCoopers’ merger and immediately following Andersen’s demise (i.e., 1998–2003) and did it change significantly? 3. What market shares did individual firms hold during this period and to what extent are the larger mid-tier firms in a position to compete in the listed company market? 4. What is the relative importance of joiners, leavers and switchers in explaining the overall change in aggregate audit market concentration? 5. Immediately following Andersen’s demise, who dominated the market at industry level? 6. Who audits former Andersen clients and did their audit and/or non-audit services (NAS) fees change significantly in the short-term? The specific contributions of the paper are fourfold. First, it provides a discussion of both the traditional and contemporary theory of industrial economics and its limitations in relation to making predictions about real markets (and the audit market in particular.) Second, it presents a descriptive analysis of the structure of the entire population of the listed company market (where existing studies cover only restricted samples) and at a detailed level (industry sector and individual firm) for a crucial period of structural change. Third, it offers insights into the complex dynamics underlying observed changes in market structure by undertaking a decomposition analysis. Fourth, it contributes to the growing, and conflicting, Andersen-related literature by (i) analysing the short-term impact of this event in the UK, where no study has yet been published; (ii) documenting the impact on market structure; (iii) analysing the fee impact of the Andersen dissolution, controlling for company size; and (iv) evaluating the possible impact of NAS fee cross-subsidisation on audit fees. Due to the global nature of many large companies, the capital markets and the audit firm networks, the characteristics of the UK listed company audit market are shared with many other markets worldwide (FRC, 2006a: p. 8). Thus, the findings and conclusions from the present study have potential relevance in the global setting. Notwithstanding this, however, national markets do have specific characteristics and features. For example, the manner of the Andersen dissolution varied across countries – in the UK most clients transferred to Deloitte & Touche, in Australia most transferred to Ernst and Young and in the US the spread was fairly wide. In the UK, Deloitte & Touche (thereafter to be known as Deloitte) offered partnership or employment to 260 Andersen UK partners and around 3500 UK employees. Andersen’s associate law firms were not involved in the agreement and Andersen’s insolvency/corporate restructuring division decided not to join Deloitte & Touche (EC, 2002). Andersen partners are reported to have voted ‘overwhelmingly’ in favour of the acquisition8; so it is likely that most audit partners did remain with Deloitte, at least in the short-term. The remainder of this paper is organised as follows. The next section provides a brief overview of the economic theory on market structure and behaviour, before considering the unique features of the audit market setting and discussing the factors that lead to changes in market concentration. This literature section goes on to review prior empirical studies of audit market concentration, the consequences of market concentration and the impact of Andersen’s demise on audit pricing. Section 3 outlines the methods used to measure audit market concentration, data sources and data collection methods. Section 4 presents the results and discussion. Finally, Section 5 concludes the study.

This paper presents evidence on audit market concentration and audit fee rates in the UK domestic listed company market during a crucial period of structural market change (i.e., following the PricewaterhouseCoopers’ merger and encompassing Andersen’s demise, 1998–2003). Concentration is shown to have been consistently high throughout the period, characteristic of a ‘tight oligopoly’. However, there is clear evidence that concentration has, in a number of respects, shown a declining trend over the six-year period, indicating that Andersen’s demise has reduced the level of inequality between the top tier firms. The main factor underlying the drop in Big 5/4 concentration based on number of audits was the relatively small number of audits gained from joiners. This finding implies that, if the mid-tier firms that dominate this market segment can retain these clients as they grow, then market concentration will decrease. The main factor underlying the slight increase in Big 5/4 concentration based on audit fees was the retention of Big 5/4 auditors by companies that have grown. A secondary factor was that they tended to gain larger companies as clients as a result of switches. This may reflect investor and client preferences for a top tier auditor as companies grow, or a Big 5/4 strategy of avoiding the smaller (and therefore higher-risk) companies ( Jones and Raghunandan, 1998 and Rama and Read, 2006). The rate of auditor change over the period (5.8% p.a.), was higher than reported in prior UK studies (4.1% p.a. in Beattie and Fearnley, 1994; 4.5% p.a. in Pong, 1999). This could reflect increased competition brought about, in particular, by increased audit committees activity in relation to auditor selection and appointment during this period (due to regulatory pronouncements in relation to corporate governance such as the Hampel Report, 1998 and the Smith Committee, 2003 guidance). Extant evidence from Australia and the UK indicates that it is industry specialism, at both national and city level, and not just brand name that contributes to fee premia and auditor selection choices (Ferguson et al., 2003, Ferguson et al., 2006, McMeeking et al., 2006 and Basioudis and Francis, 2007). This study found that in eleven sectors, one or more mid-tier firms audited at least 2% audit fees, and in 9 sectors a mid-tier firm’s market share exceeded