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Big Four break-up: What does this mean in practice?

21st Nov 2018
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Enter “the audit model is broken” into online search engines and you will find the bones of arguments predating the World Wide Web itself from commentators decrying how the Big Four firms are far too close to the businesses they inspect.

The phrase is being aired again in the UK as the government, via its antitrust watchdog, has decided the relationship between audit and consulting at the top professional services firms is too cosy, and that after decades of talk it’s finally time for action.

In floating the forced separation of the consulting and auditing arms of Deloitte, KPMG, EY and PwC, the Competition and Markets Authority cited the collapse of Carillion as the catalyst for reform in its 9 October release, but could easily have included GE, BHS, the Gupta family in South Africa, or even the doomed investment bank Lehman Brothers.

Deloitte and KPMG were the first to make pre-emptive strikes, saying they will no longer offer ancillary non-audit services to the FTSE350 firms they audit, while EY and PwC told AccountingWEB they supported the move, and their responses to the government review indicate this is exactly what they are planning to do.

Forcing the quartet to split into the ‘Big Eight’ is highly unlikely to resolve the conflicts of interest and competition worries that are again besetting the sector, and may even make it worse, experts told AccountingWEB, as more obvious and fundamental posers about the role and definition of audit itself are being missed.

“Breaking them up is extreme, and won’t achieve anything,” said Rakesh Shaunak, group chairman of Macintyre Hudson. “Making management more accountable and responsible for systems, controls and information is an essential starting point. It must be a given regardless of what else happens.”

Taking Carillion as an example, it emerged the multinational services company had gone cap in hand to the government for bailout money, less of a red flag than a luminous beacon, yet this was somehow missed by auditors KPMG.

Breaking them up is extreme, and won’t achieve anything

Putting an oversight regime in place that would lay accountability at the door of senior figures would be a clear and obvious way to resolve many of the conflict and conduct issues that have emerged over the years, said Shaunak, and would also make companies think harder about their audit appointments.

“Management and boards need to take more responsibility,” he said. “It’s all very well blaming the auditor, but they can only work on the basis of the information they are given, but boards need to take on more responsibility.” 

Another senior executive at a major UK auditor, who asked not to be named, said the firms themselves are doing a poor job of communicating how they go about business.

“Although there are significant restrictions already in place, the perception of conflicts of interest remains a huge problem,” the executive said. “No doubt this move is an attempt to avoid the more drastic threat of splitting off audit firms completely from advisory practices being imposed.”

Big Four domination

KPMG, Deloitte, EY and PwC dominate the audit market for large firms in the UK, and carried out more than 95% of the audits for FTSE 350 firms last year, according to figures from the Financial Reporting Council. Their aversion to being broken up is understandable given their success. KPMG currently earns less of its income from non-audit services than its rivals, but in the year ending September 2017 still pulled in £79m in non-audit fees and £198m in audit.

“The whole point of hiving off other services is probably to protect themselves against other changes happening to audit,” said Crawford Spence, King’s Business School’s Professor of Accounting. “The figures bandied around are very significant but given the scrutiny, the firms have been coming under, as regards Carillion etc. The regulatory change could be a lot more invasive than what is predicted.”

He said he felt the decision to stop offering non-audit services such as IT and consultancy was “largely a mirage”.

The whole point of hiving off other services is probably to protect themselves against other changes happening to audit

“You always have to be a bit sceptical, but it seems symbolic more than anything,” Spence said. “It sends a strong message to government and regulatory bodies that self-regulation is OK, that they recognise there are issues with audit, have identified the problems, and should be left to get on with it.”

The big issue is auditor independence, he said, as no one in government or industry is prepared to address the question of who appoints the auditor and why.

“It is the client themselves,” Spence said. “It’s such a bonkers model, and we’ll have to keep coming back to that every time there is a new regulatory shake-up, because until shareholders, or groups of stakeholders, are appointing auditors themselves, not that much will change.”

Experts were united on the view the role of corporate audit undoubtedly needs more scrutiny.

