Give Us The Tools And We'll Finish The Job: How Europe Ca

The European audit market has been broken for far too long. After glaring audit failures in the recent past, the legislation is once more under review. Fixing the persistent shortcomings will require serious reforms in three areas. To increase competition and rein in the dominant position of the Big Four, joint audits including at least one challenger firm should become mandatory. Auditors should be prohibited from providing their audit clients with consulting services to eliminate conflicts of interest. And the European Securities and Markets Authority (ESMA) should directly supervise the biggest audit firms to ensure effective oversight. With bold and binding tools, European decision-makers can finish the job and finally turn the EU audit market around.

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Executive summary

The European audit market is broken. When the global financial crisis revealed substantial weaknesses at some large financial institutions, also the audit firms that had provided them with ‚clean‘ bills of health were pilloried. The subsequent EU reforms targeting the financial sector did not forget the audit profession. But extensive lobbying efforts by EY, KPMG, PWC and Deloitte – the Big Four audit firms – prevented serious change. While the measures adopted in 2014 were a step in the right direction, they failed to achieve the main objectives: greater competition, reinforced professional scepticism, and restored confidence in companies’ accounts.

Concentration of market power at the Big Four, impaired auditor independence, and inadequate public oversight continue to undermine audit quality. These shortcomings are particularly pronounced at the top end of the audit market, where public interest entities (PIEs) suffer from a lack of choice. To strengthen audit quality, this paper argues that bold and binding measures are necessary in the following three areas:

First, the barriers that currently hinder challenger firms, i.e. Non-Big Four audit firms, from entering the market should be removed. To equip smaller audit firms with the expertise needed for the audit of large companies, the EU should require PIEs to engage at least one challenger firm as shared auditor and, after a transitional period, as joint auditor. In addition, all national audit supervisory bodies should offer complete transparency on inspection results and sanctions. Moreover, aggressive pricing strategies undermining audit quality should be tackled head-on and liability caps currently discriminating against smaller audit firms should be made more proportionate. Taken together, these measures would boost challenger firms‘ ability to compete with the Big Four.

Second, remaining conflicts of interest should be eliminated. The easiest way to strengthen auditor independence is to prohibit audit firms from providing their PIE audit clients with non-audit services. Furthermore, to curtail the company management’s influence, auditors should be required to present their findings at annual general meetings and answer questions raised by shareholders.

Third, public supervision of the audit profession should be beefed up. The biggest audit firms should be directly supervised by the European Securities and Markets Authority (ESMA) to ensure effective oversight at European level. Finally, the application of the European rulebook should be further harmonised across member states to meet the goal of a Capital Markets Union.

After some glaring audit failures in the recent past, the EU audit legislation is once more under review. The European Commission has staged a public consultation and is set to publish its legislative proposals in early 2023. This time, Europe needs to finish the job and adopt bold and binding measures. With the right tools, political decision-makers can finally turn the market around.

This policy paper is part of the “Visions for Europe” series that develops longer-term visions and recommendations for different EU policy areas. It is based on extensive consultation with experts and stakeholders from the national and European level, including a closed workshop held in June 2022 in Berlin. The views and opinions expressed in this policy paper are solely those of the author.

1 Introduction

Europe’s market in auditing large companies is broken.Deloitte, EY, KPMG, and PWC together dominate the statutory audit market of public interest entities (PIE). High concentration of market power at the Big Four firms, impaired auditor independence, and weak public oversight are undermining audit quality. This is problematic because statutory audit, alongside corporate governance and supervision, is meant to provide assurance that financial statements give a true and fair view of companies’ financial health. This assurance is key to financial stability as market participants rely on trustworthy information.

The EU audit market rules adopted in 2014 have not achieved their goals.In the wake of the financial crisis, the European Commission proposed far-reaching reforms to increase competition, reinforce professional scepticism, and restore confidence in companies’ accounts. However, after intense lobbying, only a few of the ambitious reform proposals finally became law. Since then, neither market concentration nor auditors’ dependence on their clients have decreased noticeably, while multinational audit firms are still not properly supervised at EU level. After prominent audit failures in the recent past, the legislation is once more under review. The United Kingdom has launched a radical process that will shake up the market there. On this side of the Channel, the European Commission is set to issue legislative proposals for the EU in early 2023.