that of one of the B4 firms. It is concluded that an effective challenge from the mid-tier firms could be made in these industries, especially if these firms adopted an investment and marketing strategy based on industry specialism. This challenge would be assisted by the implementation of the recommendations of the FRC (2007b) audit choice study. Andersen’s demise served to reduce the level of inequality between the top tier firms, with Deloitte capturing approximately 70% of Andersen clients and total audit fees. Thus, consistent with the findings of Comunale and Sexton (2003) in the US context and Ballas (2005) in the EU context (but contrary to popular belief) the exit of a top tier firm does not necessarily result in increased market concentration. However, PwC retained its position as a ‘dominant firm’, with 40% market share (based on audit fees) and market leader status in 18 out of 34 industry sectors in 2003. There is evidence that the audit fee rate of listed UK companies increased markedly following Andersen’s demise, especially in the case of the smallest companies. Several possible explanations exist. First, the Enron scandal may have lifted the intense downward pressure on audit fees by companies, due to their desire to instil confidence about audit quality in the financial market participants after this was damaged by Andersen’s misconduct (the ‘Andersen effect’). Thus, companies wanted more effort from their auditor, placing upward pressure on audit fees. Second, smaller companies may be perceived to be more risky, resulting in a higher insurance component in the audit fee. Third, Big 4 auditors may have adopted a strategy of reducing their client portfolios through auditing fewer small (possibly riskier) clients, retaining only those small company clients that were willing to pay a substantially higher fee. The finding that Big 4 audit market share (in terms of clients) has fallen significantly could reflect some small companies switching auditor to avoid such a fee increase. Moreover, since audit firms undertook additional audit work as a result of the Andersen effect, they may have hit capacity constraints, forcing resignations from certain engagements (small, risky client companies).30 Finally, the audit fee rises may simply reflect changes in the general economic climate. In relation to former Andersen clients, there was no significant above-inflation change in audit fees paid by them to their new auditors. The lack of evidence to indicate that recent structural changes have resulted in anticompetitive pricing is consistent with Duxbury et al.’s (2007) modelling of the UK setting. It contrasts, however, with the evidence in Australia, where former Andersen clients paid higher audit fees (Hamilton et al., 2008) and in the US, where initial fee discounts were reported (Chi, 2006). For non-Big 4 successor auditors in the UK, we find a median decline in audit fee of −10.0%. This can be attributed to the loss of the Big 4 audit premium and/or more significant fee discounting on initial audit engagements by small auditors (as found in the US by Ghosh and Lustgarten, 2006). Moves to Big 4 auditors other than Deloitte Touche (who acquired most of the Andersen UK business) were not accompanied by an audit fee premium yet there was also no evidence of general fee discounting, both in contrast with the US (Chi, 2006). Overall, the UK audit market response to Andersen’s decline seems to have been relatively benign, leading to a restrained ‘business as usual’ effect. The lower level of observed NAS in the year of change to a new auditor following Andersen’s demise provides little evidence of either knowledge spillover effects or cross-subsidisation of audit fees. Rather, it is consistent with a client (and audit firm) response to concerns over the potential impact of NAS on perceptions of auditor independence. The combined findings provide no evidence to indicate that recent structural changes have resulted in anticompetitive pricing in the UK listed company audit market. The key concerns remain the lack of audit firm choice and issues concerning the governance and accountability of audit firms. There is no reason to expect that this conclusion would be substantively different if another top tier audit firm ceased. While concentration levels may increase if the market leader (PwC) was one of the remaining three firms and obtained a significant proportion of the demised firm’s clients, strong forces in the audit market maintain competitiveness. However, the choice problem would become extremely critical. The most recent progress report on choice in the UK audit market FRC (2009) reports on measures designed to aid market solutions to high concentration levels. Concentration levels as at August 2009 are reported to be broadly stable, with the non-Big Four’s market share (based on number of audits) for the FTSE 100, FTSE 250, FTSE Small Cap/Fledgling and AIM market segments being 1%, 6%, 20.5% and 55.1%, respectively. In the US, no ‘immediate action’ to reduce concentration is considered necessary (GAO, 2008). It appears that regulators are maintaining a careful watching brief to give market solutions the opportunity to take effect. Given the often unintended adverse consequences of regulatory intervention, this approach seems optimal. Inevitably, this study suffers from limitations, some of which offer avenues for future research. First, we only examine the short-term impact of Andersen’s demise; further research is required to consider the medium to long-term effects. Second, the analysis does not distinguish follower from non-follower ex-Andersen clients, as we were unable to identify a public source of this data; US research has shown that this characteristic influenced post-auditor change fee levels. Finally, further longitudinal research on recent industry effects in the UK market, building on the 2003 situation presented in this paper, would be desirable.