“It’s Auditing 101, the first thing you teach students is auditor independence and the expectations gap,” said Spence. “The auditor is meant to be this big scary person that turns up and makes you quake in your boots, but that doesn’t work if you have a client relationship, where promotion in the Big Four depends on treating the client as king.”

He said he had little confidence the government would make any lasting changes other than bits “around the edges”.

“There needs a wider shake-up of corporate governance to feed into that for there to be any meaningful change,” he said.

The auditor is meant to be this big scary person that turns up ... but promotion in the Big Four depends on treating the client as king

Potential solutions: Increased oversight or more of the same?

Industry chatter favours a full-blown UK version of the Sarbanes-Oxley Act, which was brought in following the Enron crisis in the US. The law, named after the US senators who sponsored the bill, ensures senior managers must individually certify the accuracy of financial information.

It increases the oversight role of boards of directors and the independence of the outside auditors who review the accuracy of corporate financial statements. Heavy penalties, much heavier than the current sanctions available to the UK, await those who fall foul.

“This is what the US brought in when the Enron case blew up, and I think it is an excellent idea, as it focuses the mind of management, they must take more responsibly,” said Shaunak.

There are other options on the table, he added, such as dual auditing, a system currently in place in France, amongst other jurisdictions.

“I think a more radical reform is required overall, such as joint audits,” Shaunak added. “Two firms - perhaps a Big Four and a smaller firm -  would sign off, and this automatically means there are stronger checks and balances, and better collaboration to improve the standard of audit.”

Another supporter of joint audits is Grant Thornton, which told AccountingWEB this method offers better market stability, with fewer high-profile failures and greater public trust in auditing.

“Joint audits could be set up in a number of ways; we support a ‘shared’ audit model,” said Jon Roberts, head of assurance at Grant Thornton UK LLP.  “We acknowledge that joint audit has been criticised and resisted in the past by the buy-side, but we look forward to discussing this again with the CMA.”

The firm said it does not believe that structural reform is needed, even to the extent of ringfencing audit from advisory services within a firm. It added to other notions that this could have the unintended consequence of throttling business.

In keeping with the phraseology, Roberts said the CMA’s investigation reflects many of the same concerns that led to its withdrawing from tendering in the FTSE350 audit market, “due to its broken nature”.

“Even though we may be considered to be potential beneficiaries of reform, we support the objective of reducing concentration in the FTSE 350 audit market because we believe in the principles of effective competition and the consequent benefits on audit quality,” Roberts said. “Considering broader reforms to audit scope, such as increased work on a company’s viability and its anti-fraud arrangements will be important questions for any further reviews on the audit profession in future to answer,” said Roberts.

AccountingWEB approached PwC for a response, and the firm said it was open to embracing change which serves the best interests of shareholders, companies and the market.

“We appreciate that further commitments to limit non-audit services to audit clients could be necessary to promote confidence in the independence of audit firms, particularly for those companies in the listed market,” a spokesman said.

The firm said there are already measures in place to control the non-audit services that an audit firm can provide to a client, as part of the Financial Reporting Council’s Ethical Standard, which was revised by the accounting regulator in 2016, and it would carefully observe the CMA’s analysis of the effectiveness of these measures.

EY declined to comment past its own detailed submission to the CMA review, in which it backed the introduction of a UK Sarbanes-Oxley ACT (catchily titled ‘UK-SOX’).

Big Four setting the pace

The arguments are likely to continue raging over what bits are broken and in need of fixing, but whether it was symbolic or not, KPMG et al have wasted little time in acting before Britain’s competition regulator begins to probe deeper, suggesting there is more flexibility and nimbleness to business-critical decisions at the top of the audit food chain than often credited.

“The Big Four are trying to set the pace and trying to dictate the direction of travel, and I think they are sincere in what they are saying,” said Shaunak. “It’s only part of the solution, however, it is still about how one improves the quality of audit and increases competition. It will always be about improving the standard of audit.”


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