Auditing Standard 5 – Comments

I received a comment on my Auditing Standard 5 post today from the esteemed author of the blog, My Daily Fatwa. Mr. M.D. Fatwa asked in a comment,

“Do you think the new provisions will lower audit costs (with the little firms just getting a smaller share of a shrinking pot), or will the Big 4 figure out how to keep the costs up? Does AS 5 create any incentives for companies to have smaller firms run part of the audit to keep overall costs down?”

My response to the comment is in theoriginal post and below. I do not believe that AS No. 5 will reduce audit costs.

“…in short, I think the Big 4 will always find a way to make more money, preferably from existing clients (their audit clients) than from new ones. That’s because their strengths lie (and their structure lends itself more to) maintaining client relationships than new business development and marketing.”

But M.D. had a broader question about the role of the next-tier firms. I believe that, in contrast to the Big 4, the smaller audit firms will be squeezed. Their clients, the mid-size and private firms, are very cost-conscious and will demand concessions.

There are a few instances of a true cooperative arrangement between a Big 4 and a next-tier firm for cost savings purposes. Usually these situations exist, instead (such as with Parmalat and GT/Deloitte), based on legacy relationships, geographic coverage issues, or requirements for specific expertise in certain divisions. Every once and a while there are two Big 4 firms that share an audit of a very large multinational, but one is always primary and the other supportive for a specific operations. (They are very territorial that way…) I don’t see companies adding to their administrative hassle and independence constraints by tying up more than one firm with the external audit unless absolutely necessary. Companies want more choices not fewer choices for the other consulting, tax and internal audit work they need the firms for.

It remains to be seen whether the next-tier firms (GT, RSM, BDO Seidman, Blackman Kallick, and the international next-tier) can revise their approach to become more efficient when they are still on an even steeper learning curve than the Big 4 in becoming more effective. I am skeptical.

The Big 4, on the other hand, will become more efficient and effective because they have to:

1)They are being strongly criticized in the PCAOB reports on audit quality, here and here, and their ability to address concerns regarding fraud
2)There are still significant resource constraints in the audit practices and now the firms want to expand their consulting practices at the same time they will be able to sell more services to existing audit clients.

None of this will translate into lower fees, just more fees for more and different things. Why won’t fees for audit and audit related (non-audit internal control services, for example) go down? Because the conditions for premium pricing in professional services still exist:

1)Significant constraints on resources needed to perform the engagements,
2)Specialized knowledge needed to perform the engagements, with monopolistic or at least oligopolistic control over who is considered to have sufficient competence/knowledge, and
3)Deadlines and time constraints for completing the engagements that require necessary work to be compressed into existing time frames with significant reputational or financial consequences if it is not.

Prediction

The Big 4 will convince regulators that the way to improve quality and improve competition is for some of them to buy up some of the next-tier firms. The argument goes something like this:

The next tier firms are not going to become competitive, especially on a global basis, and be chosen by more very large public companies in the near future. It’s better for them to be absorbed by the Big 4 and not duplicate money and effort in trying to implement all the compliance and quality programs (and the very expensive systems and resources to support them) that are required by the new regulated age. This strategy also solves the resource constraint issue. The next tier firms have an even harder time recruiting the level of expertise needed and are competing with the Big 4 in this regard. Eliminate the competition for labor and control the cost by absorbing their resources and reduce costs for infrastructure, administration and compliance (and regulatory oversight via inspections) at the same time.