To remedy the persistent shortcomings, the EU audit market rules must undergo a profound overhaul.The disappointing results of the last round of reforms underline that minor tweaks and mere incentives are not enough on their own to break the dominance of the Big Four and improve audit quality. Instead, the EU should adopt bold and binding measures in three areas. First, market entry barriers should be removed to allow challenger firms to compete with the Big Four. Second, remaining conflicts of interest should be eliminated so as to strengthen auditor independence. And third, audit firms should be subject to effective oversight at European level.

2 Shortcomings in the European audit market

Auditing is of crucial importance for the functioning and stability of financial markets. It forms the backbone of trust between business and society. However, lack of competition, independence and public oversight are impairing the proper functioning of the EU audit market. This chapter explains the importance of robust audits and outlines shortcomings in the PIE audit market and their origins.

2.1 The importance of robust audits for financial stability

Confidence in the veracity of financial statements is crucial for financial markets to function.By verifying companies’ annual accounts, auditors reduce the risks of misstatement and thus build confidence in companies' numbers. This additional assurance of reliable and trustworthy information benefits a wide range of stakeholders. Accurate financial statements are crucial for shareholders, investors, banks, credit rating agencies, and trading partners. If they cannot trust these financial statements, they charge a risk premium. This raises the costs of capital for companies, leads to fewer investments and – ultimately – to higher prices for consumers. Employees, too, depend on auditors’ provision of a realistic view of their firm's financial health to know whether they should remain with their current employer or rather look out for a new job. Last but not least, public authorities rely on correct financial statements for tax calculation and other purposes. The fact that auditing is a service provided in the public interest is demonstrated by recent accounting scandals such as Carillion, Wirecard, and Thomas Cook which have cost investors billions of euros, undermined basic trust in corporate reporting and shaken the stability of financial markets.

The importance of sound financial statements is reflected in the legal requirement for certain companies to have their accounts audited. In the EU, medium-sized and large undertakings as well as public interest entities (PIEs), i.e. banks, insurers, listed companies and those specifically designated as such by member states, are obliged to have a statutory audit.The provision of statutory audits is regulated by the EU Audit Directive.Only natural persons (statutory auditors) or legal persons (audit firms) approved by the competent national authorities are allowed to perform statutory audits. For PIEs, the EU Audit Regulation foresees stricter requirements because the potential negative consequences of misstatements are usually greater than for other types of undertakings.

2.2 Factors undermining top audit quality

The credibility of audit opinions depends crucially on their perceived quality. If stakeholders do not trust the auditor to thoroughly assess the company’s books and report on material errors, the audit opinion will be meaningless. Three factors currently undermine the quality of auditing services in the EU: high market concentration, impaired independence, and weak public supervision. Spectacular accounting scandals have exposed blatant audit deficiencies, but evidence from audit oversight bodies shows that poor audit quality is a broader problem.

2.2.1 High market concentration

The European audit market lacks competition.In a well-functioning market with genuinely competitive forces at work companies can pick and choose among a multitude of auditors and select the one that corresponds best to their preferences on price and quality. Where the audit firm does not meet clients’ expectations, it must fear negative consequences for its reputation and risks losing other clients or failing to win any new engagements. At the top end of the European auditing market, however, this is not the case.

Since the 1980s, the audit market has become increasingly concentrated.Between 1986 and 2002, the number of large audit firms worldwide decreased from eight to four. Since then, the Big Four have dominated the global market. In Europe, PWC, KPMG, Deloitte and EY together held about two thirds of the aggregated market of PIE statutory audits in 2018 (Figure 1a). Looking at revenue from PIE audits, the Big Four with over 90% of total revenues are even more dominant (Figure 1b). Research shows that this level of market concentration can seriously undermine competition and audit quality.

Figure 1a: EU market share (2018) as measured by number of PIE statutory audits