Current Trends in the Audit Industry

IESBA CAG Meeting (September 2015)

Agenda Item F-3

Current Trends in the Audit Industry

Overview:

This paper provides background information for the panel session on the current trends in the audit industry being jointly organized by IFIAR's Investor and Other Stakeholders Working Group and Global Public Policy Committee Working Group. This session will be held in April 2015 in Taipei, during the IFIAR plenary meeting, which will further the dialog among audit regulators and audit firms on issues impacting audit quality and investor protection.

Audit firms provide an essential service to the capital markets. By promoting integrity in financial reporting and building a basis for confidence, auditors reduce financing costs, and contribute to an efficient allocation of capital to fuel economic growth.1

Changes in the economic environment and the market for audit services have impacted how the audit industry operates and how it is perceived by users and the general public. Important issues facing the audit industry include:

Commoditization of the audit; The perceived value and relevance of the traditional audit including the auditor's

responsibility to detect fraud; The impact of an increased focus by the larger audit firms to grow their non-audit

services with a specific focus on advisory / consulting services; and The impact of advances in technology and greater availability of and access to

data.

The paper first discusses the current state of and trends observed in the audit industry in six areas:

Firm revenue and growth; Competition in the audit market; Governance within the global network structure; Partnership model and the threat of litigation; Quality and extent of resources in the labor market; and Impact of emerging technologies on the audit.

In each area, the paper poses questions for discussion.

1

A number of studies have documented that audits help companies to raise funds in capital

markets. See for example, Minnis. 2011. The Value of Financial Statement Verification in Debt

Financing: Evidence from Private U.S. Firms. Journal of Accounting Research, 49 (2) (analyzes

a sample of privately-held firms and finds that audited firms enjoy an interest rate that is, on

average, 69 basis points lower than the rate received by non-audited firms).

1

The paper considers the audit industry, with a particular focus in some areas on the global Big Four network firms given their dominance in many jurisdictions.2

It is hoped that this paper and the panel sessions at the plenary meeting will assist audit regulators in better understanding the potential implications of these matters for audit quality and investor protection.

In summary, the paper raises key questions including:

What is the impact on audit quality of (1) the expansion and growth of advisory services being offered by the audit firms and (2) low growth in the traditional audit function?

Do audit firms need to improve the transparency of their governance, structures and operations to improve market knowledge?

Are the right people being attracted to and retained in the audit profession? What, if anything, should be done differently to ensure the audit profession has the right people to perform high quality audits?

How will changes in how audits are staffed and where the audit work is performed impact audit quality and the development of people in the audit practice?

Has the audit become a commodity? Might the current trends in audit fees create a challenge that audit firms may not earn a sufficient return to support the investments required to deliver high quality audits?

How will emerging technologies change how an audit is performed (including the use of data analytics and big data)?

Factors influencing the current trends in the audit industry

Key factors reflecting and influencing the current trends in the audit industry can be broken down into the following:

A. Trends in Firm Revenue and Growth

The Big Four audit firms typically deliver three types of services: audit (or assurance), tax, and consulting (or advisory). While advisory services continue to be the primary source of revenue growth for the Big Four global networks, all three service areas experienced lower growth rates in 2013 as compared to 2012.

2

The Big Four audit firms are Deloitte Touche Tohmatsu Limited, EY Global, KPMG

International Cooperative, and PricewaterhouseCoopers International Limited.

2

Big Four Global Network 3-Year Summary of Revenue (US $Millions)

Services

2011

2012

2013

Assurance3 Tax Advisory Total Revenue

$ 46,911 $ 23,386 $ 31,236 $ 101,533

$ 49,267 $ 24,904 $ 35,769 $ 109,940

$ 49,007 $ 26,191 $ 38,540 $ 113,738

% Change 2011 - 2012

5% 6% 15% 8%

% Change 2012 - 2013

-1% 5% 8% 3%

Sources: EY 2013 Global Review, Deloitte 2013 Transparency Report, KPMG 2013 Transparency Report, and PricewaterhouseCoopers 2013 Transparency Report.

Revenue from assurance services decreased in 2013 as compared to 2012. Assurance

revenue now represents 43% of Big Four global network revenue in 2013, compared to

46% in 2011. According to some studies, firms are reporting downward pressure on audit fees due to the economic climate4, users questioning the value of an audit ("the commoditization of audit"), and underbidding by rival firms.5

In managing the assurance practice, firms continue to explore ways to improve audit efficiency. This includes offshoring, establishing lower cost centres of excellence, outsourcing aspects of the audit and utilization of data technicians.6 Big Four audit firms are also innovating in IT and systems ? for example, some firms are integrating additional CAATs ("Computer Assisted Auditing Techniques") and data mining and analytic tools into the audit process with the objective of increasing the effectiveness of the audit and value of the audit to companies. At the same time, companies' operations, business models, transactions and product/service offerings have become more complex requiring auditors to exercise greater professional judgment and utilize specialized skills.

3

The assurance revenue amounts reflect revenue from various services including, for

example, statutory audits, internal audits, risk assurances, actuarial services and advice in

connection with capital markets transactions.

