Part 3 - The market for audit services


3.1 Background

The most important features of the audit market for the top 1000 Australian listed companies are that:

  • three audit firms combine to audit more than 50 per cent of the market;
  • the Big 4 (PricewaterhouseCoopers, KPMG Australia, Ernst & Young, and Deloitte Touche Tohmatsu) audit more than 65percent of the market;
  • Second tier firms (with at least three listed audit clients) audit more than 24percent of the market.

In short, just 10 firms service nearly 80percent of the market. The remainder is spread across firms that audit less than three listed clients. This analysis is based on ASIC data covering auditor appointments to April 2002.

With such concentration, companies face a restricted pool of audit firms with experience in auditing listed companies. Where one of the major audit firms is providing non-audit services to a company, the pool of possible providers of audit services may be even more limited. Choice would be further restricted if a company did not wish to contract audit services from a firm that audited a major competitor.

Recent surveys of audit firms and their clients indicate that non-audit services usually account for significantly more than half of an audit firm's revenue. This percentage is growing, and audit firm projections show non-audit services are the engine for their business growth. Audit revenues are relatively static.

3.2 Market responses to accounting developments

The market has responded quickly and in various ways to the developments of the past year in accounting and financial reporting. Summaries of these responses are shown in Boxes 1 and 2 below.

Box 1: Private sector responses to concerns about auditor independence

US Accounting firms and the American Institute of Certified Public Accountants

  • Jointly issued a list of risk factors for financial reporting and 30recommendations for addressing them (January 2002).

ANZ Banking Corp

  • Introduced in April 2002 plain English disclosure, more discussion on critical accounting policies, disclosure of off-balance sheet structures, restrictions on auditor-provided services. The only non-audit services allowed are those not perceived to be materially in conflict with the role of auditor, subject to approval by the Audit Committee. Exceptions need safeguards and Board approval.


  • In July 2002 released its first Social Impact Report with triple bottom line reporting, including governance and audit information.

Standard & Poor's

  • Created a new set of analytic standards for earnings, aimed at improving reliability.
  • Increased contact with internal auditors and Audit Committees.
  • Using transparency measures and disclosure surveys in ratings.


Added accounting, derivatives and governance teams to its ratings assessments. Increased analysis of accounting procedures, disclosure, risk management and governance.


Box 2: Major changes to the accounting and non-audit services framework in Australia


  • Instituted voluntary internal independence structures: Ethics & Conflicts Committee (majority KPMG management); external academic review of independence, conflict resolution and quality control procedures - available to clients only.
  • Spun off its consulting arm as KPMG Consulting in October 2001, containing business and technology consulting, systems design, applications implementation and system integration.
  • KPMG retained assurance, tax, legal, corporate recovery, corporate finance, transaction services and forensic accounting.
  • KPMG Consulting in arrangement with Andersen to purchase their consulting division.
  • Listed in US on NASDAQ.

Deloitte Touche Tohmatsu

  • To spin off consulting services as a private company (Braxton) by the end of 2002.
  • No longer accepts new engagements to perform internal audit outsourcing for external audit clients.
  • To retain security, actuarial, corporate finance, and tax services.

Ernst & Young

  • Sold its consulting arm to Cap Gemini in May 2000.
  • Retained assurance, corporate finance, tax, legal, and advisory businesses.
  • 75percent of Arthur Andersen accounting and audit in Australia merged with Ernst & Young .


  • Sold IT consulting arm to IBM Global Services (July 2002), and withdrew plans to spin off and list.
  • Established Audit Standards Oversight Board in May 2002 to examine quality control and processes for ensuring audit independence.
  • Spun off valuation consulting and HR outsourcing businesses in 2001.

Arthur Andersen

  • Spun off Accenture in August 2000.
  • Subsequently built a business consulting division that has since joined with KPMG Consulting (75percent) and William Buck (25percent).
  • Ceased operation in August 2002.

Many second tier accounting firms experienced business growth through non-audit services and the acquisition of non-audit service providers.


The consequences of these changes are uncertain.

  • Internally-sponsored independence and ethics committees in audit firms- these may have some positive effect on systems and processes to protect audit independence and quality within audit firms. However, the effect on investor confidence is uncertain and may be affected by concerns over the effectiveness and independence.
  • Spun-off and listed consulting arms - these may have little effect on the reality or perception of auditor independence. The remaining audit-based firms retain other non-audit service businesses, and the relationships between audit and consulting organisations are opaque. These reforms may not always result in the audit partner no longer having a financial or career interest in cross-selling non-audit services. Further, one major accounting firm has previously spun off a consulting arm and then rebuilt a consulting business.

