Deloitte fires gun on Big Four audit split
Deloitte is the first Big Four firm to break off its audit function with the establishment of an independent unit separate from the rest of its business, but experts say further legislation and tougher regulatory oversight will be necessary to ensure the changes are effective.
Deloitte said it will create an independent audit governance board (AGB), with responsibility for providing independent oversight of the UK audit practice, effective from 1 January, 2021.
The Big Four firm said the AGB will have a focus on the policies and procedures for improving audit quality and on ensuring the FRC’s objectives of, and desired outcomes for, operational separation are met.
The board will also have oversight over “the policies and processes for ensuring that audit partner remuneration reflects their contribution to audit quality appropriately”, Deloitte said.
The firm is also exploring the sale of its restructuring unit, with the executives running the arm said to be considering a management buyout, a move which would further re-model the consultancy sector as long-awaited regulatory changes begin to take shape.
In July, the Financial Reporting Council (FRC) published its guidelines for the separation of audit functions of the Big Four firms, which promised the most robust changes to the sector for several decades.
“There have been a number of high-profile cases highlighting that independence can be impaired where there is a significant level of advisory fees gained from audit clients,” said Andrew Moss, partner at DSG Chartered Accountants. “Shareholder confidence in the audit opinion has suffered as a result and a break up looks likely, which would allow the next tier of firms to compete on a more level playing field for listed audits.”
A series of major accounting failures, including the 2018 collapse of Carillion, triggered multiple overlapping probes into the audit sector. Lawmakers and regulators eventually laid out proposals intended to boost competition, reduce conflicts of interest, and to strengthen the independence of the audit function.
With little sign of movement through 2020, criticism mounted over the delays. Further embarrassments such as the collapse of Thomas Cook and the recent implosion of German fintech Wirecard, which revealed a €2bn hole in its accounts resulting from a wide-scale criminal conspiracy by senior management figures that had been missed for several years by auditors EY, hastened calls for regulators to step in and act.
“There have been ethical standards in place for accountancy firms since before there was a legal requirement for audit; unfortunately, the attraction of significant consulting and advisory fees can sometimes mean that the auditors independence is put under pressure,” Moss said. “As such, any reform of the current ethical standards would have to be backed by the regulators’ having sufficient power in order to sanction firms who breach the standards otherwise the changes may have little effect.”
Regulators must stay alert
Earlier this year, Deloitte, KPMG, EY and PwC were told to submit their plans for separating their audit practices to the FRC by October 23, and they have until 2024 to implement the split.
The lengthy implementation period gives the firms plenty of time to adjust, experts said, warning that for the regulator’s plans to have any real impact, and robust regulatory oversight of the operational separation must be maintained.
“The proof of the pudding will be in the eating with regards to its effectiveness, especially in terms of transfer pricing of transactions between the audit and non-audit parts of the practice as well as how many partners and team members cross between parts of the firm,” said David Herbinet, global head of audit and senior partner at Mazars. “We do not believe this voluntary initiative rules out the merits of further legislation or fuller regulation on audit firm separation going forward.”
Operational separation is not a substitute for effective market reform and the implementation of the Competition and Markets Authority’s thought out and independent proposals for creating a more competitive and resilient audit market, he said.
“Mazars supports their proposals to achieve this through the introduction of joint audit for FTSE350 companies, involving at least one challenger firm (except in limited cases) to be approved by the regulator or where a challenger firm is appointed as sole auditor,” Herbinet said. “This is the crucial element of the reform package that will strengthen audit quality, choice and innovation in a market where there has been excessive concentration amongst a handful of dominant firms for decades.”
Internally, firms will be considering how to revamp governance, services provided by the audit practice, partner remuneration, financial reporting and publishing information about the audit practice to provide transparency, said Carol Der Garry, Forensic Risk Alliance partner in the accounting, audit and regulatory advisory practice.
“Whilst changes are not expected to result in a ‘break-up’ of the Big Four, auditors and their clients, including audit committees, will need to focus on changes to ensure that audit quality is prioritised and that auditors are protected from influences from the rest of the firm that could divert focus from audit quality,” she told AccountingWEB. “Similar to Deloitte’s September decision to put its UK restructuring practice up for sale, the Big Four could find it prudent to sell their non-audit practices in order to better manage conflicts of interest.”
All eyes on Deloitte
Deloitte’s restructuring practice is likely to come with a hefty price tag of several hundred million pounds. The decision to sell now is likely to be prompted by the firm’s need to optimise its value during an uncertain period as coronavirus disruption continues to affect the consulting market.
An economic downturn is likely to lead to a boom for restructuring firms, but Deloitte may be prevented from taking on much of the work under the future regulatory updates due to its power in the audit market.
“Like any large firms made up of a number of different business units, consideration has to be given to whether any services become non-core and thereby disposable,” said Moss. “This decision has more likely been driven by commercial rationale rather than regulatory pressures.”
Suitors might include the likes of Begbies Traynor, he said, which has a need to demonstrate continued growth to shareholders. A private equity-backed deal could see the business unit leaders take control, he added.
“I don’t see that this is the start of a breakup and the audit reforms are more likely to see the emergence of a bigger group of large audit firms whilst the consulting and advisory arms of the big four could remain dominant.”