Creating opportunities for mid-tier audit firms to enter the international market could include relaxing ownership rules to permit investment from outsiders - non-accounting professionals - according to an independent study prepared for the European Commission.The report suggested that such a revision would result in opportunities for the mid-level firms to cope with the needs of larger clients, most of whom are currently served by the Big Four.

The study, conducted by Oxford, U.K.-based Oxera Consulting, was ordered by the commission's Internal Market Division, which has an eye to reducing concentration among major providers of audit services.

The paper noted that the rules-of-ownership structure and composition of the management board of audit firms in European national codes stem largely from the European Statutory Audit Directive (Eighth Directive). This holds that auditors have to hold a majority of the voting rights in audit firms and control the boards.

The Oxera study stated that "ownership rules of audit firms and their consequences for audit market concentration" are behind the cost of capital for audit firms, which is 2 to 3 percent greater than for similar-sized multinational companies. Consequently, returns for audit firms would have to be approximately 10 percent higher than those of a "diversified benchmark."

Currently, audit firms with partnership-like structures are unlikely to undertake the required initial investment for expansion necessary to assume larger audits, according to Oxera. But investor ownership "might be more supportive of the decision to expand, as external investors derive additional value from a longer investment horizon."

However, Oxera said that entry costs for mid-tier firms to gain an initial foothold in the large market would be "substantial." Nevertheless, the consulting concern - which specializes in economic analysis - believes that an investor-owned firm could find expansion to be economically profitable.

Oxera did stress that any changes to ownership rules would need to take into account the need to protect "human capital" in audit firms. It also makes the point that opening up ownership and control to non-auditors may create the potential for additional conflicts of interest. But on balance it believes that those issues could be dealt with by specific legislative and regulatory controls.


As to conflicts of interest, one observer of the profession raised the possibility of investments in an audit firm passing covertly from one investor, known and approved, to another. As a result, an audit client who may fear receiving an adverse opinion could theoretically invest in the audit firm and force the auditor to withdraw as a result of the conflict of interest.

Oxera states that restrictions on access to capital represent only one of several potential barriers to entry into the market for large audits. Others include reputation and the need for international liability coverage.

Another roadblock could be the impact of liability risk. In early 2007, EC Commissioner Charlie McCreevy noted, "There is a real danger of one of the Big Four being faced with a [liability] claim that could threaten its existence." Recently he added, "A large majority of respondents to the public consultation on possible reform of liability rules in the EU were concerned about the issue of lack of choice in the market for large international audits."

As evidence, Oxera cited the August 2005 settlement between KPMG and the U.S. Department of Justice, in which only certain individuals were prosecuted. That did remove concerns about a collapse of the firm as a whole. But the episode highlighted the potential risk of any one of the Big Four going out of business, which would upset the efficient functioning of the capital markets.

The Oxera report could be compared with another study, published last year by consultancy London Economics, on the subject of limited liability for audit firms, to "reduce risk caused by potential catastrophic claims" against one of the Big Four. The London Economics report painted a bleak scenario for auditors in Europe, and noted that the firms in the EU then faced 11 claims in the range of $200 million to $1 billion and five claims in excess of $1 billion. The largest single claim that the largest firm in Europe could sustain is about $700 million.

In the face of such an onslaught, the commission concurred that a liability cap was advisable. At that time, not surprisingly, the Institute of Chartered Accountants of England and Wales expressed support for limited liability, but suggested that it should be on a piecemeal basis, across the EU nations.

The Oxera study is available at:

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