4

See "Declining Audit Fees Raise Risk of Restatements", (March 3, 2014) ("In

the last few years, publicly held companies have pressured their accounting firms to lower their

audit fees. ...In many cases, this has worked, helped by the recession: Audit fees peaked at $592

per $1 million of revenue for accelerated filers in 2004 and 2005, according to Audit Analytics,

but have fallen since, to $472 per $1 million of revenue in 2012.")

5

In the United States, between 2006 and 2010, 48% of issuers in the Russell 3000 reported

a decrease in audit fees (sources: Russell Investments, Audit Analytics).

6

For a review of a panel discussion with representatives of each of the Big Four audit

firms concerning the status of their offshoring operations see Daugherty, Dickins, and Fennema.

2012. Offshoring Tax and Audit Procedures: Implications for U.S.-Based Employee Education,

Issues in Accounting Education, 27(3) (observing that "given the continuing pressure that audit

firms face to make engagements more efficient, it is likely firms will continue to increase the

amount of work they offshore.").

3

In the current environment audit fees appear to be flat or even declining in some regions of the world and there appears to be limited opportunities for growth in the audit practice on a global level. At the same time, the growth in the advisory business of the firms is expected to continue to increase at a faster rate than the assurance business through both organic growth and acquisition of other professional services firms. In general, the increase in advisory revenues is being driven by the provision of consulting services to non-audit clients.7

Revenue from advisory services now represents 34% of Big Four global network revenue, compared to 31% in 2011. Assuming advisory services continue to be the primary source of revenue growth, global network revenue derived from advisory may soon outstrip revenue derived from assurance. At the U.S. affiliates of the Big Four audit firms ? which represent the largest source of global network revenues (approximately 35%)8 ? advisory revenue already exceeds assurance revenue. In three years, assurance revenue at the Big Four's U.S. affiliates dropped from 40% of total revenue to 36% while advisory revenue increased from 34% of total revenue to 39%.

Big Four Global Network Revenue Mix

Big Four U.S. Affiliates Revenue Mix

Services

Assurance Tax Advisory Total Revenue

2011 46% 23% 31%

100%

2012 45% 23% 33%

100%

2013 43% 23% 34%

100%

Services

Assurance Tax Advisory Total Revenue

2011 40% 26% 34%

100%

2012 37% 26% 37%

100%

2013 36% 25% 39%

100%

Sources: EY 2013 Global Review, Deloitte 2013 Transparency Report, KPMG 2013 Transparency Report, and PricewaterhouseCoopers 2013 Transparency Report.

As advisory becomes the largest service line the Big Four Firms will need to ensure there is an appropriate focus on audit quality, particularly as Big Four leadership believes that the reputation and brand of the firm's audit practice plays a significant role in the ongoing success of their advisory practices.

Acquisitions of consulting businesses are playing a prominent role in driving Big Four

advisory revenue growth. In recent years the Big Four audit firms have been active

acquirers of consulting businesses, growing their range of services to include legal, management consulting, immigration, technology, and other discrete specializations.9

7

Audit Analytics. July 2013. Audit Fees and Non-Audit Fees: An Eleven Year Trend

available at: .

8

Sources: EY 2013 Global Review, Deloitte 2013 Transparency Report, KPMG 2013

Transparency Report, and PricewaterhouseCoopers 2013 Transparency Report.

9

A review of press releases issued by the Big Four audit firms identified a total of 66

separate acquisitions of consulting businesses by Big Four audit firms from 2011 to 2013, with 33

acquisitions in 2013, 14 acquisitions in 2012, and 19 acquisitions in 2011.

4

Advisory businesses differ from audit in fundamental ways, including:

The nature and identity of the client; The nature of competition and the strategies to compete; The role and pace of service innovation; The backgrounds, mind-set-and skill-set and experience of people rendering the

service; The structure of teams rendering the service; The revenue model (typically one-time services rather than annuity-based;

contingent based fees allowed); The cyclical nature of the business; and Prospects for growth and profitability.

Differences between advisory and audit businesses create stresses and conflicts within the firms, including some conflicts that could threaten auditor independence. In some jurisdictions there are prohibitions on the provision of non-audit services to certain audit clients. However, where the provision of non-audit services is permitted, a maximum percentage may be prescribed by a regulator's code of ethics to ensure no independence conflicts.

Despite the conflicts, there are reasons why firms are actively growing advisory services:

Permits firms to grow and offer opportunity to firm personnel; Expands the scale and scope of the firm's brand; Builds out the firm's global footprint and deepens the firm's competencies,

allowing the firm to better serve global clients; Leverages the trusted business advisor relationship that the audit partner has

developed offering opportunity to increase profit maximisation opportunities from a client relationship; Creates more opportunities to cross-sell a wider variety of services to clients; and Creates a bigger firm that is less susceptible to shocks to its business.

Expanding advisory services may improve audit quality to the extent that the firm deepens competencies needed to perform audits and harnesses those competencies when conducting audits.

The Big Four audit firms do not report gross margin or profit information for their

separate lines of practice. Therefore, it is difficult to determine the profitability of a firm's lines of practice and which line of practice contributes the greatest to the firm's overall profitability.10

10

It is unclear whether the advisory practices of the Big Four audit firms are more

profitable than assurance. The U.K.'s Competition Commission recently reported that, on the

basis of the firm's cost allocation choices, assurance has comparable margins to other service

lines.

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