3.3 The nature of audit contracting

The economic function of auditing is to build trust between parties involved in the capital markets. It does this in two ways.

  • By aiming to provide reasonable assurance on information quality in financial statements, investors are more able to trust what issuers claim about their financial situation. This lessens the need for investors to spend time and money on search, information gathering and due diligence.
  • By providing a review of how investors' money is used, investors can be more trusting that their capital will be used for the purposes they agreed to. This lessens the need for oversight and regulatory effort.

In both cases, building trust through auditing 'lubricates' the capital market and means fundraising is cheaper and easier for audited companies.

3.3.1 Discussion

The unique position of audit - where a 'for-profit' business is central to the public interest - may lead to apparent conflicts in incentives for auditors. These conflicts include that:

  • the audit function has a significant public interest element, yet auditors are paid by the entity they are overseeing (management);
  • there is a personal relationship between auditor and client;
  • audit partners, managers and staff may have career and financial incentives to comply with audit client wishes on the presentation of financial reports;
  • lower level audit staff may have career and financial incentives to acquiesce in audit partner wishes;
  • audit staff may see themselves more as business consulta
  • audit firms rely on non-audit services for their revenue and profit growth; and
  • corporate clients may view audit as a dead compliance cost and want to capitalise on the knowledge of audit firm professionals.

The difficulty in this structure is that:

  • only company management has direct fee payment, contract and personal contact relationships with the auditor;
  • other incentives such as regulatory penalties, professional rules, the protection of auditor reputation, and personal career development may in some cases not be as strong as those relationships; and
  • this can lead to market perceptions of auditors acting for profit rather than in the public interest.

Appointment by external body

There have been suggestions that ASIC or some type of Public Oversight Board be responsible for auditor appointment. The rationale is that auditors would then be contracting with someone representative of the public interest, and there would be financial and contractual structures supporting the public interest aspect of auditing. This is not a position the Government sees as feasible or desirable. This is because it would:

  • replace audit market competition with competition for regulatory approval;
  • be an inflexible tool in a highly dynamic and flexible environment;
  • affect the market process and business decision-making;
  • push responsibility for audit failure towards the appointing body; and
  • be unlikely to be any more effective than the suggested suite of reforms.

Loss-leading audit to sell non-audit services

There has been significant debate about the use of low-cost auditing services to provide an entry point for on-selling more profitable non-audit services. It has been suggested that the practice is commonplace.

An Australian-based study (A Ferguson, Evidence of Audit Leader Strategic Price Cutting and Fee Recovery in Non-audit Services: Implications for Independence, Working Paper 55, School of Accounting, University of Technology, Sydney) has found that loss-leading behaviour does occur in some industry sectors, and that the leading auditor in that industry sector is '...effective in gaining greater consulting revenues compared with other Big 5 firms'. However, this study also found there was no conclusive threat to independence, meaning the evidence in this area is incomplete. Nonetheless, the appearance of compromise and suggestions of loss-leading behaviour are potentially significant problems for investor confidence.

Low balling for client lock-in

Low-balling, or setting very low initial prices in order to 'lock-in' a client to later audit services at higher prices, is another problem that may arise in a for-profit audit environment.

While the evidence for this is weak, it is strong enough for the UKAccountancy Foundation to consider providing rules to address it. The current requirement in Australia to disclose prices charged for audit services helps address any perception that low-balling is occurring.

3.4 Challenges to the value of audit reports

Recent United States surveys of audit clients indicate that many believe that audit is only a compliance cost which offers them no value as a client.

Further United States studies, and current market events demonstrate that many auditors fail to correctly identify accounting irregularities or issue timely 'going concern' warnings on struggling companies.

It has been suggested that, even if audit fails to ensure compliance with standards, the fact that financial reports are audited at all means management will not allow accounting irregularities to become excessively large. However, recent experience in the United States suggests that this is not always the case (for example, events at Enron and World.Com).

3.4.1 Inadequate information in audit reports

Submissions on the Ramsay report and to the JCPAA indicate that formal audit reports are fragmented, difficult to understand and do not provide as much information as statement users would like, or auditors would like to give. Many submissions from audit firms and professional bodies have expressed a willingness to provide more information - provided there is liability reform to protect them from unwarranted litigation. This view suggests that the content and presentation of audit opinions is uninformative and recognises the growing importance of unsophisticated retail investors and the increasing needs for information of a non-financial nature.

