The Big 4’s Stranglehold on the Audit Market Is Worse Than You Thought

Posted on by Caleb Newquist

In a speech entitled "Accountability: Protecting Investors, the Public Interest and Prosperity," PCAOB member Jeanette Franzel shares some numbers:  

Currently, about 2,360 firms are registered with the PCAOB, including about 915 non-U.S. firms located in 85 jurisdictions.
 
Not all PCAOB-registered firms regularly issue audit reports for issuers, but we inspect those that do — approximately 714 firms, including more than 240 non-U.S. firms. Additionally, approximately 118 registered firms do not regularly issue audit reports for issuers; however, they report that they play a substantial role in the audits of issuers.
Accounting Today picked out the little nugget from her speech that stated 923 registered firms do not currently conduct audits that would subject them to PCAOB oversight, therefore the Board is "examining the extent of this practice and the risks that may arise from gaps in expectations about what a PCAOB registration may signify."
 
So that's interesting. But it's not quite as interesting as this: 
Together, these firms audit or play a substantial role in the audits of the previously mentioned more than 9,755 U.S. issuer companies that have approximately $26.4 trillion in global market capitalization.
 
Based on 2012 year-end data, the four largest registered public accounting firms and their global affiliates audited more than 98 percent of the global market capitalization of U.S. issuers. The next three firms and their global affiliates audited another 1.1 percent of this market capitalization.
 
This level of concentration, which has increased significantly since the 1980s, has been studied extensively. The dynamics of this market provide complexities for the Board's oversight programs and present challenges within the market for choice among audit firms.
You can crunch those numbers if you want.
 
Anyway, I think Member Franzel showed considerable restraint here by simply stating that this "level of concentration" results in "complexities" and "challenges."
 
Some in the UK haven't been so reserved and they have been much aggressive in discussing the Big 4 oligopoly. Meanwhile, here in the States our legislators are passing bills that abolish policies that aren't even being seriously considered.   
 
"Too Few to Fail" doesn't even do this justice. 
 

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PCAOB Report States That There Was a Fair Amount of Failing Going on at Ernst & Young

The PCAOB has issued its annual report on Ernst & Young having given the firm the third degree at its national office and 30 of its 80 U.S. offices. It inspected 58 audits performed by the firm but exactly who is, of course, a big secret (unless you tell us).

There were five “Issuers” that were listed in the report and some form of the word “fail” was used 25 times (that includes the footnotes).

[Issuer A] The Firm failed to adequately test the issuer’s loan loss reserves related to certain loans held for investment. Specifically, the Firm failed to reconcile certain values used in the issuer’s models with industry data, failed to test the recovery rates used in the issuerfailed to test the qualitative components of the reserves.

Damn those loan loss reserves!

[Issuer C] The Firm failed to perform sufficient procedures to test the issuer’s allowance for loan losses (“ALL”). The issuer determined the general portion of its ALL estimate, which represented a significant portion of the ALL, using certain factors such as loan grades. Data for this calculation were obtained from information technology systems that reside at a third-party service organization. The Firm relied on these systems, but it failed to test the information-technology general controls (“ITGCs”) over certain of these systems, and it failed to test certain of the application controls over these systems. Further, the Firm’s testing of the controls over the assignment and monitoring of loan grades was insufficient, as the Firm failed to assess the competence of the individuals performing the control on which it relied.

This loan thing appears to be a trend…

[Issuer D] The Firm failed to sufficiently test the costing of work-in-process and finished goods inventory. Specifically, the Firm’s tests of controls over the costing of such inventory were limited to verifying that management reviewed and approved the cost allocation factors, without evaluating the review process that provided the basis for management’s approval.

Hopefully that doesn’t blow back on an A1.

Anyway, you get the picture. The whole report is below for your reading pleasure. E&Y’s got its $0.02 in, however it was short and was mostly concerned about the firm’s right to keep its response to Part II (the non-public part)…non-public:

We are enclosing our response letter to the Public Company Accounting Oversight Board regarding Part I of the draft Report on 2009 Inspection of Ernst & Young LLP (the “Report”). We also are enclosing our initial response to Part II of the draft Report.

We note that Section 104(g)(2) of the Sarbanes-Oxley Act requires that “no portions of the inspection report that deal with criticisms of or potential defects in the quality control systems of the firm under inspection shall be made public if those criticisms or defects are addressed by the firm, to the satisfaction of the Board, not later than 12 months after the date of the inspection report.” Based on this statutory provision, we understand that our comments on Part ii will be kept non-public as long as Part ii of the Report itself is non-public.

In addition, we are requesting confidential treatment of this transmittal letter.

So this doesn’t mean much other than E&Y would prefer that no one know how it managed to tell the PCAOB to fuck right off as nicely as it could.

If you had the pleasure of being on one of these 58 engagements, we’d love to hear about your experience.

2010 Ernst Young LLP US