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October 11, 2012

CC finds reputation creates barriers to entry

In a working paper for its Statutory Audit Services Market Investigation, the CC considered three areas which may create a ‘virtuous circle’ effect for the reputation of Big Four firms. It also looked at how these factors might create potential barriers to entry into the FTSE 350 audit market for mid-tier firms.

In the first area, experience and capability, the CC found that companies want experienced auditors, with lack of experience or less experience than a competitor being the most frequent reason for a lost tender. It also found that a pre-existing relationship, including in a non-audit capacity, was advantageous, and that strength and size of a firm’s international network was important.

The second area, which covered talent, found that there is a widespread, but not unanimous, assumption that Big Four firms have better staff. This may be compounded by the fact that many FTSE 350 FDs and ACCs are alumni of Big Four firms.

In the third area, on awareness of audit firms, it was found that FTSE 350 CFOs and ACCs lacked knowledge of the current capability and international scope of the mid-tier.

The paper found that reputation was an important factor for the choice of FTSE 350 auditors, and that it may be used as a proxy for quality, as quality is difficult to measure and "cannot be observed until after the audit has occurred". It concluded that "as a result, perceived as much as actual, quality may be important to reassure shareholders and stakeholders."

The paper concludes that "there is risk that auditor selection decisions may not be based on objective information. Because reputation is only a proxy for accurate information on quality and capability it may over time depart from reality, unless an exceptional event occurs to call it into question".

The CC found that reputation may form a barrier to entry as it favoured large, incumbent firms and the time and cost necessary to enter the market may dissuade smaller firms. Furthermore, when mid-tier firms match the Big Four’s capability to perform FTSE350 audits, they may find it hard to demonstrate this fact.

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