The key requirements for audit opinions are set out in Australian Auditing Standard AUS 702 The Audit Report on a General Purpose Financial Statement. It sets out the types of opinion, the content of the report, and the circumstances resulting in a modified audit opinion. This standard also includes the minimum requirements for an audit opinion.

The Minimum Content of a Standard Audit Opinion*

In our opinion, the financial report of xxx is in accordance with

(a) the Corporations Act, including:

    (i) giving a true and fair view of the Company''s and consolidated entity''s financial position as at 31 December 2001 and of their performance for the year ended on that date; and

    (ii) complying with Accounting Standards and the Corporations Regulations; and

(b) other mandatory professional reporting requirements.

*the Audit Report must also include a Scope section setting the context of the audit opinion.


Submissions received on the Ramsay report and to the JCPAA, statements from accounting academics and other interested institutions variously claim that in a changed audit liability environment audit reports could include information on:

  • internal audit processes;
  • risk management;
  • corporate governance processes;
  • the quality of forward-looking financial data;
  • the validity of measures of management performance;
  • critical accounting policies;
  • non-financial data such as environmental and social responsibility reports; and
  • the effect on the financial statements of changing critical accounting assumptions.

The argument is that this would improve shareholder, regulator and investor understanding of the real financial position of the client company; make better use of the skills and position of auditors; and increase confidence in financial statements.

3.4.2 Usability

A key assumption of any disclosure measures is that they must be usable to be of benefit. To increase the usability of audit reports, submissions have suggested that the language be simplified and made more concrete, and key audit-related matters removed from the notes and displayed clearly.

For example, an auditor may have concern about a transaction that leads to the reporting of an emphasis of matter appearing after the unqualified audit opinion. An emphasis of matter mentions the issue and refers to a note in the financial statements dealing with it. This method of audit reporting puts relevant audit-related information in three different places, two of which are not in the audit opinion itself. This may reduce the usability of audit reports.

3.4.3 The audit expectations gap

CPAA and the ICAA examined the expectations gap in a joint working party study in 1993. In the study's report the expectations gap was defined as the 'difference between the expectations of users of financial reports and the perceived quality of financial reporting and auditing services delivered by the accounting profession.'

The basic issue is that some users of financial reports expect more from audit and accounting than the profession can reasonably be expected to deliver. For example, users may believe that audit offers a 'gu
arantee' of the accuracy of financial statements or of the absence of fraud, when in fact it does not.

Submissions to Ramsay and the JCPAA examined the audit expectations gap and proposed to reduce the gap through measures which involved:

  • improving education programs for users of financial statements, aimed at correcting unreasonable expectations; and
  • providing more information in audit reports.

3.5 Competition in audit services

The nature of product competition in the market for audit services is restricted because the audit is not fully visible to those it serves. Shareholders and investors cannot observe the audit and check that it is actually being done as required.

However, competition on audit quality also operates through individual auditor and audit firm reputation. An audit firm can experience significant reputational and liability risk associated with the quality of the audits it performs. In the extreme case of Andersen, loss of reputation arising from the Enron audit and the firm's subsequent conviction for document shredding led to a rapid erosion of its client base and liability consequences that brought the firm down.

Whereas competition for audit services previously may have centred on price, in current market circumstances greater emphasis is probably placed on reputation for providing a quality audit service. This shift has also reduced the likelihood audit will be used as a loss leader. Companies are willing to pay a premium for the quality audit services that are demanded by the market.

The increased availability of specific information on audit firm performance could encourage better market judgements about audit quality and independence.

3.5.1 Support for harmonisation with international auditing standards

The Government will continue its support for harmonising both accounting and auditing standards internationally. As well as providing broader benefits, this process will assist second tier auditing firms to compete in the auditing marketplace through mergers and the ability to provide a broader range of cross-border services, including within the region.

3.6 Conclusion

The issues raised are matters for the auditing standard setter, the profession, and where appropriate, the competition regulator. The Government is keen to ensure that the market for audit services functions efficiently and that any regulatory changes to the audit market, including those outlined in this policy paper, consider the impact on competition in the audit market. Regulation must not entrench existing market structures or players, and must allow for innovation in organisation and services delivery.