The Future of Auditing (#212)
/In this podcast episode, we discuss the future of auditing. Key points made are noted below.
More Complexity
We’re certainly looking at an even higher level of complexity as we move forward. For example, the total text of the new lease accounting standard is about 480 pages, which was close to the size of the revenue recognition standard that came out less than two years ago. And the accounting for derivatives standard is even larger.
And then we have the new initiative to reduce the accounting requirements for privately held businesses. That is fine, but what’s actually happened is that we now have two standards, one that’s simplified for private companies, and the full version for everyone else. That means the new streamlined standards are in addition to the original accounting standards – so the grand total of what the accountant needs to know just keeps getting bigger.
Changes in Compensation
So what’s the future of auditing with all of this new material? First, we can expect fewer people to pass the CPA examination, since there’ll be so much material to be tested on. However, since there’s lots of demand for auditors, the compensation packages for auditors will keep going up, so we can expect more people to try to pass the exam. A possible outcome is that we’ll have more people who’ve failed the CPA exam, but who have been hired as auditors, and have to keep trying to pass it. If they don’t pass by the time they’d otherwise be promoted to manager, they’ll be pushed out. So this could cause an oversupply of accountants moving over to the private sector.
Increased Specialization
Another prediction for the industry is more specialization. Since some of the topic areas are getting to be fairly complex, we’ll start seeing more people become experts in just one of the accounting areas, and be generalists in everything else.
For example, a person becomes completely knowledgeable in revenue recognition or derivatives, and is always called upon to audit clients who have issues in these areas. Conversely, if someone does not specialize, they could be at a disadvantage when it comes time to schedule auditors for client work. If I’m right about this, we might see colleges starting to offer separate courses in the more difficult topics. So maybe people start graduating with a degree in accounting and a specialization in revenue recognition.
Strategic Positioning
Now let’s look at auditing from the perspective of strategic positioning within the industry. A good framework for this was developed by Michael Porter in his Competitive Strategy book – which I can’t recommend enough. Porter came up with five competitive pressures that can impact an industry.
First up is pressure from customers. For example, if you’re in an industry where your main customer is Walmart, there’s going to be lots of pricing pressure, since Walmart has all kinds of pricing power. In the auditing industry, that doesn’t exist. Larger firms pretty much always pick from the among the Big Four audit firms, and those four firms don’t compete on price.
Second is pressure from suppliers. In the auditing industry, the supply is auditing recruits. And they will cheerfully sell their parents into slavery in order to get a job with the Big Four. So there isn’t any pressure there, though hiring salaries are certainly increasing.
Next is pressure from substitute products. There aren’t any. Businesses simply have to be audited, and that is that. There is no substitute – and given the risk to lenders and investors of companies not having audits done – there will never be a substitute.
The fourth competitive pressure is from potential entrants into the industry. This one is not going to happen. To enter the industry, someone starts small or acquires an existing business, but in either case, they are still not the Big Four. The Big Four audit firms are far larger than the other firms in the industry, and they routinely buy up smaller firms that look promising, so they always have more mass than anyone else.
And the final competitive pressure is from competition within the industry. The Big Four compete against each other based on the quality of their staff and services. They really try to avoid price wars, since that doesn’t help any of them.
So what does this incredibly brief look at competitive positioning tell us? In short, expect no change. The Big Four will probably still be the Big Four ten years from now, and probably in 20 years. They will all spend heavily on marketing, which improves their brand both with college recruits and with potential clients. And if any of the smaller audit firms start to get too large, they’ll buy them. In short, this is a nearly perfect oligopoly that’s guaranteed to make a large profit for a long time to come.
The Low End of the Market
So, that covers the top end of the audit market. What about lower down? I don’t expect things to change much here, either. You can always start a small audit firm and expect to have a reasonable number of smaller clients. But if the firm doesn’t add staff in order to add services, it will lose clients as they grow in size and start shifting their audit and tax work to larger audit firms.
Specialization by Industry
Having just said that there will be no change, there is an opportunity for more specialization by industry. So for example, an audit firm could decide to specialize in bank audits and nothing else, so that it has a strong competitive advantage in a particular niche. This opportunity becomes stronger as the complexity of the accounting standards increases.
Historical Changes
Even though I’m not predicting a whole lot of change, it has happened in the past. The last time was when the Sarbanes-Oxley Act was passed, which triggered the creation of the Public Company Accounting Oversight Board, which oversees the auditors of publicly-held companies. That happened in 2002. The outcome of that extra level of regulation was that a lot of smaller audit firms stopped doing public company audits, which stratified the audit industry into public company auditors and everyone else.
And – what a surprise – the prices charged for public company audits increased, since there were fewer competitors.
That kind of change is not common, but it does happen every few decades. It usually happens right after there’s been a crisis, which typically means a massive case of fraud that damaged a bunch of investors.
When that happens, the level of regulation is increased, which makes life more difficult for smaller audit firms, and drives more business toward the larger firms.